Financial conditions reach a new high

Bloomberg's index of financial conditions reached a new all-time high today. Swap, muni, agency and credit spreads are generally low, liquidity conditions are excellent, the yield curve is positively sloped, implied equity index volatility is relatively low, and yields on Treasuries and corporate bonds are relatively low. With financial market conditions are as positive as they are now, a near-term recession is highly unlikely. I note that this index turned down more than four months before the last recession, and years before the 2001 recession.

Federal budget outlook continues to improve

Thanks to four years of zero growth in federal spending (the single best achievement of our currently divided government), strong tax receipts (mostly due to economic growth, with an assist from higher tax rates), the U.S. federal budget deficit has declined from a high of just over 10% of GDP in 2009 to just over 4% of GDP today. This calls for a huge sigh of relief.

The first chart showed spending and revenues as a % of GDP, while the chart above shows nominal spending and revenues. Federal spending has surprised nearly everyone by failing to grow over the past four years, while tax revenues have risen by 37%.

Accelerated realizations of capital gains and income were clearly a factor boosting revenues in the latter part of last year and last April, but as the chart above shows, the increase in tax revenues has been ongoing for the past three years: nearly every month has seen higher revenues on a year over year basis. The fundamental driver of revenue growth is economic growth: more people are working every month, and incomes are rising; a growing tax base is predictably generating higher revenues. This has happened in every recovery.

The budget deficit is still very high from an historical perspective, but it is also well within the range of what is manageable and sustainable. If current trends were to continue, the budget would be balanced within the next 3 years! (Interesting note: in a January 2011 post, I suggested that the improvement already evident in the budget outlook at that time could result in a balanced budget by 2016. Things have evolved accordingly.)

There's lots of good news to be found here. On the one hand, Congress has managed, for whatever reason, to rein in the growth of federal spending. Four years ago it was out of control, but now spending is back within historical ranges relative to GDP. On the other hand, we've seen a significant amount of fiscal retrenchment in the past four years, yet the economy has managed to grow. Keynesians four years ago would have been apoplectic at the thought of reducing the deficit from 10% of GDP to 4% of GDP in four short years, but it turns out the sky has not fallen. Looking ahead, Congress now has more freedom of action because the budget is in much better shape. If done right, fiscal policy could become genuinely stimulative (e.g., simplifying the tax code and reducing marginal rates) in coming years.

The big news is what's not happening

As government bureaus gradually reduce the list of delayed statistics, and as we get a better picture of what happened in the economy last September, the big news is that nothing much has changed. The economy was growing moderately/modestly (disappointingly slow for just about everyone's tastes), and it's probably still disappointingly slow. But as I've been saying since January, from an investor's perspective, avoiding recession is all that matters. The big news, in other words, is that the economy is not getting weaker, nor is it entering a recession. It's still growing, and that's good news given market pricing.

When the yield on cash is essentially zero, and when the yield on default-free, 2-yr Treasury notes is not even 0.5% per year, whereas the yield on riskier investments is far higher (see chart above), the market is effectively braced for a recession or at the very least for some rough sailing. This may not be what the opinion polls say or what the surveys of investor optimism or pessimism report, but it is the message of market pricing. In the absence of extraordinary volatility, markets at any given time are in an equilibrium: right now the world's investors are just about indifferent between earning nothing on cash and only 0.3% per year on 2-yr Treasuries, or 4-8% on corporate bonds and stocks. Behind that relative indifference lies the expectation (or fear) on the part of the owners of tens of trillions of dollars of cash that even though corporate stocks and bonds promise significantly higher yields, the downside risk of holding those riskier investments is so great that the extra yield they offer is not worth the risk. The risk/reward expectation for stocks, in other words, is only marginally enticing to investors (we know that because stock prices are rising), even though the alternative is quite unattractive. Stocks are moving higher because, on the margin, there are more investors opting to take on a bit more risk. The longer we go without a recession or a significant economic setback, the more this will be the case.

For an investment in cash to break even with an investment in equities, for example, equities would have to decline in price by at least 8% (i.e., by enough to offset the dividend yield of almost 2% and the expected increase in earnings of 6%, which is the current capitalized value of earnings). That's not impossible, of course, since stocks routinely go up and down by several percentage points every week, and there was a 5.8% correction in the S&P 500 in the second quarter of this year. But in exchange for this moderate volatility, an investor who held a position in the S&P 500 for the past year has made a total return of 28%.

Back to the latest economic releases: Retail sales were a bit weaker than expected, but they continue to rise at a 3-4% annual pace.

Subtracting the more volatile sectors, and looking at long-term trends, we see the same picture in retail sales that we see in nominal GDP: there has been a huge shortfall of growth that followed in the wake of the Great Recession, and growth since then has been sub-par. But it's still growth.

Housing prices staged a pretty impressive recovery this past summer, but things have been cooling off since, mainly due to higher mortgage rates. Still, it sure looks like we've seen the worst for the real estate market.

In real terms, the recovery in housing prices hasn't been quite as impressive, but prices today are still substantially higher than they were in the mid-1990s, thanks mainly to much lower mortgage rates. The rise in mortgage rates of late has been a negative, but from a long-term perspective housing is still very affordable. That argues for slower growth in prices for awhile, but not another decline.

Equities are up at strong double-digit rates over the past year, and that has many folks screaming "bubble!" Corporate profits now stand at all-time highs, so the market is not necessarily crazy, but a portion of the gain in equity prices this year is due to an expansion of multiples. Yes, people are finally starting to pay up for a dollar of earnings. Are things getting out of line? Hardly, as the chart above suggests. PE ratios are now exactly equal to their long-term average. When PEs get to 20 or more, then we can talk about whether stocks are in a bubble.

U.S. banks currently have over $7 trillion in retail savings deposits, and that represents about two-thirds of the M2 measure of the money supply. That's the highest ratio of savings deposits to M2 that we've ever seen.

At the same time, the ratio of M2 to nominal GDP is also the highest we've ever seen, as shown in the chart above. The huge accumulation of cash, cash equivalents and savings deposits shown in these charts is the measure of just how risk-averse the world still is, especially considering the almost-nonexistent yield on cash and cash equivalents. In short, there's an awful lot of cash out there that is proving to be very embarrassing.

As I said back in January, the Fed's QE bond purchases and zero interest rate policy are designed to convince investors that holding cash doesn't make sense. This message is driven home every time there is an economic data release that shows the economy is continuing to grow, however slowly. The world can't make its cash holdings disappear, of course, but on the margin investors are trying to reduce their cash holdings in favor of the much higher yield on riskier assets. This results in a change in relative asset prices which will ultimately drive the yield on cash higher as the yield on riskier investments declines (i.e., as the prices of riskier assets rise).