Thursday, March 21, 2013

Why is everyone so gloomy?

It's fashionable to lament the economy's very slow recovery, which by some measures—notably the number of new jobs created—is the weakest in modern times. Even the Fed has succumbed to the pessimism that pervades the bond and stock markets. Yesterday the FOMC members revised downwards (albeit only slightly) their forecasts for growth. Real GDP this year is now expected to grow 2.3 – 2.8%, vs. a Dec. 2012 forecast of 2.3 – 3.0%; real GDP next year is projected to grow 2.9 – 3.4%, vs. an earlier forecast of 3.0 – 3.5%; and real GDP in 2015 is expected to grow 2.9 – 3.7%, vs. an earlier forecast of 3.0 – 3.7%. Over the longer run, the FOMC continues to expect growth of only 2.3 – 2.5%. I've used the average of those forecasts to generate the chart below.

If the FOMC members are right, then the economy is never going to return to its previous full-employment potential. For the 50 years leading up to the last recession, the U.S. economy grew at an annualized rate of about 3% per year. You can see that in the green line on the above chart. The FOMC's forecast (orange line) says we'll never return to that growth path. If that's not a pessimistic outlook, I don't know what is.

This pessimism can be seen in the TIPS market as well. 5-yr real yields on TIPS are trading at -1.72% today. That means that the purchaser of these TIPS (and by the way, the Fed is not buying TIPS at all, so it is arguable whether the Fed is artificially depressing TIPS yields) knows up front that he is guaranteed to lose 1.72% of his purchasing power every year for the next 5 years. Presumably, it only makes sense to enter into this transaction if one is extremely worried that alternative investments will yield even worse results. Furthermore, there is a form of arbitrage between the real yield on TIPS and the real growth of the U.S. economy. If one thought that the economy were going to grow 4% a year, would it make any sense at all to buy TIPS with a real yield of -1.72%? No, because an economy growing 4% a year is almost certain to throw off real returns that are well in excess of zero: it would thus be much better to buy a basket of stocks than to buy TIPS. As the chart above suggests, today's negative yield on TIPS is consistent with a market that expects real growth in the economy to be close to zero for the next few years. Note that when the economy was posting 4-5% real growth in the late 1990s, TIPS yields were 3-4%. If the Fed were absolutely confident that the economy would grow 2-3% over the next several years, would they be comfortable keeping short-term rates at zero? No. Which means that even though they "expect" real growth to be modest, deep down inside the FOMC members are very worried that if they don't "do something" growth might be closer to zero than to their current projections.

There are other telltales of gloom as well. The PE ratio of the S&P 500 is currently just over 15. That is significantly below its average of 16.6 since 1960, especially when you consider that corporate profits as a % of GDP are very near their all-time high. The only explanation of these facts is that the market expects profits to decline significantly in coming years. 30-yr Treasury yields—which are difficult if not impossible for the Fed to influence directly—are trading at just over 3%, which is very near their lowest level on record. Who would buy a 30-yr T-bond at 3% if he or she didn't expect nominal GDP growth to be 3% or less? With long-term inflation expectations fairly stable at 2.5%, that means long bonds are priced to the expectation of a miserable 0.5% annual real growth for as far as the eye can see. 

For some reason, almost everyone—including the FOMC—seems to be assuming that the world changed dramatically in the year 2008, when the labor force participation rate (the percentage of the population that is either working or looking for work) suddenly started to decline, from 66% to today's 63.5% (see the second chart above). At the same time, growth in the labor force (those working or looking for work) flatlined. Call it the "new normal" if you will. But does this really have to be permanent? Demographics don't change like that overnight; perhaps the decline in the participation rate has more to do with a change in the incentives to work. 

As the chart above shows, there was a sharp increase in the number of people receiving food stamps that began in early 2009. The number had been relatively flat for the previous two decades, but in the past four years the number of food stamps recipients has jumped by 50%. Two factors probably explain explain this: 1) the severity of the economy's decline in the 2008-09 recession, and 2) a relaxation of eligibility standards which took effect in the early weeks of the Obama administration. Although the average benefit per household today is only $277, it is possible that this has reduced the incentive of many workers to seek and accept a new job. But it's not a very convincing argument. 

You've probably heard the stats: since Obama became president just over four years ago, there has been a net increase of only 1.4 million jobs, while the number of people receiving disability benefits has increased by 1.6 million. But as the chart above shows, the number of people receiving disability benefits has been growing at a fairly steady pace for the past 20 years: about 4% annualized per year (and I hasten to note that the number is up only 2.1% in the past year). Nothing unusual happened in this program that might explain the sharp decline in the labor force participation rate beginning in 2008. That's not to say we don't have a problem with the disability program, whose ranks have been increasing four times faster than the population for the past two decades, because we do. It's just that this has been an ongoing problem for a long time. 

The chart above shows that there was a huge increase in federal spending as a % of GDP that began in late 2008. As I noted in a post last October, over 75% of the $840 billion allocated to "stimulus" spending in the 2009 ARRA was essentially devoted to transfer payments: taking from one person and giving to another. Only 8%, or $65.5 billion, was spent on transportation and infrastructure projects. In the post-war era, we have never seen an increase in government spending of this magnitude. So much money was handed out in such a relatively short period that it could conceivably have caused perverse incentives (e.g., rewarding those who weren't working) that encouraged people to "drop out" of the labor force. But when you consider that the huge increase in government spending was accompanied by a huge increase in regulatory burdens (e.g., Dodd Frank, Obamacare) and a huge increase in expected future tax burdens (a direct result of the doubling of the federal debt/GDP ratio since 2007, from 37% then to over 75% today—see second chart above), then we probably have enough ingredients for this to be an important driver of the tepid jobs market.

In short, companies are holding back on their hiring plans, worried about regulatory burdens and big increases in mandated costs. And many individuals have probably decided that the rewards to working harder or returning to work are outweighed by the costs (e.g., higher taxes) to doing so. (I for one have decided I'd rather work for free on this blog than pay a 65% marginal tax rate on any new income I might generate from starting a small business.) This article has a nice summary of what Obamacare means for many colleges and many small businesses: sharply increased personnel costs, reductions in hours worked, layoffs, increased disincentives to work. One can only begin to imagine the depressing effect of the prospect of significant increases in future tax burdens that have resulted from the huge increase in our federal debt burden in recent years: after all, spending is taxation, even if it is deficit-financed. And then there is the strong likelihood that much of the increased federal spending in recent years has been a waste of our economy's scarce resources. We've taken over a trillion dollars a year for four years and essentially flushed them down the toilet, spent on things that do not increase the economy's productivity and that reward leisure or inactivity instead of work or entrepreneurial risk-taking.

The huge growth in the size, scope, and burden of government is thus the most likely explanation for why we are living through a disappointingly slow recovery. There is hope for the future, however, since federal spending as a % of GDP is already down significantly in the past two years, and the federal deficit has already declined significantly as well (in both nominal terms and relative to the size of the economy), thanks to very slow spending growth and the ongoing recovery, which has boosted tax revenues. But for significant progress towards a healthier economy we will likely need to see outright reductions in regulatory burdens and in the growth of spending, particularly entitlement spending.


poobserv said...

I don't write off the effects of stupid incentives at the margin which cause people to make poor choices, but, there is an alternate possibility that explains the slow growth. The US financial system has had to rebuild financial system reserves. They destroyed massive amounts of capital and reserves by their corruption and malinvestment in rent seeking financial products. The corrupt litany of sub prime loans, liar loans, slicing and dicing risk etc is sickening. The list of stupid financial products that created little or no value (Asset backed securities, mortgage backed securities etc) is also sickening.

Everytime the financial system wrote off a bad loan or failed security product it, they reduced their reserves. Fortunately, the US government tided them over the bad parts until they could generate enough profits to stabilize the system.

It appears that a lot of these dumb investments have been written off and the tidal wave of foreclosures has crested. Unsurprisingly, things in the US appear to be slowly starting to improve.

Scott Grannis said...

The financial crisis of 2008 was the result of a lot of bad decisions, but I don't think the banks get all of the blame or even a good share of the blame. I strongly recommend you read the excellent book "The Financial Crisis and the Free Market Cure" by John Allison.

Anonymous said...

People are gloomy because they want to be. All you need to do is read a lot of the comments on the various financial websites (Marketwatch, Business Insider, Seeking Alpha, etc), and you'll quickly learn that there's a big segment of the population which REFUSES to believe anything resembling a recovery could possibly be in place. These people tend to despise Obama almost to a passion, and ditto for Bernanke. Some of them also seem to hate banks and bankers (you can identify these people, they call banker "banksters" and are usually gold bugs), and they also hate government. Pretty much every ingredient for them to be in the pits of gloom is there. If we even had a republican president they likely wouldn't be so gloomy.

It's pretty much all about politics and ideology.

Gloeschi said...

Jesus Christ, Scott, of course the Fed is buying TIPS:
Under operation Twist they bought 60% of net issuance in the 20yr+ TIPS market. Please!

Benjamin Cole said...

Nice authoritative wrap up.

And this marks the first time anyone, anywhere, ever called me "fashionable."

Yes, I am cautiously pessimistic. The Fed is dithering, not being bold enough in its use of QE. We are somewhat imitating Japan.

Japan was at the top of the world in the late 1980s, early 1990s. Japan, Japan, Japan.

Since 1992, you can forget about Japan. Equities, property down 80 percent. Real wages off 15 percent. Persistent mild deflation.

I completely agree on shrinking the federal government.

But, consider: In the 1960s, more than half of the US labor force was unionized. The top federal income tax rate was 90 percent. Banks were so regulated they could only offer passbook accounts, which had regulated rates. Your stockbroker charged a fixed commission for trades. Your airline charged regulated rates, and your trucker, and railroad and phone company. international trade was a sliver of the national economy.

Now the top income tax rate is 36 or 38 percent. Transportation, telephones and the financial industries much deregulated. Int'l trade is huge. The private sector is nearly totally deunionized.

Why did we boom in the 1960s? The Fed was aggressive. Perhaps too aggressive, setting off inflation.

But if the Fed could get us growing in the hamstrung 1960s, imagine what they could do now.

It win;t the size of the federal government that is killing us, though I would gladly take a smaller one. It is the Fed.

Scott Grannis said...

Re: TIPS and the Fed. As Gloeschi notes, I made a minor mistake in saying the Fed does not buy TIPS. The Fed actually bought $10.2 billion worth of TIPS in the past year.

According to Treasury, that represents less than 2% of the outstanding value of TIPS, which in turn represent about 8% of total Treasury debt held by the public. Presumably the Fed was concentrating its purchases of Treasuries in longer maturities, and bought very little, if any, of the 5-yr issue I was referencing. There is $45 billion of that particular issue outstanding.

My point remains this: the Fed is not distorting the price of TIPS nor their yield. The yields on TIPS and Treasuries are quite consistent with each other and with the market's inflation expectations and with the yields on virtually all of the many tens of trillions of bonds outstanding in the world. I cannot detect any evidence of manipulation or distortion in Treasury pricing that might be attributed to the Fed's purchases, which this year might be as much as half of the new Treasuries issued, but no more 5% or so of the Treasuries held by the public.

Bonds are fungible, which means that older issues are virtually perfect substitutes for new issues. Thus, in order for the Fed to distort the price of newly issued bonds it must also distort the price of all the bonds previously issue. And since all the bonds outstanding in the world are priced relative to Treasuries, to distort the Treasury market the Fed must distort the valuation of the entire global bond market, which is many tens of trillions of dollars in size.

I fail to see how the Fed can manipulate the valuation of tens of trillions of bonds with purchases that amount to only a tiny fraction of the total. This argument goes double for TIPS.

Gloeschi said...

So if it doesn't influence yields, why do you think the Fed keeps spending $1 trillion annually?

Scott Grannis said...

Because they don't want to be blamed for not doing everything possible to ensure a recovery. And because their efforts have been driven by the world's seemingly voracious demand for safe cash equivalents (reserves, which are similar to T-bills). In short, they've been struggling to keep up with the huge demand for money. And in the process they think maybe they bring long-term rates down a bit.

theyenguy said...

Invesors have reason to be gloomy as a stock market top has been reached, and that shock, or at least slip events are coming soon to cause investors to derisk and deleverage out of stocks.

Jesus Christ, is God’s economic and plan administrator for every dispensation, that is for every age, as presented in Ephesians 1:10. He has shifted the tectonic plates of sovereignty that produce seigniorage, that is moneyness, has broken the bedrock of prosperous financial experience, and has terminated the experience of the US Dollar, as being the international reserve currency, with the result that the diktat money system is rising to provide diktat as currency, money, wealth and power.

More specifically, we are witnessing the fulfillment of bible prophecy in the news, as the Beast Regime of Revelation 13:1-4, which is destined to have headship in all of the world’s ten regions, as regional governance ..... and dominate in all of mankind’s seven horns, that is institutions, as totalitarian collectivism, and debt servitude ..... is rising not only from the Mediterranean nation of Greece, but now also from the Eastern Mediterranean Sea island of Cyprus; this monster will replace the Banker Regime that came into existence in 1931 with the Federal Reserve Act.

For the week ending March 22, 20123, World Stocks, VT, traded 0.6% lower, Nation Investment, EFA, -0.8%, Small Cap Nation Investment, IFSM, -0.6%, and Global Industrial Producers, FXR, -0.7%, reflecting that an inflection point for risk markets was reached, and indicating that the world has entered into a global bear stock market, as Cyprus leaders and EU Finance Ministers wrangled for a solution to prevent a sovereign default in Cyprus.

Confirmation of a global bear stock market comes from The Morgan Stanley Cyclicals, $CYC, trading 0.9%, lower, Transports, IYT, -1.3%, Industrials, IYJ, -0.7%,global Industrial Producers, FXR, -0.7%, Small Cap Pure Value, RZV,-0.9%, and Small Cap Pure Growth, RZG -0.9%

The EUR/JPY traded lower this week and Action Forex, which surprisingly is long term bullish this carry trade, reports a close at 124.91. Carry trade investing has coming to an end, as reflected in the consolidation triangle seen in the chart of the Optimized Carry Traded ETN, ICI.

Monetization of debt by the world central banks has commenced debt deflation globally. With the trade lower in Major World Currencies, DBV, and Emerging Market Currencies, CEW, competitive currency devaluation is underway. Inasmuch as the US Dollar, $USD, is trading higher and currencies trading lower, the Milton Friedman Free To Choose Floating Currency System, also known as the Fiat Money System, is an epitaph on the tombstone of Liberalism. The diktat money system, where diktat serves as currency, money, and power is being established as Authoritarianism’s Banner.

Risk aversion has commenced, as is seen in the Risk On ETN, ONN, falling, and the Risk Off ETN, OFF, rising. Volatility, ^VIX, is rising with VIXY and VIXM trading higher. Investors will be massively disinvesting out of stocks, and deleveraging out of carry trade investments. A see saw destruction of fiat wealth is underway, as bonds, BND, have traded lower and now stock, VT, are trading lower on falling currency values. The age of fiat asset deflation is underway. The Proshares 200% ETFs seen in this Finviz Screener are trading higher; and the Direxion 300% ETFs seen in this Finviz Screener are trading higher as well. As Liberalism’s Inflationism is giving way to Authoritarianism’s Destructionism, the world is pivoting from credit based prosperity to debt servitude based austerity.