Wednesday, June 25, 2014

The bond market's pessimism is vindicated

I've been a close observer of the bond market for over 25 years, and it continues to amaze me with its ability to see the future of inflation and real economic growth. 

I've been featuring the above chart for a long time, using it to argue that the market was quite pessimistic about the prospects for economic growth. My theory is that real interest rates ought to track the market's expectations for real growth, and indeed they have. Real growth and growth expectations were very strong in the late 1990s, and real yields on TIPS were very high. Since then, the economy has slowed down and real yields have fallen. 5-yr real yields on TIPS have been telling us for the past year that the market was braced for real economic growth to be as low as 1% or so. With today's revision to Q1/14 GDP growth, real growth over the past 2 years has been an anemic 1.4%. In effect, the bond market saw this slump coming a year ago. Needless to say, if the economy's prospects are going to improve going forward, we ought to first see real yields on TIPS rise to at least 1%. 

The extent of the weakness in Q1/14 growth can be appreciated in the above chart. We haven't seen such negative numbers for real and nominal GDP growth without being in a recession. Yet I'm pretty sure we aren't in a recession, since the preponderance of evidence suggests the economy continues to grow, albeit relatively slowly: e.g., business investment is rising, bank lending to business is strong, residential construction is rising, unemployment claims are very low, jobs are growing about 2% per year, industrial production is rising, monetary policy is accommodative, government spending has shrunk meaningfully relative to GDP, the yield curve is positively sloped, and real short-term interest rates are negative, to name just a few. All of these are consistent with an ongoing business cycle expansion. The first quarter weakness was most likely a by-product of terrible weather.

We are very likely still in a recovery, but the problem—as illustrated in the chart above—is that the economy is more than 10% below where it could or should be if long-term growth trends are extrapolated. This is without doubt and by far the weakest recovery in history. I think the reasons for this weak growth are a huge increase in regulatory burdens (e.g., Obamacare), a significant increase in top marginal tax rates, a hugely burdensome, complicated, and distorting tax code, and the developed world's highest corporate tax rates. Accommodative monetary policy is probably a contributing factor as well, since five years of extremely low and negative real short-term interest rates have likely created disincentives to save. In short, the economy has been growing in spite of all the government's "help," not because of it. Lift the burden of a smothering fiscal sector and we'll most likely see a much stronger economy.

The end of deleveraging: update

In a post three months ago, "The end of deleveraging," I noted signs that households' risk pendulum had stopped swinging in the direction of risk-aversion, and that the public was beginning to embrace risk rather than shun it. That had important implications for monetary policy, since the underlying rationale for QE, which in essence amounts to the "transmogrification" of bonds into T-bill substitutes, was to satisfy the world's seemingly unlimited demand for safe, short-term assets. If risk-aversion is on the decline and risk-taking is on the rise, there is no need for the Fed to continue QE. I think this explains why the Fed has been able to taper QE without there being any adverse effects on the economy or the markets. We don't need QE any longer, and the Fed is acting appropriately. 

The Fed has recently released pertinent data from the first quarter of this year which reinforces this view. What follows are some updated charts and commentary.

As the chart above shows, households' financial obligations (i.e., debt payments as a % of disposable income) reached a high in 2008, but have since declined significantly. Importantly, financial burdens are essentially unchanged in the past year. This means households have rebuilt their balance sheets and restructured their finances to the point where they no longer need to tighten their financial belts. Financial burdens today are as low as they have been at any time in the past three decades, and they are unlikely to decline meaningfully going forward. This is a very healthy development and it justifies the Fed's ongoing tapering of QE.

As the chart above shows, households' overall leverage (liabilities as a % of total assets) has declined significantly—by almost 30%—since hitting an all-time high in early 2009. Leverage is now back to levels that prevailed through much of the 1990s. All of the excessive speculation that helped fuel the housing boom in the 2000s has been reversed. This is also a very healthy development that is ongoing: household liabilities are no longer declining, but the value of households' financial and real estate assets are rising. This is healthy deleveraging, not risk-averse deleveraging.

As the chart above shows, as of Q1/14 the delinquency rates on consumer loans had fallen to its lowest level in decades. Consumers haven't been so careful with their finances for a very long time.

Gold prices, shown in the first of two charts above, have been relatively unchanged for the past year, even as tensions in the Mideast have risen. As the second chart shows, real yields on 5-yr TIPS have also been relatively unchanged for the past year. Both of these developments reflect a decline in risk aversion.

Capital goods orders—a proxy for business investment—were relatively flat for most of the past year, but in recent months (the most recent data, released today, cover May) have begun to rise. This is a good sign that corporations are shedding some of their risk aversion and are beginning to be more optimistic about the future.

PE ratios have been rising for several years, and are now above their long-term average, a good sign that risk-taking is beginning to come back into fashion. This is likely to continue, given all the other signs of the risk-pendulum swinging in a favorable direction, which means that there is still plenty of room on the upside for the stock market.

I should note that all of these changes are moving at a somewhat glacial pace—nothing dramatic is happening on the margin. It's all part of a slow but relatively steady improvement in the economy that is likely to persist until Congress adopts more growth-friendly policies. 

Tuesday, June 24, 2014

Steady and slow improvement is boring, but things could be worse

Argentina has kept us busier than I anticipated this past week, so it's good that the news from the states has been unremarkable. As far as I can tell, the U.S. economy continues to grow at a disappointingly slow pace of about 2-3% per year, but it's still growing and things are still getting gradually better, and that means that it's best to avoid cash.

Argentina, on the other hand, is slowly going from bad to worse, as the government pursues economic policies that could charitably be termed inappropriate, and realistically termed crazy. Import restrictions are creating shortages of all sorts of things, and the gap between the official exchange rate and the parallel (black market) rate is huge—over 40%. (Good news: food and wine are incredibly cheap in dollar terms.)  On top of the disincentive this creates to export (exports must be cleared at the official rate), the government has severely limited exports of wheat in the absurd belief that this will keep the price of wheat and bread low and that in turn will keep the proletariat content (a certain North American country has banned petroleum exports for similar purposes). To make matters worse, agricultural exports—Argentina's main source of foreign currency—are taxed at a punitive 35%. A good friend hosted us for a long weekend on his estancia the other day, where he grows corn, soybeans, sorghum, and wheat, and he related how all of these policies simply cause him to plant less.

There's relief here that the Argentine government is making an effort to avoid a default on its debt, but it's comical to see how the government is trying to make the "vulture funds" look like the bad guys. How dare someone insist that the government meet its debt obligations? Meanwhile, the Argentine central bank has been expanding the money supply (mainly by giving "advances" to the government so that it can pay its bills) by 25-40% per year, so inflation is raging and the poor and middle class are taking it on the chin. The other night I got into a huge argument with some friends here who insisted that inflation was partly a cultural phenomenon and mostly the result of rapacious capitalists. It's fair to say that there is a grave shortage of economic wisdom in this country, especially among the ruling Peronists. As these posts point out, Obama—whom I've called the first Peronist president of the U.S.—is similarly lacking in economic wisdom and similarly fond of populist policies.

A few thoughts on today's economic releases:

New home sales in May handily beat expectations, thus throwing lots of cold water on the prevailing view among economic bears that the housing market was on the skids. As the chart above shows, new home sales have been moving steadily (though irregularly) higher for over three years. They are still very low, and have plenty of room to increase further.

Consumer confidence has been moving steadily and irregularly higher for the past five years. It's still relatively low from an historical perspective, which means that there is still a healthy amount of pessimism out there. We are years away from a situation that might be termed "irrationally exuberant."

Slow and steady as she goes; things could be a lot worse.

P.S. It's almost 10 pm here and we are leaving shortly to have dinner at a friend's house.

Wednesday, June 18, 2014

Has U.S. inflation accelerated?

I'm posting this from Argentina, where inflation has been running in the strong double-digits for the past several years. Until recently, the government was fudging its CPI calculations, reporting inflation of only 10% per year, but public pressure and IMF threats finally forced them to 'fess up. A few months ago they scrapped the old, faked CPI, and began reporting a new CPI which so far only goes back to the end of last year. So, for the first five months of this year, the government now reports that inflation has been running at a 24% annual rate. That's a lot more realistic, given that the amount of currency in circulation in the Argentine economy has been expanding by 25-30% per year for quite a few years. It's a lot higher than the previously reported inflation rate, but lower than the 30-35% annual rate that most observers have been estimating. In any event, it's still by far the highest inflation rate of any developed country that I'm aware of.

In this context, the fact that the BLS yesterday reported that May inflation in the U.S. was higher than expected (+0.4% vs. +0.2%) is hardly something to get excited about. It is, however, significant, because as the chart above shows, "headline" inflation has accelerated in the past few months from 1.5% in February to 2.6% in May, on a six-month annualized basis, despite the fact that economic growth has been weak and the economy still has oodles of excess capacity. Core inflation has also accelerated, from 1.6% to 2.1% on a similar basis. Conventional wisdom holds that a weak economy with a lot of excess capacity should be vulnerable to deflation, not rising inflation. So conventional thinking might be wrong about how inflation works, and the Fed might be underestimating inflation.

In any event, it's too early to say that there has been a meaningful or worrisome acceleration of inflation. As the chart above suggests, inflation has been running at a 2.4% annualized rate for most of the past 10 years. It slowed down just a bit starting in 2011, so the recent acceleration might just be in the nature of "catch up."

In addition, the bond market seems inclined to believe that the inflation fundamentals haven't changed at all. As the chart above shows, the current difference between 5-yr nominal and real Treasury yields—the market's expected average inflation rate over the next 5 years—is 2.04%. That's only slightly above the 1.95% average expected inflation over the past 17 years.

I'll reserve judgment for the time being, but I remain concerned that inflation risk is something to take seriously, and I would like to see the FOMC express a similar sentiment in their release later today. It's better to be proactive about inflation risk than to wait until inflation becomes too high. We don't want the Fed to be driving by looking in the rear-view mirror.

Even though current and expected inflation is relatively benign, I note that the dollar is still quite weak historically, and gold and commodity prices are still quite elevated from an historical perspective. That's certainly not the sort of stuff of which deflation is made, and it is more symptomatic of rising inflation than low and stable inflation. Moreover, as the chart above shows, the big increase in housing prices in recent years is already driving a pickup in Owners' Equivalent Rent, which makes up about 25% of the CPI, and that component of the CPI could show a significant increase over the next year or so.

Conclusion: the Fed should err on the side of worry, rather than complacency, when it comes to the outlook for inflation.

Monday, June 16, 2014

Blogging will be light for a few weeks

Today we're off to visit friends and family in Argentina for a few weeks. This promises to be a grueling and daily series of lunches, dinners and parties lasting until 3 or 4 in the morning. Despite all that hard work I still expect to have time to follow the markets and post occasionally, perhaps with some local color.

Solid gains in industrial production

The U.S. economy continues to benefit from solid and continuing growth in industrial production. This adds still more weight to the already-impressive body of evidence that shows the economy continues to improve and that a recession or even a slowdown is not in the cards. How much more of this do we need to see before the Fed realizes that it needs to start shrinking its balance sheet and raising short-term interest rates?

U.S. industrial production in May increased more than expected, and there were upward revisions to prior months. Production is up at a 4.6% annualized rate in the six months ended May, and it hasn't been much stronger in the current recovery. The level of industrial production is now well into new, all-time high territory. The Eurozone is still struggling, but making progress nonetheless. Given the very low level of inflation in the Eurozone, its understandable that the ECB feels the need to increase its monetary policy accommodation, but it's arguable whether still-lower interest rates are going to boost economic growth significantly. Both the Eurozone and the U.S. economy would benefit more from growth-friendly fiscal policies than from zero interest rates.

Manufacturing production rose at a 3.9% annualized pace over the past six months, and is up 3.5% in the past year. You could complain that manufacturing production has yet to reach a new high, but it is undeniably the case that there has been a significant and ongoing recovery. From the market's perspective, it's all about changes on the margin, not the level of production.

With the economy continuing to grow but short-term interest rates still priced to a recession or worse, it seems inevitable that the prices of risk assets will continue to rise, since their yields are significantly higher than the yield on cash. The story of this recovery has been the same for the past five years: although the recovery has been disappointingly slow, the economy has nevertheless recovered, and it has consistently performed better than the market's rather pessimistic expectations.

Thursday, June 12, 2014

Slashing the corporate tax rate is a no-brainer

Congress is beginning to understand that the key to a stronger economy is to give corporations a break from onerous tax burdens so that they can grow the economic pie, thus benefiting everyone. This is potentially a very big deal.

Rand Paul and Harry Reid are working on a deal to create a three-year corporate tax holiday, during which time corporations could repatriate foreign profits and only pay a 10% tax. That's a very positive step in the right direction, but it would be even better if Congress made the 10% permanent. Permanent changes to the tax code result in much more powerful and lasting changes to incentives. Slashing or even eliminating the corporate tax rate on a permanent basis would provide a powerful boost to economic growth.

At 35%, the U.S. corporate income tax rate is the highest of any developed country. The fact that corporations are refusing to repatriate trillions of dollars of overseas profits is proof that it is negatively impacting the economy. Overseas profits have already passed through the tax tollgate once, but to subject them to another 35% just for bringing them back to the states is unconscionable to any responsible corporate executive. 

In an ideal world, corporate profits should not be taxed at all, since the burden of corporate taxes falls almost entirely on the customers and employees of corporations. In the end, only people pay taxes, and it's highly inefficient to tax businesses and individuals separately. Today, capital faces double and triple taxation: first on business profits, again when shareholders pay tax on dividends (paid out of after-tax profits) received, and again if and when capital gains are realized. Punitive tax burdens inhibit risk-taking and capital formation, and that in turn leads to slow growth. 

And it's not just the level of the corporate tax rate that's debilitating, it's also the cost of calculating and complying with corporate taxes—which some estimate could actually exceed total corporate taxes paid. From an economy-wide perspective, The Mercatus Center last year estimated that "Americans face up to nearly $1 trillion annually in hidden tax-compliance costs, while the Treasury foregoes approximately $450 billion per year in unreported taxes." Fixing and rationalizing our tax code should be a top priority in these times of sluggish growth. Moreover, the distortions and opportunities for cronyism that our corporate tax code creates make things even worse. Getting rid of the corporate tax would instantly make subsidies and deductions a thing of the past, while turning lobbyists into an endangered species.

Thanks to the tremendous improvement in the federal government's fiscal situation in the past several years, now is a great time for Congress to consider slashing or even eliminating corporate taxes. We can absolutely afford to take the risk that cutting corporate taxes will boost the economy, resulting in little or no revenue loss within a relatively short time frame. 

As the chart above shows, federal government spending has not increased at all for the past five years. That's a remarkable achievement, but it says more about congressional gridlock than about any conscious desire to limit spending. Meanwhile, tax revenues have been growing strongly for the past four and a half years, rising at an 8% annualized rate. That's mainly due to rising jobs, rising incomes, and rising profits, and only marginally due to higher income tax rates. Economic growth and some much-need fiscal austerity have essentially solved our deficit problem that just four years ago was thought to be intractable.

The five-year freeze in spending has had the beneficial effect of sharply reducing the size of government relative to the economy, as the red line in the chart above shows. Federal spending has fallen by one-fifth relative to GDP in the past five years, giving the private sector some much-needed breathing room. Meanwhile, tax revenues have risen by one-fifth, to over 17% of GDP from a low of 14.2%.

The net effect of these two developments has been to reduce the federal deficit by two-thirds, to just under 3% of GDP today. It's high time the federal government used its greatly improved finances to make an investment in corporate America by cutting or eliminating corporate taxes.

Corporate taxes represent about 10% of federal revenues currently ($296 billion in the year ending May), or about 1.7% of GDP. Personal income, social insurance, and retirement taxes account for almost all the rest of federal revenues. We could totally eliminate corporate taxes, and assuming no knock-on effects (i.e., no additional investment, no additional jobs, no increases in employee compensation), it would only increase the federal deficit from 3% to 4.7% of GDP—a mere drop in the bucket, and a level that wouldn't be unusual at all by historical standards.

But there would almost certainly be some very positive side-effects to slashing or eliminating corporate taxes. Investment would almost certainly rise, given the substantial increase in the after-tax rewards to risk-taking, as would the number of jobs and income. More jobs and more income would boost personal income, social insurance, sales, and retirement taxes. Economic growth would increase measurably, growing the economic pie for everyone. Corporations would save not only what they currently spend in taxes, but also their tax preparation and hidden compliance costs. The happy result of all this would be difficult to underestimate.

The Joint Committee on Taxation estimates that a tax holiday as proposed by Senators Rand Paul and Harry Reid would cost the government almost $100 billion over a decade, but that is a very short-sighted analysis that ignores the incentives that are keeping foreign profits offshore. I think Paul's estimate of a windfall of up to $60 billion in new revenues in three years makes more sense, and he's most likely severely underestimating the total positive impact.

The Congressional stars appear to be aligning, the budget is greatly improved, and the economy badly needs some genuine stimulus. It's time for Congress to do something smart for a change: cut or eliminate the onerous tax on capital, and watch the economy take off.

The importance of opportunity cost

John Allison, the wise and experienced banker who now heads the Cato Institute, has some thoughts on opportunity cost in the current issue of Cato's Policy Report. Here are some excerpts:

While opportunity cost is an easily understood idea, in many decisions individuals choose to ignore it. The current economic recovery is a classic example. It is very difficult for most people to understand the radical difference in economic well-being between 2 percent growth and 5 percent growth compounded even over just five years. Many people assume the stimulus package, increased regulations, and the Federal Reserve’s quantitative easing are critical to a recovery. They do not understand that a normal recovery is 5 percent growth and not 2 percent, and that these government interventions radically slowed growth.  
It is difficult for individuals to understand the damage the FDA does when it delays or stops drug development. It is easy to see when someone dies from the misuse of a medicine, but many cannot visualize the loss of life from bureaucratic delays. It is hard to grasp that the market would develop a rational quality control alternative (like Underwriters Laboratories, in electrical products) if the FDA did not exist. People have an emotional reaction to a single death from an unexpected effect of a drug, while it takes a conceptual leap — or an economics class — to see all the lives that could be saved without the FDA. 
Good teachers in government schools support their unions’ efforts to stop school competition. They fail to grasp the opportunity cost to them from the lack of competition. In a competitive education market, good teachers would be in strong demand and would be paid more. Public school unions protect mediocre and poor teachers. 
People see the benefits paid from Social Security. They have a hard time understanding that a like amount of savings properly invested would have created dramatically more income and more capital, driving faster economic growth. The opportunity cost of incentivizing government spending through governmental Social Security instead of incentivizing private savings is tremendous. 
People often see the world through the lens of the status quo. They cannot grasp how much better things could be if different opportunities were pursued. Fortunately, in private markets, entrepreneurs who do see the opportunities make them visible to the rest of us — Steve Jobs, Sam Walton, and Bill Gates are examples. This is one reason free markets radically outperform statism. 

I would also highly recommend John's book The Financial Crisis and the Free Market Cure: Why Pure Capitalism is the World Economy's Only Hope. His is the best explanation of what caused the 2008 financial crisis that I have read. He takes you inside the crisis, viewing it from the perspective of a seasoned banking executive who has a deep grasp of how free markets work and how government regulations only make things worse.

Wednesday, June 11, 2014

10 valuation charts

Here is a random selection of charts that track valuations of various securities and asset classes. It's somewhat of a mixed bag, with Treasury yields still very low, corporate debt approaching highly-valued levels, gold still expensive, and the dollar near the low end of its historical valuation.

5-yr Treasury yields are up over 100 bps from their all-time lows of last year (0.6%). But with the exception of last year and early this year, at their current level of 1.7% they are lower than at any other time in history. Relative to inflation, 5-yr Treasury yields are very near the lowest they have ever been. Treasury yields, in other words, are still exceedingly low these days and thus the are richly valued. For several years now I've been thinking that yields were more likely to rise than fall, but I have been wrong—with the exception of last year. I still think they are more likely to rise than fall, mainly because I think the Fed is going to be forced to raise interest rates sooner than expected.

The chart above compares 5-yr Treasury yields to core consumer price inflation. The scales are offset a bit to reflect the view that yields should normally trade at a level that is somewhat higher than current inflation, if only to compensate investors for the uncertainty surrounding the future level of inflation. 5-yr Treasuries yielding 1.7% today offer a very small cushion to investors, since core inflation over the past year has been 1.8%. The explanation for the noticeable divergence in yields and inflation that began in 2011 could be that the bond market became overly concerned about the risk of another recession and/or the emergence of deflation. Both those risks have receded in the past year, however, which is why yields are up from incredibly low levels.

Nominal and real yields on Treasuries are roughly in line with historical norms. The spread between the two—expected inflation—is right in line with current and historical inflation. Neither one looks attractive relative to the other, unless you are worried that inflation will rise. But if inflation rises, then both real and nominal yields will rise as the Fed tightens monetary policy. And nominal yields would rise by more than real yields because inflation expectations would rise. So the downside risk to nominal Treasuries looks greater to me than the downside risk to TIPS. TIPS would also benefit, of course, from rising inflation, since that would boost their coupon payment. But in a rising inflation rate environment TIPS would almost certainly suffer from declining prices because real yields would tend to track the rise in nominal yields. TIPS are not a slam-dunk investment if you are worried about inflation.

Corporate credit spreads are getting pretty tight (i.e., the spread between corporate bond yields and Treasury yields of comparable maturity is pretty small). As the chart above shows, both high yield and investment grade credit spreads are now at post-recession lows, and they are approaching their all-time lows. I note that they traded at current or lower levels for at least three years during the previous business cycle expansion, so it's not unreasonable to think that they might trade at or near current levels for the next few years. But, as is the case with 5-yr Treasuries, the cushion against uncertainty is pretty small. The upside potential of investments in corporate bonds is now relatively small, whereas their downside risk is relatively large. Asymmetrical risks like this argue for trimming one's exposure to the sector.

The chart above shows the spread between high yield and investment grade corporate bonds, otherwise known as the "junk spread:" the extra amount you are paid to accept the additional credit risk of high yield bonds. This spread too is very close to its all-time lows. High-yield debt can still be attractive to conservative investors because of its extra yield, but to realize that extra return you need the economy to continue to grow by 2-3% and you need inflation to remain relatively low. If the economy grows faster, then all yields are going to rise, and the extra yield on corporates will be consumed at least in part by declining bond prices.

Corporate bond yields are also very close to all-time lows. I don't worry so much about spreads getting wider as I do about yields going up, which would almost certainly accompany a general rise in Treasury yields. Owning corporate bonds these days exposes investors to two major sources of risk: default risk and rising interest rate risk. Of the two, I think rising interest rate risk is the bigger of the two, because I don't see a recession for the foreseeable future, but I do see the potential for the economy and/or inflation to pick up and for the Fed to raise short-term interest rates sooner than expected.

Credit Default Swap spreads tell the same story as corporate credit spreads. Default risk is quite low, but it could go lower. Investment grade 5-yr CDS yield about 60 bps more than 5-yr Treasuries, while high-yield CDS yield about 300 bps more.  These securities would likely provide decent returns if the economy continues to grow at a relatively slow pace of 2-3% and inflation remains subdued. Faster growth and higher inflation, however, would likely prove a bit painful.

The first of the above two charts shows the nominal, trade-weighted value of the dollar against a basket of major currencies. The second shows the inflation-adjusted, trade-weighted value of the dollar agains a basket of major currencies and against a basket of most currencies. By any measure, the dollar is only about 5-10% above its all-time lows. Barring some disastrous mistakes on the part of the Fed, the dollar's downside risk looks relatively small to me. I think it's more likely that the dollar strengthens over the next several years, especially if the political mood in Washington becomes more favorable to investment. In this regard, I note the rising chances of a bipartisan deal between Rand Paul and Harry Reid which would create a tax holiday for the repatriation of corporate profits. The asymmetrical risk of the dollar argues for approaching non-dollar investments with caution, unless one is extremely bearish about the future of the U.S. economy.

Gold is substantially off its highs, but I think it's still very expensive. I note that the inflation-adjusted value of gold over the past century has averaged about $500-600 per oz. As the chart above shows, gold is still significantly more expensive than commodity prices. An investment in gold is likely to pay off only if the Fed makes a huge mistake and inflation soars. As it is, I think gold today is priced to a substantial increase in inflation, and has been for years. The fact that inflation has failed to rise as the gold bugs hoped is a major reason that gold has declined from its peak of $1900/oz.

Monday, June 9, 2014

Real yields and stocks

This is a follow-up to my post last week, "The importance of real yields," in which I compared real yields on TIPS to nominal yields on Treasuries, real GDP growth rates, and gold. I noted that real yields tell us several interesting things about the market's outlook: the market does not expect any meaningful change in the rate of inflation; the demand for safe assets is beginning to decline; and real GDP growth rates are expected to be low for the foreseeable future.

The chart above compares the earnings yield on equities (i.e., the inverse of the PE ratio) with the price of 5-yr TIPS (using the inverse of their real yield as a proxy for price). It shows that when equity valuations are high (i.e., when the earnings yield on equities is low), the demand for safe assets is weak, and vice versa, and that makes perfect sense. In the late 1990s, equity markets were booming, the economy was growing at a 4-5% rate, and real yields were usually high. During those go-go years, in other words, the demand for stocks was strong and the demand for TIPS was weak. By the early 2010s, things had reversed: the earnings yield on stocks had soared (corporate profits were very strong but the market was very doubtful that those earnings would hold up), and the demand for TIPS had soared because everyone feared that the economy would remain weak or suffer another recession.

Over the past year, however, we have seen a divergence between these variables. Earnings yields have declined (i.e., multiples are rising), as the market becomes more confident in the outlook for earnings, but real yields have been relatively flat and are still quite low. In other words, the demand for equities is strengthening, but the demand for TIPS is not declining.

I think this is a good illustration of the tensions that are building between the stock and bond markets. Interest rates should be higher, given the rising level of confidence in the stock market. This is a theme that I explored in another post last week, in which I argued that even if real GDP growth is only 2-3%, the Fed should react sooner rather than later to the signs of rising confidence and start raising short-term interest rates.

It seems to me that the stock market is out in front of the Fed and the bond market these days. It doesn't make sense that equity valuations are rising and net worth is at new all-time highs, but short-term rates are zero and 5-yr TIPS real yields are negative.. The Fed needs to gain the same confidence as the stock market, and begin raising short-term interest rates. This would likely help give the bond market the confidence to shun Treasuries, thus restoring the balance between earnings yields and real yields.

Friday, June 6, 2014

Why 2% jobs growth will lead to higher PEs and rising interest rates

Just about everything these days points to a continuation of steady, unremarkable 2-3% economic growth, and today's jobs report did nothing to change this. The equity market is moving higher not because the economy is doing better than expected or corporate profits are likely to surprise on the upside, but because in the absence of a recession, owning just about anything but cash makes sense. We're now in a market that is being driven by expanding multiples (PE ratios), and the Fed is encouraging this by keeping short-term interest rates at levels that are consistent with a recession. This can't go on much longer, but that's not a reason to worry.

The private sector is creating about 200K jobs a month, and it has been doing that for almost four years now. It's quite boring.

Private sector jobs are growing at roughly a 2% annual pace. Since productivity averages about 1% a year over the long haul—over the past two years it has only been about 0.5%—this pace of job growth should give us 2-3% overall growth. We're not going to see anything better than that unless and until jobs growth picks up, and that, in turn, is not likely to happen unless and until policies in Washington become more growth-friendly (e.g., reduced tax and regulatory burdens). This won't happen anytime soon, but the November elections may create fertile ground for positive change.

The private sector has fully recovered (finally), and private sector jobs now comfortably exceed their pre-recession high. Government jobs fell about 3% from 2009 through 2013, but have since stabilized; this provided a modest benefit to the economy, since government's influence on the economy was somewhat reduced.

There is no part-time employment problem. Part-time employment is doing the same thing it has in almost every growth cycle in modern times: it's steadily declining relative to the size of the workforce. Plus, there has been no increase in part-time employment for the past five years.

PE ratios are now moving above their long-term average. The growth of corporate profits has slowed—earnings per share are up at only a 2.4% annualized rate in the past three months—even as PE multiples have increased. Investors are willing to pay more for a dollar of earnings because the earnings yield on equities (now about 5.5%) is significantly better than the yield on cash, and the risk of a recession is very low (negative real yields on cash plus a steep yield curve all but rule out a recession).

A growing body of evidence points to a steady-as-she-goes, slow-growth environment that persists.  It's boring, but it's better than a lot of uncertainty. Not surprisingly, the Vix index is now at a post-recession low, which confirms that the market is fairly certain that there's not much excitement out there.

I don't think we're in "bubble" territory yet, but I worry that the Fed's rationale for keeping cash yields close to zero is deteriorating rapidly: multiples are rising and that means confidence is increasing. The banking system's willingness to hold a mountain of excess reserves is almost certainly declining, and possibly at a rate that exceeds the Fed's tapering pace. The Fed might well have to increase rates sooner than expected or else risk a disequilibrium situation (i.e., a bubble and/or rising inflation). A Fed surprise could prove unsettling to the market, since it would push interest rates up across the yield curve, but it shouldn't lead to a big or lasting decline in equity prices, since in the long run it would be the right thing for the Fed to do.

10 basic laws of economics

Jeffrey Dorfman's recent column in Forbes ("10 Essential Truths Liberals Need to Learn") is not a partisan attack on liberals. It is a clear-cut summary of some basic laws of economics that hold no matter what your political beliefs happen to be. Unfortunately, too many Republicans, Democrats, and bureaucrats are guilty of ignoring these laws. In my experience, it's also true that too many investors fail to understand these fundamental truths. I've only listed the laws here; for an explanation of each be sure to read the whole thing: (HT: Mark Perry)

1) Government cannot create wealth, jobs, or income.
2) Income inequality does not affect the economy.
3) Low wages are not corporate exploitation.
4) Environmental over-regulation is a regressive tax that falls hardest on the poor.
5) Education is not a public good.
6) High CEO pay is no worse than high pay to athletes or movie stars. 
7) Consumer spending is not what drives the economy.
8) When government provides things for free, they will end up being low quality, cost more than they should, and may disappear when most needed.
9) Government cannot correct cosmic injustice.
10) There is no such thing as a free lunch.
I'll add one to the list: Monetary policy can facilitate the creation of jobs only to the extent it fosters low and stable inflation. 

Thursday, June 5, 2014

Solid gains in household net worth

U.S. households continued to enjoy strong gains in net worth in the first quarter of this year, according to just-released data by the Federal Reserve. Thanks mainly to gains in financial assets and rising real estate prices, net worth rose to a new high in nominal, real, and per capita terms. In the 12 months ending March, 2014, household net worth increased almost 11%, or almost $8 trillion. (For purposes of comparison, consider that the market cap of global equities rose by $9 trillion over the same period.)

Household debt has not increased at all in over 7 years. Since their recession lows, real estate valuations have increased by almost $5 trillion, while the value of financial asset holdings have increased by more than $20 trillion.

Real household net worth now stands at a new high, and is on track with its long-term average annual growth rate of just under 4%.

Gains on a per capita basis have been a little less (population has grown by a little more than 1% a year), but are still impressive. Real per capita net worth has now exceeded its 2006 high.

A few trillion here, a few trillion there, and you have the makings of some serious gains in prosperity. Since 1950, real per capita net worth has more than quadrupled.

Wednesday, June 4, 2014

Service sector remains healthy

The May ISM Service Sector report beat expectations (56.3 vs. 55.5), but its apparent strength is probably due in part to a bounce back from the weather-related slump of prior months. Nevertheless, it is one more indicator that the economy is almost certainly continuing to grow, albeit at a modest rate.

Like the Service Sector Composite, the Business Activity report was also strong, right up there near the top of the current recovery's range.

The Employment report, however, was lackluster. This suggests that the strength reflected in the overall index was only temporary, a bounce back from earlier weakness. Without more aggressive hiring intentions on the part of business, economic growth is unlikely to ramp up to a higher level.

It's encouraging, nonetheless, to see that the Eurozone service sector continues to improve after emerging from a recession last summer. Taken together, the U.S. and Eurozone service sectors haven't been this healthy for several years. Synchronized global recoveries are almost always better than the alternative.

Jon Hilsenrath reports in today's WSJ that the Fed is concerned about the low level of equity market volatility ("Fed Officials Growing Wary of Market Complacency"). I made a similar observation last week, but I suggested that rather than implying that the market is complacent or vulnerable to bad news, it might be a sign that the market is vulnerable to good news. It's not hard to see why volatility is low, considering that almost all the economic indicators point to continued, modest growth. There is no sign of any disturbing increase in inflation, no sign of overheating, no sign of excessive optimism, and almost no chance that monetary policy is going to upset the apple cart any time soon. Low volatility means the market is confident that we're going to continue to experience a disappointingly slow recovery, and that's not unreasonable at all given the evidence.

Tuesday, June 3, 2014

Strong vehicle sales

Sales of light vehicles in May exceeded expectations (16.7 mil. vs. 16.1 mil.) and rose by 8.4% from their year-ago level. Vehicle sales are now up over 85% from their recession low—recording 12.5% annualized gains in the past five years—and are very close to regaining their pre-recession level (sales averaged about 17 mil. units a year from 2000-2006). This is quite impressive.

The importance of real yields

The introduction of TIPS (Treasury Inflation Protected Securities) in 1997 was an important milestone for financial markets. For the first time ever, TIPS gave us the ability to see real interest rates in real time. Before, we had to infer real yields after the fact. Real yields are a significant contribution to analysts' arsenal of data, since they can be used to discover what the market is expecting about the future of economic growth and inflation. Currently, TIPS are telling us that the market is quite pessimistic about the prospects for real growth, but not concerned at all about the outlook for inflation.

Before, when nominal yields rose we didn't know how much of that was due to rising inflation expectations or rising real growth expectations. Now, if real and nominal yields rise by the same amount, then we know it's because the market's real growth expectations are rising. If nominal yields rise by more than real yields, then we know it's because inflation expectations are rising. 

The chart above compares the nominal yield on 5-yr Treasuries to the real yield on 5-yr TIPS. If you subtract the real yield on TIPS from the nominal yield on Treasuries you get the market's expected inflation rate over the next 5 years (more commonly referred in the bond market as the "break-even" inflation rate, since that is the inflation rate that would cause holders of TIPS and Treasuries of similar maturities to have similar total returns). The main message of this chart is that inflation expectations haven't changed much over the past 17 years: the average expected inflation rate since 1997 is 1.94%, and the current expected inflation rate, by this measure, is 1.98%. The actual annualized CPI inflation rate over the past 17 years was 2.3%. So TIPS have underestimated inflation by a little. But in any event, this chart tells us that the market is not very concerned about rising or falling inflation, and that, in turn, suggests that the Fed is doing a good job.

In theory, real yields on financial instruments should tend to track real economic growth, because you need economic growth to deliver positive real returns to investors. Not surprisingly, we can observe this thanks to TIPS. Real yields on TIPS have tended to track the real growth rate of the economy, as the chart above shows. I've used 5-yr real yields on TIPS as a proxy for the market's expectation for future growth, and I've used a 2-yr annualized measure of real GDP growth as a proxy for the current level of growth. When real economic growth was in the 4-5% range in the late 1990s, TIPS' real yields were 3-4%. Since then, economic growth has been trending lower, and so have the real yields on TIPS. The current level of real TIPS yields, according to this chart, suggests that the market is priced to the expectation that real growth in coming years will be 1% at best. That's pretty pessimistic.

Real yields on short- and intermediate-maturity TIPS can also serve as proxies for the market's desire for safe assets. TIPS are unique in that they are default-free, inflation-protected, and they are the only security in the world with a government-guaranteed real yield that you know in advance. Gold is a classic "safe asset," being historically a refuge from inflation and geopolitical risk. As the above chart shows, the price of TIPS (shown here using the inverse of their real yield as a proxy for their price) has tracked the price of gold in recent years quite closely since 2007. Both have acted as safe havens for all the concerns that arose in the wake of the 2008 financial and economic collapse that affected nearly everyone around the globe. One of the more important developments of the past year or so is the decline in both TIPS and gold prices. That tells us that the world's demand for safe assets has declined meaningfully, even though it remains elevated. I've been watching these two assets very closely for over a year, looking for signs of a further decline in the demand for safe assets. Should it occur, I think that would go hand in hand with a return of optimism, a decline in the demand for money, and, eventually, an acceleration in nominal GDP and inflation. And that, in turn, would show up as higher interest rates and probably a somewhat stronger economy.

Monday, June 2, 2014

Apple disappoints on hardware, but beats on software

At today's developer conference, Apple once again disappointed the world by not introducing any new hardware products. But the company did unveil a stunning display of new software features and device integration that will make give new life to existing products, from phones to tablets to laptops and desktops. When OS X 10.10 and iOS 8 are released in a few months, the Apple ecosystem will become an even more compelling platform than it already is, one that could be very tough—if not impossible—for anyone to beat.

Apple did announce a greatly expanded cloud product/service today: iCloud Drive. This is a central storage service that syncs all data and photos across all devices. This sort of functionality had been sorely missing for some time and should be a welcome addition to everyone who uses an Apple device.

Apple's legion of developers were surprised and excited by all the new features discussed today. Swift, a new and more powerful programming language, coupled with Metal, which greatly speeds up graphics processing, plus 4,000 new APIs and the ability to have integrate apps, could all but revolutionize the future of apps for Apple devices in coming years.

Today Apple showed that it remains firmly on the cutting edge of technology and software, and, to judge by the breadth and depth of today's announcements, it should hold a commanding lead against would-be competitors for many years to come.

I've been an Apple user and fan since 1986 and an AAPL investor for over a decade (full disclosure: I am long AAPL as of this writing). I'm very excited by what I saw today. Software advances of the sort unveiled today are arguably worth more than a new hardware product. But in any event, it seems very likely that Apple in the second half of the year will come out with a larger iPhone and at least one new class of device. The future looks very bright.

Apple's current PE ratio is 15. But if you back out the overseas cash and assume they pay taxes to repatriate it, then the PE ratio drops to less than 12. This is not an expensive stock.

Apple's earnings have been in a two-year hiatus, but new products and greatly expanded software capabilities should be enough to drive earnings higher in coming years. With a current earnings yield of 6.6%, the market seems priced to the likelihood of stagnant or declining earnings for the foreseeable future. That's a very pessimistic take on today's announcements.