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Deflation and inflation are alive and well

Over the past 16 years the U.S. has experienced a unique condition: the persistence of both inflation and deflation at the same time in two major sectors of the economy. This chart compares the behavior of two of three major subcomponents of the Personal Consumption Deflator: one covers the price of services, which in turn is largely driven by the inflation component of labor costs (and here I note that the PCE deflator rose 40% over the period covered by this chart), and the other covers the price of durable goods (e.g., cars, computers, appliances, TVs, equipment). (The third subcomponent is nondurable goods.) Never before, since the data were first collected in 1959, have these two price indices moved in opposite directions.

What this chart is saying is that consumers' purchasing power, when it comes to manufactured goods, has effectively increased by a lot, mainly because wages have been rising in both real and nominal terms, while the cost of durable goods has been falling. A simple example: for $1000 today you can buy a computer that can do things that not even a computer costing $1 million could do 16 years ago. The widening gap in this chart is a graphical representation of prosperity, where an hour's worth of labor buys more and more things. The difference between these two lines amounts to an increase in consumer purchasing power of a little over 100%, which in turn is solely due to a change in relative prices. The change in relative prices, in turn, is due primarily to the increased productivity of labor. The average worker today (and around the world) is able to produce far more than ever before with a given amount of work. In short, this chart is showing us just how much more valuable labor has become relative to things.

Chinese imports undoubtedly play a key role in this massive and unprecedented divergence of prices. Thanks to the hugely increased productivity of Chinese workers, U.S. consumers can now devote a greater and greater share of their income to things other than durable goods. (Unfortunately, healthcare and government would appear to be absorbing much of this increase.) Currency fluctuations have nothing to do with this, by the way: the dollar has fallen in real terms, relative to a trade-weighted basket of currencies, by about 5% over the period of this chart, so that would have the effect of increasing somewhat the price of imported goods.

The next time you find out that repairing your watch or your computer or your pocket digital camera costs almost as much as buying a new one, remember this chart.

Inflation remains tame, but the future remains uncertain

News from the inflation front continues to be quite benign, despite the numerous signs of rising inflation pressures that I have been citing since early last year. This chart shows the headline and core measure of the Personal Consumption Deflator, arguably the most comprehensive measure of inflation at the consumer level, and also the Fed's favored indicator of inflation. Some years ago the Fed established a range of 1-2% for this indicator, and by this measure inflation has been within its target range for the past 18 months. Prior to that, however, inflation was consistently above its target from 2004 through 2008. Over the past 5 years, the PCE deflator has risen at a 2.2 annualized rate, while the PCE core deflator is up at a 2.0% annualized rate; so when viewed from a long-term perspective, the Fed is finally on the verge of getting things right.

Ordinarily I would cheering this news. After all, from a supply-side perspective low and stable inflation is of paramount importance, since it provides a fertile field for confidence in the currency and for the investment that fuels growth and job creation. However I continue to be concerned about the potential for rising inflation, if for no other reason than the fact that monetary policy is in totally uncharted waters given the massive expansion of bank reserves in the past 20 months. Traditional indicators of monetary error such as gold (up 370% in the past 10 years and inches from a new all-time high), the value of the dollar (only 5% above its all-time low in inflation-adjusted terms relative to a large basket of currencies), real interest rates (the real Fed funds rate is negative), and the yield curve (still historically steep), suggest that at the very least the Fed is erring on the side of ease, and they have been very upfront in admitting this.

So while the official inflation numbers are almost as good as one could hope for, one's confidence in the future behavior of inflation cannot be very high. There is a lot of uncertainty surrounding the inflation picture, and that is not good. Thus, I consider monetary policy to be acting like a headwind to the economy, keeping growth from being as robust as it otherwise might be. Fiscal policy is another headwind, sapping the economy's strength by redistributing money from the most productive to the least productive.

Most of the supply-siders I know share these views. Interestingly, they run completely counter to the views expressed by many mainstream economists, who see fiscal and monetary policy as important sources of stimulus. So important, moreover, that they worry terribly that the economy is effectively on life-support and could not survive even the slightest reduction in monetary or fiscal stimulus. If nothing else, it's fascinating how reasonable people can take diametrically opposing views of the facts and come to similar conclusions: namely, that while the economy is recovering, we are unlikely to experience a robust recovery, and there are many reasons to worry. And that's why I think that we are still in a bull market, because true bull markets always have to climb one wall of worry after another. Optimism is in short supply.

Corporate profits still look strong

Along with today's latest revision to Q1/10 GDP, we also received the initial estimate of corporate profits. In the year ending March '10, adjusted corporate profits after tax rose 24% from a year earlier. Compared to profits in 1998, when the S&P 500 was trading at approximately the same level as it is today, profits today are about twice as high. Looked at another way (second chart), profits as a % of GDP were about 6.5% of GDP in 1998, whereas today they are 7.7%, a level that rarely has been exceeded in the past 50+ years. Of course, many would argue that the market was entering bubble territory in 1998, but if even if that were indeed the case (though it was not obvious back then, as I recall), then surely equities are not overvalued today.

As the last chart shows, the recent strength in profits is by and large coming from nonfinancial domestic corporations, the meat-and-potatos sector of the economy, if you will.

I look at these facts and come away thinking that the corporate profits picture looks pretty darn impressive, especially considering how much the economy has been struggling in the past year or two. Equities are just not getting the respect that these numbers suggest they deserve. (Note that I am using the National Income and Products Accounts measure of profits, not the profits that are commonly used to calculate PE ratios. In my experience NIPA profits are much less volatile and more reliable, since they include all corporations and they are adjusted for inventory valuation and capital consumption allowances, so they are effectively equivalent to true economic profits. I owe a big HT to Art Laffer for this, since he has been following this series closely for as long as I can remember.)

The 10% GDP output gap

With today's release of the second estimate of GDP numbers for Q1/10—which resulted in a very minor downward revision of annualized real growth from 3.2% to 3.0%—I thought I would revisit this chart, which compares the path of real GDP to a 3.1% annual growth path. My choice of a 3.1% growth rate harkens back to Milton Friedman's Plucking Model of growth, which I discussed in a post almost one year ago. In essence, his theory is that the U.S. economy has a built-in ability and/or desire to grow by a certain amount every year, and when it fails to achieve that, because of a recession-provoking disturbance of some sort, then it has a strong tendency to snap back to that long-term trend line once the economy has adjusted to the disturbance. This behavior has been documented by the Atlanta Fed: the sharper the recession, the stronger the recovery.

If this theory holds true, then currently the economy is about 10% below where it really wants to be. This would ordinarily lead to an explosive recovery. I have been arguing for over a year now that we won't get the explosive recovery (in which the economy would grow by 6-8% for a few years), primarily because of the monumental amount of fiscal "stimulus" this time around that is holding back growth by making the economy less efficient. Instead, I've been looking for 3-4% growth, and that's what we've been seeing so far. I think a cessation of fiscal "stimulus" spending would give the economy a huge boost. Note that this goes directly counter to what conventional wisdom is saying; everywhere you look these days you see people worried that the fourth quarter of this year is going to be weak because stimulus spending is scheduled to drop.

The real problem with the "output gap" we have today is twofold: on the one hand it encourages the Fed to remain hyper-easy, out of fear that the gap exerts strong deflationary pressure on the economy; and on the other, it encourages Washington to "do something," like extend unemployment benefits (which only reduces the incentives of the unemployed to seek work) and otherwise spend money (which takes money from the private sector that could otherwise be put to better use). To the extent we can cut spending, I think the economy will be better off. And if the November elections are going to be as transformative as I think they will be, then the prospect of major cutbacks in the size and role of government in coming years should be a cause for celebration, because then the economy will have a much better chance of closing the output gap rapidly, instead of over the course of many years. And the sooner the economy starts perking up, the sooner the Fed is going to have to normalize (i.e., raise) interest rates. This won't be a problem either, because current interest rates reflect the market's pessimistic view of future growth. Stronger growth and higher rates should go hand in hand.

As fear subsides, prices should rise

The euro financial panic appears to be easing. Swap spreads are off their highs, and the implied volatility of equity options has dropped from a recent high of 48 to 30 today. This should allow substantial improvement in equity prices going forward. Europe hasn't solved its problem, but the market response to the problem has, in my view, been exaggerated. Our inefficient markets just don't have the liquidity and the transparency that's needed to keep volatility (and panics) at bay. The price of inefficiency is excessive volatility (and lots of sleepless nights). That's unfortunate, but the solution is not difficult: as the market better understands this weakness, natural market forces will be brought to bear on the problem. More and more investors will become willing to buy dips and sell rallies, and more and more will be willing to sell put and call options (both being equivalent strategies). Over time this will serve to dampen volatility, and it will help buy time until eurozone authorities figure out an intelligent response to the threat of banking system insolvency.

Shipping activity continues to be strong

I've showed these charts many times over the past year. Early in 2009 I thought the bounce in the Baltic Dry Index (a measure of shipping costs for bulk commodities in the Pacific region) was a good sign that the global economy was coming out of its 2008 slump. The Harpex Index (a measure of shipping costs for containers in the Atlantic) was a laggard, however, until just a few months ago, but it is now surging. With both indicators up significantly on the margin, it would appear that global economic activity is broadening and strengthening, and this provides a welcome counterpoint to the financial panic that is gripping Europe. Strong growth fundamentals provide an excellent source of fundamental support for European debt restructuring should it occur.

And while on the subject of European debt, here are some facts to help keep things in perspective. As my friend Mike Churchill notes, the combined GDPs of Greece, Ireland and Portugal total about 1% of global GDP, which is roughly $60 trillion. I note that Greece's sovereign debt of roughly $400 billion is about 1% of the global bond market, which is approaching $40 trillion. We're not talking about a lot of money here, even if Greek debt suffers a significant haircut in a restructuring. The main issue is whether debt-related losses are too much for the balance sheets of Europe's major banks to absorb. The rise in euro swap spreads that I highlighted yesterday confirms that this is the market's major source of concern; 2-year euro swap spreads closed at just under 80 bps today, and that is a sign of significant—but not yet fatal—concern over the counterparty risk inherent in the European banking system.


Today, Apple's market cap exceeded that of Microsoft for the first time ever ($222 billion vs. $219 billion). It's not the way I would have liked—Apple's stock has held up better than Microsoft's in the recent selloff—but it is nevertheless a milestone of sorts. Apple achieved this victory over its long-time competitor by relentlessly innovating for the past 10 years: OS X (plus 5 upgrades), iPods, MacBook laptops, iMacs, Mac mini, Apple TV, iWork, iPhones, and most recently the iPad. Microsoft, meanwhile, has managed to achieve little more than one major upgrade to its operating system (Windows 7) after one failed upgrade (Vista).

Like so many others, I anxiously await the next Apple innovation.

Capital spending is very strong

Business investment (new orders for capital goods) fell a bit in April from its March level, but thanks to upward revisions to previously released data, investment was actually up 4% versus the old level for March, and March numbers were revised up by 7%. Thus, as the charts show, capex has grown quite strongly over the past year; stronger in fact than at any time since the series began. I almost hate to say it, because I've said it so many times about different series, but this is clearly a V-shaped recovery, and it's very positive since business investment is what produces the growth and jobs of the future. It's also a good sign that businesses confidence is returning, and profits are being put to good use. There's still a mountain of corporate profits that have accumulated over the years but haven't been spent, so this story could have very long and strong legs; corporate profits after tax have doubled since 1998, but the level of capex spending has not increased at all on net.

More signs of housing market stability

According to the Case Shiller folks, housing prices in real terms in the top 20 U.S. markets have been roughly flat since the first quarter of last year. Real home prices have fallen 35% from their early-2006 peak, while over the same period 30-year fixed conforming mortgage rates have fallen by a full percentage point, reducing the cost of financing a home by 17%. Price adjustments of that magnitude are hugely significant in my book, and it would appear that they have been large enough to clear the market—large enough to deal with the oversupply of homes, and large enough to compensate for the effects of the recession on family finances. We are four years into this adjustment process, and that is a lot of water under the bridge. Unless there is another unforeseen shock to the system, it is very unlikely that prices will fall further. It's time to move on and stop worrying about the housing market.

Consumer confidence is returning

It's reassuring to see consumer confidence on the rise, but it's ironic that this news coincides with the market's rather sudden loss of confidence (see my previous post). In any event, I doubt that Europe's brewing financial crisis is going to have a significant impact on the daily goings-on in the U.S. economy. The wheels of recovery are turning, and they are unlikely to be easily derailed.

Markets rush for the exits

Swap spreads are an excellent indicator of systemic risk. (See my basic swaps primer for more details.) Currently, swap spreads are saying that something is very wrong in Europe, and U.S. investors are getting very worried about a possible contagion. Sharply rising swap spreads reflect a primal fear among investors that counterparty risk is on the rise: it's as if everyone were rushing for the exit at the same time, attempting to reduce their exposure to the risk that sovereign defaults turn into major bank defaults. The market is suddenly very distrustful of nearly everyone's solvency.

The Vix Index is a good indicator of the market's level of fear and uncertainty. Fear and uncertainty started rising over concerns that a Greek default could trigger other defaults that could eventually throw a wrench into the Eurozone economy. Now those fears are being fanned by the merger of four failing Spanish banks, and rising tensions in the Korean peninsula that threaten to spill over into weakness in major Asian economies. So many problems that might have unpleasant consequences, what is an investor to do? Run for the exits.

The world's appetite for risk is suddenly less. Stocks are down, commodities are down, even gold is down from its recent high. Short-term Treasury bill yields both here and in Europe are extremely low as a result (0.15%).

I don't have any particular insight into how the world's problems can be resolved. What I do know is that the surge in swap and credit spreads, coupled with the surge in implied volatility, offer a powerful financial incentive to those brave souls willing to shoulder the risk that the world as we know it comes to an end. Disaster insurance is now expensive enough that many will decide to forego it, and many will decide to sell it. Swap spreads can't rise by much more or stay this high for much longer without there being some confirmation of the market's fears, in the form of massive bankruptcies and widespread economic destruction. Implied volatility could spike higher, as it did in late 2008, but already the potential return to selling options is becoming quite tempting.

Another thought: how can the market move so suddenly from being calm to being stormy? Greek credit default swaps were just over 100 bps about six months ago, and now they are 700, even in spite of the Eurozone's willingness to socialize the costs of Greece's debt burden with a $1 trillion bailout package. 2-yr euro swap spreads were 50 bps in early April, and today they spiked to 90 bps. Have the economic and financial fundamentals so suddenly deteriorated? Or is it that the market is just not liquid enough or deep enough or smart enough to handle just a tiny increment in perceived risk? After reading and absorbing the message of "Panic," by Redleaf and Vigilante, I'm inclined to the latter explanation. The market is not nearly as efficient as we have been led to believe. And of course it doesn't help that policymakers, being fundamentally fallible, more often than not either pursue a wrong-headed course of action (e.g., banning naked short-selling), or fail to understand what the proper course of action should be (e.g., guaranteeing the solvency of the banking system).

Here's my take: Market inefficiency and misguided public policy, not a fundamental economic deterioration, are most likely the source of these wild price swings. The market is not well suited to dealing with the uncertainty that arises from sovereign blunders, so it offers outsized returns to those who are. I believe that sooner or later enough brave souls will be found to shoulder the risk; sooner or later politicians will stumble on the proper solutions—with the help of an outraged electorate; sooner or later the economic recoveries that are underway in all the nooks and crannies of the global economy will trump the pain of debt defaults. I don't see that the world is coming to an end, so I'm not going to rush for the exit.

Obama's ratings once again deteriorate, and that's good

A quick update on the Rasmussen polling results for Obama, which I've been tracking for over a year now. While Obama's overall approval rating a few months ago was a bit worse than it is today, I think the charts show that satisfaction with Obama has been on the decline since day one. Moreover, Rasmussen also finds that 63% of U.S. voters now favor the repeal of Obamacare, while only 32% oppose repeal. This is the highest level of opposition to date.

In the second chart we see fairly consistent readings over several months that suggest almost 55% of the people disapprove of the job that Obama is doing, and about 45% approve. Obama is surely aware of his fading popularity and weakened influence, but instead of moving to the center to shore up his support, he seems to want to add yet another "accomplishment" (likely cap and trade legislation) before prematurely becoming a lame duck (likely following the November elections).

My guess is that cap and trade will not be successful. There are too many competing constituencies, and too much controversy surrounding the larger issue of global warming, for this to be successful. Plus, cap and trade essentially boils down to a big tax on carbon-based energy sources, and this is not exactly the sort of thing the economy needs right now. Add these considerations to the growing numbers of those who not only dislike but oppose Obama's initiatives, and you have a recipe for gridlock, even before the November elections.

With the exception of the $200 billion bill that Congress is trying to pass this week (which contains some tax hikes and extensions of popular tax breaks), we are unlikely to see more economy-damaging legislation this year, and that is good.

Another V-sign

It seems the world continues to fret that recoveries are fragile things, and that something like a Greek default could bring down the euro. While it's clear that the recoveries in Europe and in the U.S. are less vigorous than prior recoveries have been, there are still so many signs of a substantial recovery that I think it is very premature to worry about another relapse. This chart of the Chicago Fed's National Activity Index is just one more of the indicators that suggest this recovery is the real thing.