Sunday, November 22, 2015

Congratulations, Argentina!

The citizens of Argentina today turned a new page in Argentine history by voting out the Peronists after 12 troublesome years of rule. I've written several times over the years about the ravages of Peronism and the disturbing echoes of the same here in the U.S. It's a relief to know that things should be changing for the better. Congratulations to all my friends and family in Argentina!

The new president, Mauricio Macri, promises to be much more business friendly than the outgoing Cristina Kirchner. Although he is quite likely to officially devalue the peso, it will only be to the extent that it has already been devalued in the black market. If he successfully pursues the right policies—liberalizing the exchange rate market, lowering the punitive taxes and tariffs on exports, and squeezing out wasteful and corrupt government spending, to name just a few—it would not be surprising to see the peso strengthen a bit from the 15 pesos/dollar level that has prevailed in the black market. Once capital knows that it is free to leave, once creditors know that their loans will be repaid, once exporters know they can keep the fruit of their efforts, then the capital outflows of recent years should reverse. Already the stock market has been celebrating in anticipation, turning in one of the strongest performances in the Western Hemisphere.

Like the U.S., the Argentine economy has been underperforming for years. It only takes a few things to go right in order to unleash stronger growth.

PS: Macri takes over beginning December 10th.

Friday, November 20, 2015

Bank lending still booming

Outstanding loans at U.S. banks have increased over $800 billion in the past 12 months, and have been increasing at about a 7.5% annualized rate over the past year and two years. One area of bank lending—Commercial & Industrial Loans—has been expanding at 10.5% annualized pace for the past 5 years, and has expanded by over $200 billion in the past year, up 11.6%. Banks still have over $2.5 trillion of excess reserves (reserves in excess of what is required to collateralize their deposits), so bank lending could theoretically continue to expand at heady rates almost indefinitely.

As the chart above shows, the pickup in bank lending got started about two years ago, after being very weak from 2008 through 2013. It may just be a coincidence, but bank lending started picking up right around the time—in early January 2014—the Fed announced that it would "taper" its purchases of notes and bonds, which turned out to be a prelude to the end of the third round of Quantitative Easing. Prior to that time, banks had apparently been eager to accumulate excess reserves, and relatively unwilling to lend to the private sector. In effect, by accumulating excess reserves, banks were lending principally to the Fed. In the past two years this has shifted, with banks lending much less to the Fed and much more to the private sector. 

C&I Loans (shown in the above chart) are a good proxy for bank lending to small and medium-sized companies—those that are too small to access the capital markets directly by selling bonds. They've been on a tear every since the end of 2010. I've interpreted this to mean that banks as well as businesses have become more confident in the future: banks are more willing to lend, businesses are more willing to borrow. Lending isn't always good for economic growth, but in this case I think it has helped boost growth, because it is the result of increased confidence. The big international corporations may be borrowing to fund dividends and buybacks (and avoid double and triple taxation on their foreign profits), but I doubt that is the case with much smaller companies.

There is no sign here of any deterioration. Lending activity remains robust, and that suggests that the underlying economic fundamentals of the economy have not deteriorated and are possibly even improving. This lends support to the Fed's decision to start normalizing interest rates.

Since increased lending is a reflection of a reduced demand for money (borrowing money is like shorting a stock: you benefit if the value of the stock declines), it is entirely appropriate for the Fed to adopt a policy that attempts to offset that decline in the demand for money. Raising the interest it pays on excess reserves makes banks more willing, on the margin, to hold those excess reserves and less willing to increase their lending to the private sector. However, increasing IOER to 0.5% is unlikely to make a big difference, so we should expect to see further rate hikes going forward.

The risk the Fed runs is raising rates too little, too late. That's what has happened in nearly every business cycle expansion, and it explains why inflation almost always rises until the point when the Fed has finally "caught up" and tightened by enough to severely constrain the supply of credit—at which point the economy slips into recession. We are still years away from another of these credit roller-coaster rides, but that doesn't mean we don't need to worry.

Wednesday, November 18, 2015

Fed liftoff is good news

Today the release of the October FOMC minutes increased the likelihood (now about 70% according to implied pricing) of a modest rise in short-term interest rates next month. The market has been dreading such a move for years, but now that it is finally upon us, investors are shedding their fears, albeit slowly. After all, if the Fed is confident enough to end ZIRP, shouldn't we all be a bit more confident in the future? The economy is certainly not sizzling, but neither is it sputtering. It's been growing at a 2 - 2.5% pace for some six years now—the weakest recovery ever, to be sure, but a fairly steady one. Moreover, the economy has already withstood several shocks over the years—the PIIGS crisis, a Greek default, the fiscal cliff negotiations, the collapse of oil and commodity prices, and the devaluation of the Chinese yuan and the plunge in Chinese stocks—without skipping a beat. Perhaps most importantly, the prices of gold, stocks, and TIPS have been pointing to better times ahead for some time now.

The chart above shows the ratio of the S&P 500 index to gold prices, and it is divided into periods in which the ratio was rising (white) and falling (green). The numbers in red show the annualized rate of GDP growth during each period. Growth has been slower during times when gold is outperforming stocks, and faster when gold is underperforming. The ratio has been trending up for several years now, suggesting that growth could pick up further in the years to come. Investors tend to prefer gold during times of great uncertainty, and they tend to shun gold during times of rising confidence. Think of the green periods as times when investors run away from financial assets and embrace hard assets, and the white periods as times when financial assets look more attractive than hard assets. Good times for financial assets mean investment is generally strong, and investment is ultimately what drives growth.

Gold prices started falling in early 2011, and a year or so later TIPS prices started falling as well (the chart above uses the inverse of the real yield on TIPS as a proxy for their price). I've referred to this chart repeatedly in recent years, citing it as a good sign that pessimism is being slowly replaced by optimism.

Falling TIPS prices are the flip side rising real yields, of course, and real yields tend to track the economy's underlying real growth rate. So falling gold and TIPS prices are good signs that the market is becoming more confident about economic growth, and all this has happened as stocks have outperformed gold.

Real yields on 5-yr TIPS can be thought of as the market's expectation for the average real Fed funds rate over the next 5 years. Rising real yields over the past two years are a sign that the market has gradually become more confident that the Fed would sooner or later start raising real short-term interest rates. In the years to come, we are likely to see both TIPS real yields and real short-term rates continue to rise, and they should be accompanied by an improving economic growth outlook.

The chart above compares stock prices (blue) with the ratio of the Vix index to 10-yr Treasury yields (red), the latter being a proxy for the market's fears, doubts, and uncertainties. Every selloff in stock prices has been accompanied by a sharp rise in the market's fears, while rallies have tended to occur as fears have subsided.

Not surprisingly, as the chart above shows, consumer confidence has been rising since 2011, along with the fall in gold and TIPS prices, and the rise in stock prices.

All of the above point to better times ahead, driven fundamentally by improving confidence.