Monday, March 2, 2015

10 charts to watch

The news and the economic fundamentals haven't changed much in recent months, but on the margin there has been some modest improvement. The following charts highlight some of the more interesting developments that bear watching.

Rising profits have been the source of most of the gains in equity prices in recent years. Since the post-recession low in PE ratios (13.9 in August 2010), ratios have increased by 35% to almost 19 today. Over the same period, earnings have increased almost 50%. However, profits growth has declined in the past year, with S&P 500 trailing earnings up only 4.4% in the past 12 months, thanks in part to falling oil prices. Fortunately, that's not exactly a bad thing for everyone. PE ratios are above average, but not by a significant amount.

I remain fascinated by the chart above, which I've been following for the past few years. It shows a decent correlation between the earnings yield on equities and the price of 5-yr TIPS (using the inverse of their real yield as a proxy for their price). When earnings yields are high and real yields are very low, that is a sign of a market that is very risk-averse: investors don't trust earnings, and are willing to pay very high prices for the safety of TIPS. Risk aversion has been declining for the past few years, however, as confidence slowly improves. This is a significant trend that is likely to continue. Expect higher PEs and higher real yields over time. 

Equity risk premiums (defined here as the difference between the earnings yield on stocks and the yield on 10-yr Treasuries) have come down sharply from their October 2009 highs, but remain relatively high by historical standards. The earnings yield on stocks today is still substantially higher than the yield on safe Treasuries. That's another sign of risk aversion: in a strong, growing economy like we had in the 1980s, investors are typically willing to give up yield (i.e., accept a lower earnings yield on risky stocks than the yield on safe Treasuries) in order to benefit from a rising equity market. Today, investors still demand a higher yield on risky equities because they are still somewhat risk averse. Today's relatively high equity risk premium is reminiscent of the high equity risk premiums that prevailed in the late 1970s, when investors were reeling from the shock of double-digit inflation, a weak dollar, and soaring Treasury yields. Today's investors are still reeling from the shock of the Great Recession.

Earnings yields on stocks are still higher than the yield on BAA corporate bonds. This is relatively rare, since corporate bonds are higher in the capital structure. In a "normal" world, equities should have lower yields than corporate bonds, since equity investors are willing to give up yield in order to benefit from the expected growth of earnings. Bond investors, on the other hand, are willing to give up price appreciation in exchange for a higher and safer yield. Today, however, investors are unwilling to pay up for equities, in a sign that risk aversion that still prevails. I wouldn't be surprised to see equity yields continue to decline (i.e., rising PE ratios) even as bond yields flatten or begin to rise.

Equity prices continue their slow upward march, climbing a major wall of worry that is fading away (e.g., Greek defaults, collapsing oil prices, Ukraine tensions, Fed tightening).

The February ISM manufacturing index was about as expected. Although it's off quite a bit from its recent highs, it is still consistent with overall economic growth of 2-3%. The economy has been doing a bit better over the past year, but it's nothing to get excited about. The outlook for growth remains moderate; not great, but not bad either, with some modest improvement on the margin. Significant improvement will come when and if fiscal policy becomes more growth-friendly (e.g., lower and flatter tax rates, especially for corporations, and reduced regulatory burdens).

One of the more encouraging developments in the past year is the pickup in C&I Loans. This reflects increased confidence on the part of banks and businesses—banks are more willing to lend, and businesses are more willing to borrow. Bank lending to small and medium-sized businesses is growing at a solid 12% annual rate these days. The increased confidence this reflects lends solid support to a forecast of continued economic growth.

Money supply growth has averaged just over 6% per year for the past 20 years. No sign here of the Fed "printing money" in any unusual way. However, nominal GDP growth has averaged 4.4% over this same period. When money growth exceeds nominal GDP growth, we can infer that the world's demand for "money" has increased; people want to increase their money balances relative to their incomes, usually out of a desire to reduce risk.

Demand for money (i.e., the ratio of M2 to nominal GDP) has risen strongly over the past 20 or so years, especially since the Great Recession. But the rate of increase in money demand is slowing, as risk aversion declines. Rising money demand was the major impetus for the Fed's Quantitative Easing, whose major purpose was to "transmogrify" notes and bonds into T-bill equivalents (bank reserves). The world wanted a lot more safe assets, and QE generated over $3 trillion of safe assets to meet that demand. As risk aversion declines, QE is no longer necessary.

The important thing to watch for is a decline in money demand. It's been a long time coming, but sooner or later we are likely to see nominal GDP growth exceed M2 growth. That time will most likely coincide with rising confidence, a stronger economy, and a tendency for rising inflation. This will test the Fed's ability to keep the supply and demand for money in balance by increasing short-term interest rates.

The main source of M2 growth since the Great Recession has been bank savings deposits. Note the slowing in the growth rate of savings deposits that began about two years ago. Savings deposits were growing about 12% per year, but have only grown at about 6% over the past year. This growth slowdown is likely to continue, as households become less interested in accumulating savings deposits that pay almost nothing in a world in world in which stocks rise 1% a month, earnings remain at record levels, and inflation is at least 1-1.5% a year and rising.

Thursday, February 26, 2015

TIPS say the deflation "threat" has passed

According to the pricing of TIPS and Treasuries, the bond market has decided that the negative inflation shock of falling oil prices has run its course. In fact, inflation expectations have been rising since year end: the bond market now sees inflation (of the CPI variety) averaging 1.7% over the next five years, and 2.0% from years 5 through 10. With the labor market having improved in recent months and long-term inflation expectations now back to levels that the Fed deems appropriate, it's only a matter of time before the Fed begins to raise short-term rates. This long-awaited "normalization" of rates should come as no surprise and should not in any way threaten the health of the economy or financial markets.

The chart above shows the nominal yield on 5-yr Treasuries, the real yield on 5-yr TIPS, and the difference between the two, which is the market's expected average annual inflation rate over the next five years. Inflation expectations began to fall last summer, about the same time the oil prices began to decline. They reached a low of 1.2% late last year, and closed today at 1.7%.

The chart above shows the price of crude oil futures; note that prices have stopped declining and have been relatively stable since early January. Investors have been speculating that the bounce in prices marked the end of oil's decline, and the bond market action is confirming this.

The price of wholesale gasoline futures (see chart above) has actually been rising in the past month: in fact, prices today are up 35% from their mid-January low.

Gasoline prices at the pump have also been rising, as the chart above shows.

The rise in oil and gasoline prices could prove to be the proverbial "dead cat bounce," but the significant decline in active oil drilling rigs (chart above) confirms what the market is saying about oil prices having hit bottom. Lower prices are having the predictable effect of shutting down exploration efforts, which, in turn, will lead to reduced oil production in the near future. Supply and demand are likely to come back into balance somewhere around the current level of prices.

As the above chart shows, inflation ex-energy has been running right around 2% a year for the past 12 years. The market is saying we're likely to see more of the same in the years ahead. The result of falling oil prices is thus likely to be stronger growth rather than lower inflation. The Fed is correct in ignoring the recent decline in inflation.

The chart above looks at inflation expectations over the next 10 years, which are now around 1.8%.

Even though inflation expectations are back to "normal," the real yields on TIPS are very low (see chart above). The market is not afraid of inflation being any different than it has been in the past (~2%), but the very low level of real yields (and the correspondingly very high level of TIPS prices) suggests that the bond market holds out very little hope for any meaningful pickup in the outlook for real economic growth. TIPS are very expensive at these levels. Investors are willing to accept an almost insignificant real yield in exchange for protection against uncertainty. Rather than cheering cheaper energy, the market continues to worry about the lack of growth and opportunity, and is willing to pay up for safety.

This same preference for safety is seen in the chart above, which compares the price of gold with the price of 5-yr TIPS (using the inverse of their real yield as a proxy for their price). Both assets are still trading at fairly high levels from an historical perspective. This suggests that the market is still dominated by pessimism, not optimism. In a very optimistic market environment, the price of gold would be an order of magnitude lower, and the real yield on TIPS would be north of 3%. We are many years away from either.

The market may be right in its belief that inflation will remain in a 1.5-2% range and economic growth will remain sub-par. But if the market is wrong, I'm willing to bet that both growth and inflation will prove higher than expected in the years to come. I'm optimistic if only because the market seems to be still so pessimistic.

UPDATE: As of 8:00 am PST 2/27, markets have continued further in the direction of higher inflation expectations: the expected inflation rate for the next five years has increased to 1.8%. The real yield on 5-yr TIPS has fallen to -0.3%, which points to an even more cautious market.

Monday, February 23, 2015

Good news overseas

The outlook for Europe has improved significantly in the past month or so, a fact that still seems to be flying under the mainstream media's radar. On balance, the outlook for the global economy continues to improve. Very good news.

Released last Friday, the Markit Eurozone Composite Purchasing Managers' Index jumped to 53.5, as shown in the chart above. This means the outlook for the Eurozone economy has brightened considerably of late, no doubt due in part to a relaxation of Russia/Ukraine tensions and the likelihood of an acceptable solution to the Greek debt crisis. Even if Greece were to exit the Eurozone, its economy is so small that it wouldn't make much difference. The important issue here is to preserve the integrity of the Euro, a goal which appears to be widely shared among ECU members; if Greece exits, it will pay a price (i.e., the higher inflation that would follow a devaluation of its currency) that will deter others from doing the same. The experience of Argentina tells us that a big currency devaluation only provides a temporary boost to growth—as some of the capital that fled in anticipation of the devaluation returns—but in the end, the inflation that accompanies big devaluations is destructive, especially for the lower and middle classes.

Meanwhile, we recently learned that the German economy expanded at a 2.8% annualized rate in the fourth quarter of last year, up from zero in the second quarter. This is quite encouraging. After a pause in the second half of last year, the Eurozone economy appears to have re-synchronized with the U.S. economy, as both continue to grow. That is an important and positive change on the margin.

As the first of the two charts above shows, since the end of last year Eurozone equities have outperformed U.S. equities by an impressive 10%, after lagging miserably for the preceding five years. But don't get too excited, because in dollar terms, Eurozone equities are still down almost 8% from last summer's post-recession high. The recent relative outperformance of Eurozone equities is overshadowed by a much weaker Euro from a U.S. investor's perspective. Nevertheless, that doesn't negate the fact that Eurozone investors do see an improved economic outlook.

Japanese equities are now at a new 15-year high. The recent improvement in the equity market closely tracks the weakening of the yen, as seen in the first of the two charts above. But unlike the situation in the Eurozone, Japanese equities are up 30% in dollar terms in the past two years (i.e., equity market gains have been much larger than the weakening of the yen). On balance, the market is telling us that things have really improved in Japan in recent years.

As the second of the two charts above shows, the yen is for the first time in 30 years approximately equal to its Purchasing Power Parity value vis a vis the dollar—according to my calculations. It's not that the BoJ has severely depressed or devalued the yen, it's that the yen is now more "normally" valued. The BoJ appears to have successfully switched from a deflationary monetary policy to a neutral monetary policy, and that, in turn, has been a positive for the economy.

Even China is doing better these days: the Shanghai Composite index is up over 60% since last summer, even though growth in the Chinese economy has "slowed" to 7% a year. If only we could all grow 7% a year....

Positive developments overseas add up to a new all-time high for the value of global equities, as shown in the chart above. In the past six years, the market cap of global equities (in dollar terms) has increased more than 160%, rising from its March 2009 low of $25.5 trillion to over $67.3 trillion today. That's a gain of almost $42 trillion! Excluding the $16.8 trillion increase in U.S. equity valuations over this same period, the value of stock markets overseas has increased by $25 trillion. We are talking real, serious money, and a genuine recovery. That's not to say things couldn't or shouldn't be a whole lot better, but the improvement is impressive nonetheless.

Not everyone is doing so well, unfortunately. The Brazilian economy stands out in this regard, with its stock market having lost about 60% of its value in dollar terms in the past four years. Many emerging market economies (e.g., Argentina, Brazil, Venezuela) are burdened by weak commodity prices, poorly-designed fiscal and monetary policies, and endemic corruption.