Thursday, April 28, 2016

The weakest recovery continues

First quarter GDP growth was miserably weak, as expected. The economy grew at a 0.5% annualized pace, which means an expansion of only $22 billion in the past three months—equivalent to a rounding error. In the past six years, we've seen miserably slow growth in the first quarter four times now, which suggests that a statistical problem may be the culprit. Whatever the case, the economy grew 2.0% in the past year, which is only slightly less than the 2.1% annualized growth rate that has been sustained since the recovery got underway in mid-2009. So it's not unreasonable to think that nothing much has changed and that we will see stronger growth numbers for the remainder of this year.


The chart above shows the real and nominal annualized growth rates of the U.S. economy by quarter. Note the green circles which highlight unusually weak growth rates in the first quarter. When four of the past six first quarters show a similar pattern it suggests there is something wacky going on with the seasonal adjustment factors. 


The chart above shows the year over year growth rate of the U.S. economy. By this measure the past year was very much in line with previous years. Since the recovery began in mid-2009 the economy has growth at an annualized pace of 2.1%.


The chart above plots real GDP on a semi-log scale in order to better appreciate how the economy has underperformed relative to its long-term trend growth rate. By failing to bounce back to its trend growth path, and by growing only 2.1% a year instead of 3.1%, the economy is now almost $3 trillion smaller than it might have been had this been a typical recovery. We've never seen such miserably slow growth following a recovery, and the problem has persisted for almost seven years now.

What explains the persistence of slow growth? The two charts below suggest that the economy suffers from a failure to thrive because of a lack of investment. Risk aversion has held back entrepreneurship and risk-taking in general. For years I've explained that this has been a risk-averse recovery.


Capital goods orders, shown in the chart above, are a good proxy for business investment. In nominal terms, capital goods orders are no stronger today than they were prior to the last two recessions. In real terms, capital goods orders today are the same as they were in 1995. But of course the economy has grown by over 60% since then. Simply put, there has been a huge shortfall of business investment, especially if you consider that corporate profits today are about 9% of GDP, which is substantially higher than the 6.5% average of the past 57 years. 


The chart above, which shows fixed private domestic investment as a percent of GDP, tells the same story: investment has been unusually weak. 

Strong profits, weak investment: its a conundrum that is difficult to explain with confidence. But it's probably not a coincidence that for the duration of this unusually weak recovery we've seen a huge accumulation of public debt, a huge increase in regulatory burdens (e.g., Obamacare, Dodd-Frank), generally high and rising marginal tax rates, and a punitively high corporate tax rate. The rewards to risk-taking, and the burdens of running a business and complying with increased regulatory mandates have depressed the economy's animal spirits. The government is slowly smothering the private sector.

Wednesday, April 27, 2016

Chart updates

This has been a slow-blogging month so far, mainly because I haven't seen much change in the economic and financial environment. The market remains worried about slow growth and weaker corporate profits, but less so than a few months ago, thanks to rising oil prices and signs of stability in China. Meanwhile, it's quite likely that the U.S. economy is still growing, albeit slowly, as jobs growth and the labor market both look healthy. There is plenty of upside potential in the future, but much depends on the future direction of fiscal policy, and that in turn depends on the November elections—with the outcome still very much up in the air.

So here are some updated charts that I find interesting, in no particular order, with some brief commentary below each one:


Industrial commodity prices are up 15% since last December. At the very least this suggests that global economic activity is strengthening on the margin. The Chinese yuan has been stable over this same period, suggesting further that conditions in China are not deteriorating as many had feared.


Commodities have risen in price in all major currencies since December. This is not just a dollar-driven phenomenon, and that reinforces the notion that rising commodity prices reflect improving economic conditions.


Oil prices have been much more volatile than other commodity prices (note the difference in magnitudes of the two y-axes). However, both have tended to move together. Oil prices are up an astounding 70% since their mid-February low.


The dollar has been relatively flat since early last year, and this appears to have provided some important support to commodity prices of all types.


Housing prices have been rising for the past four years. In real terms, prices have tended to rise about 1.4% per year on average. Prices today do not seem to be out of line with historical trends. In the past four years, home prices on average have risen by an annualized 8%.


Fear has been an important source of stock market volatility in recent years. Fears have subsided of late, and that has allowed stock prices to rise.


Credit spreads have subsided as well as fear in general. Most of the fear was concentrated in the oil patch, and rising oil prices have brought a sigh of relief to the entire corporate bond market. 




The number of active drilling rigs in the U.S. has plunged by almost 80% since late 2014, in direct response to lower oil prices. This illustrates the power of market prices, since lower prices have worked to discourage oil exploration and production while at the same time encouraging more oil consumption. Crude oil production in the U.S. has declined by7% since last June, after almost doubling in the previous six years.


Fixed mortgage rates are within inches of all-time record lows. There may never be a better time to refinance a mortgage or take out a new mortgage.


Applications for new mortgages have surged by almost 50% since late 2014, largely in response to low and declining mortgage rates. This reflects a significant improvement in housing market fundamentals.


The spread between the yield on MBS collateral and the 10-yr Treasury has been remarkably stable (70-80 bps) for the past several years. This stability suggests that the appetite for MBS has been relatively strong even as the demand for new mortgages has surged of late: borrowers are more willing to borrow, and lenders are more willing to lend.


According to Bloomberg's Financial Conditions Index, conditions are relatively healthy, though still shy of what they have been during earlier periods when markets were optimistic and economic growth was stronger.


U.S. equities have outperformed Eurozone equities by a significant and perhaps unprecedented margin over the past seven years. Eurozone equities have made no progress on balance since 1999, in contrast to the U.S. equity market which has attained new highs.


10-yr Treasury yields today are only 45 bps above their all-time record lows of mid-2012. Relative to core inflation, 10-yr Treasury yields are negative. Yes, negative yields exist in the U.S. The real yield on 2-yr Treasuries is now -1.4%! Yields are very low and even negative relative to inflation, relative to rising home prices, and relative to rising commodity prices. This encourages borrowing and speculation. In the late 1970s, negative real yields contributed to rising inflation. Some central banks have resorted to negative interest rates in an attempt to boost inflation. Since negative interest rates strongly discourage holding cash, they are inflationary since they weaken the demand for money at a time when there is an abundant supply of money, effectively creating an over-supply of money. To the central banks that are paying people to borrow money, I say "be careful of what you wish."


The chart above compares the price of gold with the price of TIPS (with the inverse of the real yield on TIPS being a proxy for their price). Both have been in a declining trend for the past several years. I've argued that this reflects a declining demand for safe assets and a gradual return of the confidence that was lost in the wake of the 2008 financial crisis. I think it also reflects less concern regarding the potential for QE to boost inflation. But the recent upturn in both prices could be an early sign that negative interest rates are beginning to bite: the market is now willing to pay more for the protection these two assets offer from rising inflation and general uncertainty. This may be the canary in the coal mine of rising inflation.


Even though 10- and 30-yr Treasury yields are very close to all-time record lows, the spread between the two is relatively high and rising from an historical perspective. This is the bond market's way of saying that short-term interest rates are quite likely to rise in the future, and it is also a sign that the economy is not on the verge of another recession (the yield curve typically flattens in advance of recessions).

Wednesday, April 20, 2016

Pessimism recedes

Not much has changed in the past few months since I posted A review of key charts: no recession, no deflation, lots of pessimism, except that things have played out more or less as expected. As I observed last week, there have been some encouraging developments that have thrown cold water on fears that China would collapse and oil prices would go to zero. Here are just three of the more important charts that are worth updating:


Commodity prices continue to rebound from their lows of several months ago. Oil prices are up much more than 50%, and as the chart above shows, industrial metals prices are up over 25% in just the past 3 months. At the very least this rules out the threat of a global economic collapse; more importantly, it hints strongly that economies around the world are beginning to improve on the margin. Later this month we'll hear that first quarter growth was miserably slow, but that's definitely old news at this point. What matters is what's happening now.


Credit spreads continue to fall, thanks to rising commodity prices. And of course 2-yr swap spreads, my favorite leading indicator of economic and financial market health, continue to be very low and thus very encouraging.


Equities continue to rally as fears are gradually allayed. I can't say the market is optimistic, however, since 10-yr Treasury yields continue to be extremely low (~1.8%). There's still a lot of pessimism priced into Treasury bonds these days, and PE ratios are only moderately above average, despite the fact that corporate profits are very strong relative to GDP.

What's driving the market higher is not optimism but receding pessimism.