Service sector continues to grow

The service sector of the U.S. economy accounts for about 70% of all jobs, while manufacturing payrolls account for about 9% and government about 15%. So the health of the service sector tells us a lot about the health of the overall economy. The latest news on the health of the service sector shows it is doing just fine, which is a good reason to think that the bond market is overly concerned about downside economic risks.

The Business Activity subindex of the IMS service sector report for June running is actually a bit higher than its 6-yr average.

The Prices Paid subindex shows that deflationary pressures associated mainly with declining oil prices have substantially dissipated.

The Employment subindex is still positive, but not by much. This reflects a lack of business confidence in the future, and that in turn dovetails with the lack of business investment in general and the fact that this recovery has been the weakest on record.

The overall Service Sector report for June was also a bit higher than its 6-yr average. Conditions are not quite as healthy in the Eurozone, but their index is still comfortably in positive territory.

Who's afraid of 1.3%?

Investors today worry about the implications of the fact that 10-yr Treasury yields fell to a new all-time low of 1.32% this morning. Does it mean the Fed is too tight? Does it reflect a threat of deflation? Is the global economy on the verge of another recession? Are we on the cusp of a exploding debt bubble? Will we never seen real growth exceed 2-3%? Are yields going to zero? Will US yields follow German and Japanese yields into negative territory?

If history is any guide, there's reason to cheer, not despair.

The previous all-time low for 10-yr yields was 1.39%, recorded July 24, 2012. Investors who bought the 10-yr that day and still hold it have received a total return of about 5.7%. Investors who bought the S&P 500 that day and held on—shunning the widespread fears of global recession and deflation that plagued markets four years ago—received a total return of 54%. Gold and commodity prices fell some 15%.

This should not be construed as a recommendation to put your life savings in stocks. It's merely to point out that the future doesn't always turn out to be as bad as the market expects. Sometimes it turns out to be much, much better, as has been the case for the past four years.

My best guess as to why yields are so low? It's simply that the market is very worried, and about a lot of things: quantitative easing, negative yields overseas, slowing growth, geopolitical tensions, bad fiscal policies, deflation, etc. The market may be right to worry, but it may also be wrong. In order for an investment in 10-yr Treasuries today to beat alternative investments, an awful lot of bad things are going to have to happen over the next several years.

UPDATE:

30-yr Treasury yields also hit a new all-time low today:

In order to reverse the decline in yields, we'll need to see more optimism regarding economic growth and/or clear signs of rising inflation. Stronger growth, in turn, will require a return of confidence that would follow expectations of improved fiscal policy (e.g., lower tax rates, reduced regulatory burdens). The House under Speaker Ryan is moving in the right direction with budget reforms, but those won't pass as long as Obama has his veto pen and fails to grasp what is really needed to get the economy moving. As for inflation, we've seen a gradual rise in core inflation at the consumer level (2.2% year over year, and 2.4% annualized over the past six months), but broad-based inflation remains below 2%.

Encouraging signs

The news is certainly mixed these days. Britain's Brexit vote stirs fears of a global slowdown in trade, which would surely be bad for the economic outlook. But that's still something out on the horizon. In the meantime, more recent data point to a pickup in growth that began a month or so ago. 

The ISM manufacturing index was stronger than expected (53.2 vs. 51.3), and as the chart above shows, this suggests that second quarter GDP growth will be stronger than the tepid 1.1% registered in the first quarter. It wouldn't be surprising to see Q2 growth come in at 3%.

The export orders subindex continues to improve, which suggests that conditions overseas are improving.

Now that oil prices have been rising for over four months, it's not surprising to see a clear majority of firms reporting higher prices paid. Once more we say goodbye to concerns about deflation.

The employment subindex remains unimpressive, which suggests that firms are still cautious about the outlook. This recovery is still dominated by worries and risk aversion, but that's not necessarily bad. The time to worry is when everyone is optimistic.

Manufacturing activity has been improving for the past few months in both the U.S. and the Eurozone. This may be tempered in months to come by the Brexit vote, so it's too early to get excited about a coordinated rebound in activity. But in the meantime it's reassuring. 

10-yr Treasury yields are still amazingly low, closing today at 1.44%. 30-yr Treasury yields are also down to all-time lows, closing today at 2.23%. But the spread between the two, shown in the chart above, has been rising since last August. From a long-term historical perspective, the long end of the Treasury curve is plenty steep, and that suggests the market still expects the economy to improve over time. The time to worry is when the yield curve gets very flat or even negatively-sloped.

The PE ratio of the S&P 500 is about 15% above its long-term average, but this has to be viewed in the context of risk-free interest rates that are at their lowest level ever. Put another way, the PE ratio of 10-yr Treasuries today is about 80, whereas the PE ratio of equities is about 20 (i.e., an investment of $80 in 10-yr Treasuries will get you an annual return of $1, whereas an investment of only $20 in equities promises a return of $1). I'm thinking this is an unprecedented valuation gap in favor of equities.

As the chart above shows, the earnings yield (after-tax profits per share divided by share price) on equities is still well above average. Moreover, EPS appears to be stabilizing, having fallen only 2.7% over the past year—and quite likely to increase now that the problems in the oil patch are in the past. If profits merely hold at current levels, the expected return on equities will be significantly higher than the return on Treasuries.