Friday, July 1, 2016

Encouraging signs

The news is certainly mixed these days. Britain's Brexit vote stirs fears of a global slowdown in trade, which would surely be bad for the economic outlook. But that's still something out on the horizon. In the meantime, more recent data point to a pickup in growth that began a month or so ago. 

The ISM manufacturing index was stronger than expected (53.2 vs. 51.3), and as the chart above shows, this suggests that second quarter GDP growth will be stronger than the tepid 1.1% registered in the first quarter. It wouldn't be surprising to see Q2 growth come in at 3%.

The export orders subindex continues to improve, which suggests that conditions overseas are improving.

Now that oil prices have been rising for over four months, it's not surprising to see a clear majority of firms reporting higher prices paid. Once more we say goodbye to concerns about deflation.

The employment subindex remains unimpressive, which suggests that firms are still cautious about the outlook. This recovery is still dominated by worries and risk aversion, but that's not necessarily bad. The time to worry is when everyone is optimistic.

Manufacturing activity has been improving for the past few months in both the U.S. and the Eurozone. This may be tempered in months to come by the Brexit vote, so it's too early to get excited about a coordinated rebound in activity. But in the meantime it's reassuring. 

10-yr Treasury yields are still amazingly low, closing today at 1.44%. 30-yr Treasury yields are also down to all-time lows, closing today at 2.23%. But the spread between the two, shown in the chart above, has been rising since last August. From a long-term historical perspective, the long end of the Treasury curve is plenty steep, and that suggests the market still expects the economy to improve over time. The time to worry is when the yield curve gets very flat or even negatively-sloped.

The PE ratio of the S&P 500 is about 15% above its long-term average, but this has to be viewed in the context of risk-free interest rates that are at their lowest level ever. Put another way, the PE ratio of 10-yr Treasuries today is about 80, whereas the PE ratio of equities is about 20 (i.e., an investment of $80 in 10-yr Treasuries will get you an annual return of $1, whereas an investment of only $20 in equities promises a return of $1). I'm thinking this is an unprecedented valuation gap in favor of equities.

As the chart above shows, the earnings yield (after-tax profits per share divided by share price) on equities is still well above average. Moreover, EPS appears to be stabilizing, having fallen only 2.7% over the past year—and quite likely to increase now that the problems in the oil patch are in the past. If profits merely hold at current levels, the expected return on equities will be significantly higher than the return on Treasuries.


Benjamin Cole said...

Terrific wrap-up.

For about 30 years US economists have said that "next year we will see higher interest rates and inflation."

Some have predicted catastrophes, such as Grant's Observer.

1.44% on 10-year UST and we are one recession away from (possibly) persistent deflation.

0.255% yield now on Japan bonds. That's a negative yield, btw.

I suspect conventional economic policies have pooped out. Times change.

In the 1930s, Japan largely sidestepped the Great Depression. They had a central banker named Takahashi.

A history worth reading.

Al said...

Excellent scott. said...

I've noticed the WFC 15 year home refinance rates haven't fallen from 3.0 as the 10 year UST has fallen from the 1.80 area to the 1.40 area.

Hans said...
This comment has been removed by the author.
Hans said...

Ben Jamin, keep an eye on the precious metal rally
which maybe portending serious problems in the near

"It wouldn't be surprising to see Q2 growth come in at 3%."

I wish economists would stop annualizing growth rates which
turns a fact into a projection.

"Once more we say goodbye to concerns about deflation."

Why, unless one worships before the idol of debt.

Hear, are some very pertinent matters which seemingly matters
little to most economists and citizens.

The SS disability has gone BK. SS, has been running in the red
since 2010. Medicare, is now projected to begin paying out
more funds than it is receiving by 2028; a very short 12 years
all you young volks. The projected deficiency will be 21%.

In the meanwhile, few raise the alarm with most Americans having
their head in the sand.

The Socshevikes continue their march towards totalitarianism, simultaneously
destroying both liberty and economic freedoms.

The gravity of this will produce either a collectist society
or an uprising; - leading to a civil conflict ending this
great (somewhat) republic.

McKibbinUSA said...

The good news is that my income portfolio grew last week lead by utilities. said...

Yes, good news for equity 'bond substitutes' like utilities & real estate investment trusts. My "O" position just continues to outperform the broad market. I have been lightening up on utilities as they rose.

marcusbalbus said...

we demand more QE

Benjamin Cole said...

Hans--precious metals? Not sure. The People's Bank of China is a heavy buyer, as are Indian and Chinese jewelry consumers.

Jim Grant says a dollar dump is inevitable as Americans have become so indebted to foreigners.

My next hobby will not be economics. Maybe gardening.

McKibbinUSA said...

A horrifying report from Bloomberg...

Take cover! Nothing is a bargain right now..

Benjamin Cole said...

1.37% on 10-year Yreasuries.

But this may be the year the Chicago Cubs win the World Series, so this may also be the year that interest rates and inflation actually go up.

Watch the Cubs.

When institutional investors buy 10-year UST at 1.38%---is that not deflation already?

Frozen in the North said...


I know you are just back from your 4th of July hot dog eating contest (real or just lots of food) but while I agree that Brexit is something on the far horizon (if ever), things elsewhere in Europe are getting interesting: Banks are in real trouble; Bad loans for Greek (34%) and Italy (17%) and Ireland (19%) are big big number -- if you compare to 2008/09 in the US where the peak was around 5% of all loans.

Talk all you want about T-rates, this morning the Swiss 50yT rate went to -2.27 bps. Free money for 50 years if you are the Swiss government.

Johnny Bee Dawg said...

Lawlessness and resulting risk aversion continues.
Comey spent a solid 5-10 minutes detailing all the laws that Hillary broke...before declaring that she should be free.
Gold took off at 11am est.
6 legal experts, including former prosecutors, ALL extolled what a horrible miscarriage of justice this was on CNBC.
The Hillary network could not find a single one who supported Comey. One called him a liar.

Gold miners and long Treasuries soaring to new highs, while stocks give back nearly 1%.

How long, Lord? How long?

Mr. Wanderer said...

Thanks for the great summary. Can you explain this please.
" I'm thinking this is an unprecedented valuation gap in favor of equities."
I couldn't get my head around this.

thanks ..

Scott Grannis said...

Wanderer: that would be the difference between the earnings yield on equities and the yield on 10-yr Treasuries, which is historically large, at the same time the yield on 10-yr Treasuries has never been so low.

Benjamin Cole said...

Deflation is not kind to equity investors.

McKibbinUSA said...

The bond market is about to go "pop!"

Benjamin Cole said...

US 10 year Treasuries to 1.33%.

Japan 20-year government bonds go to negative yields.

Gold is going up, but this time I think it is because if investors have to pay for the right to own a bond they might as well buy gold.

They keep saying the Fed and other central banks are too loose. And yields and inflation keep sinking.

My guess is that central banks won the war on inflation, and now they are making the rubble bounce.

McKibbinUSA said...

@Benjamin, our world is run by central bankers who only care about other bankers and a few other top investment personalities. All of the QE over the past eight years was helicopter money dropped through the roofs of Wall Street into bank vaults. The people got essentially nothing. Watch for the Fed and ECB to advance a multi-trillion dollar QE in the next year that will be deposited directly into the personal accounts of bankers and their top 10 account holders.

Hans said...
This comment has been removed by the author.
Hans said...

Ben Jamin, there are two profess whom are
suggesting a lost to the economy due to zoning
by as much as 1.5 trillion dollars!

We are getting a strong dose of what we
deserve by being mute and not active in civic