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Fear is unlikely to kill the US economy


Can fear kill growth? I doubt it. As this chart shows, the market's fears (as proxied by the Vix index) have surged in recent days, to levels not seen since early April '09, yet equity prices haven't fallen by much more than we would expect to see in a typical selloff/consolidation (about 10%). I think this shows that fear levels are much higher right now than obvious threats to the economy, and I think that makes sense.

As I've been pointing out for a long time, in my attempts to justify my belief that equity valuations have not been inflated, there has been no shortage of things for the market to worry about. Here's a short list: Will the Fed reverse its massive quantitative easing in time to avoid a surge in inflation? Will the coming wave of mortgage defaults trash the housing market again? Will soaring U.S. deficits lead to a major increase in tax burdens? Will the deficits of the PIIGS result in the downfall of the euro? Yesterday we saw the perfect storm: Greek riots, numerous pundits predicting the imminent demise of the euro, widespread concerns that Greece's woes will prove to be contagious and eventually cripple the Eurozone economy and short-circuit the U.S. recovery, and the coup de grĂ¢ce, electronic trading run amuck. Unusual levels of fear and uncertainty have been with us for well over a year now—it's nothing new. All that happened in the past few months was that a new source of fear (a threatened Greek default and all the consequences that might bring with it) has appeared. The market has not yet become confident enough in a global recovery to avoid panicking at one new set of unknowns.

It's understandable that investors' confidence has been shaken to the core; there are just so many unprecedented things going on in the world right now. Buying and holding equities—or any risk asset at this point, since all have been hammered of late, as the next chart shows—requires true conviction, and the willingness to put up with some gut-wrenching volatility. But isn't that the case with the early stages of any bull market? Things are never clear until well after the fact.



My approach to situations of great uncertainty, such as we have today, is to focus on the underlying fundamentals, in the belief that a) the fundamentals usually win out in the end, and b) it never pays to underestimate the ability of the U.S. economy, in particular, to cope with adversity.

For some time now we have seen so many signs of recoveries (many of the V variety) that an economic relapse seems almost unthinkable at this point: commodity prices are very strong; credit spreads are much tighter; industrial production has turned up; the ISM indices are on a tear; Asian economies are booming; world trade is expanding; the U.S. economy is in job-creation mode; corporate profits are very strong; and productivity gains in the past year have reached record-setting highs, to name just a few. None of these signs of recovery have deteriorated by any significant amount, and most just continue to improve; moreover, recoveries are self-sustaining once they get started, thanks to the inherent entrepreneurial abilities of our economy and man's insatiable desire to raise his standard of living.


So many positives, yet none of the negatives, like very tight monetary policy, that typically lead to a recession. To be sure, there is the real threat that U.S. tax burdens might rise significantly starting next year, but we have an important election in November that could shift the balance of power from those pushing for higher taxes to those pushing for reductions in spending. It's too soon to give up hope on the fiscal policy front.

But what about our markets, that appear so vulnerable still to program trading, derivatives, etc.? I think there is a good argument to be made that trading-induced volatility, such as we suffered through yesterday, brings with it the seeds of its own correction. On average nobody benefits from extreme price moves, and most people lose, even the ones who got the whole thing started. I'll wager that those running electronic trading programs will think twice and three times about letting them run unsupervised in the future. The market has evidently not regained the liquidity necessary to support a lot of trading. Until it does, the potential for expensive whipsaws is going to be a major force restraining participation in high volume trading.

In any event, high levels of implied volatility act as a natural shock absorber for nervous markets. That's because it becomes more profitable to sell options rather than buying them, and this serves to automatically dampen market moves. Selling options is akin to buying low and selling high (that's how delta hedging or dynamic option replication works), so high implied volatility provides a huge incentive for traders and speculators to adopt strategies that will effectively add liquidity to the market. In short, there are many ways in which the market, left to its own devices, can sort things out and become more efficient.

I remain convinced that we are in the early stages of a sustainable recovery. It's not a robust recovery, unfortunately, because government has grown like topsy, and regulatory and tax burdens are rising. "Stimulus" programs based largely on transfer payments and make-work projects only squander the economy's resources. But it is nonetheless a recovery, and 3-4% growth rates for the foreseeable future are entirely possible and quite likely. It still pays to be optimistic.

1 million new jobs and counting



The jobs picture is getting a lot brighter with the release of the April employment data. According to the household survey, which for some reason doesn't get much press, the private sector has created 1.15 million new jobs so far this year. The well-known establishment survey (which typically lags the household survey at economic turning points such as we have today) finds that the economy's private sector has added about half a million jobs so far this year. Perhaps the reality is somewhere in the middle, but regardless, it is now very clear that the economy is growing and will likely continue to strengthen in the months ahead. Yesterday's Monster Employment Index confirms that businesses are going to be hiring more and more.

Despite these welcome gains in new jobs, the unemployment rate jumped back up to 9.9%. How is that? Simple: the number of people who are working or would like to work (the labor force) has surged by 1.7 million this year. A lot of people who had previously said they weren't looking for work now are; formerly discouraged workers are now back in the hunt for a job. We could see even more of this going forward, by the way, since it is still the case that the labor force, which tends to grow about 1% a year, hasn't grown at all since late 2008. So even some healthy job gains in coming months could fail to bring the unemployment rate down. That makes for bad headlines, but it doesn't make the economy any weaker.


The first chart, by the way, focuses only on the private sector. As the second chart shows, the public sector has also added some jobs of late, but that is almost entirely due to census hiring. Apart from that, the public sector is being squeezed by the marked deterioration in its finances. This is not unusual at this stage of the business cycle, and it will probably continue for some time to come as the electorate revolts against bloated government at all levels.

All in all, I think this is very encouraging news. There is every reason to believe the economy will continue to grow for the foreseeable future. The private sector's inherent dynamism has managed to cope with all the difficulties thrown in its path over the past few years. Tremendous adjustments have been made, productivity has surged, businesses are profitable, and so now another expansion is underway. This can feed on itself for a very long time, and it is a lot more powerful than the problems surrounding Greece's public finances.

Weekly claims update


There's nothing here to suggest any deterioration in the employment picture. The rate of decline in claims has slowed in recent months, but this is not unusual for this phase of the business cycle, as I think the chart shows.

Widespread evidence of new hiring


Most of the Monster Employment Indices (based on online job openings) have turned up impressively in the past few months. This is unvarnished good news, as without new jobs the recovery would be unsustainable. The recovery now has legs. Some excerpts from the report:

While most industries and occupations are showing increased demand for workers, public administration remains muted and below seasonal expectations as several state and local governments continue to face budgetary pressures.

During April, online job availability rose in 17 of the Index’s 20 industry sectors and in 21 of the 23 occupational categories monitored.

Mining, quarrying, oil, and gas extraction workers see strongest rise in online job demand in April; Information and agriculture contract.

Consumer-driven sectors: retail trade; and accommodation and food services register second consecutive month of growth.

During April, demand rose in all U.S. Census Bureau regions with Mid Atlantic and New England registering the largest gains, both climbing 11 percent month-over-month.

The silver lining to the Greek crisis


Here's how the bond market sees the action in the eurozone financial markets. Yields on 2-yr Greek government debt have spiked to 15% or so, indicating the market sees a high probability of some sort of Greek default or restructuring. Not a total default, but at least a partial default; prices on Greek government bonds range from $84 for the 2-yr, to $76 for the 10-yr, to $60 for the 30-yr. So maybe the market is priced to something like a 20-25% haircut. Meanwhile, yields on German bonds have dropped, suggesting that investors see Germany as a safe haven, and/or investors see a Greek default spilling over into weaker European growth prospects.


This next chart shows how the U.S. bond market is reacting to the distress in Europe. Bottom line: it's not a big deal. Bond yields are down a bit, but not by enough to suggest any major deterioration in U.S. growth prospects. The market for some time now has been worried that the U.S. economy won't enjoy strong growth, and distress in Europe simply reinforces those concerns.


Here's how the stock market is reacting. Equity prices aren't down much at all, but implied volatility has spiked quite a bit. That suggests the market is more worried about the uncertainty of the Greek threat than it is about the threat it poses to growth. Previous spikes in the Vix saw much greater declines in equity prices than we have seen in the current episode. Perhaps this also suggests that the market has been captured by speculative fever—hedge funds looking for the next big killing are piling on to the Greek default story and its many possible "contagions." Might the euro get killed? Might global growth be derailed? Which country is next in line to default?


The euro has lost a little over 10% of its value against the dollar since January, and the dollar is up about 10% against a basket of currencies over the same period. This suggests that those worried about the situation in Europe see the U.S. as a safe haven—a refuge against contagion in Europe and the possibility that the euro itself could be at some risk. But looking at things from a long-term perspective, the dollar is still relatively weak and the euro is still relatively strong. So pricing has not yet even remotely reached crisis proportions.

I keep thinking this is a tempest in a teapot. Even if Greece defaults or restructures its debt, that is no reason for the euro to be dissolved, or for European growth prospects to collapse. Call me an eternal optimist, but this "crisis" has a bright silver lining, since it focuses the world's attention on one of the biggest problems faced by all major economies these days: bloated government. This issue is playing big in local elections all over the country; the Tea Party owes its very existence to this issue. The bond market, by refusing to buy Greek debt, is exerting powerful discipline on the Greek government.

What is so scary about cutting government spending? The only ones who will suffer will be the government workers that have been enjoying rising salaries, supremely generous pension and retirement benefits, and job security. The private sector has been putting up with far worse for a long time. Those who fear that cutting government spending will plunge economies into recession and deflation are the ones who don't understand that government spending is not stimulative in the first place. Big and growing government only weakens economies; so it stands to reason that cutting back on government should boost economies.

Rather than fear the deflationary consequences of slashing Greek government spending and freezing government salaries, it makes much more sense to cheer the end of big government. Less government means more freedom for the private sector; less spending means smaller deficits; smaller deficits leave more money for the private sector to put to more productive use; the return of fiscal discipline is a huge boost to confidence. The benefits of fixing the problem of bloated government surely far outweigh the costs!

The service sector looks reasonably healthy


Activity in the service sector is holding up nicely. In fact, the ISM measure of business activity in the service sector is as strong as it's been since mid-2006. Not much in the way of new hiring, though, with the employment index hovering just under 50 for the past three months.


But there's no sign of deflation coming from the nation's purchasing managers, as this next chart shows. On balance, about two-thirds of those surveyed report paying higher prices. (Clarification: deflation is properly defined as a decline in the general price level. That prices may be falling in some areas of the economy is not deflation, since that represents a change in relative prices: some prices are always rising and falling relative to each other as market conditions change. When a clear majority report paying higher prices, though, we do not have deflation.)

The economy enters positive jobs territory


ADP is now estimating that the private sector has been adding jobs, albeit not many—only 54,000, for the past three months. That's old news at this point, however, since the BLS establishment survey found about 150,000 new private sector jobs in the first quarter (government job gains are going to be misleading for awhile due to Census hiring). So the real question is how fast the economy will be creating new jobs going forward. The Bloomberg estimate for the jobs report this Friday says we'll see about 100K new private sector jobs. ADP is not quite so sanguine, but it has been underestimating job gains recently, so who knows? 

Corporate layoffs are back to normal


Publicly-announced corporate layoffs have dropped to their lowest level since mid-2006, according to the folks at Challenger, Gray & Christmas. It's hard to imagine things could improve much more on this front. Before hiring starts, firing has to almost grind to a halt, and it appears we are now at that point. Not surprisingly, net private sector job gains of 100K are forecast for the April employment report to be released this Friday. The only real question now is how fast the economy will add back the jobs it has lost. For politicians, the real question is whether enough jobs will be created before November to dampen anger over what increasingly appears to have been a trillion-dollar spending boondoggle (aka fiscal stimulus).

I'm guessing we will see progress (i.e., a declining unemployment rate) in coming months, but it's not going to be enough to disabuse the public of the notion that big government spending programs are a waste of money. Indeed, I've maintained all along that the "stimulus" package (which consisted mostly of transfer payments and make-work projects) effectively amounted to a headwind that would end up retarding the economy's progress. It was just the opposite of stimulus, since it wasted a lot of money that could otherwise have been put to better use (e.g., for tax cuts that would have increased the private sector's incentive to work, invest, and take risks).

Why do we punish success and reward failure?


This seems quite appropriate given the current debates about whether to have financial reform that includes measures to bail out failed banks in the future, about whether or not to lower corporate taxes—already the highest in the developed world, and about whether Apple is guilty of monopoly practices because it refuses to allow developers to use Adobe's Flash software in apps for the iPhone and iPad, preferring instead to rely on open standards. And of course, punishing success is what Obama's "spreading the wealth" is all about.

4-Block World

HT: Mark Perry.

Harpex update


Shipping activity continues to impress on the upside. The Harpex index of shipping costs (an index which focuses exclusively on container ships and is thus largely independent of the commodities market) is now up 45% from its all-time lows of late last year. How can concerns over a possible Greek default manage to derail the strong global economic momentum reflected in this index? I think the market is just suffering from another case of the heebie-jeebies.

One reason inflation remains tame: strong money demand


According to the Personal Consumption Deflator, the Fed's preferred measure of inflation (and a pretty decent one, I might add), inflation with or without food & energy remains within the Fed's target range.

Note, however, that inflation from 2004 through most of 2008 was consistently above target, and I think I know why. This period was preceded by all of the conditions that I have been worrying about for the past year. The Fed adopted a very accommodative monetary policy starting in late 2001, holding short-term interest rates below 2% through late 2004; gold prices rose from $260 in early 2001 to over $400/oz by late 2003; the dollar lost over one-fourth of its value against other major currencies from early 2002 to late 2003; commodity prices rose almost 60% from late 2001 to late 2003; and the yield curve went from being flat in early 2001 to almost as steep as it is now by late 2003. I consider that all of these signs are good leading indicators of rising inflation, and we have seen every one of them repeat over the past year or so: the dollar has fallen, gold has surged, commodity prices have surged, the yield curve has steepened, and the Fed has been holding short rates at almost zero for 18 months.

The one thing that is different this time around (history never repeats itself exactly, of course) is that for most of the past year or so the public's demand for money has been exceptionally strong. We saw the evidence of that in the big decline in velocity that occurred from late 2008 through mid-2009; in the big increase in currency in circulation and in M2 that occurred from late 2008 through March of last year; in the widespread signs of deleveraging in corporate America and among households from late 2008 through today; and in the very weak growth of bank credit.

In short, monetary policy has been exceptionally easy for the past 18 months, but the public's demand for money has been exceptionally strong at the same time. Monetary policy is inflationary only when the supply of money exceeds the demand for it. This is the essence of my rationale for why measured inflation hasn't yet increased, even though my favorite leading indicators of inflation are all pointing up: the Fed hasn't oversupplied money by enough to overcome the disinflationary aftermath of sudden and unexpected shock to confidence, a significant slowdown in economic activity, and the inflation "inertia" of the massive U.S. economy.

I note that rising inflation is now showing up in many Asian countries, and particularly in China. Most of them have effectively outsourced their monetary policy to the Fed by effectively pegging their currencies to the dollar. If U.S. monetary policy is inflationary, then it would makes sense that inflation would show up in smaller and less developed economies long before it showed up in the U.S. economy.

I think it is also worth highlighting the fact that despite the depth and severity of the recent recession, and the huge degree of "slack" or idle resources that have existed for most of the past year or so, there are no signs yet of deflation. The deflation that was predicted by popular (e.g., Phillips Curve-based) models of inflation was a total no-show. Recall that at the end of 2008 the bond market—via the mechanism of TIPS' breakeven spreads—was predicting significant deflation for years to come, yet instead we find that inflation has been running at a 1-2% rate for the past year.

In any event, and as Milton Friedman taught us, the lags between monetary policy and their impact on the economy are long and variable. That measured inflation hasn't risen yet, despite aggressively accommodative monetary policy and the appearance of a host of leading indicators of inflation, is not a reason to cheer. Investors can't wait for the signs of inflation to become obvious, since by then it's too late to react.

Prudence, a focus on the monetary nature of inflation, and a quick glance at the Fed's massively bloated balance sheet (which the Fed admits may take many years to reverse) should be enough to convince investors today to worry much more about inflation than deflation. That in turn should leave one more optimistic, not less, about the future prospects for growth in the U.S. economy (since the appearance of deflation could definitely weaken the economy, aggravate the burden of everyone's debt, and increase default risk), and it should make inflation hedges more attractive, not less. It should also argue against holding cash or cash equivalents.

Full disclosure: I hold no cash or cash equivalents, am long TIPS, long a variety of equities, long high-yield debt, long emerging market debt, and short Treasury bonds (via a 30-yr fixed rate mortgage) at the time of this writing.

More evidence of strong consumer spending


Car sales were up 20% in the 12 months ending April. This, in spite of the "cash for clunkers" program which presumably boosted sales in the third quarter of last year at the expense of future sales.

Separately, as Mark Perry notes, (see his post for details) restaurants enjoyed a huge boost in sales last March. Restaurant activity hasn't been this strong since September '07. I can add some anecdotal evidence to this: my wife and I went out for dinner last Saturday night, and were pleased to see that most restaurants in the area were full and there was lots of foot traffic in the downtown area.

Consumer spending is on the right track


As a supply-sider I tend to ignore consumer spending, since I think the major drivers of growth can instead be found on the "supply-side" of the economy: e.g., jobs, hours worked, capital spending, and industrial production. Normally, you can't have an increase in spending without first having an increase in jobs and production. But this recession/recovery cycle has been a bit different from the norm, since it was largely panic-induced. Fears of a global financial meltdown caused consumers everywhere to shut their wallets in an attempt to boost their holdings of cash. A massive increase in the public's demand for money caused a dramatic and sudden decline in spending. As I've been documenting over most of the past year, the level of panic has gradually subsided, confidence is slowly returning, and money that was hoarded is beginning to be spent. So an increase in spending is a good sign, this time, that the outlook for the economy is improving. With spending up, jobs are likely to follow.

The chart above is just one more example of how spending has come back to life. The decline in real consumption spending was quite pronounced, and while the rebound was not sudden and sharp, the recovery pattern we are seeing is not greatly different from what we have seen in other modern-day business cycles.

Construction still weak, but the outlook is improving


Total construction spending has been declining for the past four years, but the good news is that it is increasingly apparent that residential construction spending hit bottom a year ago and has likely stabilized. This is one more sign that the housing market has seen the worst, and that things are likely to be gradually improving over the next year or so. Residential construction spending last year had fallen to its lowest level ever relative to GDP, a level that ensured that new home construction would be much lower than the ongoing rate of housing formation, and thus the excess inventory of homes would be gradually but surely eliminated. We are probably very close to that point now. Looking ahead 2-3 years, we could see some dramatic increases in residential construrtion spending as the supply of homes starts to become scarce relative to stronger demand.

ISM manufacturing index very strong


The Institute for Supply Management's April index of manufacturing activity was a bit stronger than expected, but more importantly, it is telling us that the 3.2% growth rate of first quarter GDP was most likely depressed by bad weather. For the past four months, the ISM manufacturing index has been pointing to GDP growth of 5-6%. Thus, we could see a very strong rebound in second quarter GDP growth. That would be consistent with all the other V signs out there, such as commodity prices and export orders, with the latter shown in the next chart:


Furthermore, the employment index in April jumped to 58.5, its highest level since early 2005. And in yet another reminder that deflation risk is no longer a concern, the ISM prices paid index rose to 78, a level it has rarely exceeded in the past. There is a whole lot more life in the economy than what was reflected in last week's Q1 GDP release, and there are budding signs of reflation as well.