Friday, October 27, 2017

Key charts updated

3rd Quarter GDP came in stronger than expected (3.0% vs 2.6%) and a bit stronger than the 2.2% growth rate of the current expansion, but the market remains unconvinced that the US economy is indeed accelerating. Tax reform may be on Congress' table, but I can detect few if any signs that the market is optimistic about it happening, or even if it happens, whether it will be a significant positive for the economic outlook. This may sound odd, to be sure, given that the stock market has been posting serial new, all-time highs since mid-2016. But consider that since its pre-recession (late 2007) peak, the S&P 500 is up at an annualized rate of just over 5%—which is lower than its long-term average of just over 6% per year. The market is doing well, of course, but arguably it's not yet in "off the charts" mode.

I've been posting updated versions of this spectacular chart for many years now. It shows clearly how unique the current business cycle expansion has been in the economic history of the US economy. From 1965 through 2007, the US economy grew at a trend rate of about 3.1% per year. It slipped below this trend during recessions, and exceeded the trend during boom times. But it invariably returned to trend given a few years. (Milton Friedman in 1964 wrote a paper about this, calling it the Plucking Model.) The current expansion has been by far the weakest on record. Relative to its previous trend, the US economy is more than $3 trillion smaller than it might have been had things played out this time as they have before.

What's the cause of this underperformance, especially considering that since late 2008 the Fed has massively expanded its balance sheet? My list of reasons lays the blame on two major factors: 1) an oppressive expansion of government, in the form of increased regulatory and tax burdens, and 2) a shell-shocked market that has yet to regain its former level of confidence in the wake of the worst recession since the Depression.

Thanks to TIPS (Treasury Inflation-Protected Securities), which were introduced in 1997, we have real-time knowledge of the market's expectation for risk-free, inflation-adjusted returns. (TIPS pay a real rate of interest in addition to whatever the inflation rate happens to be. The price of TIPS varies inversely with the market level of the real yield on TIPS.) As the chart above shows, the level of real yields on TIPS tends to track the economy's real growth rate, much as common sense would suggest. When economic growth was booming in the late 1990s, TIPS paid a real rate of interest of about 4%, since they had to compete with the market's expectation for 4-5% real economic growth. But with the trend rate of growth having now slowed to just over 2%, the real rate of interest on TIPS is only modestly positive: 0.2% for the next 5 years, as of today. If the market thought the US economy were on track to deliver 3%+ rates of growth in the years ahead, I'm confident that the real yield on 5-yr TIPS would be in the neighborhood of 1-2%, if not higher.

The chart above compares the real yield on 5-yr TIPS (red line) with the ex-post real yield on the Fed funds rate. This is akin to viewing two points on the real yield curve: overnight rates and 5-yr rates. In effect, the red line is the market's expectation for what the real Fed funds rate is going to average over the next 5 years. And of course, the real Fed funds rate is the rate that the Fed is actually targeting. As you can see, the market expects only a very modest amount of tightening from the Fed in the years to come; 2-3 rate nominal rate hikes over the next few years, and hardly any hike at all in real overnight rates. That makes sense only if you believe that both the market and the Fed agree that the economy has very limited upside growth potential. If the market thought the economy were set to grow at a 3%+ rate for the next several years, the market would immediately assume—and the Fed would probably agree—that there would be a series of rate hikes in the future, not just 2 or 3.

The chart above compares the real and nominal yields on 5-yr Treasuries (red and blue lines) with the difference between the two (green line), which is the market's expectation of what the CPI will average over the next 5 years. With 5-yr inflation expectations today at 1.85%, the market is only a tiny bit concerned that the Fed will be unable to hit its 2% inflation target. Looking ahead, the market sees pretty much the same amount of inflation that we have seen over the past few decades. Nothing surprising. The market is thus fairly confident that the Fed is not going to do much going forward, and whatever it does, the Fed is unlikely to be too tight or too easy. You may not agree with that assessment, but that's what the market tea leaves are saying.

The chart above suggests that one reason the market is up is because the market is not very worried about whatever is going on in the world right now. The Vix index is relatively low, and 10-yr Treasury yields are near the high end of their recent range. The combination of the two (red line) suggests a lack of fear and a lack of concern that the economy could decelerate meaningfully.

If the market is not very optimistic about the economy's ability to grow at a significantly faster pace, as the charts above strongly suggest, then it stands to reason that a failure by Trump and the Republicans to pass significant, growth-friendly tax reform would not likely result in a significant equity market selloff. But should they be successful, then the market's upside potential could be significant.

I hasten to add, however, that a stronger economy would perforce result in an unexpected rise in real and nominal interest rates (and more rate hikes from the Fed than are currently anticipated). Higher-than-expected rates would obviously depress bond prices, and, in similar fashion, could depress the market's PE ratio (which is the inverse of the earnings yield on equities, and thus similar to a bond price), thus limiting further gains in equity prices to a rate that is somewhat less than the increase in earnings. So even if Trump and the Republicans are successful, we are probably not on the cusp of a monster equity rally. In other words, the next Wall of Worry could be higher-than-expected interest rates, which would put downward pressure on equity prices because they would imply a higher discount rate and a lower present value of future after-tax corporate profits. That downward pressure on equity prices would probably be offset—though not entirely—by rising earnings.


terex said...

Thanks Scott, always a good read!

One chart that I find intriguing right now is Velocity, that seems to be bottoming mby highlighting a change in attitude towards demand for money, inflation, interest rates, yields, ... valuations. A loop that can become self-reinforcing. Any thoughts on your side?


bob wright said...


In your first chart (Real GDP) you state:

"...the S&P 500 is up at an annualized rate of just over 5%—which is lower than its long-term average of just over 6% per year."

Is this real S&P 500 growth or nominal S&P 500 growth?


Bob Wright

Adam said...

On the m2 velocity,ms has observed that:

The Cliff Claven of Finance said...

Your GDP versus trend is an excellent chart, and I'm always surprised I don't see similar charts all over the place.

It's hard to explain to people why 3% real growth (6% nominal) is so much better than 2% real growth (5% nominal).

Even very smart people see an unimpressive one percentage point difference,
rather than the 3% real growth rate being a 50% higher growth rate than the 2% real growth rate.

Hope for a permanent 3% growth rate is wishful thinking, however, because the labor force growth will be one percentage point lower than when we used to have 3% real growth (consisting of 1.5% labor force growth + 1.5% productivity growth).

Just as bad as the 0.5% labor force growth, or lower, in the future, is that productivity growth has been increasing at a 0.5% too -- that doesn't add up to a long-term 3% growth rate ... or even a long-term 2% growth rate if productivity growth does not accelerate.

Your "stocks climb a wall of worry" chart title is an old stock market platitude that never made any sense to me, and still does not.

In fact, the level of worry generally declines as stock valuations rise, and worry is lowest at the ultimate market cyclical peak (meaning confidence is highest at the peak).

There are quite a few indications that investor confidence is unusually high now.

The VIX index is short term and volatile -- not a great indicator, but does show that.

More useful would be something like the U of M Consumer Sentiment Survey, showing Americans have never been more confident that stock prices would rise in the next 12 months.

Scott Grannis said...

Bob Wright: I’m referring there to nominal, not real.

Scott Grannis said...

Re M2 velocity: I'm going to do a post on this, now that we have Q3/17 GDP numbers. For the moment, M2 velocity appears to have stopped declining and may be in the early stages of rising. Rising velocity is also indicative of falling demand for money (M2 velocity = GDP/M2, M2 demand = M2/GDP). I've been on the lookout for signs that money demand is no longer rising and instead is falling, since that fully justifies the Fed's decision to raise rates (higher rates on short-term money tends to increase the demand for money, offsetting an observed decline in same). If this continues, the Fed may well have to raise rates by more than the market currently expects. This would obviously be big news for the market.

Adam: many thanks for the link to the Morgan Stanley chart, which is very intriguing and bears some further study on my part.

Benjamin Cole said...

Great review by Scott Grannis.

I am all for lower taxes, but Scott Grannis has run charts recently showing federal tax collections as share of GDP have not done much lately, and are a little lower than recent years. So, can we say "higher federal taxes are suffocating growth (any more than usual)"?

I also favor lighter regulations---unfortunately, the worst and most growth-suffocating regulations today are local, those being property zoning straitjackets. I can assure readers there would be a business and development boom along the West Coast for the generations---and a lot more jobs and profits---if this nation could rid itself of property zoning. The voters have spoken; they do not believe in free enterprise in property development and prefer socialism.

I still wonder if monetary policy is too tight. If you take out housing costs (which are escalating due to the zoning I just mentioned) you have inflation (on the CPI core) at less than 1% a year.

Yet we have a Fed that jibber-jabbers constantly about tight labor markets.

Is the Fed immune to regulatory capture? That is, the Fed is the banker's friend? What we call commercial banks actually have about 50% of loans exposed to real estate. They have a stake in continued property zoning and the artificially high prices that result. When property values decline...well you get 2008. Banks become insolvent.

So we have a powerful propertied-financial class that deeply embraces socialist property zoning.

Given that reality, the Fed should probably tolerate moderate rates of inflation, as they did before 2008. Sheesh, there were some great decades in there, like the 1990s.

Why the working sub-2% inflation target?

I do not know.

Benjamin Cole said...

Add on:

In Scott Grannis' first chart (they are not numbered, but it is the first chart), we see GDP "got sick" in 2008 and never really recovered. Oh, it grew again, but not like before.

Well, we could say that was Obama in 2008 and he was certainly a mediocre President. But was Obama any better or worse than Bush jr. for the economy? To cause a marked shift like that?

In 2008 the Fed more-or-less said it had a 1.7% to 2% inflation target, and then in 2012 the Fed adopted an official 2% inflation average target as measured by the PCE. The Fed has never really reached that target, inclining many to believe the "target" is an operative ceiling, and red hot at that. The Fed does not want to touch it.

If you believe the only job of the Fed is to control inflation, then the best central bank in more than 50 years is the one you have now.

But maybe a little more gas is needed.

steve said...

There will be no significant tax reform. GOP is predictably and pitifully punting on the deductability of state tax.

Without this exclusion, you've got damn little. Still, the increase in stock prices is quite interesting and points out strongly that market timing is insanity-especially based on valuations.

It's not different this time, it's different EVERY time!

Adam said...

Thanks to you Scott, for your effort.

Benjamin Cole said...

PCE core September up 1.3% YOY.

Sure seems to me we could emphasize growth more than inflation in monetary policy….

Scott Grannis said...

Once more Benjamin: how is it that monetary policy can create growth? Granted, monetary policy can be bad for growth, when, for example, real interest rates are forced to very high levels and the yield curve becomes inverted. But when real interest rates are very low and liquidity is abundant, as has been the case for many years now, how is it that monetary could stimulated growth?

I remain firm: monetary policy can be bad for the economy, and it can be good. But it can't create growth out of thin air. The only way that monetary policy can be "stimulative" is by being not disruptive, by being relatively stable and predictable. As it has been for the most of the past 7-8 years.

Anonymous said...

What's the cause of this underperformance, especially considering that since late 2008 the Fed has massively expanded its balance sheet? My list of reasons lays the blame on two major factors

With a MSc in electrical engineering as background, I am always STUNNED how people with a purely financial background see the world.

Scott, how is it possible, that such an intelligent person with a sharp mind like you, does not see, that Americans hardly can take in more calories and become even fatter, drive more cars (800 cars per 1000!), waste more energy, create more waste, fly more miles and create bigger traffic jams on roads with even more lanes?!

Do you understand that constant growth in percents is an EXPONENTIAL FUNCTION?

All live, our existence, just like the planet and its resources are NOT UNLIMITED.
Do you know the only thing in nature that grows exponentially? CANCER. And it ends with the exitus of the host...

Oeconomicus said...


Contrary to popular belief - economics is not just about money and finance, or creating over-consumption. Economics is not about trying to over-consume earths' scarce resources such as food, cars, infrastructure, commodities, etc.

Economics is a social science, in pursuit of study, for how to allocate said scarce resources in an environment of risk and uncertainty - all while providing an environment where people are free to choose how they want to spend their lives. Is it perfect? No. Can you imagine a perfect economic system where all humans are agreeable?

Believe it or not, a well designed economy with free functioning markets and price signals, is exactly the remedy for the over-consumption you are worried about.

And, you can't just use an exponential function argument to discredit economics. There are far more variables at play.

Thomas Robert Malthus (Malthusianism) once used this exact argument to predict the end of the human food supply. And you (and yes I am too!) hundreds of years later, are observing that people have the opportunity, if they so choose, to over consume food - in developed economies.

Anonymous said...

And, you can't just use an exponential function argument to discredit economics.

Nobody did that. The contrary. Economics should be better than trying to implement an exponentially growing function on a limited world. So why do you equalize the exponential function with economics?

Consistency. Reproducibility. Falsifiability.
The three pillars of science.
Today's economics a science? Obviously not. Otherwise the contraditcion of unlimited exponential growth as goal and the reality would reject any theory based on that flawed assumption.

Doug MacGibbon said...

Scott, I'm late to the discussion here but perhaps consider this idea for a future post.

On the Grannis GDP Growth Gap chart with $3T of current gap noted, I would like to see the area under curve calculated representing in my view the sum of the damage caused by current anti-growth policies.

It is hard to make a visual guess on a semi-log scale but it looks like about $20T, $2-3T/yr over 9 years of lost national income equal roughly to our entire federal debt. Check my math, but that is $100,000 per person aged 15-64!

I would like to see someone set up a real time visual like they have at to show the urgency of repairing misguided public policies such as the tax code.
- Doug

Scott Grannis said...

My very rough calculation says the amount of "lost output" is somewhere in the neighborhood of $13-15 trillion. That's roughly the current size of the national debt, which is $14.8 trillion. (

Note: the $20.5 trillion figure is misleading, since it includes $5.7 trillion the government owes itself. $14.8 trillion is the total amount owed to the public, and that is the relevant measure of the national debt.

Doug MacGibbon said...

Scott, thank you!