Monday, January 13, 2014

This is not a fragile recovery

When I see members of the FOMC saying that the U.S. recovery is "still fragile," I wonder if we're looking at the same economy. Sure, this recovery is the weakest ever and the most risk averse, but it looks pretty broad-based to me. The improvements are numerous and significant: total employment is only a few months away from hitting a new all-time high; auto sales are only about 10% below their highest sustained levels; industrial production is at a new high; real retail sales are about 5% above their pre-recession high, as is real GDP; personal income is up 17% since 2007; housing starts have jumped almost 130% from their recession low; corporate profits are at record highs, both nominally and relative to GDP; equities are more than 10% above their pre-recession highs; jobless claims are only 10% above their pre-recession lows.

As I see it, recoveries are "fragile" if confidence is high; when optimism about the future is abundant; when the majority of forecasts predict robust growth for as far as the eye can see. That was the case back in early 2000. Real yields on TIPS were 4%, and PE ratios were on the moon—it was common to hear people predicting that the economy would enjoy 4% real growth or more for as far as the eye could see.

This recovery, in contrast, continues to be met by a healthy degree of skepticism, and the Fed's own cautious stance is an excellent example. Today, we're more likely to read articles explaining why this recovery's sluggish growth rate is likely to persist, than we are to read articles about why the good times should continue to roll. Instead of characterizing the current recovery as "fragile," I think it makes more sense to simply label this a sub-par recovery (as it has been for a long time), while wondering why it's not stronger.

Slow growth does not necessarily increase the risk of recession. Slow growth is best thought of as symptomatic of some underlying problem that, if fixed, would result in stronger growth. Comparing the economy to an airplane flying at just above stall speed—and thus at risk of a crash—is simply not a valid analogy (though it remains quite popular). What causes an economic collapse is not slow growth, but major mistakes in fiscal and monetary policy whose consequences are poorly understood and for which markets are almost totally unprepared. The housing bust was a good example.

The fact that inflation remains very low, despite the Fed's herculean and unprecedented efforts to pump up the monetary base, is another example of weak confidence. I've argued many times that the main objective of the Fed's QE efforts was to supply a risk-averse world with risk-free securities, and not to stimulate the economy. Bank reserves, because they now pay interest, are a near-perfect substitute for T-bills, and the banking industry has shown every sign of happily amassing a significant position in them, while using only a minuscule portion to support new lending. Risk aversion—and a desire to bolster their balance sheets with high-quality, risk-free securities—has driven banks to accumulate reserves, and it has driven the private sector to accumulate over $7 trillion in retail bank savings deposits, even though they pay almost no interest. Households have reduced their leverage by one fourth (leverage as measured by the ratio of total liabilities to total assets) since 2008.

With it's QE bond purchases, the Fed has simply "transmogrified" notes and bonds into T-bill equivalents in order to satisfy the world's risk aversion and the very strong demand for cash and cash equivalents. Weak confidence has created strong demand for money, and that has kept the Fed's "stimulus" from turning into inflation.

Risk aversion and confidence are in effect two sides of the same coin. As risk aversion declines and confidence rises, the world will demand fewer and fewer safe assets like bank reserves and bank savings deposits, and the Fed would be remiss if it didn't react to increasing confidence by first tapering and then reversing its QE program.

As the charts below show, I believe that confidence is slowly but surely returning, and if this continues, then the Fed can and should proceed to wind down its QE program—sooner rather than later.

As the chart above shows, consumer confidence has been on the rise for the past four years. It's still relatively low compared to other recoveries, but it is increasing, albeit in fits and starts. Confidence can feed on itself, so the Fed should not wait until it is strong and pervasive, lest we get a "confidence bubble" that could later pop.

The chart above shows the price of gold and the real yield on 5-yr TIPS (inverted, in order to be a proxy for their price). Both of these are "safe" assets, and the decline in their prices is a good indication of a decline in risk aversion and, by inference, a return of confidence. The world is getting more confident in the future, so the demand for gold and the demand for TIPS (which are default free and immune to inflation) is declining. That makes perfect sense.

CDS spreads, shown above, are a highly liquid indicator of the creditworthiness of corporate bonds. CDS spreads are now at their lowest level since the recovery began, and are approaching the levels that prevailed one year prior to the recession, when optimism was generally abundant. The low level of CDS spreads today means the market has a good deal of confidence in the ability of corporations to service their debts in the next several years. That, in turn, infers confidence in the ability of the economy to grow. By this measure, things don't get a whole lot better than they are now.

The chart above provides another look at the creditworthiness of U.S. corporations: investment grade and high-yield corporate debt spreads, which encompass a wide variety of securities of all maturities. Here again we see that spreads are at very low levels, which means that confidence in the economy's ability to grow is substantial.

The PE ratio of the S&P 500 today is a bit above its long-term average (17.4 vs. 16.6), which suggests that the market is somewhat optimistic about the future of corporate earnings. But as the second of the above two charts shows, if we use a measure of true economic profits as calculated in the National Income and Product Accounts (see a full explanation here), instead of reported GAAP earnings, PE ratios today are still substantially below average. There is still a degree of caution among equity investors, but the outlook for the economy and corporate profits is improving on the margin.

The dollar is still very low when viewed from a long-term, inflation-adjusted basis (see chart above). This suggests that confidence in the Fed and confidence in the health of the U.S. economy (both of which help to determine the demand for dollars vis a vis other currencies) is still low. However, the dollar has appreciated by 5% or so in the past few years, suggesting that confidence is improving on the margin.

For all the Fed's efforts to "pump up" the money supply, M2 has only grown slightly faster in recent years than it has over the past 20 years, as the chart above shows. That's evidence of very strong demand for "money" from banks: they prefer to accumulate bank reserves than to accumulate loans. If making loans to the public were more attractive, on a risk-adjusted basis, than making loans to the Fed (in exchange for bank reserves), then the money supply would likely have increased dramatically by now, via our fractional-reserve banking system.

As the chart above shows, the growth of M2—arguably the best measure of easily spendable money in the economy—is closely tied to the growth of nominal GDP.

The ratio of M2 to GDP, shown in the chart above, is a measure of the demand for money. Money demand has increased dramatically in the wake of the 2008 recession, as individuals, banks and businesses took steps to increase the amount of money they held (in the form of currency, checking deposits, and savings deposits) in relation to their annual expenses. For some, this meant deleveraging, and for others it meant accumulating higher money balances, and for others it meant building up their savings deposit balances. When all was said and done, the $2.7 trillion the Fed "injected" into the economy by buying notes and bonds found its way into bank savings accounts (which have increased by over $3 trillion since 2008), and banks, in turn, lent the deposit inflows to the Fed in exchange for reserves. No unusual amount of money was created in the process.

But things are changing on the margin. As the chart above also shows, there has been almost no increase in the demand for money over the past year: the ratio of M2 to GDP only increased by 0.5% in 2013, after increasing 22% from mid-2008 through the end of 2012. In addition, the annualized growth of bank savings deposits has slowed dramatically from the strong double digits throughout most of the 2008-2012 period, to less than 6% over the past three and 12 months. The growth of money is slowing, which means that confidence is increasing.

Commercial & Industrial Loans are a good proxy for bank lending to small and medium-sized businesses. As the chart above shows, they have been increasing steadily for the past three years. This can only mean that banks have become more willing to lend, and borrowers more willing to borrow, and that is an obvious result of increasing confidence. C&I loans are still a bit below their previous high level, however, but at the current pace they should soon break new high ground. With banks absolutely flush with reserves, there is virtually no limit to how much they could expand their lending activity if they felt confident enough.

What all this means is that the only thing standing between us and an explosion of new money and higher inflation is more confidence. Confidence is the Fed's nightmare, and it's making a comeback. Rising confidence is the reason the Fed should be moving to taper and then reverse QE. Tapering and reversing QE is not what markets should fear. Markets should instead worry about the return of confidence and the Fed's inability to react decisively to that by reversing QE even faster.


JG said...

Hi Scott,

Great article.

Im a long time lurker, just wanted to say your efforts are really appreciated. There is alot of trash/ misinformation out there which I try and avoid. Your site is one of my first go to.
Being busy with work and raising 3 children doesnt give much time for much else but what you do helps people like me keep abreast of whats really going on.

Again Thanks and keep up the great work.

Scott Grannis said...

Thanks! It's nice to be appreciated.

Michael Meyers said...

Scott, great article, backed up by great data!

Ausgarry said...

Scott - agree great article as always. The issue is the speed with which inflation can take hold - many will say it shouldn't be a concern while it is under 2-3% and that the pumps work flat out until then. You (seem to say) that if it takes hold and gets to 3ish% then it is all over and the Fed will have no choice but to flatline the economy to stop inflation galloping. Can't the Fed just monitor inflation and then adjust or would that really after the horse has bolted?

Scott Grannis said...

I don't mean to say that the Fed will lose control of the situation. My main point is that worrying about tapering is a misplaced concern. It makes more sense to worry about tapering being too slow. So far the Fed has done a pretty good job, but that doesn't mean we're in the clear. Vigilance is always appropriate. said...


Why do you suppose, on your chart Nominal GDP v. M2 growth, the M2 was essentially flat for about five years, starting in 1989? In essence, M2 grew right along with Nominal GDP, except for that five year period.

Benjamin Cole said...

Masterful wrap up by Scott Grannis.

But for investors, some tricky sailing ahead.

The world has gluts of capital.

$7 trillion in US savings accounts, and there are pots of money like that all over the globe. Don't even talk about sovereign wealth funds, or pension funds worldwide.

If you can get in front of the curve (and let me know if you know how to do that) lots of money to be made.

Otherwise, the refrain, "too much money chasing too few deals" may become the global motto.

Low returns, the old supply and demand works against passive investing.

"He who has the gold rules----except when there is a glut of gold."

McKibbinUSA said...

I see the military-industrial complex, the medical establishment, Wall Street, and Federal workers enjoying a robust recovery -- most everyone else is experiencing economic depression, especially along Main Street USA -- evidence of economic depression along Main Street includes long-term declines in real working wages, long-term declines in real home values, and long-term declines in the employment to population ratio -- but I agree that the industry segments in my first sentence are definitely experiencing prosperity -- at this point, I see no hope for a recovery in real working wages, real home values, or the employment to population ratio -- in fact, I expect these indicators to continue to decline over the balance of the 21st century -- I would even go so far as to say that the situation along Main Street USA is as hopeless as it was for the American Indians during the 19th century -- I wish I had better news.

Scott Grannis said... I'm pretty sure FIRREA (,_Recovery,_and_Enforcement_Act_of_1989) was the proximate cause of the change in demand for M2 money.