Thursday, October 31, 2013

Financial conditions reach a new high

Bloomberg's index of financial conditions reached a new all-time high today. Swap, muni, agency and credit spreads are generally low, liquidity conditions are excellent, the yield curve is positively sloped, implied equity index volatility is relatively low, and yields on Treasuries and corporate bonds are relatively low. With financial market conditions are as positive as they are now, a near-term recession is highly unlikely. I note that this index turned down more than four months before the last recession, and years before the 2001 recession.

Federal budget outlook continues to improve

Thanks to four years of zero growth in federal spending (the single best achievement of our currently divided government), strong tax receipts (mostly due to economic growth, with an assist from higher tax rates), the U.S. federal budget deficit has declined from a high of just over 10% of GDP in 2009 to just over 4% of GDP today. This calls for a huge sigh of relief.

The first chart showed spending and revenues as a % of GDP, while the chart above shows nominal spending and revenues. Federal spending has surprised nearly everyone by failing to grow over the past four years, while tax revenues have risen by 37%.

Accelerated realizations of capital gains and income were clearly a factor boosting revenues in the latter part of last year and last April, but as the chart above shows, the increase in tax revenues has been ongoing for the past three years: nearly every month has seen higher revenues on a year over year basis. The fundamental driver of revenue growth is economic growth: more people are working every month, and incomes are rising; a growing tax base is predictably generating higher revenues. This has happened in every recovery.

The budget deficit is still very high from an historical perspective, but it is also well within the range of what is manageable and sustainable. If current trends were to continue, the budget would be balanced within the next 3 years! (Interesting note: in a January 2011 post, I suggested that the improvement already evident in the budget outlook at that time could result in a balanced budget by 2016. Things have evolved accordingly.)

There's lots of good news to be found here. On the one hand, Congress has managed, for whatever reason, to rein in the growth of federal spending. Four years ago it was out of control, but now spending is back within historical ranges relative to GDP. On the other hand, we've seen a significant amount of fiscal retrenchment in the past four years, yet the economy has managed to grow. Keynesians four years ago would have been apoplectic at the thought of reducing the deficit from 10% of GDP to 4% of GDP in four short years, but it turns out the sky has not fallen. Looking ahead, Congress now has more freedom of action because the budget is in much better shape. If done right, fiscal policy could become genuinely stimulative (e.g., simplifying the tax code and reducing marginal rates) in coming years.

Tuesday, October 29, 2013

The big news is what's not happening

As government bureaus gradually reduce the list of delayed statistics, and as we get a better picture of what happened in the economy last September, the big news is that nothing much has changed. The economy was growing moderately/modestly (disappointingly slow for just about everyone's tastes), and it's probably still disappointingly slow. But as I've been saying since January, from an investor's perspective, avoiding recession is all that matters. The big news, in other words, is that the economy is not getting weaker, nor is it entering a recession. It's still growing, and that's good news given market pricing.

When the yield on cash is essentially zero, and when the yield on default-free, 2-yr Treasury notes is not even 0.5% per year, whereas the yield on riskier investments is far higher (see chart above), the market is effectively braced for a recession or at the very least for some rough sailing. This may not be what the opinion polls say or what the surveys of investor optimism or pessimism report, but it is the message of market pricing. In the absence of extraordinary volatility, markets at any given time are in an equilibrium: right now the world's investors are just about indifferent between earning nothing on cash and only 0.3% per year on 2-yr Treasuries, or 4-8% on corporate bonds and stocks. Behind that relative indifference lies the expectation (or fear) on the part of the owners of tens of trillions of dollars of cash that even though corporate stocks and bonds promise significantly higher yields, the downside risk of holding those riskier investments is so great that the extra yield they offer is not worth the risk. The risk/reward expectation for stocks, in other words, is only marginally enticing to investors (we know that because stock prices are rising), even though the alternative is quite unattractive. Stocks are moving higher because, on the margin, there are more investors opting to take on a bit more risk. The longer we go without a recession or a significant economic setback, the more this will be the case.

For an investment in cash to break even with an investment in equities, for example, equities would have to decline in price by at least 8% (i.e., by enough to offset the dividend yield of almost 2% and the expected increase in earnings of 6%, which is the current capitalized value of earnings). That's not impossible, of course, since stocks routinely go up and down by several percentage points every week, and there was a 5.8% correction in the S&P 500 in the second quarter of this year. But in exchange for this moderate volatility, an investor who held a position in the S&P 500 for the past year has made a total return of 28%.

Back to the latest economic releases: Retail sales were a bit weaker than expected, but they continue to rise at a 3-4% annual pace.

Subtracting the more volatile sectors, and looking at long-term trends, we see the same picture in retail sales that we see in nominal GDP: there has been a huge shortfall of growth that followed in the wake of the Great Recession, and growth since then has been sub-par. But it's still growth.

Housing prices staged a pretty impressive recovery this past summer, but things have been cooling off since, mainly due to higher mortgage rates. Still, it sure looks like we've seen the worst for the real estate market.

In real terms, the recovery in housing prices hasn't been quite as impressive, but prices today are still substantially higher than they were in the mid-1990s, thanks mainly to much lower mortgage rates. The rise in mortgage rates of late has been a negative, but from a long-term perspective housing is still very affordable. That argues for slower growth in prices for awhile, but not another decline.

Equities are up at strong double-digit rates over the past year, and that has many folks screaming "bubble!" Corporate profits now stand at all-time highs, so the market is not necessarily crazy, but a portion of the gain in equity prices this year is due to an expansion of multiples. Yes, people are finally starting to pay up for a dollar of earnings. Are things getting out of line? Hardly, as the chart above suggests. PE ratios are now exactly equal to their long-term average. When PEs get to 20 or more, then we can talk about whether stocks are in a bubble.

U.S. banks currently have over $7 trillion in retail savings deposits, and that represents about two-thirds of the M2 measure of the money supply. That's the highest ratio of savings deposits to M2 that we've ever seen.

At the same time, the ratio of M2 to nominal GDP is also the highest we've ever seen, as shown in the chart above. The huge accumulation of cash, cash equivalents and savings deposits shown in these charts is the measure of just how risk-averse the world still is, especially considering the almost-nonexistent yield on cash and cash equivalents. In short, there's an awful lot of cash out there that is proving to be very embarrassing.

As I said back in January, the Fed's QE bond purchases and zero interest rate policy are designed to convince investors that holding cash doesn't make sense. This message is driven home every time there is an economic data release that shows the economy is continuing to grow, however slowly. The world can't make its cash holdings disappear, of course, but on the margin investors are trying to reduce their cash holdings in favor of the much higher yield on riskier assets. This results in a change in relative asset prices which will ultimately drive the yield on cash higher as the yield on riskier investments declines (i.e., as the prices of riskier assets rise).

Monday, October 28, 2013

Industrial production improves

It's old news by now, but today we learned that U.S. industrial production in September was stronger than expected (+0.6% vs. +0.4%), and registered a 3.2% increase year over year. That's decent, unspectacular growth which shows no sign of stagnating or declining. By now, it's very likely that the industrial side of the U.S. economy has fully recovered—after more than four years—to its pre-recession levels and is breaking new high ground. As the above chart shows, the Eurozone has fallen significantly behind the U.S., but appears to be firming of late. It's safe to say that the recent Eurozone recession is over and a modest recovery there is underway.

A comparison of U.S. to Eurozone equities show just how significant the shortfall in Eurozone industrial production has been. The PIIGS sovereign debt crisis and its attendant uncertainties put a real dent in Eurozone GDP, and that in turn resulted in a Eurozone equities underperforming their U.S. counterparts by roughly one-third.

The chart above shows CDS spreads on Spanish 5-yr sovereign debt. After peaking in 2012, spreads have plunged, reflecting a significant decline in Spain's default risk. Spreads have now returned to pre-PIIGS-crisis levels, a turnaround that is not widely appreciated. Eurozone equities bottomed around the same time that CDS spreads peaked, and have recovered significantly as spreads have dropped. This suggests that the recent rally in Eurozone equities has been driven by a substantial improvement in the fundamentals of the Eurozone economy: e.g., much less default risk, the end of the recession, and the gradual return of growth. We have yet to see whether Eurozone growth can outpace that of the U.S.

Friday, October 25, 2013

Bank lending to business picks up

The above chart shows total outstanding Commercial & Industrial Loans (a proxy for bank lending to small and medium-sized business) over the past four months. After being relatively stagnant for most of the summer, C&I Loans have grown 2% in the past three weeks, bringing their year over year growth rate to a respectable 8.8%.

Since late 2010, C&I Loans have grown by fully one third, and are now very near their all-time high.

The continued and relatively strong growth of bank lending to businesses is a good omen for the future, since it reflects increased confidence on the part of banks and businesses. Capital goods orders may be sluggish (see previous post), but there are still bright spots to be found in the private sector.

Capex still relatively weak

September capital goods orders were weaker than expected, and have been sluggish since the beginning of last year. This measure of business investment is hardly impressive, and reflects a chronic lack of confidence on the part of business. With corporate profits at all-time highs, but business investment in capital goods yet to surpass pre-recession levels, it's not hard to see why the economy has been growing slowly. Businesses could be doing a whole lot more, but for a variety of reasons—burdensome increases in regulations and higher taxes, to name just a few—they have been reluctant to invest in the future. The U.S. has the highest rate of corporate income tax in the developed world, the onset of Obamacare has placed additional and heavy burdens on small business, and Dodd-Frank regulations have added huge burdens to the financial industry. Government needs to get out of the way if the economy is to proceed at a faster pace.

Truck tonnage rules out a stock market bubble

This chart is the perfect comeback to those who argue that the stock market is once again in bubble territory. What it shows is that the real value of the stock market is positively correlated, over time, with the amount of freight hauled by the nation's trucks. In other words, the physical size of the economy has a lot to do with the real, inflation-adjusted value of the economy.

Truck tonnage in September hit another all-time high, up 8.4% in the past year, and up almost 30% since the economy began to recover in mid-2009. The physical economy is apparently growing much faster than the official GDP statistics suggest (real GDP growth has been about 2% per year during the current recovery). This is comforting, to say the least. And as the chart shows, since the real value of the stock market hit its all-time high in early 2000, the economy has improved dramatically, while stocks are still struggling to regain their previous high. If stocks were in bubble territory back then, it's far less likely that they're in bubble territory today.

As Calculated Risk notes, the strong performance of the trucking industry owes much to the "robustness to the sectors of the economy that are growing fastest, like housing construction, auto production, and energy output. These industries produce heavier than average freight, which leads to faster growth in tonnage versus a load or shipment measure."

UPDATE: The Chemical Activity Barometer also shows increased physical activity, which at the very least rules out a recession:

Thursday, October 24, 2013

Extended unemployment benefits explain high unemployment rates

I've featured this chart many times in recent years, always commenting to the effect that the decline in the number of people receiving unemployment insurance benefits was good news for the economy since it increased the incentives of the unemployed to find and accept jobs. Recall that Congress in 2008 took the unprecedented step of creating "emergency unemployment benefits, which had the effect of significantly boosting the number and duration of people receiving benefits. Until the Great Recession, we had never seen such a high level of unemployed receiving benefits for so long, so it is very tempting to link that with the fact that the unemployment rate has been exceptionally high in recent years.

As this paper points out, however, I may have missed the more important impact of extended unemployment benefits. Extended unemployment benefits keep worker's salary expectations high, and that has the effect of reducing employers' willingness to hire. It's not that unemployed individuals are insufficiently motivated to find work, it's that employers are insufficiently motivated to seek out more workers since salary expectations remain high.

... our estimates imply that most of the persistent increase in unemployment during the Great Recession can be accounted for by the unprecedented extensions of unemployment benefit eligibility.
... extending unemployment benefits exerts an upward pressure on the equilibrium wage. This lowers the profits employer receive from the filled jobs. As in equilibrium expected profits from filled jobs are driven down to the cost of vacancy posting, vacancy posting has to decline. Lower vacancies imply a lower job finding rate for workers, which leads to an increase in unemployment. 

In any case, the ongoing and significant decline in the number of people receiving unemployment benefits (down 21% in the past 12 months) is a good reason to remain optimistic about the economy's ability to expand total employment.

HT: Greg Mankiw

Wednesday, October 23, 2013

Credit spreads still flashing green

Corporate credit spreads are reliable and often leading indicators of the health of the economy. Currently they are trading at post-recession lows, which suggests that the fundamentals of the U.S. economy continue to improve, even though economic growth rates remain disappointingly slow.

The chart above shows 5-yr Credit Default Swap Spreads, which are very liquid proxies for corporate credit spreads and default risk in general. Currently these are trading at post-recession lows, though they are still meaningfully higher than they were in early 2007. I take this to mean that the market is still somewhat concerned about the possibility of future economic setbacks, but for the time being the economic fundamentals look pretty good and are definitely not deteriorating.

The above chart shows the average option-adjusted spread (arguably the best measure of default risk) on investment grade and high-yield corporate bonds. This too shows that spreads are at post-recession lows, but that they remain meaningfully higher than previous lows registered during times of relative economic tranquility. This confirms the message of CDS spreads: the market is still concerned about the future and somewhat risk-averse, but at the same time the market detects no deterioration in the economic fundamentals.

From an investor's perspective, credit spreads are generally attractive, especially when compared to the almost zero yield on cash. From a timing perspective, credit spreads give no indication of any impending deterioration in the outlook. From a contrarian perspective, credit spreads suggest that valuations are reasonably, but not highly, attractive. In other words, the market realizes that economic fundamentals are reasonably solid, but nevertheless the market is not willing to pay relatively high prices for the right to earn extra yield. Purchasers of corporate bonds thus have a modest cushion against things going wrong, but this cushion is an order of magnitude less than it was in late 2008, when markets were priced to something like the end of the world as we know it.

So: a word of caution to corporate bond investors, since risk premiums are still moderately attractive but on the margin much less so; and a word of encouragement to those who believe that the economic fundamentals support further gains in equity prices.

Tuesday, October 22, 2013

Apple delivers

Today Apple announced a very impressive array of new software and hardware. Apple's hardware products are now state-of-the-art across the board, with new and faster processors, retina displays, lighter weight, and refined design. Apple now produces the best smartphones, tablets, laptops, desktops, and professional workstations in the world, at least in my humble opinion. At the same time, Apple has refreshed its entire software lineup, and taken the bold step of making all the new software free and accessible to just about everyone with an Apple device.

Perhaps most impressive of all is the enhanced integration of all the new Apple products and Apple software. It's an ecosystem consisting of 1 million apps for iPhones and iPads, plus Apple productivity software—movie and photo editing, word processing and document creation, spreadsheets, presentations, and music creation, all working together via the cloud and across all devices—that no competitor can come even close to matching.

We're still waiting for the Next Big Thing from Apple, whatever it may be, but in the meantime Apple has made giant strides on the software and hardware front. It's the breadth and depth of Apple's offerings, their quality and attention to detail, all combined with their virtually seamless integration, that is the true innovation that was on display today.

I just don't see the bearish case for this incredible company that is trading today with a PE of 13 (make that 10.5-11 if Apple were to repatriate its foreign profits and distribute the resulting after-tax cash).

Full disclosure: I am long AAPL at the time of this writing.

Construction spending update

It's old news by now, but construction spending was up again in August. Residential construction spending gained 18% over the previous year, while nonresidential spending was up only 1.3%. Total spending turned in a respectable gain of 7% in the 12 months ending August.

After more than 5 years of wrenching retrenchment, the construction sector is now almost three years into its long-awaited recovery and once again contributing to overall economic growth. Sure, things could be better, but with time they most likely will be. Modest/moderate improvement is a lot better than no improvement at all.

September jobs report more of the same

The headlines say that the September jobs report was weaker than expected, but the reality is that nothing much has changed: the economy continues to add jobs at a fairly unremarkable pace. The one notable feature of the report was a significant decline in part-time employment which invalidates the popular narrative which claims that the economy has only been adding part-time jobs this year. 

As the two charts above show, the gain in private sector jobs (+126K) was well within the range that we have seen in recent years and during the mid-2000s, even though it was weaker than expected (+180K). It's a disappointing number, but it's not a scary number, and nothing out of the ordinary.

 The chart above shows the level of private sector employment according to two survey methods. It's quite apparent that the economy continues to add jobs, and that it won't be long before the number of jobs reaches a new post-recession high. It's been an anemic recovery, but nonetheless definitely a recovery.

As the chart above shows, the unprecedented decline in public sector jobs has likely come to an end. The economy has gotten rid of a significant amount of public sector bloat since the end of the last recession, and this bodes well for the future since it means the economy is fundamentally more efficient.

According to the household survey, part-time employment dropped by 828K since its all-time high last July. As I noted here, the rise in part-time employment that we saw in the July report was most likely statistical noise, and today's report confirms that. We now see that the number of part-time jobs hasn't changed much at all for the past four years. Relative to total private sector employment, part-time jobs have fallen to their lowest level since the recovery started. This recovery has seen relatively more part-time jobs than previous recoveries, but it's nothing extraordinary.

Although the September employment gains were a bit disappointing, there is no reason to think that the labor market fundamentals have deteriorated. Indeed, the surge in part-time employment that we saw earlier this year now appears to have been a statistical mirage.

I don't see any new implications for Fed policy coming from this report. The economy is slowly but surely progressing, albeit in a disappointingly slow fashion. If anything, it's hard to find much justification here for the Fed to continue its extraordinary Quantitative Easing policy. QE doesn't create jobs, it mainly satisfies the world's demand for risk-free assets.

Monday, October 21, 2013

Bank lending continues to increase

Outstanding Commercial & Industrial Loans (a proxy for bank lending to small and medium-sized businesses) have been increasing steadily for the past three years, and are now only a few billion shy of their pre-recession high. This likely reflects increasing confidence on the part of banks and businesses, and as such it points to continued economic growth. 

Banks continue to expand their lending activities to business, although the rate of increase in business lending (see second chart above) has slowed down a bit over the past year.

It's true that banks are lending far less than the Fed's super-abundant provision of bank reserves would normally allow. Thanks to the Fed's Quantitative Easing programs, bank reserves have increased almost $2.3 trillion in the past five years. Theoretically, this would have allowed bank lending to increase by about 10 times as much, or $23 trillion. But that hasn't happened, mainly because a) banks are not willing to increase their lending willy-nilly, and b) businesses are not willing to borrow excessively. In short, the Fed's QE efforts have failed to result in an explosion of new money because the private sector remains quite risk-averse. In fact, as I have argued many times over the past several years, the Fed's QE efforts have been primarily directed at satisfying a risk-averse world's craving for safe assets, rather than expanding the money supply.

As the chart above shows, M2 (arguably the best measure of the U.S. money supply) has grown only slightly faster in recent years than its long-term average growth rate. Most of this above-average growth can be attributed to a significant increase in the demand for money. Today, 65% of M2 is held in the form of bank savings deposits (just over $7 trillion, up from $4 trillion at the end of 2008), with the remainder held in the form of currency (10.6%), checking accounts (12.8%), small time deposits (5%), and retail money market funds (6%). With savings accounts paying almost nothing in interest, it's reasonable to assume, therefore, that the vast majority of the increase in money supply has been demand-driven. It's not the interest rate on money balances that is attractive, it's the risk-free nature of bank savings deposits that is attractive.

What's holding back the economy is not a shortage of money, it's a shortage of confidence. Bank lending by itself can't create growth, since growth only results from getting more output from a given amount of inputs. Bank lending can facilitate growth, of course, since many worthwhile enterprises might otherwise be unable to access the private debt markets. If confidence were higher and if banks and businesses were less risk-averse, we arguably might have a much stronger economy. But at least the ongoing increase in bank lending is a step in the right direction. Confidence is slowly returning, and risk-aversion is slowly declining, and those are essential ingredients for a stronger economy in the years to come.

The decline in the price of gold (see chart above) is another way to see how risk-aversion is slowly declining.

Saturday, October 19, 2013

The Obamacare Nightmare update

Almost a month ago I wrote a post, The Obamacare Nightmare, in which I said that if the Democrats didn't come to their senses quickly, "the country [was] on the verge of entering what could be its worst nightmare: a healthcare train wreck of epic proportions." Since then, the ill-advised rollout of the Obamacare exchanges has been nothing short of disastrous. I don't see how in the world they are going to get things fixed in time, so it's increasing likely that the individual mandate will be postponed for at least a year.

But that just creates a new problem for the Democrats, since, as I also mentioned last month, "next year's election would effectively become a referendum on Obamacare." As Rick Moran notes, by refusing to come to terms with the impending failure of their signature program, the Democrats likely will own "the failure of a government entitlement that could discredit the idea of big government for a long time." To me that is the best news ever. It's about time the population was hit in the face with the reality that government not only can't solve all of our problems, but shouldn't even try.

Am I worried about the possibility that the collapse of Obamacare could be the excuse to segue into a Single Payer system? I used to be, but I'm taking comfort from Moran's arguments. Would the voters really be willing to trust Congress "to give it another shot, this time making even bigger, more radical, expensive, and complicated changes?" "Does anyone believe that after the internal bloodletting over defunding Obamacare there are any Republicans who would vote for their own electoral execution and help pass a single-payer system?"

I'm guessing that Obama is going to have to decide to postpone Obamacare's individual mandate within the next month, just like he already postponed the employer mandate. He's gotten himself into an almost indefensible position that only becomes worse as next year's deadlines approach but the computers systems remain deeply flawed. If the business side of Obamacare wasn't ready for prime time, it's abundantly clear now that the individual side isn't ready either, and that tens millions of people could be seriously inconvenienced if not financially devastated if the administration stubbornly refuses to face the facts.

So we could be in for some really exciting times between now and the end of the year, and there's a good chance that the ultimate resolution to the Obamacare mess, which would likely come in the November 2014 elections, will be a win for limited government and free markets.

I'll say it again: "Government is now too vast to be efficient, too vast to be controlled, and too vast to achieve all the many objectives of its constituents."

UPDATE: The disruptions have already begun, and the anger is just beginning to build. Kaiser Health News reports that over half a million people have already lost the policies they thought they could keep.

Wednesday, October 16, 2013

Apple vs. Microsoft

One of the great comeback stories of all time, arguably sparked by one simple non-decision by Steve Jobs:

We argued with Steve a bunch [about putting iTunes on Windows], and he said no. Finally, Phil Schiller and I said 'we're going to do it.' And Steve said, 'Fuck you guys, do whatever you want. You're responsible.' And he stormed out of the room." - John Rubenstein

HT: John Gruber

One more twist: Apple's new "spaceship" headquarters building, which yesterday was approved by the Cupertino City Council, will be almost as big as the Pentagon.

Japan reflation update

Last January I noted that "one of the biggest things happening on the margin is the decline of the Japanese yen." The Bank of Japan was effectively pressured into a serious relaxation of monetary policy. After being extremely tight for many years—as reflected in zero/negative inflation, a relentless appreciation of the yen against virtually all other currencies, a very weak stock market and a moribund economy—the Bank of Japan has completely reversed course. This has had predictable and impressive results.

The above chart shows just how impressive the increase in Japan's bank reserves has been. Reserves are up 137% in the year ending September.

A genuine easing of monetary policy ought to result in a weaker currency, and that is exactly what has happened in Japan. The yen has gone from 78 to 99 vs. the dollar in the past year, a decline of more than 20%. And to the extent that Japan's weak economy in recent years was the result of deflationary monetary policy, then easier money and a weaker yen ought to result in a stronger equity market. And indeed, as the chart above shows, that is exactly what has happened. Japanese stocks are up over 60% in the past year in yen terms, and up 33% in dollar terms. Japan has apparently succeeded in reflating its deflated economy, and that is a good thing.

Inflation typically responds to changes in monetary policy with a lag, and that is exactly what is happening. As the chart above shows, Japan is now registering inflation of almost 1% in the past year, and it's likely to increase further over the next year. As inflation expectations increase, the desire of the Japanese to hold on to lots of yen declines, and the velocity of money increases, and that fuels faster nominal GDP growth. It's already apparent: inflation has accelerated (albeit only modestly so far), and in the first half of this year, Japan's annualized real GDP growth was almost 4%.

Japan's monetary policy has done a good job. Going forward, the key to real success will be Japan's commitment to genuine fiscal stimulus (e.g., limiting the growth of public sector spending, reducing regulatory burdens, and reducing tax burdens). Prime Minister Abe seems to understand this, but of course the proof will be in the pudding.

Monday, October 14, 2013

Even Europe is recovering

The chart above is worth a thousand words, at least, but here's a quick summary. Note 1) the strong correlation between equity prices in the U.S. and in the Eurozone over the past two decades; 2) the huge degree (over 50%) by which U.S. equities have outperformed their Eurozone counterparts since 2009; and 3) the fact that Eurozone equities are still 46% below their 2000 highs, whereas U.S. equities are 10% above their 2000 highs. In short, the Eurozone economy has followed pretty closely the direction of the U.S. economy, but in the process has fallen way behind.

This may be changing.

The above chart is the ratio of the S&P 500 index to the Euro Stoxx index. The U.S. equity market clearly led the Eurozone by leaps and bounds from 2009 through mid-2012, with much of the "credit" likely going to the PIIGS sovereign debt crisis. But for the past year or so the Eurozone appears to be holding its own and even pulling ahead, as reflected in the declining ratio.

The relative improvement in the Eurozone economy has been showing up for most of the past year in the manufacturing and service sector purchasing manager surveys, as seen in the above charts. Europe suffered a two-year recession which has recently come to an end. Even though Eurozone growth still lags the U.S. significantly, the Eurozone is doing somewhat better on the margin, and better than expected.

Caveat: I'm not predicting that Eurozone stocks will continue to outperform U.S. stocks, as they have recently. My main point is simply that it appears that the Eurozone is no longer the laggard that it has been for so many years. That's good news for Europe, and it's good news for the U.S. as well, since a stronger Europe bolsters the outlook for global growth, and that is good for almost everyone.

Awesome durable goods deflation

Mark Perry has an interesting post which highlights the fact that over the past 20 years the effective cost of clothing, measured in hours worked, for the average worker has declined by almost 50%. In that same vein, I offer an updated version of a chart (first featured over 3 years ago here, with a detailed explanation of the role China has played in this here, ) which highlights the huge and growing disparity between the prices of durable goods and just about everything else:

Since the end of 1994, the average price of durable goods has declined by almost 30%, while the price of services has increased by 60% and the price of non-durable goods has increased by 50%. Over the same period, the average hourly earnings of private sector non farm workers has increased by 74%. This means that the average worker only needs to work about 40% as much today in order to buy durable goods (e.g., computers, cameras, cars, TVs) as he or she did 18 years ago. Put another way, one hour of work today buys about 2.5 times as much in the way of durable goods as it did in 1995. 

This kind of deflation is awesome. Thanks to durable goods deflation, as Mark notes, "the standard of living for most households has actually increased significantly over the last 20 years, when measured in what is ultimately most important: household consumption and the affordability of life’s basics." 

Friday, October 11, 2013

"Equities are grinding lower"??

Sometimes you have to take the advice of the "experts" with a grain or two of salt. Case in point: Mark Zandi, in written testimony today to the Joint Economic Committee: "equities ... have been slowly grinding lower since mid-September." Zandi, a reliable source for quotes that reaffirm Keynesian economic logic and avoid ruffling consensus feathers, is trying to make the case that Congress should end the shutdown and reverse the sequester in order to boost the economy. That without these actions, the stock market is telling us that the economy is doomed to deteriorate.

Here's what "grinding lower" looks like in fact (as I write this, the S&P 500 is down 1.4% since mid-September):

I'd say a more accurate description of the equity market is just the opposite: equities have been grinding higher for the past four years or so, despite the many obstacles—like the shutdown and the sequester—that have been thrown in its path. The economy has been slowly improving as well, despite a degree of "fiscal austerity" over the past four years that would have led any Keynesian to predict a recession.

The economy's disappointingly slow growth, in my view, has almost nothing to do with fiscal austerity. Rather, it has to do with policies that are smothering the private sector: e.g., higher taxes, increased regulatory burdens, increased subsidies and transfer payments, and Obamacare.

Reversing any or all of these policies would almost surely do more for the economy than reversing the sequester.

Wednesday, October 9, 2013

Tracking important market prices

Last week I argued that the lack of government-provided statistics was not really a problem, since there are lots of real-time, market-based prices out there that speak volumes about the state of the economy. Here's an expanded list, with up-to-date charts, of the indicators I think are the most important to watch.  On balance, I don't detect anything going on that's particularly disturbing or encouraging, which means the economy is probably continuing to expand at a relatively slow pace.

1-mo. T-bill yield:

Yields on 1-mo. T-bills have jumped this month by about 25 bps, whereas yields on bills maturing in 3 and 6 months remain quite low. This reflects a modest degree of concern that the current government shutdown and debt ceiling debate may remain deadlocked and result in a temporary "default" on federal debt. If the risk of default were major and lasting, yields on all maturities would have spiked, but that is not the case, at least so far. This is akin to a tiny ripple on the pond of risk.

2-yr swap spreads:

2-yr swap spreads are about the best leading indicator of systemic risk that I'm aware of. (For more detail on what swap spreads are, see here.) Today, swap spreads in the U.S. are about as low as they have ever been, while swap spreads in the Eurozone remain somewhat elevated. This reflects almost a complete absence of any degree of risk in the financial and economic fundamentals in the U.S., and a modest degree of risk in the Eurozone economy. Conditions have not changed materially in the past year.

5-yr TIPS real yield:

As the first of the above charts shows, real yields on TIPS tend to track the real growth of the U.S. economy. Real yields have moved substantially higher in the past six months, and that is a good indication that the market believes the economic fundamentals of the U.S. economy have improved. But real yields are still quite low, suggesting that the market now expects the U.S. economy to grow at a sub-par rate whereas before the market was concerned about the potential for a double-dip recession. As the second chart shows, real yields have dropped about 50 bps from their recent high, reflecting a) some disappointment with the economy and b) less likelihood of a near-term Fed tapering. Under the new leadership of Janet Yellen, the Fed is probably less likely to taper and less likely to tighten aggressively. Real yields would have to decline further before I would worry that economic fundamentals were deterioriating.

Breakeven inflation spreads:

The above chart shows the market's implied inflation expectations for the 5-year period beginning in 5 years, which are derived from the yields of 5- and 10-yr TIPS and Treasuries. This is the Fed's preferred measure of forward-looking inflation. As the chart shows, inflation expectations today are almost exactly the same as the average of the past four years. Nothing much going on here—inflation is likely to remain subdued for the foreseeable future.

Gold vs. real yields:

The price of gold has been remarkably well correlated with the inverse of 5-yr TIPS yields (which is equivalent to saying that gold has been positively correlated with TIPS prices). I've argued that this is a sign that the world's demand for safe assets is beginning to decline. Not much has changed here in the past month or so, but this remains one of the more intriguing relationships I follow, especially since the demand for money and safe assets has been extraordinarily strong for the past 5 years. Strong money demand has led to a major decline in the velocity of M2, and has all but compelled the Fed to adopt its Quantitative Easing policy. As I've argued before, the primary function of QE is not to "print money," but to swap newly created bank reserves (functionally equivalent to T-bills) for bonds. Since there is no evidence of any increase in inflation as a result of the Fed's QE efforts, we can infer that the Fed's provision of bank reserves was likely just enough to satisfy the world's demand for safe assets. When the supply of money equals the demand for money, there are no inflationary consequences.

Gold vs commodity prices:

Gold and industrial commodity prices have tended to move together over long periods. The most striking thing in the chart above, in my opinion, is the degree to which gold "overshot" the rise in commodity prices coming out of the Great Recession. I think this reflected very strong demand for safe assets, very deep concerns over the potential for QE to be inflationary, very deep concerns about the long-term value of the dollar, and deep-seated concerns about global financial stability. But since these fears have not been realized, gold has begun to fall back in line with commodity prices, which have been relatively stable for the past few years. Not much has happened to gold in recent months, but if the world continues to avoid a disaster then I would expect gold prices to move lower. Relatively stable commodity prices tell me that there are no material changes in the strength of the global economy.

Dollar vs. other currencies:

As the first of the two charts above shows, the inflation-adjusted value of the dollar relative to a trade weighted basket of currencies is still unusually weak. However, the dollar has managed to increase somewhat in the past two years, which I take as a sign that the U.S. economy has done somewhat better than expected (or perhaps it's better to say "not as badly as expected"). The second chart looks at the nominal value of the dollar vs. major currencies for the year to date, and here we see that the dollar has only recently found a bit of support after declining from last summer's highs. There's not much love out there for the dollar, but neither is the dollar disastrously weak. On the bright side, there's a lot of room for improvement in the dollar if the outlook for the U.S. economy were to improve.

Baltic Dry Index:

This measure of shipping costs for bulk commodities has staged a remarkable comeback in the past four months. While it's difficult to draw firm conclusions from this (the index can be affected not only by demand for commodities but by changes in available shipping capacity), I think it's safe to say that global economic activity is not deteriorating, and may even be firming.

Credit default swap spreads:

CDS spreads are a very liquid proxy for the default risk of corporate bonds. That spreads are still very close to their lowest levels since the recession is a sign that the market detects no deterioration in the economic outlook. Spreads are still meaningfully higher than their pre-recession lows, however, which signals that the market is still relatively risk averse.

Vix Index:

The Vix index has jumped of late, a clear sign of increased market jitters. But from a longer-term perspective, it is still relatively low. The market is obviously concerned about the ramifications of the current government shutdown, but not terribly so. This is a contributing factor to the general mood of risk aversion that pervades most market indicators.

S&P 500 Index:

The first of the above two charts shows the PE ratio of the S&P 500 index. It's up from the lows of 2010, but is not unusually high. In fact, PE multiples today are almost exactly in line with long-term averages. I think this shows that the market is at the very least not overvalued. Indeed, since corporate profits currently are at record levels in both nominal terms and relative to GDP, I think this shows a remarkable lack of optimism. In other words, I take this as a sign that the market is still relatively risk averse, and that explains why the demand for safe assets is still relatively strong.

The second chart shows the index itself, which has been on an uptrend ever since March, 2009. Prices are near all-time highs, but valuations are still relatively subdued. There is still lots of upside potential if the market should start to feel less concerned about monetary and fiscal policy, and/or should the economic fundamentals improve.