Tuesday, December 5, 2023

Some big picture charts

While the world waits anxiously to see if the jobs report this Friday shows that too many people are working—because the Fed (erroneously) believes that might be inflationary and thus a reason to raise interest rates still further—I offer six charts that look at the U.S. economy from a big picture perspective. I don't find anything sinister or strange in these charts. Instead, I see an economy that is growing moderately (perhaps only modestly). I see a healthy labor market, an equity market that is rising at a normal pace, bond yields that have most likely risen by enough to cool inflation, credit spreads that are unremarkable (which is good), and a dollar that has been fortified by Fed tightening. 

Chart #1

Chart #1 compares the number of job openings to the number of people looking for jobs. Rarely have openings exceeded the number of job seekers by as much as they have in recent years. What's wrong with that? 

Chart #2

Chart #2 shows an index of service sector business activity. Conditions are still improving (almost 55% of businesses surveyed report improving activity). Things have been better, to be sure, but they would have to deteriorate materially to make me worry about a recession. In any event, this survey suggests that it's reasonable to expect the economy to continue to grow by, say, 2% per year. No boom, no bust.

Chart #3

Chart #3 shows the S&P 500 index from 1950 through today. As any student of long-term stock market returns knows, equity prices tend to rise by about 8% per year on average (sometimes more, sometimes less). Add about 1.5% for dividend yields, and you get a long-term total return for equities of about 9.5% per year. Today's market looks pretty normal by those standards. 

Chart #4

Chart #5

Chart #4 shows the yield on 10-yr Treasuries going all the way back to 1925. It's been a wild ride, to be sure, especially for the past few years, as yields rose by more and faster than at any time in history. Yields hit a low of about 0.5% in the midst of the Covid shutdowns in 2020, and have since risen to a high of 5%; today they closed at just over 4%. 

Chart #5 compares these same yields to year over year consumer price inflation from 1960 through today. If—as seems likely—the Fed succeeds in bringing inflation down to 2% or so and holding it there, there's no reason 10-yr yields can't trade in a range of 3.5% - 4%. We're pretty close to that already.

Chart #6

Chart #6 shows two very liquid measures of credit spreads (Credit Default Spreads). Credit spreads are notorious for moving up in advance of recessions and moving down as the economy recovers. That's because credit spreads are driven primarily by the market's outlook for corporate profits, which in turn is a function of the health of the economy. Right now credit spreads are only modestly elevated, which is consistent with a forecast of about 2% real economic growth.

Chart #7

Chart #7 compares the value of the dollar (white line) to the real yield on 5-yr TIPS (orange line). The two have a strong tendency to move together over time. Fed monetary policy is captured in the level of real yields (higher yields mean tighter policy). So a tight Fed means higher real yields, which in turn make the dollar more attractive. The dollar looks somewhat weak of late, and that probably means the market is expecting the Fed to ease policy over the next year or so. And in fact the bond market fully expects the Fed funds rate to be cut 5 times (125 bps) by the end of next year, with the first cut coming in the second quarter of next year. I wouldn't surprised to see the Fed cut rates at the March FOMC meeting, if not sooner. Real yields on 5-yr TIPS will probably be trading around 1% by the end of next year.

Thursday, November 30, 2023

A reassuring outlook

This is a short post to update M2, GDP, and inflation statistics. All are consistent with the view that the economy is growing at a moderate pace and inflation is fast approaching the Fed's target (indeed, by some measures it is already below target).

M2, the most important monetary variable that the world (and the Fed) seem resolutely to ignore, continues to decline. It ballooned in 2020 and 2021 as $6 trillion in deficit-financed COVID "stimulus" spending was mysteriously monetized. Since then, excess M2 has dropped by more than half, and the remainder has been effectively neutralized by Fed interest rate hikes.

In apparent defiance of multiple forecasts that Fed tightening would surely result in a 2023 dominated by recession, GDP grew at a recently-revised and robust 5.2% annualized rate in the third quarter. Once again, market wisdom (e.g., the economy has the unique ability to confound the majority of forecasts) has proven correct. Those who still adhere to Phillips Curve thinking are still scratching their heads: how is it that the economy can strengthen even as the Fed tightens and inflation falls?

It is now abundantly clear that the Fed has no reason to tighten monetary conditions any further. Inflation is within spitting distance of its target. Indeed, the only question at this point is When will they begin to ease? The market is now quite sure that the first easing will come at the May '24 FOMC meeting, but there is no reason they can't ease well before then. Thus, there is reason to remain optimistic about the outlook for the economy and the financial markets.

Chart #1

Chart #1 shows the level of the M2 measure of the money supply, arguably the best measure of money that is easily spendable. Since 1995, M2 grew by about 6% per year, all the while inflation remained relatively low and stable. The "bulge" in M2 has now shrunk by more than half, thanks to negative M2 growth and ongoing growth in prices and the size of the economy. 

Chart #2

Chart #2 is designed to show how growth in M2 predicts inflation by about one year. Negative M2 growth since late 2022 strongly suggests that measured inflation will be declining for the next year.

Chart #3

Chart #3 looks at what I call "Money Demand." It's the ratio of M2 to nominal GDP, and it is best described as the amount of readily-spendable cash money that households are willing to hold expressed as a percentage of their annual income. Money demand surged during the onset of the Covid crisis, only to then collapse as the world slowly returned to normal. In times of crisis it is natural for folks to want to hold bigger money balances, and to subsequently spend down those balances as the crisis passes. Money demand today is almost back to where it was pre-Covid by this measure. Today, folks are still willing to hold some extra cash thanks to the fact that interest rates on cash have soared. Short-term interest rates of 5% or so actually more than make up for current inflation rates of 3% or so. So there's an incentive to hold on to cash rather than spend it. For most of the past 3-4 years or so, those incentives were reversed: interest rates were lower than inflation, so the smart thing to do was to "borrow and buy." Today the monetary incentives are tilted to "save and invest."

Chart #4

Chart #4 looks at the 6-mo. annualized rate of inflation according to the total and core versions of the personal consumption deflator. Both have now fallen to 2.5%, which is only marginally above the Fed's target of 2%. 

The inflation drama is over. 

Sunday, November 19, 2023

Congratulations, Javier Milei!

Javier Milei first appeared on my radar screen 3-4 years ago. At the time I thought he would be the perfect person to rescue Argentina from economic oblivion, because he sees things the same way I do. But then I realized that was almost impossible. How could he, a virtual unknown, ever overcome generations of Peronist rule and endemic corruption? Well, he did, and now he has a shot at pulling off one of the world's greatest turnarounds. Milei has beaten long odds to become Argentina's next president starting December 10.

For a person like me (libertarian, classic liberal, conservative, free marketer, monetarist), Milei is just about ideal. He knows exactly what ails Argentina and what is needed to turn things around. But it won't be easy, since Argentina's Deep State (much more entrenched and corrupt than our own Deep State) won't surrender without a fight. So of course the world's capital markets will be slow to revise upwards their projections for the Argentine economy.

But here's the thing: Argentina has fallen about as far and as fast as any country in history. It's a total mess. Raging inflation, a collapsing currency, rampant poverty, endemic and generational corruption—it couldn't be much worse. So much bad news has trashed Argentina's currency (see this post). As a result, the country can be bought for fire sale prices.

Investors will justifiably worry about the odds against Milei's success. So many things can go wrong. So many hurdles to clear. Where will he get all the dollars needed to dollarize the economy? How can he slash government spending and subsidy payments without sending millions to the poorhouse? How can he possibly dislodge legions of Peronist bureaucrats who don't even bother to show up for work until it is time to collect their monthly check?

Nevertheless, if Milei manages to get some traction with the monumental changes he is proposing, the upside potential for the Argentine economy is very difficult to overestimate. In my fantasies, I see Argentina inundated by a tsunami of foreign capital in the years to come. When the cheapest economy in the world suddenly becomes the one with the most upside potential .... Well, you fill in the blanks. It could be exciting, to say the least.