Wednesday, April 14, 2021

Updated outlook and some interesting charts


It's fairly clear to all that the near-term outlook is rosy. Vaccinations are becoming ubiquitous, and although daily new cases have ticked up a bit here and there (with the notable exception of Michigan), the severity of cases and hospitalizations is declining; most of the old and most vulnerable folks have either left us or are by now largely immune, so most of the new infections are occurring amidst the young and healthy. In any event, "herd immunity" is likely only months away at the current pace of vaccinations. Jobs are growing at a healthy clip and business investment is surging—the economy has recovered most if not all of the ground lost over the past year. Optimism is on the rise, but animal spirits are somewhat restrained by still-pervasive risk aversion. None of this is likely to reverse in the next several months, so the economy will continue to benefit from a widespread, natural healing process.

Looking further into the future, however, there are dark clouds on the horizon. On the monetary front, the Fed has supplied more liquidity to the system than ever before—and by orders of magnitude—but the inflationary potential of this has been kept in check by a still-robust demand for liquidity and safety. By promising to remain super-accommodative for at least a year or so, the Fed runs the real risk of allowing inflation and inflation expectations to run wild. Who wants to hold all that cash, when cash returns are zero in nominal terms and -2% in real terms? Who doesn't want to borrow at near-zero or negative real interest rates, when just about all commodity, real estate, and equity prices are rising? Absent a blow to confidence, the demand for money is sure to decline, and that in turn could fuel a substantial rise in the general price level (aka inflation) as economic actors attempt to unload unwanted cash—unless the Fed reverses course in a timely manner. 

Perhaps the darkest of clouds is the Biden Administration's urge to expand government spending (on just about everything except a relative handful of actual infrastructure projects) while borrowing trillions in the process, reversing the de-regulation accomplishments and jacking up marginal tax rates on the rich. Common sense tells us that increased government spending, borrowing, regulatory and tax burdens, subsidies, and income redistribution cannot possibly strengthen the economy, and can only weaken it. Today we enjoy a long-awaited healing and reopening process, but by next year we could be slowly suffocating under the burden of Big Government.

It's hard to imagine a worse scenario than inflationary monetary policy coupled with anti-growth fiscal policies, but that's the risk that lies menacing on the horizon. 

I am surely not the only one to worry about such things. The bond market is so dominated by risk aversion that short-term Treasury yields are still extremely low, and risk-free real yields are frankly negative. Bond investors are willing to pay exorbitant prices for anything resembling security. The equity market is far less frothy, since valuations do not appear terribly out of line with interest rates and the global economy (see Chart #9 below). 

Chart #1

With yesterday's release of the March CPI stats, no one was surprised to see year-over-year inflation rise by over 2.6% (as compared to the weak price action of March '20). But as Chart #1 shows, most of the inflation "noise" comes from energy prices, which are by far the most volatile component of the CPI index. Subtracting energy prices, the CPI rose a little over 1.9% in the past year (red line).

Chart #2

Chart #2 shows the ex-energy CPI index plotted on a log scale y-axis. Here we see that the long-term trend of ex-energy prices has been a relatively steady 2% per year over the past two decades. We have been living in a 2% consumer price inflation world for many years, and nothing so far has changed. 

Chart #3

Chart #3 compares the price of gold to the price of 5-year TIPS (Treasury Inflation-Protected bonds), using the inverse of their real yield as a proxy for their prices. Both of these assets promise protection not only from inflation but also from geopolitical risk and general currency debasement. In short, they are classic safe-haven assets. That both are trading very near their all-time highs is a good sign that the world is still quite risk-averse. 

Chart #4

Chart #4 shows 10-yr Treasury yields, which have surged over 100 bps from last year's all-time lows. Yet yields today are only marginally higher than they were prior to the onset of the Covid crisis. Back in February of last year, a casual observer would have remarked that Treasury yields were exceptionally—and historically—very low. Yes, the outlook has brightened, but it still remains unusually dark. That investors are still eager to buy Treasuries at today's prices can only be interpreted to mean that the demand for Treasuries (arguably the safest place in the world to park long-term funds) is still very, very strong, which in turn strongly suggests that risk aversion is still very much alive and well. So strong that the nominal yield on Treasuries is fully expected to be less than the rate of inflation for the foreseeable future. 

Chart #5

Chart #5 shows the volume of passenger traffic in US airports. On a seven-day average basis, 1.4 million people took to the air as of yesterday. That's a huge improvement (about double) from just two months ago, but it is still more than one-third less than the rates we were seeing in 2019 and early 2020. There is still plenty of upside here.

Chart #6

As Chart #6 shows, equity prices have moved ever higher of late thanks in large part to a decline in the Vix "fear" index. Yet the level of the Vix today (17) is still substantially higher that the average (about 12) that is typical of periods of relative calm. Again we see that risk aversion is still alive and well, though obviously much less so than it was at this time last year. 

Chart #7

Chart #7 compares the market capitalization of Apple and Microsoft, the two leading tech giants. Both companies are worth over $2 trillion, an amount previously thought unimaginably high. If Apple were the only company to sport a two-trillion handle, we might be tempted to call it a bubble. But both companies have experienced similar gains over the years, and they were both well-positioned to profit from the new work-at-home reality which Covid fears sparked. 

Chart #8

Just for fun, Chart #8 compares the market caps of Walmart—the former world's retail giant—and Amazon, the new world-class retail giant. At $1.7 trillion, Amazon's market cap is more than four times larger than Walmart's and only a bit below that of Apple and Microsoft's. Arguably, both companies radically changed the retail world, only in very different ways and at different times.

Taken together, the market cap of these three giants adds up to about 14% of the current market cap of all US equities, according to Bloomberg. And to think they barely existed 30 years ago!  

Chart #9

Much has been made of late of the Buffett Indicator, which says that the market cap of US stocks exceeds US GDP by such a huge and unprecedented margin as to be a clear sign that the market is in a "bubble" that is set to burst. Chart #9 is my counter to that argument. I don't think it makes sense to compare the market cap of US corporate giants to just US GDP. After all, they have become huge players in the global marketplace, which is like saying their addressable market has expanded exponentially in recent decades. Globalization is a relatively new phenomenon, and it has meant that a US corporation can derive a huge portion of its profits from overseas markets which previously barely existed (e.g., China, India). Comparing after-tax corporate profits (a rough proxy for market cap) to global GDP shows no sign of an extreme. Profits have increased dramatically relative to US GDP (they averaged about 6% of GDP through 2000, but they have averaged almost 10% of GDP for the past decade), but not when measured against the surge in global GDP.

The long-term outlook is cloudy, but the near-term outlook is still favorable for investors. It's not an entirely comfortable situation, unfortunately. But the good news for now is that the risks out there are not going unnoticed, and that's a healthy sign. Will Congress really end up passing economy-crippling legislation?

UPDATE: This article by Gregory van Kipnis of AIER adds a lot of meat to my brief discussion regarding Chart #9. The author uses a rough estimate to make his point: "... half the growth in the Buffett Indicator comes from the increased importance of foreign earnings to US corporations, and another half of the growth comes from the increased amount of profits emanating from publicly traded companies."

Monday, April 5, 2021

Booming prices


The Fed continues to expand its balance sheet, the federal government continues to send out Covid relief checks, and the Fed continues to effectively monetize most if not all of this monetary "stimulus." Although this "stimulus" hasn't yet resulted in a significant rise in the general price level, we do see increasing—and potentially troubling—signs of booming prices in certain areas of the economy. I've been arguing for some time now that the Fed's profligate monetary expansion has not been inflationary because it has simply accommodated a similar, robust increase in the demand for money. But the demand for money of late is surely declining (while the supply is not) thanks to 1) rapidly spreading vaccinations and a significant increase in the US population's natural immunity, 2) increasing consumer confidence, 3) the ongoing relaxation of lockdowns and mask mandates, and 4) impressive signs of economic recovery.

In my view, we are already seeing early signs of what will eventually prove to be a meaningful increase in inflation, and this process is likely to play out over the next few years. Inflation seems sure to rise, but we do not yet know by how much.

Chart #1

As Chart #1 shows, the Fed has allowed the M2 money supply to increase at an unprecedented pace since February '20. M2 has surged by $4.2 trillion (27%) in the past 13 months, and has been rising at a roughly 15% annualized pace in recent months; that is far and above the 6.5% annualized rate of M2 growth in previous decades. The vast majority of the outsized increase in M2 can be found in bank savings and deposit accounts at the retail level. The public, in other words, has been hoarding money like never before, likely as a response to all the uncertainties raised by the Covid crisis. I calculate that M2 currently is about $2.3 trillion above its long-term growth trend. That's an extra 12% increase in the amount of money than would be held in "normal" times. If the public decides to reduce its cash holdings relative to income, this "extra" M2 could fuel a 12% increase in inflation over the next few years.

Chart #2

Chart #2 shows the Manheim Used Vehicle Value Index in both nominal and inflation-adjusted terms. Since February 2020, used cars have jumped 22% in price! In real terms, they are almost back to where they were during the boom times of the late 1990s. 

Chart #3

Used cars appear to be in very short supply (relative to demand), and new car sales these days are about as strong as they have ever been, as Chart #3 shows. No matter how you look at it, the demand for new and used cars is robust. Strong demand could be due at least in part to all those stimulus checks, coupled with very low borrowing costs and the public's pent-up demand to get out and about following a year of being shut in. 

Chart #4

Chart #5

Charts #4 and #5 show the prices paid component of the ISM manufacturing and service sector surveys. The vast majority of businesses are paying higher prices for stuff these days. That last time we saw such high levels—in the late 2000s—we also saw elevated levels of the CPI, which averaged 4% per year from mid-2005 to mid-2008. 

Chart #6

Chart #7

Housing has also been the beneficiary of unusually strong demand, as Chart #6 shows. In real terms the average home price in the US is now just about as high as it was at the peak of the 2006-2007 housing boom. Prices rose by about 11% last year and continue to move higher (it's not uncommon to see Zillow and Redfin reporting asking price increases these days, at least in local neighborhoods I follow). I expect to see this continue, fueled by exceptionally low mortgage rates and lots of cash in people's pockets. Plus, the Fed has vowed to not interfere with any of this until late next year. 

As Chart #7 shows, it takes about 18 months for big moves in housing prices (blue line) to show up in the housing component of the CPI (red line). As Milton Friedman taught us, the lag between monetary policy and inflation can be long and variable.

Chart #8

The elephant in the rising-price room is the US equity market. The S&P 500 is up over 20% since it's pre-Covid high in February '20. According to Bloomberg, the market value of all US equities has increased over that same period by about $10 trillion.

Chart #9

Non-energy commodity prices (red line, Chart #9) are up over 20% from their January '20 highs. A good portion of that rise can be attributed to a weakened dollar (blue line), but a weaker dollar is symptomatic of easy money and a precursor to inflation (as we saw in the 1970s). Note also that the dollar weakened in the 2005-2008 period and commodity prices also rose—and inflation increased meaningfully, as noted above.

Chart #10

The price of copper has jumped over 40% since the highs of January '20. This undoubtedly reflects booming construction activity around the world, but also can be attributed in part to easy money conditions in the US. 

Chart #11

Finally, as Chart #11 shows, one driver of higher prices is simply a decline in the market's level of uncertainty, as reflected in the declining Vix "fear" index. The uncertainty that prevailed throughout most of 2020 undoubtedly contributed to the public's hoarding of cash, and now this dynamic is unwinding. 

Unless and until the Fed reverses its Quantitative Easing efforts and/or raises short-term interest rates, declining fear, rising confidence, and strong economic growth are likely to fuel a palpable rise in inflation for the foreseeable future. 

Unfortunately, that in turn will give way—as has always been the case after periods of rising inflation—to tighter money, higher interest rates, and eventually (2023?) to sharply weaker economic growth.

Tuesday, March 23, 2021

The problem with unwanted money


The demand for money—as measured by the ratio of M2 to nominal GDP—currently stands very near to an all-time, eye-popping high (see Chart #1). The turmoil and fears which characterized the Covid-19 era caused the public to seek out and hold trillions of dollars of extra cash, and the Fed correctly obliged this demand for money and money equivalents by greatly expanding its balance sheet— transmogrifying notes and bonds into T-bill equivalents (aka bank reserves). (I've explained this all in detail over the course of many previous posts.) Conveniently, increased savings on the part of a terrified and sheltering public provided most—if not all—of the money that Treasury borrowed to fund Covid relief spending. 

Chart #1

Chart #2

But as Chart #1 suggests, the surge in money demand has passed. Confidence is returning and the economy is regaining lost ground. It stands to reason that the demand for money should begin to decline, and it has already declined, as we see in Chart #2, driven mainly by a sharp rise in nominal GDP. This is quite likely to continue; the main question going forward is how much of the increase in nominal GDP will be real and how much will be inflation. 

Chart #3

Chart #3 shows the daily volume of airline passengers (white) screened by TSA, with the magenta line being the 7-day moving average. Notice the sharp increase in air traffic in the past two months. Compared to the levels which prevailed 2 years ago at this time of year, air traffic is now down only 40%, whereas at the lows of last April, air traffic had plunged by an astounding 96%. With the rapid pace of vaccinations and increasing signs of optimism, there is every reason to expect air traffic to grow rapidly in coming months and the economy to grow as well.

The resurgent demand for air travel almost certainly is driven in large part by increased confidence. And with increased confidence, the rationale for the public continuing to hold a huge portion of their annual incomes in cash (i.e., the public's demand for money) surely is fading. But since the Fed has taken no steps to reverse its note and bond purchases, the M2 measure of money supply can't simply evaporate. And with the recently passed Covid relief bill, deficit-funding spending is going to ratchet up once again, which could add yet more money to the financial markets, especially since the Fed plans to continue to its purchases of notes and bonds. 

Unwanted money can't disappear, but it can fuel an expanding economy and it can bid up the prices of other assets.

Chart #4

Chart #4 provides some clues as to how this works. The bars represent the current yield on a variety of investments. The green line is the market's expected average annual increase in the CPI over the foreseeable future (about 2.3%); think of that as the average increase in the prices of all goods and services over the next 5-10 years. Owning cash, short-term Treasuries or mortgage backed securities is very likely to give you a loss in terms of purchasing power. On the other hand, yields on real estate trusts, high-yield debt, emerging market debt and the S&P 500 promise to deliver a purchasing power gain. Unwanted money (much of which is held in very short-term investments such as T-bills, bank deposits and 2-yr Treasury notes) will naturally want to seek out the much more attractive returns on just about all other assets. And as prices for other assets rise, their yields will decline. 

This is another way of saying that a tsunami of unwanted cash likely is going to lift the prices of just about everything, and that is another way of saying we are going to see more inflation in the years to come, UNLESS the Fed reverses course. Which they have promised not to do for at least another year and a half. 

Chart #5

Chart #5 shows us the bond market's way of expressing the view that inflation is likely to average about 2.3% per year for the foreseeable future. The difference between real and nominal Treasury yields gives you the market's expected rate of inflation. Note that most of the increase in inflation expectations of late has come from a rise in nominal Treasury yields. Real yields are still very low.

Chart #6

Chart #6 shows how 2-yr real yields on TIPS have a strong tendency to track the growth rate of real GDP over time. That real yields are currently so low means that the market either does not have a lot of confidence in future growth prospects, and/or the market is still very risk averse (meaning that people are willing to pay extremely high prices for the relative safety of TIPS). Going forward, we are likely to see real yields rise as long as the economy demonstrates that it has the ability to grow by at least 1-2% per year for the next several years. 

Chart #7

Chart #7 gives us a long-term view of the evolution of the Treasury yield curve (using 2- and 10-yr yields as the classic reference points for short and long-term interest rates). Bear in mind that short-term rates are heavily influenced by both the Fed's monetary policy target and the market's demand for safe assets. The yield curve has steepened noticeably since last summer, mainly due to rising long-term yields, which in turn have been driven by expectations that the economy will improve enough to allow the Fed to raise short-term rates in the future. This is a healthy development, since very low yields are a sign of a very weak and risk averse economy. There's no reason yet to worry that higher yields will derail the ongoing equity market rally.