Tuesday, December 23, 2014

More signs of strength

Today's revision to Q3/14 GDP growth was surprisingly strong (+5.0% vs. an expected 4.3%) and figures prominently in a series of indicators pointing to an acceleration of growth from the relatively miserable 2.3% trend that has prevailed for most of the current recovery. It's too soon, however, to expect robust growth, since marginal tax rates and regulatory burdens are still very high. If there's anything that is driving growth faster in the past year or so, it's the inherent dynamism of the U.S. economy, coupled with a decline in risk aversion and the emergence of some optimism. That is welcome, after years of deleveraging and strong demand for money and other safe assets. Going forward, cheaper energy prices are likely to give growth a further boost. We are most likely still years away from the next recession. Optimism is warranted.

The strength of the ISM manufacturing index has been a good leading indicator of the pickup in real GDP growth over the past several months. The chart above suggests that real growth in the final quarter of the year is likely to be in the range of 4% or so, which would give us growth of 2.7% for the year.

One widely-overlooked fact about nominal GDP growth in the third quarter (6.4%) was that it exceeded growth in M2 (3.2%) by a substantial margin. M2 is arguably the best indicator of the public's demand for money and money substitutes (i.e., currency, retail time and savings deposits, retail money market funds, and checking accounts). So the public's demand for money, shown in the chart above, has declined for the past six months (i.e., money balances relative to income have declined). That in turn implies that the public has somewhat more confidence in the future and is more willing to spend money rather than hoard it. Declining money demand also validates the Fed's decision to end QE3, since there is no longer a relative shortage of safe assets. (The primary purpose of QE was to transmogrify notes and bonds into cash equivalents, as I've argued numerous times in recent years.)

In the months and years to come, it's likely that nominal GDP growth will continue to outpace M2 growth (which is currently running about 5%) as the public's demand for cash and cash equivalents declines. Thus, a given stock of money will support a larger nominal economy, and therefore any tightening of monetary policy will not starve the economy of liquidity. By the same logic, there is no need to fear higher interest rates.

The chart above shows that the amount of credit card debt outstanding has stopped declining after an unprecedented collapse beginning in 2009. It is still about 21% below its recession high, but on the margin it is increasing (up 1.2% in the year ending September). I think this is a sign of reduced risk aversion and the return of some confidence. People no longer want to reduce their debt balances, and are now somewhat more willing to take on debt. Increased confidence is an essential ingredient to a quickening in the pace of economic growth.

The chart above shows that consumer loan delinquency rates are at all-time lows. This suggests that consumers have bolstered their finances significantly, by cutting back on outstanding debt balances and boosting their incomes (jobs and income are up in recent years). A healthier consumer is a more confident consumer, and a more confident consumer is more likely to take risks and work harder, and that in turn means more growth.

Bank lending to small and medium-sized businesses, shown in the chart above, definitely reflects more optimism. Businesses stopped deleveraging awhile ago and are now releveraging. At the same time, banks are more willing to lend. An increased propensity to borrow and an increased propensity to lend are both hallmarks of a decline in the demand for money and, by inference, an increase in confidence. The return of confidence is going to be the main theme in coming years.

The chart above shows the quarterly annualized growth rates of both nominal and real GDP. We can see the pickup in both over the past year or so. Some of the strength in the past two quarters was likely due to "payback" for the weak first quarter, so it's probably premature to extrapolate recent trends, which would otherwise point to 4-5% real growth. But at the very least it's now reasonable to think that growth has picked up from the sluggish pace of the last 5 years.

Even with the impressive growth rates of the past two quarters, real GDP remains over 10% below its long-term trend, as the chart above shows. It's going to take years of above-average growth to get back to where we ought to be. In the meantime, the amount of idle capacity (e.g., millions of workers who have given up looking for work) in the economy implies that collectively we are missing out on some $1.5 trillion of annual income. A reversal of the fundamentals that gave us sluggish growth in recent years (e.g., high marginal tax rates, heavy regulatory burdens, strong risk aversion, increased transfer payments, strong money demand, reduced risk-taking) would mean that future growth could be very impressive. Watch for Congress to make progress towards this end as bipartisanship returns in the post-Obama era. That was already evident in the recent Cromnibus bill which was decried by both sides of the aisle.

The market is slowly ratcheting up its growth expectations, but real yields are still very low from a long-term perspective. The chart above suggests that the current level of real yields on 5-yr TIPS is consistent with real GDP growth over the next few years of only 1% or so. This is a good sign that the market is still very skeptical of the future. Things are getting better, but we've got a long ways to go before we can say the market is unabashedly optimistic. I don't think it's reasonable to think we're in an equity "bubble" when real yields are still so low. The real equity bubble was in 2000, when real yields were 4% and the market expected real growth to be on the order of 4-5% per year. That reflected an abundance of optimism that is hardly the case today.

This last chart makes the same point from another perspective. Real yields on 5-yr TIPS tend to move inversely with the earnings yield on equities. When earnings yields were very high a few years ago, real yields were very low. Both were symptomatic of a market that was scared to death over the prospect of declining corporate profits and miserable real GDP growth. When real yields were very high and earnings yields were very low in the late 1990s, the market was very confident that earnings and the economy would continue to grow at impressive rates.

Now that earnings yields have declined and real yields have risen, the market is less concerned about things going sour, and somewhat more optimistic that we can see further improvement. But there is nothing in this chart that supports the notion that there is too much optimism embedded in market prices. On the contrary, there is still a healthy degree of skepticism out there, albeit less so. The current recovery is likely still in early innings.


Benjamin Cole said...

Excellent wrap-up.

And inflation is going down!

The Phillips Curve today is the "Phillips Phlat-line." We see greater output and employment does not result in inflation.
The Fed's final version of QE, the open-ended QE3, roughly worked. Too liitle, too late, too timid...but finally successful.
Can the GOP cut national security and welfare outlays? They did not 2000-2008. The Donks are similarly clueless.
Ron Paul as GOP candidate? Loooonnnnnggggshot.

Benjamin Cole said...

BTW,if I read the chart correctly, it looks like Commercial and Industrial Loans are close to double the 2000 level, nominally.

This strikes me as very good news, and impressive.

Has something changed that is causing this figure to bulge "artificially"?

That's a heck of a growth pattern....