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Velocity as a source of growth


Blogging has been light this week since we took a quick trip to Palm Springs to watch the Palm Springs Follies—something everyone over the age of 55 should see at least once in their life. It's a celebration of how productive, healthy and happy you can be in your retirement years. The ages of cast members ranges from the mid 60s to 86!

Meanwhile, here's a quick look at M2 velocity updated with the latest stats on Q1 GDP growth. First quarter growth has been dissected by just about every analyst by now, but so far I haven't seen anyone looking at the behavior of velocity. On an annualized basis, M2 money fell by 1.5% in the first quarter, while nominal GDP rose by 4.1%; thus, M2 velocity (measured by dividing GDP by M2) rose by 5.7%. You might say, in other words, that rising money velocity was by far the dominant factor in the first quarter economic expansion. Rising money velocity is the flip side of falling money demand, and money demand is falling because confidence is on the rise. Money that was hoarded during the panic of late 2008 and early 2009 is now being spent again. The public is divesting itself of money that is no longer desired, and that has fueled an increase in general economic activity. As the chart suggests, this very important change on the margin is potentially still in its infancy.

This is exactly what the Fed has been trying to do for the past 18 months. First, the Fed had to massively increase the money available to economy (by flooding the banking system with reserves) in order to offset the economy's massive increase in the demand for money at the height of the panic. That served to halt the downward spiral early in 2009, and the economy then hit bottom in mid-2009. Since then, the Fed has continued to over-supply money to the economy by keeping short-term interest rates near zero, with the intention of encouraging a decline in the demand for money. Who wants money or cash equivalents (e.g., money market funds) when they pay zero interest?

We've now had over nine months of declining money demand (rising money velocity), and rising real and nominal GDP growth. By the looks of things (e.g., strong commodity prices, V-shaped recoveries in manufacturing and exports), it appears to me that this process is self-sustaining and that we should therefore see continued growth in the months and quarters to come. I see no reason to change my long-held forecast of 3-4% real growth.

UPDATE: As my friend David Gitlitz points out, the evidence of rising money velocity also reinforces my long-held concern that inflation is likely to rise.

Rationale in a nutshell: Inflation is a monetary phenomenon that occurs when the supply of money exceeds the demand for holding it. We know that the Fed has massively increased the supply of money, by 1) holding short-term rates at close to zero for the past 18 months, and 2) more than doubling the monetary base through massive purchases of mortgage-backed securities. Rising money velocity is the flip side of declining money demand, so rising M2 velocity reveals that the public's demand for money is declining. Supply is up, but demand is down, and the rising prices of sensitive assets such as gold and commodities would appear to confirm that we have an oversupply situation on our hands.

Easy Fed, strong gold


Gold continues its upward trend against the dollar, and it is making new highs almost daily against the euro. The Fed yesterday reiterated that it is still terrified (I'm exaggerating to make a point) that the economy remains weak and unemployment remains high, so it plans to keep interest rates very low for a long time. The prospect of an "extended period" of zero yields on cash and cash equivalents is driving investors to anything that shows signs of life these days, and gold now has a 9-year rising trend in place. Gold's current uptrend started almost the same day that the Fed belatedly recognized that the economy was weakening in the wake of the dot-com crash, and as a result of extremely tight monetary policy from 1997 through 2000. Since 2001, the Fed has been much more concerned about the strength of the economy than about the outlook for inflation. That is one big reason why gold is doing so well.

Obama's choice of three new Fed governors does little to reassure investors that the Fed will ever pay more attention to the value of the dollar than it does to the health of the economy. Indeed, all three picks promise to be firmly in the "dovish" camp when it comes to the hardest choice any central banker has to face: whether to tighten to defend the value of its currency, or to ease to support the economy.

While this is an ugly picture, it is also the case that measured inflation has been relatively tame for many years. The CPI has risen at a compound rate of 2.45% over the past 10 years; 2.0% over the past three years; and 2.4% over the past year. The early warning signals of future inflation, however, are not so good. Gold is a prime example, as are commodity prices, a record-steep yield curve, and a dollar that is only marginally above its all-time lows in terms of purchasing power relative to other currencies.

On balance, and given the reinforced makeup of the Federal Reserve, I think investors need to be concerned about higher, rather than lower, inflation in the years to come.

And the fact that gold is making new highs against the euro and almost all other currencies, means simply that our Fed is not the only central bank that is deciding to err on the side of ease. This is a global phenomenon. The forces of inflation are very likely to win out over the forces of deflation.

Commodities say forget Greece


I last featured industrial commodity prices a month ago, and I note that they have since risen some 3-5%. Both of these charts reflect prices of a variety of industrial commodities, many of which do not have futures contracts associated with them and are therefore at least somewhat immune from speculative forces.

Commodities across the board are marching onward and upward, apparently oblivious to Greek indebtedness, concerns about which have been plaguing markets for months. In the end, global growth—as is strongly reflected in the commodities markets—is one sure-fire way of dealing with whatever fallout there may be from what will either be a bailout of Greece or a restructuring of its debt. To put things in context, Greek GDP is about $340 billion, which is about what the U.S. government is borrowing every three months. Fears of a default on Greek debt, which is somewhat larger than its GDP, have erased more than $1 trillion of global equity market capitalization, but Greece's total indebtedness, even when combined with other PIGS, is a small fraction of the global bond market. Keep your eye on the big things, like strong global growth and accommodative monetary policies, since those are likely to overwhelm the Greek debt situation.

Shipping update


This rather obscure index of shipping costs in the N. Atlantic has turned up in significant fashion in the past month or so, after having been very weak for most of the past year. I don't know much about this index (as I've said before), but where there's smoke there is undoubtedly fire. Shipping activity must be picking up, and this has almost nothing to do with China or with commodities. This is a clear positive for the outlook.

Consumer confidence is still very low, and that is good


The Conference Board's measure of consumer confidence rose more than expected this month, but as this chart shows, it is still in the dumps. Consumers remain extremely worried about high unemployment, out-of-control fiscal policy, the big decline in housing prices, the threat of higher taxes (a VAT tax, which the administration seems to be flirting with, would hit everyone, particularly the struggling middle class), and equity prices which haven't made new highs for over a decade. There is no shortage of things to worry about.

As a contrarian and as a bull on the prospects for the equity market, I take a good measure of comfort from this. I don't see how equities could be overvalued in an environment that is chock-full of worries and perceived risks.

The risks are so plentiful and widespread that short-term interest rates have been almost zero for more than 18 months now. Trillions of dollars are sitting in cash that pays almost nothing, and the only explanation for why the money remains in cash is that the owners of the money are terrified of the risks they perceive. Even the Fed is so concerned about the economy that they have been unwilling, so far, to entertain even tiny rise in interest rates. (This may well change with the FOMC meeting announcement tomorrow, and I hope it does.)

Home price update: still relatively stable



These two charts are my inflation-adjusted versions of the Case Shiller home price data. The top chart shows the composite index of 20 large metro areas, while the bottom chart goes back much further in time but shows only the top 10 areas.

I note that prices have been relatively stable for the past year. This is a good sign that the price adjustment process has done its job, and that a 35% decline in real prices was enough to allow the market to clear. Mortgage rates have also declined in recent years, further adding to the affordability of homes and further enhancing the clearing process. This is exactly what you would expect from a market that suddenly found itself with a huge excess inventory of high-priced homes; prices have to fall by enough to entice new buyers into the market.

Many observers continue to believe that this plateau in home prices is only temporary, and that it will be followed by yet another plunge, triggered by an avalanche of foreclosures that are set to hit the market over the next year or so. The second chart might support that notion, since it shows real prices today are still about 40% above their 1987 levels. But I have two reasons why that may not be a valid point: 1) prices in 1987 were relatively depressed, coming at the tail end of the housing price slump that began in the early 1980s; and 2) real housing prices tend to rise over time by a little over 1% a year, and the rise in real prices shown in the second chart works out to 1.5% per year annualized. I can't say definitively that prices won't fall further, only that it is not unreasonable to think they won't; prices today may be pretty close to their long-term equilibrium (or mean-reverting?) levels.

Corporate profits to rise 32% in coming year?


Bloomberg today is reporting that equity analysts (collectively) are estimating that profits on the S&P 500 companies will rise 32% over the next year (which data point I've added to the above chart). That would put profits at $85.96/share, just shy of the record $89.93/share registered in September 2007. That adds up to a pretty significant V-shaped recovery I'd say, and it also says that stocks are not expensive at all at current levels.

Dallas Fed Manufacturing Index looks very healthy


The Dallas Fed's index of manufacturing activity came in stronger than expected for April. Here are some excerpts from a Bloomberg story on the subject:

Texas factory activity increased for the sixth month in a row ... more producers reported increased activity ... 40% of respondents noting increased output ... indexes for capacity utilization, new orders and shipments showed marked increases ... growth rate of orders index jumped to its highest level since June 2006 ... employment index signaled further job growth, with the share of firms hiring workers rising to 22 percent ... wages and benefits index rose as the share of respondents noting increases doubled from 10 percent to 20 percent ... firms remain optimistic about their six-month outlook.

It would be hard to ask for more positive and optimistic news than this.