Wednesday, May 25, 2016

Risk aversion is still the order of the day

The S&P 500 is only 2% away from making a new, all-time high, and its PE ratio today of 19.3 (according to Bloomberg) is about 15% above its 55-yr average. The Fed has been taking extraordinary measures to ensure that the economy has plenty of liquidity, and has targeted extremely low short-term interest rates for over 7 years. Taking these facts into consideration, you could be forgiven for thinking that super-easy monetary policy and low interest rates have created another bubble in the price of risk assets.

There is no shortage of pundits, economists, and investors who are worried that the Fed has blown an asset-price bubble that is ready to pop. I'm among the minority who have been arguing—for many years—that this is the wrong way to look at things. I don't see the Fed as the aggressor; I think the Fed is more a follower. The Fed hasn't driven yields to absurdly low levels, the Fed has merely responded to a market that has been deeply risk averse and generally pessimistic.

The Fed has been doing what it should: in the presence of a huge demand for money and safe assets, the Fed must take extraordinary measures to increase the supply of money and safe assets. Quantitative Easing was not money printing. It was the Fed's way of turning risky notes and bonds into safe assets (i.e., bank reserves, which are functionally equivalent to T-bills, the gold standard of risk-free assets). The demand for money and safe assets has been unprecedented, and the Fed's response has been commensurate. I explained this in greater detail here.

Evidence of risk aversion (another way of describing the market's huge demand for money and safe assets) is everywhere. Investors all over the globe are willing to pay extremely high prices for risk-free assets, while at the same time shunning much higher yields on risk assets. Moreover, it's not unreasonable for there to be so much risk aversion: economic growth has been miserably slow just about everywhere, and volatility has at times been intense. Most people are still terrified of another Great Recession and/or Global Financial Market Crash. Once burned, twice shy, as the saying goes.

Here are a bunch of charts, in no particular order, which help prove my points:

Households have reacted to the Great Recession by cleaning up their balance sheets. As the chart above shows, financial obligations as a % of disposable income are now at multi-decade lows. Households have almost never been so prudent in managing their finances. Nobody wants to get caught with too much debt when/if the next financial crisis rolls around.

Leverage was all the rage in the 2000s, as home prices escalated and mortgages became easier to find and abuse. But the housing market collapse taught us all a valuable and time-honored lesson: prices can't go up forever, even if money is almost free. As a result, the average person is far less leveraged today than he or she was a decade ago, as the chart above shows.

You know things are getting shaky when delinquency rates on loans start rising, because that is evidence that borrowers are getting stretched. Today that's not the case at all. In fact, as the chart above shows, delinquency rates on consumer loans and credit cards have never been lower. People have learned the hard way that leverage doesn't always pay.

People have also learned that credit card debt is a killer. As the chart above shows, outstanding credit card debt today is still far less than it was in 2008, and as a % of disposable income, credit card debt has collapsed, and hasn't risen at all for the past several years.

The chart above is the quintessential measure of the demand for money. It shows the ratio of M2 (currency, checking accounts, CDs,consumer savings deposits and retail money market funds, all very liquid and spendable forms of money) to nominal GDP. The ratio has never been higher, and it has been rising by leaps and bounds for the past 15 years. This tells us that people want to hold an ever-increasing amount of their annual income in the form of money and money equivalents. Bank savings deposits, for example, have risen from $4 trillion in late 2008 to $8.4 trillion today (a 110% increase); over the same period, personal income has risen by a mere 27%. People have been actively socking away money like squirrels before the winter arrives. Virtually the entire avalanche of new bank savings deposits has been used by banks to buy notes and bonds which in turn they sold to the Fed in exchange for bank reserves. The banking system, in other words, invested their huge deposit inflows in the safest thing they could find: T-bill equivalents (aka bank reserves). Bank credit is growing at a 7-8% rate, but that is only a very small fraction of what it could be, given the huge amount of excess reserves that banks hold. Banks are behaving just like people who are very risk averse.

The chart above compares the price of gold to the price of 5-yr TIPS (using the inverse of their real yield as a proxy for their price). These are two classic safe assets: gold has been the safe haven asset par excellence for all of history, and 5-yr TIPS are the only way an investor can lock in a guaranteed real rate of interest on an asset that is itself risk-free. Although the prices of gold and TIPS have fallen over the past several years (they peaked around the time of the PIIGS crisis in the Eurozone), they are still quite elevated from an historical perspective. In constant dollar terms, gold prices have averaged $500-600 over the past century, while real yields on 5-yr TIPS have averaged 1.3% since their inception in 1997. Investors are still willing to pay a hefty premium for the safety these two assets afford. 

U.S. Treasury notes and bonds are universally considered to be the safest of all notes and bonds, given the guarantee of the U.S. government. 10-yr Treasury yields, shown in the chart above, today are a mere 1.87%, which is only inches higher than the all-time low of 1.4% registered about four years ago. That's another way of saying that the price of these bonds is very close to an all-time high. People all over the world are willing to pay top dollar for the safety of these bonds relative to other bonds. The PE ratio of the 10-yr Treasury today is about 53: to get a dollar's worth of yield on a 10-yr Treasury you have to pay $53. Compare that to the PE ratio on the average large cap stock today, which is just over 19, and you get a vivid feel for just how risk averse this market is.

But hold on, you say; isn't it the case that the Fed has artificially depressed the yield on Treasuries by buying trillions worth of them? Not necessarily, and most likely not. As the chart above shows, the Fed today holds the same percentage of outstanding Treasuries as it did prior to the 2008 financial crisis. And there's little or no correlation between changes in the Fed's relative holdings and the yield on those same Treasuries. For example, look at how the Fed's holdings soared in 2012-2014, at the same time that yields soared. You would have thought that huge Fed purchases would have pushed up Treasury prices and depressed Treasury yields, but just the opposite occurred. I explained this in greater detail here.

My point here is that the Fed cannot distort the yield on notes and bonds. The Fed can exert strong influence on short-term rates, but not on 5- and 10-yr rates. Besides, we have the TIPS market that helps discipline yields. In the chart above, I show the nominal yield on Treasuries and the real yield on their corresponding TIPS (Treasury Inflation-Protected Securities), and the difference, which is the market's implied inflation expectation. We know the Fed has purchased trillions of Treasuries, but they've only purchased about $60 billion of TIPS since 2008 (the Fed held 8.5% of outstanding TIPS as of March 2016). If nominal yields were artificially low because of huge Fed purchases, then the expected inflation rate should have been artificially low as well, but it is today very much in line with current inflation and forward-looking inflation expectations. 

In fact, the best measure of bond yields (i.e., their real yields) is the place to start your analysis of the bond market. As the chart above shows, there is a strong tendency for the real yield on 5-yr TIPS to track the real growth rate of the economy. That's not unusual at all. Think of the real yield on 5-yr TIPS as the risk-free expected real yield. It should be lower that the expected real return on riskier assets, just as the yield on T-bills should be lower than the expected nominal yield on riskier assets.  (This is straight out of modern finance theory.) You shouldn't be able to lock in a real rate of return that is higher than the expected real rate of return on risky assets; you should almost lways have to pay a premium for the risk-free nature of TIPS. 5-yr TIPS today have a slightly negative real yield, and that implies that the market expects that average real returns on other assets (for which real growth expectations are a good proxy) should be somewhat higher, and indeed they are, but not by much. As the chart above shows, 5-yr TIPS real yields today suggest that the market expects real GDP growth to be about 1-2% per year for the foreseeable future. That's a pretty pessimistic outlook. Real yields are low because nobody's taking the risks that are necessary to generate stronger growth; corporate profits are at near-record levels relative to GDP, but corporate investment is miserably weak. Weak growth implies low real and nominal yields on Treasuries, as long as inflation expectations remain anchored, as they still are.

Risk aversion can be found in the corporate bond market as well. As the chart above shows, credit spreads today are much lower than they were during prior panics, but they are still elevated relative to where they have traded during periods of relative calm.

As the chart above shows, fear has been a huge factor in the stock market for the past several years. I use the ratio of the Vix Index (the implied volatility of equity options, a good measure of fear and uncertainty) to the 10-yr Treasury yield (a good measure of the market's expectations for economic growth, as discussed above) as a measure of how worried and pessimistic the market is. Bouts of nerves and pessimism have driven the market lower repeatedly. Prices have recovered in the past few months as fears of deflation and fears of a China collapsed have receded. But the Vix/10-yr ratio is still elevated, thanks mainly to very low Treasury yields.

Yesterday brought the welcome news of a surge in new home sales in April, as shown in the chart above. There are still bright spots out there, thank goodness.

But as the chart above shows, the housing market is still pretty depressed from an historical perspective, even 10 years after its prior peak. Starts today are only about half what they have been during prior periods of good times.

When markets are risk-averse, as they still are today, investors enjoy a cushion of sorts against bad news, because the existence of risk aversion equates to bad news being priced in.

Tuesday, May 17, 2016

Core inflation is a solid 2%

According to the Ex-Energy version of the Consumer Price Index, inflation has been averaging about 2% per year for well over a decade. Of course, when you add back in energy prices—which have experienced gigantic swings from a low of $10/bbl in 1999 to a high of $150/bbl in 2008, to the current $50/bbl—inflation has been quite volatile. But if ever there were a time to ignore the impact of energy prices on inflation, now is the time. In real terms, oil prices today are only about 10% less than what they have averaged since 1970. So focusing on ex-energy inflation is justified and appropriate, since energy prices have increased by almost the same as all other prices, on average, for the past 45 years. Energy is not noticeably cheap nor expensive relative to other prices these days.

The chart above plots the Ex-Energy version of the CPI on a semi-log scale. It shows that inflation has had a strong tendency to average 2% per year. The only thing unusual about the behavior of inflation was in the 2006-2008 period, when core inflation reached almost 3% and ex-energy inflation slightly exceeded 3%. Since then, and despite massive increases in bank reserves, inflation has been remarkably stable and relatively low.

The chart above draws our attention to the current episode of a major decline in oil prices, and the decline of similar magnitude which occurred in 1986. Both times oil prices plunged, only to later rebound. In 1986 the headline inflation rate collapsed, then returned to the prevailing level of core and ex-energy inflation about a year after oil prices started to rebound. This time should be no different. Today we learned that the CPI increased by 0.4% in April, lifting the year over year rate to 1.1%. If the monthly increases in the CPI are only 0.2% per month for the rest of this year, inflation for 2016 would be 2.0%. That's not difficult to imagine at all.

The Fed is well aware of this dynamic, which is why they haven't panicked over the low rates of headline inflation we have seen over the past year or so. What worries them is that the economy remains sluggish and they know that the market is very nervous about the potential for higher rates to weaken the economy further. I don't think another 25 bps hike in short-term rates would do much harm to the economy, but it's hard to make a compelling argument for doing so. After all, inflation is running right around the Fed's target, and the economy is unlikely to soon defy the myriad headwinds which have been holding it back for the past seven years.

The real action these days is in the election dynamics. The future course of fiscal policy could make a world of difference to the economic outlook in coming years. But for the moment the outcome of the November elections is a jump ball. We'll just have to wait and see how things progress in the months to come. I suspect the Fed will reach the same conclusion and stand pat at the June FOMC meeting four weeks from now.

Thursday, May 12, 2016

The end of declining deficits

On a rolling 12-month basis, the federal budget deficit hit a peak of almost $1.5 trillion in February 2010. From that dizzying height of just over 10% of GDP it fell steadily for six years, hitting a low of $402 billion last February, a mere 2.3% of GDP. It's unlikely to get any lower than that, unfortunately, unless and until we see stronger economic growth and/or significant reform to entitlement programs. For the foreseeable future, the budget deficit is likely to get bigger; it's already jumped to just over $500 billion as of last month. There are several culprits: weaker economic growth, weaker tax collections, and a pickup in spending. 

The chart above shows the nominal level of federal spending and revenues on a rolling 12-month basis. Note that spending was flat from mid-2009 through last year, but is now on a clear uptrend. At the same time, it appears that the strong uptrend in tax revenues, from early 2010 through early last year, is fizzling out. Two virtuous trends have reversed. 

The chart above shows the level of federal spending and revenues as a percent of GDP. Note how both have been trendless over long periods.

It's time for policymakers to revisit Hauser's Law: there is a limit to how much tax revenue can be extracted from the private sector, and we are now approaching that limit. Tax rates have risen in the past year or so, but tax collections have weakened. Raising taxes—as both Clinton and Sanders are proposing—will almost surely fail to close our current and projected budget gap, because higher rates will discourage work and investment, while encouraging more tax evasion. 

As the chart above shows, the weakness in tax collections is concentrated in individual and corporate income tax collections—both of which are driven by weaker profits—while payroll tax collections are rising at a 4% rate that is commensurate with the ongoing rise in payrolls and wages. 

The first of the two charts above shows the nominal level of federal budget surpluses and deficits, while the second shows the level as a % of GDP. There's nothing necessarily scary here, since it will be awhile before the deficit rises meaningfully relative to GDP. The larger message is that the budget deficit is going to be returning to the headlines before too long, and politicians who fail to understand Hauser's Law will mistakenly call for a fix in the form of higher tax rates. The correct fix, of course, would be to reduce tax rates, simplify the tax code, and reform entitlement programs in order to keep spending under control.