The election should be all about growth

The economy is still stuck in slo-mo mode: it's been the weakest recovery ever for the past seven years: a mere 2.1% annualized. The first half of this year was even weaker than that (1%), but it's the nature of GDP numbers to be volatile; as with the payroll employment data, you have to look at the trends over months and years to get an approximate idea as to what is going on. Monthly, quarterly, and annual data are routinely revised after the fact, and sometimes significantly. It's amazing that the government statisticians can even come close to measuring all the activity inside an $18 trillion economy.

The data we can trust, however—tax receipts, market-based prices, corporate profits, unemployment claims—are in general agreement with the GDP stats, as I've been noting off and on for the past several months. The economy is most likely still growing at a sub-par pace of 2% or so, as it has on average since 2009 (see chart above). Just because it's growing slowly is no reason to worry that a recession is imminent. The analogy that says a slow-growing economy is like an airplane approaching stall speed is flawed. Indeed, recessions typically follow periods of excesses—soaring home prices, rising inflation, widespread optimism—rather than periods dominated by risk aversion such as we have today. Risk aversion can still be found in abundance: just look at the extremely low level of Treasury yields, and the lack of business investment despite strong corporate profits.

If Donald Trump wants to win the election, his campaign ought to promote the facts to be found in the chart above. The economy's ability to grow by a little more than 3% per year on average for over four decades suddenly vanished beginning in 2009. For the first time in post-war history, the economy failed to recover to its former growth path following the 2008-09 recession, and it has managed to grow only 2.1% since then. Seven years of slow growth following a big recession have left the economy about $3 trillion smaller than it could have been. We're missing out on approximately $3 trillion per year in income, and that's yuuge. Put another way, the average family could have been earning about 18% more this year if the economy had recovered in typical fashion, and of course there would have been many more people working. The $3 trillion GDP shortfall is the easiest way to understand the widespread level of discontent in the U.S. today.

As I noted some years ago, all the spending and borrowing that was supposed to "stimulate" the economy beginning in 2009 was essentially flushed down the toilet. Since 2009 we've conducted a laboratory experiment in the power of government spending and income redistribution to grow the economy by stimulating demand, and the result is proof that Keynesian theories are destructive, not stimulative. Neither government spending nor easy money has the power to create growth out of thin air, but politicians want to convince you that they do. The economy is weak today because we have wasted many trillions of dollars on transfer payments that only create perverse incentives to work less.

Hillary Clinton does not understand this, but Donald Trump most likely does. Clinton has vowed to "change" things for the better by raising taxes on the rich and profitable, and distributing the spoils to the middle class. But that is just a rehash of all that has gone wrong for the past seven years. Real change demands tax reform and simplification; lower and flatter marginal tax rates; a much lower corporate income tax; and extensive regulatory reform and relief. We've got to increase the after-tax incentives to work and take on risk, and reduce regulatory burdens (which add immeasurably to the cost of doing business), if we want a stronger economy. It's that simple. The reward to doing things right would be recapturing the $3 trillion annual shortfall in the economy's productive capacity. The upside potential lying dormant in today's economy is staggering. (And by the way, that's one big reason to remain optimistic.)

One of the best things about the past two decades is the strength of corporate profits, as illustrated in the chart above. From 1958 through the mid-90s after-tax corporate profits averaged about 5% of GDP (note that the right y-axis, corporate profits, is 5% of the left y-axis, nominal GDP). But while corporations have generated about $1.5 trillion in after-tax profits on average over the past seven years (about $10.5 trillion in total), federal government debt held by the public (i.e., net borrowing) has increased by about $6.8 trillion. That means that, in effect, our government has borrowed 2 out of every 3 dollars of corporate profits for the past seven years, and then handed the money out to favored constituencies. In return, the government has enjoyed the lowest borrowing costs in history, but the economy has squandered much of its scarce resources. We've plowed two-thirds of the profits of the most valuable companies in the world into (mostly) transfer payments that have generated zero net growth. This recovery has seen a colossal waste of money.

Another way to see this is to look at business investment, which has been miserable for many years. Businesses have been very profitable, but for whatever reason (e.g.,  the highest corporate tax rate in the developed world, which has discouraged businesses from repatriating trillions of dollars of overseas profits) they have been extraordinarily reluctant to reinvest those profits. Call it risk aversion, or as I've deemed it, the reluctant recovery.

Capital goods orders (see chart above) are a good proxy for business investment. Capital goods are the things that make labor more productive. You can't grow the economy without investing in tools and technology that make workers more productive. Lamentably, capital goods orders today are about the same as they were in the late 1990s. In real terms they have declined by 30%, even though the economy has grown by over one-third over the same period.

Private Fixed Investment tells the same story. Relative to GDP, fixed investment (structures, equipment, and software that are used in the production of goods and service) has declined by almost 20% since 2000. The go-go growth of the mid-80s and the late 90s were driven by strong investment. Today's weak investment climate has given us a miserably weak economy. It's not surprising. 

What is surprising is that so few seem to understand that the solution to our weak growth is to do things that encourage investment, work, and risk-taking. That includes not only lower taxes and reduced regulatory burdens but also greater confidence that conditions will remain favorable in the future. How many today are willing to bet huge sums that taxes will be lower and flatter across the board a year or two or three from now? It's almost impossible to know at this point, with the election still a toss-up between one candidate who vows to increase taxes and regulatory burdens and the other who would likely reduce them.

I despise Donald Trump as a person (just as I despised Bill Clinton as a person), but I do think both Donald and Bill have a much better understanding of how business and the economy work than Hillary does. If Trump were able to push through a growth agenda, the rewards could more than make up for his failings in other areas. It remains a mystery why Hillary wants to double down on Obama's failed economic agenda when her husband's was so different and so much more successful.

To judge from the rhetoric, the election is all about personalities: Hillary is a corrupt liar, Trump is a xenophobic, redneck egomaniac. The list of negatives is long for each. Instead it should be all about which one would be best for the economy. On that score, Trump should win hands down.

Chart updates

We enjoyed a great trip to Alaska this past week, during which time I didn't have much time to follow events (very slow and spotty internet access, plus too many other interesting things to do and see). To get back into the swing of things, I'll just review a bunch of updated charts—in no particular order—that I've been following over the years:

The latest data from the housing market shows activity has been rather flat for the past year. Starts are still significantly below what might be considered "normal," but builder sentiment suggests there is room for improvement. Indeed, starts would need to rise significantly over the next several years just to keep up with scrappage and the ongoing rise in housing formations and population.

Housing prices, according to Case Shiller, are still well below their "bubble" highs in real terms. Meanwhile, mortgage rates are at historically low levels. Both suggest that there is lots of room for further growth.

Both gold and industrial commodities have enjoyed a nice bounce since the end of last year. It's notable that the bounce in commodities has occurred even though the dollar has been relatively stable—usually it take dollar weakness to produce a healthy bounce in commodity prices. I'll chalk up the latest move in commodities to what appears to be a firming in global demand—a promising development given the doom and gloom which still pervades most markets (e.g., extremely low sovereign yields).

Sterling is the currency that has weakened the most of late, driven in large part by the perception that a "Brexit" will be a negative for the economy. I think it will work to the UK's advantage over time, but for now it just creates a lot of uncertainty. In any event, as the chart above shows, by my calculations the pound today is trading right around "fair value" vis a vis the dollar, after being quite strong for many years. If/when the UK adopts better trade agreements (freer trade), the pound has room to rise. But for now it's reasonably priced. Great time to take a vacation in the UK!

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Beginning in early 2011, Treasury yields began diverging from core inflation. The significant gap between yields today and inflation is a sign, I believe, of a market that has very low expectations for economic growth and a great deal of risk aversion. As the second chart above shows, inflation expectations have declined by almost 100 bps since early 2011, but actual inflation has risen. This is a market that worries about slow growth and a Fed that is powerless to push inflation up. I think the market is underestimating the Fed's ability to deliver 2% inflation, since core inflation is already running above 2%, and it has been 2% or better for most of the past decade. I fully expect the headline CPI to register at least 2% by the end of this year. Bonds are definitely expensive at these levels.

2-yr swaps spreads in the US have moved up a bit so far this year, but they are still in the comfort zone (15-35 bps) that is consistent with healthy, liquid markets and low systemic risk. I note that the increase in swap spreads from almost zero to today's 21 bps has coincided with a stronger equity market. That makes sense if you consider that buying swap spreads (equivalent to buying AA-rated bank bonds) is a more attractive way to hedge against a weaker economy than buying Treasury bonds, due to the onerous capital requirements imposed on bank balance sheets (i.e., going long swap spreads doesn't consume capital the way going long Treasuries does). In other words, very low swap spreads were indicative of a market that was desperate for ways to hedge against a weaker economy. That swap spreads are more normal today means the market is less risk-averse, and we see that as well in rising equity prices.

The chart above tells the same story. The ratio of the Vix index to the 10-yr Treasury yield is a measure of fear and pessimism. It has dropped in recent weeks as equity prices have risen. But the ratio remains elevated, thanks to extremely low Treasury yields. This means the market is less uncertain about the future, but not very optimistic about the prospects for growth (i.e., the Vix is relatively low and Treasury yields are extremely low).

Arguably, the most significant macro development since 2008 is the huge increase in the world's demand for money, which is shown in the chart above. For decades the ratio of M2 to nominal GDP was relatively steady, but since 2008 it has soared to levels never seen before. This is indicative of a market that is still very risk averse, and it goes hand in hand with the significant deleveraging that has occurred in the private sector. 

Even though M2 has grown much more than nominal GDP since 2008, the growth rate of M2 has been consistent with historical trends, as the chart above shows. There is no evidence here that the Fed has "printed" money in excess of what has been the historical norm. The Fed supplied more money to the system in response to a huge increase for the demand for money. There is nothing wrong with that! Without QE we would have been in a world of hurt: a shortage of money would have resulted in global deflation.

Bank savings deposits make up about two-thirds of the M2 measure of the money supply. Virtually all of the growth in M2 since 2008 is accounted for by bank savings deposits, and banks have "invested" most of that money in bank reserves (banks have lent almost $3 trillion to the Fed since the start of QE). Banks have been quite risk averse, and they have also had to deal with onerous capital requirements (e.g., Dodd Frank and Basel Accords). It's certainly possible that most or all of the increase in bank reserves was driven by much more stringent capital requirements.

The euro has been relatively weak vis a vis the dollar since mid-2014, and Eurozone equities and Eurozone growth have significantly underperformed their US counterparts over that same period. The US hasn't been very exciting of late, but the Eurozone has been even less so. By my calculations, the Euro is trading a bit on the cheap side vis a vis the dollar. It's hard to get excited about the Eurozone these days, and that helps explain why the Brits were so anxious to leave its embrace.  

Thoughts on the June payroll numbers

I will be traveling tomorrow morning (headed up to Alaska for a week or so of cruising and sightseeing) when the June payroll numbers come out, but I have some observations that might help interpret whatever the number happens to be. To begin with, there is the issue of about 35K jobs that were lost in May due to a Verizon strike, and which will be added back in June since the strike was resolved. Then there is the issue of the significant undercounting of May jobs according to the BLS vs. what ADP reported. In the past, big swings in the BLS numbers that have not been confirmed by the ADP numbers have been reversed within a month or so. This leads me to think that the June BLS private sector jobs gain should be at the very least 200K, but that is more than the consensus (+160K). If its not at least 200K, then that means we have a slowdown on our hands. But the other data suggest no fundamental weakening of the jobs market, so for now I'm expecting an upside surprise that will only mean that nothing much has changed.

The red line in the chart above is going to have to jump significantly if the June ADP number is to be believed. If it doesn't increase at least 200K, then the likelihood of a weakening in the jobs market rises, and that would not be good.

There is no indication of any fundamental deterioration in the labor market. Large corporate layoffs are just not happening.

Weekly unemployment claims continue to trend down. Based on claims, all looks quiet on the labor market front.