Wednesday, May 23, 2018

Truck tonnage evidence of a Trump Bump

For years I've had a number of posts linking Truck Tonnage to equity prices, and they've all been impressive—in the sense that the physical volume of trucking activity has had a strong tendency to track equity prices. I can't say which leads which, but when they move together they appear to be self-validating.

Chart #1

As Chart #1 shows, truck tonnage has surged 9.5% in the year ending April '18, and the S&P 500 Index is up almost 14% over the same period. Both have experienced substantial growth since Trump's election, in what might be called a "Trump Bump." This further suggests that the economy's growth rate is picking up.

Tuesday, May 22, 2018

Waiting for GDP

In my last post of 2017 (Predictions for 2018), I argued that the investment theme which drove markets in 2017 was the potential for tax reform, and that this year's meme would likely be waiting for GDP. Tax reform brought with it a one-time upward revaluation of after-tax future profits, and arguably, most if not all of that had been priced in by last January. For the past several months, markets have fretted over the impact of rising bond yields and a potential trade war with China, not to mention concerns over a nuclear NoKo. Fortunately, these concerns appear to have ebbed, and a certain calm now prevails. Looking forward, all eyes will be on the lookout for signs that last year's tax reform will result in a significant pickup in economic growth, which I believe we'll see. There are early indications that this is playing out, as I show in the following charts:

Chart #1

As Chart #1 shows, the market's degree of anxiety (proxied by the ratio of the Vix index to the 10-yr Treasury yield) recently has settled back down to relatively low levels. Prices have drifted higher, though they have yet to return to their January '18 highs. The market has digested the impact of higher yields, and Trumps' tariff wars have failed to materialize. In fact, there appears to have been a measure of progress with regards to relations with China and North Korea. In the absence of unexpected distress, and in the presence of rising profits, equity prices are floating slowly higher.

Chart #2

As Chart #2 shows, Credit Default Swap spreads are trading at relatively low levels. These spreads are an excellent, market-based proxy for the outlook for corporate earnings. Investors are saying that it doesn't get much better than this.

Chart #3

Chart #3 tells the same story: credit spreads in general are low, which implies that the market is confident in the future of corporate earnings.

Chart #4

Chart #4 focuses on 2-yr swap spreads in the US and Eurozone. US 2-yr swap spreads at current levels are also about as good as they get, which in turn suggests that credit markets have plenty of liquidity and systemic risk is very low. This further suggests that financial market fundamentals are strong, and that is consistent with improving economic growth conditions.

Chart #5

Chart #5 shows Bloomberg's index of a variety of market-based indicators of financial conditions. It too is a sign of low systemic risk and improving growth conditions.

Chart #6

Chart #6 compares the real yield on 5-yr TIPS with the 2-yr annualized rate of growth of the US economy. This shows that there is a connection between prevailing real economic growth rates and real interest rates; both tend to rise and fall over time. The modest rise in real yields which began last year has coincided with a modest increase in the economy's growth rate. The bond market senses that growth fundamentals are improving, but by no means has the market become overly optimistic.

Chart #7

Chart #8

Chart #7 and #8 compare international interest rate spreads to the value of the dollar. It's important to note that nominal and real interest rates spreads between the US and the Eurozone today are at record highs. With spreads sharply in favor of the US at present, it is very tempting to think that the dollar has significant room to appreciate.

Chart #9

Chart #9 shows that excess bank reserves have declined about 30% from their all-time high. This is the result of 1) increasing levels of bank deposits, which require banks to hold a certain level of bank reserves as collateral, and (mostly) 2) the gradual shrinking of the Fed's balance sheet, which has largely been accomplished by not reinvesting the proceeds of maturing securities. This should not be mistaken for Fed "tightening," however. QE was not about printing money, and the gradual unwinding of QE is not about tightening. This is best viewed as the Fed reversing part of its massive injection of dollar liquidity that began almost 10 years ago, a move that was designed to supply risk-free T-bill substitutes to a market that was desperate for safe and liquid assets. Today the demand for safe money is declining, so it is entirely appropriate for the Fed to be shrinking its balance sheet.

Chart #10

Chart #10 shows the significant decline in the rate of growth of bank savings deposits, a process that began in early 2017. Savings deposits account for about two-thirds of the M2 money supply, and they mushroomed from $4 trillion at the end of 2008 to now over $9 trillion. I consider bank savings deposits to be excellent proxies for the demand for money, especially over the past decade, since they have paid almost nothing in the way of interest. People poured trillions of dollars into bank deposits not for their return, but for their safety. But now the era of strong demand for money has ended. Confidence is up, and people are attempting to shift their portfolios away from risk-free assets to more risky assets. The Fed absolutely needs to reverse QE to accommodate this, lest the financial system finds itself with excess money—a condition that would likely foster an unwanted acceleration of inflation. 

Chart #11

Chart #11 gives you the big picture behind the Treasury yield curve. The curve has flattened substantially in recent years, and this is typical of economic expansions. It is also typical of periods during which the Fed is raising short-term interest rates. Much has been made of the flattening of the yield curve, because flat and inverted yield curves typically have preceded recessions. But the curve is not flat, it is still positively sloped, and it has been this way several times in the past when recessions were still on the far horizon.

Chart #12

Chart #12 adds more information to the shape of the yield curve, since the yield curve is only one way that the Fed acts on the market and the economy. The other key variable is the real Fed funds rate (blue line). Recessions are reliably preceded not only by a flat or inverted yield curve but also by a significant increase in real borrowing costs. Today, short-term real borrowing costs are effectively nil. The Fed is not tight.
Chart #13

Chart #13 compares the current real, inflation-adjusted Fed funds rate (red line) with what the market expects the real funds rate to average over the next 5 years (red line). Here we see that the market fully expects the Fed to continue raising short-term interest rates gradually over the next several years. If there were any hint that the economy is weakening, the market would be expecting the Fed to stop raising rates and/or to begin to lower rates in coming years. That is not the case today.

Chart #14

Chart #14 shows the history of nominal and real 5-yr Treasury yields and their spread (green line), which is the market's implied forecast for what the CPI will average over the next 5 years. Here we see that despite all of the supposed "money printing" of the past decade, inflation expectations are well anchored. The bond market fully expects that inflation in the years ahead will be just about what the Fed is targeting, i.e., 2% or so per year. This further suggests that the Fed has yet to make a serious mistake. It's also worth noting that essentially all of the increase in 10-yr yields from their all-time low of July '12 is accounted for by rising real yields. Yields are higher because the market is more confident about the outlook for real economic growth. This is an optimal development.

Adding it all up, financial market and economic conditions are quite healthy. Add to the mix the fact that corporate income tax rates have been sharply reduced, and you have a recipe for stronger economic growth, which will likely be a by-product of increased corporate investment. We can't say for sure this will happen, but the evidence is mounting and the market is still only in the early stages of pricing this in.

Thursday, May 10, 2018

Laffer Curve strikes again: lower tax rates produced more revenue

The results of last year's Trump tax cut are starting to roll in, and they should not be surprising to students of the Laffer Curve or readers of this blog. As I noted last October, not cutting taxes rates is boosting the deficit:
Since early last year (February 2016, to be exact), when talk of tax cuts began to spread and politicians on both sides of the aisle began to agree that our corporate tax rate—the highest in the developing world—should be cut, revenues from corporate and individual income taxes have flatlined, despite the fact that personal incomes have increased by almost 5%, trailing earnings per share have increased 8%, and the stock market has jumped some 30%.
Indeed, there was zero growth in federal revenues beginning in February 2016 through the end of last year. Further, as I predicted back then, "if the tax code is reformed, and marginal tax rates on incomes, capital gains, and corporate profits are reduced, Treasury will see an almost immediate surge in revenue." And it is happening.

Today's April Treasury report showed that April tax receipts not only set an all-time record, but were fully 12% higher than last April's receipts. People and corporations had been postponing income and accelerating deductions for the 22 months leading up to last December's landmark tax reform, and now they are beginning to realize that income and stop postponing deductions. Tax receipts are once again growing, and there is every reason to expect more of this for the foreseeable future.

Chart #1

As Chart #1 shows, individual income tax receipts have jumped this year, led by very strong receipts in April. Corporate income tax receipts are still soft, but that's not too surprising considering the huge reduction in the corporate tax rate. In any event, individual income tax receipts account for the lion's share of federal income, and they have once again turned up in decisive fashion. 

Chart #2

As Chart #2 shows, spending has been rising at a fairly constant rate (about 4% per year) since 2015. On a rolling 12-mo. basis, federal revenue has risen at a 3.4% rate over what it was a year ago, and it could easily be recording 5-6% rates of growth going forward. With just the tiniest bit of spending restraint, we could see the budget deficit hold steady or decline between now and year end.

Chart #3

As Chart #3 shows, the federal government's finances are very dependent on the health of the economy. They always deteriorate during and after recessions, and they almost always improve during periods of growth. The recent increase in the budget deficit is anomalous in that regard. But when seen through the lens of the Laffer Curve, it is understandable and thus likely temporary.

The Laffer Curve can be summed up as follows: people respond to incentives, especially changes in tax rates. When there is talk of a future reduction in tax rates, it is reasonable to expect tax revenues to decline in anticipation, then subsequently rise once the rates have been cut. Business investment was weak in anticipation of a reduced business tax rate, and now it should be stronger, with the result being more jobs, more income, more profits, and more revenues to Treasury.

The one thing to worry about is the spending side. Spending discipline unfortunately is lacking in today's Congress, and the unchecked growth of entitlements promises to wreak havoc with federal finances in coming years.

Tuesday, May 8, 2018

Jobs nirvana

The economy isn't booming, but labor market fundamentals have never been so good.

Chart #1

The BLS today reported that April job openings were the highest ever recorded (see Chart #1). The current business cycle expansion has added 10 million net new private sector jobs to the economy since late 2007, yet businesses are looking to hire another 6.55 million. Impressive.

Chart #2

The unemployment rate has fallen to a mere 3.9%, and there are only 6.4 million people actively looking for work, according to the BLS. If there is a problem it is the apparent inability of those looking for work to qualify for or accept the jobs being offered. (see Chart #2) Geographical mismatches are one overlooked but likely culprit: the WSJ noted the other day that a growing number of cities around the country are paying people to relocate there because they have a shortage of able-bodied workers. And with businesses enjoying peak earnings these days, it would not be surprising for many to sweeten their salary offerings in order to fill jobs. What's not to like?

Chart #3

As a percent of the workforce, layoffs are now down to their lowest level ever, as shown in Chart #3. Never before has job security been so solid.

Chart #4

Small businesses are where by far the most new jobs are created, and the owners of those businesses have rarely been so optimistic about the future, as Chart #4 shows.

Chart #5

As Chart #5 shows, real disposable personal income per capita is at an all-time high of $39.5K. That is up 10% from the end of 2007 (i.e., just before the Great Recession hit), and it is just about double what it was 38 years ago, in 1980. Granted, the pace of gains in the past decade has been only about 1% per annum, which is disappointing compared to the 2.1% per annum gains of the 1980-2007 period. But we are making progress and the future looks bright.

Capital today is relatively abundant, thanks to years of growth, rising profits, and lower corporate income taxes. An abundance of capital is an unqualified boon for labor, because when capital is abundant labor sooner or later becomes scarce. This means that the price of labor is bound to rise further, and that should take the form of higher real wages and salaries, plus more job opportunities as businesses seek to ramp up investment. 

UPDATE (5/10/18): First-time claims for unemployment continue to decline. No one ever would have predicted such low levels. The last time they were this low was in 1969, when the total number of jobs was less than half of what it is today:

Chart #6

Monday, May 7, 2018

Argentina just got a $5 billion lesson in the Laffer Curve

Recently, and in the short span of 4 trading days, Argentina's peso suffered a 10% drop, leaving it down 30% vis a vis the dollar over the past year. The Central Bank spent some $5.5 billion of its reserves trying to stem the latest decline, which was arrested only after the central bank hiked short-term rates to a punishing 40% and the government promised to cut spending.

The catalyst for the latest peso decline appears to have been a new 5% income tax on non-residents' holdings of central bank debt (Lebac). This tax, which was part of a comprehensive—and mostly positive—tax reform passed late last year, took effect on April 25th, the very same day that the central bank suddenly was faced with significant outflows of foreign capital. It would seem that foreigners were unhappy paying a tax of 5% of their 30% Lebac coupons. In effect, some $5.5 billion of Lebac was unloaded by foreign investors, converted—thanks to the central bank's sales of its foreign reserves—to dollars, and then shipped out of the country. This was equivalent to the exodus of almost 10% of Argentina's precious foreign reserves. And all because of a 5% tax that might have generated, in the best of cases, about $0.5 billion per year. Ouch. As Art Laffer tells it, "when you tax something more, you should expect to get less of it." Less, in this case, being foreign capital, which Argentina desperately needs to jump-start its economy.

Most observers blame Argentina's ongoing problems on its inability to reign in government spending and tame its 25-30% inflation rate. I think the problem is simpler. As I noted 18 months ago, Argentina has been addicted to money-printing for a long time. Its monetary base has been growing about 30% per year for the past 9 years. Money printing has been and continues to be a major source of financing for the government's deficits. In the U.S., federal deficits are financed almost entirely by the sale of government debt. In Argentina, however, if the government can't finance its deficit by selling debt, then it simply resorts to asking the central bank for money, in exchange for an IOU. The U.S. spends money it borrows from the market, but the Argentine government spends money created out of thin air by its central bank.

Argentina has two ways to proceed if it wants to get things under control. One, reign in government spending in order to reduce the deficit (no more taxes, please!). Two, establish enough credibility with foreign investors so that government deficits can be financed with debt sales. Nothing wrong with doing both, of course, while at the same time eschewing money-printing.

Chart #1

Chart #1 documents Argentina's primary problem: massive money printing. For the past 9 years, the central bank has allowed a 30% annual expansion of the monetary base (two-thirds of which is currency in circulation). Not surprisingly, inflation has been running around 25-30% per year. Inflation, as Milton Friedman famously noted, is a monetary phenomenon. Inflation happens when the supply of money exceeds the demand for it. And in this case, a ten-fold increase in the money supply over 9 years clearly and by far outpaced money demand, so the value of the peso plunged and prices in turn soared.

Chart #2

Another problem that has plagued the country off and on over the years is the government's attempts to manage the peso's exchange rate. If the peso's decline can be slowed, as government bureaucrats typically argue, then that will reduce inflation pressures (thus conveniently shifting the blame from money printing to the foreign exchange market). Notably, the Macri administration, which began in late 2015, wisely abandoned the "official" rate and allowed the peso to float freely (this is shown in Chart #2 where the red and blue lines converged). That restored confidence, and the peso slowed its decline for the next year or so even though money printing continued apace, because demand for pesos improved with improved confidence.

Chart #3

But they have reverted to type of late, by selling $5.5 billion of their forex reserves in order to keep the peso from plunging, as seen in Chart #3. Since that didn't work, their only choice was to jack up short-term interest rates in order to bolster demand for the central bank's debt. Higher interest rates can work in the absence of a decline in money printing (note the similarity to the Fed's use of IOER to bolster banks' demand for bank reserves in the presence of an abundance of excess reserves), but that's not a lasting solution nor will it inspire long-term confidence.

In the end, the math is compelling: since mid-2009, the monetary base has expanded ten-fold, and the peso has lost 83% of its value. The culprit is money printing, and it has got to stop. Any other "fixes" will only prove temporary. Short-term interest rates on Lebac are only effective if they offer investors after-tax compensation for the expected depreciation of the peso. With money printing running at 30% and the peso down 30% in the past year, the after-tax coupon on Lebac needs to be well above 30% to avoid further capital outflows. (Thus it's no surprise that with Lebac rates today at 40%, the peso appears to have stabilized.)

Argentine President Mauricio Macri is, like Donald Trump, a successful businessman who has pledged to restore prosperity to his country. Macri has done a lot of good to date, but this recent peso problem is an unfortunate blemish on his record. I'd like to think that he will take the appropriate steps to get things back on track. So far he's made serious inroads on government corruption and red tape, and the economy's fundamentals have improved measurably (in dollar terms, the Argentine stock market is up 33% since Macri took over). It would be a crime if he didn't set a better course for monetary and fiscal policy. Please, Mr. Macri: cut government spending, pledge to honor Argentina's commitments, get rid of unnecessary taxes, and instruct the central bank to reign in the growth of the money supply.