No boom, no bust

My reading of the economic and financial tea leaves is that the economy continues to grow at a sub-par pace (about 2%), just as it has for the past 8 years. I don't see evidence of a coming boom, nor of an imminent bust. I think the market expects roughly the same thing; it's not priced to either a boom or a bust, just more of the same. Dull.

Here are a baker's dozen charts, with the latest updates, to flesh out the story:

The chart above is one of my enduring favorites. It shows that the ISM manufacturing index does a pretty good job of tracking the growth rate of the economy. What's especially nice is that the index comes out with a relatively short lag of just a week or two, whereas we usually have to wait months to get a read on the economy. What it's saying now is that GDP growth in the current (third) quarter is likely to be in the range of 2-4% annualized. That won't necessarily mean that the underlying pace of growth is picking up though; it's more likely that some faster reported growth in the current quarter which will make up for the relatively weak growth of recent quarters. Such is the volatile nature of GDP stats.

The two charts above are encouraging, since they show that global economic activity is likely picking up. US manufacturers are seeing relatively strong overseas demand, and Eurozone manufacturers have experienced a significant improvement over the past year or so, after years of weak activity.

The chart above shows that US manufacturers are at least somewhat optimistic about the future of their businesses, since many reportedly plan to increase hiring activity in the months to come.

The chart above shows that the ISM manufacturing index does a pretty good job of predicting corporate revenues. For months now, the ISM index has been telling us that revenues per share for the S&P 500 were likely to increase, and they have indeed in increased by over 5% in the 12 months ended July. 

Not surprisingly, faster growth of revenues has gone hand in hand with increased profits. Trailing 12-month earnings per share (earnings on continuing operations) were up over 9% in the year ending July. No wonder the stock market continues to edge higher. Profits and prices are both at all-time highs and rising.

The current trailing PE ratio of the S&P 500 is just over 21, according to Bloomberg's calculation of earnings from continuing operations. That's a good deal above its long-term average of just under 17, but it's not impossibly high. The inverse of the PE ratio—the earnings yield on stocks—is still a healthy 4.7%.

The chart above subtracts the yield on 10-yr Treasuries from the earnings yield on stocks. Equity investing still gives you a yield that is substantially higher than the risk-free yield on Treasuries. It's not always thus. In fact, during periods of robust growth and strong stock markets—such as the 1980s and 1990s—the earnings yield on stocks was usually less than the yield on Treasuries. When investors are confident and the economy is strong, investors are willing to accept a lower yield on stocks because they expect to more than make up for that with capital gains (i.e., rising share prices). The situation today is quite the opposite: a positive equity risk premium suggests that investors are skeptical of the ability of earnings to grow, and are thus willing to accept a lower yield on Treasuries in exchange for their increased safety.

Not all is rosy, however. As the chart above shows, the dollar has taken quite a hit since the "Trump bump" of last November. It's down about 10% in the past 8 months, in what is surely a sign that the world has become a lot less excited about the growth prospects of the US economy.

The chart above provides more evidence that the market doesn't expect the US economy to be very strong going forward. The current real Fed funds rate—the best indicator of whether monetary policy is tight or not—is about -0.25%. The current 5-yr real yield on TIPS (a good indicator of what the market expects the real funds rate to average over the next 5 years) is only 0.11%. This means the market doesn't expect the Fed to do much more in the way of tightening for the foreseeable future. And that, in turn, means the market holds out very little hope for any meaningful improvement in the US economy.

The chart above suggests there is very little reason to expect a recession for the foreseeable future. Every recession for the past half century has been preceded by a monetary tightening sufficient to raise real short-term rates to at least 3-4%, and to flatten or invert the Treasury yield curve. We're a long way away from either of those conditions today. The Fed is relatively easy, and is not expected to tighten much, if at all, because the economy is not expected to improve much, if at all. 

The chart above compares the 2-yr annualized growth of real GDP to the 5-yr real yield on TIPS. I use a 2-yr measure for GDP to "edit out" the quarterly fluctuations which are more due to statistical vagaries than to any real change in the economy's strength. The chart suggests that the current level of real yields is a sign that the market thinks the economy is still likely on a 2% growth trend. (The latest revision to GDP boosted growth during the 2014 -2015 period, but reduced it in the past two years. That is consistent with my repeated observations that the trend growth rate of jobs has slipped in the past year or so from 2.0% to 1.6-1.7%.)

Another not-so-rosy-sign is construction spending, which has softened and dipped year to date. This could just be a pause that refreshes, but in a worst case scenario—if this weakness continues—it could be an early warning sign of another recession. I doubt that is the case, since mortgage originations and home sales are still relatively healthy, but if you want something to worry about, here it is.

I highlighted this chart a few weeks ago, noting that the stability of China's foreign reserves this year is a healthy sign that the yuan has moved to a level that is balancing capital flows (forex reserves under a floating-pegged currency regime such as China's are a direct measure of net capital flows). The yuan has appreciated a bit more of late, a sign that the situation in China is improving on the margin (more money wants to get in than out). Good news from overseas is always good news for the US, especially for a major player like China.

To sum up: I see no sign of excessive optimism or pessimism in market prices. The market's expectations are for a dull economy to remain dull and for inflation to remain relatively low. 5-year expected inflation, according to TIPS and Treasury prices are 1.7%. There is no compelling reason to worry about a recession, or to get excited about a boom. The market is thus "vulnerable" to signs of emerging weakness or increased strength. If we get a decent tax reform package, look for optimism to emerge. If we don't get tax reform, the downside risk is likely not significant, since reform expectations have not been priced in. Fortunately, we have had some meaningful reform in the area of regulatory burdens so far this year, and this should give the economy enough of a lift to keep things on an even, 2% growth trajectory or maybe slightly better. 

Easy healthcare fixes

Congress has once again failed to fix the problem of healthcare—a problem exacerbated (but not created) by Obamacare. Arguably, the main reason for this failure is the fact that trying to manage the healthcare industry by government fiat is impossible. It's manifestly impossible for any collection of politicians and bureaucrats, no matter how smart or how well-intentioned, to design a healthcare system that covers pre-existing conditions, expands access, improves services and lowers costs. The best and most efficient healthcare system can only be achieved by a freely-functioning market that is not burdened by government meddling, subsidies, regulations, or mandates.

The best way to "fix" healthcare is to get the government out of the business of "fixing" healthcare. Steve Horwitz has a few simple suggestions that would go a long way to improving  the healthcare industry. (Big HT to Mark Perry!)

If you want to really reform health care and make it cheaper and provide easier access, you can start with the following, after you end the ACA:

1. End the tax-favored treatment of employer-provided insurance
2. End the limits on interstate competition in the insurance market
3. End the community standards legislation
4. Tort reform
5. Deregulate the supply side of the market by loosening or ending licensing provisions and the AMA's monopoly on the supply of physicians.
6. Encourage the development of more walk-in clinics and other ways of avoiding third-party payment.
7. Encourage health insurance to be actual insurance for major medical problems, not third-party payment for health maintenance
8. Expand the use of pre-tax dollars in health savings accounts

There are surely more. But all of these have been on the table as alternatives for years. They would work from both the supply and demand side to accomplish the goals of lower cost and higher quality care.

It would not guarantee universal coverage, but the cost of covering everyone is that you give up on lowering cost and will eventually have to ration supply. You cannot have lower costs, expanding supply, and universal coverage. At best, pick two.

While this would help a great deal, it doesn't address the problem of the poor, the unfortunate, and those with pre-existing conditions. Fortunately, there are ways to solve this problem, as I discussed in this post—as John Cochrane has proposed, we should raise taxes to directly support charity care and subsidies, instead of using the system of cross-subsidies that so greatly distorts things today.

I posted the chart below a long time ago, and it bears repeating:

Since the consumers of healthcare are for the most part not the ones who pay the bill, there is no price discovery, there is no transparency, and there is no way for competition to work effectively to reduce prices and improve services. We must get rid of the third party payer problem if we want to have any chance of improving the healthcare industry. That can be accomplished very easily by changing the tax code: for example, let everyone deduct the cost of healthcare insurance. Since WW II, the government has allowed only employers to deduct the cost of healthcare insurance. This created a powerful incentive for everyone to get as much healthcare insurance as possible (insurance that covers not just major expenses but also very minor expenses) from their employer. And it's now the case that almost 90% of all money spent on healthcare is spent by someone other than the person receiving healthcare services.

Suppose we did the same thing for food. Suppose we said as a society that food was a universal right; that it would be inhuman to not provide quality food for everyone. Suppose we made food a single payer commodity—let everyone have access to food and have the government pay for it all. What incentive would there be for producers to supply all the things people want and in the right quantities? Why would anyone buy what are now the cheap cuts of beef? Think of the amount of food that would go to waste in people's refrigerators. Soon there would be shortages of food, and the inevitable result would be the rationing of food. Single payer for anything can never be a good solution. History is littered with failed experiments in single payer, aka socialism.

It is immoral to declare a "right" to healthcare, because by doing so we make anyone who works in the healthcare field a slave of everyone else. No one should have the right to the services of someone else—to argue otherwise is to condone slavery, and ultimately to empower the government at the expense of the liberty of all.

Fixing healthcare isn't really all that difficult. What's difficult is accepting the reality that government can't fix healthcare except by drastically reducing its influence on the healthcare market. We don't need a government healthcare fix; we need to restore market forces to the healthcare industry.

Global green shoots

If you want bad news and arguments for why the market is due to collapse any day now, just spend a few hours reading Zero Hedge or browsing the media and punditry. Very few observers these days are willing to pound the table for stocks, considering they have been rising for more than 8 years and are hitting new highs almost every day. Is there anyone who isn't dismayed that Trump and the Repubs haven't been able to repeal and replace Obamacare after years of trying? Is there anyone who is confident that Trump and the Repubs will succeed in massively lowering tax rates? I don't see any evidence that the market is pricing in a stronger economy: 5-yr real yields on TIPS are a mere 0.15%, a level that suggests the market is priced to sluggish growth for as far as the eye can see. And then there are the geopolitical risks. The chances of North Korea dropping a nuclear bomb somewhere are frighteningly high, and China seems bent on expanding its ocean domain. And of course, the Fed is in tightening mode, and tight monetary policy has been the precursor of every recession in modern times.

Yet amazingly, despite the obvious problems out there, complacency reigns: the Vix Index and the MOVE index (the bond market's version of the Vix) are both down to all-time lows. Isn't it scary that the market is moving higher at a time when there are so many troubling things going on and complacency is rampant? Anyone in his right mind would be concerned, no?

Investors are on the horns of a dilemma: it's tough to be bullish, but it's also expensive to be bearish. The earnings yield on stocks is still quite high relative to the yield on cash and bond market alternatives; so hiding out in cash means giving up a lot of precious yield. But almost $9 trillion in bank savings deposits paying almost nothing says that there are lots of people who are reluctant to take on market risk. Indeed, when I look at the market, I see more evidence of caution than I do of exuberance. Bill Miller, a long-time friend and former colleague, maintains that the market is still in a "safety bubble" after the shock of 2008. I've long observed that real yields on TIPS are miserably low, and for that matter nominal yields on sovereign bond markets nearly everywhere are very low. So it's not at all obvious that the market is running on fumes.

Amidst all the worries, however, there are actually some encouraging developments. Call them global green shoots. The U.S. may be stuck in slow-growth mode, but the rest of the world is looking better on the margin. Some charts follow which help flesh out the story:

China is pulling back from the abyss, after scaring the bejesus out of nearly everyone two years ago (check out the "Walls of Worry" chart below), when it looked like their stock market and economy were tanking. As the chart above shows, real GDP growth now looks to have stabilized in a 6-7% range.

As the chart above shows, China's forex reserves have been stable for most of this year, after having plunged from $4 trillion to $3 trillion over the previous two years. The fact that the yuan has stopped falling suggests that the central bank has managed to maneuver the yuan to a level that is balancing capital flows. This further suggests that the fundamentals in China has improved significantly in the past two years. Capital inflows and outflows are about equal these days. (The level of forex reserves is a direct result of net capital flows; reserves decline when outflows exceed inflows, and vice versa.)

Due to the yuan's strength and relative stability against the dollar, inflation in China is virtually identical  to inflation in the US, and it has been for a number of years. This further suggests that the Chinese currency could remain relatively stable against the dollar going forward. What's good for China is good for the world.

As the chart above shows, the Chinese stock market has been trending higher for the past 18 months after the bursting, beginning in mid-2015, of what in hindsight looks like a huge speculative bubble. Now that the dust of that bursting has settled, we see that the Shanghai Composite has actually kept pace with the S&P 500 over the past four years. This is a problem? On the contrary.

The Eurozone has been struggling for many years and continues to struggle. Since the beginnings of our bull market in March, 2009, Eurozone stocks have underperformed their US counterparts by over 30%, as the chart above shows.

But as the chart above shows, Eurozone industrial production now is outpacing US industrial production.

Eurozone ISM manufacturing surveys confirm that the industrial side of the Eurozone economy is regaining its health. And the Euro is strengthening on the margin of late, another sign that the outlook for Europe is not as gloomy as it used to be.

Industrial metals prices are up strongly in nearly every currency over the past 18 months. This is an excellent sign that global economic activity is picking up.

Emerging market stocks have been doing exceedingly well in the past 18 months, as the charts above show. In dollar terms, the Brazilian stock market has more than doubled and the MSCI emerging market equity index (second chart) is up some 50% since early last year. It's not that emerging economies are booming; rather, it's that the outlook has improved from dismal to maybe Ok. Emerging economies are also being bolstered by stronger commodity prices: the CRB Spot Commodity index is up 20% in the past 18 months.

The current PE ratio (using 12-month trailing earnings from continuing operations) of the S&P 500 is just under 22. That's well above its long-term average, but is that a sign of unwarranted exuberance?

Not necessarily. Earnings are growing, as the chart above shows. 12-month trailing earnings are up more than 7% in the past year, and we see positive earnings surprises almost daily.

The current earnings yields on stocks (the inverse of the PE ratio) is 4.6%. That means that if earnings held steady at current levels and if companies paid out all their earnings, the dividend yield on stocks would be 4.6%. The chart above compares the earnings yield on stocks to the yield available on risk-free 10-yr Treasuries. It's unusual for stocks to yield a lot more than risk-free bonds, as they do today. By this measure stocks look cheap. About as cheap, in fact, as they were in the late 1970s, when the world was terrified of stocks. When the stock market is fueled by optimism, as it was in the 1980s and 1990s, the yield on stocks is typically less than the yield on bonds. People are willing to accept a lower yield on stocks because they expect that stock prices and dividends (and earnings) will rise in the future.

The chart above shows yields on a variety of different investments, from Treasuries to mortgage-backed securities to corporate bonds, REITs and emerging market debt. The yield on stocks stacks up quite favorably to the alternatives, and that again is unusual. If the market were optimistic, the yield on stocks would be much lower than the yield on less risky alternatives. Put another way, when the yield on stocks is relatively high, thus the price of stocks is by inference relatively low.

Shown above is an update of one of my favorite charts. The equity market rally which began last November has been driven in no small part by a decline in fear and uncertainty, coupled with a belief that the economy is likely to continue to be relatively sluggish but also relatively stable (which is reflected in a modest rise in 10-yr Treasury yields since November).

The chart above shows the implied volatility of stocks and bonds. Both are now at new lows: that means the stock and bond markets have never been so unconcerned about the future. In a sense, the capital markets appear to be pretty sure that nothing much is going to happen to the economy for the foreseeable future: growth is going to remain modest, inflation is going to remain relatively low, and the Fed is not likely to upset the applecart. In addition, the market seems pretty sure that earnings are not going to increase, and are more likely to be flat or to decline.

To sum it up, although the market is priced to mediocrity (sluggish growth, flat to lower earnings), the global green shoots are hinting that the future may be a bit more exciting. If Trump and the Repubs manage to pull off a successful tax reform, then things could get really exciting.