A quick look at GDP and corporate profits—not bad!

Third quarter GDP growth and inflation were revised upwards by a modest amount, but it remains the case that the economy has proved surprisingly resilient in spite of the Covid woes, and inflation has definitely cooled off. Corporate profits have been amazingly strong, and PE ratios look reasonable. And despite relatively weak growth in jobs—which now show a net gain vs. pre-Covid levels of a mere 1%—the economy has managed net growth of 4.4%, with the result that labor productivity has been quite impressive. Businesses have managed to do more with fewer people while at the same time boosting after-tax profits by 20% since pre-Covid levels. 

Chart #1

Chart #1 shows the year over year growth of real GDP, which was 1.94% as of Q3/22. This is very close to the growth rates the economy experienced from 2010 thru 2019. The Covid growth gyrations are now in the past. The economy looks to be on track to growth at about a 2% annual rate—nothing spectacular, but not bad considering all the problems that still exist in the world and at home.

Chart #2

Pay close attention to Chart #2, since you're unlikely to see anything like it elsewhere. To begin with, it's plotted using a logarithmic y-axis, which means that straight lines are equivalent to constant rates of growth. The dotted green line represents the annual growth trend which started in 1966 and persisted through 2007: 3.1% per year. That is, over this 56-year period the economy managed to grow by an annualized rate of 3.1%. Sometimes by more, sometimes by less, but over time it always came back to this trend line. The dotted red line shows the growth trend in place since mid-2009: 2.2%. Something happened during the Great Financial Recession of 2008-09 to put a permanent damper on growth, and it's not just demographics—demographics don't change dramatically from one year to the next. Instead, I think it has a lot to do with 1) the explosion of transfer payments during the Great Recession (see Charts #2 and #3 in this post), and 2) the general expansion of government influence, plus higher tax and regulatory burdens which plagued the economy during this period. These all work like headwinds to slow the economy.

It's tempting to speculate that had the economy pursued a 3.1% growth path until now, then the economy would be 24% bigger today, and average incomes might be 24% higher in inflation-adjusted terms. That's a lot of money that, arguably, may have been left on the table!

Chart #3

Chart #3 shows the quarterly annualized rate of change in the GDP deflator. This is the broadest measure of inflation that exists. Inflation in the third quarter slowed dramatically (from 9.1% to 4.4%), and that is consistent with my observations in recent posts that the peak of inflation occurred sometime around the middle of this year. This is most reassuring, and I would like to think it won't escape the Fed's notice. 

Chart #4

Chart #4 shows the price/earnings ratio of the S&P 500, using trailing 12-month profits from continuing operations. The PE ratio of the market today is about 18.5, only slightly higher than its long-term average. 

Chart #5

Chart #5 shows PE ratios for the S&P 500 using the National Income and Product Accounts as the source for economy-wide, after-tax corporate profits instead of trailing reported earnings. Like the current PE ratio shown in Chart #4, PE ratios by this measure are 19.5, only slightly higher than their long-term average. The advantage of this method is that the measure of profits used is a quarterly-annualized number, not a trailing 12-month average—thus it's much more timely.

Chart #6

Chart #6 shows the same NIPA measure of profits as a percent of nominal GDP. What stands out here is the consistently high level of profits in the period following the Great Financial Recession, compared to what prevailed in prior decades. It's no wonder the stock market has been so strong this past decade or so—corporate profits have never been so consistently healthy. 

I think the main reason for this is globalization, which picked up speed some years after the opening of the Chinese economy in 1995. Successful corporations today can address the entire world market, whereas before most businesses were able to address only part of global market. Apple would be successful if it were restricted to just the US market, but today it can leverage its successful products by many times since its market is an order of magnitude larger today than it would have been 15-20 years ago. 

Higher interest rates have solved the inflation problem

As I've been pointing out for over two years, rapid growth in the M2 money supply is a big deal, and one that has not received much attention, if any. At first (i.e., mid- to late 2020) it was OK, because the public felt comfortable holding on to large amounts of cash in their bank deposit and savings accounts at a time of great Covid-related uncertainty and economy-wide lockdowns. But starting early last year, when the worst of the Covid panic was subsiding and life was beginning to get back to normal, people began spending that money. Soon, a flood of spending collided with supply shortages and a still-crippled economy, and the result was higher prices. By the end of last year, inflation was galloping towards 10% or so, but the Fed ignored it, asserting it was merely "transitory." It wasn't until March of this year that the Fed began to get worried. True to form (unfortunately), the Fed was—once again!—late to the inflation party, and they have been trying to catch up ever since. As we now know, they embarked on an impressive series of rate hikes which took short-term rates from 0.25% last March to now 4.5%. That marked the most aggressive monetary tightening in history.

Last week the Fed reiterated its intention to snuff out inflation with still more hikes. Sadly, they are now overstaying their welcome at the inflation party, because we know that inflation peaked many months ago. Unfortunately they didn't get my memo on the subject.

The market is rightly concerned to be worried by all of this.

When all is said and done, the Fed has but one job: to keep the demand for money in line with the supply of money. When the supply of money exceeds the demand for it, inflation is the result, as Milton Friedman taught us long ago and which the experience of the past several years shows us. (I should add that, according to their official mandate, the Fed is also charged with maintaining full employment, but we'll put that aside, especially since they now hint that they won't feel comfortable until they see the economy weaken significantly.) 

Beginning early last year, the demand for money fell even as the supply of money (best measured by M2) continued to rise. It's no wonder that inflation rose. In fact, rising inflation confirmed that the demand for money was failing to keep pace with the supply of money. But beginning about 6-8 months ago, when (not coincidentally) the Fed started to raise interest rates, inflation started to decline. This, we know now, was early evidence that the demand for money stopped falling, while at the same time the M2 money supply started shrinking. My recommendation to the Fed, therefore, has been to give the economy time to adjust—they had done plenty enough.

Over the past six months or so, it has become quite clear that higher interest rates have served to bolster the demand for money. No longer are people trying to aggressively spend down their bank balances, because now they can earn a decent rate of interest on their cash. Put another way, the Fed has raised interest rates by enough to once again bring money supply and demand back into balance. It's also the case that supply chain problems have all but dried up. We know all of this because sensitive prices (e.g., housing prices, commodity prices, the value of the dollar and the price of gold) have fallen. Money demand looks to be much more closely aligned with money supply these days.

In the housing market it's beginning to look like interest rates are too high, in fact, as the following charts illustrate. 

Economics is all about scarcity and incentives. Higher interest rates give people an incentive to hold on to cash rather than spend it, and they give people less incentive to buy and hold on to things like housing. To judge from falling home prices and collapsing home sales and residential construction, higher interest rates have REALLY had a significant impact on the demand for money. Any higher and we'll have a recession on our hands—and that is exactly what worries the equity market these days.

Chart #1

Chart #1 compares the level of housing starts (blue line) with an index of homebuilders' sentiment. Not surprisingly, sentiment tends to precede starts. The more optimistic builders are about the housing market, the more likely they are to embark on new construction. The recent collapse of sentiment thus portends a dramatic decline in housing starts.

Chart #2

Chart #2 shows the number of residential building permits, which recently have begun to decline markedly as Chart #1 predicted. Look for further weakness in all these numbers. 

Chart #3

Chart # shows the number of single family home sales, which have collapsed in recent months. A plunge in sales is one of the reasons homebuilders are much less optimistic. 

Chart #4

Chart #4 shows an index of the number of new mortgage applications (first-time buyers seeking a mortgage to purchase a home). This also has plunged, down by over 40% so far this year.

Chart #5

Chart #5 shows the reason why all this is happening: 30-yr fixed mortgage rates have more than doubled in the past year. Never before has a shock of this magnitude occurred in the housing market. Higher mortgage rates on top of rising home prices have increased the cost of home ownership by an order of magnitude. And why have rates soared? Because the Fed has jacked up interest rates by several orders of magnitude and this has pushed up interest rates across the yield curve. Soaring interest rates have crushed the bond market and this in turn has led to many investors scrambling to hedge themselves against further rate hikes. No one wants to own 30-yr mortgage paper if rates rise further, because that means refinancings will grind to a halt and that paper will acquire a significant amount of duration risk: the value of a fixed rate mortgage will decline by more than about 10% for every 1 percentage point increase in mortgage rates.

As a result, the spread between mortgage rates and 10-yr Treasury yields has widened to just about its widest point ever, over 300 bps. Everything is working against the housing market. 

Does the Fed really want to crush the housing market by hiking rates further? I think they will come to their senses pretty quickly and back off of their recently-announced tightening pledge. The demand for money is soaring and that means inflation will continue to decline. Nobody needs higher rates right now.

PPI inflation plunges

Sometimes the headlines are just plain wrong. Here's an example.

Bloomberg headline this morning: "US Producer Prices Top Estimates, Supporting Fed Hikes Into 2023"

How do they reach this conclusion? By observing that "the PPI for final demand climbed 0.3% for a third month," when market expectations called for only a 0.2% rise in November. Huh? The monthly change in this index was 0.01% higher than expected, and you think that is a reason for the Fed to raise rates further?

I see it quite differently, as these charts show:

Chart #1

Chart #2

Chart #3

No matter how you look at the data, these charts lead you to an inescapable conclusion: Inflation at the wholesale level peaked in June of this year, and since then it has virtually plunged. 

The message this sends to the Fed is clear: there is no reason to raise rates further. Stop the hikes. Whatever you've done so far is definitely working. Don't overdo it!