Thursday, August 28, 2014

What happened to all the profits?

In the six years ending June, 2014 (a period which encompasses the worst of the 2008 financial crisis and the entirety of the recovery to date), the after-tax profits of U.S. corporations totaled about $8.9 trillion. This marked an all-time record for corporate profits, both nominally and relative to GDP: profits averaged about 9.4% of GDP per year. By comparison, over the past 55 years, after-tax corporate profits have averaged only about 6.4% of GDP per year.

Over the same six-year period, the federal government borrowed about $7.4 trillion from the U.S. and global capital markets to fund its deficit. This resulted in a doubling of the federal debt burden, from 36% of GDP in mid-2008 to about 73% today.

Despite assurances from politicians and most economists of Keynesian persuasion, not only did the biggest and most rapid increase in our federal debt burden since WW II fail to boost the economy, it coincided with the weakest recovery in history—growth of only 2.2% per year on average. (I was among those who warned in late 2008 that this would happen, and quite a few times over the years following.) This is not a problem of not spending enough, it is a failure of ideology, and arguably the most expensive such failure in the history of the world.  

Here's the failure in a nutshell: The government can't stimulate the economy by borrowing from Peter and sending a check to Paul, because that doesn't create any new demand—it's like taking a bucket of water from one end of the pool and pouring it into the other end; the level of the water doesn't change. And the government can't stimulate the economy by spending more, because the government is notoriously inefficient (not to mention the fraud, waste, and incompetence that surround most major public initiatives); the private sector is far more likely to spend its money wisely and productively than the government is. Growth only happens when an economy produces more from a given amount of resources—when productivity rises. And productivity only rises when people work more, smarter, and more efficiently, and that takes hard work and risk. You can't just dial up productivity, you have to work for it. We can't "spend our way to prosperity," as the late and great Jude Wanniski told us.

The past six years in effect have been a laboratory experiment to determine whether Keynesian economic theory is valid. The result? Keynesian economic theory is (or should be) officially dead. It doesn't work. Government can't boost the economy by borrowing or spending more money. Politicians will be unhappy to hear this, of course, since they would prefer that we think they can dispense growth and prosperity on demand. Those who insist in perpetrating this myth should be voted out of office.

Here's my interpretation of what really happened in a nutshell: the private sector generated $8.9 trillion of profits in the past six years, and the federal government borrowed 83% of those profits to fund a massive increase in transfer payments, income redistribution, bailouts, subsidies, and a modest increase in infrastructure spending (as I noted here, only 8% of the 2009 American Recovery and Reinvestment Act went to transportation and infrastructure). Update: we recently learned that $5 billion was spent by the USDA on "questionable or unsupported costs."

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.

Now of course many will object to my grossly simplified explanation of what happened. It's true that a good portion of U.S. corporate profits still reside overseas—they haven't been repatriated because companies are loathe to pay the onerous 35% corporate income tax on profits that have already been taxed at their point of origin. But those profits are nevertheless made available to the global capital markets, and money is quite fungible. A trillion dollars of unrepatriated corporate profits can easily find its way back to the U.S., where it can end up being invested in Treasuries owned by a foreign entity. It might just as easily end up being borrowed by companies who want to expand their operations. But no matter how you look at it, corporate profits—wherever they are earned, and wherever they end up—are a source of funds for capital markets, and Treasury borrowings are one way those funds are put to work (or squandered, if you will). It doesn't matter if corporations didn't directly purchase all the bonds that Treasury sold: the net result is that $8.9 trillion of corporate profits were dumped into the capital markets over a six-year period, and the Treasury borrowed $7.4 trillion from those same capital markets over the same period. 

Record profits and record (post-War) government borrowing, all to no avail. 

The following graphs document many of the points made above:

Bailouts and the 2009 ARRA "stimulus" bill resulted in a significant boost to federal spending from mid-2008 to mid-2009. At the same time, the devastating effect of the Great Recession resulted in a predictable collapse of revenues as jobs were lost and profits shrunk. The gap between the red and blue lines was funded by the issuance of about $7.4 trillion of Treasuries.

The true burden of federal borrowing can only be appreciated by comparing how much the government owes relative to the size of the economy, because it's the economy that is the ultimate source of the funds to repay the debt. A $7.4 trillion increase in federal borrowing from mid-2008 to mid-2014 resulted in a record, post-war doubling of the federal debt burden in just six years, from 36% to 73% of GDP.

Despite an unprecedented increase in fiscal "stimulus," the economy has grown at only slightly more than 2% per year on average during the current expansion. This is by far the weakest recovery ever. The conclusion should be obvious: at the very least, fiscal stimulus didn't help, and it's not a stretch to think it actually hurt the economy.

Although this has been the weakest recovery ever, corporate profits have never been stronger. That (the unprecedented sluggishness of the economy despite the unprecedented growth of corporate profits) most likely can be explained by the fact that federal government borrowing consumed almost all of the profits; corporations generated tons of economic resources (i.e., capital) that the government then squandered. When the government commandeers a huge portion of the fruits of the private sector's labor, much money is wasted through inefficiencies, bureaucratic costs, waste, fraud, and the creation of perverse incentives (e.g., taking/borrowing from the most productive members and giving/lending to the least productive). The result is meager growth. 

This is the first recovery in which real growth has not rebounded, within a few years, to its long-term trend. Thus there is arguably a "shortfall" of growth that amounts to $2 trillion dollars or so in lost income each year. We are paying a huge price for this failed experiment in government "stimulus."

Tuesday, August 26, 2014

Durable goods orders blowout

Janet Yellen just took a roundhouse blow to the chin: July durable goods orders rose by an astounding 22.6%, and are up over 33% in the past year, thanks mainly to a surge in Boeing's aircraft orders. This virtually demolishes her meme that the economy is sickly and in need of ongoing, extraordinary monetary ministrations. We know that aircraft orders are quite volatile on a month-to-month basis, but as the graph above shows, the July jump in orders is unprecedented. Orders of this magnitude don't come from an economy that is struggling. This news reflects a global increase in confidence in the future of travel that is simply staggering, and historically cheap borrowing costs have undoubtedly contributed to the euphoria. 

Capital goods orders, shown in the graph above, strip out the volatile transportation and defense sectors, and are a standard proxy for business investment. But even here we see that orders have increased by over 8% in the past year. A few months ago this series was moribund, reflecting a lack of business confidence in the future. No longer. Orders still have a ways to go before reaching new high ground in real terms, but at the current rate that is likely to happen within a few years, if not sooner.

This remains the slowest recovery on record, but the economy looks to be on solid ground, and very likely to improve with time. If I were a member of the FOMC I'd be sweating bullets right now. Easy money increasingly looks to have overstayed its welcome.

Monday, August 25, 2014

The dollar is up but it's still weak

In the past three years, the dollar has risen over 10% against a basket of major currencies (see graph below). That's good on the margin, but the fact remains that the dollar is still quite weak from a long-term historical perspective. To put it another way, rather than saying that the dollar is strong on the margin, it's more accurate to say it's "less weak." However you put it, though, the dollar is confirming that the Fed is on the right track and the U.S. economy is doing better on the margin than most other countries, even though this remains the weakest recovery ever.

This chart compares the dollar to a trade-weighted average of the Euro, Yen, Pound, Canadian Dollar, Swedish Krona, and Swiss Franc. Here we see that the dollar today is worth a bit more than its average of the past five years or so.

Mid-2011 saw the all-time low in the dollar, both in real and nominal terms. The chart above compares the inflation-adjusted value of the dollar against a very large (broad) basket of currencies and against all major currencies. This is arguably the best measure of the dollar's strength or weakness. Relative to its all-time low, the dollar is up 8-14%. Relative to its long-term average, the dollar is down about 10% or so.

The fact the dollar is still weak helps explain why commodity prices are still relatively strong, as the graph above suggests. (Note the inverted axis for the dollar's value: the dollar's big decline from 2002 coincided with the big rise in commodity prices over the same period. The two tend to move inversely.) If the dollar continues to improve, however, I suspect that will be bad news for commodity prices.

Gold too should suffer from a stronger dollar, since it has tended to track commodity prices directly.

As the graph above shows, gold prices and TIPS yields have tended to move inversely for a number of years. Since bond yields and bond prices move inversely, the blue line is a proxy for the price of TIPS. What this chart shows is that the price of gold and the price of inflation-adjusted bonds have moved together, and both are down significantly from their highs of a few years ago. Higher interest rates going forward—especially real interest rates—are thus likely to coincide with a stronger dollar, weaker commodity and gold prices, and a stronger economy.

The graph above (and the two that follow) show my calculation of the dollar's Purchasing Power Parity (i.e., the value of the dollar that would make prices in the U.S. approximately equal to prices in other countries) against other major currencies. The principle source of the dollar's gains in recent years has been the weakness of the Japanese yen. The yen is now much less overvalued vis a vis the dollar than it was a few years ago, thanks to the BoJ's aggressive easing measures. Japanese inflation has risen from negative territory last year to 3.6% in the 12 months ended June 2014.

The pound remains substantially overvalued vis a vis the dollar, despite the fact that U.K. inflation in recent years has outpaced U.S. inflation.

The Euro has weakened a bit in recent months as it has become obvious that the Eurozone economy is still quite weak compared to the U.S. economy, and the ECB is gearing up to take more aggressive QE measures. But it is still somewhat overvalued vis a vis the dollar according to my calculations.

Stocks still shy of a real high

In the span of just over 5 years and 5 months, the S&P 500 index of U.S. stocks has tripled from its March 9, 2009 closing low. Today it breached the 2000 mark for the first time ever. Its long upward march over the decades remains intact, with yet more room on the upside.

In real terms, however, the S&P 500 is still about 5% shy of its all-time set in August 2000, as the graph above shows.

Relative to nominal GDP, stocks today are around the same level as they were in the early 1960s. Back then inflation was low and stable, and 10-yr bond yields were 4% and relatively stable. However, real growth in the early 1960s was relatively robust, averaging 5-6% per year, whereas now real growth is only about 2% or so. After-tax corporate profits in the early 1960s were 7-8% of GDP, whereas currently they are 9-10% of GDP, thanks largely to huge growth in overseas profits, which in turn is a function of rapid growth in emerging market economies. So although real growth today is much slower than it was back in the early 1960s, corporate profits are much stronger, and Treasury yields are much lower. All things considered, it's hard to find anything here that is seriously out of whack.

Wednesday, August 20, 2014

Great news: the Fed is likely to raise rates sooner rather than later

Since all the evidence to date suggests that the economy continues to improve on the margin, the FOMC (in their statement released today) is right to think that they may have to raise short-term interest rates sooner than expected. The market agrees, and that makes higher-interest-rates-sooner-than-expected virtually certain. At this point, I'm guessing that the FOMC will begin to raise rates no later than March of next year. However, at the rate things are improving, there is no reason they couldn't begin to "lift off" sooner than the end of this year.

This amounts to a triple dose of good news for investors: 1) the economy is definitely improving, 2) short-term interest rates are going to rise to more attractive and reasonable levels within the foreseeable future, and 3) all of this should serve to boost optimism and reduce uncertainty about the economy's prospects.

Here are some charts updated for recent announcements that are also germane to investors' decisions going forward.

The outlook for commercial real estate looks solid, as I noted earlier this week, and the July housing starts and recent survey of builder sentiment (see graph above) released today point to continued improvement—albeit relatively modest—in the residential market.

Architectural billings in July suggest that the outlook for commercial construction activity is positive and improving.

Nominal GDP has been growing at about a 4% pace for most of the past four years, yet the Fed has kept short-term rates extremely low. This is unsustainable. The sooner the Fed gets short-term rates back to levels consistent with 4% nominal GDP growth, the better. As the chart demonstrates, there is no reason to think that higher interest rates are detrimental to growth. Higher interest rates are instead a logical consequence of growth.

The CPI has increased at about a 2.3% annualized pace for more than 10 years. At this rate, prices increase by over 25% every decade. That's not insignificant, and it's not even close to deflation. It's not healthy either. In fact, it transfers hundreds of billions of dollars from the private sector to the federal government every year. How? The interest rate on cash, savings deposits, T-bills, bank reserves, and other short-term instruments is about 2% lower than the inflation rate. That means that holders of cash and short-term securities are losing 2% of their purchasing power every year, and the federal government and the Fed (which transfers any and all profits on its balance sheet holdings to the Treasury) are the direct beneficiaries.

It makes little or no sense for the Fed to continue to keep real short-term interest rates in deeply negative territory. It's potentially quite destabilizing, since it encourages excessive borrowing and leveraging and speculative activity. Eventually it could become a potent source of higher inflation, since negative real interest rates undermine the demand for money at a time when the Fed is still eager to supply it, and that is the classic prescription for an inflationary environment.

Over the past six months, both the total and the core version of the CPI have accelerated: consumer price inflation now is running somewhere between 2 and 2.5%. With short-term interest rates pegged at 0.25% or lower, real short-term interest rates are about -2% or worse. There are at least $10 trillion of short-term deposits and securities paying negative real interest rates, which amounts to a wealth transfer of $200 billion or more from the private to the public sector. This weakens the private sector—the source of most of the economy's strength—and strengthens the public sector, which is the sector with the highest propensity to squander scarce resources. It's a prescription for chronic economic weakness. It once made sense given the public's tremendous risk-averseness and the world's huge appetite for money, but with every day that brings news of an improving economy, it makes less and less sense.

Short-term interest rates are still quite low relative to current inflation trends. Holders of 5-yr Treasuries are losing purchasing power at the rate of about 0.5% per year. With inflation at 2%, 5-yr Treasury yields should be closer to 3%, or about double their current level.

Fortunately, it doesn't look like risk markets have become overvalued—yet. But the Fed could well find itself with this problem before too long. For now, credit spreads (see graph above) are not abnormally low, and PE ratios are only modestly above average (see graphs below). But if borrowing costs remain in negative territory—thus encouraging borrowing and leverage—the prices of risk assets could experience significant upside potential that at some point could become vulnerable to a crash. We're not there yet by any stretch, but that is what we need to watch out for.

The first of the above two graphs shows the conventional measure of PE ratios: equity prices divided by 12-mo. trailing earnings. The second uses the Shiller CAPE method: equity prices divided by a 10-yr moving average of earnings. (For a more detailed discussion of equity valuations, see this post from one year ago. Equities are less attractive today than they were then, but valuations do not appear to be stretched or unreasonable, given the exceptionally strong performance of corporate profits since 2009.) PE ratios by both measures are only modestly above their long-term averages.