Tuesday, December 3, 2019

The news is decidedly mixed, but it's not crazy to remain optimistic

I haven't done much posting of late, mainly because conditions haven't changed much. The economy has been growing at a modest (~2%) pace, and the economic news has been mixed: undeniably weak manufacturing data, trade frictions continuing, weak business investment, offset by healthy growth in jobs and incomes, strong financial fundamentals, and very low unemployment claims. Consumer sentiment has been generally upbeat, but uncertainties persist (e.g., impeachment, geopolitical tensions, and a global trade and manufacturing slowdown). Equity prices have been drifting irregularly higher, but safe-haven demand for bonds has driven interest rates to very low levels. Very cautious optimism best describes the market these days, with few willing to bet that things will improve.

Here are some charts and thoughts to round out the picture:

Chart #1

Chart #1 compares stock prices (blue line) with a measure of the market's fears and uncertainties (red line). When fear (the Vix index) rises and uncertainty rises (i.e., as strong demand for the safety of 10-yr Treasuries pushes yields down), stock prices have a strong (and understandable) tendency to weaken. Most of today's concerns revolve around Trump's tariff wars, as has been the case for most of the past year.

I note that the S&P 500 rose at a 14% annualized rate during 2016 and 2017, boosted no doubt by a significant reduction in corporate tax rates. But gains have been only about half as much from 2018 to today. The latter is most likely more suggestive of future returns than the former. Still, the prospect of 7% price gains plus 1.5% dividend gains going forward—while in line with long-term trends—is an order of magnitude larger than the returns on 10-yr Treasury bonds. The equity risk premium is still compelling for those willing to take the risk.

Chart #2 

Chart #2 compares an index of manufacturing health (red line) with the quarterly annualized change in real GDP growth (blue bars). The relationship between the two has weakened considerably in the past decade, however. And regardless, the huge decline in the manufacturing index over the past two years has failed to put it in territory that in the past has coincided with recessions. At current levels, the ISM index suggests that overall economic growth in the current quarter will probably be 1-2%, which not surprisingly happens to be the market's current consensus.

Chart #3

As Chart #3 shows, the big decline in the manufacturing index began early last year with Trump's imposition of punitive tariffs on Chinese goods. But as the chart also suggests, we have probably seen the worst. The Markit manufacturing index has turned up of late, as has the Eurozone manufacturing index.

Chart #4

Chart #4 compares manufacturing conditions here and in the Eurozone. Both have weakened during the Trump tariff wars. Conditions appear to have improved a bit in the Eurozone of late.

Chart #5

Chart #5 shows the relationship between real yields on 5-yr TIPS (a good proxy for real yields in general) and real GDP growth (which I measure over a rolling 2-yr period to get a proxy for the market's perception of trend growth). Not surprisingly, real yields tend to track real economic growth trends. A very strong economy demands high real yields, whereas today's near-zero real yields point to modest 2% real growth rates. In short, the bond market is priced to 2% real growth for the foreseeable future. That's not enough to convince the Fed to raise rates, but it's slow enough to justify the current low level of rates.

Chart #6

Chart #6 compares the level of the Chinese yuan with the level of China's foreign exchange reserves. For the past several years, the Chinese central bank has been targeting stable forex reserves, which means that strength or weakness in the yuan is a direct reflection of changing demand for yuan. Under this monetary regime, if capital tries to leave the country, the central bank allows the yuan to weaken; if capital flows turn positive, the yuan strengthens. The yuan has fallen about 11% vs the dollar since Trump's imposition of punitive tariffs on Chinese goods. This reflects deteriorating expectations for the Chinese economy and it also serves to lessen the impact of tariffs on US consumers, since a weaker yuan gives exporters the ability to lower their prices (since they receive more yuan for a given level of dollar sales) in order to offset the impact of US tariffs. Bad for China, but good for the US.

Chart #7

As Chart #7 shows, the weaker yuan has caused Chinese inflation to rise relative to US inflation. A weaker yuan makes the prices of all imported goods rise, and that helps fuel a rising price level in China.

Chart #8

As Chart #8 shows, thanks to a decline in the yuan's value vis a vis the dollar, US tariffs have not impacted China's exports to the US as much as higher China countervailing duties (and a weaker yuan) have negatively impacted China's imports of US goods. The Chinese economy is suffering as a result: rising inflation, weak currency, declining imports and exports, and slowing economic growth.

Chart #9

Chart #9 shows that world trade volume has been flat to slightly down as a result of global tariff wars. Nobody is benefiting from Trump's tariffs. But if they convince the Chinese to reform their ways, and Trump responds by reducing or eliminating tariffs, then the world will be better off in the end. That's my hope.

Chart #10

Chart #10 shows that business investment has been relatively weak for the past several years. That's disappointing given the significant reduction in corporate tax rates, but it's somewhat understandable given the general climate of fear, uncertainty and doubt (FUD), which in turn is driven in large part by the potential for tariff wars to foster global economic weakness.

Chart #11

Chart #11 shows that capital goods orders—a good proxy for business investment—have been flat for the past year, thus reinforcing the message of Chart #10. Business investment has been and continues to be a disappointment, and that is keeping the economy in slow-growth mode.

Chart #12

Jobs growth in the US has slowed over the past year, but with modest productivity growth (~1%) this suggests that 2% economic growth is likely to continue. Slow jobs growth is likely the product of weak business investment and a shortage of experienced labor.

Chart #13

Chart #13 shows the remarkable and unprecedented decline in weekly unemployment claims. This reinforces the idea that the slowdown in jobs growth has more to do with a reluctance to invest on the part of business and a shortage of qualified labor, rather than businesses reacting to a deteriorating economy by cutting back. What turnover remains in the labor market is mostly a function of workers looking for new opportunities. How many people do you know who have been given an unexpected pink slip this past year?

Chart #14

Chart #14 shows Bloomberg's survey of consumer confidence/sentiment. It has risen strongly since Trump won the 2016 election. Every measure of consumer sentiment is at relatively high levels from an historical perspective. And why not? Layoffs have never been so low relative to the size of the labor force. The unemployment rate is very low. Real median family incomes are at record highs. Mortgage rates are near all-time lows.

Chart #15

As Chart #15 shows, households' financial burdens (recurring payments as a percent of disposable income) are about as low as they have ever been.

Chart #16

The housing market shows no signs of a bubble. Indeed, housing starts are still historically low and are likely still in an uptrend, judging by builder sentiment (see Chart #16). Applications for new mortgages (not including refis) have risen 67% in the past 5 years, thanks to mortgage rates that are about as low as they have ever been. Yet the the volume of new mortgage applications today is only about half what it was at the peak of the housing market "bubble" in 2005-6. The housing market is on solid ground these days.

Chart #17

It's hard to find any sign of financial distress or instability. Chart #17 shows the all-important level of 2-yr swap spreads in both the US and the Eurozone. Very low spreads imply abundant liquidity and a very low level of systemic risk. This in turn portends a healthy outlook for the economy, since swap spreads have been good leading indicators of financial and economic health.

Chart #18

Chart #18 shows Credit Default Swap spreads, a highly liquid measure of generic credit risk. Spreads are very low, suggesting that the outlook for corporate profits—and by extension the economy—is healthy.

Chart #19

Chart #19 shows the classic measure of the slope of the Treasury yield curve. It's now slightly positive. The Fed's last interest rate cut brought short-term rates down to a level below that of long-term rates. This further suggests that Fed policy is not restrictive or otherwise threatening to the economy.

Chart #20

As Chart #20 shows, real, inflation-adjusted short-term interest rates are now roughly zero. Virtually all past recessions were preceded by unusually high real interest rates. Fed policy is once again accommodative. Borrowing costs are unusually low.

Chart #21

Chart #21 underscores just how risk-averse the world is these days. It shows the 3-mo. annualized rate of growth of bank savings and demand deposits. Despite short-term interest rates trading at historical lows, both in nominal and real terms, demand for "safe" deposits that pay almost nothing has exploded. Trump's election in late 2016 kicked off an impressive decline in money demand, but Trump's tariff wars have largely reversed this. While it's unfortunate this has occurred, it's important to recognize that any improvement in the global trade outlook has the potential to unleash a tsunami of cash. 

In my judgment, it pays to remain optimistic.

Saturday, November 23, 2019

Trump's best defense against impeachment

Michael Anton, author of "The Flight 93 Election," arguably one of the most influential essays written in the runup to the 2016 presidential election, has another important essay which will be published in the next edition of The Claremont Review of Books, titled "The Empire Strikes Back." (If you're interested in the cutting edge of conservative thought, I highly recommend a subscription to this quarterly journal.)

If you're not up to reading the whole thing—it is a bit long—I'm here to help. Towards the end of the article is a solid, common-sense rationale for why, even if you stipulate that Trump did indeed withhold funds from Ukraine in an attempt to force them to investigate Burisma and Biden, that was far from being an impeachable offense. Here is the relevant excerpt:

The worst charge thus far alleged against President Trump is that he attempted to make $400 million in aid to Ukraine contingent on that country’s government investigating possible corruption by the Bidens. This is the much hoped for “smoking gun,” the “quid pro quo”—as if the foreign policy of any country in history has ever been borne aloft on the gentle vapors of pure altruism. 
… would that be sufficient to convince a majority of Americans, and a supermajority of senators, that Trump should be removed from office? 
I don’t see it. Especially since a) no aid was actually withheld; b) no investigation was actually launched; c) the American people don’t care about Ukraine and would probably prefer to get their $400 million back; and d) they would inevitably ask: so were, in fact, Joe Biden and his son on the take from a foreign government? And if it looks like they might have been, why, exactly, was it improper for the president to ask about it? 
Trump’s enemies’ answer to the last question is: because the president was asking a foreign government to investigate a political opponent for purely personal gain. Really? Is potential corruption by a former vice president—and potential future president—and his family a purely private matter, of no conceivable import or interest to the public affairs of the United States? That’s what you have to insist on to maintain that the request was improper. That’s the line we can expect the Democrat-CLM axis to flog, shamelessly and aggressively. But will a majority of Americans buy it? Especially since career officials at the Department of Justice already determined, and anti-Trump witnesses appearing before Representative Adam Schiff’s secret star chamber reluctantly conceded, that nothing Trump did or is alleged to have done was technically, you know, illegal.

I ask that any comments be focused not on Trump's myriad character flaws and tweets, but on the question of whether what he has done in Ukraine rises to the level of an impeachable offense.

Friday, November 1, 2019

The weakest recovery and the longest expansion

If it weren't for Trump's trade wars and a dearth of business investment, the economy would be in excellent shape. As it is, growth continues along the moderate 2% path that it has followed for more than 10 years. It's been the weakest recovery ever, but also the longest business cycle expansion. And with no obvious excesses or systemic problems in view, it promises to continue. 

Chart #1

The Q3/19 GDP report—1.9% annualized growth—makes the current expansion the longest on record. Chart #1 shows the quarterly annualized growth rate of both nominal and real GDP. To be sure, 2% growth isn't a barn-burner, but it's impressive given the degree to which the manufacturing sector has been hit by Trump's tariff wars.

Chart #2

Since the recovery started just over 10 years ago, annualized GDP growth has been 2.3%; in the past year it was 2.0%, and in the most recent quarter 1.9%. As Chart #2 suggests, for most of this past year the market has been expecting growth to slow, and indeed it has. That is reflected in the more than 100 bps decline in the real yield on 5-yr TIPS since late last year. At today's real yield of a mere 0.05%, 5-yr TIPS appear to be priced to the expectation that real GDP growth will average about 2% per year going forward. Not surprisingly, Chairman Powell recently chimed in with a similar view, saying the FOMC expects moderate growth of about 2%.

Chart #3

Chart #3 compares real economic growth with private sector jobs growth. Not surprisingly, the two tend to move together: more jobs means more growth. The recent slowdown in GDP growth is reflected in a similar slowdown in jobs growth (the October jobs report was much better than expected, but it didn't do much to change the trend growth rate of jobs, which has been declining so far this year).

Both jobs and GDP have suffered from a lack of business investment, which likely has a lot to do with the uncertainties surrounding international trade. Private sector jobs currently are growing at pace of about 1.3% per year. If jobs grow at least 1% per year and productivity registers at least 1% per year (which it has in recent years), then 2% real economic growth is sustainable. (Jobs growth plus productivity growth is a decent first approximation for overall economic growth.) For growth to move higher, we would need to see a pickup in business investment, which not only creates jobs but improves the productivity of existing workers. A resolution to the tariff wars would undoubtedly prove a catalyst in that regard.

Chart #4


Demographic factors (more and more boomers are retiring) likely also play a part in this year's slowdown. Employers continue to complain that their biggest problem is finding qualified workers. Chart #4 shows that more small business owners than ever before report that "job openings are hard to fill."

Chart #5

But it's not like the economy is running out of available workers. As Chart #5 shows, the labor force participation rate (the percentage of the working age population who are either working or looking for work) looks to be increasing, albeit slowly. People who had been on the sidelines are being enticed to return, perhaps because they see better opportunities. Or in the case of not a few retired baby-boomers I know, they have decided that working is better than just sitting around watching TV. Regardless, there are still almost 6 million people out there who officially are looking for work, according to the BLS.

Chart #6

Chart #6 compares actual growth in real GDP to its long-term trend. (Note that this is plotted using a semi-log scale for the y-axis; a straight line on this chart thus corresponds to a constant rates of growth.) By only averaging 2.3% per year, the current recovery—the weakest in history—has resulted in a $3.4 trillion "shortfall" of growth relative to what might have been had the economy rebounded to its long-term trend as it did after every prior recession. Had this been a "normal" recovery, real median family income might have been almost 18% higher (~ $1000 per month) than it is today. 

Chart #7

Chart #8

Charts #7 and #8 show two measures of business investment. Both show that investment in the current business cycle has been weaker than in previous business cycles (especially in real terms, as Chart #7 highlights). Weak investment is likely major factor behind the economy's unimpressive 2% growth rate. Which is unusual, because corporate profits have been unusually strong in the past decade. 

Chart #9

What other factors might be restraining the economy's ability to grow? The size of government ought to top anyone's list. In the past 12 months, the federal government spent a staggering $4.5 trillion, almost 21% of GDP, and 8% more than the same measure a year ago. Even more staggering, though, is the composition of that spending: 72% of what the federal government "spent" in the past year ($3.2 trillion) was in the form of transfer payments (see Charts #9 and #10). That's money that is spent on things like healthcare, social security, income security, and interest payments on debt (as of last June the annual interest on federal debt outstanding was a little over $600 billion, or 13.3% of federal spending). Only 28% of federal spending was for goods and services (i.e., true purchases). Think of purchases as a proxy for what it costs to run the government, while transfers are basically entitlements—spending that is determined not by the budget process but rather by eligibility. 

Chart #10

Note how the growth in transfer payments has surged relative to the growth of purchases since the early 90s. As Chart #10 shows, since 1970 transfer payments have more than doubled relative to total spending. By far the biggest role of the federal government in today's economy is that of an income transfer agentNeedless to say, with $3.2 trillion per year (and growing) on autopilot, the potential for fraud and waste is ginormous. It's safe to say that the huge size of government transfer payments acts as a drag on overall economic growth and efficiency. And it's only going to get worse unless changes are made to entitlements eligibility (e.g., raising the social security retirement age and/or indexing social security payments to inflation rather than wage growth). 

These are problems that have been and are going to be with us for a long time. In the meantime, it's reassuring to note that financial market conditions look quite healthy:

Chart #11

The threat that an inverted yield posed to the economy (a threat I discounted long ago), has now disappeared. As Chart #11 shows, the Treasury yield curve is now positively-sloped (the 1-10 spread is about 20 bps today), and the real Federal funds rate is essentially zero. The Fed is not tight, and their recent decision to lower their target rate, while overdue, was welcome. The Fed has now caught up to the market and things are thus looking copacetic.

Chart #12


The real yield curve is actually a better thing to look at, and here too things look good. The blue line in chart #12 is a proxy for the overnight real rate, while the real yield on 5-yr TIPS is the market's estimate of what the overnight real rate will average over the next 5 years. Both are identical. By lagging the market's expectation of falling real rates for most of this year the Fed had been threatening with policy arguably "too tight." But now the Fed is neutral. A sign of relief.

Chart #13

Swap spreads (see Chart #13) are my favorite leading and coincident indicator of systemic risk, financial market liquidity, and fundamental economic health (the lower the better). Swap spreads are now low both here and in the Eurozone. Things could hardly be better.

Chart #14

Chart #14 shows Credit Default Swap spreads, a highly liquid and generic indicator of the market's confidence in the outlook for corporate profits. Spreads are quite low, which means the market is confident that the outlook for profits—and by extension the outlook for the economy—is healthy.