Tuesday, August 31, 2021

Home prices and the M2 surge

The latest Case-Shiller statistics for June (which is actually the average of April, May, and June prices) show that national home prices rose almost 20% from the prior year. This is by far the most dramatic increase in home prices ever recorded. Could it be a coincidence that the M2 money supply rose by 28% over this same period, also an all-time record? If we want to understand the burst of inflation that has occurred over the past year or so, we need look no further than the money supply. For prices to rise significantly across a range of assets and markets, there must be a corresponding and significant rise in the money supply.

With the Fed assuring us that there will be no reduction in its balance sheet and no meaningful increase in short-term interest rates through the end of next year, the US economy is going to be awash in extra money for a long time. The recent burst in inflation is therefore highly unlikely to prove temporary or transient.

This is huge and very unwelcome news.

Chart #1

Chart #1 shows the nominal and real index of national home prices, as calculated by the S&P CoreLogic Case-Shiller methodology, which is widely considered to be the gold standard for home price trends. Prices are now at all-time highs, both nominally and in inflation-adjusted terms. Prices are on track for blowing away the sky-high prices we last saw in 2005-2006, which in turn were temporarily goosed by crazed lending practices.

Chart #2

Chart #2 shows the year over year change in this index, about 18%. It's a safe bet that we'll see prices continue to rise for at least the next several months. 30-yr fixed rate mortgages are going for about 3% these days, which is only modestly higher than the all-time low of 2.85% which was set in February of this year. Those same rates averaged about 6% in 2006, by the way. 

Chart #3

Chart #3 documents the virtual explosion in the M2 money supply that began in March of last year. The M2 money supply is now (as of the end of July) about $3.7 trillion above its long-term trend line. That extra $3.7 trillion can be found almost entirely in retail bank checking and deposit accounts, all of which are readily convertible into spendable cash. We have never before seen anything like this in the monetary history of the US. We have seen things like this in Argentina, however, where soaring inflation has always been preceded and accompanied by huge growth in the money supply.

Milton Friedman must be rolling over in his grave these days.

Friday, August 27, 2021

Inflation update: this is serious

We now have inflation data through July, including the CPI and the all-important PCE deflators. Here are some updated charts and commentary. This situation is developing and I plan to watch these numbers closely.

Chart #1

Energy is by far the most volatile component of the CPI. Chart #1 shows the ex-energy version of the CPI, which rose by about 2% per year for almost 20 years. It's now risen significantly above that trend line, and this suggests that the rising inflation we've seen this year is not likely to be temporary. The whole price level has been lifted by an excess supply of money, and the Fed has no plans to raise short-term rates or to withdraw excess reserves from the banking system for a very long time.

Chart #2

Chart #2 shows two versions of the CPI using a 6-mo. annualized rate of change—which is more representative of the current behavior of pricing. We haven't seen inflation like this for a very long time.

Chart #3

Chart #3 shows the consequence of rising inflation for bond investors. The real yield on 10-yr Treasuries is now deeply in negative territory. This represents a significant loss of purchasing power for anyone holding Treasuries. Caveat emptor. How much longer will bond investors tolerate a government-guaranteed loss of purchasing power? How much longer will people keep tons of money on deposit in the banking system, when it pays no interest and is losing at least 4-5% of its purchasing power every year?

Chart #4

Chart #4 shows versions of the CPI year over year back to 1982, just after inflation peaked. We may well be revisiting the painfully high levels of inflation which first surfaced in the late 1970s.

Chart #5

Chart #5 shows the 3-mo. annualized change in the Core CPI. Yikes.

Chart #6

Chart #6 shows inflation as measured by the Personal Consumption Deflator, the Fed's (and most economists') favorite inflation statistic, given that it reflects a broad basket of goods and services and is periodically updated to reflect changing tastes and markets. There's no denying that we have seen a meaningful increase in a broad range of prices. Only overly accommodative monetary policy can support such price action. If monetary policy were not so loose, a surge in durable goods prices would likely act to depress other prices (because people would not have an unlimited supply of cash).

Chart #7

Chart #8

Charts #7 and 8 show the behavior of prices for services, non-durable goods, and durable goods. I chose 1995 as the starting point of Chart #8 because 1) it was the first year when the China export machine began to impact global markets, and 2) it marked the first time in history in which we saw a sustained decline in the price of durable goods—which lasted for a remarkable 26 years. No longer: demand for "things" has been very strong, and shortages due to chip shortages are a fairly recent phenomenon. The numbers in green represent the total change for each component over the period of the chart. 

UPDATE: Thanks to reader Peter Barnes for bringing up the subject of money velocity. I've written a response and I want to add a chart to this post to illustrate my argument.

Chart #9

Chart #9 shows the demand for money (M2/GDP) which is simply the inverse of the velocity of M2 (GDP/M2). I think it's more logical to think of this in terms of people's willingness to hold on to M2 money, which predominately consists of retail bank deposits of various sorts). I think the chart shows that there is a clear tendency for money demand to rise during recessions (gray bars) and during periods of great turmoil, such as 2008-9 and the second quarter of last year. When people are scared and faced with uncertainties, it is natural to want to accumulate cash as a form of protection against the unknown. But for the past year things have been getting slowly better, and in fact the demand for money has declined by about 5% since June '20 by my calculations and estimates of current conditions. If the demand for money declines but the supply of money holds steady or increases, that is the classic prescription for a higher price level (i.e., inflation). And in fact that is what we have seen over the past year. 

Viewed in velocity terms, what has happened over the past year is that people have been trying spend their money instead of accumulating more money. Dollars are being passed around faster and faster, and that supports a growing economy and/or rising prices. 

If the demand for money were to fall back to pre-Covid levels, that would be the equivalent of unleashing a flood of $4-5 trillion into the economy (the M2 money supply is currently just under $21 trillion). And that would almost surely result in a bigger economy and much higher prices.  

Thursday, August 26, 2021

Corporate profits are impressive!

The economy could be doing a lot better, but corporate profits are about as good as they get. Which suggests that the equity market rally still has legs.

Today we received the first revision to Q2/21 GDP, which included the first estimate of corporate profits for the period. GDP was revised upwards by a modest—though still impressive—amount, posting a 6.6% quarterly annualized growth rate. Corporate profits, on the other hand, soared at a 44% annualized rate, and are now at a new, all-time high. All of this despite the fact that the unemployment rate is still quite elevated (5.4%) and there are 6 million fewer people working than at the pre-pandemic high.

If there's a silver lining to the Covid cloud, it is here, in the form of a spectacular increase in the economy's productivity. And with many of those 6 million idle workers likely to be snapped up by desperate employers starting next month (when super-generous unemployment benefits expire), the economy has plenty of room to expand in coming quarters. 

A storm still threatens on the horizon, unfortunately, in the form of the Democrats' $3.5 trillion so-called "infrastructure" reconciliation bill that just passed the House. If the spending it entails ever sees the light of day, it will result in a massive expansion of the welfare state and an equally massive and crushing new tax burden on all of us. The economy will find it very hard to thrive with so much spending, since there is almost certainly going to be many hundreds of billions of dollars wasted due to inefficiencies, perverse incentives, corruption and graft.

So if there's a silver lining to the Afghanistan cloud, it can be found in the recent and precipitous drop in Biden's popularity, thanks to his abrupt decision to surrender to the Taliban. Our ship of state is virtually rudderless, and it strains credulity to think that a seriously weakened administration can actually push through a radical expansion of the administrative state and a massive increase in income redistribution. 

The charts that follow focus on corporate profits and GDP, both of which are looking pretty good these days. I also discuss the outlook for inflation, which is not very good. Finally, I discuss equity market valuation, which by several different measures is not at all outrageous. That's a very good thing.

Chart #1

Chart #1 gives some much-needed, long-term perspective on the economy's growth trajectory. For over 40 years, the economy followed a 3.1% annual growth track. That changed dramatically, however, in the wake of the Great Recession of 2008-2009. Since then, the economy has grown at about a 2.1% rate per year.

Chart #2

Chart #2 zooms in on Chart #1, showing just the past 20 years. Today's economy is about $4.5 trillion below what it would have been had it followed a 3.1% annualized growth track. That represents a potential loss of almost 20% in real national income. What also stands out is the economy's fairly rapid recovery to its 10+ year trend growth track in the past year. 

Chart #3

Chart #2 shows the quarterly annualized rate of inflation across the entire economy (i.e., the GDP deflator). Inflation according to this broadest of measures surged at a 6.2% annualized rate in the second quarter. That's the highest rate by far since the early 1980s. 

Keynesians look at this surge in inflation as an inevitable—but likely only transitory—consequence of the massive monetary stimulus that was necessary in order to get the economy back on its feet in short order.

I agree that this surge in inflation has a monetary source, but I don't believe that expansive monetary policy is what drives a recovery. The Fed has no power to create jobs with its printing press. The most the Fed can do is to provide extra liquidity—which they did to the tune of almost $4 trillion—to satisfy the economy's desire for safety during troubling and highly uncertain times. Without that liquidity it might have been more difficult for the economy to recover. Indeed, the economy might have suffered more without an extra injection of liquidity, because markets might have seized up. 

But looking ahead, an abundance of liquidity is not necessary. As confidence returns and jobs are added and profits increase (!), the economy doesn't need an abundance of liquidity. There's way too much liquidity these days, in fact, which is why short-term interest rates are virtually zero. Yet the Fed has not reversed course; they have not withdrawn excess reserves and they have not increased short-term interest rates. As a consequence "unwanted" money and liquidity are piling up and people are trying to get ride of it. They can only do this by spending the money on "things." But of course that doesn't make money disappear, since the person selling the thing I buy must in turn do something with the money he or she receives.

So the economy finds itself with an abundance of money and people are trying hard to spend that money by buying lots of different things. Real estate prices are up, food prices are up, hotel occupancy is up, private jet travel is surging, commodity prices are up, computer prices are up, and many more prices are up. Shortages are developing. Over time some shortages will disappear, but without the Fed taking action to drain liquidity, prices are unlikely to fall back to where they were. A new equilibrium will eventually be achieved in which most prices are higher (perhaps significantly so), the economy grows, and the current stock of money will have fallen in relative terms to a point in which people are no longer trying to reduce their money balances. 

Chart #4

Chart #4 compares the level of economy-wide corporate profits to nominal GDP. Both are at all-time highs, and it's obvious that corporate profits have increased faster than nominal GDP in the past year.

Chart #5

Chart #5 shows corporate profits as a percent of nominal GDP. Profits have never been so strong relative to nominal GDP.

It's no wonder, then, that equity prices are also at all-time highs. We're in a profits nirvana of sorts, thanks in part to expansive monetary policy, but probably in large part due to corporate efforts to cut costs and streamline their business—all necessary to survival during times of Covid. Extremely low real interest rates are also a boon, since financing costs have never been so cheap. 

Chart #6

Chart #7

Chart #6 is a long-term view of Chart #4. What stands out here is the surge in profits that began around the mid-1990s. Profits averaged about 5% of nominal GDP from 1959 through the mid-1990s, but then they surged to 8-10% of nominal GDP. Years ago I discussed the then-prevailing view among many bearish investors that profits were mean-reverting and would eventually fall back to 5-7% of GDP. I disagreed, since I saw the rise in profits as a boon triggered by globalization. China's big boom started in 1995, not coincidentally. As world markets globalized, successful firms found themselves operating in a much bigger market with seemingly endless possibilities. Chart #7 compares US corporate profits to global GDP, and by this measure not much has changed over time. (The chart only covers the period ending 12/20.) Since global GDP has grown faster than US GDP, global corporations have seen their sales rise relative to the size of the US economy.

Conclusion: it is not necessarily the case that profits have to fall back to some much lower level of nominal GDP. Profits are arguably sustainable at current levels. That further suggests that equities are not necessarily or fundamentally overvalued at current levels.

Chart #8

Chart #8 shows my calculation of the PE ratio of the S&P 500 using the National Income and Product Accounts measure of corporate profits (the source for profits shown in the above charts) as the "E" instead of the traditional 12-month trailing average of GAAP reported profits. Yes, PE ratios by this measure are high, but nowhere near as high as they were in 2000. 

Chart #9

Chart #9 compares NIPA corporate profits to reported profits (12-mo. trailing average of adjusted profits, according to Bloomberg). These two different measures tend to track each other fairly well over the years, except that NIPA profits, being based on the most recent quarter, usually point the way to trailing profits. What that means is that there is likely more good news to come for the stock market. 

Chart #10

Chart #10 shows the risk premium of the S&P 500, which I calculate by subtracting the 10-yr Treasury yields from the current earnings yield of the S&P 500 (which in turn is the inverse of the reported PE level). What we have today is a relatively attractive risk premium. Equities, in other words, are not necessarily overpriced at all. In fact, during the bull market of the 1980s and 90s, the risk premium was negative. 

Brian Wesbury, Art Laffer and I all use a similar model to value the equity market. This model assumes that the discounted present value of future profits guides current market valuations.  This is a capitalization model which essentially divides current profits by the current 10-yr Treasury yield to get a sense of where the fair value of stocks is. When discount rates are low, such as they are now (10-yr Treasury yields are only 1.3% or so!) then the fair value of equities should be high.

At this point one should be worried about what happens when interest rates revert back to a higher level (where they should be given the prevailing rate of inflation). Does the inevitable Fed tightening mean that the stock market is headed for another crash? Not necessarily.

By my calculations, equities today are priced to almost a 4% discount rate. If they were priced to a 1.3% Treasury yield, then the fair value of equities would be multiples of what it is today. In other words, the market is already assuming that rates rise, so rising rates needn't be the death knell for equity markets.

UPDATE: Since this post includes a description of how I see monetary policy becoming a force for rising prices, I recommend reading my June post on the subject of inflation in Argentina: Argentine inflation lessons for the U.S. 

Saturday, August 14, 2021

Biden is making the wrong call

My good friend Nuni Cademartori was nice enough to create this cartoon for your viewing pleasure while we enjoy the beach. It's particularly apt with Congress set to vote in the coming month on mega-spending atrocities the likes of which have never before been seen in the wild. At a time when the economy's main problem is dealing with pent-up demand on top of supply and labor shortages, throwing a few more trillion around could make things considerably worse. And it's doubtful whether the Fed would be willing to tighten in the face of a new spending storm. Fiscal overreach and rising inflation are thus the twin monsters threatening our economy right now.

Our economy needs to be free right now, as in free from government meddling. It most certainly does not need more debt!

Thursday, August 12, 2021

On the beach

We're staying at our favorite Maui beach for the next few weeks, so I don't expect to do much blogging.

For the time being, I haven't see anything that has changed my mind about what's going on in the economy and the markets.

The Fed is promising to be too easy for too long, and that means the current inflation surge is very unlikely to prove temporary. That, in turn, means that interest rates—which are currently expected to remain very low for a long time—are very likely to rise above expectations. 

Fiscal policy is dangerously "stimulative." No need for Congress to do anything except get out of the way of the private sector. A $3+ trillion dollar "stimulus" is not only unnecessary but harmful to the economy's prospects. More spending, an expansion of the welfare state, more regulations, more taxes, more subsidies, and more transfer payments will seriously weaken the economy's long-term prospects. Not in the near term (i.e., the remainder of the year at least) but in the long haul.

In this context, I would view the passage of Biden's spending goals to be very bearish. By that logic, if Congress grows a backbone and blocks trillion dollar deficit spending, the outlook would brighten considerably.

Unfortunately, there is little that investors can do. Cash remains trash, as its purchasing power is being seriously eroded by inflation. Ditto for most fixed-income securities. Better to own productive assets that can ride the tide of higher prices (equities, commodities, commercial property). Prudent levels of debt (at long-term fixed rates especially) should benefit from higher prices and a general loss of purchasing power.

Back to the beach, it's a perfectly beautiful day!