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.