Wednesday, April 29, 2015

GDP gap: 10% and growing

Real GDP growth in the first quarter was weaker than expected (0.2% vs. 1.0%), but it wasn't much of a surprise. It's now been almost six years that the economy has managed only meager growth—about 2 ¼% per year on average. As a result, by my calculations, real GDP is a little over 10% below its long-term trend potential. That's more than $2 trillion in lost income every year, and it's getting worse. 

Weak quarters happen from time to time, as the chart above demonstrates. First quarter growth this year was negatively impacted by West coast port strikes (which reduced exports), terrible weather, and fallout from a sharp cutback in oil drilling activity. Nevertheless, we'll most likely see a pretty decent rebound in the current quarter, much as we did last year, as those temporary factors disappear. 

The chart above shows the 2-yr annualized rate of real GDP growth, in order to abstract from quarter-to-quarter volatility. By this measure, the economy looks to be growing about 2.5% per year. Since the recovery began in mid-2009, the economy has posted annualized growth of about 2.25%.

The chart above compares the level of real GDP to a long-term trend growth rate of 3.1%. This confirms once again that we are stuck in the slowest recovery ever. It's my belief that the persistence of slow growth is largely the result of bad policies, though demographics likely plays a part too. Corporate profits have been very strong, but business investment has been very weak. Without new investment and risk-taking, we are not going to see a pickup in productivity which is, at the end of the day, what drives stronger growth and higher living standards. Investment has been weak probably because marginal tax rates and regulatory burdens have increased significantly in the past six years. In a sense, and expansion of government has suffocated the private sector.

Things are not going to change much for the better until policies become more pro-growth.

Whether the persistence of relatively weak growth is a reason for the Fed to continue to keep short-term interest rates extraordinarily low is one of the key questions of our time. I don't see how low interest rates stimulate investment or enhance productivity. Only private initiatives can do that.

On the bright side, if policies do become more favorable, there is tremendous upside potential to look forward to. Closing the GDP gap would be nothing short of exhilarating.

Tuesday, April 28, 2015

Rising home prices are contributing to inflation

The housing market recovery continues, and the ongoing rise in home prices is going to be adding to official inflation statistics over the next year or two.

As the chart above shows, nationwide housing prices are only about 8% below their 2006-2007 highs, and prices are up 4-5% over the past year. It won't be long before housing prices reach new nominal highs.

Housing prices feed into the CPI via "Owner's Equivalent Rent," which is the BLS's estimate of how much homeowners would be paying to rent the house they own. Rents don't always track home prices, of course, but over time there is a strong tendency for rents to track prices. As the chart above shows, prices have outpaced rents since 1987 by about 30%. With prices rising 4-5% a year, it's a good bet that rents are going to keep rising, and probably at a faster pace than we've seen in recent years. 

As the chart above shows, rents have been rising a little more than 2.5% per year. The chart also suggests that, given the increase in home prices to date, rents are likely to rise by at least 3% in the next year or so. The chart further suggests that there is a lag of about 18 months between home prices and rents, with prices leading rents. Since OER constitutes about 25% of the CPI, this is going to be an important source of rising inflation in the next year or two. More and more, it is looking like deflation is a thing of the past.

In inflation-adjusted terms, housing prices are still about 25% below their 2006 highs. A return to the inflation-adjusted levels of 2006 would be symptomatic of another housing market bubble. We're not there yet, and probably won't be for quite a few years. But if current trends continue, another bubble looks more likely than another crash.

Mortgage rates are very near their all-time lows. Low rates plus increased confidence could easily drive home prices higher. Even if mortgage rates were to rise, that is no reason to worry about housing. Housing has thrived under much higher rates than we have today. Higher rates would likely be symptomatic of a stronger economy and rising confidence, both of which would be supportive of higher home prices.

Sunday, April 26, 2015

Surprising facts about the minimum wage

For years I've had fun at cocktail parties by asking this question: what percent of all the people who work in the U.S. are paid minimum wage or less? Of the hundreds of people I've asked, only one has come even close to the right answer. The vast majority of the answers I've received (try it yourself!) range from 10% to as much as 50%, when the correct answer is 2.3%. Most people mistakenly think the minimum wage affects a significant portion of the working population, and that's why politicians are able to exploit the minimum wage issue for political gain.

The facts can be found in a recent BLS publication: Characteristics of Minimum Wage Workers, 2014:

In 2014, 77.2 million workers age 16 and older in the United States were paid at hourly rates, representing 58.7 percent of all wage and salary workers. Among those paid by the hour, 1.3 million earned exactly the prevailing federal minimum wage of $7.25 per hour. About 1.7  million had wages below the federal minimum. Together, these 3.0 million workers with wages at or below the federal minimum made up 3.9 percent of all hourly paid workers. 

According to these BLS figures, there were roughly 131.5 million wage and salary workers in 2014, and the percentage of all the people working who were making minimum wage or less was (1.3 + 1.7)/131.5 = 2.3%. Further, only 1.3% of all those who work in the U.S. made less than the minimum wage (1.7/131.5), and 97.7% of those who work made more than the minimum wage without any help from government fiats.

But here's where it gets really interesting: "Almost two-thirds of workers earning the minimum wage or less in 2014 were employed in service occupations, mostly in food preparation and serving-related jobs." In other words, 66% of those making minimum wage or less work in restaurants, where they undoubtedly take home more than minimum wage if you count their tip income. That means last year there were only about 1 million people in the U.S. who actually made minimum wage or less. More than 99% of those who worked last year took home more than the minimum wage for their efforts.

So the next time you're at a cocktail party, ask the person next to you to guess the percentage of U.S. workers that earn minimum wage or less. You won't be lying when you tell them it's 1% or less, and if they don't believe you, tell them the facts can be found in a recent BLS publication.

Raising the minimum wage would presumably benefit less than 1% of the working population, but it would probably make it harder for young and inexperienced workers to get a job. It's already hard enough: the unemployment rate for those aged 16-19 is over 20%. Politicians should be lobbying to reduce or eliminate the minimum wage, not increase it.

(This post updates some facts from a similar post early last year.)

HT: Mark Perry, who adds more color to the issue.

Wednesday, April 22, 2015

Commercial real estate booms

Updating my comments from January: U.S. housing starts have almost doubled in the past 5 years, and, according to Case-Shiller, housing prices have recovered 56% of their recession-era losses. But the recovery of the residential real estate market pales in comparison to the boom in commercial real estate, where prices have recovered substantially all of their recession-era losses, thanks to double-digit annual gains for the past 4-5 years.

Repeating the comments from this month's Co-Star report on commercial real estate:

COMMERCIAL REAL ESTATE PRICES CONTINUED TO CLIMB IN FEBRUARY. The two broadest measures of aggregate pricing for commercial properties within the CCRSI—the value-weighted U.S. Composite Index and the equal-weighted U.S. Composite Index— gained 1.5% and 1.4%, respectively, for the month of February 2015. Both indices have increased by more than 13% over the 12 months ending February 2015 as the pricing recovery for commercial property expanded into smaller markets and secondary property types.

HIGH LEVEL OF INVESTMENT ACTIVITY SUGGESTS COMMERCIAL REAL ESTATE WILL CONTINUE TO BE A SOUGHT-AFTER ASSET CLASS IN 2015. ... transaction activity through February 2015 suggests this will be another active year for commercial real estate acquisitions. The U.S. composite sales pair count of 2,357 and sales volume of $18.9 billion in the first two months of 2015 exceeded totals from the same period in 2014. Meanwhile, the share of commercial property selling at distressed prices fell from 32% in 2011 to less than 10% for the 12 months ended February 2015. 

The strength of commercial real estate belies the fact that this continues to be the weakest economic recovery on record. That's a conundrum which in turn suggests that 1) the economic fundamentals are arguably stronger than most people realize, 2) very low borrowing costs (i.e., easy money) are artificially boosting property values, and/or 3) commercial real estate never experienced a bubble of the magnitude that residential real estate did. I think government meddling in the mortgage market was a significant factor contributing to the overbuilding, overpricing, and eventual crash (think Fannie Mae, Freddie Mac, no-down payment loans, stated income qualifications, government guarantees, and interest-only loans). Things never got so carried away in the commercial real estate sector, where market forces were still operating to keep things more or less rational. 

In any event, a vibrant commercial real estate market is at the very least a source of comfort for us bulls. Things can't be that bad if commercial real estate values are increasing more than 10% per year.

Monday, April 20, 2015

Recommended reading

I can highly recommend John Tamny's new book, Popular Economics: What the Rolling Stones, Downton Abbey, and LeBron James Can Teach You about Economics. John is a long-time supply-side friend and a solid thinker who knows how to make complex issues simple to understand.

George Will praised Tamny's book in a recent column, calling him "a one-man antidote to economic obfuscation and mystification." George Leef also praised the book, and proffers a good distillation of its contents.

This book should be required reading for high school, college, and graduate school econ classes. Instead of signing pledges, politicians should simply declare they have read the book and can't find anything wrong with it. It's especially timely, since many of the issues discussed in the book are at the heart of important national debates (e.g., wealth inequality, the estate tax, government regulation, progressive taxation).

To compile this sampling of the many economic truths he lays out and explains in simple terms with examples that come straight from daily life, I've simply drawn from the titles of the books' chapters:
Taxes are nothing more than a price placed on work 
When we tax corporations, we rob them of their future
Government spending has never created a job 
Budget deficits don't really matter—government spending does
Capital gains are what really drive innovation 
The best way to "spread the wealth" is to abolish the estate tax 
Weath inequality is beautiful 
Government regulation almost never works 
Anti-trust laws are counter-productive 
Outsourcing is great for workers 
Falling prices for computers are not deflationary
Energy independence would be economically crippling 

If some of these strike you as very wrong (and I'm sure many will), I urge you to read the book. There's a good chance you will discover you haven't thought about these issues in the right way.

Thanks, John, for this much-needed contribution to economic wisdom.

Friday, April 17, 2015

2% inflation is alive and well

The prevailing inflation meme is that it is dangerously low, and for years central banks have been trying very hard—without much success—to get it to rise. The reality—at least in the U.S.—is that the underlying "core" rate of consumer inflation has been running at close to 2% for over a decade. Energy prices have been the principal cause of variations from this trend. 

The chart above shows the 6-mo. annualized rate of inflation according to the CPI and the Core CPI (ex-food and energy). The experience of the past decade is a great example of why it pays to ignore big swings in food and energy prices. The core rate of inflation has been much more stable, and inflation according to these two indices has been exactly the same since 1986 (2.7% annualized per year). The core CPI is up 1.75% in the past year, and in the past six months it has risen at an annualized rate of 1.77%. It's very likely that the overall CPI will soon be averaging about the same rate.

If we look at the ex-energy rate of consumer price inflation (see charts above), it has averaged very close to 2% per year since 2003. The 10-yr annualized rate of ex-energy inflation currently registers 1.99%, and the year over year rate of ex-energy inflation is 1.84%.

Unsurprisingly, the bond market is very much aware of these underlying trends. As the chart above shows, the expected rate of CPI inflation over the next 5 years (as embedded in 5-yr TIPS and Treasury prices) is currently 1.89%.

The chart above shows the bond market's expected rate of CPI inflation over the next 10 years, which is currently 1.92%.

Inflation is not dangerously low. It is running just below 2%, and that's where it's been for many years and where the bond market expects it to be for at least the next decade. There is no reason for the Fed to be trying to boost inflation. 

Wednesday, April 15, 2015

Why the drop in industrial production is actually good news

Industrial production fell much more than expected in March (-0.6% vs. -0.3%), but the weakness was driven by good news: lower oil prices and better weather.

The chart above compares industrial production in the U.S. and in the Eurozone. The U.S. has registered a staggering amount of growth in recent years, leaving the Eurozone in the dust. One piece of good news is that the Eurozone economy is now beginning to grow again after languishing for the past five years. Production in the U.S. has been soft (down 1%) for the past four months, however. Is this the beginning of another economic downturn? No, and here's why:

The chart above is the oil and gas well drilling subcomponent of the the industrial production index. It's down 40% in the past four months, and the Baker Hughes U.S. rotary rig count is down 50% over the same period. The huge decline in oil and gas drilling activity is directly attributable to the 50% drop in oil prices that began last summer. The world now enjoys a glut of oil and sharply lower oil prices, and that's great news. We can now devote more of our economy's scarce resources to the production of other, more useful things.

The chart above shows the utility subcomponent of the industrial production index. March weather was much better than February's, with the result that the output of the utility industry fell almost 6% in March. That's more good news.

Manufacturing production (which excludes utilities), shown in the chart above, was up in March and is only down 0.7% in the past four months. That could easily be attributable to the west coast port slowdowns, but in any event is in keeping with the normal historical volatility of this index. It's still up 2.4% over the past year.

Business equipment production, shown above, was also up in March and a little soft in recent months, but not by a significant amount. It's still up 3.2% in the past year, which is a bit more than overall GDP growth.

Tuesday, April 14, 2015

Ignore the recent weakness in retail sales

Retail sales in the first quarter of this year were obviously impacted by lower gasoline prices and bad weather. Both of those have faded in importance, however, so it's important to see if there has been any change in the underlying trends. As I see it, nothing much has changed. The economy continues to grow, but at a disappointingly slow pace compared to other recoveries. Many argue that this is the "new normal" and reflects durable demographic changes. I think demographics is only part of the story (they don't change dramatically from one year to the next), and the bigger story is the burden of government (high marginal tax rates, massive income redistribution, egregious regulatory burdens). These latter conditions don't have to be permanent, and can change for the better, so there is reason to hope for stronger growth in coming years. 

The chart above shows nominal retail sales ex-Autos and Gasoline. This series has been growing at about a 4% annual rate since mid-2009. Sales today are almost 15% below where the could have been had the economy recovered back to its long-term trend. This is the measure of our discontent.

Oil prices have been extremely volatile since 1970, but in real terms they are now close to their average for the past 45 years. As the chart above suggests, big declines in the real price of oil have been reliably associated with a growing economy, and big increases in oil prices have almost always been followed by recessions. So it is reasonable to think that the weakness in retail sales in the first quarter will be followed by stronger growth in the current quarter. Money saved as a result of cheaper gasoline is likely to be spent on other things, and lower energy prices in general lower the economic hurdle rate for new economic activity.

Monday, April 13, 2015

Federal budget deficit < 3% of GDP

For the 12 months ending March, 2015, the federal budget deficit was $510 billion, up from a post-recession low of $436 billion last November, and down by almost two thirds from its record high of $1.48 trillion just over five years ago. From the looks of things, both spending and revenues are growing about 6-7% a year. If this keeps up we're unlikely to see lower nominal deficit numbers, but the deficit is likely to shrink somewhat relative to GDP as the year progresses. 

The past five years were remarkable ones for federal finances: spending was relatively unchanged while revenues surged by more than 50%. Things are now reverting to their long-term trends, with spending and revenues growing 6-7% per year.

The major source of rising federal revenues was individual income tax payments. This in turn was driven by increasing employment, higher incomes, and capital gains realizations. Economic growth proved much more lucrative for the government than higher tax rates.

The budget deficit is now just under 3% of GDP and may shrink a bit further as the year progresses. This is a very manageable figure. Over the long haul, however, rising entitlement spending threatens to swell the budget deficit again, unless Congress can muster some restraint. We don't need to actually cut spending, we just need to slow the growth of spending and keep the economy growing in order to reduce the deficit further.

Friday, April 10, 2015

Business lending is booming

As the chart above shows, Commercial & Industrial Loans outstanding at U.S. banks grew at a 19% annualized pace in the first three months of this year. These loans are mostly to small and medium-sized businesses that are not able to access the capital markets directly. It's good news not because more loans mean more spending and/or more economic activity (lending doesn't create growth, but it can facilitate growth by distributing capital to people and businesses can make productive use of the money). It's good news because it reflects a significant increase in confidence on the part of banks and businesses. Confidence has been in short supply for most of the current recovery, as can be seen by the tepid growth of business investment and the disappointingly slow growth of the economy. That looks to be changing for the better now.

Banks have had the ability to increase their lending virtually without limit ever since the Fed began its Quantitative Easing program in late 2008. However, lending didn't really pick up until the beginning of last year, right around the time the Fed announced the tapering and eventual end of QE. Things have changed dramatically since then. With rising confidence comes a reduced demand for money (i.e., money in the form of cash and cash equivalents like bank reserves, which exceed required reserves by about $2.5 trillion), and this validates the Fed's decision to stop growing its balance sheet. On the margin, banks are becoming less and less willing to sit on trillions of excess reserves; they'd rather lend money to the private sector than to the Fed, and they are beginning to do that in spades.

With lending activity booming, this is no time to be pessimistic about the economy's prospects.

Thursday, April 9, 2015

With claims this low, hiring is likely to increase

First-time claims for unemployment have been declining for six years, and have reached levels that are very low by historical standards. Yet the economy remains mired in its weakest recovery ever. Pessimists worry that every time claims fall to current levels another recession is right around the corner. Recession fears are fueled by weak growth, which many feel puts the economy at risk of hitting "stall speed" and slumping. But in the absence of any of the typical precursors of recession (e.g., very tight monetary policy, rising swap spreads, a flat or inverted yield curve, and valuations that imply very optimistic assumptions for future growth) I think the risk of recession remains very low. 

What we have is an economy that is plodding along, burdened by high tax and regulatory burdens and hobbled still by risk aversion left over from the Great Recession. Business investment remains surprisingly weak despite record-setting profits, and investors are still willing to accept extremely low yields in exchange for the relative safety of bonds. The economy is still facing significant headwinds, growing despite the many obstacles to growth. It's not an economy that is running on fumes, it's an economy that still has lots of untapped potential. The stimulative effects of sharply lower oil prices are under-appreciated, and U.S. investors are still not fully appreciative of the recent strength of foreign equity markets (which I noted yesterday), particularly those in the Asia/Pacific region. Taking the measure of the pros and cons, I think the balance of risks is still skewed to the upside.


As these charts show, unemployment claims are very near their long-term lows in nominal terms and relative to the size of the labor force. Workers in general are less at risk of getting fired today than at almost any time in the past. At the very least this should gradually add to consumer confidence. With layoffs at such low levels, any increase in business confidence and investment should translate into increased job creation.

Wednesday, April 8, 2015

The Libertarian moment has arrived

Since this blog started, back in September, 2008, readers have seen numerous comments regarding the inefficiencies of the public sector and the greater efficiencies of the private sector; the power of markets relative to the powerlessness of monetary policy and spending to stimulate growth; and the fatal flaws of legislation (e.g., Obamacare) that pretends to better organize significant portions of the U.S. economy. This has been the weakest recovery on record not because government has failed to do enough, but because government has done far too much: too much "stimulus," too much regulation, and too many mandates. It is my fondest hope that the electorate is beginning to understand this, and that the 2016 elections will result in a mandate for less, rather than more, government. 

Readers will also know that I am a huge fan and supporter of the Cato Institute. The scholars who inhabit Cato are some of the best thinkers on the planet.

Cato's David Boaz is arguably the best spokesman for what it means to be a "Libertarian." He recently published The Libertarian Mind, an excellent book that explains the Libertarian world view in a way that most people can understand, yet in a way which too few people have seen. The book was distilled in a superb essay in Cato's recent Policy Report, which I highly, highly recommend. Here are just a few excerpts—read them, but please read the whole thing if you possibly can. His main point is that too many politicians these days—on both sides of the aisle—try to convince us that our collective identities are more important than our individual needs and ambitions. That sleight of hand can and does lead to huge problems that, fortunately, can be solved by fairly simple remedies.

Individuals are, in all cases, the source and foundation of creativity, activity, and society. Only individuals can think, love, pursue projects, act. Groups don’t have plans or intentions. Only individuals are capable of choice, in the sense of anticipating the outcomes of alternative courses of action and weighing the consequences. Individuals, of course, often create and deliberate in groups, but it is the individual mind that ultimately makes choices. Most important, only individuals can take responsibility for their actions.

But what about society? Doesn’t society have rights? Isn’t society responsible for lots of problems? Society is vitally important to individuals. It is to achieve the benefits of interaction with others, as Locke and Hume explained, that individuals enter into society and establish a system of rights. But at the conceptual level, we must understand that society is composed of individuals. It has no independent existence.

The human need for cooperation has helped to create vast and complex networks of trust, credit, and exchange. For such networks to function, we need several things: a willingness on the part of most people to cooperate with others and to keep their promises, the freedom to refuse to do business with those who refuse to live up to their commitments, a legal system that enforces the fulfillment of contracts, and a market economy that allows us to produce and exchange goods and services on the basis of secure property rights and individual consent.
Today libertarians believe, as John Stuart Mill famously wrote, that “Over himself, over his own body and mind, the individual is sovereign.” That applies to gay people and to everyone else. Thus libertarians oppose laws criminalizing any consensual sexual activity among adults, in the United States and elsewhere. Many libertarians argue for the complete privatization of marriage, making marriage a matter of individual contract and for some people a religious ceremony, thus removing any need for state recognition of marriages.
How fares the individual in America today? Conservatives, liberals, and communitarians all complain at times about “excessive individualism,” generally meaning that Americans seem more interested in their own jobs and families than in the schemes of social planners, pundits, and Washington interest groups. However, the real problem in America today is not an excess of individual freedom but the myriad ways in which government infringes on the rights and dignity of individuals.
Libertarians sometimes say, “Conservatives want to be your daddy, telling you what to do and what not to do. Liberals want to be your mommy, feeding you, tucking you in, and wiping your nose. Libertarians want to treat you as an adult.” Libertarianism is the kind of individualism that is appropriate to a free society: treating adults as adults, letting them make their own decisions even when they make mistakes, trusting them to find the best solutions for their own lives.

Global equity markets march higher

For more than two years I've been highlighting the big improvement in the outlook for the Japanese economy that has resulted from the BoJ's determined efforts to weaken the yen. (For background, see a series of related posts here.) It's nice to see that things continue to improve, and not only in Japan but now also in China and Europe as well. The U.S. stock market hasn't made much headway for the past several months, but global equity markets appear to be taking up the slack. As the U.S. takes a breather, the rest of the world is moving ahead, fueled by cheaper oil prices. This can't be bad for the U.S., since it means the economic fundamentals all around the globe are improving.

The chart above says it all. The market cap of global equity markets, as calculated by Bloomberg and measured in dollars, has reached an all-time record high of almost $70 trillion. Valuations are up 9% since year end, even as the U.S. market has been relatively flat and the dollar has risen against most other currencies. That's pretty impressive.

The Japanese stock market is up almost 14% year to date, and it has almost tripled since the lows of 2009. As the top chart shows, stocks have improved in concert with a weaker yen. But that's not the whole story: the bottom of the two charts above shows the value of the Nikkei in dollars, and it has more than doubled since the lows of 2009. In other words, Japanese equity market gains are not just due to the decline of the yen, they are most likely due to some genuine improvement in the outlook for the economy, and part of that improvement is a weaker currency.

The first of the two charts above compares the Euro Stoxx 600 index to the S&P 500, while the bottom of the two charts shows the Euro Stoxx 600 Index in dollar terms. Eurozone stocks are up to new highs in Euro terms but not yet in dollar terms. That's not too surprising, considering how Eurozone economies have been struggling in recent years, burdened by default concerns and the turmoil in Ukraine.

The big news is to be found in Asia: year to date, the Hang Seng index is up 11%, and the Shanghai Composite is up 23%. In the past 9 months, the Shanghai Composite has almost doubled. These gains come independent of currency behavior, since both the Hong Kong dollar and the Chinese yuan have been relatively stable vis a vis the dollar.

The chart above focuses on the dramatic improvement in Chinese equities since mid-2014. Is it just a coincidence that oil prices have fallen by 50% over the exact same period? Or could it be that cheaper energy is a tremendous boon to the Asian economies?

The chart above compares the Shanghai Composite (white line) to the inverse of oil prices (orange line). The correlation looks pretty compelling. Cheaper energy prices are contributing strongly to a healthier outlook for the Chinese economy.

Question for the Fed: with all this remarkable improvement going on around the world, why are you guys still so concerned with keeping interest rates at exceptionally low levels?

Monday, April 6, 2015

Nothing wrong with the service sector

A few days ago I argued that the market was probably overly-concerned about the prospects for U.S. growth, based on a weak ISM manufacturing report and disappointing payroll employment data for March. Today's ISM report shows that the service sector—roughly twice the size of the goods-producing sector—is doing just fine. Manufacturing was hit by temporary factors (e.g., the slowdown in West coast ports, and the rather sudden 50% decline in active oil drilling rigs in the past four months), but there is little reason to expect a significant spillover to the service sector. Money freed up by lower oil prices and economic activity made more profitable as a result of cheaper energy is likely show up as a positive for the economy in ways we have yet to see. Until we find out who the beneficiaries are, it's comforting to know that swap and credit spreads do not show any signs of meaningful deterioration in the economy's fundamentals.

As the first chart above shows, March readings of the health of the service sector in both the U.S. and Eurozone were relatively healthy, in contrast to the weaker readings for manufacturing, shown in the second chart. I'm actually quite encouraged by the improvement we've seen in the Eurozone in recent months; Eurozone equities are up 17% since the end of last year, and have outperformed their U.S. counterparts by almost 15%.

As the chart above shows, 2-yr swap spreads in both the U.S. and the Eurozone remain firmly in "normal" territory (i.e., 15-30 bps). According to this highly liquid, market-based indictor, there is to date no indication of any meaningful deterioration in the economic or financial market fundamentals.

Friday, April 3, 2015

Climbing a slow-growth wall of worry

The March jobs report was disappointing, but there is little reason to think that the first quarter weakness in the economy goes beyond the effects of bad weather, West coast port slowdowns, cutbacks in energy-related investments and statistical "noise." The economy most likely slowed down in the first quarter (the Atlanta Fed is now forecasting zero growth), but it is just as likely to resume moderate growth of 3% or so going forward. The market, however, continues to worry about slower growth, just as it has worried about other things in the past (e.g., Ukraine, Eurozone/China slowdowns, sharply lower oil prices). I suspect we will eventually overcome this new "wall of worry" just as we have overcome many others in recent years.

The March ISM report added fuel to the slowdown worries, coming in much lower than expected. But as the chart above suggests, the drop in the ISM manufacturing index is still consistent with decent underlying growth conditions of 2% or so.

As the chart above shows, swings in payroll growth such as we have seen in recent months do occasionally happen. We're likely to see a bounce back in the months to come.

As the chart above shows, the six-month annualized rate of growth in jobs hasn't changed much at all, and is likely to be around 2-2.5% for the foreseeable future. In order to see an acceleration from recent levels, we will need to see growth-friendly changes in fiscal policies (e.g., lower and flatter taxes on income and capital, reduced regulatory burdens).

Part-time employment is behaving exactly as it has during previous business cycles. There has been almost no growth in part-time employment since 2009, while it has fallen relative to total employment by a substantial degree. This is still the weakest recovery in modern times, but it is fairly typical in many other respects.

Real yields on 5-yr TIPS have fallen about 100 bps from their recent highs, which is a good sign that the market has repriced to much lower growth expectations (as low as 0-1%, as the chart above suggests) going forward. Weaker growth is priced in and pessimism has returned, at least for now. Barring a recession, this leaves the market vulnerable to upside surprises; arguably, this could take the form of simply avoiding another recession. The following all suggest that a recession is quite unlikely: the yield curve is still steep, real yields are very low, and swap spreads are firmly in "normal" territory.

The principle source of the recent rise in the Vix/10-yr index is the decline in 10-yr yields to 1.84%, which in turn has been driven by reduced expectations for economic growth. That has pushed back the timing of the Fed's first interest rate hike. If the economy continues on its current relatively weak path, the Fed is not likely to raise rates in May. Previous episodes of spikes in the Vix/10-yr ratio had more to do with nervousness in general (reflected in a rising Vix index).