Monday, August 18, 2014

Solid gains in commercial real estate


According to data from the CoStar Group, the commercial real estate market is enjoying very healthy conditions. Prices have been rising at a 10% annualized rate for the past five years. Sales activity was up 14.5% in the first half of this year compared to a year ago, and only 8.7% of properties were selling at distressed prices, the lowest such rate since Q4/08.

It's hard to find anything to complain about here: there's been a robust and ongoing recovery in a market that was severely punished in the Great Recession. This wouldn't be happening if the economy weren't improving. However, the strength of property prices is likely driven at least in part by easy money and low interest rates, and as such could be a "canary in the coal mine" signaling rising inflation pressures. It's certainly hard for the Fed to square this data with the need for extremely low interest rates for the foreseeable future.

Meanwhile, it's a bonanza for investors in commercial real estate: 10% annual price gains plus rental income of 4% or more. That helps explain why the Vanguard REIT ETF (VNQ) has registered a total annualized return of 23% since mid-2009: back then, investors feared that the real estate market would never recover, and consequently many real-estate-related securities were trading at seriously depressed valuations. In any event, should the Fed indeed make an inflationary mistake by keeping interest rates too low for too long, investors should remember that real estate has traditionally been a good hedge against unexpected inflation.

Friday, August 15, 2014

Why the U.S. economy is not doomed to a Japan-style deflation or stagnation

10-yr sovereign yields in Germany have plunged to just under 1%, and Japanese yields are a mere 0.5%. U.S. 10-yr yields seem to be following suit, dropping from 3.0% at the end of last year to 2.34% today. Is the U.S. going the way of Japan? Are the industrialized economies doomed to very slow growth for the foreseeable future? The following graphs say no.


The above graph shows the evidence that's grabbed the market's attention of late: yields in Germany and the U.S., which tend to move together, appear to be converging with those of Japan. 


German sovereign yields are to the Eurozone bond market as U.S. Treasury yields are to the U.S. bond market: the risk-free benchmark. Here we see the huge difference between the strength of the German economy and the Eurozone average. Germany is being dragged down by its weak neighbors, but it is still somewhat ahead of the U.S. economy over the past 17 years. But's it's also clear that the Eurozone as a whole is just treading water, much like the Japanese economy until a few years ago, and that provides some justification for the very low Germany bond yields. But the U.S. economy has been far stronger, and continues to be, so there is little or no reason to think the U.S. yields have to converge with German yields.


July manufacturing production in the U.S. rose at a strong, 8.2% annualized pace in the past six months, and has now reached a new, all-time high. After the devastating recession of 2008-2009, manufacturing production has risen by more than 25%. It's a shame it's taken this long to recover to former highs, but the growth and improvement is nonetheless impressive. 


July producer price inflation is up at a solid 2-3% pace, as the graph above shows.

There is no sign in these graphs that the U.S. is in danger of getting sucked into a Japan-style deflation and/or stagnation. If anything stands out here, it's the relatively low levels of U.S. yields in light of the economy's strength and ongoing inflation.

Wednesday, August 13, 2014

Why retail sales aren't important



July retail sales came in below expectations (0.0% vs. +0.2%), but the month-to-month volatility of this series makes this fact meaningless, as the graph above suggests. Retail sales growth may have slowed a bit in the past year or so, but there is no indication of any significant decline. And in any event, this is not one of those series that tends to be a leading indicator. If anything, it's a good lagging indicator. Careful readers of this blog will know that I rarely feature this statistic.


One subset of the retail sales number is the so-called "Control Group," which takes out the most volatile components: autos, building materials, and gas stations. Not surprisingly, it is less volatile than total retail sales. Regardless, it too was relatively weak, increasing only 0.08% for the month. But as the graph above shows, sales continue to trend higher, but at a slower rate than in prior decades. This is the "new normal" that everyone talks about.


We see the same "new normal" phenomenon in the inflation-adjusted Control Group, shown in the graph above. The economy is just not growing as fast as it used to, and the apparent "output gap" continues to widen to a significant degree—currently about 15%, or a little more than $40 billion per month of sales that would have occurred if the economy were back on its long-term trend growth path. That's pretty significant: about half a trillion a year in sales that have failed to materialize.

The main reason for the sales shortfall is obvious: job growth has been very modest during the current recovery, and there are still as many as 7-10 million people of working age who are on the sidelines for whatever reason. And the reason for that is obvious: business investment has been relatively anemic, despite record-setting profits. Even though capital is abundant, there's a shortage of people and corporations that are willing to take the risk of starting a business or expanding an existing business.


Capital goods orders, shown in the graph above, are a good proxy for business investment. In real terms, orders are still significantly below where they were in 2000, yet after-tax corporate profits today are more than double what they were back then. Without new investment in plant, equipment, machinery, computers, software, office equipment, and research, the economy is just not going to be able to grow very fast. And without more people working, retail sales just aren't going to grow as fast. 

Note: as a supply-sider, I believe that more investment and more jobs are what drive retail sales; retail sales do nothing by themselves to grow the economy. It's the supply side of the economy that drives growth, not the demand side. Supply creates its own demand, to paraphrase the French economist Jean-Baptiste Say. Looked at from a global perspective, the world can "demand" goods and services only to the extent that it can pay for those goods and services. The vast majority of the world would love to buy and consume more than they do, but they lack the means. Give them a job and their purchases of goods and services will increase. And by the way, you can't augment aggregate demand by borrowing, since that only shifts the existing supply of money from one pocket to another. For that matter, all money earned (with the exception of what is literally stuffed under the mattress) is always spent: if I don't spend all I earn, then I must give my "savings" to someone else to spend, and I'll hope that he is able to spend or invest that money in a way that allows him to pay me back with interest in the future. 

In order to have a stronger economy, I believe that we need to do everything possible to encourage work, investment, and risk-taking. A straightforward way of doing that is to make the tax rates lower and flatter by eliminating deductions and subsidies. Lower taxes increase the after-tax reward to taking risk, and it is natural to think we would see more investment if tax rates were lower, especially today, when marginal tax rates are unusually high, especially for businesses that have to compete in the world economy with offshore corporations that pay a much lower tax rate. In addition to lowering taxes we need to reduce the costs and complexities of running a business, since that lowers the hurdle rate for new investment. Complying with today's astonishingly complex regulatory environment just gets harder and harder as the number of pages in the Federal Register expands exponentially.

One thing for sure: exceptionally low interest rates are not going to stimulate more investment. The past five years is proof of that. Besides, the Fed hasn't so much depressed interest rates artificially, as it has accommodated the tremendous amount of risk aversion in the world that followed in the wake of the financial crisis and recession of 2008. Interest rates are low because people and corporations are reluctant to take risk. We've been living in a very risk-averse environment. We can break this cycle by increasing the after-tax rewards to taking risk and by reducing the regulatory burdens that plague new investment. Unless and until Washington adopts a supply-side agenda, we're likely to be stuck in a slow-growth world. Policymakers need to entrust the private sector with engineering a stronger recovery, and empower it with business- and work-friendly policies.




Tuesday, August 12, 2014

Taxes don't lie

As far as I can tell, the debate over the U.S. economy's health and growth—or lack thereof—still rages. I've argued since late 2008 that the recovery would be a sub-par recovery, mainly due to excessive government spending and inflationary/uncertain monetary policy. (See more references to a sub-par recovery here.) I've consistently argued that even though the economy would likely experience a disappointingly slow recovery, it would nevertheless be a better recovery than the market was expecting, and that would be good for equities. Both of those forecasts have been vindicated, even though I thought we'd see growth of 3-4%, and instead we've seen growth of only 2.1% since the recovery began about 5 years ago.




Meanwhile, there is no shortage of (mostly Keynesian) economists, notably Paul Krugman, arguing that the recovery has been weak because government spending stimulus was insufficient. Lately, there have been a growing number of economists arguing that the recovery has been weak because of a significant decline in government spending. To me the Keynesian arguments are weak, because they all cheered the passage of the ARRA in early 2009, one of the most significant expansions of federal spending in generations. Yet regardless of whether federal spending increased or declined relative to GDP, real growth has been pretty steady at about 2-2.5% on average for the past 5 years. You can see this in the graphs above: despite a gigantic increase in federal spending relative to GDP in 2009, and a huge, subsequent decline in spending relative to GDP, real economic growth since 2009 has been a pokey 2-2.5% throughout. We had a similar decline in spending relative to GDP in the 1990s (though it never went so high as it did in 2009), yet economic growth averaged a solid 4% per year the latter half of the 1990s, thanks in part to lower tax rates.

As a supply sider, I don't see the logic behind the theory that more government spending is stimulative and less is restrictive. How can taking money from those who are working and giving it to those who aren't create a bigger economic pie? It creates perverse incentives, for one thing. And it also channels the economy's scarce resources into the less-productive sectors of the economy. True economic growth only comes about when scarce resources are utilized in a more productive manner. I think the massive amounts of deficit-funded spending we've seen since 2008 are one of the main reasons the economy has been so weak. Bigger government is not better. With spending now having shrunk to historic norms relative to GDP, I'm tempted to say that growth has a chance of picking up.

Be that as it may, it still appears that the debate today centers around the question, Is the economy growing? I think the evidence of growth is significant, even though growth is sub-par. But one sure way to tell if we're growing and prospering is to look at tax receipts. Tax receipts don't lie: they are driven by incomes and profits and the number of people working.


As the graph above shows, federal revenues have been rising for over 4½ years. Annual federal revenues are up by almost $1 trillion from their recession lows. They are up $365 billion from their pre-recession high, for a gain of 13.7%. Most of the gain has come from individual income taxes (including capital gains taxes) and payroll taxes. That is powerful testimony to the fact that the economy is generating more jobs, higher incomes, and higher profits. Corporate taxes probably would have contributed a lot more if our corporate profits tax weren't so high, since more and more companies appear to be avoiding the repatriation of their foreign profits. These days the government is earning 35% on lots of nothing, when instead it could be earning, say, 10-15% on $500 billion or more (of repatriated profits) per year if we had the wisdom to reduce our corporate tax rate.


And in any event, as the graph above shows, federal revenues today as a % of GDP are almost exactly equal to their post-war average. Imagine how much higher they might be if this had been a robust recovery with lower and flatter tax rates!

It's the weakest recovery ever, but it is nevertheless a recovery. Taxes don't lie. And it could be a much stronger recovery if tax rates and transfer payments were reined in.

Saturday, August 9, 2014

Bring back the wise old men

When will this country once again be guided by older men, wise in the ways of the world, and not by academics with pipe dreams and magical solutions conjured by spending and monetary "stimulus?" For example: a man like George Shultz, whose op-ed in today's WSJ, "How to Get America Moving Again," speaks in simple terms of powerful, market-based solutions that could revitalize our economy. Here I summarize a few:

"Cleanse the personal income tax system of deductions and lower the marginal rate on a revenue-neutral basis."

Stop taxing corporations' foreign earnings twice, and lower the corporate tax rate to a more competitive 20%.

Simplify the overly complex regulations that make running a business so difficult and costly.

Make monetary policy more predictable by making it rules-based.

Reform (and in the process save) Social Security by adjusting benefits by prices, not wages, and by applying the change only to those under the age of 55. Increase the normal retirement age, and
"when workers reach age 65, stop any payroll deductions and employer contributions to encourage them to stay in the labor force. Their pay will increase and they will be less costly employees. Incentives work."

(As a 65 year old retired person I am painfully aware of the additional 15.3% marginal FICA tax I would face on self-employed income up to $114K, on top of the federal, state, and medicare taxes I'm already paying. It's a powerful disincentive to work.)

Allow insurance companies to offer high-deductible catastrophic healthcare policies, and encourage the use of health-saving accounts. (I note in addition that powerful free-market forces could be unleashed by a simple change to the tax code that allowed everyone, not just employers, to deduct healthcare insurance expenses.)

"We must have a robust military capability. And then we need to conduct ourselves in a credible way."