Thursday, July 20, 2017

Global green shoots

If you want bad news and arguments for why the market is due to collapse any day now, just spend a few hours reading Zero Hedge or browsing the media and punditry. Very few observers these days are willing to pound the table for stocks, considering they have been rising for more than 8 years and are hitting new highs almost every day. Is there anyone who isn't dismayed that Trump and the Repubs haven't been able to repeal and replace Obamacare after years of trying? Is there anyone who is confident that Trump and the Repubs will succeed in massively lowering tax rates? I don't see any evidence that the market is pricing in a stronger economy: 5-yr real yields on TIPS are a mere 0.15%, a level that suggests the market is priced to sluggish growth for as far as the eye can see. And then there are the geopolitical risks. The chances of North Korea dropping a nuclear bomb somewhere are frighteningly high, and China seems bent on expanding its ocean domain. And of course, the Fed is in tightening mode, and tight monetary policy has been the precursor of every recession in modern times.

Yet amazingly, despite the obvious problems out there, complacency reigns: the Vix Index and the MOVE index (the bond market's version of the Vix) are both down to all-time lows. Isn't it scary that the market is moving higher at a time when there are so many troubling things going on and complacency is rampant? Anyone in his right mind would be concerned, no?

Investors are on the horns of a dilemma: it's tough to be bullish, but it's also expensive to be bearish. The earnings yield on stocks is still quite high relative to the yield on cash and bond market alternatives; so hiding out in cash means giving up a lot of precious yield. But almost $9 trillion in bank savings deposits paying almost nothing says that there are lots of people who are reluctant to take on market risk. Indeed, when I look at the market, I see more evidence of caution than I do of exuberance. Bill Miller, a long-time friend and former colleague, maintains that the market is still in a "safety bubble" after the shock of 2008. I've long observed that real yields on TIPS are miserably low, and for that matter nominal yields on sovereign bond markets nearly everywhere are very low. So it's not at all obvious that the market is running on fumes.

Amidst all the worries, however, there are actually some encouraging developments. Call them global green shoots. The U.S. may be stuck in slow-growth mode, but the rest of the world is looking better on the margin. Some charts follow which help flesh out the story:


China is pulling back from the abyss, after scaring the bejesus out of nearly everyone two years ago (check out the "Walls of Worry" chart below), when it looked like their stock market and economy were tanking. As the chart above shows, real GDP growth now looks to have stabilized in a 6-7% range.


As the chart above shows, China's forex reserves have been stable for most of this year, after having plunged from $4 trillion to $3 trillion over the previous two years. The fact that the yuan has stopped falling suggests that the central bank has managed to maneuver the yuan to a level that is balancing capital flows. This further suggests that the fundamentals in China has improved significantly in the past two years. Capital inflows and outflows are about equal these days. (The level of forex reserves is a direct result of net capital flows; reserves decline when outflows exceed inflows, and vice versa.)


Due to the yuan's strength and relative stability against the dollar, inflation in China is virtually identical  to inflation in the US, and it has been for a number of years. This further suggests that the Chinese currency could remain relatively stable against the dollar going forward. What's good for China is good for the world.


As the chart above shows, the Chinese stock market has been trending higher for the past 18 months after the bursting, beginning in mid-2015, of what in hindsight looks like a huge speculative bubble. Now that the dust of that bursting has settled, we see that the Shanghai Composite has actually kept pace with the S&P 500 over the past four years. This is a problem? On the contrary.


The Eurozone has been struggling for many years and continues to struggle. Since the beginnings of our bull market in March, 2009, Eurozone stocks have underperformed their US counterparts by over 30%, as the chart above shows.


But as the chart above shows, Eurozone industrial production now is outpacing US industrial production.


Eurozone ISM manufacturing surveys confirm that the industrial side of the Eurozone economy is regaining its health. And the Euro is strengthening on the margin of late, another sign that the outlook for Europe is not as gloomy as it used to be.


Industrial metals prices are up strongly in nearly every currency over the past 18 months. This is an excellent sign that global economic activity is picking up.



Emerging market stocks have been doing exceedingly well in the past 18 months, as the charts above show. In dollar terms, the Brazilian stock market has more than doubled and the MSCI emerging market equity index (second chart) is up some 50% since early last year. It's not that emerging economies are booming; rather, it's that the outlook has improved from dismal to maybe Ok. Emerging economies are also being bolstered by stronger commodity prices: the CRB Spot Commodity index is up 20% in the past 18 months.


The current PE ratio (using 12-month trailing earnings from continuing operations) of the S&P 500 is just under 22. That's well above its long-term average, but is that a sign of unwarranted exuberance?


Not necessarily. Earnings are growing, as the chart above shows. 12-month trailing earnings are up more than 7% in the past year, and we see positive earnings surprises almost daily.


The current earnings yields on stocks (the inverse of the PE ratio) is 4.6%. That means that if earnings held steady at current levels and if companies paid out all their earnings, the dividend yield on stocks would be 4.6%. The chart above compares the earnings yield on stocks to the yield available on risk-free 10-yr Treasuries. It's unusual for stocks to yield a lot more than risk-free bonds, as they do today. By this measure stocks look cheap. About as cheap, in fact, as they were in the late 1970s, when the world was terrified of stocks. When the stock market is fueled by optimism, as it was in the 1980s and 1990s, the yield on stocks is typically less than the yield on bonds. People are willing to accept a lower yield on stocks because they expect that stock prices and dividends (and earnings) will rise in the future.


The chart above shows yields on a variety of different investments, from Treasuries to mortgage-backed securities to corporate bonds, REITs and emerging market debt. The yield on stocks stacks up quite favorably to the alternatives, and that again is unusual. If the market were optimistic, the yield on stocks would be much lower than the yield on less risky alternatives. Put another way, when the yield on stocks is relatively high, thus the price of stocks is by inference relatively low.


Shown above is an update of one of my favorite charts. The equity market rally which began last November has been driven in no small part by a decline in fear and uncertainty, coupled with a belief that the economy is likely to continue to be relatively sluggish but also relatively stable (which is reflected in a modest rise in 10-yr Treasury yields since November).


The chart above shows the implied volatility of stocks and bonds. Both are now at new lows: that means the stock and bond markets have never been so unconcerned about the future. In a sense, the capital markets appear to be pretty sure that nothing much is going to happen to the economy for the foreseeable future: growth is going to remain modest, inflation is going to remain relatively low, and the Fed is not likely to upset the applecart. In addition, the market seems pretty sure that earnings are not going to increase, and are more likely to be flat or to decline.

To sum it up, although the market is priced to mediocrity (sluggish growth, flat to lower earnings), the global green shoots are hinting that the future may be a bit more exciting. If Trump and the Repubs manage to pull off a successful tax reform, then things could get really exciting.

Thursday, July 13, 2017

Fiscal policy dreaming

The Federal government last month passed a dubious milestone, having spent $4 trillion over the previous 12-month period for the first time ever. That works out to over $11 billion per day. To make matters worse, the budget deficit is once again on the rise, as spending is outpacing revenues. The budget deficit is now running over $700 billion per year, or roughly 3.4% of GDP, up from a post-recession low two years ago of $411 billion, or about 2.2% of GDP.

Although we obviously need to rein in spending, it would also be smart to cut taxes, particularly corporate taxes. The Feds collected $300 billion from corporations over the past year, which was less than 15% of adjusted corporate profits (according to NIPA figures) in the year ended last March. A relative handful of corporations reportedly hold well over $2 trillion in profits they refuse to repatriate—they've already paid tax once on that money overseas, why pay another 35% for the "privilege" of repatriating the money? If corporate income taxes were lowered, say, to 15%, the Feds might wind up doubling corporate tax collections (15% of $2 trillion) overnight as those profits were repatriated, and everyone would be thrilled. Most importantly, however, a much lower corporate tax rate would most likely result in a reverse wave of corporate inversions—the U.S. would instantly become the most attractive place on earth to do business! With companies rushing to repatriate profits and new companies rushing to relocate here, it's a safe bet that employment would surge and individual income taxes would surge as well. What's not to like about that?

Just about everyone—on both sides of the aisle—agrees that corporate income taxes are too high. Why is this such a hard problem to fix? It's the lowest-hanging fruit out there. Instead, the Republicans are struggling with healthcare reform, which is not something that government can easily achieve. The healthcare industry responds weakly (and mostly negatively) to politician's ministrations, but it would surely respond powerfully and productively if the heavy hand of government were removed altogether. Free markets always beat administered markets. The proper role of government might be limited to administering subsidies to the poor and the unfortunate among us, but then again that's what charity is for. I've always believed that private charities work far better than government bureaucracies at taking care of the sick and the poor. I have more discussion of this in a recent post.


In the 12 months ending June 2017, federal spending totaled just over $4 trillion, while revenues were $3.3 trillion. Spending is rising at a 6-10% pace, whereas revenues have been stagnant for the past 16 months.


The weakness in revenues can be traced to individual and corporate income tax collections. Payroll taxes have been rising at a steady 5-6% pace for the past several years, in line with the growth in jobs and incomes. Wealthy individuals and corporations can minimize their taxes by postponing income, accelerating deductions, and avoiding the realization of capital gains, but working stiffs have no way of avoiding their monthly FICA deductions. The anticipation of future cuts in income taxes is likely having a big adverse impact on federal tax collections these days, and it's not helping the economy to grow either. Best to get this done ASAP, GOP!


The chart above shows the evolution of the federal budget deficit. We were staring into the abyss in 2009, with a staggering deficit $1.5 trillion, which was more than 10% of GDP. Things look better now, but federal finances are once again deteriorating on the margin.


The chart above shows the long-term trends in spending and revenues as a % of GDP. If anything is out of line, it's spending, which is running above its postwar average and is accelerating on the margin. All that's really needed is to slow the growth in spending and apply a good dose of tax-cutting, which would likely boost the economy and tax collections as well, much as we saw in the late 1990s. Spending restraint and growth are the sweet spots that Congress needs to be hitting.

Friday, July 7, 2017

Another jobs nothing burger

As I said two months ago about the April jobs number (April jobs: a nothing burger), today's June jobs report doesn't change the big picture at all, even though it was touted as an upside surprise (+222K vs. +178K). The best that can be said about the jobs market is that the rate of growth of private sector jobs—which was roughly 2% by the end of last year but which has slowed to 1.7% of late—has stopped declining. With jobs growth of 1.7% and productivity of 0.5% or so, real GDP is likely going to average a little over 2% for the foreseeable future. Which is what it has been doing since mid-2009. These two charts tell you all you need to know about the jobs market:


Private sector jobs are the ones that really count. They've increased by about 175K per month over the past year. That's substantially less than the 240K per month we enjoyed in the 1997-99 period. And the rate of growth has been trending downward at a modest rate over the past year or two.


The best jobs growth we've seen over the past 15 years or so was just over 2% per year. Currently, private sector jobs are growing at a 1.7% pace. Nothing to write home about, but not exactly a disaster either. 


The reason this has been a tepid recovery is that we've had weak jobs growth on top of very weak productivity growth, and both are explained by a dearth of productive investment. To be sure, corporations have generated significant profits in the current recovery, but most of those profits ended up funding the federal government's voracious appetite for debt. I explained this three years in this post.

What happened to all the profits? Almost all of the most incredible surge in profits in modern times was squandered by our government, flushed down the Keynesian drain.

Thursday, July 6, 2017

A 16-chart review of the outlook

Blogging's been light of late, mainly because there hasn't been much going on. The economy is still growing at a disappointing pace, inflation is still relatively low and stable, and the equity market is no longer cheap but neither is it overly optimistic. It's encouraging to see the progress that Trump has made towards reducing regulatory burdens, but it's disappointing to see that his major legislative initiatives (tax and healthcare reform) are bogged down in Congress. I wish he had chosen the low-hanging fruit (reducing the corporate tax rate) first, rather than tackling the very messy and complicated task of repealing and replacing Obamacare. Reducing the corporate tax rate is something just about everyone understands must be done, and it would have already unleashed a wave of new investment in the economy, and that in turn would have made all the other reforms easier on the margin. Fortunately, it's still too early to rule out some major policy developments which could significantly improve the economic outlook. If there's a silver lining to the cloud of sub-par growth, it's that the economy has tremendous upside potential—if Trump's pro-growth policy promises become reality.

In recent months there have been some negative developments in the economic outlook (a slowdown in housing starts, car sales and jobs), but those have been outweighed, in my view, by a variety of positives (tight credit spreads, strong ISMs, rising industrial commodity prices, rising real yields, and increased global trade). I review these below in 16 updated charts.

Meanwhile, my major worry continues to be North Korea, since it is difficult to see how we can find a non-violent resolution. As one wag put it, we've been kicking the can down the road for decades, and we've finally run out of road. A nuclear attack somewhere in the world is now more likely than it has been for decades. One well-placed EMP bomb, moreover, could wreak massive, incalculable destruction in any of the world's highly developed economies.


Housing starts weakened considerably in recent months, and have now been flat for the past few years. The continued rise in builder sentiment suggests that the slowdown is likely to prove temporary. In the meantime, mortgage rates remain historically low, so housing affordability is not a negative. 


Car sales have also weakened of late, and have been flat for several years. One likely explanation is that the advent of ride-sharing services has sapped demand for car rentals, which in turn has depressed sales of new cars to rental fleets.



Notwithstanding the slowdown in housing and autos, the labor force continues to expand, albeit at a slower pace. The growth of private sector non-farm payrolls has slowed from a 2% pace last November to a 1.6% pace as of May. Slower jobs growth is disappointing, but there is no sign at all that employers are shrinking their workforce: unemployment claims remain very low, and corporate layoffs have rarely been lower than they were last month. As long as jobs keep growing, families keep growing and cars keep wearing out, it's reasonable to think that housing and car sales are likely to experience at least modest growth going forward.

The June ISM Manufacturing Index was strong, and it suggests that second quarter GDP growth is likely to be substantially better than first quarter. The Atlanta Fed currently estimates Q2/17 growth to be about 2.7%; combined with first quarter's 1.4% growth, that would average out to 2% for the first half, which is right in line with the economy's growth trend over the past 8 years. Ho-hum. 


Export orders are one area of strength, and that jibes with a widely observable global pickup in trade so far this year. It's hard to overestimate how important global trade is to prosperity.


The all-important service sector continues to look healthy as well.


As the chart above shows, industrial metals prices have increased over 50% since early last year. Industrial commodity prices in general are up over 25% during the same time period. All of this despite the fact that the dollar has been roughly flat for the past two years. This strongly suggests that global economic activity is picking up, not inflation.


2-yr swap spreads, excellent indicators of market liquidity and systemic risk, are at optimal levels in the US and are only modestly elevated in the Eurozone. This further suggests that financial fundamentals are healthy, and the economic outlook is likely improving.


5-yr Credit Default Swap spreads are an excellent and highly liquid proxy for the financial health of corporations. These spreads are at relatively low levels, and that in turn belies concerns that corporations may be over-leveraged or that the economic outlook may be deteriorating.


Real yields on 5-yr TIPS continue to inch higher, suggesting that the outlook for the economy is improving. I posted at greater length on this subject here.


C&I Loans, shown in the chart above, were flat for the past 8 months or so, but the latest data showed a resumption of growth. It remains unclear whether the pause—which interrupted six years of steady and strong growth—was a sign of a restriction in lending or a decline in the demand for credit. In any event, the lack of growth in business lending does not appear to have had any obvious impact on the economy.


With the recent release of Q1/17 data, we see that households' financial burdens (see chart above) remain relatively low and stable. The federal government and businesses in general have been leveraging up, but not households.


PE ratios today are about 25% above their long-term average, according to Bloomberg (using earnings from continuing operations as the E and the S&P 500 index as the P). One could argue that this shows that stocks are moderately over-valued.


But if you look at PE ratios in the context of the current yield on risk-free bonds, then stocks are still cheap. The chart above subtracts the yield on 10-yr Treasuries from the earnings yield (the inverse of the PE ratio) of the S&P 500. The typical stocks offers an earnings yield that is about 230 bps higher than the yield on 10-yr Treasury bonds. That is unusual, since equities have a higher expected return (being much more risky) than Treasuries. This can only mean that the market is very distrustful of the ability of corporations to continue to growth their earnings. That's been the case throughout the current bull market, and it was the case in the late 1970s, when stocks were in the throes of a major bear market. In other words, the market is hardly exuberant these days.


If anything stands out as worrisome, it's the fact that the market does not appear to be very worried at all. The Vix/10-yr ratio, my favorite indicator of the market's nervousness about the prospects for growth, remains relatively low.