Growth persists

We're still in the weakest recovery ever, and despite widespread fears that it is running out of gas, the US economy continues to expand. Here are some charts that document the ongoing, modest business cycle expansion:

The ISM May manufacturing index was a bit stronger than expected (51.3 vs. 50.3), but it suggests that the economy is growing at a pace (2% or so) that is the same as we have seen, on average, over the past seven years. It's likely, therefore, that Q2/16 growth will be substantially higher than the 0.8% registered in Q1/16. This won't imply any meaningful acceleration of growth, however, since quarterly growth rates are typically much more volatile than the underlying growth trend.

The export orders subindex of the ISM manufacturing report was mildly positive, since it points to some modest improvement in overseas economies.

With oil prices having risen 50% in the past 4-5 months, it's not surprising to see the prices paid subindex jump to levels not seen for almost 5 years. Deflation is yesterday's news.

The employment subindex of the ISM report is symptomatic of what continues to ail the economy: a lack of investment. Companies are not confident enough about the future to commit to serious expansion and hiring plans.

Manufacturing activity in the Eurozone is about as un-robust as it is in the US.

The chart above suggests that changes in the ISM manufacturing index tend to lead (though not always) changes in 12-mo. trailing revenues per share of the S&P 500 companies. If this relationship holds, we should see a return to rising revenues per share by year end. As it is, revenues per share have only dropped. 1.2% over the past year—a relatively modest slowdown.

I wish it were more pronounced, but the decline in the prices of TIPS and gold over the past month or two suggests that the market has become a bit less worried and pessimistic.

Less worry translates into a modest rise in equity prices, as the chart above shows.

As the chart above shows, the rise in oil prices has coincided with a firming in non-energy commodity prices. Over time, the correlation of the two is strong, but oil prices are far more volatile (note the difference in the scales of the two y-axes).

The chart above shows that commodity prices have risen vis a vis most currencies in recent months. So it's not just a currency phenomenon, it's more likely that global economies have strengthened on the margin. It's worth highlighting here the fact that the Swiss franc has been the most stable—in commodity terms—of the major currencies over the years.

The housing market continues its recovery, with prices approaching their highs of just over 10 years ago. I note the apparent trend for inflation-adjusted (real) housing prices to average just over 1% per year (shown in the second chart), a rate that would be consistent with ongoing improvements in quality, size and amenities. UPDATE: This is bolstered by recent Census Bureau data, as summarized in  Mark Perry's post showing how square footage has increased over the years.

This chart has been one of the most reliable guides to upcoming recessions that I'm aware of. It suggests that recessions typically follow sharp increases in real short-term interest rates and a flattening or inversion of the Treasury yield curve (both conditions being symptomatic of very tight monetary policy). Today we are not even close to those conditions. Real interest rates are still very low, and the slope of the yield curve is a bit above average. In the absence of tight money and in the presence of relatively cheap energy prices, it's likely that the economy will continue to grow.

It's been a sluggish recovery and many millions are still without jobs. But in aggregate, real disposable incomes have been rising and continue to do so. Gains in the past year (3.2%) are in line with historical experience, but the level of disposable income remains significantly less than it might have been had this been a typical recovery. Jobs and income have gone missing, but it is a recovery nonetheless.

All of this makes a strong case for avoiding the very low yields on cash and cash equivalents.

Recommended reading: Howard Marks on Economic Reality

Howard Marks did not build a highly successful money management firm (Oaktree Capital) by ignoring the fundamental truths and the basic laws of economics. In his latest memo, "Economic Reality," he explains simply and eloquently why it is that a) monetary policy cannot stimulate an economy or create growth, b) governments cannot create growth by subsidizing industries, c) government regulations (e.g., minimum wage laws) cannot produce prosperity, d) higher taxes on the rich cannot make an economy stronger or increase the general welfare of a country's citizens, e) higher inflation mainly benefits governments with big debts, at the expense of its citizens, f) devaluing one's currency cannot strengthen an economy, g) bringing jobs back to the U.S. is not necessarily going to raise our standard of living (and Trump's promise to impose huge tariffs on Chinese goods is crazy), and h) redistributing wealth and central planning are sure-fire ways to destroy an economy.

I highly recommend this memo to everyone. It's long, but chock-full of wisdom that is sorely needed (and distressingly lacking) in today's political debates.

Risk aversion is still the order of the day

The S&P 500 is only 2% away from making a new, all-time high, and its PE ratio today of 19.3 (according to Bloomberg) is about 15% above its 55-yr average. The Fed has been taking extraordinary measures to ensure that the economy has plenty of liquidity, and has targeted extremely low short-term interest rates for over 7 years. Taking these facts into consideration, you could be forgiven for thinking that super-easy monetary policy and low interest rates have created another bubble in the price of risk assets.

There is no shortage of pundits, economists, and investors who are worried that the Fed has blown an asset-price bubble that is ready to pop. I'm among the minority who have been arguing—for many years—that this is the wrong way to look at things. I don't see the Fed as the aggressor; I think the Fed is more a follower. The Fed hasn't driven yields to absurdly low levels, the Fed has merely responded to a market that has been deeply risk averse and generally pessimistic.

The Fed has been doing what it should: in the presence of a huge demand for money and safe assets, the Fed must take extraordinary measures to increase the supply of money and safe assets. Quantitative Easing was not money printing. It was the Fed's way of turning risky notes and bonds into safe assets (i.e., bank reserves, which are functionally equivalent to T-bills, the gold standard of risk-free assets). The demand for money and safe assets has been unprecedented, and the Fed's response has been commensurate. I explained this in greater detail here.

Evidence of risk aversion (another way of describing the market's huge demand for money and safe assets) is everywhere. Investors all over the globe are willing to pay extremely high prices for risk-free assets, while at the same time shunning much higher yields on risk assets. Moreover, it's not unreasonable for there to be so much risk aversion: economic growth has been miserably slow just about everywhere, and volatility has at times been intense. Most people are still terrified of another Great Recession and/or Global Financial Market Crash. Once burned, twice shy, as the saying goes.

Here are a bunch of charts, in no particular order, which help prove my points:

Households have reacted to the Great Recession by cleaning up their balance sheets. As the chart above shows, financial obligations as a % of disposable income are now at multi-decade lows. Households have almost never been so prudent in managing their finances. Nobody wants to get caught with too much debt when/if the next financial crisis rolls around.

Leverage was all the rage in the 2000s, as home prices escalated and mortgages became easier to find and abuse. But the housing market collapse taught us all a valuable and time-honored lesson: prices can't go up forever, even if money is almost free. As a result, the average person is far less leveraged today than he or she was a decade ago, as the chart above shows.

You know things are getting shaky when delinquency rates on loans start rising, because that is evidence that borrowers are getting stretched. Today that's not the case at all. In fact, as the chart above shows, delinquency rates on consumer loans and credit cards have never been lower. People have learned the hard way that leverage doesn't always pay.

People have also learned that credit card debt is a killer. As the chart above shows, outstanding credit card debt today is still far less than it was in 2008, and as a % of disposable income, credit card debt has collapsed, and hasn't risen at all for the past several years.

The chart above is the quintessential measure of the demand for money. It shows the ratio of M2 (currency, checking accounts, CDs,consumer savings deposits and retail money market funds, all very liquid and spendable forms of money) to nominal GDP. The ratio has never been higher, and it has been rising by leaps and bounds for the past 15 years. This tells us that people want to hold an ever-increasing amount of their annual income in the form of money and money equivalents. Bank savings deposits, for example, have risen from $4 trillion in late 2008 to $8.4 trillion today (a 110% increase); over the same period, personal income has risen by a mere 27%. People have been actively socking away money like squirrels before the winter arrives. Virtually the entire avalanche of new bank savings deposits has been used by banks to buy notes and bonds which in turn they sold to the Fed in exchange for bank reserves. The banking system, in other words, invested their huge deposit inflows in the safest thing they could find: T-bill equivalents (aka bank reserves). Bank credit is growing at a 7-8% rate, but that is only a very small fraction of what it could be, given the huge amount of excess reserves that banks hold. Banks are behaving just like people who are very risk averse.

The chart above 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). These are two classic safe assets: gold has been the safe haven asset par excellence for all of history, and 5-yr TIPS are the only way an investor can lock in a guaranteed real rate of interest on an asset that is itself risk-free. Although the prices of gold and TIPS have fallen over the past several years (they peaked around the time of the PIIGS crisis in the Eurozone), they are still quite elevated from an historical perspective. In constant dollar terms, gold prices have averaged $500-600 over the past century, while real yields on 5-yr TIPS have averaged 1.3% since their inception in 1997. Investors are still willing to pay a hefty premium for the safety these two assets afford. 

U.S. Treasury notes and bonds are universally considered to be the safest of all notes and bonds, given the guarantee of the U.S. government. 10-yr Treasury yields, shown in the chart above, today are a mere 1.87%, which is only inches higher than the all-time low of 1.4% registered about four years ago. That's another way of saying that the price of these bonds is very close to an all-time high. People all over the world are willing to pay top dollar for the safety of these bonds relative to other bonds. The PE ratio of the 10-yr Treasury today is about 53: to get a dollar's worth of yield on a 10-yr Treasury you have to pay $53. Compare that to the PE ratio on the average large cap stock today, which is just over 19, and you get a vivid feel for just how risk averse this market is.

But hold on, you say; isn't it the case that the Fed has artificially depressed the yield on Treasuries by buying trillions worth of them? Not necessarily, and most likely not. As the chart above shows, the Fed today holds the same percentage of outstanding Treasuries as it did prior to the 2008 financial crisis. And there's little or no correlation between changes in the Fed's relative holdings and the yield on those same Treasuries. For example, look at how the Fed's holdings soared in 2012-2014, at the same time that yields soared. You would have thought that huge Fed purchases would have pushed up Treasury prices and depressed Treasury yields, but just the opposite occurred. I explained this in greater detail here.

My point here is that the Fed cannot distort the yield on notes and bonds. The Fed can exert strong influence on short-term rates, but not on 5- and 10-yr rates. Besides, we have the TIPS market that helps discipline yields. In the chart above, I show the nominal yield on Treasuries and the real yield on their corresponding TIPS (Treasury Inflation-Protected Securities), and the difference, which is the market's implied inflation expectation. We know the Fed has purchased trillions of Treasuries, but they've only purchased about $60 billion of TIPS since 2008 (the Fed held 8.5% of outstanding TIPS as of March 2016). If nominal yields were artificially low because of huge Fed purchases, then the expected inflation rate should have been artificially low as well, but it is today very much in line with current inflation and forward-looking inflation expectations. 

In fact, the best measure of bond yields (i.e., their real yields) is the place to start your analysis of the bond market. As the chart above shows, there is a strong tendency for the real yield on 5-yr TIPS to track the real growth rate of the economy. That's not unusual at all. Think of the real yield on 5-yr TIPS as the risk-free expected real yield. It should be lower that the expected real return on riskier assets, just as the yield on T-bills should be lower than the expected nominal yield on riskier assets.  (This is straight out of modern finance theory.) You shouldn't be able to lock in a real rate of return that is higher than the expected real rate of return on risky assets; you should almost lways have to pay a premium for the risk-free nature of TIPS. 5-yr TIPS today have a slightly negative real yield, and that implies that the market expects that average real returns on other assets (for which real growth expectations are a good proxy) should be somewhat higher, and indeed they are, but not by much. As the chart above shows, 5-yr TIPS real yields today suggest that the market expects real GDP growth to be about 1-2% per year for the foreseeable future. That's a pretty pessimistic outlook. Real yields are low because nobody's taking the risks that are necessary to generate stronger growth; corporate profits are at near-record levels relative to GDP, but corporate investment is miserably weak. Weak growth implies low real and nominal yields on Treasuries, as long as inflation expectations remain anchored, as they still are.

Risk aversion can be found in the corporate bond market as well. As the chart above shows, credit spreads today are much lower than they were during prior panics, but they are still elevated relative to where they have traded during periods of relative calm.

As the chart above shows, fear has been a huge factor in the stock market for the past several years. I use the ratio of the Vix Index (the implied volatility of equity options, a good measure of fear and uncertainty) to the 10-yr Treasury yield (a good measure of the market's expectations for economic growth, as discussed above) as a measure of how worried and pessimistic the market is. Bouts of nerves and pessimism have driven the market lower repeatedly. Prices have recovered in the past few months as fears of deflation and fears of a China collapsed have receded. But the Vix/10-yr ratio is still elevated, thanks mainly to very low Treasury yields.

Yesterday brought the welcome news of a surge in new home sales in April, as shown in the chart above. There are still bright spots out there, thank goodness.

But as the chart above shows, the housing market is still pretty depressed from an historical perspective, even 10 years after its prior peak. Starts today are only about half what they have been during prior periods of good times.

When markets are risk-averse, as they still are today, investors enjoy a cushion of sorts against bad news, because the existence of risk aversion equates to bad news being priced in.