It's fairly clear to all that the near-term outlook is rosy. Vaccinations are becoming ubiquitous, and although daily new cases have ticked up a bit here and there (with the notable exception of Michigan), the severity of cases and hospitalizations is declining; most of the old and most vulnerable folks have either left us or are by now largely immune, so most of the new infections are occurring amidst the young and healthy. In any event, "herd immunity" is likely only months away at the current pace of vaccinations. Jobs are growing at a healthy clip and business investment is surging—the economy has recovered most if not all of the ground lost over the past year. Optimism is on the rise, but animal spirits are somewhat restrained by still-pervasive risk aversion. None of this is likely to reverse in the next several months, so the economy will continue to benefit from a widespread, natural healing process.
Looking further into the future, however, there are dark clouds on the horizon. On the monetary front, the Fed has supplied more liquidity to the system than ever before—and by orders of magnitude—but the inflationary potential of this has been kept in check by a still-robust demand for liquidity and safety. By promising to remain super-accommodative for at least a year or so, the Fed runs the real risk of allowing inflation and inflation expectations to run wild. Who wants to hold all that cash, when cash returns are zero in nominal terms and -2% in real terms? Who doesn't want to borrow at near-zero or negative real interest rates, when just about all commodity, real estate, and equity prices are rising? Absent a blow to confidence, the demand for money is sure to decline, and that in turn could fuel a substantial rise in the general price level (aka inflation) as economic actors attempt to unload unwanted cash—unless the Fed reverses course in a timely manner.
Perhaps the darkest of clouds is the Biden Administration's urge to expand government spending (on just about everything except a relative handful of actual infrastructure projects) while borrowing trillions in the process, reversing the de-regulation accomplishments and jacking up marginal tax rates on the rich. Common sense tells us that increased government spending, borrowing, regulatory and tax burdens, subsidies, and income redistribution cannot possibly strengthen the economy, and can only weaken it. Today we enjoy a long-awaited healing and reopening process, but by next year we could be slowly suffocating under the burden of Big Government.
It's hard to imagine a worse scenario than inflationary monetary policy coupled with anti-growth fiscal policies, but that's the risk that lies menacing on the horizon.
I am surely not the only one to worry about such things. The bond market is so dominated by risk aversion that short-term Treasury yields are still extremely low, and risk-free real yields are frankly negative. Bond investors are willing to pay exorbitant prices for anything resembling security. The equity market is far less frothy, since valuations do not appear terribly out of line with interest rates and the global economy (see Chart #9 below).
Perhaps the darkest of clouds is the Biden Administration's urge to expand government spending (on just about everything except a relative handful of actual infrastructure projects) while borrowing trillions in the process, reversing the de-regulation accomplishments and jacking up marginal tax rates on the rich. Common sense tells us that increased government spending, borrowing, regulatory and tax burdens, subsidies, and income redistribution cannot possibly strengthen the economy, and can only weaken it. Today we enjoy a long-awaited healing and reopening process, but by next year we could be slowly suffocating under the burden of Big Government.
It's hard to imagine a worse scenario than inflationary monetary policy coupled with anti-growth fiscal policies, but that's the risk that lies menacing on the horizon.
I am surely not the only one to worry about such things. The bond market is so dominated by risk aversion that short-term Treasury yields are still extremely low, and risk-free real yields are frankly negative. Bond investors are willing to pay exorbitant prices for anything resembling security. The equity market is far less frothy, since valuations do not appear terribly out of line with interest rates and the global economy (see Chart #9 below).
Chart #1
With yesterday's release of the March CPI stats, no one was surprised to see year-over-year inflation rise by over 2.6% (as compared to the weak price action of March '20). But as Chart #1 shows, most of the inflation "noise" comes from energy prices, which are by far the most volatile component of the CPI index. Subtracting energy prices, the CPI rose a little over 1.9% in the past year (red line).
Chart #2
Chart #2 shows the ex-energy CPI index plotted on a log scale y-axis. Here we see that the long-term trend of ex-energy prices has been a relatively steady 2% per year over the past two decades. We have been living in a 2% consumer price inflation world for many years, and nothing so far has changed.
Chart #3
Chart #3 compares the price of gold to the price of 5-year TIPS (Treasury Inflation-Protected bonds), using the inverse of their real yield as a proxy for their prices. Both of these assets promise protection not only from inflation but also from geopolitical risk and general currency debasement. In short, they are classic safe-haven assets. That both are trading very near their all-time highs is a good sign that the world is still quite risk-averse.
Chart #4
Chart #4 shows 10-yr Treasury yields, which have surged over 100 bps from last year's all-time lows. Yet yields today are only marginally higher than they were prior to the onset of the Covid crisis. Back in February of last year, a casual observer would have remarked that Treasury yields were exceptionally—and historically—very low. Yes, the outlook has brightened, but it still remains unusually dark. That investors are still eager to buy Treasuries at today's prices can only be interpreted to mean that the demand for Treasuries (arguably the safest place in the world to park long-term funds) is still very, very strong, which in turn strongly suggests that risk aversion is still very much alive and well. So strong that the nominal yield on Treasuries is fully expected to be less than the rate of inflation for the foreseeable future.
Chart #5
Chart #5 shows the volume of passenger traffic in US airports. On a seven-day average basis, 1.4 million people took to the air as of yesterday. That's a huge improvement (about double) from just two months ago, but it is still more than one-third less than the rates we were seeing in 2019 and early 2020. There is still plenty of upside here.
Chart #6
As Chart #6 shows, equity prices have moved ever higher of late thanks in large part to a decline in the Vix "fear" index. Yet the level of the Vix today (17) is still substantially higher that the average (about 12) that is typical of periods of relative calm. Again we see that risk aversion is still alive and well, though obviously much less so than it was at this time last year.
Chart #7
Chart #7 compares the market capitalization of Apple and Microsoft, the two leading tech giants. Both companies are worth over $2 trillion, an amount previously thought unimaginably high. If Apple were the only company to sport a two-trillion handle, we might be tempted to call it a bubble. But both companies have experienced similar gains over the years, and they were both well-positioned to profit from the new work-at-home reality which Covid fears sparked.
Chart #8
Taken together, the market cap of these three giants adds up to about 14% of the current market cap of all US equities, according to Bloomberg. And to think they barely existed 30 years ago!
Chart #9
Much has been made of late of the Buffett Indicator, which says that the market cap of US stocks exceeds US GDP by such a huge and unprecedented margin as to be a clear sign that the market is in a "bubble" that is set to burst. Chart #9 is my counter to that argument. I don't think it makes sense to compare the market cap of US corporate giants to just US GDP. After all, they have become huge players in the global marketplace, which is like saying their addressable market has expanded exponentially in recent decades. Globalization is a relatively new phenomenon, and it has meant that a US corporation can derive a huge portion of its profits from overseas markets which previously barely existed (e.g., China, India). Comparing after-tax corporate profits (a rough proxy for market cap) to global GDP shows no sign of an extreme. Profits have increased dramatically relative to US GDP (they averaged about 6% of GDP through 2000, but they have averaged almost 10% of GDP for the past decade), but not when measured against the surge in global GDP.
The long-term outlook is cloudy, but the near-term outlook is still favorable for investors. It's not an entirely comfortable situation, unfortunately. But the good news for now is that the risks out there are not going unnoticed, and that's a healthy sign. Will Congress really end up passing economy-crippling legislation?
UPDATE: This article by Gregory van Kipnis of AIER adds a lot of meat to my brief discussion regarding Chart #9. The author uses a rough estimate to make his point: "... half the growth in the Buffett Indicator comes from the increased importance of foreign earnings to US corporations, and another half of the growth comes from the increased amount of profits emanating from publicly traded companies."
