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Corporate profits look very strong

With the final revision to Q1/10 GDP released today, we see a nice upward revision to corporate profits, which were already pretty strong to begin with. In the top chart the blue line reflects total after-tax corporate profits, while the red line shows the profits of nonfinancial domestic corporations. Note how the latter has surged by 83% since the low of late 2008; this means that your average home-grown company's profits have nearly doubled since the depths of the recent recession. That the red line has risen proportionately more than the blue means that the profits of financial corporations have lagged, which is not surprising given all the problems in the banking sector.

Pessimists would be quick to note that profits are now almost as high, relative to GDP, as they have ever been, and thus there is nowhere to go in the future but down. I would counter that by noting that corporate profits have doubled since 1998, long before the equity market reached bubble territory, but equity valuations as measured by the S&P 500 have not risen at all in the intervening years on net. I think this makes a strong case for stocks being undervalued today, depressed by, among other things, a) fears of a double-dip recession, b) anticipated future tax hikes, c) increased government regulation, and d) worries over how the Fed is going to unwind $1 trillion of monetary stimulus. It's not a secret that there are all sorts of problems out there, and there is no shortage of things to worry about these days. These numbers suggest that the market has already discounted a lot of problems, if not all of them. So if anything starts to move in a positive direction (e.g., the November election results in a big mandate to cut spending and avoid tax hikes), then the market should have plenty of upside potential.

Rising consumer confidence is a good sign

Consumer confidence is anything but a reliable leading indicator of the economy's health, but this time it may be. That it is still relatively low from an historical perspective simply reflects the fact that we've through a pretty rough recession. Confidence was deeply shaken, and it takes time to rebuild. Recessions typically happen when everyone is very confident, because then the unforeseen can be terribly disruptive. But now most folks are still looking cautiously around every corner and under every rock, worried that the unforeseen may strike again. This is quite normal and consistent with the early stages of just about every recovery. That confidence has been slowly rising for the past year is more encouraging this time around, since the latest recession was all about a huge shock to confidence (i.e., widespread fears of a global financial meltdown), so as confidence returns, money that was socked away under mattresses gets gradually spent, and that helps economic activity recover. We are in the midst of a virtuous circle, where rising confidence boosts spending, rising spending boosts production, and rising production boosts confidence, etc.

Financial conditions are not all that terrible

This is a chart of financial conditions as measured by Bloomberg. It "combines yields spreads and indices from the Money Markets, Equity Markets, and Bond Markets into a normalized index. The values of this index are z-scores, which represent the number of standard deviations that current financial conditions lie above or below the average of the 1992–June 2008 period."

Yesterday the index registered -.92, which is better than the May 20th low of -1.53 and far better than what we saw in the runup to the Lehman crash. Swap spreads in the U.S. are about average, the Vix index is elevated (just under 30 today), and European swap spreads are elevated (2-yr swap spreads are just under 80 bps). The world is very worried about a Greek default or restructuring, as evidence by the 950 bps spread between 2-yr Greek and German bonds (bottom chart), enough so that it would be surprising at this point if Greece did not default; a significant default is effectively priced into the market today. In short, things could be a lot better, but this is hardly a crisis, disaster or a replay of 2008.

Weekly claims lower than expected

In a departure from the behavior of most economic statistics of late (when reports were not as good as expected), weekly unemployment claims in the latest period were a bit lower than expected (457K vs. 463K).  The 4-week average move up a bit, but the trend since January is downward-sloping (though not by much—see second chart). The pace of improvement may be disappointingly slow, but the economy nevertheless continues to strengthen.


The pace of business investment is strong, but the level is still disappointing

New orders for capital goods in May were 17% higher than a year ago, and that amounts to very strong growth in business investment. At this pace, capital spending will regain its 2008 high in about a year. That's much faster than the recovery from the 2001 recession, when it took six years to recover to previous highs. But as impressive as is the growth rate of business investment currently, the level is remarkably low, given the absence of growth over the past 10 years. Moreover, corporate profits after tax have doubled over the past 10 years, yet business investment is flat. Cash is piling up in corporate coffers, and much of that cash is effectively being borrowed by the federal government to fund its deficit.

While things are definitely improving on the margin, the underlying strength of the economy is being undermined by deficit-fueled government spending that we can be sure is far less productive than if the same amount of money were being spent by the private sector. Once again, a reason to expect that overall growth in the economy will be less than robust (which, given the depths of the prior recession would be on the order of 6-8%), but still somewhat better than average (long-term trend growth is probably 3%). So I'm sticking with my forecast of 3-4% growth over the next few years.

It's about time: austerity is the new fashion in Europe

From the Washington Post: "Britain announced a far-reaching deficit-reduction plan Tuesday aimed at saving billions of dollars over the next five years, becoming the latest European nation to slash spending amid increased worries about rising public-sector debt."

It's not perfect news, though, since about one-fourth of the deficit reduction will supposedly be achieved by increased taxes, but it's a good start. The spending cuts are impressive in that they target spending programs directly, and the same thing is happening in Germany and France. "Britain's decision to cut rather than spend follows a wave of austerity packages recently unveiled across Europe, including almost $100 billion worth of cuts in Germany and public-sector pension reforms in France."

Obama, of course, cautioned the Europeans to avoid premature austerity measures since they might harm economies. The market, however, reacted to the news by boosting the value of the pound (up 13% in the past month); plus, German stocks are up about 10% in the past month, and UK stocks are up 5%. If too much spending causes huge deficits and raises fears of huge tax increases (a bad thing in the eyes of investors), then cutting back on excessive spending can only be a good thing.

This U.S. needs to join this party, and the sooner the better.

UPDATE: This party is spreading around the world to Australia: "Julia Gillard became Australia's first female prime minister after Kevin Rudd stepped aside as leader of the governing Labor Party, paving the way for the government to drop a controversial new 40% levy on mining profits that has damaged its standing in voter polls."

Not to mention the many municipalities and states that are now being forced to look at trimming out-of-control pension obligations.

UPDATE: The WSJ has a great op-ed which summarizes the failure of Keynesian stimulus efforts around the world, and how the political tides are turning against them.

Fed remains in reactive mode, which is not helpful

Today's FOMC statement made no contribution to the market's understanding of the economy or the future course of Fed policy. The Fed knows just about as much as the market about what's going on—the U.S. economy is probably still growing, but there is the risk that the Euro debt crisis could be contagious. From a longer term perspective, the Fed is managing policy by looking in the rearview mirror, trying to nurse a sick economy (sick because it is almost 10% below trend growth) back to health with cheap money. Fed policy remains about as easy as it has ever been, as this chart suggests.

Fed governors, with the exception of Kansas Fed President Hoenig, have no interest in the message being sent by strong commodity prices, soaring gold prices, and the generally weak level of the dollar—namely, that money is in abundant supply and there is almost no chance that Fed policy is posing any problems for the economy. If anything, ongoing monetary accommodation may be fueling unrest among investors who worry about how the Fed's addition of $1 trillion to bank reserves will be unwound and what problems that may create in the interim (e.g., rising inflation, asset price bubbles).

Investors also worry about fiscal policy, which has been incredibly "stimulative" according to the Keynesian framework. Very easy money plus very stimulative fiscal policy for the past 18 months and we only have a modest recovery that is at risk of a Greek debt default? Yikes, maybe the economy is hanging by a thread...

A better way to understand things is from a supply-side/monetarist/classical economic perspective. Easy money can't create growth, it can only create inflation. Deficit-fueled spending also can't create growth, especially when, as now, it consists mostly of transfer payments that simply redistribute wealth in a way that weakens incentives to work and invest. Huge deficits and huge new government spending programs (e.g., Obamacare) further weaken investor confidence since they hold the threat of a major increase in future tax burdens. A lack of investor confidence in the future stability and strength of the dollar and the future level of tax rates and tax burdens equates to uncertainty, and uncertainty is bad for investment. If investment is weak, then economic growth is hard to come by. It takes hard work and risk-taking to create new companies and new jobs.

So the more the Fed tries to pump up growth with low interest rates, and the more Congress tries to pump up growth with new spending schemes, the worse it is for the economy. There is a dreadful lack of understanding of the basic principles of economics in Washington, especially among the Obama administration and members of the Democratic Party.

I believe that the market has been worried for a long time about the course of fiscal and monetary policy. Investors and risk-takers understand how things work much better than most politicians do. There are abundant signs of just how concerned the market is, from zero interest rates on cash to 3% interest rates on 10-yr Treasury bonds, and from above-average credit spreads to historically high implied volatility and $1200 gold prices. Morever, equity valuations have severely lagged the growth in corporate profits.

In this view of the world, the market advance to date has largely occurred despite the bad news from Washington, the Fed, and the Greeks, and the economy is recovering despite all the headwinds, thanks to the inherent dynamism of the U.S. economy and a free people's innate desire to improve their lot in life by working harder and finding ways to do things more efficiently. It's not a huge recovery or even a typical recovery, given the depth of the recent recession, but it is a recovery and it is likely to continue.

The one bright spot on the horizon, and something that could make a huge difference to the economy and the markets, is the upcoming November elections. It is the hope—and the increasing likelihood—that these elections could yield a significant rightward shift in fiscal policy that is sustaining what little optimism can be found. I think it's hard to underestimate the importance of this, because all the signs on the margin point to a sea-change in the public's attitude toward fiscal and monetary policy. When and if this change translates into an improved policy outlook, we could see an explosion of optimism, and that would be a very good thing indeed.

New home sales distorted by incentives

The big drop in new home sales in May was most likely "payback" for strong sales in April, which in turn were fueled by people rushing to take advantage of the soon-to-expire homebuyers tax credit of $8,000. As Brian Wesbury notes, the underlying level of sales is consistent with the very low level of new construction we have seen for the past year, and does not therefore represent any new deterioration in the economy. Bear in mind as well that residential construction has fallen to its lowest level relative to the economy (just over 2% of GDP), so even if new home construction were to weaken substantially from here it would have a minimal impact on the overall economy.

... new homes were sold at a 446,000 pace in April, but fell to a 300,000 rate in May. The underlying trend is probably in between, or 373,000 per year. For comparison, in the past two months, single-family homes were started at a 517,000 annual rate. Of the 517,000, we estimate that roughly 150,000 do not need to be sold because the plot has already been sold. That leaves 367,000 per year that need to be sold (517,000 minus 150,000), which is right in-line with the pace of sales. In other words, as bad as today’s report was, it does not signal a need for home builders to slow down the pace of construction. Confirming this, today’s report showed that the inventory of new homes declined 1,000 to 213,000, the lowest level since 1970.

Strong growth in the hiring of temp workers

With a HT to Mark Perry, who has been following this index for some time, I offer this version of his chart that includes an extra year of data. This index "estimates weekly changes in the number of people employed in temporary and contract work," and as Mark notes, the index "is considered to be an accurate leading indicator of employment trends," especially when the economy is coming out of a recession. Indeed, the index started rising beginning in July of last year, six months prior to a rise in the household survey measure of private sector employment.  It has risen 25% from the year-ago period, a strong sign that business activity is expanding and permanent hiring will continue to rise.

Putting commodity prices into perspective

This chart shows the entirety of the bull market in commodities which began in late October, 2001. The index shown is composed of very basic industrial commodity prices (e.g., 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, and zinc), many of which do not have associated futures contracts, and therefore are less likely to be influenced by speculative activity. From its time high last April, the index is down a mere 4.5%, and it is only  11.4% below its all-time high in July, 2008.

We can only speculate about the combination of forces that has driven commodity prices up 107% in just under 9 years (7.8% annualized). But the likely candidates would be: strong global growth, particularly in China and India and most emerging market economies; accommodative monetary policies from most of the world's central banks; and the inability of commodity producers to keep up with demand, following a period (from the mid 1990s to the early 2000s) in which very tight monetary policies had severely depressed demand for commodities.

To explore the possible contribution of monetary policy to today's commodity prices, I offer the following chart, which plots the same CRB Spot index in real terms (using the PCE deflator).

The three periods shown in the chart correspond to major monetary policy eras: the easy money of the 1970s, which led to sharply rising inflation and a commodity booms; the tight money that began with Fed Chairman Volcker and ended in the wake of the dot-com disaster; and the easy money that has characterized monetary policy since the Fed began to worry about a weak economy and deflation risks in 2003. One thing should be obvious, and that is that today's prices are relatively cheap from a long-term historical valuation perspective. Prices haven't yet recovered to the levels that prevailed in 1970 (and prices were relatively flat from 1960 to 1970). The other obvious point is that monetary policy can have a major impact on commodity prices.

In any event, I don't see the rationale for why there is necessarily a commodity price bubble, or why there should be a bursting of the bubble. From a long-term perspective, commodities might be considered to be still in the early stages of a recovery from very depressed levels. Julian Simon, if he were alive today, would argue that commodity prices in real terms should have a strong tendency to decline over time, since man cleverly invents new and more efficient ways to extract commodities, and more efficient ways to use commodities. But even if you believe this, today's price action is not anomalous.

Shipping update--looking better and better

The Harpex index of container shipping rates in the N. Atlantic has almost doubled so far this year, after having plumbed unimaginable lows. That's a V-shaped recovery in my book, even though rates have yet to regain their pre-crisis levels, and at the very least it severely weakens the bear case for European growth.

Update: At the request of a reader, here is a chart of the Baltic Dry Index, which measures shipping costs for bulk commodities in the Pacific. The index is enormously volatile, and has dropped 40% in past month. But as the chart shows, it is still up significantly from its end-2008 lows. As recently as 2001, today's levels would have been considered almost impossibly high. I think today's reading is consistent with an ongoing global economic recovery.

Further evidence the Euro scare is passing

This chart of 3-mo. T-bill yields is further evidence (in addition to the decline in swap spreads, credit spreads, and the Vix index) that the mini-panic over Eurozone debt defaults is passing. Such was the panic a week ago that investors were willing to sacrifice almost all yield in order to enjoy the safety of T-bills. Rising T-bill yields today are equivalent to the market breathing a huge sigh of relief.

As this chart of 10-yr Treasury yields shows, however, the market is still very concerned about the future of the U.S. economy. Investors are willing to accept 3.2% yields on 10-yr Treasuries only because they have a very dim view of the economy's ability to grow, and because they remain concerned about the threat of deflation. So between the two charts we see that while the market is no longer absolutely terrified of another financial meltdown, it is far from being optimistic about the future. Reading the bond market tea leaves is how I come to believe that valuations in the equity market remain relatively depressed.

Housing market continues to stabilize

Sales of existing homes "fell unexpectedly" in May, according to today's headlines, but as the top chart shows, they remain 15% above what appears to be the floor level of sales for the past two years. The housing market is almost certainly not in a V-shaped recovery (I'm discounting strong sales during the April-May period because they were likely influenced by the expiration of the $8,000 tax credit program), but neither is it showing any signs of another collapse. This is a drawn-out "U" shaped recovery if anything. The important things to note are these: the housing market peaked about five years ago; sales and prices declined for about three years; and things appear to have stabilized for the past two years. We're five years into this downturn in the housing market, and sufficient time has passed and enough adjustments have occurred (median home prices have fallen roughly 25% since 2005) to support the view that things are going to slowly get better instead of getting worse.

You don't need to see housing moving up to be optimistic, you only need to know that the housing market has stabilized. Stable prices come first, then higher prices. (Actually, prices in May were up about 2% from a year ago.) As long as prices no longer decline, then the prices of mortgage-backed securities can stabilize and eventually rise. (And actually, some home-equity-backed security prices are up 17% from their year-end levels.)

Spread update—good news on the margin

Just an update to show that, as of last Friday, credit spreads had reversed about half of their recent widening. The scare that started in Euroland with the Greek debt crisis and threatened to spread to the U.S. economy is passing. Given the action in HY debt funds today (higher prices), it's a safe bet that spreads today were lower than is reflected in the charts. Good news.

Dollar weakens against the yuan

Most observers are cheering China's decision over the weekend to allow its currency to once again appreciate against the dollar (top chart), and I agree that it is probably a good thing, if for no other reason than that it reduces the risk that U.S. politicians will screw things up by starting a trade war with China.

But it's also a good thing for China itself, since a stronger currency reduces the risk of higher inflation, which was already uncomfortably high and rising (second chart). A stronger currency will also lead to higher Chinese living standards, since the purchasing power of Chinese incomes will rise in proportion to the yuan's rise against other currencies.

But instead of focusing on the stronger yuan, I think the real focus should be on the dollar. What the Chinese are doing is withdrawing their support of the dollar—effectively voting against the dollar. They were buying dollars and otherwise accumulating reserves in order to keep the yuan pegged at 6.83 to the dollar. If they hadn't taken enforced the peg, then presumably net capital inflows would have driven the yuan higher at the expense of the dollar. So now they will buy fewer dollars and allow the yuan to rise. (I made some more extensive comments on the history of the yuan's link to the dollar here, but in rereading the post I note that my conclusion—that the Chinese would only revalue if the dollar weakened further, which it hasn't—was wrong.)

The Chinese decision also highlights the dollar's fundamental weakness. Being pegged to the dollar meant that China experienced the full effects of U.S. monetary policy. Rising Chinese inflation is strong evidence that the Fed has been too easy, and that the dollar has been too weak. Chinese inflation is like the canary in the coal mine for U.S. inflation—monetary policy acts faster in the Chinese economy because it is much smaller and more dynamic. Plus, trade is much more important to the Chinese economy than it is to the U.S., so changes in the value of the yuan, which have been primarily driven by changes in the dollar's value, flow through to the general price level faster in China than they do in the U.S.

By revaluing against the dollar, China will experience a tightening of monetary policy. And, by reducing the demand for dollars, China's action will result in a further easing of U.S. monetary conditions. Therefore, inflationary pressures in China will diminish, while they will increase in the U.S.

I doubt that this decision will prove to be of great benefit to U.S. exporters, but it should be of some benefit on the margin since a stronger yuan will make all imports cheaper for Chinese consumers. One collateral effect of this is that Chinese demand for commodities will strengthen, and that is likely to push commodity prices higher over the long run.

China's decision is likely to be detrimental to U.S. consumers since the prices of Chinese imports will tend to be higher than otherwise. But that is just another way of saying that what really happened today is that U.S. monetary policy has effectively become easier—through a weaker dollar—and that will eventually increase U.S. inflation. Higher U.S. inflation, in turn, will tend to drive Treasury yields higher.

At the very least, this decision adds to the reasons why deflation is not a serious risk. And to the extent that deflation is not a risk, that brightens the outlook for the U.S. economy, and, in turn, for risky assets in general.

Natural gas rebound

Natural gas prices have been extraordinarily volatile over the past 15 years, and the recent experience is no exception—at today's $5.12, prices have more than doubled since last September, yet they are still less than half what they were in 2008. I don't pretend to understand much about this market, but I note that the recent rally may be due to hedge funds that are being forced to buy back their short positions. Presumably they thought that massive new gas discoveries would combine with a weak economy to keep prices depressed. Commodity price speculation can cut both ways, as those who were betting on deflation have now learned.