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The coming political tsunami

By the time the tsunami hit Hawaii today it was pretty tame. But there is a huge political tsunami that is headed to Washington, and it is expected to hit in early November of this year. This chart, which shows Obama's Approval Index hitting an all-time low for the second time, is the evidence for my claim.

The chart makes it clear that more and more people strongly disapprove with what Obama is doing, at the same time that fewer and fewer strong approve. Obama and the Dems seem to think the reason for this is that they haven't done enough to advance the liberal agenda, but for any objective observer, I think it's clear that they have tried to do way too much.

The sudden birth of the Tea Party movement about a year ago was like the first of a swarm of earthquakes that have since generated bigger and bigger aftershocks. The Massachusetts election of Scott Brown last month was not only a major aftershock, but it eclipsed all of the prior ones. Just two days ago was the healthcare reform summit, another major aftershock. (Don't miss Peggy Noonan's excellent description here.) The tsunami waves have been set in motion, and they are traveling all around the 50 states, gathering momentum and amplification as the errors of Washington collide with political topography of the country.

Are there enough Democrats really willing to sacrifice everything in order to engineer a government takeover of almost one-fifth of the economy? Rahming it through via reconciliation is surely a no-win situation. The public doesn't support the package at all, and any attempt to force it through, especially if more behind-the-scenes wheeling and dealing is necessary to accomplish it, will only sour the public even more. I don't see Nancy Pelosi getting the votes. And the harder she tries, the worse it's going to be. And even if the bill does somehow pass, it is so riddled with fatal flaws that it is unlikely to ever be implemented.

So my sense is that Democrats will be scurrying for high ground in the months to come, just as the residents of Hawaii evacuated the shoreline this morning in advance of the tsunami's arrival. Gridlock will be the likely result, and that's a very good thing at this point.

The true path to high ground lies in radically scaling back the ambitions of Washington lawmakers. Otherwise, they are going to be swamped. Mark Steyn has a good analogy for all this:

While Barack Obama was making his latest pitch for a brand new, even more unsustainable entitlement at the health care "summit," thousands of Greeks took to the streets to riot. An enterprising cable network might have shown the two scenes on a continuous split-screen - because they're part of the same story. It's just that Greece is a little further along in the plot: They're at the point where the canoe is about to plunge over the falls. America is further upstream and can still pull for shore, but has decided, instead, that what it needs to do is catch up with the Greek canoe.

Think of Greece as California: Every year an irresponsible and corrupt bureaucracy awards itself higher pay and better benefits paid for by an ever-shrinking wealth-generating class. In Greece, they've run out Greeks, so they'll stick it to the Germans... in America, Obama, Pelosi and Reid are saying we need to paddle faster to catch up with the Greeks and Germans. What could go wrong?

We need to stop the runaway growth of government, entitlement programs, wealth redistribution, transfer payments and taxes, and we need to send politicians to Washington who understand this. I think this can happen, and that's one reason why I remain optimistic. The coming political tsunami is going to wash away a lot of the deadwood and corruption in Washington, and it's going to leave in its place a new generation of politicians who understand that the best thing for the country is to just leave the people alone.

Existing home sales

Existing home sales have plunged in recent months, but mainly because of the anticipated expiration of the homebuyer tax credit in November, which caused many to accelerate their purchases into October. Now that it has been extended, the pace of sales has settled back down, and may be returning to "normal." I note that the inventory of homes for sale has declined by 27% since its peak, as shown in the next chart, while sales activity has been relatively stable. This doesn't look to me like a market that is collapsing or off balance. And with inventories down, there is room for the market to absorb new foreclosures.

Canadian banking system beats ours

Almost 200 U.S. banks have failed since early 2008, but not a single Canadian bank has. The delinquency rate last December for home mortgages in the U.S. was 9.47%, but only 0.45% in Canada. What explains this incredible difference? Read Mark Perry's fascinating article to find out, but here's a summary:

• Full recourse mortgages
• Shorter-term fixed rates
• Mortgage insurance
• No tax deductibility of mortgage interest
• Higher prepayment penalities
• No Community Reinvestment Act
• Much larger banks
• Less mortgage securitization

Canada has largely eschewed policies which encourage home ownership and insulate homeowners from the consequences of their purchase decision, yet Canada has a higher home ownership rate than we do. We could learn a lot of lessons from our northern neighbors when it comes to banking and home ownership.

UPDATE: I noted that an Australian pointed out many of these same issues way back in Oct. '08. The origins of our housing crisis have nothing to do with free markets; it's government intervention in free markets that screws things up.

Manufacturing V-shaped recovery continues

This is a chart of the Chicago Purchasing Manager's Index, whose February reading, released today, exceeded expectations (62.6 vs. 59.7). The Chicago index has traditionally been highly correlated (0.87) to the overall ISM index, which will be released Monday. That index, in turn, has done a pretty good job of tracking the quarterly growth of GDP, as shown in the next chart. What it all means is that the recovery in the manufacturing sector has been remarkably dynamic, and this strongly suggests that the economy will experience growth of at least 4% in the current quarter.

Financial conditions -- another V-shaped recovery

I'm getting a lot of pushback of late for my unrelenting optimism in the face of some disappointing market stats and economic releases. So I thought it appropriate to review at least some of my reasons for thinking that things are indeed getting better despite the occasional setback.

I last commented on this chart in early December. It's Bloomberg's index of financial conditions, a composite of key financial fundamentals such as credit spreads, implied volatility, interest rates, and P/E ratios. The y-axis of the chart is measured in z-scores: the number of standard deviations above and below the average of the 1992-June 2008 period.

The peak of the financial crisis in late 2008 was literally off the charts from an historical perspective, shown here as a 9 standard deviation event (the actual low for the index was -12.6, which occurred on Oct. 10 '08). This was a market that for all intents and purposes was priced to Armageddon: a deep depression accompanied by paralyzing deflation and lasting for years. In just over a year we now find ourselves back to something that resembles normalcy, and more than 9 months into a recovery.

What a difference a year makes! It's hard to underestimate the importance of this: the reality we are living today far surpasses even the most optimistic forecasts of a year ago.

Notwithstanding the power struggles in Washington which seem to have left us in legislative limbo (thank goodness for the respite), financial markets have undergone a significant healing process in the past year, and we have seen plenty of signs of recovery, this chart being an important one.

Meanwhile, I don't see any of the typical signs that presage economic downturns. Swap spreads have been trading at "normal" levels for months now, and credit spreads are significantly tighter and much more stable than they were a year ago. Very tight monetary policy has been the leading cause of every post-war recession, but we certainly don't have that problem today. All of the key measures of monetary conditions suggest monetary policy is accommodative: the yield curve is very steep, real yields are relatively low, the dollar is relatively weak, and gold prices are up hugely. If anything goes wrong in the near future, it will not be for a lack of money.

Fiscal policy has been turbulent this past year, but we have yet to see policies, such as a significant increase in tax burdens, a serious outbreak of trade wars, or a major increase in regulatory burdens, that have in the past contributed to a meaningful economic slowdown. There are of course concerns in all these areas, but if anything, the likelihood of a nasty turn in fiscal policy has decreased over the past year, thanks to very visible and growing opposition to the direction Obama has been trying to take us. Why else would Obama take such pains to emphasize that he is "an ardent believer in the free market?"

I have an enduring belief that when left largely alone and fed a diet of financial normalcy, the U.S. economy is quite capable of growing, even in the face of fiscal adversity.

As the chart above shows, financial markets have healed. Asset markets have healed as well, with home prices stabilizing and commodity prices recapturing much of their 2008 losses. We've got tens of millions of entrepreneurs out there, all of whom want to make more money than they made last year. We've got 130 million people working 5% more productively in the nine months ended last December. Corporate profits after tax likely rose over 20% last year. Business investment is up at a 15% since last April. U.S. corporations raised over $450 billion by selling new bonds in the past 12 months. The ISM manufacturing index has surged to levels that are fully consistent with 4+% growth. The stock market is up over 60% from its recent lows. Homebuilders' stocks are up fully 126% from their March lows, even though residential construction has collapsed to a mere 2.5% of GDP. Exports have jumped at a 27% annual rate since last April. Despite the Fed's massive liquidity injections, the dollar today is worth almost the same, relative to other major currencies, as in mid-2007, before the recent crisis was on anyone's radar screen.

The list of positives could go on, but suffice it to say that to be pessimistic today you have to ignore an awful lot of good news.

Outlook for mortgage rates

Calculated Risk today has a good post on the outlook for mortgage rates now that we are approaching the end of the Fed's MBS purchase plan, which is 96% complete. He concludes that "mortgage rates will rise 35 to 50 bps relative to the Ten Year when the Fed stops buying agency MBS at the end of March."

That's pretty much the same conclusion I've come to. I'll add some charts to the discussion which make the same point from a different approach.

This chart shows the 26-year relationship between Fannie Mae collateral and 10-yr Treasury yields, with the spread on the bottom. Note that the spread has averaged about 125 bps, and currently stands at about 70. The spread has rarely traded at less than 100 bps, which suggests that Fed purchases may have caused spreads to tighten by 30-55 bps.

This next chart shows a more unconventional spread, comparing FNMA collateral to the 5-yr Treasury yield for the period that began with the Lehman collapse in 2008. Note that the Fed first started buying MBS in significant quantities around the middle of March '09. Prior to the start of its MBS purchases, the spread averaged about 240 bps for several months; subsequently it fell to a fairly stable 200 bps. This suggests that Fed purchases could account for a spread tightening of about 40 bps.

Thus we circle back to the conclusion that when the Fed ceases its MBS purchases at the end of March, we should expect mortgage yields to rise by roughly 30-50 bps relative to Treasury yields. Most of that rise could be absorbed by conforming mortgages, since the spread between jumbo and conforming loans is still quite wide by historical standards. But in any case, the likely rise in mortgage rates will still leave them quite low by historical standards (barring, of course, a major increase in 10-yr Treasury yields). Thus I don't see a big threat to the housing market looming.

The development that stands the biggest chance of causing a significant rise in mortgage rates is a big rise in Treasury yields. As I've pointed out before, however, a big rise in 10-yr Treasury yields is most likely to coincide with and signal a much stronger economic outlook. A stronger economy, in turn, would have the effect of offsetting (via rising incomes and greater optimism) most if not all of the rise in mortgage rates.

Healthcare reform

President Obama and Congressional bigwigs are talking at each other today on the subject of healthcare reform. Arnold Kling offers a good summary of why they are wasting their time:

There are two ways to approach reducing the use of high-cost, low-benefit procedures. You can have the government tell people what they can and cannot have. Or you can have individuals pay for a larger fraction of the medical procedures that they consume. It really comes down to those choices.

Advocating either one of those is political suicide, and talking about anything else is a waste of time. The Democrats will not advocate government rationing, and the Republicans will not advocate scrapping most of our current system of third-party payment in medicine. Instead, the summit, like the entire "health reform debate" this year, will be a waste of time.

On a more positive note, the WSJ today has a good article by Cogan, Hubbard and Kessler that lays out a simple and easy-to-implement plan that would go a long way toward improving our healthcare system. Here are the key points:

To bring down costs, we need to change the incentives that govern spending. Right now, $5 out of every $6 of health-care spending is paid for by someone other than the person receiving care—insurance companies, employers, or the government. Individuals are insulated from the reality of what their decisions cost. This breeds overutilization of low-value health care and runaway spending.
To reduce the growth of costs, individuals must take greater responsibility for their health care, and health insurers and health-care providers must face the competitive forces of the market. Three policy changes will go a long way to achieving these objectives: (1) eliminate the tax code's bias that favors health insurance over out-of-pocket spending; (2) remove state-government barriers to purchasing and providing health services; and (3) reform medical malpractice laws.

The tax code's favorable treatment of employer-sponsored health insurance over out-of-pocket health-care payments means that, for most families, buying health care through an employer is 30%-40% cheaper than buying it directly. The best way to address this clear bias is by making all health spending—including out-of-pocket payments, purchases of individual insurance, and purchases of COBRA coverage—tax-deductible.

There are two additional steps to reforming private insurance markets. First, individuals must be allowed to buy health insurance offered in states other than those in which they live. The current approach of state-by-state regulation has raised costs by reducing competition among insurance companies. It has also allowed state legislatures to impose insurance mandates that raise prices, while preventing residents from getting policies more suitable for their needs.

Second, reasonable caps on damages for pain and suffering need to be established in medical malpractice cases. Caps on these kind of damages reduce costs and decrease unnecessary, defensive medicine.

These three policies ... fundamentally change incentives among individuals, insurers, and providers to gradually slow the growth in costs by reducing inefficient demand without sacrificing quality and innovation. Instead of radically changing health care overnight, they take an incremental approach, respecting the tremendous uncertainty surrounding the effectiveness of different approaches to rein in costs.

Capital goods orders tick down but still strong

Durable goods orders jumped 3% in January, much more than expected. But if you subtract transportation orders, they fell more than expected. My favorite version of these numbers (non-defense, ex-aircraft orders) is shown in this chart, which I consider to be a proxy for business investment spending. While the January number was below expectations, the December number was upwardly revised by about $1 billion, so the net change was a small negative. In any event, this series is notorious for its month-to-month volatility. Abstracting from the monthly noise, business investment is up at an annualized rate of 15.5% since hitting a low last April. That's a strong rebound by any definition. Business investment like this will create a good base for future productivity gains and eventually a return to new hiring.

Weekly claims' progress derailed

The impressive decline in unemployment claims that began last April has been derailed. This may be a sign that the economy is turning south, but it may also be just one of those things that happen on the road to recovery. I note that similar setbacks occurred several times (and more severely) in the early years of the recoveries following the '90-91 recession and the '01 recession. The recent jump in claims may also be due to weather, and it seems likely that snowstorms in the East will contribute to a disappointing jobs number next week. I think you have to expect data to be volatile from time to time. It's much more likely that we are just seeing random noise here than that there is a fundamental change in the economy's direction afoot.

UPDATE: As an alert reader reminds me, non-seasonally adjusted claims have actually plunged from 800,000 during the week of Jan. 8th, to 452,000 in the most recent week. That the seasonally adjusted number has risen over this same period means that claims haven't fallen as much this year as they might normally be expected to. But it's possible, especially given the gyrations of the past few years, that the seasonal adjustment factors are off. This is a good reminder that you should always take statistics like this that are subject to seasonal adjustment with a grain of salt.

Gold and commodities

This chart shows the relation between gold prices and the spot prices of non-energy industrial commodities (burlap, butter, cocoa beans, copper scrap, corn, cotton, hides, hogs, lard, lead scrap, print cloth, rosin, rubber, soybean oil, steel scrap, steers, sugar, tallow, tin, wheat, wool tops, zinc). The correlation between the two is pretty impressive, and it's also noteworthy that gold prices tend to lead commodity prices by as much as a year or two.

The huge current gap between gold and commodity prices is just screaming to be addressed. Are we on the cusp of a major upturn in commodity prices? What is driving these prices higher: inflationary monetary policy or stronger global growth, or both? I don't have solid answers, but the surge in gold prices in recent years, coming at a time when virtually all major central banks are pursuing accommodative money policy, suggests to me that the monetary explanation for higher commodity prices is the dominant one, though that certainly does not preclude increasing global demand as a factor. At the very least, as I mentioned in a recent post, I think this means deflation is dead. (The one-month drop in the January Core CPI notwithstanding; the big increases in PPI inflation at the crude and intermediate levels are pretty impressive, and a portent that inflation pressures will eventually make it to the consumer level.)

If deflation is dead and inflation is alive and well, as this chart suggests, then the downside risks to the economy are much less scary than conventional wisdom holds. It's my sense that there are a lot of people—including Bernanke and other Fed governors—who are very worried about the possibility of Japanese-style deflation and weak economic growth plaguing the U.S. economy for years to come. Those concerns are built on Phillips Curve thinking, which holds that when an economy is operating at a level significantly below its potential, then there are persistent downward pressures on overall prices. Downward price pressure—deflation—in turn saps consumer demand, or so the thinking goes, because consumers can make money by simply not spending it.

These concerns fail to account for the fact that the monetary fundamentals in Japan and the U.S. are completely different, and offer a better explanation of why deflation has been a persistent problem for the Japanese. The Bank of Japan has been pursuing a deflationary monetary policy for decades, as reflected in the fact that the yen has been appreciating against most currencies for the past 40 years, whereas the dollar is close to all-time lows against a basket of currencies. Moreover, U.S. demographics ensure healthy population growth for the foreseeable future, whereas Japan is now experiencing a shrinking workforce and a rapidly aging population.

To be sure, inflation is not a friend to economic growth. Inflationary psychology diverts much of the economy's energy to price speculation, rather than to jobs-creating investment. Plus, too much inflation inevitably leads to economic weakness, especially when central banks are forced to tighten monetary policy to bring inflation down.

But in the current environment I think it is the absence of deflation risk that is the important thing to focus on. If you truncate the deflationary side of an expected distribution of returns, you boost expected returns significantly. The disappearance of deflationary risk means the Fed will be less likely to be too easy for too long. The greater likelihood of inflation means consumers are less likely to continue hoarding money; money velocity is thus likely to increase, and this will help drive growth going forward.

It's very unfortunate that we have to be worrying about these issues in the first place. It would be far better to have had a stable monetary policy and stable (and low) inflation expectations over the past few decades. But we, like the Fed, are stuck with the consequences of past monetary actions and errors, and we need to deal with them. The situation we are faced with today is not one of deflationary risk, and it's important to understand that.

Confidence is weak, but so what?

Consumer confidence, according to the Conference Board's survey, unexpectedly fell this month (it was expected to hold steady, according to Bloomberg's survey), and this news today helped push the stock market down and the bond market higher. I have never paid much attention to confidence indicators, since they are reliably lagging indicators of what is going on in the economy. As this chart shows, confidence typically declines well after the end of recessions, and usually hits  new highs just before recessions begin. If anything, this chart is a great contrary indicator, and today's news should be taken as bullish. Consumers are usually the last ones to realize the economy is doing better.

For comparison purposes, the next chart shows confidence data as put together by the University of Michigan. Although their survey also declined in February, it was a very modest decline, and the trajectory of the index since the end of this recession has been noticeably stronger than the Conference Board's.

In any event, it's difficult to imagine consumer confidence improving significantly between now and the November elections, mainly because unemployment is likely to continue to be unusually high. There will be lots of talk this year about how this is another one of those "jobless recoveries." This in turn will predictably lead to more calls for another "stimulus" bill or "jobs package." That of course is exactly what we don't need. In my view, one of the main reasons this recovery has been unimpressive to date is the massive amount of stimulus spending that was approved last year. Most of the "spending" authorized by those bills was in the form of transfer payments, and those do little or nothing to create jobs or growth. What we are left with is more government interference in the economy, and a much higher debt burden. This in turn creates expectations of much higher tax burdens, and that stifles the incentives to take risk and create real jobs.

But even though confidence is low, it can improve slowly, as can the economy. We don't need new jobs to have a stronger economy, since the existing workforce can work harder and more efficiently, as indeed it has over the past year—nonfarm worker productivity rose an impressive 5% in the nine months ended last December. Over time, productivity tends to be about 2% per year; add this to a meager 1% growth in jobs (which is not enough to bring the unemployment rate down, since the workforce tends to grow about 1% a year) and you get economic growth of 3%. I've been saying we are likely to see growth of 3-4% this year; that's above the market consensus, but it is still consistent with only a very modest decline in the unemployment rate, and continued low readings of consumer confidence.

Home price stability returns

The Case Shiller index of home prices in 20 major metropolitan areas (seasonally adjusted) has risen seven months in a row. Given the lags built into the way the index is calculated, this means that the bottom in U.S. home prices likely occurred last February or March, almost one year ago. In real terms, as shown in this chart, home prices haven't changed much at all since the end of 2008. Thus, stability has returned to a market that suffered from extraordinary volatile for many years. The popping of the housing bubble resulted in an almost catastrophic 35% decline in real home prices, which in turn caused trillions of dollars of mortgage- and asset-backed securities to evaporate, threatening the viability of the entire world's banking system.

Fortunately, the dust is continuing to settle, markets are clearing, and life goes on. The stabilization of home prices has allowed the prices of securities such as shown in the chart below to rise for the better part of the past year. That's because the panic which set in over a year ago caused such selling pressure that the prices of asset-backed securities fell to levels that implied a continuing decline in home prices that was way too pessimistic.

Thoughts on government redistributionist schemes

"If someone gets something for nothing, then someone else must be doing something and getting nothing in return."

"If you rob Peter to pay Paul, Peter will eventually stop working."

"Government has little or no ability to create anything, but it can move wealth around and discourage its production."

HT: Russell Redenbaugh

Commercial real estate update: signs of a bottom

According to December '09 data released today by Moody's, commercial real estate prices in the U.S. are up 5% from their October lows. They are still down by a whopping 41% from their late 2007 highs, however, which is much worse than the 30% decline in nationwide housing prices according to the Case Shiller data. Nevertheless, I take this as preliminary evidence that we have seen the bottom in commercial real estate prices. (The bottom in residential real estate prices still seems to have been in the March-April '09 time frame.)

Combining the news on real estate prices with the prices of commercial real estate-backed mortgage securities in the chart below—prices have been rising for much of the past year—gives the same conclusion: as far as the market is concerned, we have seen the worst of the news from the commercial real estate sector, and we have probably seen the bottom in prices.

This stands in sharp contrast, of course, to the steady drumbeat of bad news from the commercial real estate sector, and the expected increase in default rates on commercial real estate loans. Hard as it may be to understand, I think this is just one more example of how the market anticipates events. Even though actual default rates are likely to rise in the coming months, the market today is telling us that the default rates we are likely to see are going to be less than what the market had expected and feared some months ago. The reality is going to be bad, indeed, but it is not going to be as bad as many had feared. All of the bad news has already been priced in. This is good news.

Bank credit update

This chart shows Total Bank Credit as measured by the Federal Reserve, a measure which focuses on lending to small businesses. Banks have been lending less (about $650 billion less, or 6.8% less than the high water mark) since the start of the financial panic in October 2008, and I'm sure everyone has heard that it is very difficult if not impossible for small businesses to get credit these days. The reasons for this are several: banks have tightened lending standards, not being eager to lend more in an uncertain economic environment; demand for loans has declined on balance, as lots of people and businesses have made a conscious effort to deleverage and otherwise clean up their balance sheets; and loan covenants have forced many borrowers to deleverage given the decline in the value of assets collateralizing their loans.

This chart suggests that there is another story that is playing out as well. Banks had gone on a lending spree in the years leading up to 2008, creating a lending or credit bubble of sorts, and the decline in lending since then is having the effect of bringing bank credit back into line with the size of the economy.

(Note that the 7% trend line on the chart reflects the annual average rate of bank lending growth from 1984 through the present. The average annual growth rate of nominal GDP over this same period was 5.7%, so even 7% annual growth represents an expansion of bank credit that is more than enough to accommodate growth in the economy.)

I would argue from these facts that, despite the recent decline in bank lending, there is no shortage of money in the economy (a theme I talked about frequently in the latter part of 2008). There has been some rationing of credit to some sectors which has been painful, but overall the economy has plenty of liquidity and plenty of credit. I suspect that given time and given more improvement in the economy, we will see banks once again expanding credit to those sectors most in need of credit. It's already the case that lending to large, well-established corporations has grown at a very impressive 13% annual pace since the end of 2008, according to the growth in the face value of the Merrill Lynch Corporate Master Index. Paradoxically, it's much easier for big companies to borrow hundreds of millions than it is for small companies to borrow millions. I doubt that banks will continue to forego the opportunity to profit from lending to small companies for much longer.