Wednesday, April 16, 2014

The economy continues to expand



March industrial production figures exceeded expectations (+0.7% vs. +0.5%) and February was revised sharply higher (+1.2% vs. +0.6%). Over the past six months, industrial production has expanded at a solid 5% annualized pace. This is impressive. Industrial production in the Eurozone is still lagging, but nevertheless is still on the mend. Industrial commodity prices are up almost 3% in the past two months to a one-year high, suggesting that global manufacturing activity is doing just fine.


The manufacturing component of industrial production was also strong, but was nevertheless outpaced by gains in utilities (think cold weather). Still, manufacturing production was up at a 3.5% annualized pace over the past six months.


By the Fed's estimates (they can only estimate it, since there is no way to actually measure it), the utilization rate of the nation's productive apparatus rose a good deal more than expected (79.2% vs. 78.7%). Utilization rates are still below their pre-recession high, however, suggesting the economy still has a decent amount of "slack." This is the Fed's justification for keeping real short-term interest rates firmly in negative territory. However, as the chart above shows, gains in capacity utilization of the magnitude that we have seen in the past four years typically would have elicited a substantial Fed tightening by now. 

The Fed is still in uncharted territory. It's not a question of whether they will tighten, it's when and by how much. Continued gains like we have seen today will almost certainly tip the scales in favor of sooner rather than later.


Housing starts posted lackluster gains in March, but that is not surprising given the poor weather that persisted. As the chart above shows, builder sentiment is still strong enough to expect housing starts to move higher in the coming months. The housing boom has cooled off in recent months, but it is still underway.

Tuesday, April 15, 2014

Deflation risk is low and that's good for the dollar

There seems to be an inordinate amount of concern these days about the threat of deflation. Yes, inflation is low, but there's nothing wrong with that. Inflation in the U.S. is currently running around 1.5 - 2.0%, which is as low as it's been on a sustained basis since the early 1960s, but that was a time of robust economic growth.

Many commentators use a "black hole" or a "slippery slope" analogy when talking about the risk of deflation. They argue that just a little bit of deflation can lead to more; that deflation can be very difficult to escape; and that once deflation sets in it is unambiguously bad for economic growth. Analogies like these can become popular and convincing to the layman, but that doesn't mean they are good or valid. I've debunked the "stall speed" analogy—which says that when an economy is growing very slowly it is vulnerable to collapse—in several previous posts, but it remains popular to this day and contributes, unjustly, to many investors' concerns about investing in risk assets.

Deflation doesn't work like a black hole or a slippery slope. Deflation is what happens when an economy experiences a shortage of money relative to the demand for money. When money becomes scarce, prices of things tend to fall because the value of money increases. A scarcity of money can result from monetary policy that is very tight (e.g., when a central bank pushes short-term interest rates significantly above the rate of inflation) or when the demand for money is very strong and a central bank fails to accommodate this extra demand with extra money and/or lower real interest rates. As I'll show in the charts below, there is no evidence of a scarcity of money in the U.S. today.


The chart above shows the inverted value of the dollar and a broad index of non-petroleum commodity prices. This shows there was a scarcity of dollars in the early 2000s because the dollar was strong and commodity prices were weak. When the Fed subsequently relaxed monetary policy, the dollar weakened and commodity prices rose. The sharp rise in the dollar and the sharp decline in commodity prices in 2008 are evidence that the Fed was slow to react to a big increase in the demand for money that caused a relative scarcity of dollars. Dollars were so scarce in late 2008 that the bond market came to expect years of deflation. Commodity prices currently show no sign of weakness and are in fact quite high from an historical perspective, just as the dollar today remains quite weak—from which we can conclude that there is currently no scarcity of dollars that might cause deflation.


As the chart above shows, the dollar is indeed quite weak from an historical perspective, even when adjusted for inflation and compared to a broad basket of other currencies.


With the dollar weak and commodity prices generally strong, it is not surprising that gold prices are also quite strong. To be sure, gold prices have dropped meaningfully over the past few years, but they are still very strong relative to other commodity prices, as the chart above shows. As I see it, gold "overshot" commodity prices and is now correcting. I've been anticipating a further correction in gold prices for the past year. It's hard to worry about deflation when gold and commodity prices are still trading at levels far in excess of where they traded during the 1980-2000 period.


As the chart above shows, the bond market is convinced that the Fed is not putting the monetary screws to the economy. Every recession on this chart was preceded by a sharp increase in real short-term interest rates and a flattening or inversion of the yield curve, both of which are classic signs of monetary tightening. Today we have just the opposite: very negative short-term real rates, and a relatively steep yield curve. Monetary conditions are accommodative today, not tight. This implies that a recession is extremely unlikely, and it is strong evidence that money is not scarce—thus deflation risk is very low.


Today's release of the March CPI statistics shows that inflation is running quite solidly at just under 2% (see chart above). This is in line with inflation as measured by the broader PCE and GDP deflators. This is not scary or dangerously low, this is good. If inflation averaged 1.5% per year for the foreseeable future, I would expect the economy to strengthen since low and stable inflation would boost confidence, strengthen the dollar, and make the U.S. more attractive to investment.


Don Luskin, a good friend, superb analyst, and fellow supply-sider, inspired me with a chart similar to the one above in his current research report. What this shows is that changes in the growth rate of housing prices (I've used the Case Shiller 10-city index) tend to lead changes in the Owners' Equivalent Rent component of the CPI (OER accounts for about 25% of the CPI) by about 18 months. What this suggests is that the CPI is very likely to be boosted over the next year or so by the strong growth in housing prices that we have seen in the past year or two. We've already seen a little of this in recent months, and there's likely a lot more to come. Rising housing prices tend to lead to rising rents, and that's how housing prices feed into the BLS's calculation of inflation. It's hard to worry about deflation when housing prices are rising.

In contrast to the U.S., the Eurozone is somewhat vulnerable to deflation, because monetary conditions there are relatively tight. You might not think so if you just looked at Eurozone interest rates, since they are quite a bit lower than their U.S. counterparts. German 2-yr bunds yield 0.12% vs. 2-yr Treasuries at 0.4%, and 10-yr bunds yield 1.5% vs. 10-y Treasuries at 2.6%. Typically, monetary tightness shows up as rising interest rates, but this is one of those times when interest rates are very low because inflation is very low and economic growth is relatively weak and money is relatively scarce. Although the ECB has taken significant steps to reduce short-term interest rates, it has not engaged in the massive Quantitative Easing that the Fed has. Weak growth and very low inflation are fertile ground for strong money demand, and it's probably the case that the ECB has not been aggressive enough in its willingness to supply money, and that's why money is relatively scarce in the Eurozone.


As the chart above shows, core inflation in the Eurozone has been less than 1% over the past year, almost a full point lower than U.S. core inflation. The harmonized measure of CPI in the Eurozone is up only 0.5% in the past year, and it is up at a mere 0.35% annualized rate over the past six months. The inflation facts support the theory that money is tighter in the Eurozone than in the U.S..


It's also the case that the euro is a good deal stronger than the dollar. The chart above shows my calculation of the euro's Purchasing Power Parity vis a vis the dollar. At the current level of 1.38, I figure the euro is about 20% "overvalued" against the dollar. The Eurozone faces a moderate amount of deflation risk (if you can call it a risk, since there is no a priori reason an economy with falling prices can't grow) because the euro is relatively strong and inflation is very low. It's not a serious risk, because gold and commodity prices in euro terms are still very high and housing prices in the peripheral Eurozone markets are rising, but it's certainly more of a risk than in the U.S.

What all this means is that the Fed has more leeway than is commonly thought to tighten policy should that become necessary—because monetary policy is relatively easy—whereas the ECB may have to ease policy further because monetary policy is still relatively tight. If the Fed tightens sooner than expected and the ECB eases (e.g., by pursuing some form of QE), that would likely result in a meaningful rise in the dollar vis a vis the euro. And that would be a good thing for just about everyone.

Thursday, April 10, 2014

Federal deficit collapses

If President Obama wants to distract voters' attention from the ongoing failure of Obamacare and the miserably slow recovery, he should simply direct everyone to this blog post. Under his watch, the federal budget deficit has collapsed by two-thirds, from almost $1.5 trillion in his first year as president (in which he inherited a lot of emergency spending from the Bush administration and began spending the almost $1 trillion included in his ARRA) to just under $0.5 trillion in the year ending last March. 


The chart above shows the federal deficit as a % of GDP. By this measure the deficit has plummeted from a high of 10.2% of GDP in 2009 to 2.9% (my estimate) in the 12 months ending last March.


This rather extraordinary achievement was not due to any of his initiatives, however. As the chart above shows, the big reduction in the deficit has been the by-product of flat to declining spending in recent years and multi-year increase in tax revenues. Most of the reduction in spending can be credited to a deadlocked Congress (which has ignored Obama's repeated requests for ever-rising spending), and to declining costs for social safety nets (mainly unemployment insurance, which still remains unusually high). The bulk of the increase in tax revenues is due to an expanding tax base (e.g., increasing numbers of jobs, rising incomes, and rising corporate profits, all of which flow from even a weak recovery), with a modest boost attributable to the higher tax rates which took effect last year.


Despite effective marginal tax rates that are now at their highest level ever for many taxpayers, tax revenues relative to GDP are still relatively depressed. That's mainly a reflection of the weakness of the current recovery, which has yet to create more jobs than existed at the end of 2008. There would have been upwards of 10 million more jobs today if this had been a typical recovery, and that would show up in the form of much stronger revenues, which would probably be well over their post-war average of 17.5% of GDP by now.


The reduction in spending relative to GDP, on the other hand, has been extraordinary—we haven't seen anything like this since the unwinding of WW II spending. Federal spending topped out during WW II at over 40% of GDP in 1945, then promptly collapsed to 14.7% by the end of 1947. Then, as now, a huge decline in government spending failed—despite the warnings of Keynesian-trained economists—to generate a depression, and failed to send the unemployment rate skyrocketing. Supply-siders, in contrast, have an answer for what happened that makes sense: when the government controls fewer of the economy's resources, the private sector has more room in which to practice that in which it uniquely excels: entrepreneurship, cost-cutting, risk-taking, and productivity gains.

One reason Obama is unlikely to link to this post: If we hadn't had all that massive emergency and "stimulus" spending in the 2008-2012 period, the economy would be much stronger today. But now that the spending has been scaled back there is a decent chance that the private sector can give us some better growth numbers going forward. Those chances would rise appreciably if Washington could manage to reduce today's unprecedented regulatory burdens (e.g., Obamacare, Dodd-Frank), reduce corporate tax rates from the highest level of any developed country, and simplify our mind-numbing and hugely burdensome tax code in exchange for a reduction in marginal income tax rates.

UPDATE: Charles Koch has written a brilliant and powerful essay in the WSJ on many of the problems that need to be fixed: "I'm Fighting to Restore a Free Society."

If there's any reason to be optimistic these days, it's that there are so many problems out there that could be fixed in relatively easy fashion.

On the margin: 1.3 million people

The economy seems to be plodding along at a 2-3% real growth rate pace, pretty much the same as it has for the past several years. But amidst all the ho-hum statistics there is one that stands out: the demise of emergency unemployment benefits for 1.3 million people in early January, and the 1.3 million increase in the labor force that followed. I'm speculating a bit here, since we really don't have enough data to be sure, but I can't resist highlighting any important change on the margin, since that's where all significant changes occur. What this statistic could mean is that there are 1.3 million people who rather suddenly received a new incentive to look for and accept a new job, and that could introduce a new dynamic to the labor market that could end up giving a modest boost to growth over the course of the year.


The chart above shows what's happened: the "Emergency Claims" program, which began in mid-2008, authorized up to 99 weeks of unemployment benefits. It expired at the end of last year, at which time about 1.3 million people were receiving benefits. That reduced the total number of people receiving benefits by about 22%, literally overnight. That's definitely a big change on the margin. What we don't know for sure yet is what those 1.3 million people have decided to do since then.


The chart above shows the size of the civilian labor force—the number of people working and looking for work. Since the end of last year the labor force has jumped by 1.3 million (note the part of the chart I've highlighted). As I mentioned last week, this is unlikely to be a pure coincidence. Theoretically, the 1.3 million people that were receiving benefits before the emergency program expired were included in the labor force data, but it's possible that some at least were pretending, when asked, that they were looking for a job.  Regardless of how accurately the Dept. of Labor's survey was in picking up on this nuance, it is the case that 1.3 million people suddenly stopped receiving a weekly stipend and many of them may be more actively seeking employment. At least some portion of the 1.3 million who lost their benefits are now more genuine members of the labor force. They could end up boosting the number of new jobs in the months to come, an outcome already made more likely by the return of better weather. 


Last week, the number of people filing for new unemployment benefits fell to the lowest level since May, 2007—300K. It doesn't get much better than that. If the level of claims holds at 300K for the rest of the month, the degree of "workforce disruption" as measured in the chart below (claims as a % of the workforce) will be very close to an all-time low. This is the weakest recovery ever, and the unemployment rate is still very high, but at least those who are working have an excellent chance of keeping their job. Things could be a lot worse.


Tuesday, April 8, 2014

The market looks at Ukraine and shrugs

If the situation in Crimea/Ukraine has the world on edge, markets don't seem all that worried. Key indicators of the market's perception of systemic risk and the economy's health have hardly budged, and point to continued, albeit relatively sluggish, growth.


The Euro is up a bit so far this year, but as the chart above shows, it has been strengthening since mid-2012, when it first became clear that the Eurozone sovereign debt crisis was receding and the Eurozone economy was emerging from its recession. A stronger Euro is a good sign that the outlook for the Eurozone continues to improve.


Eurozone equities, shown in the red line of the above chart, have been tracking U.S. equities higher since mid-2012, albeit with a significant lag. To judge from the behavior of Eurozone equities and the Euro, the outlook for the Eurozone continues to improve despite the uncertainty that has arisen in Ukraine.


Eurozone 2-yr swap spreads, shown in the chart above, have been falling for the past several months, and are close to their lowest level in many years. This suggests that systemic risk in the Eurozone is almost down to normal levels (e.g., spreads of 20-25 bps). It's clear that whatever problems the Eurozone faces today are, in the eyes of the market, an order of magnitude less than the problems caused by the sovereign debt crisis a few years ago. It appears that, for now, Eurozone growth prospects are trumping the risks of Russian incursions into neighboring countries.


U.S. 2-yr swap spreads, shown above, are still trading at extraordinarily low levels, which means that markets are extremely liquid and generally quite healthy. It's hard to see here whether rising geopolitical risks have made any difference at all to the U.S. economy and investors' confidence.


The chart above shows the yield spread between investment grade and high-yield corporate bonds—a good measure of the likelihood of a significant deterioration in the economy. By this measure, the economic outlook is still improving, with credit spreads at or near post-recession lows. 


The Vix index, shown above, has ticked up a bit in recent weeks, but remains relatively low compared to where it has been in recent years, when the Eurozone sovereign debt crisis threatened the global recovery. Markets are a little worried, but no one is paying outrageous sums to seek downside protection; if they were the Vix index would be much higher, since it is an indication of how expensive it is to buy put and call options in order to limit one's downside risk.


Gold prices are up about $100/oz. so far this year, but as the chart above shows, that is in the nature of a minor blip on the geopolitical risk radar screen. On the margin over the past few weeks, gold prices and TIPS prices are down, which suggests the market has actually become less worried about an end-of-the-world scenario developing. I hasten to add, however, the gold prices are still quite high from a long-term historical perspective, and the real yields on TIPS are still quite low. Both tell me that markets are still willing to pay a substantial premium for the ultimate safety of gold and the default-free inflation protection of TIPS. There is still a good deal of risk aversion out there, but on the margin it is declining.

I'm merely reading the market tea leaves here, not trying to forecast the outcome of what's going on in Ukraine and the Middle East. It strikes me as somewhat unusual that the market would be so relatively complacent in the face of problems that could become quite serious if left unchecked. For those folks who are very worried, it's not too late—or too costly—to seek protection from events that could threaten the health of the economy and push equity prices lower. Options are not terribly expensive, and equity prices are still very close to their post-recession highs.