Richer than ever

This post is the latest in a series of updates on the fabulous wealth that has been created in the U.S. economy.

Today the Fed released its Q1/17 estimate of the balance sheets of U.S. households. Once again, our net worth reached a new high in nominal, real, and per capita terms. We have been struggling through the weakest recovery ever for the past 8 years, yet we are better off than ever before, and by a lot.

As of March 31, 2017, the net worth of U.S. households (including that of Non-Profit Organizations, which exist for the benefit of all) reached a staggering $94.84 trillion. That's up $7.3 trillion in just the past year, for an impressive gain of 8.3%, and up $27.2 trillion since the pre-2008 peak. Of note, household liabilities have increased by a mere $510 billion since their 2008 peak, for a gain of only 3.5%. The value of real estate holdings is up about $1.9 trillion (+7.6%) from that of the "bubble" high of 2006, and financial asset holdings have soared by almost $24 trillion (+45%) since pre-crash levels, thanks to significant gains in savings deposits, bonds, and equities. The gains in wealth are not just due to a raging stock market, since the market cap of all traded U.S. equities has risen by only $8.4 trillion since its pre-2008 high, according to Bloomberg. 

In real terms, household net worth has grown at a 3.5% annualized rate for the past 65 years, as seen in the chart above. That works out to almost a 10-fold gain in wealth roughly three generations, and that's impressive by any standard. Perhaps more importantly, there is no sign that this rising trend has been compromised or degraded in the past decade.

On a real per capita basis (i.e., after adjusting for inflation and population growth), the net worth of the average person living in the U.S. reached a new all-time high of $292K, up from $63K in 1950. This measure of wealth has been rising, on average, about 2.3% per year since records were first kept beginning in 1951. By this metric, life in the U.S. has been getting better and better for generations. Real per capita net worth has almost quintupled in three generations.

The ongoing accumulation of wealth is not a house of cards built on a bulging debt bubble either, regardless of what you might hear from the scaremongers. As the chart above shows, the typical household has cut its leverage by one third, from a high of 21% in early 2009 to 13.8% by the end of last quarter. Households have been prudently and impressively strengthening their balance sheets over the past eight years by saving and investing more and by reducing the use of debt financing.

Inevitably, skeptics will point out that although the amount of wealth created in the U.S. economy is spectacular, the distribution of that wealth is heavily skewed, being held mostly in the hands of relatively few. Zero Hedge has a good summary of the relevant facts. I (and many others) would argue, however, that the distribution of wealth is not nearly as important as the per capita amount of wealth. Consider: an employee of Apple, now the world's most valuable company (market cap of $808 billion as of today) may have zero personal net worth, but he or she enjoys a job that never existed before. Or consider users of Apple's iPhones who also may have zero personal net worth, but now enjoy more computing power and knowledge in their pocket than was even conceivable just 10 years ago. Increased wealth means more jobs, more opportunities, and more productivity for everyone. Society's accumulated net worth can be seen in buildings, factories, homes, gadgets, streets, and transportation networks, and all of this can be enjoyed and exploited by nearly everyone for their personal gain and/or happiness. It doesn't matter who owns the factory; what matters is how good the jobs are in that factory.

Free markets and capitalism have proven to be the greatest creators of wealth and prosperity in the history of the world. They maximize wealth creation and opportunity for all, but they can't possibly deliver equality of wealth distribution. To expect it would be to fail to understand how free markets and capitalism work. Some people's comparative advantage lies in building companies and accumulating wealth, while others' advantage lies in supplying the labor that allows capital to be put to work for the benefit of all. Everyone needs each other, and everyone enjoys the fruits of our prosperity. You can't have an Apple without a Steve Jobs becoming fabulously wealthy, and you can't have an Apple without millions of people working to produce and use its products.

Durable goods deflation is wonderful

I've been featuring this chart off and on for years, and it's worth repeating once again. The chart shows the evolution of the Personal Consumption Deflators for Services, Non-durable Goods, and Durable Goods. It starts in 1995 because of three reasons: 1) that was approximately the year that China began to be an export powerhouse, 2) it was a year after China's major devaluation against the dollar, and the first year that the yuan began to stabilize against the dollar, and 3) it was the first year ever that the US durable goods deflator experienced a decline of more than a few months.

I don't think it's a coincidence that the emergence of China as a major exporter of durable goods (e.g., TVs, computers, cameras) coincided with the beginning of a sustained decline in the prices of durable goods. If there's been an identifiable source of deflation in the US economy, it's not been the Fed, but the vast increase in the productivity of the Chinese economy, and the vast increase in the volume of imported Chinese goods to the US economy. Thanks to the industrialization of China, the world has been able to produce manufactured goods much more cheaply than ever before.

This has been a boon to just about everyone in the US economy, and the first chart is also proof of that. Consider that the price of "services" is largely driven by wages, and service sector workers are about 86% of total payrolls. What the chart shows is that the earnings of the great majority of US workers have increased 2.7 times more than the price of durable goods. In other words, an hour's worth of work for the typical American today buys 2.7 times more in the way of durable goods than it did in 1995. When it comes to durable goods, the average American's purchasing power has nearly tripled over the past 22 years, thanks largely to China.

As these last charts show, China did NOT become an export powerhouse by unfairly devaluing its currency. On the contrary, the yuan has appreciated in real terms vis a vis the currencies of its trading partners by about 75% since 1995, as the second chart shows. Furthermore, China's reserves have been relatively stable for the past several months, and this suggests that the yuan is likely to remain relatively stable—there's no hanky-panky going on (significant increases or decreases in forex reserves are symptomatic of an mis-valued currency). It's encouraging that Trump has dropped his threat to "punish" China for boosting our purchasing power so dramatically. We could use more countries like China, and so could the world. When it comes to trade, everyone is a winner.

Fed tightening has been a positive for markets

For years people have worried that a Fed "tightening" would derail the economy and the markets, but the facts say otherwise. The Fed first hinted at a tightening a few years ago, with the first hike coming in late 2015. Since then, short-term interest rates have risen by 75 bps and another tightening is virtually assured for next month's FOMC meeting. Today the dollar is stronger, but not too strong; the yield curve is flatter, but not too flat; credit spreads are tighter, but not too tight; equity prices are up, but the equity risk premium is still positive; commercial real estate is up, but not to record highs; equity and bond market volatility is down; and inflation is relatively low but not too low.

What's not to like? To be sure, the economy hasn't yet picked up from the 2% pace that has prevailed for the duration of this rather long recovery, but business and consumer optimism is up significantly in recent months, and that combined with Trump's tax and regulatory reform proposals, if passed, would almost certainly result in a stronger economy. Things could be better, but they aren't half bad—except for the growing threat of a nuclear NoKo and radical Islamic terrorism. For my money, NoKo is the darkest cloud on the horizon. Unfortunately, there's not much an investor can do in the face of that kind of uncertainty.

Here are some charts which put some meat on the story:

The chart above compares the inflation-adjusted current Fed funds target rate (blue) to what the market expects that rate to average over the next 5 years (red). This is effectively a picture of how the real yield curve has evolved over time and is expected to evolve. Recessions are almost always preceded by a flat to inverted real yield curve, because that is the market's way of saying that monetary policy is too tight and it is hurting the economy. Today the market is saying that the Fed will probably raise the real funds rate another couple of times over the next year or two, but not by much more. That tells me the market is not pricing in a robust economy, nor is it predicting a weaker economy, since that would call for a reduction in the real funds rate. It's more a prediction of "steady and slow as she goes."

Note also the all-time low in real 5-yr yields in March 2013, when they fell to almost -1.8%. That was a sign that the market was extremely pessimistic. We've come a long way since then, but real yields are still very low from an historical perspective.

As the chart above shows, 5-yr real yields are still right around zero, where they've been for several years now. It's not a coincidence, I would argue, that real GDP growth has been stuck at 2% for about the same length of time. Translation: the market doesn't see much if any improvement for the foreseeable future. This is not an optimistic market.

Credit Default Swap spreads are a little tighter than they were in March 2013, despite higher real yields and a flatter yield curve. They've been tighter before (e.g., in the late 2000s).

The chart above compares the yield on a variety of assets as of March 31, 2013 (when real yields hit their all-time lows and Fed policy was effectively extremely easy) and as of today (red). Note that short-term yields have risen much more than longer-term yields, resulting in a flatter yield curve. Note also that yields on REITS, BAA bonds and equities have declined even as the Fed has tightened and market yields have risen. All of this is pretty straightforward, right out of the textbooks. Tighter money flattens the yield curve, and when it's not too tight it's good for most asset classes because a positively-sloped yield curve is symptomatic of a reasonably healthy economy. The Fed is not threatening anybody these days.

The dollar began rising once the market started pricing in Fed tightening. That's a good thing. But the dollar today is far from being too strong, as it was in 1985 and 2001. Today it's only marginally higher than its long-term historical average.

With the dollar just above the middle of its long-term range, it's not surprising to see real oil prices trading close to their long-term range. Oil is neither expensive nor cheap, and that can't be bad for the outlook for the economy.

As the chart above shows, 5-yr inflation expectations (as embodied in the market for TIPS and Treasuries) say that consumer price inflation will likely average about 1.7% for the foreseeable future. That's not bad at all: not too high, not too low. In my ideal world, inflation would be close to zero and stable, but nobody is going to worry much if it's 1.7%. Indeed, the Fed would prefer to see inflation above zero. The Fed is not a threat in these conditions.

As the chart above shows, the equity market has suffered from numerous panic attacks in recent years (i.e., spikes in the Vix/10-yr ratio, accompanied by declines in equity prices). Today, however, implied equity volatility is quite low and nobody expects anything outrageous from the Fed, so it's not surprising that equity prices are floating higher.

PE ratios (using earnings from continuing operations) today are a bit over 21, according to Bloomberg, but that's not at all unusual given the very low level of 10-yr nominal and 5-yr real yields. As the chart above shows, the earnings yield on the S&P 500 tends to follow the inverse of the real yield on 5-yr TIPS. If anything, the current earnings yield on stocks suggests that real yields are too low (meaning the Fed could be tighter and real yields higher). Stocks, in other words, appear priced to higher yields than the bond market is assuming.

As the chart above shows, the equity risk premium (the difference between earnings yields on stocks and the yield on 10-yr Treasuries) is still relatively high. That means investors are quite willing to forego the yields and capital gains potential of stocks in exchange for the safety of Treasuries. Again, this is not an overly-optimistic market. If the market were exuberant, the equity risk premium would be negative, not positive. 

What's driving equity prices higher is not anything sinister nor dangerous. Given that the market doesn't expect things to change much, investors are reluctantly conceding that the much higher yields on equities and other asset classes—relative to cash and Treasury note and bond yields—are attractive.