Thursday, September 18, 2014

Solid gains in net worth

U.S. households continued to enjoy strong gains in net worth in the second quarter of this year, according to just-released data by the Federal Reserve. Thanks mainly to gains in financial assets, net worth rose to a new high in nominal and real terms; on a real per capita basis, net worth is within inches of an all-time high. In the 12 months ending June, 2014, household net worth increased by 10%, or almost $8 trillion. (For purposes of comparison, consider that the market cap of global equities rose by over $11 trillion in the same period.)

Household debt totaled just under $14 trillion in the second quarter, for a net increase of zero over the past 7 years; in real terms that represents a reduction of over 10%, and that counts as some serious deleveraging. The ratio of household debt to net worth has now fallen from a high of 25% in the first quarter of 2008 to 17%—a reduction in leverage of about one-third.

Since their recession lows, real estate valuations have increased by about $2.2 trillion, while the value of financial asset holdings have increased by more than $21 trillion.

Real household net worth now stands at a new high, and is on track with its long-term annualized growth rate of 3.6%. 

On a real, per capita basis, net worth in the second quarter was slightly less than its pre-recession high. Annualized gains over the long haul have been 2.4%, reflecting population growth of a little more than 1% a year. The average family of four now has a net worth of just over $1 million.

A few trillion here, a few trillion there, and you have the makings of some serious gains in prosperity. Since 1950, real per capita net worth has more than quadrupled, and new highs are just about inevitable.

Does it matter that the rich control a disproportionate share of total net worth? Not as much as you might think. The vast bulk of the wealth of the rich is tied up in real estate (mostly commercial) and ownership stakes in successful businesses. Those holdings are valuable only because they provide much-needed and much-desired goods and services to all of us. Without their wealth we would all be much less prosperous.

Wednesday, September 17, 2014

No need to fear Fed tightening

The August CPI report showed inflation to be a bit lower than expected (-0.2% vs. 0.0%), thanks mainly to falling energy prices. As the chart above shows, both total and core consumer price inflation are running a little under 2% per year, which is largely unremarkable. The bond market, however, is making some interesting adjustments these days: TIPS prices have fallen significantly, as inflation fears subside and the market adjusts to a somewhat improved outlook for economic growth.

The above graph shows what I think are the two most important variables to watch these days: the real yield on 5-yr TIPS and the price of gold. (The blue line is the inverse of the real yield on 5-yr TIPS, so it is a good proxy for their price.) The prices of both gold and TIPS have been under downward pressure in the past few years, with pressure intensifying of late: real yields on 5-yr TIPS have jumped by some 45 bps in just the last month, while gold prices have fallen over 7% in the past two months. 

As detailed here in a post one year ago, I think this reflects an important decline in the market's demand for safe assets, which is equivalent to an increase in the market's general confidence in the future, and equivalent to a decline in risk aversion. This is very important because the whole purpose of the Fed's Quantitative Easing programs, as I see it, has been to satisfy the world's demand for safe assets, not to stimulate the economy. In other words, QE was a response to the tremendous risk aversion which arose in the wake of the Great Recession. Risk aversion is now beginning to fade, so it is appropriate that the Fed should end its QE program. The FOMC announcement today confirms that QE3 will end next month, and the Fed will begin increasing short-term interest rates next year by raising the interest rate it pays on reserves. 

The rise in real yields on TIPS is also a sign that the market's outlook for economic growth is improving. As the chart above shows, real yields tend to track the economy's growth potential over the years, which makes a lot of sense. TIPS are unique because they offer a guaranteed real rate of return. That risk-free real return should be somewhat less than the expected real growth of the economy, since that is fundamentally uncertain. But real yields have been unusually low for the past few years (e.g., real yields have been -0.5%, whereas real economic growth has been a little over 2%), which I've taken to be a sign that the market was very pessimistic about the outlook for growth. That's now beginning to change for the better, as real yields move higher. It's not that the market has turned optimistic, however; it's more accurate to say that the market now has become less pessimistic.

The two charts above show the nominal and real yields on 5- and 10-yr TIPS, and the difference between those yields, which is the market's expected average rate of inflation over the next 5 and 10 years. The current expected rate of inflation over the next 5 years is about 1.8% per year, and the expected rate of inflation over the next 10 years is about 2.1%. This implies that the expected rate of inflation from 2020 to 2024 is about 2.5% (otherwise known as the 5-yr, 5-yr forward expected rate of inflation). This is not particularly scary, but it does suggest that the Fed can't afford to wait too long before tightening policy, since long-term inflation expectations are somewhat higher than the 2% the Fed now considers to be optimal.

The chart above shows Bloomberg's calculation of the 5-yr, 5-yr forward expected rate of inflation. Expectations today are almost identical to what they have been on average over the past seven years. No sign of deflation, and no sign of unpleasantly high inflation either—almost a goldilocks outlook. But with the outlook for the economy improving on the margin, it doesn't make sense for the Fed to continue its ultra-accommodative monetary posture much longer. Given the muted reaction to today's FOMC's announcement that QE3 is almost finished and higher short-term rates are coming next year, it appears the market agrees.

This is all good. The Fed and the bond market are responding appropriately to declining risk aversion and a somewhat improved economic outlook. There is no reason to fear the end of QE or the beginning of higher short-term interest rates.

Tuesday, September 16, 2014

Some interesting charts

One unique characteristic of the past two decades is the more than 30% decline in the prices of durable goods. Outside of durables, prices of just about everything else have been rising. The decline in durable goods prices began in 1995, which not coincidentally was about the time when China pegged its currency to the dollar (after devaluing it by one third the year before) and launched its export boom. We have China to thank for deflating the prices of most of the durable goods we enjoy these days. That's "good" deflation, since it's not monetary in origin, but rather the result of a huge increase in the productivity of the Chinese economy which has ended up benefiting everyone all over the world.

Personal computers are one very obvious source of durable goods deflation. Since the end of 1997, the BLS calculates that the prices of personal computers and peripherals on average have declined by about 95%—which works out to an annualized decline of 16%. Most of this decline is the result of hedonic pricing, which means that although actual prices haven't declined by anywhere near 95%, if you adjust for the increasing quality, capacity, and capabilities of personal computers and such, then prices have effectively declined by 95%. Since 2010, prices have been falling at an annualized rate of about 8% per year.

The Producer Price Index was flat in August, but up a little more than 2% over the past year. No sign of deflation here.

The dollar's recent 5% rise vis a vis the Euro owes a lot to the fact that the Fed is getting ready to tighten policy, whereas the ECB is trying hard to ease policy further. those expectations are being reflected in German 2-yr yields, now -0.06%, and U.S. 2-yr yields, now 0.53%. The first of the two charts above shows the history of 2-yr yields, while the second shows the spread between the two and the value of the Euro, which have been highly correlated.

The chart above provides convincing evidence for why the Fed is likely to pursue tighter policy than the ECB. U.S. industrial production has been rising strongly for years, whereas industrial production in the Eurozone has been relatively stagnant. The U.S. economy is fundamentally stronger than the Eurozone economy, so short-term U.S. interest rates are very likely to rise relative to their Eurozone counterparts.

The relative outperformance of the U.S. economy has been significant, and is reflected in equity prices. The S&P 500 has outpaced the Euro Stoxx index by 68% over the past five years. U.S. equities now have the added advantage of a strengthening dollar.

As measured by the difference between 10-yr Treasury yields and the level of Core PPI inflation, real yields have been in a declining trend for the past 30 years. This means that, in general, the effective cost of borrowing money for U.S. businesses hasn't been this low since the late 1970s. This is one reason why companies like Apple are borrowing money here to fund dividends and buybacks instead of repatriating overseas profits. Borrowing costs almost nothing, and they avoid double taxation on foreign profits.

Monday, September 15, 2014

U.S. Tax Competitiveness Stinks

Today the Tax Foundation released its 2014 index of International Tax Competitiveness. Of the 34 countries ranked on the basis of "more than forty variables across five categories: Corporate Taxes, Consumption Taxes, Property Taxes, Individual Taxes, and International Tax Rules," the U.S. came in #32, only a few points ahead of notoriously tax-loving France. 

The chart above shows my representative sampling of 20 of the countries included in the index.

Key findings:

Estonia has the most competitive tax system in the OECD. Estonia has a relatively low corporate tax rate at 21 percent, no double taxation on dividend income, a nearly flat 21 percent income tax rate, and a property tax that taxes only land (not buildings and structures). 
France has the least competitive tax system in the OECD. It has one of the highest corporate tax rates in the OECD at 34.4 percent, high property taxes that include an annual wealth tax, and high, progressive individual taxes that also apply to capital gains and dividend income. 
The ITCI finds that the United States has the 32nd most competitive tax system out of the 34 OECD member countries. 
The largest factors behind the United States’ score are that the U.S. has the highest corporate tax rate in the developed world and that it is one of the six remaining countries in the OECD with a worldwide system of taxation. 
The United States also scores poorly on property taxes due to its estate tax and poorly structured state and local property taxes. 
Other pitfalls for the United States are its individual taxes with a high top marginal tax rate and the double taxation of capital gains and dividend income.

As the study notes,

Taxes are a crucial component of a country’s international competitiveness. In today’s globalized economy, the structure of a country’s tax code is an important factor for businesses when they decide where to invest. No longer can a country tax business investment and activity at a high rate without adversely affecting its economic performance. In recent years, many countries have recognized this fact and have moved to reform their tax codes to be more competitive. However, others have failed to do so and are falling behind the global movement.

This goes a long way to explaining why the U.S. economy has been struggling in recent years.

Today's WSJ has an op-ed that sheds even more light on the issue.

To be sure, not all the countries that rank higher in the index have stronger economies. Indeed, the U.S. economy is doing better than most these days, although it is only managing to post annual growth of slightly more than 2%.'

If there's any surprise here, it's that the U.S. economy is not doing worse. We are still relatively prosperous in spite of our onerous and burdensome tax code. This speaks volumes to the inherent dynamism of the U.S. economy, which is rather adept at overcoming adversity. If we only freed the economy from its tax shackles, it's hard to imagine how much better we could be doing.

We need serious and far-ranging tax reform. Now.

Thursday, September 11, 2014

Federal government finances continue to improve

The latest budget data through August continue to reflect ongoing, gradual improvement in the federal government's finances. Spending growth is very slow, revenue growth is healthy, and the deficit is a very manageable 3% of GDP. 

Fiscal policy has been a significant drag on growth for most of the current recovery—not because of a declining deficit, but because of excessive spending. Spending is taxation, as Milton Friedman taught us, because spending must eventually be paid for by higher taxes. Spending is also bad because government doesn't spend money with the same efficiency as the private sector; you surely spend your own money much more carefully and frugally than you would if you got to spend someone else's money.

The good news is that even though the federal government arguably is still spending way more money than it should (federal spending is running about $3.5 trillion per year), federal spending as a % of GDP has been declining steadily for the past five years, so the drag of fiscal policy today is much less than it was just a few years ago. It's also good because the big decline in the federal budget deficit has all but eliminated the need for higher tax rates. As the public sector shrinks relative to the private sector, the private sector has more room to grow, and it's the private sector that delivers prosperity. 

The following charts illustrate some of the points made above:

Federal spending has been effectively flat for the past five years, thanks mainly to congressional gridlock and an improving economy, which in turn has reduced the need for social safety net spending. Federal revenues have been rising steadily, thanks mainly to more jobs, rising incomes, capital gains, and rising profits, and only partly thanks to higher tax rates imposed beginning last year. In retrospect, we would have been much better off not raising tax rates on anybody.

Federal spending relative to the size of the economy has declined by almost one-fifth, from just under 25% of GDP to just over 20% of GDP. This has reduced expected future tax burdens enormously, and on the margin it has helped to boost the economy's overall efficiency. Revenues are now about 17.2% of GDP, which is only slightly less than the 17.4% they have averaged since 1968.

The result of flat spending and rising revenues has been a two-thirds reduction in the federal budget deficit (from $1.5 trillion to $0.5 trillion). Relative to GDP, the deficit has collapsed from a high of 10.2% to now only 3%. 

The decline in the unemployment rate has correlated very closely to the decline in government spending relative to GDP. A significant decline in government spending relative to the economy did not in anyway harm the economy by this measure. As the graph above suggests, further declines in spending relative to GDP are very likely to coincide with a healthier labor market.

All in all, lots of good news here, even though there is plenty of room for further improvement. Things could be a lot better, of course, but at least they are getting better.