Thursday, December 1, 2016

Manufacturing and inflation get a lift

Both inflation and real growth are getting a modest lift these days. Recent economic data continue to support the notion that economic activity has firmed a bit in the second half of the year, after being weak in the first half. The improvement is modest, but nevertheless encouraging, especially since there are signs that overseas activity is picking up as well. The market is also pricing in a modest pickup in inflation, with expectations now centering around 2% over the next 5 and 10 years.


As the chart above suggests, he November ISM manufacturing report is consistent with an economy that is growing at a modest 2-3% pace.


It's encouraging that Eurozone manufacturing surveys point to some improvement in the second half there as well.


Industrial metals prices have surged almost 45% year to date, and that is very impressive. Some of the upward impetus could be speculative in nature, a bet that a Trump administration ramp up infrastructure spending in a big way. The hoopla surrounding the ARRA infrastructure spending bonanza was way overblown, but this time could be different. Instead of relying on local governments to identify "shovel-ready" projects, Trump may instead rely more on tax incentives and private sector funding, and that could mean an infrastructure push that could be more efficient and more productive. Caterpillar stock, up 60% since January, is sending the same message. However, I note that prices have been increasing all year, well in advance of any expectation that Trump might win.


This year has seen a remarkable divergence between the value of the dollar and industrial commodity prices. They normally move inversely (e.g., a stronger dollar coinciding with weaker commodity prices), but this year both the dollar and commodity prices have moved up (resulting in the divergence shown in the chart above). When prices move inversely it is a sign that the change in commodity prices has a monetary component (e.g., tight money is pushing the dollar up and deflating commodity prices). Now that they are moving together it could be that the rise in commodity prices is mostly being driven by improving economic fundamentals both here and abroad: prices are rising because demand is outstripping supply. The dollar has its own reasons for rising: the Fed is clearly in a mood to raise rates, while most other central banks are still on the sidelines. More recently, the dollar has gotten a boost from speculation that a Trump administration will be more growth-friendly.

Traditionally, a stronger dollar has spelled bad news for emerging market economies. That's because a stronger dollar has usually coincided with weaker commodity prices, and commodities are very important to emerging market economies. But this time emerging market economies have been taking a beating of late, even though commodity prices have been rising. Perhaps there is too much pessimism? Might it be the case that a stronger dollar and an improving U.S. economy and rising commodities will act like a rising tide that lifts all economies, particular those in the Western hemisphere?


The yen has fallen almost 13% against the dollar in just the past 3 months, and Japanese stocks have reversed to the upside. The strong inverse correlation between the value of the yen and the stock market is still in place. It's unusual for a weaker currency to be good for a country's stocks, but the case of Japan looks different from that of most countries. A weaker yen may be a sign that deflationary pressures—which have weighed heavily and uniquely on Japan's economy for many years—are being replaced by some much-needed reflation.


The U.S. stock market has outperformed the Eurozone stock market for many years now, and nothing seems to have changed of late. The outlook for the U.S. economy is still brighter than it is for the Eurozone economy.


Inflation expectations, as derived from the prices of TIPS and Treasuries, have moved meaningfully higher in the past three months. The chart above shows how this has played out with 5-yr TIPS and 5-yr Treasuries. Nominal yields have risen much more than real yields, with the breakeven spread (equivalent to the expected average annual rise in the CPI over the next 5 years) rising from a low of 1.3% in early August to now 1.9%. 10-yr inflation expectations are now 2.0%. At the very least this means that deflation worries are a thing of the past.

Caution: if this process continues (i.e., if inflation expectations continue to rise), it will mean that the Fed is falling behind the inflation curve and will therefore need to speed up its normalization of short-term interest rates. As I've warned for years, the Fed's biggest nightmare is the return of confidence, and confidence is definitely picking up these days. With rising confidence and less risk aversion, the pubic's demand for all the money that has been created in the past 8 years will begin to decline, unless the Fed takes offsetting measures to boost money demand by raising short-term interest rates.

UPDATE: As seen in the chart below, the Chemical Activity Barometer is still rising impressively, up 4% in the year ending November. Such a move has tended to foreshadow a pickup in industrial production, which has been flat for quite awhile.


Wednesday, November 30, 2016

Corporate profits are still healthy

The collapse of oil prices that began over two years took a big bite out of corporate profits, but now that oil prices have been relatively stable for the past year or so, corporate profits are rebounding. Profits are still below their previous highs, both nominally and relative to GDP, but they are still healthy from an historical perspective. Using the measure of corporate profits that comes from the National Income and Product Accounts as the E, and the S&P 500 index as the P, PE ratios are only modestly above their long-term average.


The chart above shows after-tax corporate profits (for all corporations), adjusted for capital consumption allowances and inventory valuation. This is considered to be the best measure of "economic" profits over time, as distinct from FASB profits. Note that profits are up over 13% in the past nine months, and were only briefly higher in the period just before oil prices collapsed. Note also that profits have tripled in the past 16 years, over which period the S&P 500 rose only about 50%.


The chart above compares this same measure of profits to nominal GDP. For the past 70 years or so, profits have averaged just over 6% of GDP. Today they stand at 8.5%. (The y-axes of the above graph are set so that the red and blue lines intersect when profits are equal to 5% of GDP.) For years, stock market skeptics have argued that profits were mean-reverting, and would inevitably fall from the 8-9% levels relative to GDP that were achieved in late 2009 and early 2010. That has not happened. I've theorized for years that profits can sustain a level relative to GDP that is higher than what we saw prior to the late 1990s because of globalization: U.S. firms are now able to address a market that is significantly and permanently larger than it was prior to the mid-1990s. As an example, consider that since the mid-1990s, U.S. international trade has roughly doubled in size relative to GDP, from 6-7% to almost 15%.


If NIPA profits are superior to FASB profits, as Art Laffer has argued for decades, then it makes sense to use NIPA profits to calculate PE ratios. The chart above does just that, using NIPA profits as the E, and the S&P 500 index as the P. (The S&P 500 index is arguably a reliable proxy for the valuation of all U.S. corporations.) I've normalized the numbers so that the long-term average of this series is equal to the long-term average of PE ratios as calculated by Bloomberg, using adjusted FASB profits. Here we see that PE ratios are only slightly above average (17.5 vs. 16.5).

At the very least, these charts support the notion that stocks are not egregiously overvalued, as many continue to argue.

Tuesday, November 29, 2016

Closing the Obama Gap

Third quarter GDP growth was revised upwards slightly today, from 3.0% to 3.2%. This is encouraging, of course, but it does little to change the bigger picture, which is one of unusually slow growth. Over the past year, the economy has expanded by a very modest 1.6%, and over the past two years it has risen at a mere 1.9% annualized rate. It's managed annualized growth of only 2.1% since the recovery began in mid-2009. I can think of no better way to emphasize how painful this recovery has been than the following chart, which I have been featuring and updating regularly for many years now:


The chart above uses a semi-log scale on the y-axis to emphasize how, for 40 years, the economy has followed a 3.1% annualized real growth path, bouncing back after every recession except for the last one. Never before has the U.S. economy posted such a weak recovery and such a long period of sub-par growth. Demographics—the retirement of baby boomers—can explain some of the slow growth since late 2008, but not all of it; demographic changes take years to unfold.

What we do know is that business investment has been very weak, especially in recent years, and despite record-setting profits; jobs growth has been modest; and productivity has been miserable. At root, I believe the underlying problem has been a lack of "animal spirits," a shortfall of confidence, and the persistence of risk aversion. People have simply been unwilling to work and invest more. We also know that, beginning in 2009, the economy has been burdened by 1) an unprecedented remaking of the entire healthcare industry (Obamacare) which in turn has impacted the lives and healthcare costs of nearly everyone, 2) sweeping new regulatory burdens on the financial industry (e.g., Dodd-Frank), 3) a massive increase in government spending and transfer payments (the ARRA), 4) higher marginal tax rates on income, dividends, and capital gains, and 5) a huge increase in the federal debt burden. You don't have to have a political bias to believe that these changes could go a long way to explaining why the economy has been so weak during the Obama years.

Let's call this the Obama Gap. It's depressing because it represents a huge amount of lost income and jobs that were never created. But to look on the bright side, it is a measure of the massive amount of untapped potential in the U.S. economy. If my analysis of the economy's current malaise is correct, then if the Trump administration can succeed in rolling back the burdens heaped upon the economy in the past 8 years, the future growth potential of the U.S. economy could be enormous. For example, it would take 5% real growth per year over the next 8 years just to close the Obama Gap.

Here are some recent and encouraging developments that suggest the market is in the very early stages of anticipating the unlocking of the economy's upside potential:


I've been following this chart for a number of years, and the relatively tight relationship between the price of 5-yr TIPS and gold never ceases to amaze me. (I use the inverse of the real yield on 5-yr TIPS as a proxy for their price.) Two completely different asset classes have behaved in a similar fashion for the past 10 years! The one thing that gold and TIPS have in common is that they are both a refuge from uncertainty: gold is the classic "port in a storm," and TIPS are not only government-guaranteed but also promise protection from inflation. Both have declined in price in recent weeks, and I think that is a sign that the market is less desirous of paying for protection, and by inference, somewhat less risk averse.


The Conference Board today released their November estimate for consumer confidence, and it registered a new high for the current business cycle. Confidence is still lower than it has been during previous recoveries, but it is moving a positive direction.


Since November 4th, the Vix index has fallen from 22.5 to 12.7, and the 10-yr Treasury yield has jumped from 1.8% to 2.3%. That adds up to less uncertainty and more confidence in the economy's ability to grow. Not surprisingly, the stock market is up almost 6% over the same period.


The chart above shows that there is a decent correlation between the economy's underlying growth rate and the level of real yields on 5-yr TIPS. Real yields are up some 40 bps since November 4th, which suggests the market is pricing in a modest increase in the economy's underlying growth potential. This might be just the beginning of a significant rise in real yields, however: the chart suggests that if the economy manages to sustain 4-5% annual rates of growth, real yields could rise to 3% or more. That would further imply 5% nominal yields, assuming inflation expectations don't change much from where they are currently. If we manage to close a decent portion of the Obama Gap, then the Fed is still in the very early stages of hiking short-term rates.

Would a huge increase in nominal and real yields kill the economy? No, because yields don't cause growth; yields are driven by inflation, growth, and expectations for the future. Higher yields would be the natural consequence of stronger growth, not the enemy of growth.


Monetary policy only becomes a threat to growth when the real and nominal yield curves become flat or inverted. Flat or inverted yield curves are a sign that the market realizes that the Fed is more likely to cut rates in the future than raise them, and that in turn only happens when high real and nominal rates begin to depress economic activity. The chart above shows the current real short-term rate (red line) and the market's expectation of where real short-term rates will be in five years (blue line); it's positive, and that means the real yield curve is still upward-sloping. I wouldn't start to worry about the Fed unless and until the red line moves above the blue line—which is what happened prior to the last two recessions. We're likely still years away from that point.