Interesting chart updates

We're back from a long trip to Argentina. Since we were there two years ago, the only thing that has changed in a meaningful way is the peso, which has effectively appreciated by a significant amount—another way of saying that the prices of just about everything have gone up a lot in dollar terms. The exchange rate back then was 1500 pesos to the dollar, and it's the same today. But there has been inflation (in peso terms) of 40-50% in the intervening two years. This has been made possible by a 50% increase in the central bank's foreign exchange reserves in the past two years. The central bank has been buying up a portion of the dollars that have been pouring into the country. I see lots and lots of new foreign investments coming into Argentina, and these will translate into more and more jobs and prosperity in the coming years.

Other than that, there are interesting parallels between Argentina and the United States. Prices are up, lots of people are complaining, jobs are hard to find, and a lot of people are upset with their president. Fortunately, no one is talking about a coup or the possibility that Milei will reverse course. Meanwhile, life goes on, there's plenty of traffic, the food is delicious (wine, notably, is very cheap and very good), and the people are extremely friendly. We took a 3-day side trip to Cafayate, which is the #2 wine region in the country. It's in the northwest part of Argentina, near Salta. It's gorgeous and worthy of a visit for anyone who loves wine and mountain views. (Our favorite winery, San Pedro de Yacochuya, is located at about 7,000 feet elevation.) I did note, however, that restaurants are not packed at 10:30 pm as they would be if everything were normal. 

What follows are some charts I've been working on in the past few days. Nothing of great concern emerges from this review. Inflation fundamentals haven't changed, the economy is doing Ok (1.5-2% real growth), corporate profits are tremendous, and there are no signs of a looming recession or even a slowdown. 

Chart #1

In the past several months there has been a notable pickup in the growth of the M2 money supply. So far it's nothing to be concerned about, especially in an historical context. But it bears watching.

Chart #2

Chart #2 is my way of calculating the demand for money: it's the ratio of the M2 money supply to GDP. It hasn't changed much in the past few years, and is only marginally above pre-COVID levels. I would be concerned if it were falling, since that would imply that the Fed would need to increase interest rates in order to persuade the market to hold money instead of spending it. 

Chart #3

Chart #3 shows the growth trends of the three main components of the Personal Consumption Expenditure Deflator, the Fed’s preferred measure of inflation. Note that durable goods prices (cars, appliances, etc.) have been unchanged since 2022, while non-durable goods (food, clothing, gasoline, etc.) prices have also been largely unchanged EXCEPT for the last few months, during which time the Iran conflict has boosted energy prices. Inflation in recent years has been driven primarily by service prices, which in turn have been driven primarily by labor and shelter costs. 

Chart #4

Chart #4 compares the number of job openings to the number of job seekers. This suggests that labor market conditions haven't changed much in the past two years. No boom, no bust. No abundance of new jobs, but no contraction either.

Chart #5

Chart #5 shows the level of nominal and real (inflation-adjusted) housing prices in the United States. In real terms prices have actually declined a bit in the past several years, while in nominal terms prices have been rising at a slower and slower pace. It’s clear to me that we are seeing top in prices, which will likely be followed by a period declining prices. It's often said that the housing market goes through cycles like this about every 10 years. And of course, with declining prices, shelter costs will be declining and contributing to lower inflation. 

 

Chart #6

Chart #6 compares the prices of bitcoin and the S&P 500. Bitcoin prices are down by two-thirds from their high last year, while equity prices continue to rise. As the chart notes, holders of bitcoin have lost about $2 trillion since the peak. Ouch. I have been a resolute bitcoin skeptic for a long time, and I'm tempted to say that we haven't seen the worst yet. Bitcoin was never more than a speculators' game that had some mathematical credibility but little else. Given its volatility to date, it is not a reliable store of value nor a hedge against anything. Bottom line: bitcoin has no inherent value.

So: what does this mean? I am an inveterate optimist, so I tend to see this as a good thing. Speculators are getting whupped, and they are being forced to retreat to good old-fashioned things that are tied to productive assets and productive activity. That's another way of saying that the bitcoin bubble popping is generating an increased demand for money. At the very least that further suggests that the Fed does not need to raise interest rates; with no change in rates but a big upward shift in money demand, monetary conditions in the US are effectively tightening. That's one more reason why I think inflation fundamentals remain intact and sound.

Chart #7

Chart #7 shows the ratio of corporate profits to GDP, which now stands at a record all-time high. Note how the ratio in recent years has been about twice as high as it was in the 70s and 80s. That is a huge deal. No wonder the stock market is doing so well!

Inflation likely to subside, growth likely to improve

Rising real interest rates and falling non-energy commodity prices are laying the foundation for lower overall inflation. Meanwhile, there are encouraging signs of improving economic growth conditions.

Chart #1

Chart #1 is all about interest rates and inflation expectations. Interest rates have been rising of late, but not because inflation is rising. We know this because real interest rates have risen much more than nominal rates in the past several months. The top (white) line shows the nominal yield on 5-yr Treasuries, while the orange line shows the real yield on 5-yr TIPS. The line at the bottom of the chart is the difference between the two, which is the market's expectation of what the CPI will average over the next 5 years. 

Inflation expectations reached a peak in mid-March of this year, boosted by sharply higher oil prices, which in turn were a by-product of the Iran conflict. Those expectations were (briefly) validated by the March, April and May CPI releases. But inflation fundamentals are already reversing for the better. 

Chart #2

Chart #2 shows the price of gold (white line) and non-energy commodity prices (orange line). Both were rising smartly from September '25 through February of this year, even as measured inflation and inflation expectations remained muted. I'll admit to worrying last year that rising gold prices were throwing shade on my low-inflation predictions. Gold, as everyone knows, has throughout history been a refuge from inflation and economic and political risk. I didn't see either, thinking gold was simply getting carried away by momentum dynamics. Now, however, it turns out that gold was prescient: tensions in the Middle East were heating up and boiled over at the beginning of March. 

The other side of this story, though, started playing out in late March as gold prices dropped, followed a month or so later by falling non-energy commodity prices. Gold and non-energy commodity prices may well be telling us that Middle East tensions are declining and—thanks to higher real interest rates which have effectively tightened monetary conditions—we are soon likely to see falling inflation. And perhaps, as Charts #4 and 5 suggest, an improving economic outlook. Who needs gold, now that the war is winding down. (Buy at the sound of cannon, sell at the sound of bells.)

 

Chart #3

Chart #3 reinforces a more optimistic outlook. As the chart shows, real interest rates (orange line, 5-yr real rates on TIPS bonds) have a strong tendency to strengthen or weaken the dollar (white line). Higher real rates simply make a currency more attractive to own and less attractive to borrow. The recent rise in real rates suggests that the dollar is likely to strengthen. A stronger dollar, in turn, would reinforce a lower inflation outlook because a strong dollar is symptomatic of strong demand for money. And with the M2 money supply growing at a modest rate, strong dollar demand means an effective shortage of money that might otherwise fuel rising prices.

Chart #4

Chart #4 shows the ISM manufacturing indices for the US and Europe. Both have risen of late, strongly suggesting improving conditions in the manufacturing sectors.

Chart #5

Last week's release of the May jobs statistics lends further support to the strengthening economy thesis. Jobs growth appears to have turned the corner for the better. It's still very weak, of course, but things are improving on the margin and that is the most important fact. 

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As an aside, we are in Argentina right now visiting friends and relatives. The macro fundamentals, as I see them—lots of foreign investments inflows, rising central bank reserves, and a stable currency (the peso has actually strengthened meaningfully since I was last here two years ago)—suggest the economy is very likely to improve in the months and years ahead. Yet people are terribly frustrated, as they are in the US as well. Change is always painful at first. 

More on Argentina to come.

Key macro charts update: still looking good

Consumer confidence is low, and surveys find that the majority of the US population thinks the economy is getting worse. According to Rasmussen, only 43% approve of the job Trump's doing. Gas prices are high—the other day I paid almost $7/gal—and there are widespread reports of consumers cutting back on non-essential goods and services. Reported inflation has jumped, and the market fully expects the Fed's next move will be to raise rates. Despite this grim backdrop, the stock market is making new highs almost daily (the S&P 500 is up 28% in the past year!), and corporate profits are simply fabulous. I can't remember another time with such a disconnect. 

It's time to review some important macro indicators:

Chart #1

Chart #1 shows that the M2 money supply continues to grow at a moderate pace—up just 5.1% in the past year, and in the past two years up a mere 4.3% annualized. Headline inflation has jumped, however, thanks to the complications of the Iran war which have sharply reduced the global supply of oil. If the Fed under new chair Kevin Warsh stands firm, higher prices for energy will not trigger a broad-based rise in prices. Meanwhile, the market has effectively tightened monetary policy by pushing 5-yr real interest rates up by 50 bps since the end of February, and by pricing in the near-certainty of a one quarter point tightening over the course of the next 12 months. 

From 1995 through 2019, the M2 measure of the money supply grew at a compound annual rate of 6%, a period characterized by relatively low and stable inflation. The money supply then exploded by some $6 trillion from 2020 through early 2022 as the federal government sent out Covid "stimulus" checks that—at first—sat idle in bank checking and savings accounts. As consumers and businesses regained confidence and the economy emerged from the Covid shock in early 2021, that extra M2 eventually became monetized, and that in turn provided the fuel for a sharp rise in inflation.

Today, M2 is only about 5% ($1.2 trillion) above where it likely would have been in the absence of the great Covid monetary shock. The Covid-related explosive increase in money has been absorbed by higher prices and a growing economy. Monetary policy has been back on track for several years now. This is key to the inflation outlook.

Chart #2

Chart #2 shows real (blue) and nominal (red) 5-yr Treasury yields, and the difference between the two (green) which is effectively the market's expectation for what the CPI will average over the next 5 years. Just before Covid hit in early 2020, inflation expectations were relatively low—about 1.6%. The Covid shutdowns at first caused inflation expectations to plunge to near-zero, then to soar to 3.7%. Today the bond market is priced to inflation averaging 2.54% over the next 5 years—only modestly above levels that the Fed should be prepared to tolerate. People may be worried about rising inflation, but not the bond market. 

Chart #3

Capital goods orders (Chart #3) are key to economic growth and prosperity, since new machinery, factories, and computers are what will drive future productivity. In inflation-adjusted terms, capital goods orders have been usually weak since the turn of the 21st century. Is it surprising that the economy has managed only moderate growth in the current business cycle which began in 2009. The recent strength in this series is a welcome breath of fresh air, and a sign that economic growth may continue to improve in the months and years ahead.

Chart #4

Chart #4 breaks down the Personal Consumption Deflator (the Fed's preferred measure of inflation) into its three major components. Things to note: since 1995, when China's economy started opening to the world and unleashing a flood of cheap electronics and appliances, the prices of durable goods have fallen by 30%. Meanwhile, service sector prices have risen by 141%, a direct result of rising real wages and a growing economy. Until the start of Iran hostilities, non-durable goods prices rose a bit less than 1% per year since mid-2022. Bottom line: outside of wages, and prior to the Iran war, inflation was largely confined to service sector prices, which in turn are largely determined by wages. These facts suggest that in the past 35 years, an hour's worth of wages now buys almost three and a half times more durable goods and 30% more nondurable goods. Wow.

Chart #5

Chart #5 is one of my favorite charts. The dotted green line reflects the growth trajectory of the US economy from 1965 through 2007, when the economy grew at a compound annual rate of about 3.1% per year. The dotted red line in the trajectory since the end of the Great Recession in mid-2009, when the growth trend abruptly slowed to 2.3% per year. If our economy had followed the 3.1% growth path, it would be 23% bigger today. The likely causes of this dramatic underperformance? Inefficient green energy subsidies, a huge increase in transfer payments, and increased tax and regulatory burdens figure at the top of my list. The recent strength in capital goods orders is the first indication that the economy may be regaining its former vitality.

Chart #6

Chart #6 shows corporate profits as a percent of nominal GDP. Think of this as a proxy for corporate profit margins: for every dollar of GDP, corporations today capture more than 11 cents of after-tax profits. That's  twice as much as during the 1970s and 1980s (as indicated by the dashed green lines). No wonder the stock market is making record highs! Corporate profits have never been so healthy. Wow.

Chart #7

Chart #7 shows the year over year change in the overall Consumer Price Index as compared to its ex-energy version. Energy has always been the most volatile component of the CPI, and today is no exception. The important thing here is that energy prices do not cause inflation. Monetary policy is the chief determinant. And as we have seen in prior charts, there is no sign that monetary policy has become inflationary. The ex-energy version of the CPI is up 2.8% in the past year, and that is only marginally higher than the 2.5% inflation expectations priced into the bond market. Bear in mind that this number continues to be artificially inflated by the flawed measure the BLS uses to calculate shelter costs. Nationwide housing prices are up by a mere 0.7% in the past year; on an inflation-adjusted basis, housing prices are down 3.7% from their peak in mid-2022. These facts have yet to be captured by the BLS, which uses the year over year change in housing prices from 18 months ago to compute shelter costs.

If you focus less on the headlines in the media and more on the underlying statistics, the picture becomes clear: the economy is in good shape and likely to get even better.