Tuesday, May 26, 2015

Housing still a bright spot in an otherwise dull economy

According to the BEA's first estimate, the economy grew at a miserable 0.2% annualized rate in the first quarter of this year. The current consensus of opinion holds that this will be revised down to -0.9%. However, we've seen this movie before (e.g., last year's first quarter growth was miserable too), and what happens is that growth bounces back in the second quarter. The GDP numbers are notoriously volatile, much more so than the actual economy, which has considerable "momentum."

Most of the data I've seen over the past few months suggests that the economy continues to grow at a relatively slow pace. Most importantly, there are none of the classical warning signs of deterioration. Swap spreads continue to be very low and relatively stable. Credit spreads are relatively low, and have come down somewhat from their January highs—most of the damage in the credit sector has occurred in the energy and oil-related space, and even there spreads have tightened in recent months. Monetary policy continues to be accommodative, and the nominal and real yield curves are still positively sloped. Real borrowing costs are very low or negative for most borrowers. Commodity prices are down on the margin, but are still much higher (about 40% higher) than they were a decade ago. Fiscal policy could be much more pro-growth, but it's quite unlikely to take a turn for the worst; in fact, it's not unreasonable to think that tax and regulatory burdens are more likely to ease in the future than increase. 

One notable exception, however, is the recent trend in cities like Los Angeles and San Francisco to jack up minimum wages. This is like slapping small businesses with a big new tax, as Mark Perry points out, and that is very likely to hurt growth in the affected local economies. The economic ignorance and willingness to pander of politicians apparently knows no bounds. As a reminder, I noted a few months ago that only about 1% of those who work actually earn minimum wage or less. The ones hurt the most from higher minimum wages will be the young and the poor who find that it's much harder to find that first job. The vast majority of workers—and the lion's share of the economy—will not be much affected.

Today's economic releases show that the housing market continues to recover at a fairly impressive pace. According to Case-Shiller, U.S. home prices are up over 30% since early 2012, and are only 13% below their all-time highs of 2005. In real terms, prices are still about 25% below their 2006 highs, so we're likely years away from another housing "bubble." Meanwhile, April New Home Sales were up a very strong 26% from year-ago levels.

Charts and commentary follow:

The two charts above show the nominal and real level of housing prices as measured by Case-Shiller. Both show that prices have been moving steadily higher for more than three years.

As the chart above suggests, the ongoing rise in home prices (which are up 4.7% in the past year), is likely to contribute positively to the CPI over the next year or so. Higher home prices mean higher future rents, and rents make up about 25% of the CPI.

April New Home Sales were stronger than expected (517K vs. 508K), and were 26% above year-ago levels. There is still plenty of upside potential here.

April Capital Goods Orders were also stronger than expected (+1.0% vs. +0.3%), but they remain quite sluggish. I prefer to look at a 3-mo. moving average of capex, and by that measure orders were on the weak side and haven't increased at all since early last year. In real terms, capex hasn't increased at all for the past two decades! This is the least impressive part of the economy, since it reflects a dearth of business investment, and that limits the economy's future potential growth. As a consequence, while it's quite likely that GDP growth will be much stronger in the second quarter than it was in the first, that won't change the underlying fundamentals, which continue to point to growth of roughly 2-3%, with a large (about 10%) and growing "output gap" that I estimate to be about $2 trillion. 

Friday, May 22, 2015

Treasury yields are very low relative to inflation

Volatile oil prices have distorted the Consumer Price Index; removing them reveals that inflation has been running at a relatively stable 2% rate for the past 12 years. No one—especially the Fed—needs to worry that inflation is too low. If anything is too low, it is Treasury yields.

As the chart above shows, the year over year change in the headline CPI has been unusually volatile in the past decade. Core inflation (ex-foor and energy) has been much more stable. The main difference between these two measures of inflation is oil prices.

The chart above plots the CPI index ex-energy on a semi-log scale to show that it has been increasing at a 2% annual rate, on average, since 2003. There is no indication at all that the underlying rate of inflation today is any more or less than it has been for over a decade. For all intents and purposes, inflation is only slightly less than 2%, which is precisely what the Fed has been aiming for.

The chart above compares the year over year change in the Core CPI to 5-yr Treasury yields. Yields tracked inflation trends fairly closely from 2003 through early 2011. Beginning around mid-2011, the PIIGS crisis began to erupt, pushing the Eurozone economy into a recession, which in turn raised concerns that the U.S. economy was vulnerable to a double-dip recession as well. Strong demand for the safety of Treasuries, fueled by risk aversion, has kept sovereign interest rates abnormally low—relative to underlying inflation—for the past four years.

Fears of a Eurozone credit crisis sparking another financial collapse also drove gold prices to $1900 in September, 2011, while strong demand for the safety of 5-yr TIPS drove real yields deep into negative territory. The world was terribly concerned that economic growth was going to be miserable and financial markets were at risk. Demand for the safety and security of gold, Treasuries, and TIPS was intense. As the chart above shows, demand for gold and TIPS eased measurably in 2013, but remains relatively strong: risk aversion has eased somewhat but it is still very much with us today.

The chart above shows the real yield on 10-yr Treasuries (using the Core measure of CPI) since 1960, during which time real yields by this measure have averaged 2.4%. Today's level of real Treasury yields is clearly abnormally low from a long-term historical perspective. The reason for this, I believe, is the persistence of risk aversion and an enduring skepticism about the prospects for economic growth.

If economic policies were to become more growth-oriented, and if regulatory burdens were to decline, it's reasonable to think that Treasury yields could almost immediately rise by 150-200 bps or so, thus restoring real yields to more historically "normal" levels.

Thursday, May 21, 2015

Claims keep falling, but risk aversion is still the problem

This continues to be the weakest recovery in modern times, but it has set a record for the lowest rate of layoffs.

Using a 4-week moving average, initial claims for unemployment last week fell to their lowest level in 15 years. 

Relative to the number of people working, claims are now at their lowest point in recorded history. The average worker has never been so little at risk of losing his or her job.

Meanwhile, after-tax corporate profits have never been so strong.

Nevertheless, despite record-setting profits, business investment has been quite weak. In real terms, capital goods orders, a good proxy for business investment, are at the same level today as they were 20 years ago, even though the economy has grown by over 60% in that time! 

The problem today is not layoffs and unemployment, it's a lack of investment. Animal spirits are lacking, and risk aversion is still high.

Sovereign yields in developed countries are very near their all-time lows. That is the best proof that animal spirits are lacking and risk aversion is still high. The world is willing to pay extraordinarily high prices for the safety and security of sovereign debt. Why? Because the world is very afraid of the alternatives, even though they yield substantially more.

As the chart above shows, the earnings yield on the S&P 500 has rarely been so high relative to the yield on 10-yr Treasuries.

Weak investment and tepid jobs growth have created a $2 trillion annual shortfall in GDP (by my calculations, the so-called output gap is about 10% of GDP).

Even a massive increase in government spending and transfer payments couldn't boost the economy. Indeed, it's quite likely that it was the big increase in government spending and transfer payments that weakened the economy.

The solution to this dilemma is straightforward. We don't need more attempts at government stimulus. What we desperately need is more incentives for private investment. We need lower marginal tax rates and we need reduced regulatory burdens.