Thursday, September 24, 2020

Recommended reading: Blue Truth Matters


"Blue Truth Matters" by Heather MacDonald

Heather MacDonald is a fount of statistical wisdom, one of the best I know. This essay of hers appeared a few days ago on The American Mind, a website run by The Claremont Institute, whose website is also a fount of wisdom, and whose mission is to promote "the philosophical reasoning that is the foundation of limited government and the statesmanship required to bring that reasoning into practice."

Here's an excerpt:

The American public is clueless about how disproportionate violent street crime is. Even hearing the numbers makes many well-meaning whites uncomfortable, though no one seems to cringe when law enforcement is accused of a reign of racist terror.

The press touts the fact that blacks are two and a half times more likely to be fatally shot by the police than whites. Predictably, that favored statistic uses the irrelevant population benchmark. Substitute a homicide benchmark, and the ratio reverses. When homicide rates are taken into account, whites are three times more likely than blacks to be fatally shot by an officer.

Sunday, September 20, 2020

Recommended Reading: Covid is no longer an emergency


Open letter from Belgian doctors and health professionals. 

Read this and you will see a detailed explanation for why governments the world over should call off the Covid-19 emergency NOW. It's the best collection of facts and recommendations I have come across since this whole thing started. Lockdowns and masks are not only unnecessary, they cause far more damage than they prevent. Time to stop the madness!

UPDATE: To fully appreciate the arguments made in this open letter, I append the latest charts from Sweden, a country of almost 11 million people which eschewed lockdowns altogether and made only modest suggestions relative to social distancing and restrictions. Sweden continues to see new Covid cases but has enjoyed virtually zero deaths for the past two months. On the basis of Covid deaths per 1 million population, Sweden (580) has fared slightly better than the US to date (615). Source

I also recommend reading this post by a Swedish doctor who describes a typical, virtually-mask-free day in Stockholm. Excerpt:

When I sit in the tube on the way to and from work, it is packed with people. Maybe one in a hundred people is choosing to wear a face mask in public. In Stockholm, life is largely back to normal. If you look at the front pages of the tabloids, on many days there isn’t a single mention of covid anywhere. As I write this (19th September 2020) the front pages of the two main tabloids have big spreads about arthritis and pensions. Apparently arthritis and pensions are currently more exciting than covid-19 in Sweden.

 


And please, everyone, schools should be open! My grandkids are fed up with Zoom classes. "We're not learning anything!"


Friday, September 18, 2020

A few charts and thoughts on the election

From time to time I update a chart or make a new one, and I realize it is worthy of highlighting. But then I delay posting it, looking for some broader theme to tie it too. I invariably regret doing that, so here is a short post with just 4 charts and some brief comments.

Chart #1

Chart #2

A few days ago the Census Bureau released its calculation of Median Household Income for 2019. As Chart #1 shows, this measure of prosperity increased at a historically significant rate. It rose a record-setting 8.7% from 2018 in nominal terms, and 7% in real terms, the latter being shown in Chart #2. Trump can claim credit for much of this, given his significant tax cuts and regulatory reform which began to take effect in 2018. 

It's arguable, of course, but I think Biden's agenda, which calls for significant tax hikes across the board, as well as an environmental agenda that would involve huge costs, economic turmoil (you don't easily get rid of an addiction to fossil fuels), and re-regulation (especially of the labor market), would be a drag on growth. Biden's agenda is anti-growth and anti-business, in the belief that addressing income inequality, social justice, and global warming are paramount.

UPDATE: Mark Perry's recent post on this same subject makes an important point I overlooked. Since the size of the median family has decreased steadily for the past several decades, if this data is adjusted for household size, by measuring income per member of the median household, the increase in median income growth has been much greater than my charts show: "the percent increase in median household income per household member since 1967 of 86.6% is almost exactly twice the percent increase in real median household income over the last half-century of 43.3%."

Chart #3

Chart #3 shows a huge, record-setting increase in homebuilder sentiment, which in turn foreshadows a significant pickup in housing starts. It's no secret that historically low mortgage rates have been a boon to the housing market and home construction, as well as to consumer sentiment. Who couldn't love sub-3% mortgage rates? 

Mortgage rates are low because the 10-yr Treasury yield, currently only 0.7%, is at levels once that though impossibly low, and the 10-yr is the primary driver of mortgage rates. And Treasury yields are low not because the Fed is promising to keep short-term rates near zero for the next 2-3 years, but because investors the world over are desperately demanding safety and security. The Fed is keeping rates low because it is forced to accommodate the world's huge demand for safe assets. On the bright side, the wave of risk aversion that has carried Treasury yields to unbelievably low levels is helping to generate a wave of new willingness to invest in homes as well as many other hard and financial assets. Remember, the new meme that the Fed is promoting is "Borrow and Buy," as I have noted in recent posts. When interest rates are super-low, it pays to borrow, and it pays to buy almost anything that will eventually benefit from renewed growth and—possibly—higher inflation.

Chart #4

On a less promising note, Chart #4 shows that passenger air traffic, which a few weeks ago was picking up (Labor Day holiday-related) has now resumed its flat trend. This detracts from the otherwise V-shaped recovery narrative that we have seen in housing, employment, industrial production, and retail sales. I think the economy will continue to improve at a relatively fast pace, but it's not yet gangbusters.

For all the promise of renewed growth, it remains the case that this year's gargantuan government spending and income redistribution will be a serious drag on growth for the foreseeable future. By borrowing many trillions, the government has commandeered a significant portion of the economy's resources and redirected those resources in ways which are very likely not as efficient as if those resources had been left in the hands of the private sector. Government can never spend other people's money as wisely and as efficiently as people can spend their own money, to paraphrase the great Milton Friedman.

From my supply-side perspective, the most important things to watch are confidence, employment, investment, and incentives to work and invest, all of which drive supply. Supply, as supply-siders believe, creates its own demand. Investment, production, and risk-taking are what deliver productivity, and productivity, coupled with more people and more work, is what delivers growth and prosperity. Spending follows production and growth; spending is not what drives the economy. 

Paying extra-generous unemployment benefits surely (and justly) helps those who were on the wrong side of government-mandated shutdowns, and it helps sustain consumption. But in the end it is harmful to the overall economy. There is no free lunch. It is increasingly clear that, as I predicted last April, government-ordered shutdowns were a catastrophic mistake, since nowhere in the world have they managed to derail the spread and devastation of the Covid virus, while in every case they have been hugely expensive and economically destructive to the lives and businesses of countless millions.

Supply-siders, as well as conservatives generally, believe that free markets and individual freedom are what create the fertile ground in which growth prospers. Modern-day liberals (as opposed to traditional liberals) believe that government actions (income redistribution, subsidies, price controls, regulations, industrial policies) are the main drivers of growth. Conservatives put their trust in individuals and businesses; liberals put their trust in government. You are free to choose, especially in the upcoming elections.

UPDATE (9/19/20): Mark Perry has a very interesting post on the demographics behind the household median income data. Excerpt:

It’s highly likely that most of today’s high-income, college-educated, married Americans who are now in their peak earning years were in a lower-income quintile in their prior younger years when they were single and before they acquired education and job experience. It’s also likely that individuals in today’s top income quintiles will move back down to a lower-income quintile in the future during their retirement years, which is just part of the natural dynamic lifetime cycle of moving up and down the income quintiles for a majority of Americans. So when [we hear] the incessant chatter from the mainstream media and progressive politicians about an “income inequality crisis” in America, we should keep in mind that basic household demographics go a long way towards explaining the differences in household income in the United States. And because the key income-determining demographic variables are largely under our control and change dynamically over our lifetimes, income mobility and the American dream are still “alive and well” in the US.

Monday, September 14, 2020

Consumer inflation has averaged 2% for 18 years

Depending on how you measure it, inflation has been running 1.5 - 2% per year for the past 18 years. It's a mystery to me why the Fed feels it needs to be higher. I remain convinced that less inflation is always better than more inflation, and I'm not hung up on inflation always needing to be positive. Why should money always lose value relative to goods and services?

Chart #1

We have been living in a 2% inflation world for the past 18 years. Sometimes that fact gets obscured by the sheer volatility of year-over-year inflation, which has ranged from -2.1% to 5.6% in the past two decades. Super-volatile oil prices are largely to blame for this; having ranged from $19 to $140 per barrel over this same period. Chart #1 helps illustrate this. The blue line is the total CPI, whereas the red line excludes energy prices. The Personal Consumption Deflator, on the other hand, has been running a bit over 1.5% for the past two decades; it's fairly typical for the CPI to register more inflation than the PCE deflator, since the deflator is more responsive to shifts in consumer preferences (consumers, being generally smart and thrifty, shy away from high-priced items, preferring instead cheaper substitutes).

Chart #2

Ex-energy, the year over year change in the CPI has ranged from -.7% to 3.1%, as seen in Chart #2. Taking out food prices in addition (which would be the so-called "core" rate of inflation) would make a very small difference. Energy is much more volatile than food prices, so that is my preferred measure of underlying inflation.

Chart #3

As Chart #3 shows, over the past 18 years the CPI ex-energy rate of inflation has averaged 2.0% per year (note that the index is plotted on a log scale, so its constant slope is equal to a constant rate of growth, in this case 2% per year). It may come as a surprise, but over that same period the total rate of CPI inflation has averaged almost exactly the same. In fact, since 1957, when the x-energy version of the CPI started, both ex-energy and total CPI inflation have also increased by virtually the same amount (~ 3.6% per year).

The price of oil has been by far the most volatile of any commodity. Take out oil, and you get a much better idea of where things are going on a year-to-year basis.

Chart #4

Chart #4 is interesting since it shows how much energy costs have shrunk as a share of total personal consumption. Energy today is only 3.4% of personal consumption expenditures, whereas it was almost three times more in the early 1980s. Food and energy together account for 11.7% (food is 8.2%).

Chart #5

Chart #5 compares the price of oil to the prices of non-energy commodities. Note the relatively tight correlation between the two. More importantly, note how the scale for crude goes from 1.4 to 280 (i.e., crude prices have increased by a factor of almost 200 times!), while the scale for non-energy commodity prices increases by a factor of only about 6 ⅔. Huge difference, yet very correlated! This confirms my preference for non-energy inflation as the best measure for underlying inflation trends.

The August readings for the CPI (+2.1% ex-energy over the past year) should put an end to speculation that the economy's virus-induced collapse would result in deflation. It's likely the Fed won't tighten for quite some time, but there is no reason at all to worry that they need to be easier. If I had to bet, I'd say the next tightening comes before the market expects it; that is to say, I think the risks are skewed to inflation exceeding expectations over the next few years.

Thursday, September 10, 2020

Spread monitor: looking good

Often, prices alone cannot tell the story. Knowing a stock has gone up 10% is nice, but if that happens in the context of the broad market rising 20% then it's not so nice. In the bond market, comparing one yield to another is essential to understanding value. Virtually every bond in the world is priced relative to Treasuries of comparable duration or maturity. The Treasury yield curve is the "backbone" of all yield curves; it sets the gold standard for yields of all maturities because Treasuries are the most liquid, risk-free securities in the world. Without the Treasury yield as a universal benchmark, the bond market would be much less efficient.

Looking at the "spread," or difference between the yield on, say, a corporate and a Treasury bond of similar maturity is essential to understanding the value of that bond, which in turn depends on how risky the market perceives its issuer to be. The greater the spread, the riskier, and the smaller the spread, the safer. Spreads can also tell us about the health and underlying liquidity conditions of the market as a whole. And by inference, spreads can also tell us about what the outlook is for the economy, since a healthy financial market is essential to a healthy economy.

The following charts cover the spreads I consider essential to understand the economic and financial fundamentals. Fortunately, they are all telling a good story.

Chart #1

Chart #1 looks at the "TED" spread, which is the difference between the yield on 3-mo. LIBOR securities and 3-mo. T-bills. (The acronym TED comes from Treasury vs EuroDollar.) LIBOR is a standardized measure of short-term yields of dollar-denominated securities which trade overseas in what is commonly referred to as the eurodollar market. The TED spread is equivalent to the extra yield over risk-free T-bills that investors require to accept the credit risk of a major overseas bank, since it is those banks that pay LIBOR when they borrow. Long story short, the TED spread is a good proxy for how risky the global banking system is. Current spreads are about 15 bps, which is the difference between the 25 bps yield on 3-mo. LIBOR and the 10 bps yield on 3-mo. T-bills. That's about as low as the TED spread has ever been, and that's a very good thing, because it means global financial markets are in very good shape.

Chart #2

Swap spreads are the extra yield that investors require to enter into a swap agreement with a major broker-dealer or financial institution. Swap agreements involve one party paying, for example, a fixed rate to another party and accepting a floating rate in return. Swap transactions effectively allow investors and financial institutions to efficiently manage their risk. You can find a longer explanation of swap spreads here.

Chart #2 looks at 2-yr swap spreads, which is the extra yield that one party requires in order to enter into an agreement in which the investor receives a floating yield in exchange for paying a fixed, 2-yr yield. 2-yr swaps represent a highly liquid market and are thus an excellent proxy not only for the health of financial markets but also the general liquidity conditions of financial markets (a high degree of liquidity leads to very low spreads). Current swap spreads in the US are very low, while spreads in the Eurozone have clearly moved into "healthy" territory after spending many years in not-so-healthy territory.

Bottom line: swap spreads tell us that global financial markets are in very good shape, and that can often be a good predictor of future economic health. They also tells us that central banks for the most part are not a threat to the markets or the economy. No one is being starved for liquidity, and real interest rates (and thus borrowing costs) are extremely low. Note also that this predictive ability of swap spreads can be seen in Chart #2, as swap spreads rose in advance of the 2008 recession and fell in advance of the recovery.

Chart #3

Chart #4

Chart #3 shows 5-yr Credit Default Swap spreads. CDS spreads are a very liquid market that gives a good proxy for 5-yr corporate credit risk. Spreads are trading at pretty low levels, suggesting that credit risk is minimal, and by extension, that investors perceive the outlook for the economy to be healthy. Chart #4 shows the difference between investment grade and high yield CDS spreads, something that is called the "junk spread." This too is a good proxy for the extra risk an investor experiences as he or she ventures into the junk bond arena.

Chart #5

Chart #5 is an amalgamation of the credit spreads on two classes of corporate bonds of all maturities—and there are many. Here again we see that spreads are generally low, thus the implied outlook for the economy is healthy. Investors are not overly concerned about the outlook for corporate profits. 

Chart #6

Chart #7

Charts #6 and #7 show the spreads between nominal and real yields on Treasuries and TIPS (TIPS = Treasury Inflation Protected Securities). This difference, or spread, is equivalent to the market's expectation for future annual inflation rates. In both cases, it appears the market is expecting consumer price inflation to average just over 1.5% per year for the foreseeable future. If this proves to be an accurate forecast I—and most people—will be happy. I worry, however, that the Fed wants the inflation rate to be higher, and I've learned to never doubt the Fed's ability to get what it wants.

It's important to realize that most people's understanding of how inflation works is faulty. Inflation is not a by-product of strong growth or strong demand. Inflation happens when there is more money in the system than people want to hold. Inflation lies in the intersection of a central bank's willingness to supply money and the public's desire to willingly hold that money. Too much money is what leads to inflation. There is certainly plenty of money these days, as I have documented in prior posts. What is keeping inflation in check is the apparent fact that the public is happy to hold all that money, because there are still many things to worry about and money provides security.

What we need to be attentive to is the return of confidence, since that will act to reduce the demand for money. And if the Fed doesn't react to this by increasing short-term rates in a timely fashion, we will end up with higher-than-expected inflation and eventually much higher interest rates as the Fed is forced to tighten monetary conditions. This is how almost every recession (except this year's) has started, by the way, so it's not a pleasant prospect. Fortunately I don't see this happening any time soon, but next year is still out there on the horizon.... 

Wednesday, September 9, 2020

Promising signs

In my last post, August 30th, I noted signs of a possible stall in the economy (TSA throughput, very low real yields, high levels of uncertainty). Since then there are a number of indicators which show continued improvement and even some surprising strength.

Chart #1

Chart #1 shows an index of the prices of non-energy commodities. Prices have now rebounded to where they were prior to the onset of the Covid Crisis, and that is a strong indicator that the global economy is rebounding. To be sure, soaring prices could also be due to the inflationary impulse of monetary policy, as I also noted in my last post: by promising to keep rates at extremely low levels, the Fed is actively encouraging people to spend the money they have stockpiled, and in addition to borrow more. "Borrow and Buy" is the new Fed mantra, in my view, though you won't hear it from many other sources—most people are worried that the Fed is pushing on a string and deflation hangs over our heads like a dark cloud. Curiously, those same people are probably arguing that the Fed is just inflating asset bubbles which will sooner or later pop.

Chart #2

Small businesses were crushed by the lockdowns, and sentiment was in the dumps not too long ago. But as Chart #2 shows, small business optimism has rebounded strongly, and is now higher than it was at any time during the slow-growth Obama years. However, optimism is still substantially lower than it was two years ago.

Chart #3

Chart #4

Chart #3 adds some meat to the small business story. Here we see that hiring plans recently have soared to relatively high levels (blue line). Despite the small army of the unemployed looking for work (~13 million, as Chart #4 shows), businesses continue to report difficulties in filling positions with qualified workers (red line, Chart #3). There is a lot of activity going on behind the scenes—and the LA freeways are getting more congested.

Chart #5

Chart #5 shows a very surprising surge in the prices of used autos in the past 3 months. Used car prices are now 16% higher than they were a year ago! Some lucky people must have found themselves with extra money, while others are finding cheap borrowing rates (borrow and buy!). Everyone is eager to get back out on the road again. You can also find hints of inflation in this chart. After almost two decades of declining inflation-adjusted prices (red line), prices are now exploding to the upside no matter how you look at it. We're haven't seen anything like this since the inflationary 1970s.

Chart #6
Chart #7

Chart #6 shows that the late summer doldrums in air travel are now giving way to what looks like a renewed surge in air travel. The blue line represents actual daily passengers going through TSA security lines, while the green line is simply the 7-day moving average, which is important to follow because there are very definite intra-weekly patterns in this data. What you don't see in this chart is that August is typically a slow month for air travel. Last year, TSA throughput in the month of August actually declined by 15%. So the fact that TSA throughput held steady in August this year means it was unusually strong. That fact shows up better in Chart #7, which shows how the the 7-day moving average this year stacks up relative to the same period last year. Here we see that air travel was picking up relative to 2019 throughout the month of August, and over Labor Day it really picked up. I've heard from not a few friends that they are feeling better about flying these days. Air travel today is still only 37% of last year's levels, but that is up significantly from what it was just a few months ago.

Chart #8

Finally, Chart #8 is an update to what is now a perennial favorite of mine. Here the latest stock market drop looks a lot like all the others in recent years, in the sense that all the important declines in equity prices have been strongly correlated with a surge in the fear index (Vix). Fear is still very much with us, given the still-elevated level of the Vix, and risk-aversion is still quite strong, as evidenced by the 10-yr Treasury yield, which is hugging extremely low levels (0.6 - 0.7%). These are not the symptoms of an over-extended market.

I know that a lot of people worry that stocks are in a Fed-blown bubble, but with a 1-yr forward PE ratio of 26-27, stocks today are simply discounting a sizable pickup in earnings over the next year. If the economy continues to improve as it has these past few months, that's not unreasonable at all. Especially considering that the alternativez to stocks—notes and bonds—sport PE ratios that are an order of magnitude higher than stocks. One quick example: the 0.7% yield on Treasuries is equivalent to a PE ratio of 143.

Sunday, August 30, 2020

The virus, the elections, and the Fed



I haven't made a post for over three weeks. If there's a reason, it stems from the uncertainty created by the unprecedented economic collapses suffered by most of the world's economies—in turn the product of the most colossal public policy errors in the history of mankind, all for a virus that is equivalent to a bad flu—coupled with the radically different public policy prescriptions of our two presidential candidates and now magnified by the Federal Reserve's recent decision to adopt a radical change in its policy focus. And to think that, despite all this, equity prices are making new all-time highs and interest rates are marking all-time lows. 2020 really does deserve to go down in history as the Crazy Year.

I can only offer some observations which may be of help to investors trying to sort out what this all means. I'm an inveterate optimist, but even so I am humbled by the task of trying to make sense of all this. For what they are worth, here follow some observations.

I can't argue that the market is over-extended, but neither can I argue that the market is too pessimistic (which long-time readers will know is my favored habitat). Current PE ratios are historically high, but forward-looking PE ratios are only moderately elevated. That's not all that strange given the extremely low level of interest rates.

The elephant in the living room these days is the November elections. There couldn't be a starker contrast between Biden and Trump. Biden's policies would undoubtedly be bad for the economy (e.g., sharply higher tax rates and much more regulation), while Trump's would be good (lower tax rates and more deregulation). Trump brings a lot of character baggage to the race, but his accomplishments (e.g., lower taxes, deregulation, strong-arming NATO allies, getting tough on China, winding down wars instead of starting new ones) remind me that the only way to understand Trump is to pay no attention to what he says or tweets, but instead to simply focus on what he does. Biden, on the other hand is a nice, decent guy, with few if any major accomplishments to his credit, but displaying all the signs of an elder politician that is way past his prime and bordering on senility. His worst decision ever could prove to be his selection of Kamala Harris as VP, since she is a socialist at heart and a policy lightweight yet would very likely succeed Biden before his term is over. Imagine our lives if and when BLM has a friend in the White House. Since the polls still favor Biden but the market behaves as if Trump will win, I can only conclude that great downside risk lies ahead should Biden prevail.

So now we turn to the charts and what they tell us about what's going on in the economy and the markets.

Chart #1

It's been a wild and crazy ride in stocks this year, with fear being the source of nearly all the volatility, as Chart #1 shows. Since the end of 2017, the annualized total return of the S&P 500 has been 12.9%. Whether that's adequate compensation for all the nerve-wracking twists and turns along the way, I'll leave it up to each individual to decide. And as the chart also shows, the level of nervousness (as reflected in the Vix index) is still somewhat elevated.

The main source of recent fears has been a lowly virus, fear of which convinced nearly every politician in the world to shut down their economies in unprecedented fashion. As I've noted repeatedly for many months, "The decision to shut down the US economy will prove to be the most expensive self-inflicted injury in the history of mankind.™" It probably sounded foolish at the time I first said it way back in early April, but it's rapidly becoming accepted wisdom as more and more countries tally up the damage while also realizing that it's tough—if not impossible—for anyone to show any correlation between lockdowns and the eventual course of the pandemic. In fact, the anti-lockdown Sweden probably made the best decision of all: its deaths per capita are in the same ballpark as other major countries, but its economy has fared far better.

Chart #2

As Chart #2 shows, the US economy shrank at a 19.4% annualized pace in the first half of this year, with the worst of that coming in the second quarter, when GDP shrank at a 34% annualized pace. In level terms, real GDP fell by $2.26 trillion, a decline of 10.4%. In Europe it was much worse, with real GDP falling 15.2%; that decline sent the Eurozone economy back to levels last seen 15 years ago. The US economy, in contrast, was only set back a little over 5 years. Regardless, nothing even remotely similar has occurred in such a short period in recorded history. 

Chart #3

Despite all the economic and psychological devastation, some sectors of the economy have rebounded strongly. As Chart #3 shows, the residential construction industry as of last July is almost back to its pre-crash levels, and housing prices are now making new all-time highs.

Chart #4

As I've noticed while driving the freeways of Los Angeles lately, traffic is still somewhat light, but it has improved dramatically from April's lows. Chart #4 shows how motor gasoline supply has rebounded strongly in recent months, and that is as good a proxy for miles travelled as you're likely to find.

Chart #5

However, as Chart #5 shows, while the airline industry rebounded rather quickly through the end of June, since then growth has stalled. (TSA traveler checks are an excellent proxy for total air travel.) Air travel today is running about 70% below the levels that prevailed a year ago. Airlines have been hammered.

Chart #6

So the economy is definitely on the mend, but not uniformly. Unemployment remains extraordinarily high (10.2% as of last month), down from a mind-numbing high of 14.7%. Driving is almost back to normal, but air travel is still way below normal. Housing is practically on fire. Throughout all this, the Fed has reacted in extraordinary fashion—thank goodness—by reducing interest rates to near-zero and expanding bank reserves by $1.25 trillion (see Chart #6).

Chart #7

The Fed needed to greatly expand banking system liquidity in order to accommodate the huge increase in the demand for money, as shown in Chart #7. Think of this chart as showing how much cash the average person or business wants to hold as a percent of their annual income. Money demand has soared to previously unimaginable levels as the economy shrunk and tens of millions lost their jobs. People were desperate for the safety of cash because the virus and governments' response to it had put us into uncharted and frightful territory.

Chart #8

Chart #9

Everyone scrambled for safe havens. Bank checking and savings deposits exploded (see Chart #9). As Chart #8 shows, the price of gold and TIPS soared, a direct reflection of the demand for safety. But as Chart #9 also suggests, we have probably seen the peak of the demand for money and safety. 


Chart #10

Vaccines are on the horizon, therapeutics are hitting the market, confidence is slowly returning, and in most of the world we are seeing a definite and very welcome slowdown in the growth rate of new deaths (see Chart #10). 

So the economy and nerves are on the mend, albeit slowly and nervously. But we're not out of the woods by any stretch, with the biggest unknown being the future of monetary policy. The Fed recently announced a landmark shift in its policy-making. Instead of preemptively fighting inflation, the Fed is now hoping to see inflation rise. How exactly will this play out? No one has the slightest idea. 

I have always been an advocate of very low and preferably zero inflation. From my years of experience in Argentina I know first-hand how inflation distorts an economy and business decision-making, and how it ruins the lives of nearly everyone. Not many realize that the biggest victims of inflation are those who are least able to protect themselves from it: the poor, the uneducated, and the old. Already we can quantify the losses accruing to anyone these days who is holding large amounts of cash or cash equivalents (e.g., currency in circulation which totals  almost $2 trillion, and bank savings deposits which now total a gargantuan $11.6 trillion). This simple measure of "cash" is equivalent to almost 70% of GDP, and it pays almost nothing in interest. Ex-energy inflation is already running about 2% a year, so those holding cash and cash equivalents are suffering annual losses of roughly $270 billion in terms of purchasing power (2% of $13.6T). And its likely to get worse, since the Fed has all but guaranteed that short-term interest rates will remain very low for the foreseeable future while they also hope that inflation rises.

Chart #11

Even the smartest of investors can't escape the ongoing loss of purchasing power for holding cash, cash equivalents, and Treasury notes. Real short-term interest rates (available through investments in TIPS) are strongly negative. You can have the security of a 5-yr Treasury note, but you are guaranteed to lose almost 1.5% per year in the purchasing power of your investment. Yikes. And by the way, interest rates are extremely low for two reasons: 1) the demand for short-term, safe securities is intense (which causes their prices to be extremely high and their yield to be therefore exceedingly low), and 2) the Fed is promising to keep its Fed funds reference rate close to zero for the foreseeable future. 

Chart #11 shows the history of nominal and real rates on 5-yr Treasury notes, and the difference between the two, which is the market's implied expectation of future inflation (currently about 1.7% per year for the next 5 years). 

Chart #12

Chart #12 compares the ex-post real yield on Fed funds (blue) with the market's expection for what the real funds rate will average over the next 5 years (red). Both are hugging -1.5% per year. Nobody thinks rates are going to rise from their very negative real levels for many years. That thinking is driven by a combination of 1) pessimism over the economy's long-term growth prospects and 2) a belief that the Fed will deliver on its current promises to keep rates low for a long time.

But here is the real story: by promising to hold interest rates at today's rock-bottom levels for an extended period, the Fed is trying hard to discourage people from holding cash and short-term investments. The Fed wants you to spend that money instead, and it would also like you to borrow money instead of save it. The new mantra is "borrow and buy."

It shouldn't take long for people to begin to figure this out. In fact, many already have, as we'll see in the following charts.

Chart #13

As Chart #13 shows, the level of the dollar's value vis a vis other major currencies (blue) is inversely correlated to the price of gold. A weaker dollar typically leads to rising gold, and vice versa. The recent rise in gold has probably been driven by the expectation that the Fed would seek to weaken the dollar (by increasing inflation, which erodes the value of the dollar). Gold is now back to its all-time highs in inflation-adjusted terms. If this interpretation of gold is correct, then it's too late to buy gold as an inflation hedge. What the gold market expected (a very easy Fed has already happened.

Chart #14

We see the same dynamic with copper prices (Chart #14) and for most commodities as well, except that most commodities (with the exception of gold) are only now just beginning to react to a weaker dollar. Of course, rising copper prices may also be symptomatic of a stronger global economy. But if the global economy continues to improve and rising inflation begins to take hold, copper prices would likely have plenty of upside potential.

Chart #15


Chart #15 shows the stunning increase in lumber prices in the past several months. This likely reflects at least in part the robust conditions in housing construction that we saw in Chart #3. On the other hand, strong demand for housing could be due to people figuring out that in a rising inflation environment, real estate tends to do well—as do most all real assets. And it's part and parcel of today's ultra-low interest rate environment, which makes it cheap to borrow. Without saying it directly, the Fed is encouraging people to borrow and buy. The Fed is keeping interest rates low in order to reduce the attractiveness of holding money. There are two ways you can reduce your money holdings: either by borrowing money or by using your money to buy stuff. Both are now being observed in the wild. The seeds of rising inflation have been sown, but the fruits won't be seen in the official inflation statistics for awhile.

Unless, of course, the Fed is able to react to a declining demand for money by withdrawing the bank reserves which it has recently injected. What are the chances they can withdraw trillions of dollars of new reserves at just the right time to avoid unwanted and unexpected inflation? It's anybody's guess, but the stakes have never been higher.

Chart #16

Ultra-low interest rates on cash equivalents and short-term securities also encourage people to buy other types of assets. Chart #16 shows the current yields on selected sector investments. In order to find a yield higher than the Fed's 2% inflation target, you need to look at things like lower-quality corporate bonds, REITS, and emerging market debt. Stocks too offer attractive yields, with the S&P 500 currently showing an earnings yield of 3.66% (the inverse of its current 27.3 PE ratio). Stocks, in other words, are benefiting from very low interest rates. In a new age of near-zero interest rates, PE ratios of 27 may seem high from an historical perspective, but in actuality they could well be seen as attractive. And in any event, PE ratios based on 1-yr forward earnings expectations today are only 21.2. It's not obvious that stocks are over-extended at today's prices.

Chart #17

Inflation expectations have picked up a bit in recent months (see Chart #11), but they are still well within normal ranges. Likewise, the yield curve has steepened a bit (see Chart #17), but it is still relatively flat from an historical perspective. The bond market appears to be in the very early stages of anticipating rising inflation and an eventual Fed tightening. There is lots of room left in this trade.

As for Covid:

The three charts below come courtesy of Brian Wesbury at First Trust. In the first, we see that Covid deaths occur overwhelmingly among people 65 and older (gulp, that includes me!). Unfortunately, the MSM have utterly failed to communicate this effectively to the population. As a result, the country has been swept up by a pathological paranoia that has resulted in, among other bizarre behaviors, young people wearing masks outdoors even when walking alone or riding a bike. In the second we see how dramatic the decline in hospitalizations has been in states previously categorized as "hot spots." The third chart is welcome news of a quick-and-easy Covid antigen test which is just around the corner.

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Finally, I recommend this 7-minute video ("Shut up and put on your mask") from Graco. In support of its thesis, I recommend this summary of a recent NBER study that found that lockdowns and mask mandates do NOT lead to reduced Covid transmission rates or deaths. All they succeed in doing is to destroy economies and lives, while handing immense power to public officials who have trampled the civil and constitutional rights of billions of individuals by making decisions not supported by facts. Thus, a very dangerous precedent has been set that poses significant risks to economies and the general well-being of the entire planet in the years to come.

If you want to really worry, this is where you should place your chips. Think of a mask mandate as the first step on a slippery slope to despotism and socialism. We are not "all in this together;" our leaders are not more intelligent than a market of billions of individuals. Kamala Harris, I do not need you to tell me what to wear and what to think.

Friday, August 7, 2020

Is a 50% recovery in 3 months just chump change?

I'm hearing some analysts say the July jobs report was disappointing because it shows the economy still has a huge number of people out of work. That's true: the unemployment rate has only come down from a high of 14.7% in April to 10.2% in July, and that's still way higher than February's low of 3.5%. To bolster their case, they also note that seasonal adjustment factors overstated the job gains in July. That's true too: the non-seasonally-adjusted employment growth figure rose by only 591K in July vs. the seasonally adjusted headline figure of 1763K.

So: is this glass really half empty? Let me explain why I see it as half full.

Chart #1

Chart #1 is my long-time preferred measure of the health of the jobs market: the level of private sector jobs on a seasonally-adjusted basis (the private sector is where all the economy's dynamism comes from). From a high of 130 million in February, jobs fell to a low of 109 million in April. They have since increased to 118, and that represents a recovery of 9 million jobs, or 43% of the total loss. To be fair, you could say that since the economy has recovered only 43% of the jobs it lost, the economic glass is half empty.

Chart #2

However: Chart #2 shows the non-seasonally-adjusted version of Chart #1. Here we see that jobs fell from a high of 128 million in February to a low of 108 million in July, and they now stand at 119 million. That's a recovery of 11 million jobs, or 55% of the total loss. So by looking at the raw data, one could argue that the glass is more than half full. To be fair, let's average the 43% of jobs recovered using seasonally-adjusted data with the 53% of jobs recovered using non-seasonally-adjusted data and say that in the past three months the economy has recovered about half the jobs lost in the Covid shutdown catastrophe.

Is this just chump change? Just how lousy is a 50% recovery of the jobs lost during a deep and painful recession in just 3 months? Consider the recession of 2008-2009, which you can see in Chart #1. The total job loss from the 116 million high in December '07 to the 107 million low in February '10 was 9 million. Coming out of that Great Recession, it took the economy about two years (until early 2010) to recover half of the jobs lost. Today's economy has bounced back very quickly by historical standards. You might even call it a "V" shaped recovery, no?

I think it's very impressive, especially considering the huge headwind that Congress' $600/week bonus unemployment payout created. I pointed this out in early May, by the way. That bonus of $600/week effectively gave a raise to about two thirds of those collecting unemployment—they made more by being unemployed than they made while working. In effect, the government was giving millions of workers a raise and at the same time telling them to take a 3-month paid vacation, because the bonus $600/week would extend through August 1st. So despite very generous unemployment benefits, roughly half of the unemployed have returned to work! I won't be surprised to see stronger job gains in the months to come, thanks to the loss of $600/week that has now kicked in.

Unless, of course, Nancy Pelosi has her way and extends the $600/week bonus through the end of the year. If Trump has his way instead, he will direct the IRS to stop collecting payroll taxes through the end of the year (he would then promise to sign legislation next year to forgive these taxes). This would be very bullish, because it would not only increase the after-tax wages received by all those who work, it would also reduce the after-tax cost to employers of every worker. Employers would have a significant new incentive to re-hire or add to their workforce, and employees would have a new incentive to find a job and/or go back to work.

Pelosi's plan would be a disincentive to growth, Trump's plan (championed by my long-time friend Steve Moore at the Committee to Unleash Prosperity) would instead incentivize growth.

There is reason to be optimistic.

Now for some quick updates to charts I'm watching on a daily basis:

Chart #3

As Chart #3 shows, the stock market has recovered almost all of its Covid/shutdown losses, and investors' fear levels have fallen significantly. The market is looking across the valley of despair in the belief that a recovery is underway and we will eventually return to some semblance of normality within the foreseeable future.

Chart #4

Chart #4 compares the price of gold to the price of 5-yr TIPS (using the inverse of their real yield as a proxy for their price). Both of these utterly different assets are in a sense safe-havens. Gold protects against the unknown and is considered by many to be a hedge against inflation. TIPS are default-free and promise investors a government-guaranteed inflation hedge (their effective yield is the sum of actual inflation plus their real yield). Both work as a safe port in a storm. That both are soaring in price is a sign that investors these days are willing to pay a steep price for protection. Risk aversion, in other words, is alive and well.

Chart #5

Chart #5 shows the nominal and real yields on 5-yr government bonds (red and blue), and the difference between the two (green), which is the market's implied inflation expectation over the next 5 years. Note that pretty much all of the rise in expected inflation this year is due to a decline in the real yield on TIPS. Investors are paying up for inflation protection, as Chart #4 also shows, but expected inflation is still expected to be relatively tame (currently just 1.5% per year) from a historical perspective. If anything stands out on this chart, it is the unusually low level of real yields. Real yields are heavily influenced by current and expected real growth rates in the economy, as shown in Chart #6, so this is a sign that the market is still quite concerned about the long-term outlook for economic recovery.

Chart #6

Chart #7

As Chart #7 shows, airline passenger traffic was roughly flat for most of July, following a fairly dramatic recovery in April, May, and June. The latest data hint at a resumption of growth. To be fair, this chart does not support the view that the economy is still in a v-shaped recovery mode.



But it's not unreasonable to think that the so-called "second wave" of Covid new cases and new deaths, shown above, which sparked renewed attempts by a number of states to roll back their re-openings, was the reason economic growth appears to have stalled (as Chart #7 suggests) in the past month. If that's true, then we can take heart from the fact that new cases appear to have subsided of late (which further suggests that new deaths are likely to soon peak). This reduces the need for continued restraints on state economies.

In my view it's terribly unfortunate—and rather scary from a libertarian viewpoint)—that state and local authorities have resorted to draconian measures (e.g., shutting down churches, gyms, and many restaurants) to hobble their economies in a vain attempt to "beat" the virus. I have not been able to find anyone who can marshall compelling evidence that lockdowns improve Covid outcomes. Most statistical analyses I have seen find no relation between the degree of economic lockdown and the number of deaths from Covid.

In our understandable and collective rush to save lives and deny the virus, we are tragically ignoring a fundamental truth of economics. Thomas Sowell, arguably our greatest living economist, put it simply: “There are no solutions, there are only tradeoffs.” Viruses can’t be “beat,” they can only be slowed down or minimized. Locking down an economy today may postpone deaths but it can’t eradicate the virus. Most importantly, economic lockdowns incur terrible costs, as we now know, that are measured in trillions of dollars of lost income, tens of millions of lost jobs, hundreds of thousands of bankrupt businesses, and countless lives lost to other diseases and suicides.