With a little luck we'll survive Biden's departure

This is one of those times when it's easy to find things to worry about, and right now they add up to a big deal. Figuring out what that means for the world of investments is the tough part.

To begin with, for years the federal government has been spending way too much money on non-productive things, thus sapping the economy's inherent strength. The federal debt is now almost 100% of GDP, and debt service costs are rising rapidly. The Fed is most likely too tight, holding short-term interest rates uncomfortably high relative to current and expected inflation. Meanwhile, the economy is growing at a modest pace that is unlikely to pick up anytime soon. Interest-sensitive sectors (particularly housing) are really being squeezed.

But the elephant in the living room is HUGE. The press and the DNC can no longer hide the fact that the president of the United States is mentally and physically unable to perform the duties of his office, and he's getting worse by the day. There is no question that he will not be the Democratic candidate for president on the November ballot (for proof of this, see this editorial in the NY Times). By all rights, and since he is unqualified to run, he is also unqualified to serve. It is thus quite likely that he will depart the Oval Office well before November, since he is now the DNC's worst nightmare. Worst of all, he poses a threat to global peace; nature abhors a vacuum, and the vacuum that pervades the White House is intolerable.

When you consider all this in the context of an equity market that has reached new highs in both nominal and real terms, it is troubling to say the least.

One way to make sense of all this is to conclude that the market is looking across the valley of despair to better times ahead. Biden's vow to allow the Trump tax cuts to expire at the end of next year and to instead raise taxes on the economy's engines of growth is now off the table. Happily, Biden will no longer be able to make foreign policy mistakes (he's been on the wrong side of every foreign policy issue for the past four decades, as Robert Gates once said). The Supreme Court recently issued decisions which will drastically curtail the power of the administrative estate, long Biden's ally, and Trump is likely to do even more in that regard. Green Energy subsidies are now an endangered species, as demand for electrical vehicles crumbles and the nation's power grid struggles to compensate for unreliable wind and solar power generation.

The charts that follow highlight some of the problems the economy is facing, as well as some of the indicators that suggest all is not yet lost.

Charts 1 & 2

Chart 1 shows government transfer payments (e.g., social security, medicare, medicaid, welfare) as a percent of disposable personal income). Since 1970, transfer payments have swelled from 10% of disposable income to now over 20%. Chart 2 shows the percentage of people of working age who are currently working, which began to collapse right around 2008-2009, when transfer payments surged in response to the Great Recession. Transfer payments essentially give money to people who aren't working. To paraphrase Art Laffer, when you pay people who aren't working, don't be surprised to find that fewer people are willing to work. 

Chart #3

It's not surprising, then, that the economy can only muster sub-par growth, as Chart #3 demonstrates. The 3.1% trend growth line (green) began in 1965, only to finally break down in the wake of the Great Recession and its avalanche of transfer payments. 2.2% per year seems now to be the new norm, as the red line illustrates. Had 3.1% prevailed, the economy today would be about 25% bigger. What a difference a 1% annual shortfall in growth can make after 17 years!

Chart #4

Chart #4 is one of my long-time favorites, since it shows two variables that have, until recently, foreshadowed the onset of every recession in my lifetime (with the solitary exception being the Covid black hole). When the Fed raises short-term rates to levels significantly higher than inflation—otherwise known as monetary tightening—and the Treasury yield curve inverts (red line), recessions typically follow. We are now very close to seeing both of these variables manifesting: real rates (blue line) are 3% and rising (still a bit shy of past peaks however), and the yield curve has been inverted for several years. If the economy avoids a recession it will likely be due to the Fed's policy of abundant reserves, an argument I've been making for the past 15 years. Abundant reserves all but guarantee that liquidity remains abundant, and that has the effect of inoculating the economy against credit busts and related recession. I've been making this argument frequently in the past 18 months.

Chart #5

Chart #5 reminds us that interest rates tend to follow inflation, albeit with a lag. (I've chosen ex-energy inflation to illustrate this since energy prices are by far the most volatile of all prices.) Note the asterisk on the lower right-hand side of the chart: inflation ex-shelter prices has been a mere 2.1% for the past year. Given the past behavior of housing prices, headline inflation is very likely to continue trending down. See this post for more information on why this is a valid point to make.

Chart #6

My no-recession-for-now call is not without risk, as Chart #6 suggests. The recently-released Small Business Optimism survey of employment intentions has deteriorated markedly in recent months, approaching levels associated with past recessions. 

Chart #7

Chart #8

Fortunately, financial markets to date show no sign whatsoever of any deterioration in the outlook for corporate profits. That's the message of Charts #7 and #8. Credit spreads on corporate bonds remain quite low.

Although the Fed's tight monetary stance is applying unnecessary pressure to the economy, it has not yet reached critical levels. And given that all signs point to a continuing disinflationary process (see my last post for more details), the Fed essentially has only one choice to make: when and by how much to lower interest rates. They are dragging their feet, but eventually they will figure this out. 

In the meantime, I think we'll need to worry more about external threats to global peace than about the US economy. Unfortunately my crystal ball holds no special insights into the minds of Vladimir Putin and Xi Jinping.

Monetary conditions are returning to normal

On June 25th the Fed released the May '24 data for M2 (the release is scheduled for the fourth Tuesday of each month for the previous month's data). There were no surprises.

The M2 story as I tell it goes like this: Beginning shortly after the economy was put into Covid lockdown by overzealous and panicked officials, Washington flooded the economy with some $6 trillion worth of "stimulus" checks in an attempt to mitigate the pain. The public, having no ability or desire to spend this bonanza in an era of extreme uncertainty, allowed the money to accumulate in their bank accounts, thus swelling the M2 numbers but having little impact on the economy. Then, as the economy began to slowly return to normal beginning in early 2021, the public began to spend their bonanza, having little or no desire to let trillions of dollars sit in bank accounts paying little or no interest. Extra, unwanted money began to inflate prices and fuel a return to economic growth. The Fed was slow to realize this, waiting for almost a year to begin (slowly) raising short-term interest rates in an attempt to entice people to hang onto the money. But the damage was done, with the result that the economy was flooded with almost $5 trillion of extra demand (i.e., about 28% more M2 than usual) that enabled the price level to rise by about 20% or so.

Today the economy is once again functioning normally, growing at about a 2% pace. The excess of M2 has been largely worked off, and what remains of above-target inflation is an artifact produced by estimates of shelter costs that seriously lag reality and are questionable at best (see this post for a more detailed explanation). The M2 wave crested two years ago, and ex-shelter inflation has been 2.1% over the past year, well within the Fed's upper limit of 2.5%.

The big inflation episode is essentially over, but the Fed is once again slow to figure this out, and thus reluctant to lower interest rates. Meanwhile, high interest rates have all but crippled the housing market (30-yr mortgage rates at 7% are prohibitive at a time when wages are failing to keep pace with prices). Commercial real estate prices have tumbled over 20% according to figures compiled by the CoStar Group, and there is lots of talk about a coming wave of bankruptcies. Floating-rate loans taken out at 3% interest rates are resetting sharply higher, to the dismay of borrowers already suffering from stagnant real wages. The dollar is king of the hill these days, thanks to world-beating interest rates, but this is squeezing commodity producers as well as the offshore profits of major industries.

To be sure, not all is bad. The Covid lockdowns led to many unforeseen productivity enhancements (e.g., zoom meetings, remote work). The Fed has been reluctant to tighten, so liquidity conditions remain near-optimal. The return of low inflation has boosted confidence. Corporate profits have not disappointed. Credit spreads are low and relatively stable.

Chart #1

Chart #1 illustrates how the almost $5 trillion of "extra" M2 growth has gradually disappeared. The green line extends the growth rate of M2 from 1995 through 2019). Currently, M2 stands only about 9% above where it might have been without the Covid distortions.

Chart #2

Chart #2 shows currency in circulation, which also experienced a burst of growth but has since returned to its long-term trend growth. Currency is a good proxy for money demand, since people only hold currency if they want to—unwanted currency quickly finds its way back to the bank system to be exchanged for interest-bearing deposits. Money demand surged in 2000-2021, but has since returned to "normal" over the past year.

Chart #3

Chart #3 is another way to measure the demand for money, by dividing M2 by nominal GDP. This is a proxy for the amount of liquidity people are comfortable holding as expressed by a percentage of their annual income. Here too we see things are returning to what might be considered "normal," or pre-Covid levels. 

To sum up, the monetary situation has for the most part returned to normal. This lends strong support to the belief that the Fed has essentially managed to once again tame inflation. Interest rates are quite likely to decline going forward, and the only question is one of timing. Meanwhile, the Fed has lots of "dry powder" to unleash (in the form of lower interest rates) should the economy stumble.

The biggest obstacle the economy faces now is fiscal policy, which will depend to a great deal on the outcome of the November elections. Much as I detest Trump's personality and his affinity for tariffs, I strongly believe his policies (e.g., lower tax rates, reduced regulation, smaller government) would result in a stronger economy than if Biden were granted another term in office.

P.S. Sorry for the dearth of posts this month. We spent a lot of time in Argentina recently, where, among other things, we attended the Cato conference in Buenos Aires. There is still tremendous enthusiasm for Milei and his policy prescriptions, but there are concerns that he may delay dollarization for too long. In the meantime he has accomplished much more than anyone would have thought possible in his first six months in office. 

Tight money hasn't hurt corporate profits

The market tries, but just can't shake its Phillips Curve instincts, which is why any news that is considered to increase the likelihood of interest rates being "higher for longer" is deemed bad for the economy and bad for stocks, and vice versa. It's not surprising that this is so, since decades of experience have taught the market that recessions reliably follow periods of tight monetary policy. ("Tight" being defined, traditionally, as high and rising real interest rates, and a flat to inverted yield curve, and a strong currency. I've maintained for many years, however, that a better definition of tight money would include high and rising credit spreads.)

What the market is missing is that the Fed in 2009 adopted an abundant reserve regime that changed everything. Higher interest rates since then have not equated to bad news for the economy because abundant reserves mean abundant liquidity, and that in turn is what keeps the economy on an even keel and credit spreads low. Meanwhile, falling inflation restores confidence to the economy, and that boosts investment and productivity. That's certainly the case today: credit spreads are quite low—which in turn suggests that markets are functioning well and the outlook for the economy's health is decent. Even though monetary policy is almost certainly tight.

Chart #1

Currency in circulation (Chart #1) grew at a fairly steady pace of 6.6% per year from 2010 through 2019. It then exploded upward in the wake of the massive Covid stimulus spending. Over the past few years the pace of currency growth has slowed dramatically: currency in circulation has increased by only 1.3% over the past year. 

If the trend line in Chart #1 represents "normal," then this chart suggests that money supply (in the form of currency) now matches money demand and monetary conditions are supportive of a low inflation outlook. (As I've argued before, the supply of currency is always equal to the demand for currency, since unwanted currency is simply returned to banks in exchange for deposits.)

Chart #2

The M2 measure of money supply grew at a fairly steady pace of 6% per year from 1995 through 2019, as shown in Chart #2. It then exploded upwards by about $6 trillion, which was the result of the monetization of $6 trillion in COVID "stimulus" checks. For the past two years, M2 growth has been flat to negative. As the chart suggests, it's only marginally higher today than it would have been in the absence of COVID spending. By this measure, monetary conditions have gone from extremely easy to reasonably tight. Tight, because the money supply has shrunk, inflation has fallen, real yields are relatively high, and interest-sensitive sectors of the economy (such as housing) are suffering.

Chart #3

As I define it, "money demand" is best expressed as the ratio of M2 to nominal GDP, which can be thought of as the amount of cash that the average person wants to hold compared to his or her annual income. Chart #3 suggests that, as is the case in the previous two charts, monetary conditions have almost returned to normal. Money demand surged during the Covid crisis, only to reverse once the economy got back on its feet. Money demand now is almost back to pre-Covid levels. There is no longer a huge surplus of unwanted money to fuel rising prices.  

Chart #4

Chart #4 shows the value of the dollar vis a vis a relatively small basket of major currencies and a large basket. Most importantly, the chart adjusts for inflation differentials, which means that it is a good indicator of the purchasing power of the dollar in different countries. By any measure, the dollar today is quite strong from an historical perspective. This is way tight money works: attractive interest rates plus confidence in the Fed's ability to constrain inflation create extra demand for dollars relative to other currencies. 

Chart #5

Chart #5 shows the rate of inflation according to the total and core versions of the Personal Consumption Deflator. Clearly, whatever the Fed has done in the past two years ago has resulted in a significant decline in inflation. 

Chart #6

Chart #6 shows the three major components of the Personal Consumption Deflator. Here we see that prices of durable goods have actually declined in the past year, while the prices of non-durable goods have increased only marginally. The only significant source of inflation is in the services area, which is dominated by wages. It's not unusual for wages to lag price increases in other sectors. Wage increases are thus likely to moderate going forward, and this will bring headline inflation back down to the Fed's target.

Chart #7

Chart #7 shows that corporate credit spreads are very low from an historical perspective. This is the bond market's way of saying that investors are quite confident in the outlook for corporate profits. And, by extension, confident in the future health of the economy. 

Chart #8

I have been updating and publishing Chart #8 for at least the past decade. To this day it amazes me that it has not received more attention. The 3.1% trend line (green) represents the growth path that the economy followed from 1965 through 2007. The 2.2% trend line (red) represents the growth path that largely has prevailed since mid-2009. If the economy had regained the 3.1% growth path after the 2008-2009 Great Recession, it would be fully 25% bigger in real terms today! (What a difference 1% less growth per year can make!) What explains today's slower growth should be the issue that is front and center of the national debate. My short explanation is that the economy has lost its dynamism due to 1) excessive government spending, 2) increased tax and regulatory burdens, and 3) rising transfer payments.

Chart #9

Chart #10

Charts #9 and #10 compare the level of corporate profits to the nominal size of the US economy. By either measure, profits are exceptionally strong. If this is the price of "tight money" then let's have more of it! (Note: I have excluded profits and losses generated by the Federal Reserve's abundant reserve regime from overall corporate profits.)

Chart #11

A traditional measure of equity valuation on a macro level compares the price of stocks to the trailing 12-month sum of after-tax corporate profits (the price-earnings ratio, or PE). Chart #11 does the same, but it uses the level of after-tax corporate profits as calculated by the National Income and Products Accounts over the past quarter. This is a more timely and more consistently-calculated measure of profits than the traditional PE ratio. (I credit Art Laffer for this, an approach he has been using for over 40 years.) By this measure stocks are relatively expensive, but not extremely so. 

Chart #12

Borrowing from Art Laffer again, Chart #11 compares the theoretical level of corporate profits (calculated as the capitalized value of NIPA profits—profits divided by the 10-yr Treasury yield) to the market value of stocks as proxied by the S&P 500. Note that, according to Chart #12, stocks were hugely "overvalued" in 2000, and they were also very overvalued at that time according to Chart #11. Today, however, stocks appear to be appropriately valued, since their actual and nominal valuations are roughly equal. 10-yr Treasury yields both drive and explain the differences between these two measures of equity valuation.

This in turn implies that lower interest rates (which should follow the decline in inflation) will increase the appeal of equities as an asset class. This in a nutshell is the "Fed put" that I mentioned in my previous post. Tight money hasn't hurt the economy at all.