Charts that call my attention

There's no unifying theme to this post. It's just a collection of charts which I find interesting, some reflecting positive developments, others suggesting caution.

Chart #1

Chart #2

Chart #1 compares the year over year change in the CPI with the ex-shelter version of same, which makes up about ⅓ of the total CPI. Of note, the ex-shelter change in the CPI has been 2% or less in 13 of the past 16 months. If you believe, as I do, that the BLS's method for calculating housing/shelter inflation is flawed, then that means the Fed managed to tame inflation well over one year ago. As I've shown in previous posts, it looks like shelter costs, which drive ⅓ of the CPI, are based on the year-over-year change in US housing prices from 18 months ago; that is the only reason the overall CPI has not fallen below 2%. Chart #2 illustrates this. In the past year or so, housing prices have increased at a much slower rate.

Chart #3

Chart #3 compares industrial production levels in the U.S. and Eurozone. There are several remarkable things going on here. For one, U.S. industrial production levels haven't increased at all over the past decade! Two, Eurozone industrial production is tumbling in a way that suggests recessionary conditions. One reason for this is Germany's obsession with renewable energy sources at the expense of cheap and reliable natural gas and petroleum. Germany's electrical grid is seriously compromised as a result, and electricity costs have skyrocketed. Read all about it, courtesy of Robert Bryce, the best energy analyst I know. 

Key takeaway: the goal of renewable energy is a pipe dream, and seeking it out is kneecapping electric grids and retarding economic progress everywhere, penalizing the poor to satisfy the preening elites who will apparently make any sacrifice in the name of quixotically saving the planet. Cracks in the green energy coalition are already forming in Holland, and this seems sure to spread to other countries in coming years.

Chart #4

Chart #4 makes it clear that housing construction is depressed. Housing starts have been falling for the past two years, and builders see little hope in sight for improvement.

Chart #5

Chart #5 shows why housing is depressed. Mortgage rates have soared in recent years, and new mortgage initiations have plunged and stagnated. Very few can afford to buy homes given sky-high prices coupled with nearly 7% interest rates on mortgages. At the same time, very few homeowners want to sell, since it would mean giving up their 3% mortgages. This is an unstable situation that will eventually be resolved by falling home prices and/or falling mortgage rates.

Chart #6

Chart #6 compares the strength of the dollar (blue line, inverted), with an index of non-energy industrial commodity prices in constant (real) dollars. Up until a few years ago, commodity prices were strongly and inversely correlated with the strength of the dollar (i.e., a stronger dollar tended to depress commodity prices while a weaker dollar tended to boost commodity prices). This relationship broke down starting in early 2021 when inflation began to rise. I suspect that restrictive monetary policy will eventually restore this correlation—meaning commodity prices face downward pressure.

Chart #7

Chart #7 is constructed in a similar fashion to Chart #6, but instead of commodity prices it shows real gold prices. Commodity prices fell sharply beginning in early 2022, but gold prices started to soar in late 2023 in the wake of the Hamas attack on Israel. Unlike virtually all other commodity prices, gold prices have been making new all-time highs (on both a nominal and inflation-adjusted basis) ever since. I think the conclusion is obvious: geopolitical tensions in eastern Europe and the Middle East are close to red-hot. Gold is acting like the ultimate port in a storm that threatens another world war. Steven Hayward describes the mess we're in succinctly. Another thing this chart shows is that the dollar is relatively strong and strengthening of late; both the dollar and gold are benefiting from their status as safe-haven assets. 

Chart #8

I've been fascinated by the decade-long decline in small cap stock prices relative to large cap stock prices. On a total return basis, the S&P 500 index has more than doubled the return on the Russell 2000 index! Chart #8 illustrates this, while also suggesting that the Fed's monetary policy tightening and easing cycles has had something to do with this. 

The blue line in this chart is the ratio of the Russell 2000 Small Cap Index to the S&P 500 Index. The red line is the inflation-adjusted (real) level of the Fed funds rate, which in turn is the best measure of how tight or how easy the Fed's monetary stance is (inverted to show that a rising red line corresponds to easier monetary policy and vice versa). It's not a perfect correlation, but it seems that Fed easing (which usually comes in the wake of economic weakness) inevitably leads to small cap stock outperformance. By now it's clear the Fed has embarked on an easing cycle. With Trump's policies promising a significant reduction in regulatory burdens (which would help smaller companies much more than larger companies), I think we may therefore be at the beginning of a period of small cap outperformance.

Chart #9

Chart #9 shows the astonishing outperformance of US equities vs. Chinese equities over the past 30 years. (Both y-axes have a similar ratio scale, and both are plotted on a logarithmic basis). China's economic model has failed utterly to compete with ours.

Milei and Trump share victories

I've written several times about my admiration for Argentina's Javier Milei (see MAGA down south). Many called him crazy, but he, like Trump, overcame seemingly insurmountable odds to beat the candidate of the ruling party. Argentina was teetering on the precipice of an economic collapse, and now, after just one year of Milei's ministrations, inflation has been radically downsized, from 25.5% per month when he assumed office a year ago to only 2.7% last month, and the economy is once again growing, with some projecting real GDP growth of almost 10% in the coming year. Confirming the dramatic improvement in the outlook, the free market peso (the "Blue" dollar) has been almost unchanged over the past year (see Chart #1), and the Argentine stock market (using ARGT as a proxy) has surged by almost 75% in the past year in dollar terms.

Chart #1

U.S. consumers are still reeling from the jolt of inflation unleashed by $6 trillion of Covid "stimulus" spending, but as I've been pointing out for almost two years, there is clear evidence that inflation has since returned to 2% or so. Many problems remain, however, and a clear majority of the public felt that Trump was more likely to deal successfully with those problems than Harris. 

My Argentine friend, Nuni Cademartori, is both a talented artist and a fan of Trump and Argentine President Milei, whom many consider to be Argentina's Trump. Milei is also a fan of Trump's, and was reportedly the first foreign leader to congratulate Trump on his victory in person. I publish Nuni's congratulatory cartoon below, and I join Nuni in breathing a sigh of relief that our futures look brighter. Three cheers for Milei and Trump!

P.S. (Nov. 21). The obvious convergence of the peso’s market and official rate (now only 10% apart) is good evidence that Milei’s program is working. It means that the official rate is essentially the same as the market rate, which in turn means that the government could effectively dollarize the economy at today’s rate (approximately 1000-1100 pesos per dollar) and at the same time liberalize the exchange market so that capital could flow in and out freely. The rate might vary somewhat, but it is not far off from where it should be right now. The dynamic that most observers miss is that as confidence in Milei and Argentina grows, more capital wants to come into the economy than wants to leave. That means the demand for pesos is strong relative to the supply of pesos (which is growing at a slower and slower rate) is greater than the supply of pesos, and that is why inflation is falling. 

It’s no wonder that the Argentine stock market is on fire. It’s beaten the S&P 500 for the past 1, 2, 3, 4, and 5 years, and by a wide margin. 

Abundant reserves enabled a soft landing

In the Old Days (pre-2009), when bank reserves paid no interest—they were considered a "dead" asset—banks held the minimum amount of reserves necessary to collateralize their deposits. When the Fed needed to bring inflation down (usually as the result of a prior mistake that allowed inflation to rise), the Fed restricted the supply of reserves in order to force their price (the cost of borrowing reserves) higher, and to slow the growth of the money supply and bank lending. Higher interest rates and a scarcity of money eventually did the job, but unfortunately, a recession typically followed, heralded by sharply rising credit spreads. 

Around the end of 2008, the height of the financial panic at the time, the Fed made a momentous decision: reserves would become an interest-bearing and default-free asset, and there would be plenty of them. The Fed would control short-term interest rates directly, without having to restrict the supply of reserves. The Fed would pay interest on reserves using funds it received on its holdings of Treasury and mortgage-backed securities, which in turn were purchased by issuing reserves. Reserves effectively became T-bill substitutes, and as such, an ideal asset for the banking system.

At first, most analysts, myself included, feared that an abundance of reserves would result in a surge of lending and higher inflation. Fortunately, that didn't happen. In fact, for the next 11 years, inflation and interest rates would be low and relatively stable. In the first half of 2009 I stopped worrying about abundant reserves becoming inflationary, because I realized that banks had an almost insatiable appetite for holding reserves. The supply of reserves had exploded, but so had the demand to hold them. Thus, abundant reserves were not inflationary.

Then came Covid-19, and panicked politicians shut down the economy. To compensate for the loss of income which followed, Treasury sent roughly $6 trillion in checks to individuals and companies over the course of the next 18-20 months. Initially, most of the extra money sat idle in bank savings and deposit accounts. Then, in early 2021, as the economy began to get back on its feet, people began to spend the money, only to find that supply chains had been disrupted. Demand for goods and services soon outstripped supply, and inflation took off. If Milton Friedman had been alive at the time, he would have realized that his helicopter-drop-of-money analogy had become real: dumping trillions of extra dollars on the economy had ballooned the price level by 20-25%. In early 2021 I began forecasting a serious increase in inflation because I realized that the demand for all the extra money that had been created was beginning to decline.

To its everlasting regret, it took the Fed a year or so to figure out that rising prices were not in fact "transitory," but the real thing. So in March '22 they began the process of tightening by raising short-term interest rates. It wasn't easy to break the back of inflation, because the supply of money (M2) had surged by $6 trillion; they not only needed to reduce the money supply but to persuade (via higher interest rates) people to not spend the money so fast. Meanwhile, pundits and economists of every stripe predicted that, as it always had over the previous 50 years, a recession would inevitably follow the Fed's energetic monetary tightening. Very few, myself included, thought that a monetary tightening that occurred during a period of abundant reserves and ample liquidity would not result in a "hard landing."

To the great surprise of nearly everyone, we have experienced a "soft landing." The Fed has regained control of monetary conditions, inflation has come down to its target, and the economy has managed to grow at a decent rate throughout the tightening process. Abundant reserves arguably were the key. Thanks to abundant reserves, liquidity has been abundant in the financial markets as evidenced by low and relatively stable credit spreads. Financial markets were thus able to act as a shock absorber for the disruption to the economy caused by higher prices and higher interest rates.

Unfortunately, as Milton Friedman famously said, there is no free lunch. Supercharged federal spending has distorted the economy by not only causing inflation, but also by transferring trillions of dollars from the productive sector of the economy to consumers and enlarging the size of the government in the process. Pre-Covid, the federal deficit was almost $1 trillion per year. Currently, the deficit is running at almost a $2 trillion annual rate. Government payrolls have surged at a more than 2% annual rate since early 2023, even as private payroll growth has slowed from 4% in late 2022 to now only slightly more than 1%. Government spending has been the main source of economic growth in recent years, while business investment and manufacturing have been weak. This is not a prescription for solid growth in the years to come. Although real GDP growth in recent years has been about 2.2-2.4% annually, it is likely to slow down in the years to come unless policy shifts in favor of investment rather than transfer payments.

Chart #1

Chart #1 illustrates the gigantic increase in bank reserves that began in late 2008 when the Fed decided to make reserves abundant while also paying interest on reserves. Prior to that, reserves were a direct constraint on bank lending, since banks needed to hold reserves to collateralize their deposits, and reserves paid no interest. QE4 (aka massive Covid-related "stimulus") was the proximate cause of our destructive bout of inflation in recent years. Prior episodes of Quantitative Easing were not inflationary because they were neutralized by strong demand for cash and cash equivalents.

Chart #2

Chart #2 shows the difference between credit spreads on investment grade and high-yield corporate debt. This is an excellent measure of future economic health and financial market liquidity (higher spreads reflect concern about corporate profits and a general shortage of liquidity, while lower spreads reflect optimism about future economic growth and liquidity). Big spikes in credit spreads have reliably predicted recessions. Today, credit spreads are very low, and recession risk is also low—but that doesn't rule out sluggish growth.

Chart #3

Chart #3 shows the level of real economic growth (blue line) and different trend growth rates. The 3.1% annual trend line was in place from the mid-1950s through late 2007, while the 2.3% trend line began in mid-2009. If the economy had followed that 3.1% growth rate following the 2008-9 recession, it would be about 20% larger today.

Chart #4

Chart #4 shows the year over year change in the GDP deflator, the broadest measure of inflation. From a peak of almost 8% it is now only slightly above 2%. This confirms that the Fed has succeeded in controlling inflation. Unfortunately, the price level today is still almost 20% higher than it would have been if inflation had been instead averaged less than 2% per year, as it did in the decade leading up to Covid.

Chart #5

Chart #5 shows the 6-mo. annualized change in the Personal Consumption deflator and its core (ex-food and energy) version. By these measures inflation is also once again under control.

Chart #6

Chart #6 shows the three components of the Personal Consumption deflator. Service prices, dominated by shelter costs, are the only ones rising. Non durable goods prices are almost unchanged for the past two years, while durable goods prices have been declining for two years. Deflation in the durable goods sector has returned.

Chart #7

Chart #7 is a reminder that every recession prior to the Covid recession was the result of tight monetary policy. Monetary policy was tight because real interest rates were very high and the Treasury yield curve was inverted. Those two conditions have returned of late, but there is no recession in sight. What's different this time? Abundant reserves.

Chart #8

Chart #8 shows the ISM purchasing managers survey of the manufacturing sector. This has been notably weak since late 2022. That the economy has grown by almost 3% in the past year is due almost entirely to government spending and transfer payments. 

Chart #9

Chart #9 shows the monthly change in private sector payrolls over the past 3 years, as well as the rolling 6-mo average of same. In early 2022, payrolls were growing by about 600,000 per month; now they are growing by only 100,000 per month. (I assume the very low number for October to be the result of hurricanes, strikes, and random variations which can and do happen quite often.) While this is not necessarily a precursor of recession, slow jobs growth does point to a loss of vitality in the economy which could persist and/or worsen. We are not likely to see 3% GDP quarters on a sustained basis; be prepared for 2% or less. At least that will make it easier for the Fed to continue to cut interest rates.