Friday, November 30, 2012

Some things never change

As Democrats and Republicans face off over what to do about our trillion-dollar deficits—raise taxes or cut spending?—I can't resist posting this page from the New York Daily News, dated Nov. 4th, 1949. This debate is as at least as old as I am.

(click to enlarge)

I provided some important and worthwhile long-term perspective on this issue a few weeks ago.

Monetary policy update

With today's release of the Core PCE deflator (the Fed's preferred measure of inflation), I thought I would update some monetary policy charts. Core inflation is relatively benign at 1.6% over the past year, but it is substantially higher than the short-term rates the Fed is targeting, and that results in negative real borrowing costs. Real short-term borrowing costs are the best way to measure how "easy" or "tight" monetary policy is. By this measure, the Fed has never been so easy for so long.

The chart above shows the real Fed funds rate, calculated by using the Core PCE deflator. There are several things to note, most important being the see-saw nature of Fed policy. Fed tightening was likely the proximate cause of every recession in modern times, and it was almost always done in response to rising inflation. The Fed typically starts easing as recessionary conditions develop, and stays easy for the first few years of a recovery. But after being easy for several years, inflation typically picks back up, to be followed a few years later by Fed efforts to tighten once again. We are currently in the longest period of negative real borrowing costs. It would not be surprising to see inflation start to pick up in the next few years, to be followed by a recession a few years later.

This next chart overlays the slope of the yield curve on the first chart. Note that the yield curve slope tends to move inversely with monetary tightenings and easings. Recessions typically follow the point at which the Fed tightens policy by enough to invert the yield curve.

If there is one comforting message here, it is that monetary policy does not pose any threat to the economy. Indeed, policy is quite easy, as it almost always is during the early stages of a business expansion. Put another way, if we experience a recession in the next year or so, it will not be because the Fed has tightened too much. There is absolutely no shortage of money in the system these days.

What the Fed is doing is to actively encourage people to borrow money. Borrowing money at or near the funds rate to buy anything that is likely to rise in price even just a few percentage points a year is likely to be a profitable speculation. Leveraged investments, in other words, are almost a license to print money in this environment, and the Fed is all but guaranteeing that this will be the case for the next several years.

The good news is that investors can benefit from leveraged investments. The bad news is that this diverts capital from other areas of the economy that might be more promising. The Fed is promoting speculation, not long-term investment with this policy. Similarly, Fed policy is punishing savers in order to reward borrowers. This does not help the economy grow, and it likely is one of the reasons that growth has been disappointingly slow in recent years.

Thursday, November 29, 2012

Three under-appreciated GDP facts

Everyone knows that the economy is weak, and that this recovery has been the weakest ever. So weak that the Fed believes it is going to have to keep interest rates at zero and continue buying bonds by the bushel for the next several years. So it is rather surprising to look inside today's third quarter GDP revision and discover three under-appreciated areas of strength: nominal growth last quarter was the strongest in over 5 years, inflation is running above the Fed's target, and corporate profits are extremely strong.

As the above chart of quarterly GDP shows, in the third quarter the economy posted its fastest rate of nominal growth in over 5 years. The last time nominal GDP grew by more than Q3/12's 5.55% pace was the second quarter of 2007, when it registered 6.5% annualized growth. On a nominal basis, Q3/12 growth was a good deal better than the 4.0% average pace of quarterly growth since the current recovery started in mid-2009. And at 2.7%, real growth in the third quarter was comfortably better than the 2.2% average for the current recovery. Despite almost universal gloom, last quarter stands out as one of the best in the current recovery.

The above chart shows the quarterly annualized rate of inflation according to the GDP deflator, the broadest measure of inflation available. The latest reading for the third quarter was 2.8%, and that is above the Fed's professed inflation target of 1-2%. Taken together, both growth and inflation in the third quarter were non-threatening. So why is the Fed still panicked? 

What worries everyone, of course, is that the economy has fallen way behind where it could have been if this recovery had been a normal one, and if the economy's potential growth rate track were the same as it has been for most of the past 50 years. With an output gap (see above chart) of as much as 13%, there aren't enough jobs to bring the unemployment rate down to healthy levels. The Fed wants to close the actual/potential GDP gap since that will increase jobs and reduce the unemployment rate.

The question everyone should be asking is whether monetary policy is capable of accomplishing such a feat.  Is the economy struggling because there is a shortage of money? Can zero interest rates on cash convince small businesses to hire more people? No one really knows, but neither has anyone ever argued that monetary policy was an effective tool for generating real growth. The Fed is in uncharted territory, with regards to the magnitude of its quantitative easing efforts and the scope of its policy objective.

The chart above compares total after-tax corporate profits (as calculated by the Bureau of Economic Analysis) to the level of nominal GDP. The two y-axes are calibrated so that both show a similar range. Note how strong profits have been during this recovery, and over the past decade. The growth rate of profits appears to be tapering off, but profits are still up 4% over the past year.

As this next chart shows, corporate profits have displayed unprecedented strength in this recovery. Never before have profits been such a big percentage of GDP (with the exception of last year's fourth quarter). 

This chart of PE ratios is constructed using the S&P 500 index (normalized) as a proxy for the value of all corporate businesses (the P), and the after-tax corporate profits measure shown in the preceding two charts for the E. PE ratios by this measure have rarely been lower, even though profits have never been stronger.

For purposes of comparison, the chart above shows the traditional measure of the PE ratio of the S&P 500 index, using trailing 12-month reported earnings. Both this chart and the one above it tell the same story: PE ratios are substantially below their long-term average, despite record-setting profits. The only explanation for this anomaly is that the market apparently believes that the current level of profits is not sustainable, and that profits will likely revert to their mean (e.g., 6% of GDP) in coming years—which would entail a huge decline in nominal terms.

The chart above compares total corporate profits to nonfinancial domestic corporate profits. which make up about half of total profits. This shows that the strength of corporate profits is broad-based, since both measures have increased by a similar order of magnitude in the current recovery.

This last chart compares corporate profits to global GDP. Here we see that profits are not unusually high at all, and not much different from their long-term average. This casts doubt on the need for, or the likelihood of, a big, mean-reverting decline in profits in coming years, and that further suggests that the market may be much too pesssimistic about the outlook for profits. U.S. companies now make a much larger percentage of their profits from overseas, and that is to be expected since the world has become much more integrated and many foreign economies are experiencing exceptional growth (e.g., India, China). The global marketplace has expanded much more rapidly than the U.S. economy, and U.S. corporations are benefiting from that expansion. Over the past decade, U.S. exports have grown 40% more than U.S. GDP.

So two puzzles remain: if corporate profits are so strong and there is little reason to expect them to collapse, why are PE ratios so low, and why aren't corporations using those profits to boost GDP by investing in more plant, equipment, and personnel?

I'm compelled to note here that total after-tax profits of U.S. corporations have averaged about $1.3 trillion per year since the recovery began in mid-2009, and that this happens to be almost identical to the annual federal budget deficit over the same period. Think of it this way: corporations have generated over $4 trillion in profits during the recovery, and substantially all of those profits have been borrowed by the U.S. government to finance what for the most part has been a huge expansion of transfer payments and a shortfall of tax collections (due to the output gap and the reduced level of employment).  Corporations may not have directly funded the federal deficit, but the funds they have saved and supplied to the credit markets, being fungible, have in effect found their way into Treasury notes and bonds. Since the U.S. government is highly unlikely to be able to spend $4 trillion as productively as corporations could, much of the money has, in a sense, been squandered. Collectively, we have not spent those funds in a very productive manner, so it is not surprising at all that the recovery has proved to be unusually weak.

Of course, that still leaves unanswered the question: Why aren't corporations using their profits to expand? The only sensible answer to that is that there is still a great deal of uncertainty about the future, which in turn stems from 1) the possibility that taxes on capital could increase dramatically in coming years, 2) the fact that Obamacare imposes significant new taxes on many people and significantly higher costs on small businesses, 3) the strong likelihood that regulatory burdens will be increasing, especially with the implementation of Dodd-Frank, and 4) concerns over the ability of the Federal Reserve to reverse its massive quantitative easing program in time to avoid a significant increase in inflation. All of these represent uncertainties, higher costs, and headwinds that weigh on any business' decision to put capital at risk.

In the end, the story boils down to this: government spending is a tax, and too much of it can smother an economy's growth potential. Japan is the prime example. Having engaged in massive deficit-financed public sector spending over the past few decades (enough to make ours look tame by comparison), it is not surprising that Japan's economic growth has been much weaker than ours.

We must find ways to reduce projected federal spending, especially on entitlements, if this economy is going to regain its former luster.

Wednesday, November 28, 2012

The Laffer Curve is alive and well in the UK

The Laffer Curve (a stylized version of which is shown above) is a very simple statement about the relationship between tax rates and tax revenues. For example, the Laffer Curve says that tax rates that are too high can result in reduced revenues. The UK has just proved that this is true. A few years ago, the UK raised the top tax rate on those making more than £1 million to 50%. The result? Tax collections from millionaires fell by £7 billion. Many millionaires (perhaps as many as two thirds) left the country, while others figured out how to reduce their reported income.

Here are the facts:

In the 2009-10 tax year, more than 16,000 people declared an annual income of more than £1 million to HM Revenue and Customs.
This number fell to just 6,000 after Gordon Brown introduced the new 50p top rate of income tax shortly before the last general election.
George Osborne, the Chancellor, announced in the Budget earlier this year that the 50p top rate will be reduced to 45p from next April.
Since the announcement, the number of people declaring annual incomes of more than £1 million has risen to 10,000.
Last night, Harriet Baldwin, the Conservative MP who uncovered the latest figures, said: “Labour’s ideological tax hike led to a tax cull of millionaires."
Far from raising funds, it actually cost the UK £7 billion in lost tax revenue.

To further explain the Laffer Curve: We don't know the actual shape of the Laffer Curve (the red portion of the chart above), but we do know where three points on the curve lie: if tax rates are zero, tax revenues obviously will be zero (#1); if tax rates are 100%, tax revenues will also be zero, since no one will be willing to work (#2); and there is a tax rate "C" that maximizes revenue (#3), because it minimizes tax evasion, maximizes the incentives to work and invest, and strikes the most efficient balance between the size of the public and private sectors, thus boosting overall economic growth and increasing the tax base. Furthermore, we know that in the region "A" of the curve an increase in tax rates will lead to reduced revenue, while in region "B" an increase in tax rates will lead to increased revenue.

As Jean Baptiste Colbert once said, "The art of taxation consists in so plucking the goose as to get the most feathers with the least hissing.”

This is what the fiscal cliff negotiations now underway in Washington are all about: Will higher rates on the so-called "rich" produce increased tax revenues or not? The Democrats say they will, believing that we are in region B of the Laffer Curve, while the Republicans say they won't, believing that we are in region A.

As a supply sider, and in my experience, I think politicians too often underestimate the impact of taxes on people's incentives to work and invest. In fact, when the CBO projects the budget impact of proposed changes to tax rates, it explicitly ignores the dynamic effect of changes in tax rates, assuming that an increase in tax rates will always produce a proportionate increase in tax revenues. The UK has just proved that you can't always assume this will be true. Higher tax rates do reduce people's incentives to work harder, save, and invest, and that can lead to a weaker economy and a smaller tax base. Moreover, higher tax rates can lead to increased tax evasion, or to increased tax avoidance activities.

The UK's experience with raising taxes on the rich provides a timely lesson for our politicians in Washington. We would all be much better off if they avoided higher tax rates on the rich, and instead focused on simplifying the tax code (by eliminating or limiting deductions, loopholes and subsidies), reducing taxes on business wherever possible (consumers are the ones that ultimately pay the bulk of corporate taxes), and reducing spending, particularly on entitlement programs.

Tuesday, November 27, 2012

Confidence is up, but it's still very low

"Consumer confidence in U.S. reaches highest level in more than four years," reads the headline today. But as this chart shows, confidence is still very low; it's about as low as it was during the recessions of 1990-91 and 1980-82. But of course it's the change on the margin which is important, and that change is positive. Things are improving, even though the economy is still miserably weak.

Meanwhile, capital goods orders—a proxy for business investment—are down over 6% this year, although they have stabilized and even increased a bit in the past four months. This underscores the fact that the economy is weak, but it's not collapsing. A recession is not inevitable. Taken together, these charts also are consistent with the view that the strength in the equity market is not being driven by optimism, but rather by a gradual decline in pessimism.

Housing update: prices continue to firm

According to the Case Shiller indices of housing prices, the housing market has been consolidating for the past three years, and that comes after 3 years of the most brutal collapse in home prices in modern times. Altogether, the housing market has undergone six years of intense adjustment. With prices stabilizing (and even going up in some markets) and housing starts up fully 65% since early last year, there's ample reason to think that we've seen the worst, and that the housing market is now getting back on its feet. 

Both of these indices of housing prices show year over year gains: the Case Shiller index is up 3%, and the Radar Logic index is up 5%. Moreover, both indices are relatively unchanged for the past three years. 

From a longer term perspective, housing prices appear to have come back down to earth in a big way. Over the past 25 years, housing prices have risen only 15% more than rents, and that seems quite reasonable considering that 30-yr fixed rate mortgages have fallen from over 9% in 1987 to only 3.5% today. It's not a stretch to say that housing has never been more affordable. If anything is holding back the market now, it's the fact that banks are still risk-averse in their lending practices, and regulators have also tightened lending rules.

Monday, November 26, 2012

Gold looks expensive

Here are some charts that put the current price of gold ($1750/oz.) in perspective.

In nominal terms, gold is very close to its all-time high of $1900/oz. Since its low of $254 in early 2001, gold has risen at a compound annual rate of 17.8%. That's almost hard to comprehend, until you compare it to AAPL, which has posted an even more incredible 42% compound annual growth rate over the same period.

In constant dollar terms, gold today is below its all-time high set in early 1980. But relative to the average real price of gold over the past 100 years, gold is trading at a premium of 230%.

It's not a coincidence that periods of strongly rising real gold prices have corresponded to periods in which Federal Reserve monetary policy was "easy," and falling real gold prices only occurred when the Fed was "tight." When individuals perceive that the Fed is oversupplying dollars to the world by keeping real interest rates very low, they tend to react rationally, seeking out and paying a premium for gold for its ability to maintain its purchasing power over long periods. In contrast, when money is tight and real interest rates are high, gold loses its luster as investors prefer financial assets.

This chart compares gold to a basket of non-energy industrial commodity prices. Note that gold and commodities tend to track each other over time. But note also that the right-hand y-axis of gold prices spans a range of 250 to 2000—a difference of 8 times—while the left-hand y-axis of commodity prices spans a range of 200 to 800—a difference of only 4 times. Gold prices have been far more volatile than commodity prices.

When we compare gold prices to crude oil prices, however, the two are very close to their long-term average relationship, in which one ounce of gold buys about 19 barrels of oil. Using Arab Light crude prices, the ratio today is one ounce to 15.4 barrels, which means that gold is a bit cheap relative to crude. But that is mainly due to the fact that Arab Light crude is trading at a substantial premium (about 27%) to American crude as traded on NYMEX because of geopolitical concerns. The ratio of gold to NYMEX crude is a little less than 20 today. On balance, let's just say that gold and crude oil are trading fairly close to their long-term average relationship.

If the Fed continues its massively accommodative monetary policy, gold prices conceivably could move higher. But I think that would require some evidence that inflation is picking up, and that evidence is still lacking. In my view, gold is essentially priced to a significant increase in inflation already. The premium that investors are willing to pay for gold today (defined as the amount by which today's price exceeds the average historical real price) is almost as much as it was in early 1980, when inflation had already attained double-digit levels.

By this same logic, if the Fed were to even suggest that it is contemplating a reversal of its quantitative easing (which could be accomplished by raising the rate it pays on reserves, or by draining reserves), then gold would be quite vulnerable to losses. Gold today is a very expensive inflation hedge.

Wednesday, November 21, 2012

Financial fundamentals are quite healthy

It's curious, to say the least, that financial market fundamentals should be relatively calm and healthy at a time when the economy faces significant risk in the form of the so-called fiscal cliff. That is not to say that all is well, however, since the consensus of the market looks for years of very slow growth.

This chart of swap spreads is one of my favorite indicators, not only of systemic risk and financial market health (the lower the spread the better), but also of the outlook for the economy. Swap spreads have a record—albeit not a very long record—of anticipating changes in the health of the economy. They rose in advance of the past three recessions, and fell in advance of the past three recoveries. Currently, swap spreads are unusually low, a sign that financial markets enjoy plenty of liquidity and there is little if any fear that conditions in the financial markets or the economy will deteriorate meaningfully in the next 2 years. In short, considering the low level of swap spreads, it would be very surprising to see the economy slip into a recession over the next year.

Bloomberg has developed a "Financial Conditions Index" which includes not only swap spreads but 14 other key indicators of financial market health. Not only has this index improved significantly over the past year, it is now at a relatively high level from an historical perspective. Nothing here would suggest any deterioration in the financial market fundamentals. When financial market fundamentals are as healthy as they are today, that points to a very low probability of any meaningful deterioration in the economy.

Yet despite all the encouraging signs of financial market health, the extremely low level of real yields on TIPS suggests that the market believes that the economy is likely to be relatively stagnant over the next several years. Nominal yields on Treasuries are at rock-bottom lows as well, and both nominal and real yields are consistent with a view that the Fed will keep interest rates near zero for the foreseeable future. That, in turn, will only happen if the economy continues to struggle, and continues to suffer from a significant "output gap."

Ordinarily, the extremely low level of nominal yields that exist today would be a sign of very low inflation or even deflation. Yet as this chart shows, the expected inflation rate for the next 5 years that is embedded in TIPS and Treasury prices is more or less "normal." Expected inflation according to the Treasury market is 2.1% per year for the next 5 years, and 2.9% for the subsequent 5 years, and that is not at all out of the ordinary compared to the past 15 years. So very low real and nominal yields say nothing unusual about inflation; instead they shout out a very dismal outlook for the economy.

Consumer confidence has increased over the past year, and now stands at a post-recession high according to the University of Michigan's survey. While this is encouraging, the level of confidence is still relatively low from an historical perspective, and only slightly better than the levels we saw during the tumultuous years of the early 1980s. As I see it, consumers are saying that although we have pulled back from the abyss, the outlook remains bleak.

Healthy financial fundamentals, but miserable expectations for economic growth: quite an unusual combination that can only mean that the market is braced for a lot of bad news, as I've been arguing for a long time.

Monday, November 19, 2012

Bank lending continues to expand

This chart of C&I Loans represents bank lending to small and medium-sized business. The expansion in this important source of funding for companies unable to access directly the credit market has been impressive and ongoing for the past two years. This measure of outstanding loans is up 12.5% in the past year, and is up at an annualized rate of 11.5% over the past six months. From the post-recession lows two years ago, C&I Loans are up by almost $300 billion.

The most important takeaway here is not the volume of new loans, but the fact that the ongoing increase in new lending is symptomatic of important changes on the margin: banks are more willing to lend, and businesses are more willing to borrow. This reflects improved confidence in the future, and that in turn holds out the promise of continued—albeit relatively slow—economic growth.

Housing market continues to improve

If I had to guess, I would say that a majority of people in the country still view the housing market in a negative light. They note the still-large overhang of foreclosed properties, the still-low rate of new housing starts, and the still-depressed level of housing prices in many parts of the country. But that is looking at the market from a static viewpoint; on the margin, there have been some very important improvements in the housing market over the past 18 months. It's hard for me to believe that these changes are ephemeral—they have all the makings of a clear turnaround that is underway and likely to continue.

The chart above shows the results of a monthly survey of home builders' perceptions of current single-family home sales and sales expectations for the next six months. Even though home builders' sentiment is still below 50—which signifies that somewhat more builders still view conditions as poor rather than good—the improvement in the index so far this year has been dramatic.

There may be lots of housing inventory "waiting in the wings," but currently the number of homes for sale is relatively small compared to the current rate of sales. Again, dramatic improvement on the margin.

The chart above shows the fraction of homes for sale that are vacant. While still somewhat high from an historical perspective, there has been a significant decline in the number of vacant homes for sale this year.

As this chart shows, the stocks of major home builders have increased significantly from their lows of October 2011—up 94%. Stocks are still depressed from their bubble highs of 2005, but the recovery from the lows has been dramatic.

UPDATE: October housing starts handily beat expectations. As the chart below shows, residential construction is unquestionably in the midst of a genuine recovery. Starts are up 65% since the end of 2010, and have soared by 42% in just the past year. In retrospect it's easy now to see that the housing construction began its recover sometime around the middle of last year. We are still in the early stages of the turnaround in the housing market, but it's for real.

How Federal largesse traps the poor

Welfare, food stamps, the earned income tax credit, and healthcare insurance subsidies are all designed to help the poor and even much of the middle class. But the unintended consequence of these income assistance programs (i.e., transfer payments) is that they make it much harder for people to work their way out of poverty. That's because all that money being handed out has to be taken away as people climb the income ladder, and that has the effect of increasing marginal tax rates.

This chart, courtesy of the Congressional Budget Office, comes from a new study of effective federal marginal tax rates. The top range of each of the bars is the effective marginal tax rate faced by some people in various income groups covering 80% of all taxpayers. Note that some of those making 100-149% of the poverty rate face marginal tax rates of as high as 60%!! If someone at the poverty line wants to work harder, he or she may only be able to keep 40 cents of each additional dollar earned.

On average, the vast majority of workers have effective marginal tax rates of 30%. As Greg Mankiw notes, "In 2014, after various temporary tax provisions have expired and the newly passed health insurance subsidies go into effect, the average effective marginal tax rate will rise to 35 percent." That is almost as much as the marginal tax rates of the rich.

As the chart above shows, average tax rates for the poor are relatively low, with 80% of taxpayers in 2007 paying an effective average tax rate of between 4% and 17%. We do indeed have a very progressive tax code if all you look at are average tax rates (i.e., total taxes divided by income). But it's marginal tax rates which have the greatest impact on incentives, and marginal tax rates are much higher than average rates under a progressive tax system loaded with subsidies. On a marginal basis, our income tax is actually regressive—the poor face marginal tax rates that are much higher than those faced by the rich.

Although the CBO study is an eye-opener, the reality for some people could be even worse. In a post last year, I quoted Daniel Kessler's WSJ article, in which he describes the punitive marginal tax rates (higher than 100%!) that will be faced by some families if ObamaCare is implemented:

Starting in 2014, subsidies will be available to families with incomes between 134% and 400% of the federal poverty line. For example, a family of four headed by a 55-year-old earning $31,389 in 2014 dollars (134% of the federal poverty line) in a high-cost area will get a subsidy of $22,740. A similar family earning $93,699 (400% of poverty) gets a subsidy of $14,799. 
But a family earning $1 more—$93,700—gets no subsidy. Consider a wife in a family with $90,000 in income. If she were to earn an additional $3,700, her family would lose the insurance subsidy and be more than $10,000 poorer.

There is no getting around it: a highly progressive tax system that relies on subsidies and other income assistance for the poor and even upper-middle income earners will inevitably yield very high marginal tax rates. This makes climbing the income ladder more difficult, and effectively "traps" many of the poor. Why work harder if you can only keep a fraction of the extra income?

Greg Mankiw also provides a reasonable solution:

... we could repeal all these taxes and transfer programs, replace them with a flat tax along with a universal lump-sum grant, and achieve approximately the same overall degree of progressivity.

UPDATE: John Cochrane has an excellent post that nicely expands on the issue of how marginal tax rates for the poor have become prohibitively high, with several real-world examples and more charts. Simply put, very high effective marginal tax rates for those on the low end of the income spectrum end up trapping many people in poverty. The Law of Unintended Consequences is very much alive and well.

UPDATE 2: Here is an excellent presentation by Gary Alexander (Secretary of Public Welfare, PA) that illustrates how disastrous our welfare system is. More importantly, however, it also shows how this can be fixed relatively easily. Here are two charts from the presentation that show how welfare programs create "welfare cliffs" that result in marginal tax rates that exceed 100% (translation: many families on welfare find that they are better off working less than working more, since earning more can cause their disposible income to decline). (click to enlarge) HT: Brian McCarthy

Saturday, November 17, 2012

In your pocket

Couldn't resist posting this. Your typical smartphone now includes a built-in computer, TV, CD player, DVD player, stereo, still camera, video camera, video editor, photo editor, darkroom, phone, typewriter, calculator, radio, inertial guidance system, GPS, complete maps of the world, global library, encyclopedia, interpreter, newspapers, magazines, photo albums, rolodex, video games, multiple listing services, accounting services, remote controls, barcode scanner, portfolio management, stock ticker, travel agency, medical reference library, stargazer, mail-order catalogs, flight simulator, textbooks, math tutor, alarm clock, weather station ... . This would have been inconceivable just 10 years ago. HT: Mark Perry.

Friday, November 16, 2012

SNAP is out of control

The Food Stamp program (officially know as the Supplemental Nutrition Assistance Program, or SNAP) was created in 1969. That year there were only 2.88 million people enrolled (1.4% of the population), and their monthly benefits were $6.63. Today the number of people receiving Food Stamps has exploded to over 47 million (15% of the population), and the monthly benefit is $134. In 43 years, the size of the program has increased 1,450% (an annualized growth rate of 6.6%, more than double the rate of growth of the economy), and the cost has increased by 315,000% (an annualized growth rate of over 14% per year). If this is not an example of a government program begun with good intentions but now out of control, I don't know what is.

There is plenty of blame to spread around here, but the worst of the outsized growth of this program started about 10 years ago.

The above chart shows the number of people receiving food stamps since the program's inception. Note that there were two periods of exceptionally fast growth since then: 1970-75, and 2002-2012. From 1975 through 2001 the number of people receiving food stamps did not go up at all. I'm willing to ignore the rapid growth in the first six years of the program, since it likely has a lot to do with getting the program up and running and spreading the word about its availability. From the late 1970s through the late 1990s, the program functioned pretty much as one would expect: adding people during recessions, when times are toughest and unemployment rises, and shedding people during recoveries, as unemployment declines. But over the past 10 years the program has just grown and grown. Since the end of the 2001 recession, the number of people receiving food stamps has increased 173%, or 9.5% per year.

This next chart shows total spending on the SNAP program. Since the end of the 2001 recession, the cost of this program has surged by 345%, or 14.5% per year. That's so far out of line with growth in the economy (1.7% per year annualized) and inflation (2.2% per year annualized) that it simply screams for attention. Monthly benefits have increased at an annualized rate of 5.4% over this same period, more than twice the rate of inflation.

Has the economy deteriorated in the past 10 years by enough to justify the enormous growth in the size and cost of this program? I don't see how it could have. But I can see how the uncontrolled growth of this program has contributed to the generally slow growth of the economy over the past decade. As government grows, and as the number of people who depend on government grows, the private sector gets squeezed and the percentage of people of working age who want to work declines. Federal government spending relative to GDP has grown from 18.3% at the end of 2001 to 22.8% today; that's a 25% increase in the relative size of the federal government in just 11 years, and the bulk of that increase takes the form of transfer payments, such as food stamps. The percent of the population working or wanting to work has declined from a high of 64.7% in 2000 to 58.8% today.

 Soaring spending on food stamps is just one small part of an expanding entitlement state in which each person working ends up supporting more and more people who are not working.

Needless to say, this is not a formula for a strong economy.

This chart shows monthly data (which is not available prior to late 2008) for the past four years. The number of people receiving food stamps has jumped by 53%! If there is any silver lining in this otherwise very dark cloud, it is that the growth in the number of people receiving food stamps has slowed significantly in the past year or so.

In April 2009, a 17% increase in monthly benefits (from $114.67 to $132.21) gave a significant boost to the overall cost of the program, which has increased 70% in just the last four years (14% per year).

It's time to blow the whistle on SNAP. No government giveaway of this magnitude can happen without significant fraud and corruption, and anecdotal evidence of that abounds. What really needs to happen, however, is a complete re-examination of the underlying premises and objectives of this program. When government hands out food stamps to almost 1 out of every 7 inhabitants of this country, something is very wrong. This was never part of the original intent of the SNAP program, and government was never supposed to become such a huge part of people's everyday lives. If we can't fix this, the economy will only get weaker and weaker with time.

Thursday, November 15, 2012

Reading the market tea leaves: lots of bad news is priced in

As the world waits to see how politicians figure out how to avoid the looming "fiscal cliff," nerves are on edge. Even though the risks of failure perhaps might not be high, the consequences of failure could be very serious. Moreover, politicians might avoid the fiscal cliff but still implement policies (e.g., sharply higher tax rates on small businesses, the engine of jobs growth) that could hamstring the economy.

Now is a good time to look once again at key market indicators that can help us understand how much bad news is already priced into the market. As I see it, the market is already braced for an unpleasant outcome to the fiscal cliff negotiations. That's not to say that we should expect an unpleasant outcome, but rather to say that should the outcome be unpleasant, that would not necessarily be bad news.

The above chart compares the real yield on 5-yr TIPS to the running 2-yr annualized growth rate of real GDP. The underlying premise of the chart is that government-guaranteed real yields that are available for purchase in the TIPS market can tell us a lot about the market's expectations for real economic growth. If I buy a 5-yr TIPS bond today, I have locked in a risk-free real rate of return of -1.4% per year for the next 5 years. Don't be quick to dismiss the importance of this; TIPS prices are not distorted. The spread between 5-yr TIPS real yields and 5-yr Treasury nominal yields is just over 2%, which means that the market is expecting the CPI to average about 2% per year for the next 5 years, and that is not unreasonable at all, considering that the core CPI has risen at an annualized rate of 1.7% over the past 5 years, and the CPI has increased at a 2.1% annualized rate over the same period.

Apparently the market is quite content to lock in a guaranteed loss of purchasing power with TIPS. I think that only makes sense if you accept that the market is willing to do this because there is a lot of fear out there that buying and holding any riskier asset is likely to mean real returns in coming years that are disappointingly low. By inference, if the market expects real returns on risk assets to be very low (perhaps even negative) over the next 5 years, then the market also expects the real growth of the economy to be very disappointing. That's precisely what the above chart shows: the current level of TIPS yields is consistent with real GDP growth that is close to zero over the next 5 years. That could be variously interpreted of course: it might mean 2 years of recession followed by 3 years of a moderate recovery, or it could be just total stagnation.

Note how in the chart real TIPS yields do a pretty good job of tracking the growth rate of the economy over the past 15 years. When economic growth was robust in the late 1990s, TIPS yields were very high; and with growth rates slipping to the current 2%, TIPS yields have declined.

And it's not just the bond market that is pessimistic. As the chart above shows, the stock market's confidence in the stability of earnings has also tracked the real yield on TIPS. As the real yield on TIPS has fallen over the years (shown here inverted), the earnings yield on the S&P 500 has risen (and the market's PE ratio has fallen). Why would the market today be priced to an earnings yield of 7.3%, when real yields on TIPS are -1.4%? The only way that makes sense is to accept that the market is demanding a very high equity earnings yield today because it expects earnings to be much lower tomorrow. If the market had any confidence at all in the stability of earnings going forward, then PE ratios would be higher (at least above their long term average of 17) and earnings yields would be lower—at least below the current 4.5% yield on BAA corporate bonds.

CDS spreads tell the same story. Credit default swaps are a very liquid market and a very good indication of the market's confidence in the future health of the economy. CDS spreads today are at the same level they were just prior to the onset of the Great Recession. The market is obviously concerned that default risk is relatively high, and that only makes sense if the market also worries that the economy might experience another recession. 5-yr high-yield bonds are trading with yields that are 6 percentage points higher than 5-yr Treasuries because the market thinks that there is a significant risk that corporate defaults will be troublesome in the years ahead, and that is only likely to happen if the economy is very weak.

When 10-yr Treasury yields are trading at extremely low levels (these bonds have almost never been so expensive), it's a safe bet that the world is very risk-averse.

And it's not just the U.S. that is in trouble, according to market expectations. As the above chart shows, sovereign yields in the U.S. and Germany are converging on the yields of that paragon of miserably slow growth, Japan. The market is behaving as if the world's major developed countries are going to be experiencing the same stagnate growth as Japan, which has suffered zero net growth since the end of 2006 (as compared to 4.4% growth in the US over the same period) and annualized growth of only 0.7% over the past 10 years (as compared to 1.6% in the US over the same period). Note also, for comparison purposes, that 5-yr real yields on Japanese inflation-indexed bonds are -0.6%. Negative real yields and extremely low nominal yields all point to one thing: a market that expects agonizingly slow growth to prevail—much slower than we have seen in recent years.

If extremely low 10-yr Treasury yields are symptomatic of miserably low real growth expectations, and if the Vix index is a good proxy for the market's level of fear, then the ratio of the Vix index to 10-yr Treasury yields (shown in the chart above) is a good indicator of how worried the market is about  the future level of growth. The Vix/10-yr ratio has spiked during every major crisis in the past few decades, and although it is significantly lower today than it was at the height of the 2008 meltdown—when the market fully expected a global financial market collapse and years of depression and deflation—it is still extremely high by historical standards. In short, this indicator suggests that the market is quite fearful of another recession.

Finally, the above charts show how investors are voting with their feet. Equity mutual funds continue to experience heavy outflows, while bond funds continue to experience strong inflows. This is a picture of a market that is very worried about the future and very concerned about seeking shelter.

If there is one thing out of place in this picture of a market obsessed with concerns about growth, it is swap spreads. Swap spreads have been excellent coincident and leading indicators of the fundamental health of the financial market and of the economy. As the chart above shows, swap spreads rose well in advance of each of the last three recessions, and declined well in advance of the onset of recoveries. Today swap spreads are unusually low, which is telling us that the fundamentals of the economy are not in the least shaky. Systemic risk—actual risk as perceived by market participants—is very low. The wheels are not about to come off this economy. The best explanation for why so many indicators point to troubles ahead but swap spreads say everything is fine, is that the market is very worried about something that has not yet even begun to happen. And it might not happen, either, if swap spreads are still good leading indicators.

In short, as I see it, the market is priced to lots of bad economic news that has yet to hit the tape. The market may end up being right, of course, but there are reasons to think that the market may be too pessimistic. At the very least we know that the market has had plenty of time to work itself into a frenzy of concern, since there is no shortage of things to worry about: political gridlock in Washington, a president who is anti-business and anti-wealth, trillion-dollar deficits for as far as the eye can see, a Middle East in turmoil, a huge increase in regulatory burdens, the onset of ObamaCare—which promises wrenching adjustments for one-sixth of the nation's economy, millions of underwater mortgages, and monetary policy that is far advanced into uncharted territory, to name just a few. It should not be surprising or controversial to discover that, in a time bad news is in plentiful supply, that the market is priced to pessimistic assumptions.

If you're worried about the future, you have plenty of company. If you're seeking refuge and protection, it's extremely expensive. The world is braced for lots of things to wrong. As I mentioned last August, it might make sense instead to worry about something going right.