Wednesday, July 23, 2014

Recovery rests on solid, not liquid ground

It's not hard to find analysts who argue that this recovery owes everything to the Fed's massive injections of liquidity. By pumping money and keeping short-term interest rates near zero, the Fed has forced liquidity into risky assets, thus propping up equity prices excessively and artificially.

As long-time readers of this blog know, I think that argument is weak at best. The Fed has not been printing money with its Quantitative Easing programs. The Fed has simply been swapping bank reserves (which are functionally equivalent to T-bills) for notes and bonds, and they have been doing this in size in order to accommodate the world's demand for safe assets. The Fed hasn't been dumping tons of new money into the system, the Fed has been supplying liquidity that the market demanded. We haven't seen any unusual increase in inflation because the Fed's supply of money has been equal to the demand for money.

But even if the Fed were "pumping" money into the economy, it's a stretch to think that extra money can translate real growth. If printing money could make an economy grow, Zimbabwe and Argentina would be economic powerhouses—but they aren't. Printing money that no one wants is the basic recipe for inflation, and that's not been the story of the current business expansion in the U.S. economy.

Here are some charts that focus on the physical growth of the U.S. economy. This is real growth, not make-believe, liquidity-driven growth.


Manufacturing production (the volume output of industrial establishments in mining, quarrying, manufacturing, and public utilities) has increased by 25% in the past five years. It's almost at a new all-time high. The manufacturing side of the economy survived, and has largely recovered from, its steepest plunge in history.


Actual shipments by truck, rail, waterways, pipelines and aircraft, as measured in ton-miles by the Dept. of Transportation, has increased over 25% in the past five years, and is now at a new all-time high.


Truck tonnage, as measured by the American Trucking Association, has increased by almost 30% in the past five years and is now very close to its all-time high. As the above chart shows, there is a decent correlation between the level of truck tonnage and the real value of the equity market. When the physical size of the economy increases, so do equity prices in real terms. Furthermore, equity prices do not appear excessive when compared to the increase in the physical size of the economy. (They did look excessive in 2000, however, and they looked extremely depressed in 2009.)


The nation's architectural firms report an increasing number of billings, a good sign that the commercial real estate market is expanding.


New housing starts are up about 80% in the past five years, and builders appear reasonably confident that construction activity will continue to increase.


U.S. exports of goods have increased 65% in the past five years and are at a new all-time high.


World trade volume has increased almost 35% in the past five years, and is now at an all-time high.


U.S. crude oil production has surged over 70% in the past five years, with the result that the U.S. has surpassed Saudi Arabia as the world's largest oil producer. Back in 2008 this would have been unthinkable, and it's all due to the ingenuity of oil producers (i.e., fracking technology).


A composite index of chemical industry activity has increased 27% in the past five years, and has grown by 4.3% in the year ending June 2014—a good indicator that the U.S. economy continues to grow.


The private sector has created almost 10 million jobs in the past four years, and private sector jobs are now at a new all-time high. 


The jobs market is stronger and unemployment is lower primarily because fixed investment (e.g., investment in new things—new buildings, new homes, new plant and equipment) has increased faster than the overall economy.

There's still a lot of room for all of these indicators to improve. It's still the case that this has been the weakest recovery in history. But it is nevertheless a recovery, and the economy has without question been growing in a real, physical sense. This is a genuine economic expansion, and the rise in equity prices is a reflection of that growth. It's not a liquidity-driven mirage, it's real.

Monday, July 21, 2014

Commercial real estate enjoys double-digit growth



Commercial real estate prices have yet to exceed their pre-recession highs, but they are getting close, according to the repeat-sales indices of the Co-Star Group. As the chart above shows, Co-Star's value-weighted index of commercial property prices has been rising at about a 10% annualized rate for the past four years. That's a pretty impressive recovery in my book, even though prices in inflation-adjusted terms are still 12% lower than their 2007 highs. (The Value-Weighted Index is a more liquid, and thus more reliable and more responsive index, than the Equal-Weighted Index.)

The first thing I think about when looking at a chart like this is that it flies in the face of the Fed's ongoing concern about the health of the U.S. economy. Short-term interest rates shouldn't be at zero in an environment of double-digit price gains for the commercial real estate sector, since it invites excessive speculation.

For the time being, however, it looks like commercial real estate will continue to boom. As Calculated Risk notes, distress sales have been steadily declining for the past 3 years. As Co-Star notes, "in the early-recovery, coastal markets of Los Angeles, San Francisco and San Jose, distress levels are nearly non-existent."

Friday, July 18, 2014

Corporate inversions: the facts

Those who claim that companies seeking to reincorporate overseas in order to reduce their tax burdens are "unpatriotic" are not only ignorant of the law but also ignorant of how businesses operate. If there is any one message that should be making the headlines, it would be "Companies seek to escape insane U.S. tax code." When companies vote with their feet, it's a good sign that something is wrong here in the U.S. 

In case you've missed them, here are three short essays, with brief excerpts, that clarify the issues surrounding corporate tax "inversion."

Miles D. White, "Ignoring the Facts on Corporate Inversions:"

... inversion is legal. Period. It's allowed in the tax code. The tax code even specifies the terms and conditions under which it may be done. 
Inversion doesn't change a company's tax rate. A company pays the same tax rate in the U.S. after inversion as it does before inverting. A company also pays the same tax rates in foreign domiciles before and after inversion. 
Inversion does not relieve any pre-existing tax burden. It does not reduce the tax that any company would ultimately have to pay on past earnings overseas that have been deferred under the U.S. tax system. 
What does change after inversion is a company's access to its future foreign earnings generated outside of the U.S. tax system. Those future earnings may be used for any capital allocation purpose the company may have, including investment in the U.S., without the additional U.S. repatriation tax. 
The U.S. is among only a handful of countries, and the only one in the Group of Seven, that taxes companies on world-wide earnings rather than the earnings in their home domiciles. It's a double whammy: the highest rate, by far, and it's applied worldwide.
Legislation to block inversion is not tax reform. It would make the U.S. even less competitive globally. It would not stimulate economic recovery.

The pace of inversions has been picking up as more CEOs conclude that President Obama isn't serious about tax reform. These executives have a fiduciary duty to their shareholders, and they can't cede a permanent tax advantage to their global competitors. So they decide to move. 
Mr. Lew doesn't know much about economics or he'd realize that his rush to block these inversions will have the perverse effect of driving even more deals in the coming months. If CEOs think Congress will close the inversion possibility, and that tax reform is dead until Mr. Obama leaves office, more of them will decide to move while they still can. 
A real agenda for "economic patriotism" would support a tax policy to make America competitive again as a destination for global investment and job creation.
Michael J. Graetz: "Inverted Thinking about Corporate Taxes:"

Inversions by U.S. companies to take advantage of more favorable corporate tax laws abroad are nothing new. Of the more than 25 U.S. companies that inverted between 1982 and 2002, more than 20 made Bermuda or the Cayman Islands their home.

To ask, "How do we stop American companies from leaving for more favorable tax jurisdictions?" is asking the wrong question. The right question is "How do we make the United States a more favorable location for investments, jobs, headquarters, and research and development activities?" That will require genuine tax reform. The U.S. is the only OECD country that doesn't have a national tax on consumption. Relying, as we do, so heavily on individual and corporate income taxes to pay for federal expenditures hobbles us in today's global economy.
I would add that, in the 12 months ended June, 2014, the federal government received a total of $303 billion in corporate income tax payments. That represented only 10.3% of total federal revenues over the same period. Eliminating that source of revenue entirely would increase the federal deficit from its current 3.1% of GDP to 4.9%, all else remaining equal. This would not be an earth-shaking loss, and it would very likely be offset to a significant degree by increased corporate investment, more hiring, more incomes, and lower prices to consumers.

Corporate tax reform is a matter requiring urgent and thoughtful attention. Let's do it right, please.

Wednesday, July 16, 2014

The U.S. economy just keeps growing

Despite enduring concerns about the health of the U.S. economy and the supposed threat of deflation, the economy continues to grow and inflation is alive and well. A few quick graphs to make those points using data released today:


Producer price inflation is running at a solid 2-3% pace. In the past six months, the PPI has actually increased at a 4.1% annualized pace.


Real Treasury yields are at levels that were associated with rising inflation in the late 1970s. When bond yields fail to compensate for inflation this weakens the demand for money (e.g., by making borrowing cheap, and by increasing the attractiveness of speculation).


It's difficult to understand the Fed's preoccupation with "stimulating" the economy when the U.S. is doing demonstrably better than Europe and doing quite well on a standalone basis. U.S. industrial production is up at a 4.7% annualized rate in the past six months, and U.S. manufacturing production is up at a 4.1% rate over the same period. This is unambiguously strong. What's amazing is the gap between U.S. and Eurozone industrial production, which has become gigantic.


A survey of home builders' sentiment in July was stronger than expected (53 vs. 50), so as the graph above suggests, housing starts are likely to continue to move higher, albeit relatively slowly. The housing market has been taking something of a breather in the past 6-9 months, but that isn't necessarily the precursor to another slump.

Tuesday, July 15, 2014

The outlook for interest rates

Everyone knows that interest rates are going to rise in the future. So the real question is not whether they will rise, but when and by how much. Janet Yellen didn't change the consensus opinion regarding these questions much in her testimony today. The market thinks the Fed is almost certainly going to end the tapering of QE3 in October, and about six months later, give or take a few months, the Fed is expected to start raising short-term rates. They will probably do this by increasing—very slowly—the interest rate they pay on bank reserves, using reverse repo transactions, and by not rolling over maturing Treasuries and MBS.


The above graph shows the Treasury yield curve at different points in time: April 2013 (the all-time low for the 10-yr Treasury yield), today, and two and five years in the future. The latter two are derived mathematically from the current Treasury curve. If you compare this graph to the one in my post last March ("How much are yields going to rise?") you can see that not much has changed of late. The Fed is expected to raise short-term rates in a very gradual fashion beginning next year, and five or so years from now rates are going to be topping out around 3½ to 4%.


There's nothing very scary about this. As the graph above shows, for most of modern history 5-yr Treasury yields have traded well in excess of 3%. That 5-yr yields today aren't expect to rise above 4% for as far as the eye can see is pretty unusual from an historical perspective.

Interest rates aren't expected to rise by much because 1) the market doesn't think the U.S. economy has much chance of returning to its former growth glory, and 2) the market doesn't think that inflation has much chance of exceeding 2-3%. In other words, the bond market today seems fairly convinced that growth will be sluggish and inflation will therefore be tame for as far as the eye can see.

If you disagree with the assumptions behind the market's current consensus, then you can take actions to bet that interest rates will be either higher or lower than current expectations. For example, if you see more potential for growth and inflation, then bet that rates will rise faster than expected: lock in long-term borrowing costs today; keep the duration of bonds you own as short as possible; and avoid excessive leverage (or place hedges to protect against higher-than expected borrowing costs). Consider an increased exposure to real estate, since it should benefit from stronger growth and higher inflation, and it is not necessarily expensive today. Consider also an increased exposure to equities, since stronger growth and higher inflation should have a positive impact on future expected cash flows.

For my part, I acknowledge that I have been overly concerned about rising interest rates for most of the past 5 years or so. Being wrong for so long is humbling, but it is not a reason to shy away from worrying about a faster-than-expected rise in interest rates today. In the end, it's all about what happens to the economy and to inflation.


I'm still an optimist on the economy, since I think the market's growth expectations are overly pessimistic. I think 5-yr real yields on TIPS tell us a lot about the market's underlying expectations for real economic growth. As the graph above suggests, the current -0.38% real yield on 5-yr TIPS points to economic growth expectations of perhaps 1% per year, which in turn is a bit less than we've seen in recent years. If the market were convinced that future growth would be a solid 3% a year, then real yields today would be a lot higher than they are now.


I'm still more worried about inflation than the market is, since I think the market is being a bit too complacent about the inflationary potential of the Fed's massive balance sheet expansion and the Fed's ability to reverse course in a timely fashion. As the graph above shows, the market expects CPI inflation over the next 5 years to average a mere 2.1%, which is actually less than the 2.3% it's averaged over the past 10 years. I'm not predicting hyperinflation or anything like it, I'm just saying that expecting inflation as usual for as far as the eye can see despite the Fed's huge and unprecedented experiment in quantitative easing is a bridge too far for me.

There's nothing scary about expecting interest rates to rise more than expected. Rates aren't likely to surprise on the upside unless real growth expectations and/or nominal GDP expectations rise, and given the pessimism inherent in the market's current expectations, either one of those would be very welcome developments.

Interest rates are a good barometer of the market's expectations for growth and inflation. That they are still so low today means that the market holds little hope for any meaningful improvement in the outlook for the economy and/or any meaningful rise in inflation. We're living in a slow-growth, low-inflation world for now, and—as often occurs just before something hits us from left field—the market is extrapolating that today's conditions will prevail for as far as the eye can see.