Calafia Beach Pundit

The 13% GDP gap

2012-01-27T13:39:00.000-08:00

This chart nicely illustrates just how weak the current recovery has been—it's actually unprecedented. According to my calculations, there is a 13% "gap" between the current size of the economy and where it would be if it were following its long-term trend growth rate (3.07% compound annual growth, which breaks down on average into 1% annual growth in the workforce and 2% annual increases in productivity). The current output gap is equivalent to lost income of $1.75 trillion, and that's inextricably bound up with the fact that there ought to be at least 10 million more jobs today if the economy were on its long-term trend growth track.

The precise cause of this huge output gap will be the subject of discussion among economists for years, but most of the evidence I see points to the highly unusual expansion of government spending (mostly in the form of transfer payments) over this same period as the leading culprit. Since 2008, federal payments to individuals as a % of GDP have increased by at least one-third, to their highest level ever. Income redistribution on a massive scale like this can not only fail to create growth, it can stymie growth by creating perverse incentives (e.g., rewarding the lack of work and punishing success).

One thing about today's fourth quarter GDP report that caught my eye was the relatively weak growth (3.2%) in nominal GDP, which was entirely due to sharply lower inflation. This can be traced to the same decline in inflation that shows up in the CPI and the PCE deflator over the same period, and which, in turn, was mostly a function of a decline in energy prices, which have since stabilized. As the chart above shows, real growth has been accelerating for the past three quarters, so it's not unreasonable to think that nominal GDP will accelerate in the current quarter, as I suspect it will. Faster nominal GDP growth would also be consistent with a decline in money demand, a phenomenon which I think will be driven by the lessening of concerns over the Eurozone financial crisis. Of course, even if we do get an acceleration in nominal GDP this year, the output gap will likely remain large. Faster nominal GDP is good for corporate cash flows and debtors, but it is not necessarily a big job-creator. For more jobs we need less government and better and permanent after-tax incentives to work and invest (e.g., a simpler and flatter tax code) for individuals as well as corporations.

Today's GDP report also amounted to one more shot across the bow of the Phillips Curve theory of inflation: an output gap this large and this persistent should have resulted in years of deflation, according to standard thinking. Instead, the GDP deflator (the broadest and arguably best measure of overall inflation) has risen a total of 6.5% since the peak of the last business cycle.

Brian Wesbury also makes an interesting point, which is that a reduction in public sector spending was one of the sources of weakness in Q4: "Excluding government, real GDP grew at a robust 4.5% annual rate in Q4 and was up 2.6% for 2011 as a whole." In other words, cutbacks in local, state, and federal spending reduced the growth in GDP last year by 1 percentage point. That's not surprising, since we know that public sector payrolls have been declining for the past three years, and we know that our military presence in the Middle East has been winding down of late. But it's not exactly bad news, since our public sector had grown like topsy in the years preceding. A smaller government footprint on the economy means more room for the more-efficient private sector to grow.

So even though today's GDP report was bit weaker than expected, it's not necessarily bad news at all.

The Eurozone crisis is slowly fading away

2012-01-26T09:08:00.000-08:00

Eurozone swap spreads are still elevated, but they have come off their highs and as such are no longer signaling an imminent disaster. U.S. swap spreads have moderated substantially, having returned to the low 30s, well within the range that is considered "normal." The Eurozone banking system has avoided a meltdown, and banks' access to dollar liquidity (blue line in second chart above) continues to improve, suggesting further declines in euro swap spreads are likely. Meanwhile, from the perspective of U.S. markets, contagion risk has declined considerably.

If anything sums things up, it's this chart of the ratio of the Vix index (a measure of fear and uncertainty) to the 10-yr Treasury yield (a proxy for the economy's growth prospects). We are still far from optimum conditions, of course, but the worst of the panic and gloom-and-doom is a thing of the past. There is definitely light at the end of the tunnel.

Three PIIGS are looking much better

2012-01-26T08:43:00.000-08:00

Here's an updated chart of the short-term yields on sovereign debt in the questionable countries of the Eurozone. I haven't included Greece, since Greek 2-yr yields are off the chart (over 180%), and Greece is a lost cause anyway: most Greek notes and bonds are priced at 21 cents on the dollar.

Spain has made excellent progress. 2-yr Spanish yields haven't been this low since Nov. '10, and Italian yields are not far behind. Ireland gets credit for the most dramatic improvement of any of the PIIGS, with 2-yr yields having plunged from a high of 23% to just 5.2% today. The big decline in yields on the bonds of these three countries is one reason our Vix index has fallen from the 40s to now below 20; markets are breathing a big sigh of relief.

Bear in mind that Greek losses of $360 billion have already been priced in, as have Portuguese losses of some $110 billion, and the Eurozone sky has not fallen. The ECB gave the Eurozone banking system a liquidity reprieve with its recent loan facilities, and with liquidity conditions restored, the banking system has continued to function even as sovereign debt losses are likely to be on the order of half a trillion or so. There's no reason this can't continue.

As I've been pointing out since last July, the consequences of debt defaults have been greatly exaggerated because most people apparently don't understand that debt is a zero-sum game. The defaulting debtor wins, and the creditor loses. Debt is simply a promise to redistribute cash flows in the future, and if the debtor can't generate those cash flows, he can't redistribute them. The over-spending and over-borrowing that has been the bane of the PIIGS long ago resulted in economic losses, because the money they borrowed was not spent on productive activities. The Eurozone economy's scarce resources have already been wasted, and that's water under the bridge. All the gnashing of teeth and pulling of hair since last summer has just been about who will have to take the losses on his balance sheet. The economic losses have been incurred, now it's just about who will have to account for them.

Even if PIIGS debt losses were to reach $1 trillion, that would only be a drop in the global stock and bond market bucket, which is worth over $100 trillion.

More fiscal and monetary stimulus means more slo-flation

2012-01-25T11:53:00.000-08:00

The Law of Unintended Consequences, coupled with a contrarian mindset, is often the best way to understand the impact of government policies on the economy: whatever the government is trying hardest to do, expect the opposite. At the very least, remain very skeptical.

Today the FOMC reminded us that they are trying really, really hard to stimulate the economy by keeping short-term interest rates very, very low, "at least through late 2014." Notably missing in today's FOMC statement was boilerplate which promises that the FOMC will keep its eye on the evolution of inflation and inflation expectations. The Fed is trying to be bold, but even they realize that "a highly accommodative stance for monetary policy" is only likely to foster more inflation rather than more growth. Rising inflation expectations sap some of the economy's vitality by steering resources to speculative activities (e.g., buying gold and stockpiling commodities, buying other currencies), rather than taking on real risk by investing in new plant and equipment and creating new jobs.

Last night, in his SOTU speech, Obama reminded us that he is willing to do just about anything to help the economy grow—except to give the private sector more room to work its growth magic. That would expose the fatal conceit of those, like him, who believe that nothing good can come if it does not originate in Washington. It's not enough to just lower the corporate tax rate to a more competitive level and eliminate loopholes and tax subsidies. He'd rather punish corporations that "export" jobs overseas, and reward those who bring them back, as if the federal government or mere politicians knew better how to manage a business like Apple than Tim Cook. Unfortunately, the more changes to the tax code designed to create politically-favored outcomes, the more distortions this introduces to the economy and the less growth we are likely to get.

Today's market reaction to the SOTU speech and today's FOMC news was consistent with this interpretation: thanks to myopic fiscal and monetary policies, we're likely to see somewhat more inflation, and only modest real growth. Call it slo-flation, rather than stagflation.

The 10-30 Treasury spread is the only part of the yield curve that is more or less immune to Fed ministrations. By pledging to keep short-term rates very low for years, the Fed can dominate interest rates out to the 10-yr maturity area. But they have very little control over interest rates beyond 10 years. The 10-30 spread has been widening since last October, in line with the rise in forward-looking inflation expectations, as shown in the above chart. Both jumped today because the bond market is getting nervous about the prospects for inflation.

Gold shot up by $43 in the wake of the FOMC announcement. This makes perfect sense, since extremely low borrowing costs locked in for a long time make it easier and safer for speculators to bet on rising gold prices, and extremely accommodative monetary policy promised for as far as the eye can see only undermines the outlook for the dollar's purchasing power, thus boosting the demand for tangible assets.

The S&P 500 inched higher, up only 0.5% as of this writing. The trailing PE ratio of the S&P 500 is still less than 14, substantially lower than its long-term average of 16.6, and Apple's trailing PE of 12.75 and expected PE of 11.21 is hardly what one would expect to see for a rapidly-growing company. Low PE ratios—especially in today's environment of super-low interest rates—can only mean that the market is highly skeptical about the prospects for future growth.

Equity and high-yield debt prices are rising—reluctantly—mainly because the risk of deflation is disappearing, and rising inflation means faster nominal growth and that is good for corporate cash flows. But PE ratios remain depressed, since the promise of true growth remains elusive.

Apple is simply amazing

2012-01-24T15:08:00.000-08:00

Apple today announced earnings and revenues that far exceeded expectations—once again. As the above chart from MacRumors shows (HT: John Gruber), the biggest source of revenue gains was iPhone sales, which totaled over 37 million units in the latest quarter. And as Matt Richman notes (HT also to John Gruber):

In 2009, Apple sold more iPhones than it did in 2007 and 2008 combined. In 2010, Apple sold more iPhones than it did in 2007, 2008, and 2009 combined. Last year, Apple sold 93.1 million iPhones, slightly more than it did in in 2007, 2008, 2009, and 2010 combined. The pattern continued.

The pattern: "iPhone sales double with every new model."

Here's the history of Apple's share price, including today's after-hours gain of (only) 8%. It's amazing to me that a company that has more than doubled its revenues and its profits in the past year can trade at this morning's PE of 12, with an expected PE of only 12. Moreover, as Bloomberg notes, "per-share profit for the quarter was more than the company earned in any fiscal year before 2010." Is this the greatest American growth story ever, or what?

If you focus on the almost $100 billion that Apple now has in cash, and subtract the taxes necessary to bring the offshore portion of that money back to the U.S., Apple shares ex-cash are trading in after-hours right now for a PE of only 10.5.

Conclusion: this is a very pessimistic market.

P.S. Alert readers may note that my "favicon" is a miniature graph of Apple's stock price. Long-time readers will know I've been an Apple fan for more than three years.

Truck tonnage is very impressive

2012-01-24T11:58:00.000-08:00

Truck tonnage (Calculated Risk has lots of details here) is a great way to track the real, physical improvement in the economy. It can be volatile from month to month, but there's no denying that this index is reflecting some very impressive growth in the economy in recent years. The December reading was an all-time high, and was up fully 10.5% from Dec. 2010, the strongest year-over-year showing since 1998.

This chart compares the truck tonnage index with the S&P 500, and clearly it is suggesting that equity prices have plenty of room to rise just to keep up with the physical expansion of the U.S. economy. It's hard to argue with truck tonnage: there's been a lot of improvement going on out there. Meanwhile, equities are still priced to the expectation that corporate profits are going to collapse in coming years. Good news for contrarians like me.

Dollar review: still very weak

2012-01-24T11:13:00.000-08:00

By almost any measure, the U.S. dollar is at or near its weakest levels ever, whether nominally or in real terms. This is in part a reflection of the fact that U.S. inflation has tended to be higher than that of other countries, but perhaps more importantly, it shows that the market's outlook for and confidence in the U.S. economy is dismal.

This first chart is the most common measure of the dollar's value (DXY) as compared to a relatively small, trade-weighted basket of six major currencies (EUR, JPY, GBP, CAD, SEK, CHF). The dollar is bouncing along the bottom, today about 10% above its all-time low, and it has lost 50% of what it was worth at its peak in 1985.

This next chart is arguably the best measure of the dollar's value against other currencies. Calculated by the Fed, it shows the dollar's value on a trade-weighted and inflation-adjusted basis against a very broad basket of currencies (over 100), and against a smaller basket of major currencies. Again we see that today the dollar is only marginally above it's all-time lows and has lost one-third of its all-time high value in 1985, when the economy was booming and the Fed had conquered double-digit inflation. Since early 2002 it has lost 25% of its purchasing power against other currencies.

The chart above shows the dollar vs. the yen (blue line), and my calculation of the dollar's Purchasing Power Parity exchange rate against the yen. The idea of PPP is to start with a base value of an exchange rate, preferably chosen from a time when trade and capital flows were in rough balance and inflation differentials were minimal, and then adjust that value for inflation differentials. If country A has less inflation than country B, then country A's PPP exchange rate will rise against B's currency, as it must in order to keep prices equal in the two economies. (In all the charts here, an upward sloping line means that U.S. inflation has on balance between greater than the inflation rate of each individual country.) If a currency trades above its PPP, then it can be considered "overvalued" relative to the dollar, since prices in that country will be higher than in the other country, and a currency trading below its PPP is consequently undervalued relative to the dollar.

If a PPP calculation is done correctly (caution: it's more art than science), then if a currency tracks its PPP over time, tourists from each country traveling in the other should find that prices are roughly the same as what they pay at home for similar goods and services. In the case of Europe, my calculation of PPP suggests that prices in Europe today are roughly 13% higher than prices in the U.S. In other words, the Euro is about 13% overvalued against the dollar.

As this next chart shows, Japan has experienced significantly less inflation than the U.S. since the late 1970s, and that is reflected in the sharply upward-sloping PPP line for the yen. Not surprisingly, the yen has appreciated tremendously against the dollar since 1970 (100 yen buys 4.6 times more dollars today than it did then), as purchasing power parity theory would predict. By my calculations, the yen currently is about 50% overvalued against the dollar, meaning that for a U.S. tourist, traveling in Japan is very expensive.

In contrast to the ever-appreciating yen, the long-term trend of the the pound vis a vis the dollar has been down, as this next chart shows, because U.K. inflation has been higher than U.S. inflation. I was unfortunate to have my youngest daughter studying in London some 5 years ago, when the pound was at its strongest level ever relative to dollar. Today, prices in the U.K. are still more expensive than in the U.S., but not by much—only about 17% by my calculations.

The Canadian dollar today is almost as strong relative to the U.S. dollar as it has ever been, and on a par with the strength of the yen. What a contrast from its weakest level, back in 2002! With Canadian inflation being very similar to U.S. inflation over the past two decades, I doubt that the loonie is going to appreciate further. Canada likely has benefited as much as it ever will from the global commodity price boom. With the loonie trading at close to parity to the dollar, Canadians are finding U.S. prices irresistibly cheap, and on the margin this could put upward pressure on U.S. prices and downward pressure on Canadian prices. For that matter, tourists from almost all parts of the world are finding that U.S. vacations are cheap thanks to the weak dollar.

The story in Australia is very similar to the one in Canada. Like Canada, Australia's economy is heavily influenced by its bounty of natural resources, and commodity prices today are still very near their all-time highs. The commodity boom has been great for the Australian economy, and by extension great for the Aussie dollar. But given the current degree of overvaluation (over 50%), I doubt the Aussie dollar has much upside left.

I haven't calculated the PPP value of the Chinese yuan, but this chart shows the real value of the yuan relative to a basket of currencies on an inflation-adjusted basis, as calculated by the BIS. What it shows is that since pegging its currency to the dollar at the beginning of 1994, the yuan has appreciated 68% in real terms against the currencies of its trading partners. That puts the yuan right up there with the yen in the ranks of strong and appreciating currencies in recent decades. Over this same 18 year period, the dollar (DXY) index has fallen 16%, and the Real Broad Dollar Index has dropped 6%, so the yuan has unmistakably appreciated in every sense, and significantly, against not only the dollar but against most other currencies. Protectionists in the U.S. should stop complaining about the supposed "unfair advantage" that a supposedly cheap yuan confers on Chinese exports. And anyway, if the Chinese want to sell us cheap stuff, why should we complain? Cheap Chinese goods only hurt a small segment of our economy (i.e., those few that have to compete with Chinese imports, which comprise less than 3% of what U.S. consumers spend every year), but they greatly benefit everyone else. And of course, the strong yuan is the flip side of a weak dollar. Why would we want to cheapen the dollar, since that can only make imported goods more expensive for everyone?

The dollar is worth only marginally less relative to gold than ever before. If the price of gold says anything about a currency's value, the 10-yr surge in gold prices is a gigantic vote of no confidence in the dollar, and an implicit bet by the market that the dollar will lose even more of its value against other things and other currencies in the future.

Non-energy, raw industrial commodity prices are only 16% off their all-time highs, but way above their average in the 1980s and 1990s. This also reflects poorly on the dollar's purchasing power, and it is no coincidence that the rise in gold and commodity prices started at almost the same time as the dollar's decline (relative to other currencies) from its early 2002 highs. Gold and commodity prices act like canaries in the monetary gold mine, warning of dollar debasement.

Crude oil prices are about one-third less than their 2008 highs, but orders of magnitude higher than they were 10 years ago, which not coincidentally was the latest high-water mark for the dollar. It's worth remembering that crude oil, commodity, and gold prices all began soaring very soon after Nixon decided to break the dollar's tie to gold in the early 1970s.

Real estate stands out as one of the very few tangible assets that are not even close to an all-time high. Commercial real estate, for example, is worth about the same today as it was when the dollar reached its peak in early 2002, and residential real estate, according to the Case Shiller property index, is worth only 15% more (though the cost of financing real estate is at an all-time low). In other words, the dollar is worth a lot more relative to real estate than it is relative to other currencies and commodities. That in turn suggests that real estate is the cheapest hedge against further dollar weakness.

Finally, corporate profits aren't worth very much in terms of dollars. Considering that PE ratios are 17% below their long-term average and the dollar is very close to its all-time lows, U.S. equities are practically on a fire sale in the eyes of foreign investors. A dollar of earnings has almost never been so cheap for the rest of the world, yet after-tax corporate profits today are at all-time highs, both nominally and relative to GDP. This has only one meaning: the market has almost no faith that the outlook for the U.S. economy will be anything but dismal. This reflects poorly on our monetary policy, which has the potential to greatly increase future inflation, and on our fiscal policy, since trillion-dollar-plus annual deficits and massive unfunded entitlement liabilities have the potential to significantly increase future tax burdens.

All of the above adds up to a very depressing message: the market thinks the U.S. sucks. However, it also confirms my repeated assertions that valuations are still extremely depressed. Conditions are terrible, even grim, but lots of bad news is priced into just about everything. If U.S. monetary and fiscal policy can move even modestly in a more positive/less negative direction in coming years, there is plenty of upside for equity prices.

Bank lending still accelerating

2012-01-23T15:28:00.000-08:00

Commercial & Industrial Loans (a good proxy for bank lending to small and medium-sized businesses) have been expanding at an accelerating rate for more than a year now, having grown by $154 billion since their low in October 2010. Over the past six months, C&I Loans have risen at a 13.4% annualized pace. This is a rather remarkable development that has been way under-appreciated, in my view. It is now very clear that not only are banks increasingly willing to lend, but that businesses are increasingly willing to borrow. I view this as convincing evidence of returning confidence. The deleveraging and general risk-aversion that dominated the private sector's financial decisions since the financial panic of late 2008 has now been replaced by a renewed willingness to take on risk.

Banks are required to hold "bank reserves" at the Fed to support their deposits. Required reserves, shown in the chart above, are thus an excellent indicator of the net impact of bank lending. The fact that required reserves (above chart) have more than doubled since the beginning of the Fed's first Quantitative Easing program in late 2008 is convincing evidence that banks are expanding the money supply by making net new loans. And by an amount that is unprecedented: the M2 measure of the money supply has increased by over $1.9 trillion over this same period, or by 25% in just over 3 years. It's hard to imagine how anyone could think that the Fed's efforts to add liquidity to the economy have failed. At the very least, it can be argued that the Fed's massive attempts at accommodation have been sufficient to satisfy the world's voracious demand for extra dollar liquidity, since inflation has been positive and ongoing, the dollar is roughly unchanged against other major currencies since QE began, gold prices have doubled, industrial commodity prices have risen 14%, and the inflation expectations embedded in TIPS and Treasury prices have risen from almost zero in late 2008 to levels now that approximate what inflation has averaged over the past two decades. If the Fed had been stingy with money, we would most likely have seen convincing signs of deflation in these same indicators. Instead, these indicators strongly suggest that the Fed's efforts to be accommodative have succeeded in adding at least some inflationary impulse to the global economy.

If the economy is suffering from a lack of anything these days, it is most certainly not a shortage of money.

Consequently, I continue to believe that the economy will continue to grow, albeit at a sub-par pace given how far it fell in the last recession. Moreover, I have every reason to think that the pace of nominal GDP growth will likely accelerate at least somewhat over the next few years. If that is the case, faster nominal GDP growth will support growth in corporate cash flows and profits, and help keep default rates low, thus auguring well for the outlook for equities and corporate bonds, particularly those rated below investment grade, where implied default rates are still relatively high.

Panic is slowly fading.

2012-01-20T12:25:00.000-08:00

The first chart above is a closeup look at the Vix/10-yr ratio, and the second chart shows the longer-term picture of the same. The market is still nervous (the Vix is still substantially above where it would be in normal times) and holds out little hope for a healthy economy (the 10-yr yield is still at levels that were associated with the Depression), but those sentiments are slowly giving way to the fact that the financial fundamentals in Europe are improving and there are quite a few indicators that show the U.S. economy is improving as well.

The Vix/10-yr ratio was priced to a global catastrophe at its peak in early October, and markets are breathing a tentative sigh of relief that so far nothing all that bad has happened. This year is off to a good start, if only because it's not proving to be as terrible as expected.

The bond/equity disconnect

2012-01-20T11:39:00.000-08:00

Over the past several years, bond yields have correlated pretty well with equity prices—yields rise and fall along with the ups and downs of the stock market. Higher stock prices reflect increased optimism (or less pessimism) about the future, and bond yields move in synch because a more healthy economy increases the odds of higher inflation and a tighter Fed. Most of the time the correlation between stocks and bond yields has been 0.6 to 0.8, interrupted with a few relatively brief periods of negative correlation, as can be seen in the two charts below. Over the past few months, we have once again entered one of those periods where the correlation has gone to zero. Equity prices are up, but bond yields remain very low and relatively stable. As the above chart suggests, either bond yields should be at least 100 bps higher, or equity prices should be a lot lower.

In my view, this disconnect reflects a buildup of tension in the market—something is likely to break pretty soon. Bond yields have been depressed because risk-averse investors have been seeking shelter from a potential Eurozone collapse that might trigger another global recession/depression/deflation. But equity prices have been rising because in the meantime, while the world waits for the Eurozone to implode (and we've been waiting for at least 18 months now), the U.S. economy continues to improve. Bonds are the doomsday trade, while equities are more realistic about what's happening right now.

I can think of an alternate explanation, but it's not very convincing. Maybe bond yields are low because the market is absolutely convinced that no matter what happens to the economy, inflation is going to be very low for a very long time, and central banks, and particularly the Fed, are going to remain at or close to their "zero bound" for as far as the eye can see. To counter this explanation, I note that break-even spreads on TIPS reflect inflation expectations to be in a 2.0- 2.7% range, which is pretty close to the average rate of CPI inflation over the past two decades (2.5%), and during that time 30-yr bond yields have averaged 5.5%. In other words, I find no evidence to suggest that bond yields today are priced to deflationary concerns, so their low levels therefore more likely reflect an intense risk aversion on the part of investors.

In any event, it's unusual and I think unnatural for capital markets to be so schizophrenic. The assumptions driving bonds and stocks should ordinarily reflect the same world view, but these days they don't seem to.

My money is on bonds catching up to stocks—bond yields are more likely to rise than stock prices are to fall. What could trigger this? Maybe the Fed bows to the same realities that are driving equity prices higher, and informs us that with the economy doing better on the margin, the Fed mostly likely won't have to keep yields at zero for the next several years as the market currently believes it will. Or maybe Greece finally executes its default, but the world does not come to an end (after all, a huge default has been fully priced in for a very long time, so it should not prove surprising or disruptive when it finally happens). Or maybe the simple passage of time without anything disastrous occurring will do the trick—markets can't stay priced to disaster forever if a disaster doesn't occur.

Meaningful improvement in Eurozone fundamentals

2012-01-20T08:42:00.000-08:00

Here's a quick recap of important indicators of financial market health, which all register substantial improvement, especially in the Eurozone. Even though a Greek default is a virtual certainty (Greek 2-yr yields today are 180%), these indicators suggest that the risk of contagion to other countries has dropped significantly, and the Eurozone financial system is not destined to collapse any time soon.

2-yr swap spreads are an excellent indicator of financial market liquidity and systemic risk. Spreads are down meaningfully in the Eurozone, albeit still quite elevated. U.S. spreads are now back to a level that is consistent with "normal" conditions.

Euro basis swaps reflect the difficulty that Eurozone banks are having in obtaining dollar liquidity. Funding pressures have eased significantly in the past month, leading the way to reduced swap spreads, also a measure of counterparty risk. Eurozone financial markets are exiting the danger zone when liquidity dries up and trading freezes.

2-yr yields on sovereign debt are a good measure of the market's estimation of default probabilities. Greek yields have soared, but all other countries have seen meaningful declines in the past few months. Italian 2-yr yields have fallen by half since their peak in late November. This is rather impressive.

The cost of obtaining insurance against Eurozone defaults has not declined as much as 2-yr yields, but the CDS contracts represented here cover a 5-yr period. The combination of only marginal improvement in CDS plus significant improvement in 2-yr yields means that while the market realizes that defaults are not likely in the near term, they remain a risk over a longer time horizon. Efforts to restore liquidity and confidence to Eurozone markets have been reasonably successful, but investors have yet to see any meaningful steps on the part of the PIIGS governments to address their fundamental problem, which is bloated, deficit-financed government spending.

The decline in systemic risk in the Eurozone is one reason that the U.S. equity market has been able to move higher in recent weeks, and the implied volatility of equity options has dropped to a 5 1/2 month low. As risk declines, risky asset prices rise.

Effective tax rates are highly progressive

2012-01-19T21:19:00.000-08:00

There's a lot of chatter these days about whether the rich pay a high enough tax rate. Warren Buffett comes to mind, as do the recent attempts to shame Mitt Romney for paying only 15% of his AGI in tax.

Confusion arises only if we look at part of the picture. For example, everyone who is employed pays social security tax and personal income tax. But only those with investment income pay capital gains and dividends tax. And in order for investors to receive capital gains and dividend income, the companies they have invested in—with after-tax dollars—need to pay a corporate income tax. Consider, for example (and I'm simplifying), a worst-case scenario person who is self-employed, whose income puts him in the top Federal and California income tax bracket, and who has substantial income from investments. He pays 35% federal income tax, 9% state income tax, a 15% social security tax, and a 2% medicare tax. Any income he receives from his investments—which were originally made with after-tax dollars—is effectively what the companies he owns have earned after paying a 35% corporate income tax, and on top of that he must pay 15% of what is distributed to him—he might be paying an effective tax on his total investment income of as much as 45%. Depending on how the numbers stack up, this unfortunate person could be paying an enormous effective tax rate—well over 50%—on his total income.

When Warren Buffet says he only pays a 15% effective tax on his income, that's because his income mainly comes from capital gains and dividends, and he is completely ignoring the fact that the companies he owns must pay a corporate income tax of as much as 35% before he can receive those gains and dividends.

Fortunately, we do have access to facts that do not distort or color the picture. The chart below uses the numbers as crunched by the Congressional Budget Office. The effective total tax rate shown is the ratio of total federal taxes (income, social security, corporate, excise) divided by comprehensive household income. As Greg Mankiw notes, our tax system is highly progressive: "the rich face average tax rates more than twice those of the middle class, and about seven times those of the lowest quintile." And these effective tax rates include all the benefits of whatever deductions may have been available to individuals and companies along the way.

Greg Mankiw also has a nice summary of how progressive our tax system actually is:

1. The U.S. personal income tax is generally progressive, and substantially so. Click here to see the numbers. The average tax rate for tax returns with over $1 million in income is 25 percent. The average tax rate for returns with income between $50,000 and $75,000 is 7 percent.

2. It is arguably better to use an average tax rate that is all-inclusive. That is, we should include not only personal income taxes but also payroll and corporate income taxes. CBO analysts regularly do that. They find a substantially progressive tax system, as I have pointed out before.

3. If we added transfer payments (which are essentially negative taxes), we would find an even more progressive fiscal system. Those data are harder to come by, as data on transfers are rarely integrated with data on taxes.

4. It make little sense to aggregate payroll taxes with personal income taxes and ignore corporate income taxes.

Inflation remains relatively tame

2012-01-19T14:32:00.000-08:00

The headline Consumer Price Index in December was flat, compared to expectations of a 0.1% increase. On a year-over-year basis, the CPI has fallen from a high of 3.9% to 2.4% in the past three months. As this chart shows, all of that decline was due to energy prices, which have been relatively flat to down for the past three months (oil was up but gasoline prices have fallen and natural gas prices have dropped significantly). The CPI ex-energy has continued to pick up.

Inflation is not dead, deflation is not a threat, and so far inflation has not been the problem I thought it would be. Thank goodness.

Housing starts rose 25% last year

2012-01-19T08:48:00.000-08:00

December housing starts were less than expected (657K vs. 680K), and were 70% below their early-2006 peak; a pessimist would say that's pretty grim. But an optimist like me is quick to note that last year housing starts rose by a very impressive 25%. The big housing bust that began in early 2006 likely ended about a year ago—5 long years of terrible destruction for the residential construction industry. But it's over, finally.

For all those who have been saying that we'll never get a decent recovery until the housing market starts improving, your time to turn optimistic about the future has come.

For all those who say that those on the right of the political spectrum are hoping for a lousy economy so that Obama can be forced out, I want to emphasize once again that I think the economy is improving not because of anything Washington is doing but rather in spite of all the things that Washington has been doing to try to help. As I said in my forecast for 2012, "Left to its own devices, and given enough time to adjust to adversity, the U.S. economy is perfectly capable of growing—and that is what is happening now. No reason this can't continue." This is an organic recovery, if you will. The U.S. economy is by nature dynamic; it never pays to underestimate it. The economy will probably be doing a little better come November, but I suspect that Obama will find it difficult to turn that to his advantage. Unemployment is still going to be high, the deficit will still be gigantic, gasoline prices will be high, the dollar will still be relatively weak, and government's presence in our midst will still be oppressive.

Claims continue to fall

2012-01-19T08:22:00.000-08:00

First-time claims for unemployment last week fell by a surprisingly large amount, and were significantly less than expected (352K vs. 384K). Nevertheless, at this time of the year, when layoffs are just coming off their annual peak, the seasonal factors are very large so we have to take this news with a few grains of salt. Still, it's clear that employers by now have done the bulk of the cost-cutting and cutbacks that they needed to do, so the next phase of the economy's expansion will see more emphasis on new jobs rather than getting rid of jobs. That process is underway, but only gradually. Things could improve more convincingly as the year wears on and employers get more comfortable with the likely future direction of fiscal and monetary policy.

Thoughts on producer inflation

2012-01-18T11:12:00.000-08:00

Once again the headline measure of Producer Price Inflation came in below expectations (-0.1% vs. +0.1%), with the result that on a year-over-year basis, this measure of inflation has been declining for the past 5 months. Unfortunately, that good news is fully offset by higher-than-expected core PPI inflation. And unless oil prices spike again, these trends are likely to continue. I note, for example, that the headline PPI is up a cumulative 40% over the past 10 years, while the core PPI is up only 20%; this divergence is bound to narrow over time, with the core measure catching up to the headline measure as higher energy prices slowly filter down to other prices.

One thing that should stand out here is that PPI inflation over the past 10 years (with a compound growth rate of 3.4% per year) has been and continues to be higher than it was in the previous 10 years (when the compound growth rate was 1.2% per year). And what has changed in the past decade? Monetary policy was undeniably tight in the 1990s, but the Fed has been working overtime to be accommodative for most of the past 10 years. That same message can be found in the dollar, which rose throughout the 1990s and early 2000s and has been falling for the past 10 years. It works like this: monetary policy impacts the value of a currency, and a declining currency eventually results in higher inflation.

Another thing that doesn't receive as much attention as it should is that Treasury yields have been lower than the rate of PPI inflation for most of the past four years. We haven't seen such low real interest rates since the highly inflationary 1970s, when the Fed was chronically "behind the curve," repeatedly failing to raise interest rates enough to constrain the high inflation that was triggered by the collapse of the dollar early in the decade.

Low real interest rates, a weak dollar, and an accommodative Fed are a combination that augurs for inflation that continues to surprise on the upside for the foreseeable future. In fact, that's been the case (higher than expected inflation) ever since the end of the last recession. Recall that at the end of 2008 the expected 5-yr, 5-yr forward annual CPI inflation rate embedded in TIPS prices was 0.5%. Instead, the CPI has averaged 2.1% a year over the past 3 years.

When inflation exceeds expectations and real interest rates are uncommonly low for several years running, this has distorting effects on economic activity. Since borrowing costs have been unexpectedly low and the returns to commodity investing have been unexpectedly high, it's not surprising that the mining and related sectors have been on fire, and commodity producers like Australia and Canada are at the top of their game. I wish I knew how much longer this will go on, but one thing is for sure: central banks are setting up the global economy for an inevitable and sharp correction in commodity prices and a return to rising borrowing costs.

More signs of improvement

2012-01-18T08:22:00.000-08:00

The U.S. economy continues to struggle with high unemployment, only moderate jobs growth, and an oppressive level of government spending and regulation, but the outlook is nevertheless improving, as several indicators released today show.

The most surprising news was the stronger-than-expected rise in the NAHB Housing Market Index of homebuilder sentiment. It was also gratifying to me since a year ago I predicted that by the end of last year the housing market would be showing signs of life, and my prediction for this year calls for continued gradual improvement. My sense of the market's sentiment is that most people see housing construction and prices either flat or down this year, so gradual improvement coming off a multi-year and extremely low bottom are quite a surprise. Today's index reading is the best we have seen in four and a half years. Sentiment can play an important role in the housing market, so the increasing signs of a bottom could create a "buy it now before the price goes up" mentality, especially since houses have never been more affordable than they are today.

This chart shows an index of new mortgage application activity. It's been choppy of late, but an uptrend from the lows of summer 2010 is in place I believe, and this is consistent with the rise in the homebuilders sentiment index (top chart) and the increase in construction activity in the past year.

December industrial production increased 0.4%, and production is up at a 4.8% annualized pace over the past six months. The charts above show how manufacturing production continues to improve, rising at a 5.2% annualized pace over the past six months and 4% over the past year. The manufacturing sector has yet to recover its pre-recession high, which is unfortunate, but progress is being made, and that's what is important on the margin.

See how your DNA works

2012-01-17T12:01:00.000-08:00

Time out from econ and finance for an amazing animation from Drew Berry that allows you to see how DNA works inside your cells. I can't figure out how to uncrop the video, so going directly to the TED talk might be your best approach.

Money demand is the key monetary variable

2012-01-17T11:29:00.000-08:00

The most remarkable development on the monetary front in recent years has been the unprecedented surge in money demand, as shown in this chart. (I'm measuring money demand as the ratio of M2 to nominal GDP.) Think of money demand as the ratio of your liquid, cash, readily spendable assets (M2) to your income (GDP). From the end of 2007 to the end of 2011, money demand surged by 21%: that is, the M2 money supply increased 21% more than nominal GDP.

Virtually all of the increased demand for money occurred in the savings deposit category (the largest component of M2), which increased by just over $2 trillion from Dec. '07 through Dec. '11. In general terms, and roughly speaking, households and firms increased their savings deposits relative to their incomes by $2 trillion over the past four years. It's not hard to understand why, either. The flight to cash and safety was driven by the recession that developed over the course 2008, the collapse of U.S. housing prices, and the near-collapse of the global financial system in late 2008. Then we had the Eurozone sovereign debt default scare which began last year and which threatened to create another global financial panic and economic collapse. In short, firms and households have been hit with one panic after another, and not surprisingly have become extremely risk-averse in the process. Nearly everyone has been setting aside cash and building up savings deposits for a rainy day.

The huge increase in money demand doesn't show up as an extraordinary increase in M2, however, as the two charts above suggest. M2 is growing a bit more than its long-term average (6% per year), and that outsized growth can be easily traced to the financial panic of 2008-2009 and the PIIGS default panic that hit last year. But the extra M2 growth has come at a time when nominal GDP has experienced a significant deceleration, which is why the ratio of M2 to GDP has increased so dramatically.

The Fed has had to accommodate this huge increase in risk aversion and money demand by hugely expanding bank reserves. Bank reserves have increased almost $1.5 trillion since the Lehman crisis hit, and most of those reserves sit on the Fed's balance sheet as excess reserves, parked there by banks that are also very risk averse and unwilling to make the massive loans that those reserves would ordinarily allow. If the Fed had not taken extraordinary action to expand the monetary base by $1.8 trillion ($1.5 trillion of new bank reserves plus $250 billion of new currency), today we would probably still be engulfed in the global depression and deflation that so many were expecting at the end of 2008.

What this all means is that there is approximately $2 trillion that has been set aside by households and firms for a rainy day. It's a massive dam of liquidity that has been held back by fear. Should that rainy day fail to materialize (e.g., should Eurozone defaults fail to plunge the global economy into a depression, and should the U.S. economy continue to slowly improve), then there is the potential for a $2 trillion flood of liquidity to released. It's not likely to happen overnight, but over the next several years we could see that liquidity being gradually shifted into more equity exposure, more consumption, and higher prices in general. And the key to that gigantic potential shift is money demand, which has been driven by fear. If and when fear fades and confidence in the future returns, there is huge potential for changes on a number of fronts.

More importantly, I believe this process is already getting underway, as shown in a variety of indicators: a significant pickup in Commercial & Industrial Loans (increased borrowing is the flip side of reduced demand for money), today's big increase in the Empire State Manufacturing Index, the 6.5% increase in retail sales over the past year, the reversal of euro basis swaps, the decline in weekly claims, the pickup in hiring, the decline in the Vix Index, the 24% increase in housing starts in the past 12 months, and the big increase in the Citi Economic Surprise Index, to name just a few.

New York Manufacturing Index very impressive

2012-01-17T09:25:00.000-08:00

I usually don't pay much attention to regional Fed manufacturing surveys, but today's Empire State survey caught my eye, and Mark Perry's comments were compelling. This chart shows the six-month outlook for general business conditions, and it has brightened significantly in the past two months, about on par with the improvement we saw just prior to the economy's emergence from the 2008-9 recession. Add this to the growing list of improving economic fundamentals in the U.S. economy, contrast that to the still-gloomy assumptions priced into equity markets and Treasury yields, and you begin to understand why the equity market is moving grudgingly higher, as I explained in greater detail last week.

Credit spread update

2012-01-17T09:05:00.000-08:00

Credit spreads are still elevated, as the top chart of 5-yr generic credit default swaps shows. In fact, today they are higher than they were at the beginning of the last recession. At the very least this reflects a market that is very concerned about the possibility of another recession, and any student of early warning indicators knows that spreads at this level are a classic sign of a recession that is either underway or just about to start. Normally I pay a lot of attention to the level of credit spreads, but now—and I hate to say "this time is different"—is one of those rare times when the signal deserves to be ignored.

The next two charts help explain why things are very different today. The first chart above shows spreads on 5-yr A1-rate industrial company bonds and 5-yr swap spreads (equivalent to AA bank credit risk). Swap spreads aren't particularly high, and aren't signaling any grave concerns, but industrial spreads are at or near levels that have preceded recessions in the past. The second chart above shows the components of industrial spreads: industrial yields and Treasury yields. What should be immediately obvious is that spreads have widened over the past year even as industrial yields have collapsed. It was very different in 2008, when spreads and yields soared at the same time. The key difference today is that Treasury yields are at all-time lows, driven by the world's desperate attempt to find a safe asset. Industrial companies have never had it so good—they've never been able to sell debt at yields below 2%. Firms are not being starved of credit, as usually happens when spreads widen; investors are eager to buy corporate paper because it yields almost twice as much as Treasury debt, which pays almost nothing.

In short, spreads are elevated not because corporate default risk is rising, but because Treasury yields have collapsed.

But couldn't the collapse in Treasury yields be the market's way of saying the end of the world is just around the corner, and that default risk is indeed therefore quite high? If you think that Eurozone defaults are imminent, that they will bring down the Eurozone financial system, and that in turn will precipitate a major global economic collapse and depression, then yes, you will interpret the current elevated level of credit spreads as a bad sign. But if you think a catastrophe can be averted, then spreads today are not a warning, they are an opportunity.

There's not much value in high-quality corporate bond yields, however, as the chart above shows. Earning a coupon of less than 2% on a high quality industrial bond is not going to make you rich, and the bond itself is subject to some price risk if Treasury yields ever move up from today's rock-bottom levels. High-yield (junk) debt is much more attractive, however, since yields are averaging a little over 8%. This gives you some decent protection against defaults and rising Treasury yields.

Who's afraid of S&P?

2012-01-13T10:52:00.000-08:00

S&P downgraded several European governments today. If anyone out there thought these governments were triple-A and bullet proof, they were surprised by the action. But for the vast majority of investors in the world, S&P was just playing catch-up. Anyone with money to manage and a brain has known for a long time that the risk of defaults in the Eurozone was rising, and they almost certainly took the appropriate measures to reduce their risk if they thought that was necessary. U.S. money market funds took their money out of French bank CP many months ago, for example.

Eurozone 2-yr swap spreads today fell to their lowest level in 2 months on the news, in a sign that S&P's decision was not only fully discounted but lagging, as usual, the facts on the ground. Swap spreads and euro basis swap spreads have been telling us for the past week or so that there has been some fundamental improvement in Eurozone liquidity conditions, and this is much more important than anything S&P might have to say.

If anything, the S&P announcement might be considered a positive, since it is equivalent to a public rebuke of governments that are reluctant to take the necessary steps to rein in spending.

The world's biggest hedge fund

2012-01-12T23:52:00.000-08:00

John Cochrane stole the words out of my mouth—I was planning to write something very similar, but he beat me to it:

The world's largest hedge fund paid $79.3 billion dollars to its main investor last year, as announced to the press and reported by the Wall Street Journal this morning.

It followed classic hedge-fund strategies. It's leveraged about 55 to 1, meaning that for every dollar of capital it borrows 55 dollars to fund 56 dollars of investments. Its borrowing is mainly overnight debt. It used that money to make aggressive bets in long-run government bonds, as well as strong speculative positions in mortgage-backed securities and direct distressed lending. Lately it's been putting bigger bets on loans to Europe and currency swaps. (Balance sheet here.)

The payout was actually conservative, as it reflected only the greater interest payments earned on its portfolio of assets and realized gains, not the substantial unrealized capital gains it made over the last year as long-term bond prices rose.

Who is this miraculous fund? Why our own Federal Reserve of course!

He is absolutely right, and I'll take this opportunity to elaborate. The Fed borrows money by paying for what it buys with bank reserves. The current interest rate on bank reserves is 0.25%, and the Fed decides what that interest rate will be. Imagine having a hedge fund that had virtually no limit on how much it could buy, was not subject to any regulatory scrutiny, and also had the power to determine the rate at which it borrowed money? What a deal. And by the way, this most fantastic hedge fund we call the Fed has already bought close to $3 trillion worth of assets, three times as much as it held in early September 2008. What could possibly go wrong? Unfortunately for those of us in the private sector, the Fed's profits come at our expense, and to the benefit of our government (the Fed hands over its profits to Treasury). And should the Fed end up on the wrong side of rising interest rates, the Fed's losses will be paid for with our taxes and via higher inflation.

At the very least, this is one reason that the world's investors are willing to pay $1700/oz. for gold, an amount that is more than three times the average inflation-adjusted cost of gold over the last century.

I'm not saying that a disaster awaits us, only that there are plenty of reasons these days for investors to be worried about what's going on. And that's why so many things are so cheap.

This helps explain the lack of jobs

2012-01-12T23:29:00.000-08:00

It takes a Hungarian to help us understand why the U.S. economy is not creating enough jobs. Bottom line: taxes are too high, regulations are too onerous, you can't fire anyone, it's easy for employees to sue you, the law favors employees over employers, those who skirt the law have the advantage, the press vilifies success, and the tax code punishes success and rewards slackers.

Read this rant, translated decently from Hungarian. HT: John Cochrane, whose recently-started blog is off to a great start. Excerpt:

I could hire 12 people with €760 net salary, but I don't. I'll tell you why. You could work for my service provider company in a nice office. It's not telemarketing, it's not a scam. You would do serious work that requires high skills, 8 hours a day, weekdays only. I would employ you legally, I would pay your taxes and social security. I could give such a job to a dozen people, but I will not, and here I'll explain why.

I wouldn't hire a woman.

The reason is very simple: women give birth to children. I don't have the right to ask if she wanted to. If I had the right, and she answered, she could deliberately deceive me or she could change her mind.

Don't get me wrong, I don't have any problem with women giving birth to children. That's how I was born and that's how my child was born. I wouldn't hire a woman because when she gets pregnant, she goes for 3 years maternity leave, during which I can't fire her. If she wants two children, the vacation is 6 years long.

Of course, work has to be done, so I would have to hire somebody who works instead of her while she is whiling away her long holiday years. But not only couldn't I fire her while she's away, I couldn't fire her when she comes back either. So I would have to fire the one who's been working instead of her the whole time. When a woman comes back from maternity leave, I would be legally forced to increase her salary to the present level in her position. Also, I would be required to give out her normal vacation days, that she accumulated during her maternity leave. When she finally comes back to work, she would start with 2-4 months of fully paid vacation.

Federal finances update

2012-01-12T12:43:00.000-08:00

With today's release of December federal budget numbers comes good news and bad news. The good news is that federal spending is not growing very much and is shrinking relative to GDP. The bad news is that revenue growth has also slowed, and the deficit continues to be well north of $1 trillion per year.

Since the end of the last recession, federal spending (on a rolling 12-mo. basis) has increased only 4.1%. Revenues, in contrast, have increased 6.8%. Both have slowed down in the past six months.

In relation to GDP, spending has declined from a peak of 25.3% in Sep. '09, to 23.3% as of last month, by my estimates. Revenues have increased from a low of 14.5% in Mar. '10 to 15.1% as of last month.

As a result, the deficit relative to GDP has declined from a high of 10.4% in Dec. '09 to 8.1% as of last month. On a nominal basis, the 12-mo. deficit has fallen from a peak of $1.48 trillion in Feb. '10, to a current $1.25 trillion. If current trends continue, the deficit is likely to continue to decline—albeit slowly—relative to GDP. It will likely remain very high for the foreseeable future, but at least it is going to be less than the 9% which studies have shown is the critical level above which deficit-financed spending can lead to a weaker and weaker economy and an unstable outlook.

This chart shows federal debt outstanding owed to the public, which is a better measure than the oft-cited total federal debt which has now reached $15.2 trillion, almost the size of current GDP (which I estimate was about $15.4 trillion at the end of last year). That's because total debt includes about $4.8 trillion which is "owed" to social security; debt that the government owes to itself is not the same thing as debt that is owed to someone else—it's just an accounting fiction. The last datapoint in the chart is my estimate of what the true federal debt will be at the end of this year, based on current trends in spending and revenues. In the four years ending Dec. '12, I project that the federal debt will have increased by $5.47 trillion, or 86%, to $11.8 trillion. Federal government debt will have almost doubled in just four years. The only good thing that can be said about this is that the rate of growth in the debt is declining, albeit only slowly.

Retail sales remain strong

2012-01-12T10:17:00.000-08:00

December retail sales were lower than expected, but hiccups like that are to be expected every now and then in this series. The bigger picture is still one of recovery, as the chart above shows. Adjusted for inflation, retail sales are up 3.9% in the past year, and have almost returned to their pre-recession highs, despite the fact that 6 million fewer people are working today than were at the peak. That's pretty impressive, and a sign of rising incomes, increased confidence, and strong productivity gains.

Labor market update

2012-01-12T09:46:00.000-08:00

Weekly unemployment claims last week were higher than expected (399K vs. 375K), but the miss was well within the range of error at this time of the year, when claims always post their biggest increases and seasonal adjustments can be tricky. As the chart above shows, the 4-week average of claims is still firmly within a declining trend.

December claims represented only 0.28% of payrolls, a level that was better than most of the go-go years of the 80s. Employers are firing fewer and fewer people, which suggests that businesses have undergone most of the restructuring and cost-cutting needed to survive. The jobs market is thus less vulnerable to future disruptions.

The number of people receiving unemployment insurance always rises at this time of the year, but relative to the same time last year, the number is down 18%, or 1.5 million people. This is undeniable progress, even though the ranks of the unemployed are still extremely high.

More improvement in eurozone financial markets

2012-01-12T09:30:00.000-08:00

As a follow-up to yesterday's post, I note that euro basis swaps and swap spreads continue to improve, and in rather convincing fashion. Liquidity conditions in the Eurozone financial markets are improving, and although this doesn't necessarily lessen the risk that one or more sovereign defaults will occur, it means that the impact of any eventual defaults will be less severe than markets had come to fear. As liquidity returns, the risk of catastrophic defaults or financial meltdowns has declined measurably.

Not surprisingly, Spain and Italy today had successful bond auctions that resulted in a significant decline in yields. With the exception of Greece, where 2-yr yields have soared to 170%, 2-yr yields in Portugal, Ireland, Italy and Spain haven't been this low for many months; Irish yields are back down to levels not seen since last February. With improved liquidity comes improved confidence, and with improved confidence, markets can function more normally and economic growth is less likely to suffer. All very positive developments.

European liquidity conditions appear to be improving

2012-01-11T15:30:00.000-08:00

This may be somewhat esoteric for many readers, but the discussion here focuses on key indicators of Eurozone liquidity conditions which appear to be improving. If that is indeed the case, then systemic risk is declining and the likelihood of a Eurozone-led catastrophe may be lessening. Nevertheless, it remains the case that the fundamental problem facing the Eurozone—bloated government spending against a backdrop of struggling economies—has not been addressed, so what improvement we see here is unlikely to be definitive, and only partial (i.e., access to dollars is normalizing, but default risk remains).

This chart compares 2-yr Eurozone swap spreads (a measure of systemic risk and bank counterparty risk) with the cost that Eurozone banks must pay to access dollar liquidity (the Euro Basis Swap).

According to Macrostory, the Euro Basis Swap is "a derivative product that allows the holder in the case of a Euro swap the ability to swap EUR for US dollars. In simplest terms the more negative the value the greater the demand for USD." (HT: Mike Churchill) The rise in the blue line (note that the y-axis represents negative values) in the above chart illustrates how difficult it became for Eurozone banks to acquire dollar liquidity beginning in August. As my friend Brian McCarthy explains, one reason for this is that US-based money market funds have all but eliminated their holdings of French bank commercial paper. This entailed the repatriation of dollars, which left the Eurozone market very short of dollars, and it coincides with the Euro's weakness against the dollar since last August. In a more generic sense, it reflects the increased reluctance of U.S. investors to lend to the Eurozone financial community.

Swap spreads rise when banks and large institutional investors are reluctant to take on counterparty risk, and that usually happens when there is increasing stress on an economy and/or financial markets, since that means more default risk to any lending activity. In the case of the Eurozone, swap spreads have risen in lockstep with the increased risk over the past six months or so that one or more of the PIIGS will end up defaulting, since such an event increases the likelihood of widespread Eurozone bank failures and/or a financial market meltdown.

I note that the two variables are highly correlated over this period, and I also note a slight tendency for the basis swap to lead swap spreads. I don't know if this relationship is likely to hold, but it does suggest that the pronounced decline in the basis swap in the past week or so could be foreshadowing a welcome reduction in Eurozone systemic risk. That, in turn, could be the result of the Fed's new-found willingness to open swap lines with Eurozone banks, and also the result of the ECB's recent attempt to ease financial stress by offering in late December an almost unlimited amount of long-term financing (LTRO) to Eurozone banks, with an expanded list of collateral options.

All of this would help explain the significant decline in Italian and Spanish 2-yr yields (see chart of Spanish 2-yr yields above), in the past several weeks.

In short, the ECB and the Fed have been working hard to apply what might be termed by skeptics as "band-aid" solutions to the sovereign debt crisis, and the evolution of basis swaps and swap spreads noted above is evidence that their efforts have had some traction. At the very least this provides more time for the market to sort out and adjust to the fundamental risk presented by countries like Greece and Italy that have spent and borrowed more than they can easily repay. This doesn't mean that defaults are less likely, but it does suggest that they may be more easily absorbed by the market, and thus that the consequences of a PIIGS default might not be as catastrophic as the market has been fearing. And, as I noted yesterday, that brightens the outlook for risk assets in general.

Climbing walls of worry: update

2012-01-10T12:49:00.000-08:00

There are two ways of looking at the upward progress of equity prices since last summer. For optimists, who see the glass as half full, the market is gradually shedding some of the panic that gripped the world when the risk of Eurozone sovereign debt defaults started to look inevitable. For pessimists, who see the glass as half empty, the market is once again levitating on the fumes of optimism, poised to crash once again as the global economy collapses in the wake of Eurozone defaults (or the second down leg of the US real estate market, or the collapse of the Chinese economy—or all three, take your pick). I'm in the optimists' camp, of course, because as I have been pointing out repeatedly there is plenty of evidence that the market is priced to some dire expectations. Like all true bull markets, this one has been climbing walls of worry for most of the past three years. This is not a market driven by optimism, it's a market that has had to overcome several major bouts of fear and trembling in recent years, and it's still plenty worried about the future.

To begin with, this chart shows how the level of unemployment claims—a proxy for the underlying health of businesses—has been leading the equity market higher. Businesses are firing fewer and fewer people because they have cut costs to the bone, leaving them well-prepared to cope with any future adversity. You can't have a legitimate rally if the fundamentals are not improving.

The Vix index, which measures how much investors are willing to pay to reduce their risk (because it reflects the cost of owning options, which is less risky than owning the assets underlying the options), is a good proxy for the market's level of fear. As the above chart shows, major selloffs in equity prices have typically been driven by increased fear, and rallies by decreased fear.

But even though the Vix has dropped significantly from last summer's peak, it is still elevated from an historical perspective. Plus, 10-yr Treasury yields, which are a good proxy for the market's expectation for long-term economic growth, are still trading at extremely low levels—lower even than at the end of 2008 or during the depths of the Depression. The combination of the two, shown in the chart above, reflects a market that is still somewhat fearful, while having given up almost all hope for a return to decent economic conditions. Call it fearful despair. Moreover, there is still plenty of room for fear and despair to fade away, before we might say that the market has become priced to something resembling optimism.

As the first chart above shows, the PE ratio of U.S. stocks is still at very depressed levels. That PE ratios can be substantially below their long-term average at a time when corporate profits are booming (after-tax corporate profits are now at record levels both nominally and in terms of GDP) can only mean that the market is priced to the expectation that profits will collapse in coming years.

In conclusion, the market is still priced to very pessimistic assumptions about the future. What this means for investors is that lots of very bad and terrible things would have to happen to undermine the current level of valuations. If the world can just avoid another calamity, then risk asset prices can continue to rise.

The U.S./Eurozone decoupling continues

2012-01-10T10:06:00.000-08:00

With 2-yr swap spreads as a proxy for systemic risk, we see that conditions in the Eurozone have been deteriorating for the past two years, and especially since last July, thanks primarily to the growing risk of sovereign debt defaults in the PIIGS countries. Meanwhile, investors have been terrified that defaults in the Eurozone could lead to another global banking crisis and a global economic collapse. Those fears have depressed equity prices and economies everywhere, even as corporate profits have been very strong. But markets can only worry so long about the end of the world being right around the corner.

Despite all the fears, the U.S. equity market has diverged significantly from Eurozone equities. The two charts above compare the S&P 500 index to the Euro Stoxx index, and here we see a significant divergence between the two starting in August of 2010. Since that time, U.S. equities have outperformed Eurozone equities by over 30%. This is a major difference between two huge players on the global stage. We've seen divergences of this magnitude before, but as the top chart shows, this is the first time that the Eurozone has underperformed the U.S. Whatever is happening in Europe is increasingly being contained in Europe.

I think this fits with my thesis that Eurozone sovereign debt defaults are not likely to be as destructive to the world as the market has feared. By staging a major divergence, equity markets are slowly coming to that realization. The impact of the Eurozone debt crisis has already hit the Eurozone economy: it doesn't take a default to cause a loss, because the market has already priced in defaults of $1 trillion, and because the money that the PIIGS borrowed was squandered long ago on unproductive activities that sapped the underlying strength of the Eurozone economy. All the losses are water under the bridge. Europe is foolishly trying to postpone the recognition of this reality, when it should instead be wiping the debt slate clean, recapitalizing its banks, and shrinking the size of its bureaucracy. While Europe dithers, the U.S. economy moves slowly ahead.

This is not to say that the U.S. is golden, of course. We have our own debt binge to worry about, with the federal government having borrowed $5 trillion in the past three years. That's an awful waste of money, but our debt/GDP ratio is still within the range of being payable, and we don't have the problem that Greece has of owing money in a currency we can't control. I believe the U.S. economy would be a lot stronger today if we had spent and borrowed less, because like the Greeks, much of what we have borrowed was spent on unproductive activities (e.g., transfer payments). At the same time, our federal debt was not concentrated in our banks, the way it was in the Eurozone.

Meanwhile, believe it or not, federal spending as a % of GDP has declined meaningfully in the past three years, thanks to a dramatic decline in the growth of spending. Amidst all the bad news there are some tidbits of good news to be found in the U.S.

Predictions for 2012 (bumped)

2012-01-09T10:13:00.000-08:00

(For some reason my post on this subject showed up as having been made last Friday. I'm reposting it here so it won't get lost in the shuffle.)

As detailed here, the biggest source of error in my predictions for 2011 was my belief that the economy would be somewhat stronger than expected, and that this, coupled with higher-than-expected inflation, would force the Fed to raise interest rates sooner than the market expected. I got the inflation part right, but the economy proved weaker than both I and the market expected. That in turn prompted the Fed to promise very low rates for a very long time, thereby collapsing interest rates across the maturity spectrum. The weak economy coupled with the Fed's extreme measures to resuscitate it, plus the growing likelihood of sizable sovereign debt defaults in the Eurozone, helped convince the market that the situation was dire. So now the key question, from the market's perspective, is whether the economy can avoid a calamity.

I say this because I observe that the market today is even more fearful about the future than it was a year ago. I see that in 2-yr Treasury yields of 0.25%, which say that the market fully expects the Fed funds rate to be extremely low for at least the next two years; that is likely to happen only if the economy remains in miserable shape and inflation remains relatively low. I see it in 10-yr Treasury yields, which are as low as they were in the depths of the Depression, and lower even than they were at the end of 2008, when panic reigned. I see it in equity PE multiples that are only marginally higher than they were at the end of 2008, when the market was priced to a global depression and years of deflation. Equity multiples have declined over the past two years even as corporate profits have soared to all-time highs; the only way this makes sense is to assume that the market believes growth will be abysmal and profits will collapse in coming years. I see fear in credit spreads that are as high or higher than they have been prior to previous recessions. I see tremendous uncertainty in gold prices that have risen by a factor of 6.5 over the past 10 years, a sure sign that investors have lost almost all confidence in the ability of the global economy to grow, and in the ability of central banks to successfully negotiate the current financial straits without something spinning out of control. Finally, I note that the Vix index (implied equity volatility) continues to reflect an above-average level of risk-aversion.

I do see some light at the end of this gloomy tunnel, however, and I expect it will brighten over the course of the year as the presidential elections focus the country's attention on what has caused our economic funk and how best to get out of it. If there is any good that has come out of the trillions of dollars of wasteful government spending in the past several years, it is the growing realization that government spending can not stimulate the economy, and only does more harm than good, by squandering precious resources and promoting crony capitalism. It's been a very expensive lesson in how Keynesian economics not only doesn't work but doesn't make sense to begin with. Bureaucrats cannot spend money more efficiently than the people who earn the money, and politicians cannot make better investment decisions than private enterprise. Industrial policy has never worked anywhere, and we see multiple examples of its failure almost every day in the headlines (e.g., Solyndra).

I believe the elections this year will reaffirm the message of the 2010 elections: the electorate wants less government, not more; lower and flatter taxes, not higher; a simpler tax code, not more complexity. The changes might not be dramatic or immediate, but the political winds are blowing to the right, and over time this will push policies in a direction that will be more favorable/less destructive to growth. I believe that government spending can be throttled back without harming the economy; indeed, I think that a reduction in the size of government can actually boost economic growth, because it means that the market and the private sector will regain a measure of control over the decisions of how best to utilize the economy's scarce resources.

I see important signs that the economy has undergone substantial adjustments that now pave the wave for continued growth: businesses are firing fewer and fewer people since they have already cut costs to the bone; productivity and profits have improved measurably; jobs have been growing for almost two years; housing prices have reversed all of their previous excess; residential construction is beginning to come back to life; banks are once again lending, and at a faster pace; the Fed has ensured that there is no shortage of money; business investment is on the rise. Left to its own devices, and given enough time to adjust to adversity, the U.S. economy is perfectly capable of growing—and that is what is happening now. No reason this can't continue.

One key assumption I'm making is that sovereign debt defaults in Europe—which appear quite likely to happen—are not likely to be as destructive to growth as the market assumes. (Imagine the boom in risk asset prices if the Eurozone sovereign debt crisis were to disappear overnight, and you understand what a pall this has cast over all markets.) I've explained why defaults shouldn't be catastrophic here, but the short answer is that debt defaults don't destroy demand or productive capacity, and they are better thought of as a zero-sum game in which wealth is transferred from creditors to defaulting debtors. Many banks may fail as a result of major defaults, but banks can be replaced and/or recapitalized, and there is no shortage of capital in the world to do so. The losses that are eventually confirmed by a default have, in an economic sense, already occurred—they are water under the bridge. Defaults will also dictate that bloated Eurozone governments have no choice but to change their ways, and that will improve the prospects for future growth. They also will likely help the U.S. understand that we cannot continue with our spend-and-borrow ways.

I am not a huge optimist about the prospects for U.S. economic growth over the course of this coming year, because I see important headwinds to growth continuing: bloated government spending which appropriates the economy's scarce resources for inefficient and unproductive ends; the promise of higher tax burdens implicit in the soaring federal debt; huge regulatory burdens; and tremendous uncertainty surrounding the long-term implications of the Federal Reserve's massively bloated balance sheet. In short, I think the economy is growing despite all the supposed "help" from fiscal and monetary policy stimulus. I think that's because the U.S. economy is inherently dynamic and most people have a strong desire to work hard and get ahead. If the economy grows only 3-4% this year, I think the market will be pleasantly surprised, even though 3-4% growth won't result in any meaningful decline in the unemployment rate. Even modest growth would be much better than what the market is currently expecting, and that makes me an optimist in a relative sense because the market is so clearly pessimistic.

So, having outlined my assumptions—which are the key to any forecast—here goes:

The economy will grow by 3-4% in 2012, and if there is a surprise it will be on the high side. I think this is a safe prediction, since jobs currently are growing at a 1.7% annualized pace, and the productivity of the average worker tends to average about 2% a year. Growth could pick up towards the end of the year if the market gains confidence that fiscal policy will be more conducive to growth in the future, and that Eurozone defaults are not likely to deal a lethal blow to the global economy.

Inflation will moderate in the first half of the year, but will be roughly unchanged or somewhat higher by the end of the year.

The Fed will not engage in another round of quantitative easing because it will not be necessary or justifiable. If the economy grows 3-4%, inflation doesn't collapse, and Eurozone defaults don't bring about the end of the world as we know it, the Fed will be hard-pressed to justify another round of QE no matter what form it might take. Before the year is out, I think the issue of how to unwind previous quantitative easings will be more important than whether we need another round of quantitative easing.

Interest rates are likely to rise across the board as the outlook for growth improves. It is inconceivable to me that any improvement in the long-term outlook for the economy would not be accompanied by higher interest rates.

The housing market is likely to improve gradually over the course of the year. I think this is a process that is already underway, but it's very gradual. Residential construction is slowly improving, and although housing prices have yet to make a definitive bottom, I think we'll see more evidence of one as the year progresses.

MBS spreads are likely to widen over the course of the year. (I'm repeating last year's forecast here.) The main impetus for wider MBS spreads next year is likely to come from an across-the-board increase in the extension risk of MBS as Treasury yields rise. Mortgages, which currently behave like intermediate-maturity bonds, are at risk of becoming long-term bonds as interest rates rise and refinancing dries up.
Equity prices are likely to rise by 10-15%. Even if, as I suspect, the growth in corporate profits slows down, there is plenty of room for an expansion of equity multiples driven by improving confidence/receding fears.

Investment grade, junk, and emerging market bonds are likely to deliver decent returns. If Treasury yields rise, it will be because the economic outlook is improving, and that will mean lower default rates. Thus there is plenty of room for credit spreads to contract if Treasuries run into trouble. Even if we remain in a muddle-through scenarios, spreads—particularly of the high-yield variety—are generous and offer a substantial cushion against defaults.

Commodity prices are likely to rise. This follows from my belief that activity is severely depressed by fears of a sovereign debt crisis, and that these fears should dissipate or prove exaggerated. It also is a bow to the very accommodative nature of monetary policy around the world.

Emerging market economies are likely to improve.

Gold prices are likely to be very volatile, with the potential for a major decline. I think gold has already priced in the expectation of so many bad things (e.g., a big increase in inflation, a global depression, collapsing currencies) that any improvement in the outlook should convince investors that equities and corporate bonds offer much more attractive long-term returns than gold.

The dollar is likely to rise as the prospects for the U.S. economy improve relative to other developed economies. The dollar is still quite weak against most currencies from an historical and inflation-adjusted perspective.

Cash and Treasuries will likely be very poor investments.

Quotes of the day

2012-01-08T09:41:00.000-08:00

Chip Mellor, chief of the Institute for Justice, commenting on campaign finance laws in today's WSJ:

There continues to be the false premise that the problem in politics is too much money, when in fact the problem is too much government for sale ... these campaign finance laws are really treating only a symptom, not the disease. Until you get to the root cause, which is too much government, you are really not doing anything productive and in many cases you are doing harm.

George Will, writing in Government: The redistributionist behemoth:

Liberals have a rendezvous with regret. Their largest achievement is today’s redistributionist government. But such government is inherently regressive: It tends to distribute power and money to the strong, including itself.

Government becomes big by having big ambitions for supplanting markets as society’s primary allocator of wealth and opportunity. Therefore it becomes a magnet for factions muscular enough, in money or numbers or both, to bend government to their advantage.

When taxes are levied not to efficiently fund government but to impose this or that notion of distributive justice, remember: Taxes are always coerced contributions to government, which is always the first, and often the principal, beneficiary of them.

... when government engages in redistribution in order to maximize the happiness of citizens who become more envious as they become more comfortable, government becomes increasingly frenzied and futile.

Proof the housing price bubble has burst

2012-01-07T23:16:00.000-08:00

In the process of updating some older charts, I stumbled across this gem, and couldn't resist posting it. It shows the inflation-adjusted price of existing single-family homes, and very clearly depicts the "bubble" in housing prices which began around 1997 (when Clinton cut the capital gains tax on home appreciation), and the deflating of that bubble which is now complete, with prices having fallen fully 39%—in real terms—from their 2005 high.

But maybe you think that prices will have to go all the way back to 1968 levels, in which case there is still another 20% decline waiting in the wings.

As a counter to that, I would note that mortgage rates today are lower than they were in 1968, and real personal incomes have increased 250% since then. Do housing prices really need to decline further? I seriously doubt it—prices are incredibly cheap by almost any measure you care to come up with. The bubble has popped, and it's time to think about how much it might inflate again.

Bank lending accelerates

2012-01-07T12:16:00.000-08:00

Commercial & Industrial Loans are a good proxy for bank lending to small and medium-size businesses, the kind that aren't big enough to access the credit markets directly through bond issuance. Contrary to popular belief (i.e., "banks aren't lending" despite all the reserves they have on tap at the Fed), bank lending has been picking up ever since hitting a low in September 2010. Since then, banks have increased their outstanding loans to businesses by $140 billion, with loans growing at a 13.8% annualized pace over the past three months, and at a 12.5% annualized pace over the past six months. This is a very positive development, not because bank lending per se creates new money or increases demand, but because it reflects increased optimism on the part of banks and businesses—banks are more willing to lend, and businesses are more willing to borrow.

Predictions for 2012

2012-01-06T12:51:00.000-08:00

As detailed here, the biggest source of error in my predictions for 2011 was my belief that the economy would be somewhat stronger than expected, and that this, coupled with higher-than-expected inflation, would force the Fed to raise interest rates sooner than the market expected. I got the inflation part right, but the economy proved weaker than both I and the market expected. That in turn prompted the Fed to promise very low rates for a very long time, thereby collapsing interest rates across the maturity spectrum. The weak economy coupled with the Fed's extreme measures to resuscitate it, plus the growing likelihood of sizable sovereign debt defaults in the Eurozone, helped convince the market that the situation was dire. So now the key question, from the market's perspective, is whether the economy can avoid a calamity.

I say this because I observe that the market today is even more fearful about the future than it was a year ago. I see that in 2-yr Treasury yields of 0.25%, which say that the market fully expects the Fed funds rate to be extremely low for at least the next two years; that is likely to happen only if the economy remains in miserable shape and inflation remains relatively low. I see it in 10-yr Treasury yields, which are as low as they were in the depths of the Depression, and lower even than they were at the end of 2008, when panic reigned. I see it in equity PE multiples that are only marginally higher than they were at the end of 2008, when the market was priced to a global depression and years of deflation. Equity multiples have declined over the past two years even as corporate profits have soared to all-time highs; the only way this makes sense is to assume that the market believes growth will be abysmal and profits will collapse in coming years. I see fear in credit spreads that are as high or higher than they have been prior to previous recessions. I see tremendous uncertainty in gold prices that have risen by a factor of 6.5 over the past 10 years, a sure sign that investors have lost almost all confidence in the ability of the global economy to grow, and in the ability of central banks to successfully negotiate the current financial straits without something spinning out of control. Finally, I note that the Vix index (implied equity volatility) continues to reflect an above-average level of risk-aversion.

I do see some light at the end of this gloomy tunnel, however, and I expect it will brighten over the course of the year as the presidential elections focus the country's attention on what has caused our economic funk and how best to get out of it. If there is any good that has come out of the trillions of dollars of wasteful government spending in the past several years, it is the growing realization that government spending can not stimulate the economy, and only does more harm than good, by squandering precious resources and promoting crony capitalism. It's been a very expensive lesson in how Keynesian economics not only doesn't work but doesn't make sense to begin with. Bureaucrats cannot spend money more efficiently than the people who earn the money, and politicians cannot make better investment decisions than private enterprise. Industrial policy has never worked anywhere, and we see multiple examples of its failure almost every day in the headlines (e.g., Solyndra).

5 million discouraged workers

2012-01-06T11:58:00.000-08:00

The market is not impressed with the bigger-than-expected December jobs gain and the decline in the unemployment rate. The decline in the unemployment rate is indeed overstating the health of the labor market (see below for details), but I think the market is not fully appreciating the significance of the growth in jobs.

The decline in the unemployment rate has been driven not so much by the growth of jobs as it has been by the decline in the labor force. As the top chart shows, more than 5 million people appear to have dropped out of the labor force, so discouraged about their job prospects that they have given up looking and are thus no longer counted in the labor force. As the two top charts show, the labor force for many years has grown about 1% a year, but beginning in 2009, growth ground to a halt. The bottom chart shows the labor force participation rate—the proportion of the population that is in the labor force—and it has dropped two percentage points since 2009. 2% of the 322 million U.S. population equates to about 6 million people, confirming the implication of the top chart. If you added 5-6 million people back into the labor force (as unemployed looking for jobs), the unemployment rate would be 11-12%. Something happened starting in 2009 that resulted in many millions of people deciding to "drop out" of the labor force; the only question at this point is whether they have permanently given up or whether they could be enticed to return. In the meantime, they have been the cause of the sizable decline in the unemployment rate, rendering it fairly meaningless as an indicator of improving economic health.

But: the jobs gains we have seen in the past two years are a legitimate indicator of a slowly but steadily improving economy. The most important thing is not the level of employment, or the participation rate, but the change in employment on the margin, and that is decently positive. As I mentioned in the previous post, both the household and the establishment surveys are registering similar rates of growth (1.7% annualized, or about 160K per month on average), and that has been the case for several months now. These jobs may be "low quality" jobs, but they are still jobs.

The economy is growing and things are improving, even though we would probably be doing much better by now if it weren't for the huge increase in government spending since 2008 (which wastes the economy's scarce resources), the huge increase in regulatory burdens (which make it more difficult and expensive to start and run a business), the huge increase in the deficit (which increases the expected burden of taxation), and the Fed's massive increase in the monetary base (which creates tremendous uncertainty about the future of monetary policy and the stability of the dollar).

A decent jobs report

2012-01-06T08:10:00.000-08:00

As the top chart shows, both the household and establishment surveys of jobs are telling the same story: the number of jobs continues to expand at a fairly steady pace. The unemployment rate is still very high (it would be higher still if millions of discouraged workers had not given up looking for a job), and economic growth is sluggish, but nevertheless, a little more than 3 million private sector jobs have been created in the past two years. Moreover, as with a lot of recent data releases, there is no sign in today's report of any emerging weakness.

The pace of job creation is not a strong as it should be to keep pace with the growth of the working age population and reabsorb those laid off in the past, but the economy is creating private sector jobs at about a 1.7% annualized pace, which translates into roughly 160K new jobs per month. December was a bit stronger than that, with 212K new jobs reported—more than the 178K expected, but not as much as the 325K new jobs found in the ADP survey reported yesterday. At this rate of job creation, the economy is perfectly capable of growing at a 3-4% pace (~1.7% growth in jobs plus ~2% growth in productivity).

It is encouraging to see that the public sector workforce continues to shrink, since it had grown much more than the private sector over the past decade. It's also comforting to see that growth in government spending has slowed to a crawl (up only 2.7% in the past year), as that has resulted in some important shrinkage in the size of government relative to the economy. As the public sector continues shrinking its body count and its spending relative to GDP, this returns resources to the more productive private sector and should allow stronger overall growth in the future.

2011 review

2012-01-05T14:24:00.000-08:00

My predictions for last year produced mixed results (7 out of 12 right or mixed, and 5 out of 12 wrong), but on balance they were handsomely rewarded from an investor's perspective.

The economy will grow by 4% or more in 2011. Wrong. Through the third quarter of 2011, real GDP grew at an annualized 1.2% pace, and given current expectations for growth in the fourth quarter, the year-end tally will probably be 1.7%. One reason for the shortfall in growth was the Japanese tsunami, of course, which disrupted economies all over the world. The biggest reason, however, was the flareup of concerns over sovereign debt defaults in the Eurozone, a prospect that sent tremors through global financial markets and capital fleeing to the safety of Treasuries. The tsunami was an act of God, but sovereign debt problems were well known at the end of 2010, so I can't claim to have been blindsided by that—I simply didn't think the situation would escalate to the degree it did.

Inflation will trend slowly higher. Right. All measures of inflation moved higher over the course of the year. On a year-over-year basis, the CPI rose from 1.5% to 3.4%; the PCE deflator rose from 1.4% to 2.5%; and the GDP deflator rose from 1.6% to 2.4%. A popular inflation-adjusted bond portfolio (TIP) enjoyed a total return of 13.2%.

The Fed will raise rates sooner than the market expects. Wrong. For the past three years I have consistently underestimated the Fed's willingness to embrace monetary ease, and at the same time I have underestimated the world's demand for dollar liquidity. In retrospect, I would say that the Fed did the right thing by keeping rates low and pursuing quantitative easing, even though I thought they were making a mistake by doing so. This is one mistake I'm not too sorry to have made, even though it led me to be too optimistic regarding the potential returns to equity investing.

The housing market will be showing signs of life by the end of the year. Right. Housing starts turned up over the course of the year, rising some 30% from their year-end 2010 level. Activity remains extremely depressed, of course, but on the margin construction activity is definitely improving. Moreover, the decline in housing prices has slowed overall, and in some areas prices appear to be firming.

Interest rates on Treasury bills, notes and bonds would be higher than the market expects. Wrong. This prediction was driven by my Fed and GDP forecasts, which were also wrong. Treasury yields fell to levels not seen since the Great Depression, as weak growth and fears of a Eurozone financial collapse drove safe-haven demand to unprecedented levels and convinced the Fed that they needed to pursue an aggressively accommodative policy. A diversified portfolio of Treasury Notes and Bonds returned 9.8% last year.

MBS spreads are likely to widen over the course of the year. Right (but for the wrong reason). I thought that mortgage rates would be driven higher as Treasury yields rose, but as it turned out mortgage rates fell by less than Treasury yields. However, as I suspected they would, mortgages delivered a decent return of 6.1% for the year despite wider spreads.

Credit spreads are likely to decline gradually over the course of the year. Wrong. Credit spreads widened mainly because Treasury yields collapsed, and also because of fears of a Eurozone-sparked financial crisis that could lead to a global slump. Despite wider spreads, however, corporate bonds were a profitable investment. Investment grade bonds returned 7.5% for the year, while high-yield debt returned 4.4%. One popular high-yield fund (HYG) enjoyed a 6.7% return.

Equity prices are likely to register gains of 10-15% next year. Wrong (but not terribly). The S&P 500 produced a total return of 2%, the Dow 8.4%, and the NASDAQ -0.8%. However, Apple, my favorite and highly recommended stock, posted an impressive return of 26% last year.

Commodity prices will continue to work their way higher over the course of the year. Mixed. The CRB Spot Index of non-energy commodities fell by 7.4% last year, but oil prices rose by 8.2%.

Emerging market economies are likely to do somewhat better than industrialized economies. Mixed. On average, emerging market economies grew by more than industrialized economies (China, for example, most likely grew by at least 8%), but due to declining commodity prices and fears that a Eurozone financial collapse could prove highly contagious, emerging market equities suffered. On the other hand, according to JP Morgan, emerging market debt delivered a return of 8.1%.

Gold will probably move higher. Right. Gold prices rose 10% last year, but along the way they suffered a 20% correction. This reinforced my belief that the potential volatility of gold prices was very high, making gold an extremely speculative investment.

The dollar is likely to move higher against most major currencies, and hold relatively steady against emerging market and commodity currencies. Mixed. Against a basket of major currencies, the dollar rose by 1.5% last year. It rose against the Euro and the Canadian dollar, was basically flat against the pound and the Aussie dollar, and fell by 5% against the yen. Meanwhile, the dollar rose against most emerging market currencies.

On an absolute return basis, a portfolio holding almost any reasonable mix of long positions in dollar-denominated equities, commodities, corporate, high-yield, and emerging market bonds, mortgages, and TIPS—all consistent with my forecasts—would have enjoyed a return substantially in excess of the return on cash. Avoiding cash, in other words, was a very rewarding experience. Despite my mixed forecast record, I don't feel bad at all about the results.

Service sector steady as she goes

2012-01-05T08:55:00.000-08:00

The December ISM service sector survey was lackluster, in that it showed no unexpected strength. But neither did it show any unexpected weakness. On balance, it was consistent with an economy that is growing at a modest-to-moderate pace, and that is something that we already knew. If there is optimism to be found here, it is that to date there is no sign of the much-anticipated double-dip recession that many, most notably the folks at ECRI, have been calling for.

The prices paid survey continues to show that a majority of businesses are paying higher prices. Inflation is alive and well—albeit still relatively muted—and deflation remains a distant memory.

The employment index shows no meaningful improvement in hiring activity, and that is about what you would expect from an economy that is growing at a 3% rate.

The good news from this survey is that there was no bad news. That may not sound very impressive, but I think it is, since I believe that the market continues to be priced for disappointing news. When the market expects deterioration, the simple absence of deterioration becomes bullish.

The labor market continues to improve

2012-01-05T08:42:00.000-08:00

Weekly claims for unemployment continue to decline, and the improvement in the past three years has been impressive, as the first chart shows, with claims falling from a high of 659K to 372K—a decline of 44%. The current recovery to date has been notable for its dearth of new jobs, to be sure, but the significant reduction in firings that shows up on this chart is strong evidence that businesses have undergone tremendous adjustments in order to adapt to new economic realities. The economy may not be growing very fast, but it remains very dynamic and adaptable, and that alone is reason to remain optimistic about the future.

This second chart shows the non-seasonally adjusted number of people receiving unemployment insurance benefits. It normally moves up around the end of each year, but today the number of people "on the dole" is 15% less than at the same time last year: 1.15 million fewer people are receiving unemployment benefits, and that is a very healthy trend. It may be politically incorrect to say this, but Congress' willingness to extend and extend unemployment benefits in recent years (via "emergency claims," a move without precedent in modern times) has undoubtedly contributed to the weak nature of this recovery. A person who is paid to not work has much less incentive to find and accept a job than one who is not paid.

The Challenger survey of announced corporate layoffs shows that the corporate world was quick to make some big adjustments—layoffs have been unusually low for the past two years. (The bulge last September was caused by planned troop reductions.) It also shows that the corporate world has not run into any unexpected difficulties, and that businesses in general are structured in a very "lean and mean" fashion. This has undoubtedly contributed to record levels of corporate profits, and it means there is plenty of room for corporations to expand hiring activities if the economic outlook improves. On that score, Washington holds some critical keys in the form of spending and tax policy. If spending can be cut back and corporate tax rates can be made more competitive, we could see some dramatic improvement on the new jobs front over the next few years.

Today's ADP estimate of December private sector jobs growth was so much higher than expected (372K vs. 206K) that most observers suspect it was a fluke caused by seasonal factors which can be difficult to get right at year end. But even if the reality is less than the ADP estimate, it is still likely that there was some substantial improvement in December relative to November. This holds out the promise for an upside surprise in Friday's jobs number, currently expected to show a gain of 175K private sector jobs.

Overall, lots of good news on the labor front today.

The outlook for construction brightens

2012-01-03T09:52:00.000-08:00

November construction spending beat estimates, but that's pretty old news by now. I think the more important observation is that both residential and nonresidential construction appear to have hit bottom, as this chart shows. Residential construction has been flat for almost 3 years, and nonresidential construction has been flat for almost 2 years now.

Real estate markets operate with very long lags (typically 5 years or so), and construction activity has had plenty of time to adjust to the surplus of homes that appeared in 2006. That was a painful adjustment that required massive amounts of the economy's resources to shift from the construction sector to other sectors. Meanwhile the population continues to grow, the economy continues to grow, incomes continue to grow, and sharply lower real estate prices and historically low mortgage rates have allowed the market to unload a ton of excess housing inventory. The real estate problem, in short, most likely has been largely solved. Instead of worrying about whether more foreclosures are going to cause another price collapse and further reductions in construction activity, it makes more sense to wonder when construction activity and prices will begin to pick up, and by how much.

The good news, in other words, is that we have probably seen the end of the bad news in the housing and construction sectors. The lack of more bad news will optimism to return to a market that has been literally crushed by the worst setback in modern memory.

A decent manufacturing report

2012-01-03T07:54:00.000-08:00

The December ISM manufacturing report was yet another in a string of recent reports that shows the U.S. economy is slowly improving rather than sliding into another recession. The weakness that surfaced last summer has been at least partially reversed. As the top chart suggests, the current level of the ISM index is consistent with real GDP growth in the fourth quarter of at least 3%, and possibly as high as 4% (I think 3-3.5% is likely).

Even export orders picked up, which is good since this suggests that Europe's financial woes have not seriously affected the health of the global economy.

The ISM report was far from being robust, but it definitely refutes the notion that the U.S. and global economies are struggling. In the context of a market that is still priced to something like a global recession or even depression (i.e., 2-yr Treasury yields of .25% and 10-yr Treasury yields of 2.0%), this is very good news.

PIIGS update

2011-12-28T13:06:00.000-08:00

These charts illustrate the macro state of financial affairs in the Eurozone. As the top chart shows, 2-yr Eurozone swap spreads are still very high, almost as high as they were at the peak of the 2008 financial crisis, when the world confronted the perceived threat of a global financial market meltdown, several years of deflation, and a global depression. The bottom chart, on the other hand, shows that the risk of sovereign defaults has declined significantly in the past month or so, particularly in the case of Italy and Spain, the two largest PIIGS debtors. (The likelihood of a Greek default, of course, is extremely high, and it would surprise no one if the country actually did default.)

So the Eurozone banking system is still hanging by a thread, to judge from the level of swap spreads, but the outlook for the Eurozone's larger debtors has improved measurably—an apparent contradiction. One plausible explanation for this is that the ECB's massive balance sheet expansion in the past week or two (see chart below, which is measured in trillions of dollars) has artificially depressed Italian and Spanish yields, but has not done anything to address the fundamental problem of the Eurozone, which is that too many governments have borrowed and spent more than they should have, and on unproductive activities. Thus, Spanish and Italian debt prices have improved, thanks to ECB purchases, but the whole Eurozone financial structure, as reflected in very elevated swap spreads, rests on very shaky bedrock.

It makes sense that the ECB can't fix the Eurozone's problems simply by buying the bad debt of struggling PIIGS countries. The ECB can, however, buy time for the system to fix itself, and there are signs that the PIIGS countries are beginning to take needed action to reduce their spending. But in the meantime, what about the consequences of massive central bank balance sheet expansion? Doesn't that just compound the problem by introducing the risk of hyperinflation?

Not necessarily. As with the Fed's balance sheet expansion, the vast majority of the bank reserves that have been "created" in the process of accumulating Treasury, MBS, and sovereign debt are still sitting idle on the central banks' balance sheet in the form of excess reserves. In essence, all that has happened is that the central banks have exchanged bank reserves for bonds—the rough equivalent of transforming risky bonds into risk-free bills. The market has been happy to unload trillions of dollars of bonds for bank reserves, and this means that a huge share of the burden of default risk of PIIGS debt has been shifted to the ECB. It has also satisfied the huge demand for safe-haven assets.

But if the ECB's new assets end up defaulting or being written down significantly, this will erode the ECB's balance sheet and impair its ability to defend the value of the Euro. How would that work? Presumably, at some point the world will become less fearful of an economic and/or financial market collapse, and the demand for money will decline. A declining demand for money is equivalent to an increased desire to borrow money, and the existence of trillions of bank reserves gives banks a virtually unlimited ability to create new spendable money. Money supply expansion could become brisk and eventually undermine the value of the Euro; the ECB would ordinarily avoid that by withdrawing reserves from the banking system, and that would be achieved by selling off its accumulated balance sheets assets. Of course, if those assets have dwindled due to defaults, then the ECB couldn't fully reverse its reserve injections, and the Eurozone could end up with a huge surplus of money.

For the time being, there is no sign of any unusual expansion in the Eurozone money supply (the chart above uses the latest data available, as of 10/30/11). M2 in both the Eurozone and in the U.S. has been growing at slightly more than a 6% annualized rate for a long time.

So although the situation is far from ideal, it is neither catastrophic nor beyond hope.

Real estate update

2011-12-27T12:13:00.000-08:00

This is a slow week with not much happening, so I'm just going to post some updated charts and brief commentary.

The October Case Shiller home price index was a bit weaker than expected, and it has hit a new post-recession low. The Radar Logic home price index continues to track the Case Shiller index pretty tightly, and it confirms that housing prices on average are at a new post-recession low. Prices have been drifting slowly lower since mid-2010.

On a longer time scale, using prices only from the top 10 metropolitan areas and adjusting for inflation, the downward drift in prices in recent years is a bit more pronounced, but it's nothing at all like a free fall.

This chart compares the prices of residential properties to commercial real estate property values. Commercial real estate has fallen by more than residential real estate from its highs (-42% vs. -33%) and faster, but perhaps because of its more significant correction, commercial real estate now shows more signs of having stabilized. Prices are down significantly just about everywhere, and financing costs are at historical lows. The combination of the two makes for a gigantic effective price adjustment, and that's what it has taken to clear the property markets. Whether we need a significant further adjustment is the question on everyone's mind. If the heavy lifting is over (i.e., no more major downward price adjustments), then now would be a good time to start getting back into the real estate market.

Bond yields are ignoring the good economic news

2011-12-22T10:54:00.000-08:00

The Bond Vigilantes blog caught my eye this morning, with an excellent post and chart which inspired this version above. What this chart shows is that (up until last summer, that is) bond yields have been strongly influenced by the market's understanding of how weak or strong the economy. The white line is the Citi Economic Surprise Index, which tracks how actual economic news releases compare to expectations. The index has moved up strongly since last summer, as almost every economic indicator has come in stronger than expected (with the weekly claims report this morning the latest example). In the past, a stronger-than-expected economy such as we've seen in recent months would have led to a substantial rise in Treasury yields (10-yr yields are shown in orange). But not now, most likely because (and here I agree with the Bond Vigilantes) the market is terrified of PIIGS defaults. The news in the U.S. has clearly gotten better, but the news coming out of the Eurozone has been pretty awful, and Treasuries end up being the beneficiary of the world's intense demand for safe-haven assets.

The Fed and others might argue that Operation Twist (the Fed's current program of selling short maturity bonds and buying longer maturity bonds) is responsible for holding down 10-yr yields, but I don't buy that. The Fed can control the level of short- and intermediate-term yields, but not long-term yields. Thought experiment: if the news in Europe suddenly took a turn for the better (e.g., PIIGS governments took genuine steps to curtail spending), wouldn't you expect 10-yr yields to rocket higher?

The bond market is likely a tightly coiled spring, with yields compressed by fears of Eurozone defaults and a possible collapse of the Eurozone financial system. 2-yr Eurozone swap spreads confirm this, as they are still trading at nosebleed levels of 115 bps. To push yields down further would require these fears to be realized by a succession of truly awful events (and that's where I disagree with the Bond Vigilantes).

More good news

2011-12-22T09:16:00.000-08:00

Third quarter GDP today was revised down by a few billion dollars, but that's old news. The more recent news provides more evidence that fourth quarter growth will be stronger, and the U.S. economy continues to beat the market's rather dismal expectations.

Seasonally adjusted unemployment claims once again surprised the market by coming in lower than expected (364K vs. 380K). This is the best reading we've seen since the recovery got underway, and at the rate we're going we should see further declines in claims in the weeks ahead. Businesses have pared costs and employees to the bone, so they are likely to fire a lot fewer people than usual as the holiday season winds down.

The ongoing decline in claims is an excellent indicator that the outlook for the U.S. economy is improving, so we should also see the equity market forge ahead to higher levels, as this chart suggests.

The ongoing decline in implied equity volatility (the Vix index) also argues for higher equity prices. With the news showing that the U.S. economy is not only not deteriorating but actually improving, despite the anguish in the Eurozone regarding PIIGS defaults, this removes an important source of uncertainty, and less uncertainty is almost always good for equity markets.

I'm usually reluctant to place much stock in the Conference Board's Leading Indicators, but they do not even remotely suggest that the U.S. economy is in trouble. Fourth quarter real GDP growth is now looking to be in the 3-4% range.

Consumer confidence usually lags reality, so the somewhat stronger-than-expected increase in the December Michigan Consumer Confidence survey reported this morning is simply confirmation that things haven't turned out as bad as most people were expecting. Confidence has picked up of late, but it is still at extremely low levels from an historical perspective. That's the recurring theme we've been seeing since last summer: markets and consumers were braced for a serious deterioration in the economic outlook, yet the economy has actually managed to improve somewhat. But the market is still climbing walls of worry, since on balance the market is not yet even slightly optimistic about the future. After all, we have yet to see the fallout of the Greek default which will almost certainly happen soon.

Chart of the day: implied equity volatility tumbles

2011-12-21T12:38:00.000-08:00

This chart of the implied volatility of equity index options is sending a powerful message: the market's level of fear and uncertainty has declined significantly in recent weeks and months. We can only guess at the reasons for this, but the improved outlook is not just a function of today's massive ECB refinancing operation or yesterday's strong housing starts.

I would argue that there is a whole host of developments that have brought more clarity and calm to the markets. Economic data have so far failed to reveal any economic collapse, despite the continued high level of stress in Eurozone financial markets (2-yr swap spreads are still in nosebleed territory at 115 bps). Markets have had 20 months to prepare for a Eurozone default, panicky investors have had plenty of time to take refuge, over-extended banks have had plenty of time to hedge themselves, and risk-loving hedge funds and distressed debt investors have had plenty of time to marshall their forces in eager anticipation of panic-driven sales. The U.S. economy shows every sign of continuing to grow, albeit at a disappointingly slow rate. Corporate profits continue to be very strong. Central banks have embraced their role as lenders of last resort, and liquidity in most parts of the world remains abundant. Profligate government spending is meeting strong resistance almost everywhere.

If there is a single message here, it is that we are not on the cusp of the-end-of-the-world-as-we-know-it. Given how fearful the market has been, that's very good news.

Housing update

2011-12-21T12:11:00.000-08:00

There were large revisions to the past few years' data on existing home sales, but the net result was a substantial reduction in the inventory of homes for sale. (See today's excellent posts on Calculated Risk for a detailed discussion of this.) The current inventory is now back down to levels last seen in 2005, and that brightens the outlook for the housing sector. Even the shadow inventory of homes (those with serious delinquencies and very likely to be foreclosed and sold) has declined, though it remains substantial. And even though the current sales rate is still far below what we saw in the heydays of the housing boom, the month's supply of inventory (second chart above) is now substantially lower than the levels that prevailed throughout the 1980s, and that, in turn, diminishes the threat of the shadow inventory.

In sum, the housing market has undergone a gigantic and very painful adjustment, but the market is clearing, and the overhang of unsold homes now is on a par with what we have seen before and survived. Moreover, financing costs are at record-low levels, and the economy continues to grow and incomes continue to rise. Therefore I don't think it is likely that the existing and shadow inventory of homes for sale implies a further wrenching adjustment. I continue to believe that we have seen the worst for the housing market.

Fear subsides, prices rise

2011-12-20T12:22:00.000-08:00

As this chart shows, the Vix index has dropped to a new post-Greece-is-likely-to-default, and the-end-of-the-world-as-we-know-it-is-nigh low. Ostensibly, today's good news on housing starts is the trigger for the S&P 500's 3% advance. But the good news has been accumulating for awhile now (e.g., jobs growth, car sales, exports, inventories, bank lending, retail sales, capex, corporate profits), even as the stress in the Eurozone financial system approaches the extremes of late 2008.

Call it panic exhaustion: it's tough to continue to worry about the end of the world being right around the corner when the fundamentals continue to show improvement. And it's tough to worry that a Eurozone default will be a surprise or catch anyone off guard now that the world has had 20 months to prepare for it and markets have already marked down $1 trillion worth of sovereign debt. It's tough even to worry that a major sovereign default will bring down the global economy, since defaults are a zero-sum game that don't destroy demand. The bad thing about defaults is what led up to the defaults: all that deficit-financed spending that was squandered on transfer payments and faux-stimulus policies.

What's pushing the market up is the growing realization that despite all the concerns out there, the global economy is not hanging by a thread. On the margin, fears are declining. In part, that's because billions of people continue to go to work every day, and corporations continue to rake in record profits. It's also the case that, despite their best efforts to muck things up with "stimulus" policies that only work to restrain growth and increase uncertainty, governments and central banks are rapidly approaching the point where they can do no more harm. Keynesian stimulus policies have been almost completely discredited. Monetary policies have reached the "zero bound." Quantitative easing has been so massive already that adding a few more hundreds of billions to bank reserves can't possibly make any difference, except to further weaken currencies and boost destructive speculation. Meanwhile, the fundamentals that lead to real growth—the private sector's dynamism and willingness to work and invest—have been slowly and quietly improving behind the scenes, despite all the headwinds and roadblocks that governments have thrown in their way.

To prevent capital flight, don't try to stop it

2011-12-20T11:40:00.000-08:00

Argentina's central bank has been hemorrhaging reserves this year in its attempt to keep the paso from falling more rapidly against the dollar. Money is fleeing Argentina—possibly as much as $20 billion dollars so far this year—because people don't trust the government and don't trust the currency. The peso is becoming overvalued, the government is understating inflation, and the government is trying accomplish by force that which can only be achieved by trust. The government is actively trying to prevent people from taking money out of the country. In the latest move, sniffer dogs are being deployed at border crossings to detect bundles of dollar bills.

The more the government tries to stem capital flight, the more there will be. Capital only stays in places where it is welcome and free to leave. Argentina instead punishes capital with steeply progressive tax rates, by hiking export taxes and limiting access to cheap and essential imports, and now by limiting how much Argentines can spend when they want to travel abroad. It is almost impossible for a government to prevent capital flight by force; there is no shortage of ways that fearful citizens and corporations can manage to circumvent capital controls—and the more a government tries to stop it, the more fearful and resourceful people become. We've seen this movie many times in the past, and it always ends with a tragedy. If there is one thing certain about Argentina's future, it is that there will be yet another major devaluation and the inevitable recession that follows. The only question is when. At this rate the timetable is accelerating. Very sad.

HT: David Gordon

Housing starts are recovering

2011-12-20T08:52:00.000-08:00

November housing starts beat expectations by almost 8% (685K vs. 635K). Not only that, but they are up 30% so far this year, and up 43% from their all-time low, April 2009. They say that housing cycles typically last 5 years, but this one has been the worst ever and has lasted almost 6 years. Thus, there is every reason to believe that we have indeed seen the bottom in housing and that a recovery is now underway. They also say that an upturn in residential construction is an essential part of a larger economic recovery; if so, then maybe the recovery skeptics will finally have to change their tune.

Unvarnished good news, and the harbinger of much more good news to come. The collapse in housing starts has allowed a huge reduction in the excess inventory of homes, bringing supply back in line with demand. As the economy slowly improves, new family formations advance, and more people working want new and better homes, the nation could find itself with a shortage of housing before too long and much higher prices and interest rates to boot. This is a recovery that can feed on itself, and its still in its infancy.

This index of homebuilders' stocks has almost doubled from its late-2008 lows, and has the potential to double and even triple from here if housing starts regain their former altitude.

Bank lending continues to rise

2011-12-19T14:31:00.000-08:00

Commercial & Industrial Loans (a good proxy for bank lending to small and medium-sized businesses) are up 9.6% in the past year, or $116 billion.

Remodeling activity is very strong

2011-12-19T14:03:00.000-08:00

As this chart shows, remodeling activity has surged this year (source). I should know, since we have done quite a bit of it ourselves this year and last. Plus, some contractor friends—particularly one that specializes in energy retrofitting—tell me that business is doing very well.

As Calculated Risk notes: "The BuildFax Residential Remodeling Index increased for the twenty-fourth straight month in October to 147.6, a new high for the index. This was up from 141.4 in September, and up 39% year-over-year from 105.8 in October 2010. This is based on the number of properties pulling residential construction permits in a given month."

Not everything is in the dumps, as you might expect if you only looked at the stock market, PE ratios, and 10-yr Treasury yields.

M2 update

2011-12-19T11:16:00.000-08:00

The first chart shows the history of M2—arguably the best and broadest measure of "spendable" money—over the past 17 years. As should be obvious, there is no shortage of money; M2 has been growing by more than 6% a year for a very long time. The second chart narrows the focus to the past 5 years. On this scale, two "bulges" in M2 growth stand out, and they correlate nicely with periods of financial panic which caused the public's desire to hold "money" to rise. The late 2008 bulge gradually disappeared as the recession ended and the confidence returned. The current bulge also looks to be gradually fading, which could be a welcome sign that fear of a Eurozone financial collapse is beginning to abate.

Almost all (80%) of the latest "bulge" in M2 has come in savings deposits at large commercial banks, and this category is by far the largest component of M2 (see above chart). The Fed cannot force-feed money into savings deposits; people park money in banks only because they want to hold it, and that is especially true now that the interest rate on savings deposits is virtually nil. In other words, exceptional M2 growth in recent years has been almost exclusively a demand phenomenon, rather than a supply phenomenon: it's not that the Fed is running the printing presses in order to push prices up, it's that the demand for money has surged to unprecedented levels, and the Fed has been willing to accommodate this with generous supplies of bank reserves. Exceptional M2 growth has not sparked a big rise in inflation, because it has been the result of increased money demand. This may well change in the future, of course. If the demand for money begins to decline and the Fed does not act in a timely fashion to withdraw bank reserves from the system, then we could have an inflationary problem. This is one of the fears the weighs heavily on markets, and is likely one of the reasons that the price of gold has doubled since 2008.

This chart tracks money demand (the ratio of M2 to GDP). Since the onset of the 2008 recession and subsequent financial panic, the public's demand for money balances has soared in unprecedented fashion, and to an all-time high. The M2/GDP ratio has increased almost 20% since the end of 2007; i.e., money growth has exceeded nominal GDP growth by 20% in the past four years. If the increased demand for M2 in recent years were to reverse without there being an offsetting decline in the amount of M2, this could eventually fuel an extra 20% increase in nominal GDP, and much of that could come in the form of higher inflation.

In fact, money demand has most likely already fallen from its peak, because annualized M2 growth in the most recent 3-mo. period has been only 2.6%, while nominal Q4/11 GDP growth is likely to be at least 5% (e.g., real growth of 3-4% and inflation of 1-2%). If the Eurozone crisis manages to morph into a non-catastrophic problem, then confidence will slowly return, money will come out of hiding and be spent (e.g., be withdrawn from savings deposits), and economic activity will almost certainly pick up. We could be in the very early stages of this process already.

A CPI Christmas present

2011-12-16T11:38:00.000-08:00

The November CPI report was uneventful, but if anything it's a nice Christmas present because it shows that inflation is not the problem that so many—including me—have worried about, at least for now. Most measures of inflation in fact have been relatively tame in recent months, showing inflation to be running at about a 2% annual rate, which is nothing at all to be concerned about.

The first chart above shows the year over year change in inflation, while the second shows the 6-mo. annualized rate of inflation. Using more recent data, this second chart highlights the relatively tame nature of current inflation.

Falling energy prices have been a big part of the reason inflation has been so tame. This chart shows the CPI ex-energy, but even that is only running at 2.4% over the past six months.

Natural gas prices have fallen significantly, thanks to huge new discoveries and production in the U.S. As Mark Perry notes, in looking at the CPI report, natural gas is "the only item that has fallen in price over the last 12 months (-1.3% vs. a 19.7% increase in gasoline)." If anything is disruptive, this is, because (as the second chart above shows) natural gas has now become incredibly cheap relative to oil. This is going to transform energy-intensive industries and enrich the lives of everyone.

I'm not letting down my inflation guard, however, but for the time being my level of concern has eased, and that adds to my belief that the outlook for the economy is better than most people think.

Exports remain strong

2011-12-15T13:45:00.000-08:00

I first noted that outbound container traffic was a good leading indicator of goods exports in an April 2009 post. Container traffic data comes out in a much timelier fashion than goods exports, and it turned up months before we learned that exports had indeed started to recover; that proved to be an excellent end-of-recession indicator. With today's release of November container traffic data from the Port of Los Angeles—up 15% from a year ago—it looks like goods exports are still enjoying robust growth. That's excellent news for the U.S. economy, and it also suggests that the economies of our trading partners are improving as well.

PPI update

2011-12-15T13:06:00.000-08:00

The November PPI was in line with expectations, and didn't show anything unusual. As the chart above shows, the pace of headline PPI inflation has moderated a bit—it's up at only a 3% annualized pace over the past three months—but core PPI inflation has picked up a bit.

With this chart of the actual producer price index, I'm trying to show the bigger picture. The y-axis is plotted on a logarithmic scale so that rates of growth become easier to appreciate. Note the huge 9% annualized growth in the 1970s, followed by the 1.7% annualized growth in the 1980s and 1990s; that's a dramatic statement about just how inflationary monetary policy was in the 1970s and how well Volcker and Greenspan were able to arrest that inflation. In the past 8 years, however, the pace has picked up again, with inflation posting a 3.7% annualized growth rate, double the rate of the preceding two decades. Inflation is far from being a menace, but it has definitely picked up. The Bernanke Fed can not claim to have done a very good job delivering price stability.

The chart above shows the same pattern, only it focuses on intermediate goods, and uses a 10-yr rolling annualized return. Inflation has clearly picked up in the past 8 years, and I note that this same measure is up 15% over the past year. Moving further up the production pipeline, the PPI crude materials measure of inflation has risen at a breathtaking 9.6% annualized pace over the past 10 years, which translates into a 150% increase in prices. From this I conclude that it's premature to view the moderation of the overall PPI in recent months as a precursor to a more moderate inflation regime.

Some encouraging developments

2011-12-15T10:55:00.000-08:00

Sometimes it is difficult to see signs of improvement in the aggregate data until a trend is clearly underway. Changes on the margin can be hard to detect, and nothing is for sure until things are clear, but of course by then it may be too late to get on board. Here are some charts of relatively obscure developments that are looking very good on the margin.

This chart compares the yield on 2-yr Spanish (white line) and Italian (orange line) bonds. The outlook for Spain has improved dramatically in the past three weeks, with yields plunging from 6.1% to 3.7%, thanks to what looks like an emerging political consensus that supports austerity measures. Things have even improved for Italy, with yields falling from 7.7% to 5.5%. Italy may not have the austerity consensus that Spain does, but Italy's deficit is less than 5% of GDP, so the fundamentals have never been even close to awful. As a caveat to this otherwise good news, I note that 2-yr Eurozone swap spreads are still hovering around 110 bps, and that is very high. There has been some piecemeal improvement in the Eurozone, but not enough to make a significant difference to the overall level of systemic risk facing the banking industry. But a few more bits of good news like this could mark a tipping point of sorts.

The Vix index today fell to its lowest level since the August eruption of bad news from the Eurozone. I've called this "panic exhaustion," but it could also be the result of the simple passage of time, since that gives markets an opportunity to brace for bad news. Markets do not stand idle when challenges and risk present themselves. Given time, those with too much risk exposure can lighten up, while others with more risk appetite can marshall their resources, and that in turn improves the market's fundamentals. I see this decline in underlying risk as a very healthy development, a precursor of real fundamental changes in the outlook.

As the chart above shows, a decline in the Vix suggests that we could see some improvement in equity prices going forward.

The ongoing decline in weekly claims for unemployment is also pointing to higher equity prices. An improving U.S. economy goes a long way to negating the Eurozone headwinds.

Weekly claims continue to improve

2011-12-15T08:41:00.000-08:00

The news from the weekly unemployment claims front just keeps getting better, as claims for the recent week came in substantially below expectations (366K vs 390K). Claims are very timely data, and they paint a picture of a jobs market that has been improving almost continuously for the past two years. There is absolutely no sign here of the double-dip recession that ECRI insists is imminent, because a sustained rise in seasonally adjusted claims has marked the beginning of every recession in the past 40 years.

On a seasonally adjusted basis, declining claims at this time of the year means that layoffs are not rising as much as they have in prior years. Layoffs typically rise beginning in October and reaching a peak in early January. This year they have also risen, but by much less than they would have in a typical year. This means that businesses have really gotten lean and mean—minimizing seasonal hiring and relying more on working existing employees harder, and that is one reason corporate profits continue to impress. This also means that as the economy continues to pick up, it becomes more likely that the pace of hiring will not only continue at its recent 1.5% annual pace, but increase and gradually bring down the unemployment rate. Nothing is likely to happen fast, however, so I doubt there will be substantial improvement before next year's elections, which means that a sluggish and disappointing recovery is almost certainly going to be one of the election's major themes.

Bond yields are out of whack

2011-12-14T14:56:00.000-08:00

The bond market is out of whack, because bond yields are not consistent with the inflation expectations embedded in bond prices.

The top chart compares yields on 10-yr Treasuries to the year over year changes in the Core CPI. Normally, the two should move at least in the same direction, and at approximately the same level, since over time the rate of inflation is the major determinant of bond yields. Instead, they have moved sharply in opposite directions over the past 6 months or so. Ok, you say, but maybe the decline in bond yields is simply the market saying that inflation will be much lower in the years to come?

If that were the case, then the second chart would look very different. As it is, it plots the market's 5-yr, 5-yr forward expected annual rate of inflation, based on the relative prices of 5- and 10-yr TIPS and Treasuries. This is the sensitive, forward-looking measure of inflation expectations that the Fed considers to be the most important and most reliable. Inflation expectations by this measure are about where they've been for the past 10 years (between 2 and 2.5%), so there's nothing unusual here. And if you consider the third chart, which compares 10-yr Treasuries to 10-yr TIPS, the message is the same: inflation expectations are nothing out of the ordinary, and very much in line with what we have seen over the past decade.

So the problem is that the current level of 10-yr bond yields is priced as if inflation were headed to zero, when a broader look at the TIPS and Treasury market reveals that inflation expectations are somewhere in the neighborhood of 2-2.5%.

The only reasonable explanation for this divergence, as far as I can tell, is that the level of Treasury yields is artificially depressed. TIPS and Treasuries of similar maturities, when taken together, are priced to normal inflation expectations, but in isolation their yields are too low to be consistent with their implied inflation expectations.

This is a highly unusual circumstance that can only have highly unusual roots. I think those roots are most likely to be found in the Eurozone. Such is the fear that the PIIGS defaults will destroy the Eurozone banking system and ultimately lead to a global depression and a financial market collapse, that investors are willing to pay exorbitant prices for Treasuries in view of their safe-haven status. The risk-free status of Treasuries seems paramount, far more important than possible concerns about inflation.

If there is a message here for investors, it's that fear has reached extraordinary levels, artificially inflating the prices of Treasuries. And it's not a stretch to go from that conclusion to the belief that fear is also artificially depressing the prices of equities.

Current prices can hold only if we really are on the cusp of a major collapse. To be bearish you have to believe that the collapse will be unlike anything we have ever seen before, or maybe even worse.

The message of gold

2011-12-14T12:18:00.000-08:00

Gold is down 18% from its summer highs. The euro has dropped 12% against the dollar since April, while the yen has risen almost 10%. These all sound like big numbers for such a small time span, but the chart above shows that they are mere ripples in a very large pond.

The big story here is that all currencies have depreciated massively in terms of gold over the past decade. Some (like the yen) by less, some (like the dollar and the euro), by much more. In yen, gold is worth less today than it was at its early 1980 peak (one third less, to be exact); in dollars, gold is worth 90% more.

The relative worth of currencies tells us a lot about the underlying inflation fundamentals of each. As this chart shows, the dollar has fallen massively relative to the yen since 1978, with the yen soaring from 240/dollar to 78. This fact alone dictates that the dollar has suffered from much more inflation than Japan. So its not surprising that since 1978, U.S. consumer prices have risen 264%, while Japanese consumer prices have risen only 50%. Since the dollar has fallen 30% against the DM over that same period, it makes sense that German consumer prices have risen by 40% less than U.S. consumer prices (115% vs. 264%).

Gold is a good reference point to compare the relative behaviors of currencies (A Gold Polaris, as the late Jude Wanniski put it), and arguably, it also tells us about the market's future expectations for how currencies and their purchasing power are likely to behave. Since gold has risen significantly against all currencies in the past several years, that tells us that the market is expecting inflation in all countries to rise in coming years. Since gold has risen the least in terms of yen, that implies that the market expects the yen to suffer from much less inflation than most other currencies.

As I see it, the huge rise in gold in dollar terms in the past decade was the market's way of worrying that U.S. monetary policy was adrift, no longer tied to something like a Taylor Rule, and instead more focused on promoting growth and bailing out banks and debtors at the expense of sacrificing purchasing power. The dollar's rise against the euro since last April, while both have fallen relative to gold, is the market's way of saying that the Eurozone sovereign debt crisis is changing the outlook for ECB monetary policy: the ECB has become a less reliable advocate for low inflation and is now instead more likely to succumb to pleas to bail out the southern European nations by running the printing presses faster.

Meanwhile, the dollar of late has benefited at the expense of the euro not only because the ECB seems to be losing its independence, but also because the U.S. economy is gradually decoupling from the problems of the Eurozone. U.S. growth has been gradually picking up (though still painfully slow), while the Eurozone economy has been slowing down; U.S. stocks have outperformed Eurozone stocks by 25% over the past year. But I hasten to add that the price of gold today is still pointing to the very real risk that the U.S. government will resort to the printing press to help address the looming problem of out-of-control spending and soaring debt burdens.

How to explain the fact that gold prices have fallen 13% in dollar terms, 16% in yen terms, and 11% in euro terms since gold hit its all-time highs last September? I'm going to guess that the across-the-board selloff in gold may be an indication that the market was priced to Armageddon last September—a global depression and massive monetary and fiscal policy uncertainty—and is now seeing that while things are still bad, the end-of-the-world-as-we-know-it is not inevitable (e.g., the U.S. economy is slowly improving, the political winds are moving in the direction of less profligacy, even in Europe). Others might say we are simply seeing the forced unwinding of massive and leveraged gold speculation, but I think there is a fundamental explanation in addition to a technical one.

Fixed rate mortgages hit another all-time low

2011-12-14T09:35:00.000-08:00

30-yr fixed rate mortgages have never been cheaper. The latest data show that the nationwide average for conforming, 30-yr fixed rate mortgages is 3.99%, and the rate for jumbo mortgages is 4.28%, both at new all-time lows. Plus, the spread between conforming and jumbo rates is now down to just 30 bps, which in turn is the average spread during times of relative market calm. It doesn't get much better than this for homebuyers.

Anecdotally, I was talking with a prominent realtor friend the other day and remarking about how incredibly affordable housing has become. She agreed, but noted that the problem as she sees it is that most people are just plain terrified of buying a house these days. That's one very good reason why houses are so cheap.

This chart comes from Mark Perry, and is the best one I've seen when it comes to housing affordability.

The dollar is still very weak

2011-12-13T13:20:00.000-08:00

Since the end of April, just before the Eurozone sovereign debt crisis started heating up, the dollar has risen against other major currencies by about 10% (see top chart above). A stronger dollar is always good news, in my opinion, since the strength of the dollar is a significant part of our standard of living and reflects importantly on the overall health and viability of our economy. But most of the dollar's gains this year have come at the expense of the confidence-weakened euro, and that's hardly a ringing endorsement of the dollar. As the second chart above shows, the real value of the dollar (adjusted for relative inflation differentials) is still very low from an historical perspective; by my estimates, the dollar today is only about 7.5% above its recent all-time low against a large basket of currencies.

Measuring the value of the dollar against other commodities is certainly a useful exercise, but it also helps to know how the dollar is faring against things (e.g., gold, commodities, energy, real estate). On that score the dollar also is not doing very well. As the first two charts above show, the dollar has lost considerable ground against gold, commodities and oil, though it recently has recovered a portion of what it lost in the past 10 years. Relative to real estate (third chart), the dollar has done much better, only losing a fraction of its value against home prices, and hardly any of its value against commercial real estate prices. The fourth chart shows the real price of gold, which is still shy of the peak it briefly reached in early 1980.

Overall, the dollar looks pretty weak, with the notable exception of real property. That suggests that if you're looking for some way to hedge against a further decline of the dollar's value, buying real estate (and possibly leveraging it with a record-low fixed rate mortgage) might be the best candidate.

Selling the dollar against other currencies is a risky proposition, given that it is close to its all-time lows, and as the second chart at the top suggests, there is likely to be some support at these levels. The chart above suggests that the dollar is very undervalued relative to the Aussie dollar, and that is a reflection of how important commodity prices—which are close to record highs against the dollar—are to the Australian economy. If commodities were to weaken further, the Aussie dollar would probably follow suit.

Retail sales growth remains impressive

2011-12-13T10:10:00.000-08:00

November retail sales rose a bit less than expected, but growth since the recovery got underway has been fairly impressive. Nominal retail sales are now at a record high, 5.5% above their pre-recession high, despite the fact that non-farm employment is still 6.3 million below its pre-recession high. Even after adjusting for inflation—which has not exactly been quiescent—real retail sales are only about 1.5% below their prior high while employment is 4.5% below its prior high. Today's workforce is a lot more productive than it was just a few years ago, and consumer confidence and willingness to spend has apparently not been much affected by the sluggish recovery.

Mark Perry adds some color: "Retail spending in November was 6.7% higher than the year-earlier level, and spending in every category except department stores (-3.0%) registered annual gains last month, with especially strong gains in auto sales (+7.5%), miscellaneous stores (+7.7%), gasoline stations (12.9%) and nonstore retailers (+13.9%). Excluding gasoline sales, retail sales increased by 6% on an annual basis."

Federal finances update

2011-12-12T14:27:00.000-08:00

The above chart summarizes the current state of Federal finances over the most recent 12-month period ending November. The good news is that for the past two years, revenues have been slightly outpacing spending—hard to believe, I know, but nevertheless true. The bad news is that the gap between spending and revenues is still enormous.

This chart contrasts total federal revenues with the portion that comes from individual income tax receipts. Here we see that the biggest source or rising tax revenues has been income taxes, since they have risen at a much faster rate. One reason for the sluggish growth in total revenues, of course, is the cut in social security withholding rates that has been in place for the past year and is quite likely to be continued. The chart also highlights the fact that since the Bush tax cuts were first instituted in mid-2003, income tax receipts are now substantially higher—36% higher (almost $300 billion on an annual basis)—than they were when tax rates were higher. Once again, we see here concrete evidence that Art Laffer's vision (and his famous curve) was anything but crazy: lower tax rates can promote stronger growth, and thus result in higher tax revenues. If it weren't for the 20080-9 recession, which had everything to do with a collapse of the housing bubble and a 6 million decline in the number of private sector jobs, and almost nothing to do with low tax rates, both the economy and tax revenues would now be considerably higher.

The state of federal finances remains abysmal, but nevertheless it is the case that the deficit as a % of GDP has declined from a high of 10.4% at the end of 2009 to 8.1% today. In nominal terms, it peaked at $1.48 trillion in Feb. '10, and in the most recent 12 months is now $1.25 trillion. If current trends continue—which is unlikely unless our major entitlement programs are reformed—then the U.S. could escape the fate that has engulfed the PIIGS countries, where deficits are above 9% of GDP.

This chart (inspired by Brian Wesbury) again bears repeating, since it lends support to claims by the anti-Keynesians (of which I am one) that the biggest factor that has worked to slow economic growth in recent years is the huge increase in federal spending. Instead of "stimulating" the economy, enormous increases—in both nominal and relative terms—in federal spending have ended up "stimulating" the unemployment rate more than anything else. The reason? The public sector spends money much less efficiently than the private sector. And when you consider that over 70% of federal spending takes the form of "payments to individuals" (i.e., transfer payments, see chart below), and that this has been the most rapidly growing portion of total spending, and you understand Milton Friedman's assertion that you don't spend other people's money on yourself nearly as carefully and efficiently as you spend your own money on yourself, then it becomes easier to understand. The vast bulk of government spending these days boils down to transferring money from those who are working and producing the most, to those that are working and producing the least, and that is not a prescription for a strongly growing economy.

While depressing to contemplate how large and inefficient our federal government has become, it is nevertheless the case that spending vs. GDP is slowly declining and the economy is slowly improving. If Congress can see fit to further curtail the growth of federal spending in the years to come, then the future should be much brighter.

The PIIGS crisis is fading in importance

2011-12-12T12:14:00.000-08:00

Even as the likelihood of major Eurozone sovereign defaults continues to rise, there are signs that the the denouement of the Eurozone sovereign debt crisis may not be nearly as bad as everyone has been led to believe. This is a theme I've been developing since last July ("Carmageddon, free markets and the PIIGS crisis"), and have updated several times since (Panic exhaustion?, Eurozone panic update, Panic exhaustion revisited). The idea is simple: when markets are given ample time and warning, they are very good at making the necessary adjustments to accommodate the arrival of bad news. As I discuss below, markets have already written off $1 trillion of PIIGS debt, and the sky has not fallen, nor have markets or global economic activity collapsed. In fact, economic life goes on, the U.S. and many other economies continue to grow, and many equity markets have moved substantially higher in recent months. We've had so much "panic" for so long that it's simply fading away.

The PIIGS debt crisis first surfaced in April of last year, which means that markets have now had about 20 months to adjust. That is completely different from the situation surrounding the Lehman bankruptcy and the subsequent financial meltdown of late 2008, because back then there was almost no advance warning of what was coming; the news sparked a classic rush for the exits, in which panic selling drove prices to absurdly low levels, thus making the panic and confusion even worse. The subprime mortgage collapse was also completely different from the PIIGS crisis, because back then the market found it almost impossible to value the thousands of often obscure and arcane mortgage-backed securities that were tied to many millions of homes whose prices were tumbling at different rates all over the country. With the PIIGS crisis, we are dealing with only a handful of borrowers who have issued fairly straightforward debt securities.

This chart shows the price of the current Greek 2-yr bond, which has fallen from almost 100 at the beginning of last year to a mere 26.625 today. The $470 billion of outstanding Greek debt is now trading at about 20-25 cents on the dollar, which means that the market has effectively written off about $350 billion of Greek debt. In other words, if Greece tomorrow were to restructure its debt and impose a 75% haircut on its creditors, nothing much would happen because markets have already priced in that eventuality.

After Greece, where a major default is almost a certainty, the next-most-likely-to-default country is Portugal, with about $220 billion of outstanding debt. The chart above shows the price of the current Portuguese 2-yr bond, which has fallen from 110 early last year to 85.2 today. Portuguese government bonds are now trading at 50-60 cents on the dollar on average, which means that the market has already written off some $100 billion.

Continuing with Ireland, 2-yr Irish bonds have fallen from 106 to 96, and the $150 outstanding of Irish debt is trading at about 80-85 cents on the dollar, for a write-down of roughly $25 billion.

Continuing with Italy, 2-yr Italian bonds have fallen from 100 to 94, while the value of the $2.1 trillion of outstanding Italian debt is trading at 85-90 cents on the dollar, for a write-down of roughly $260 billion.

Finally, the $870 billion outstanding value of Spanish debt is trading at about 95 cents on the dollar, for a write down of roughly $40 billion.

Now let's look at what has happened while global bond markets have been busy shaving $1 trillion off the value of sovereign PIIGS debt.

The S&P 500 index is up 10% from the end of 2009, and about as much since the peak of the sovereign debt crisis and double-dip recession fears of early October.

The Vix index (a good proxy for the market's degree of fear) is still at levels which indicate serious concern, but we see in this chart that the market has weathered two storms of volatility (in the 2nd quarter of last year, and in the past several months) and panic "exhaustion" appears to be setting in, with the Vix trading at 27 today after hitting a peak of 48 last August. Even though a major Greek default has never been more likely nor as large as it is today.

The VIX/10-yr ratio is a good proxy for the market's level of fear and despair. While still extremely elevated from an historical perspective, it has declined from near-Lehman levels to 13.5 today. This chart also reminds us that periods of fear, panic, and despair occur every so often, but eventually they fade away and economic life goes on.

This chart shows how strongly the equity market has been influenced by fear in recent years. But as markets adjust to expectations of PIIGS defaults, fear subsides, and equity prices rise.

This chart compares the level of 2-yr swap spreads—a good proxy for systemic risk and financial market health—in the U.S. and the Eurozone. The message here is that although the Eurozone banking system is still in the grips of a very serious crisis of confidence (the likelihood of bank failures and thus counterparty risk is very high), the U.S. banking system has gradually decoupled from the problems in Europe over the past few years. Systemic risk in the U.S. is a little elevated, but not seriously by any means. This suggests that even though the Eurozone may yet experience some wrenching bank defaults, and the fallout may well be very economically disruptive to the Eurozone economies, it shouldn't prove too unsettling for the U.S.

As I mentioned in a post last month ("Putting PIIGS debt into context"), the value of liquid, global debt and equity markets is about $110 trillion, and this total can vary up and down by trillions of dollars every day. So the loss of $1 trillion in PIIGS debt is not a big deal from a macro perspective, and I think the charts I've shown here reinforce the point that the reality of a major PIIGS default—should it occur—is likely to be much less catastrophic than the headlines would have you believe. Meanwhile, there is still no reason to give up hope that the PIIGS countries (save, perhaps, Greece) will eventually realize that the best solution to their problems (e.g., fostering more private sector growth by shrinking the size of their governments and lowering and flattening their tax structures) is also the easiest. Major defaults, restructurings, and/or devaluations all have devastating and lasting consequences, but reversing the trend to ever-more-burdensome government is a great solution for the majority of the population.

Household balance sheet update

2011-12-08T11:10:00.001-08:00

The Federal Reserve today released its Flow of Funds report for Q3/11, and this chart extracts the relevant data for the status of households' balance sheet. Net worth fell about $2.5 trillion in the third quarter, mainly due to the 14% decline in the stock market during that period (the third quarter ended one day before stocks hit their Oct. 4th low for the year). Real estate values increased marginally, and debt declined marginally during the quarter.

I think it's important to note that households have rebuilt their net worth to almost what it was in 2005, just prior to the great housing market collapse. Given the rebound in equities to date, household net worth today is likely very close to its 2005 levels. In other words, despite the massive destruction of home equity values and the meager 2% average annual return on the S&P 500 since the end of 2005, households have managed to regain their financial footing mainly by boosting savings. We would all like to be richer, and millions would still love to again find they have positive equity in their homes, but we are making progress.

Inventories continue to rise

2011-12-08T10:50:00.001-08:00

Wholesale inventories in October rose much more than expected. With the help of this chart, which shows the level of inventories with a logarithmic scale, we can see that inventories are slowly getting back to their long-term trend. This is yet one more of the many indicators that the recovery is still proceeding despite all the headwinds. On the margin, things are improving, even though the degree of improvement is disappointing.

Markets, however, are priced to the expectation that things will begin deteriorating soon, and probably in a serious way. For markets to rally, all we need is to avoid a big deterioration. A continuation of meager, 3% growth should be enough to push equity prices higher, because that would be a far better outcome than what is currently expected.

Best argument for limited government

2011-12-08T10:37:00.001-08:00

Jon Corzine's testimony regarding the disappearance of many hundreds of millions of his customers' money: "I simply do not know where the money is, or why the accounts have not been reconciled to date."

As Kevin Williamson notes:

Why should we believe that the motives of people in (cough, cough) “public service” are different from the motives of people in the for-profit sector? Was Jon Corzine a rapacious self-seeker at Goldman Sachs, then a public-spirited man when he was in the Senate and in New Jersey’s governorship, only to revert to form when he went to MF Global? If you doubt that this is true, and suspect that Jon Corzine was the same guy all along, why would you want to give government more power?

Credit spread update

2011-12-08T09:42:00.001-08:00

This chart compares the spread on 5-yr, A1-rated industrial bonds with 5-yr swap spreads. Swap spreads have risen a bit from their lows earlier this year, but are not particularly high, which suggests that U.S. financial markets are only mildly stressed and that the level of systemic risk in the U.S. economy is fairly low. Industrial spreads, however, have risen by a greater degree, and are now at the same levels that we saw going into the 2008 recession. Are credit spreads thus foreshadowing another, and perhaps imminent, recession? I think the message here is too mixed to be conclusive. At the very least, swap spreads would need to be a lot higher than they are today to worry about an imminent recession. But can we safely ignore the message of credit spreads?

I would argue that this chart says the answer to that question is "yes." The chart compares the yield on 5-yr A1 industrial bonds with the yield on 5-yr Treasuries (the baseline against which A1 and swaps are measured in the top chart). Credit spreads are typically thought of as the extra yield that investors demand to compensate for the perceived risk of default. So spreads are a good proxy for default risk. But sometimes spreads can exaggerate default risk, and I think now is one of those times. As this second chart shows, the main reason that credit spreads have increased this year is that Treasury yields have plunged to exceptionally low levels. Credit yields are at their lowest level ever, which means that A1-rated industrial companies now enjoy the lowest borrowing costs of all time. A1 industrial yields today are fully 300 bps lower than they were at the onset of the 2008 recession. That's not exactly the same as saying the bond market is fearful of lending to these companies. In fact, if all you knew was the level of corporate bond yields, you would conclude that the bond market was highly infatuated with industrial bonds.

What is distorting the message of spreads is the exceptionally low level of Treasury yields. Those yields, in turn, are likely being artificially depressed by the world's intense desire for safe-haven assets in a time of great sovereign debt uncertainty in the Eurozone. The creditworthiness of U.S. firms is not the issue. The financial fundamentals of the U.S. economy are not reflecting any significant deterioration at this point.

Claims point to a U.S./Eurozone decoupling

2011-12-08T08:18:00.001-08:00

Seasonally adjusted claims for unemployment fell to 381K, their lowest level (with the exception of one week last February, which we now know was purely the result of a seasonal adjustment problem) since July '08. Actual claims, however, rose by 151K to 524K. This is the time of the year when companies begin laying off people that were hired earlier in order to meet the demands of the holiday season. So today's news tells us that actual claims rose by less than is usual around this time of the year. We may see a repeat of this in coming weeks, since actual claims will almost certainly rise by much more going into the first week of January, but maybe not by as much as the seasonal factors expect. Firms may well continue to fire fewer people than usual, because they have already pared staffing to the bone, and that is one reason why corporate profits have been so strong.

In any event, the continued decline in the level of adjusted claims is a legitimate indicator that the economy is on a more solid footing. The labor market fundamentals continue to slowly improve, and that is consistent with a lot of other indicators which point to ongoing economic growth of about 3% or so.

Markets, however, are still very fearful that growth fundamentals are on the verge of deteriorating. Eurozone sovereign defaults are widely thought to be the likely catalyst for a sudden and sharp deterioration in global economic activity, and markets fear that it will be very difficult for the U.S. economy to avoid contagion. No one can say for sure that the U.S. can avoid contagion, but so far the U.S. economy appears to be decoupling from Europe, as Europe slumps but conditions here continue to improve.

Malkiel disses Treasuries, and he's right

2011-12-07T12:24:00.001-08:00

Burton Malkiel, author of the classic (and frequently updated and highly recommended) A Random Walk Down Wall Street, and long-time proponent of portfolio diversification and the virtues of passive vs. active investing, has decided that enough is enough: government bonds stink. In his op-ed in today's WSJ, "The Bond Buyer's Dilemma," Malkiel takes the courageous step of urging investors to un-diversify their portfolios and actively eschew government bonds. And he is right.

I highly recommend his article, and I offer here some charts, thoughts, and additional recommendations to help flesh out his larger points. As the above chart shows, 10-yr Treasury yields today are as low as they have ever been. Malkiel argues that interest rates on government bonds are being artificially depressed by policymakers in an effort to "inflate away" the real and growing burden of debt. While that may be true at least in part, I prefer to think that yields are extremely low because investors are extremely fearful of the future and are willing to pay an exorbitant price for default-free, interest-bearing assets such as Treasuries, TIPS, German Bunds, and Japanese government bonds. Whatever the drivers of extremely low government bond yields, it is true, as he says, that:

Artificially low interest rates are a subtle form of debt restructuring and represent a kind of invisible taxation. Today, the 10-year U.S. Treasury bond yields 2%, which is below the current 3.5% headline (Consumer Price Index) rate of inflation. Even if inflation over the next decade averages 2%, which is the Federal Reserve's informal target, investors will find that they will have earned a zero real rate of return. If inflation accelerates, the rate of return will be negative.

Actually, the negative real rates of return are already with us. As the above shows, real interest rates on 10-yr Treasuries have been declining for the past 10 years and are now distinctly negative. If and when Treasury yields rise, real returns could not only be very low or negative, as they were in the rising inflation 1970s, but bondholders would also suffer from sharply declining bond prices as interest rates inevitably rise, thus suffering miserable total returns for years to come.

Malkiel recommends that investors who want a better alternative to the safety and income of government bonds should look to other bonds with "moderate credit risk where the spreads over U.S. Treasury yields are generous." He suggests municipal bonds, and I would add that lower-quality corporate bonds with generous yield spreads are also very attractive. As the chart above shows, the yield on high-yield (junk) bonds is almost 9%. That's a huge spread to Treasuries, and it signifies that investors perceive that many of these bonds are highly likely to suffer defaults in the years to come. But if you are even the slightest bit optimistic about the ability of the U.S. and most global economies to avoid a calamity, and if you are worried that super-accommodative monetary policies from most major central banks are going to push inflation higher in the years to come, then high-yield corporate bonds should do pretty well. Actual defaults are likely to be lower than expected if we avoid another economic calamity, and rising inflation will improve the cash flow of almost all corporate borrowers, which in turn would also work to reduce default risk. My chart compares the yield on high-yield bonds to 2-yr swap spreads, in order to show that the current level of systemic risk in the U.S. economy is relatively low, and that the yield on junk bonds is priced accordingly.

Malkiel likes the bonds of some countries, like Australia, where fiscal policy is a lot more conservative than ours (i.e., fiscal deficits are much lower) and interest rates are substantially higher. I would caution, however, that while his reasoning is sound, buying Australian government bonds is not a clear-cut, obvious strategy. As the chart above shows, the Aussie dollar is currently about as strong relative to the U.S. dollar as it has ever been (i.e., the gap between the current value of the currency and its purchasing power parity is huge, reflecting what might be called an "overvaluation" of the Aussie dollar). In other words, investors are well aware of Malkiel's arguments, and have already bid up the price of the Australian currency to reflect the much more optimistic outlook to be found there these days. If the outlook for the U.S. were to improve relative to the outlook for Australian, the Aussie dollar could suffer a significant decline in the years to come, thus wiping out most or all of the current interest rate advantage offered by Australian bonds. Hedging the currency risk is not a complete fix for this problem either, since current hedging costs run on the order of 4% per year.

Malkiel also likes "blue-chip stocks with generous dividends" as a better alternative, and I would agree. Not only are the dividend yields on many stocks competitive with government bond yields, but the earnings yield on the entire S&P 500 is much better than the yield on junk bonds, as my chart below illustrates.

This is a highly unusual state of affairs, since this chart shows that investors are willing to give up about one-third of the earnings yield on large-cap stocks (currently 7.5%), and forego any future price appreciation, in order to enjoy a privileged position in the capital structure and receive a yield of 5.3% or less on BBB corporate bonds. This only makes sense if investors are scared witless by the potential for a global economic and financial market meltdown.

What this all boils down to, of course, is that the major asset classes are priced to really awful expectations for the future. Government bonds with no default risk are priced at incredibly high levels, while just about everything else is priced to the expectation that the sky is going to be falling, and soon. If you agree with the doomsayers, then it makes sense to ignore Malkiel's advice. And who knows, perhaps the doomsayers will be right this time. But if you have even a shred of optimism; if you think that the U.S. economy is likely to continue to grow at least modestly while the Eurozone struggles and maybe suffers from PIIGS defaults; then the opportunities to be found outside of government bonds are fantastic. Faced with pricing that reflects the expectation of something like the-end-of-the-world-as-we-know-it, I'm an optimist. Even though I am fully aware of all the headwinds still confronting the U.S. economy.

Housing fundamentals are starting to improve

2011-12-07T10:28:00.001-08:00

The top chart shows the rate on 30-yr fixed conforming and fixed-rate mortgages, and the bottom chart is an index of new mortgage applications. Mortgage rates have been at all-time lows for the past several months, and new applications for mortgages have jumped 30% since last August. It's looking like the appeal of cheap financing and the unprecedented affordability of housing prices have finally gotten the attention of consumers. Demand for home purchases is finally responding to favorable prices. Or, to put it another way, prices and financing costs have finally fallen by enough to stimulate demand. The recent upturn in new mortgage applications may prove to be the signal that the housing market has finally hit bottom and is beginning to pick up. Very encouraging.

This chart shows the housing affordability index published by the National Assoc. of Realtors. It is saying that a median family income is now almost double what is needed to purchase a median-priced home using conventional financing. Homes are more affordable than ever before.

This chart shows the S&P Homebuilders ETF, which is behaving in a manner consistent with the housing market having seen the worst, and the beginnings of improvement, albeit still modest. Homebuilders' stocks are down almost 70% from their 2005 high, and new housing starts are down by a similar amount. If the outlook for housing is indeed beginning to improve, homebuilders' stocks could have some tremendous upside potential in the years to come.

Good news: income tax receipts are booming

2011-12-07T09:29:00.001-08:00

This chart shows the 12-mo. rolling sum of federal revenues: total revenues in blue, and individual income tax receipts in red. A very remarkable thing has occurred over the 12 months ending last October: individual income tax receipts have increased by almost 22%, far outstripping the 7% increase in total federal revenues over the same period. If income tax receipts are booming, then it's a safe bet that incomes are booming as well. Although we have seen only modest jobs growth over the past year (130K per month on average, with a yearly gain in total jobs of only 1.2%), incomes are rising much faster. This helps explain why retail sales growth has been robust, and personal consumption expenditures have climbed almost 5% in the past year. It's not that consumers are over-spending, it's that consumers are in much better financial shape than the broader economic statistics suggest. Incomes are rising much faster than jobs, a fact that has somehow remained under the radar and under-appreciated. This is a very healthy development, to say the least. I note, furthermore, that income tax receipts are very real and not likely to be overstated.

TIPS update

2011-12-06T12:53:00.001-08:00

TIPS are Treasury bonds whose principal is adjusted for consumer price inflation; buy $1000 worth of TIPS and their face value will appreciate in line with the rise in the CPI. TIPS have a coupon which is paid on the inflation-adjusted principal, so the coupon functions as a real yield. The owner of TIPS receives a total return that is equal to the rise in inflation plus the real yield. Like all bonds, TIPS prices vary inversely with their real yield. So today's 0% real yield on 10-yr TIPS means that the price of TIPS has reached an all-time high; in absolute terms, TIPS have never been more expensive. (The colored zones in the chart above are my way of appreciating the "value" inherent in TIPS' real yield.)

Another way of assessing the value of TIPS is to compare them to regular Treasury bonds
of similar maturity. The difference between the nominal yield on Treasuries and the real yield on TIPS is the "break-even" or expected rate of inflation over the life of the bonds. Today, the expected annual inflation that is priced into 10-yr TIPS and 10-yr Treasuries is 2.1%, which is just a shade better than the average that has prevailed since TIPS were first issued in 1997, and a little below the 2.4% average annual rate of consumer price inflation since 1997. So relative to Treasuries, TIPS are about "average:" neither expensive nor cheap, because they are priced to an expectation that inflation in the future will be about the same as it has been in the past.

In sum, if you buy TIPS today, you are paying a very high price (i.e., you are receiving a very low real yield) in exchange for the expectation of receiving an inflation adjustment that is in line with historical experience. The main reason TIPS are so expensive is not that investors are willing to pay an exorbitant price for inflation protection; rather, it is that Treasury yields in general are extremely low because investors are extraordinarily risk-averse (i.e., willing to pay an exorbitant price for protection against default) and have very low expectations for future economic growth.

So what does this mean? How would TIPS perform if inflation turns out to be higher or lower than the market currently expects?

If inflation turns out to be higher than expected—say, 5% per year—then 10-yr TIPS would deliver a 5% annual coupon return (zero real yield plus 5% CPI). That would handily beat the 2.1% annual coupon on 10-yr Treasuries. But what would happen to yields if inflation proved to be significantly higher than is currently expected? Undoubtedly, Treasury (nominal) yields would rise significantly, and the difference between Treasury and TIPS yields would also rise, because future inflation expectations would very likely rise. About the best that TIPS investors could hope for in this scenario would be for TIPS real yields to remain at or close to zero, while Treasury yields rose, perhaps by as much as 500 bps. It's more likely, however, that in a rising inflation environment all yields, both real and nominal, would rise, with nominal yields rising by much more than real yields. That's because higher inflation would eventually force the Fed to raise rates in both nominal and real terms, and that would push up real and nominal rates higher across the board. Of course, rising real yields would cause the price of TIPS to decline, so even though TIPS investors would benefit directly from higher inflation, the price of TIPS would fall by some amount, thereby offsetting, on a mark-to-market basis, some or even a substantial portion of the higher coupon received.

If inflation turns out to be lower than expected—say, 1% per year—then 10-yr TIPS would deliver a 1% annual coupon return (zero real yield plus 1% CPI). That would not be as much as the 2.1% annual coupon on 10-yr Treasuries, which would be disappointing to TIPS investors. The lack of inflation would likely result in the price of TIPS declining, and their real yields increasing, even as Treasury yields held fairly steady. So a very low inflation environment would probably result in lower TIPS prices and a disappointingly low coupon yield—a double negative whammy, so to speak, which might result in zero or negative holding period returns.

So in the best of scenarios for TIPS investors, TIPS are likely to deliver less than whatever the future rate of inflation happens to be. In the worst of scenarios, TIPS are likely to deliver very low or negative returns. TIPS are not likely to produce exciting returns no matter what happens, because TIPS yields have been forced to extremely low levels by the dismal prospects for U.S. economic growth. In short, TIPS, like Treasuries, are extremely expensive and thus not very attractive, even if you think that inflation is going to come in much higher than the market expects. TIPS would likely outperform Treasuries in a rising inflation environment, but not by a whole lot.

About the only reason to get excited about buying TIPS today is if you believe that a) the prospects for real economic growth are dismal at best, b) you are extremely worried about the potential for default risk, and c) you are convinced that inflation is going to rise meaningfully but the Fed is not going to raise rates very much, if at all. I note that one popular TIPS mutual fund (TIP) is very close to its all-time high, and appears to be running out of upside potential.

Full disclosure: At the time of this writing, I hold no TIPS and have only a small exposure to WIW, a TIPS fund that is trading at an 11% discount to net asset value.

The solution for the Eurozone debt crisis is simple

2011-12-05T12:37:00.001-08:00

There was some excitement today over the announcement that Merkel and Sarkozy have decided that the European Union treaty needs to be rewritten to include sanctions on countries that exceed the 3% debt/GDP limit that they all agreed to way back when the EU was first established.

The problem with this "solution" is that the mechanism for enforcing sanctions is a deeply flawed concept. The best, and probably the only way to impose real sanctions on governments who spend and borrow too much is to let the market do it. When the yield on your bonds starts to skyrocket, you quickly realize that you can't continue to borrow. You either mend your ways and borrow less, and/or figure out how to grow more, or you default on your debt obligations. And even if you default, you will find it very difficult—if not impossible—to continue to be profligate. That's the way it has always worked in the bond market. It's quite simple: if lenders don't think you can repay your debts, they won't lend you any more money.

A market-based solution doesn't need any agreements or rewritten treaties. It also has the virtue of essentially eliminating moral hazard, since lenders would have a powerful incentive to do their due diligence every time they buy a bond, instead of simply relying on what ratings agencies are saying, or betting that they will be bailed out by taxpayers or other countries if things turn sour. A true market-based solution would even make the ratings agencies obsolete. No serious investor would ever base his decisions on what a ratings agency says anyway; the only purpose that ratings serve in today's world is to facilitate the ability of bureaucrats and technocrats to decide, for example, which assets qualify as Tier 1 capital for banks, effectively overriding the investment decisions of the private sector and thus providing fertile ground for moral hazard.

The only reason that no one is talking about a simple, proven, market-based approach to solving the Eurozone sovereign debt problem is that politicians (urged on no doubt by their investment banking constituents) fear that highly indebted Eurozone countries are more likely to default (i.e., to act irresponsibly) than they are to cut spending, and that this, in turn, puts Eurozone banks (who hold tons of Eurozone sovereign debt) at risk, and that this, in turn, puts the very viability of the Euro and the Eurozone economies at risk. Politicians love to think this way, because it makes them indispensable. The truth, however, is that when politicians step into the fray to fix things, they almost always make the situation worse.

Eurozone countries may indeed default, and defaults may be large enough to bring down the Eurozone banking system, but a collapse of the Eurozone economies is not necessarily the only way this can play out. Defaults happen all the time. Banks fail all the time. Defaults don't destroy currencies, they just destroy the value of debt issued in that currency. Defaults don't destroy wealth, since they are just the accountant's way of recognizing economic realities. Defaults don't destroy demand either, since debt is a zero-sum game: one man's liability is another man's asset. The value of global financial assets fluctuates by trillions of dollars every day and yet economic life goes on. There is a virtually unlimited supply of capital in the world ready to fund profitable new ventures and/or to recapitalize failed banks. Truth be told, the market has already wiped out almost 80% of the market cap of Eurozone financial institutions in the past four years, yet the Eurozone economies continue to function as always.

Will the politicians please stop trying to "fix" this Eurozone debt problem? A trillion or two of defaults might end up doing us all a world of good.

Service sector report unimpressive

2011-12-05T09:24:00.001-08:00

The November ISM service sector report was lackluster. It paints a picture of an economy that is just muddling along. There are sectors of the economy that are doing much better, however, which are not reflected in this report: mining and technology, for example. But overall the economy is growing only modestly faster than the growth of population.

Despite lackluster growth in the service sector, and despite the economy's huge supply of unused physical and human resource capacity, more businesses report paying higher prices than report paying lower prices. This has been a persistent theme for well over a year now, and I believe it is a testament to a) the fact that monetary policy is accommodative, and b) the Phillips Curve theory of inflation is fundamentally flawed. If anything, this tells us that the risk of a monetary policy error (e.g., the Fed not having eased enough to promote a recovery) is very small at this point.

A few months ago this chart was upbeat, but now it is not. It might be reflecting the onset of a double-dip recession, but I think we would need to see meaningful deterioration in a variety of other indicators before getting worried. Consider all the positives that are still extant: weekly unemployment claims are still declining, private sector jobs are still growing, manufacturing and capital indicators are still positive, the yield curve is still steep, auto sales are strong, commodity prices are still quite elevated, industrial production is still expanding, capital spending is still strong, and corporate profits are very strong. Plus, there are increasing signs that the Eurozone is not going to give up without a fight: Italian 2-yr yields are down over 200 bps in the last 10 days, hitting 5.6% today; that's still quite elevated from an historical perspective, but it is meaningfully below the 7% level which many consider to be critical.

3 million jobs and counting

2011-12-02T09:10:00.001-08:00

This has been one of the weakest recoveries in modern times, but nevertheless it has generated about 3 million new private sector jobs. This is shown in the top chart, which compares the results of the household and establishment surveys of private sector jobs. These two surveys don't always track each other closely, but over time they do tend to tell the same story. Over the past six months, the growth rate of private sector jobs according to the two surveys has been almost identical: 1.5% annualized. And since the recovery started, the household survey has found 3.2 million new private sector jobs, while the establishment survey has found 2.9 million. Call it 3 million new jobs and you're on pretty solid ground. We are still 6 million jobs shy of reaching a new high, however.

At the current 1.5% growth rate for jobs, the economy is on track to post real growth of 2.5-3.5%, since productivity tends to average about 2% per year, but it has only been 1% over the most recent 12 months. This isn't all that great, but it sure beats zero growth, and it is progress.

Meanwhile, the public sector continues to shed jobs. This is good news, since it shows that the U.S. economy is already undertaking the unpleasant task that faces many European economies, by shrinking its bloated public sector. If we could only be cutting spending the way we have been cutting government jobs, our deficit outlook would be dramatically improved. Regardless, we have only begun to scratch the surface of the problem: public sector jobs have only shrunk by 2%, while private sector jobs are still 5% below their 2008 high; and private sector jobs haven't grown at all for the past 10 years, whereas public sector jobs are still up over 3%.

The unemployment rate has dropped from 10% to 8.6%, which is more than would be expected given the relatively tepid rate of jobs growth, since the labor force tends to grow about 1% per year. But unfortunately, the labor force hasn't grown at all in the past four years, so tepid jobs growth translates into a larger decline in the unemployment rate. Apparently lots of folks have become discouraged and dropped out of the labor force. (Or maybe dropping out has been made easier by the huge increase in food stamps and unemployment insurance benefits.)

Today's jobs reports provide solid evidence of an economy that is growing at about a 3% pace. That's very slow given how many people are still looking for jobs, but it is better than a lot of other developed economies. And of course, there is no sign of the dreaded double-dip that so many have been calling for. We could be doing a lot better if we had more growth-oriented policies, but it is a testament to the dynamic nature of the U.S. economy that it has been able to grow in spite of all the headwinds it has faced: massive and wasteful "stimulus" spending, a 25% increase in federal spending as a % of GDP, a wrenching housing market collapse, a big increase in regulatory burdens, great uncertainty over the future course of monetary policy, and a historically weak dollar.

Perhaps more importantly, the U.S. economy today is in far better shape that it was expected to be just three years ago. As 2008 was drawing to a close, financial markets were priced to a global economic armageddon; credit spreads were predicting that as many as half of the companies in the U.S. would be bankrupt in 5 years' time; at 2.1%, 10-yr Treasury yields were priced to years of deflation and a multi-year depression; and the one-year forward-looking PE ratio of the S&P 500 was a mere 12.6. Yet despite all the improvement, the forward PE ratio of the S&P 500 today is only 12.1, and the 10-yr Treasury yield is only 2.06%. By these measures, the market is even more concerned about the future today than it was three years ago. In short, the market is expecting the fallout from Eurozone sovereign defaults to be worse than anything we have seen so far.

Auto sales remain strong

2011-12-01T15:37:00.001-08:00

November auto sales exceeded expectations (13.59M vs. 13.40M) and are up almost 11% in the past year. From the disastrous low in early 2009, sales are up almost 46%. They are still well below their pre-recession levels, but double-digit growth rates are nevertheless impressive.

Eurozone pulls back from the brink

2011-12-01T10:44:00.001-08:00

This chart gives an overview of the current state of 2-yr yields in the PIIS countries (I exclude Greece because there appears no hope of avoiding a significant default, with 2-yr Greek yields trading at about 120%). One thing stands out, and that is the recent decline in yields on Italian and Spanish debt. They have pulled back from the 7+% brink (France down about 100 bps from its recent highs, Spain down 130 bps), but they are still elevated. Both countries appear serious about controlling spending and reducing their deficits, but it will take a long time to convince skeptical investors that these countries have really changed their spendthrift ways. Eurozone 2-yr swap spreads have only declined marginally, from a recent high of 115 bps to 109 bps today; Europe is still facing enormous challenges.

The chart above shows that 2-yr French yields have sharply reversed, an indication that France remains almost as solid as Germany and is not likely to turn into another Italy. French spreads to Germany had blown out to 140 bps a few days ago, but are now back in to about 75 bps. That is a very welcome improvement, but in a normal world the spread would be close to zero.

Meanwhile, Eurozone equities are up some 15% from their recent lows. This is a palpable sign of relief—a decent pullback from the brink of an awful abyss. But it is probably premature to conclude that conditions in Europe will continue to improve in a straight line from here, even though its tempting to think. As a long-term investor, however, I think it makes sense to bet that the Eurozone economies will eventually do the right thing, and that makes today's equity valuations very attractive.

Economic news roundup

2011-12-01T09:43:00.001-08:00

The November ISM manufacturing index was a bit stronger than expected (52.7 vs. 51.8), and it reinforces the growing list of indicators which point to moderate growth and not a double-dip recession. As the chart above suggests, the current level of the ISM index is consistent with real economic growth in the current quarter of 3% or so, which is also consistent with the views of an increasing number of forecasters.

Construction spending was flat in October. Residential construction spending has been flat since mid-2009, continuing its worst performance on record. Total construction spending is now a mere 2% of GDP, also the lowest on record. This sector has been down and out for so long now that the only question is when the rebound will start. The more time passes, the more likely we are to see a rebound, and when it gets underway it could be very powerful. But that good news will probably come after we have seen more good news from other sectors of the economy.

Weekly claims for unemployment haven't changed much in the past few weeks, but the next few weeks could be very interesting. Seasonal adjustment factors anticipate a surge in claims in the coming week, so if actual claims don't surge, then the adjusted number will decline. Seasonal factors then anticipate another surge in claims towards the end of December and the first two weeks of January. If actual claims don't almost double from current levels in the next 6 weeks, then reported claims will decline. I suspect that companies are running at very lean and mean levels, and that would suggest that actual claims will not surge by as much as they have in the past around this time of the year. Something to look forward to in any event.

Monetary ease takes the edge off the panic

2011-11-30T10:49:00.001-08:00

A coordinated easing move by the world's major central banks was well received by most markets today. Lower interest rates can't solve all problems, however, and they won't fix the fundamental problem of bloated Eurozone government spending, but they can take the edge off the panic by backstopping the financial markets. 2-yr swap spreads are a good indicator of the tensions in financial markets, and today they dropped by over 10 bps in the U.S. Eurozone swap spreads remain quite high, however, as do yields on PIIGS debt. The wider gap between U.S. and Eurozone swap spreads indicates an increased likelihood that the U.S. economy will be insulated from the fallout of a PIIGS default, and that is a very positive development. With lots of recent economic indicators showing marginal improvement in the U.S. outlook, any steps taken to foster continued improvement in the U.S. economy also provide some indirect support for the Eurozone economy as it struggles toward a solution. A solution which in the end must consist at a minimum of restructured debt and meaningful cutbacks in government spending. There is no painless way to fix the PIIGS' problems, but avoiding financial market panic is a good way to allow the process to proceed.

The chart above show the ratio of the Vix Index and the 10-yr Treasury yield, which is a good measure of panic (a high Vix index signals panic) and despair (a low 10-yr yield signals little or no hope for growth). We're still in red-zone territory, but it would appear that there has been some progress toward a resolution.

The employment outlook is improving modestly

2011-11-30T10:01:00.001-08:00

I haven't seen any recent reports from the folks at ECRI, but I've got to believe they are getting nervous about the recession call they made a few months ago. Today's news from ADP was a definite upside surprise, in which they report that private sector jobs grew by 206K in November (vs. expectations of 130K), and they revised upwards the prior two months by 35K. Of course even these levels of job growth are puny compared with what we would expect to see in a normal recovery, but it sure is nice that things are improving—however modestly—instead of deteriorating as so many have been fearing.

The Challenger survey of announced corporate layoffs in November also confirmed that there is no sign of any deterioration in the jobs market.

While I'm on the subject of good news, it is also nice to see that the mortgage purchase index (above chart) has registered some solid improvement in the past several months, albeit from very low levels. Things could be a lot better, to be sure, but a 20% pickup in new mortgage applications—which is echoed in a pickup of pending home sales—is a sign that consumers are able to respond to record-low mortgage rates, and the housing market is clearing.

Putting PIIGS debt into context

2011-11-29T13:31:00.001-08:00

These two charts distill the essence of what is currently mesmerizing markets and economies around the world: the growing likelihood of one or more PIIGS defaults, which could potentially involve several trillion dollars worth of debt. Surely, the thinking goes, a multi-trillion dollar default would absolutely devastate the Eurozone economy, dragging most other economies down into an abyss even worse than the one we teetered on the edge of in late 2008.

Although "trillions" is undoubtedly a pretty huge number of dollars, the value of liquid, global bond and debt markets is about $110 trillion. The chart above shows the market cap of global equities, currently some $45 trillion. According to Merrill Lynch's indices of liquid bond markets, there are some $42 trillion of investment grade global bonds, and $21 trillion of high-yield global bonds. As the chart above also shows, the destruction (and creation) of trillions of dollars of equity cap happens routinely, sometimes on a daily basis. In one month alone (mid-September to mid-October '08), $15 trillion of global equity market capitalization was wiped out—not to mention the trillions that were erased from U.S. mortgage-backed securities—yet it was only a matter of 7-8 months before a global recovery got under way.

The world is a pretty big place, and markets are very deep. Italy's entire national debt is only 2% of the value of global capital markets, and much less if we add in the value of global property markets. Can the relatively tiny PIIGS tail seriously wag the huge global economy dog?

Stocks and bonds represent claims on future cash flows, and those cash flows in turn are generated by economies that are driven by billions of industrious workers utilizing hundreds of trillions worth of factories, roads, bridges, telecommunications systems, etc. Wiping out a few trillion of claims on those cash flows does not erase an economy's productive potential. It would be extremely disruptive, to be sure, but it's highly likely that at least 95% of those working today would be working and producing in the days, weeks, and months following even a multi-trillion dollar PIIGS default.

A big PIIGS default doesn't need to be earth-shattering. One important consideration that is often overlooked is that the world has had some 18 months to prepare for this. It won't be a "black swan" event that catches the world by surprise. The worst part of the financial collapse in late 2008 was just that: it came out of nowhere, totally surprising all but a very few, and the ensuing panic selling made things far worse than they otherwise would have been.

Apologies

2011-11-29T12:54:00.001-08:00

My apologies to those who frequent this blog and by doing so "contribute to our national paralysis." In his NY Times column yesterday, former editor-in-chief Bill Keller laments that one of the downsides of the internet is that it brings out the worst in economic commentary, distracting us from the unifying principles of "mainstream economics." If the only ones to comment were "serious scholars," then we could solve our national economic problems quickly. Instead, "lesser economists are thrust forward for their moment of fame as witnesses on behalf of dubious claims." As an example, he cites the 132 economists who agreed that Speaker Boehner's policy approach would "do more to boost private-sector job growth in America in both the near-term and long-term than the ‘stimulus’ spending approach favored by President Obama."

Reputable number-crunchers like Moody’s Analytics and some top-tier economists of both parties said Boehner’s statement would have little or no impact on the short-term employment problem. So who were these 132 economists? With a few exceptions they were academics from off-the-beaten-path colleges (no offense to Dakota State University), bloggers (the Calafia Beach Pundit?) and economists from devoutly libertarian think tanks.

And he went on to say:

Surely this dilution of authority contributes to our national paralysis. At the very least it befogs the discussion and fosters a pervasive cynicism.

I hasten to add that while Bill Keller and I graduated from Pomona College within a year of each other, I would like to think my training in philosophy (under the expert hand of the late Professor Fred Sontag) allowed me to keep a more open mind. Wisdom and experience do not come only to those in positions of "authority."

UPDATE: Another of the 132 signers of Boehner's letter writes a devastating critique of Keller's use and mis-use of economic theory in his Forbes column.

Housing price update

2011-11-29T12:18:00.001-08:00

The September release of housing price indices reveals that prices appear to be still in a gentle decline, especially after adjusting for inflation. But after adjusting for the fact that real incomes are growing and borrowing costs are at all-time lows, housing prices are more affordable today than at any time in recent decades, as shown in the chart (below) of housing affordability (when the index is 100, that means a family earning the median income has exactly the income needed to purchase a median-price resale home using conventional financing; levels higher than 100 mean that a median-income family has that much more income than needed).

Commodity recap

2011-11-28T12:09:00.001-08:00

With the future of mankind supposedly hanging by a Eurozone sovereign debt thread, paying attention to anything other than the political struggles in Europe to avoid default would seem silly. But since the damage has already been done, all we are witnessing these days is a game of financial musical chairs: who will be the unfortunate holder of PIIGS debt once it is eventually restructured? The economic losses have already occurred, since the PIIGS spent their borrowed money in very inefficient and non-productive ways. Debt defaults occur all the time, and they needn't imply the end of the world as we know it, even if they are huge. That's mainly because a debt default does not destroy demand, it simply makes lenders poorer and borrowers less poor—debt is a zero-sum game. But meanwhile there is no reason why a combination of defaults—surely Greece will default on a significant portion of its debt—restructurings, and more prudent fiscal policies couldn't allow the global financial markets to avoid a total collapse. And if the fiscal policy changes are growth-favorable (e.g., they avoid higher tax rates, and focus instead on flattening the tax code and cutting back on the size of spending relative to GDP), the global economy might even emerge from this mess in better shape.

So while we wait for the music to stop to find out who the winners and losers are, it might be worthwhile to review the action in the commodity markets.

Crude oil still trades at about two-thirds of what it briefly was worth in mid-2008, but it is still orders of magnitude more expensive than it was 12 years ago.

In constant dollar terms, crude is worth about 15% more today than it was in the early 1980s.

But we spend about one-third less for energy today than we did in the early 1980s, thanks to huge gains in energy efficiency. So on balance, energy prices do not represent an unprecedented burden on the economy.

Non-energy spot commodity prices are down 16% from their April '11 highs, but are still way above the levels that prevailed throughout the 1980s and 1990s.

Copper prices are about 25% off their highs, but still way above the levels of 10 years ago.

The problems in Europe may well have taken some of the edge off commodity prices, but by just about any measure, commodity prices are still relatively high. I think that reflects the fact that a) global demand remains sturdy, and b) monetary policy at most central banks remains very accommodative. I fail to find any sign in the commodity markets of a significant deterioration in the underlying economic fundamentals.

Consumers continue to deleverage

2011-11-28T08:55:00.001-08:00

According to the Fed, delinquency rates on consumer loans have fallen significantly since the last recession. This is a sure sign that consumers have been actively deleveraging, and that is good. The most recent reading on all consumer loans, 3.15%, is below the 3.5% average since this series began in 1987. The most recent reading on credit card delinquencies, 3.5%, is substantially below the 4.5% average since the series began in 1991. As I've noted before, this is also evidence that deleveraging does not destroy demand or otherwise necessarily weaken an economy. When a borrower pays down his debt, the lender must do something with the money received; either loan it to someone else or spend it on goods and services. Indeed, consumer deleveraging is a very normal part of a business cycle recovery, as this chart illustrates; it is not something to be feared.

HT: Mark Perry. And as he notes, if we could only get the U.S. government to demonstrate the same kind of financial responsibility as U.S. consumers have....

The demise of the euro has been greatly exaggerated

2011-11-27T18:02:00.001-08:00

With all the talk these days about the eurozone crisis, a coming eurozone crash, the death of the euro, etc., I thought it might be helpful to include this chart of the history of the euro from its inception through today, vis a vis the dollar. Maybe both are going down together, but the euro is still strong relative to the dollar. From the looks of this chart alone, you would never guess the euro is in serious trouble. Perhaps because it's not?

Maui sunset

2011-11-26T11:08:00.001-08:00

Last night we were treated to a spectacular sunset. By the way, I took this photo with my iPhone 4S—hand-held, no special settings or adjustments. The sun is setting behind the island of Lanai.

Maui morning

2011-11-23T11:02:00.001-08:00

Idyllic Napili Bay in northwest Maui, where we are staying. The island of Lanai is in the background on the right.

Weekly unemployment claims show continued improvement

2011-11-23T10:23:00.001-08:00

As both these charts show, the trend in weekly unemployment claims remains down, and that reflects positively on the health of the U.S. economy. No sign of a double-dip recession here.

The real question, of course, is whether the U.S. economy's growth path—which is hardly robust—can withstand the deterioration going on in Europe.

As this chart shows, Eurozone stocks have really been clobbered relative to U.S. stocks in the past year (down by about one-third), and the Eurozone sovereign debt crisis is the most likely culprit. The chart also shows that the big trends in Europe and the U.S. have a strong tendency to coincide. (Actually, all major economies tend to move in synch these days.) I'm tempted to think that Europe's problems are fairly unique, and that a sovereign debt default or two will not result in a serious deterioration in the Eurozone economies. Thus, it shouldn't derail the U.S. recovery. What we have seen so far is a lot of anguish over this question that has not yet translated into any hard evidence of U.S. economic deterioration.