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Corporate profits are very strong




Along with today's revision to second quarter GDP, we received the first estimate of corporate profits for the quarter. Profits rose 3% from the first quarter, and are up 25% in the past year. Plus, they continue to look very strong relative to GDP.

The worst thing you could say about corporate profits, as Art Laffer argues, is that corporations may be doing their best to accelerate profits—to book profits now before taxes go up next year. So profits might be overstated to some extent. But I see profits growing consistently for several quarters, so I'm not sure how significant the overstatement is. Regardless, it remains the case that profits have more than doubled since 1998, while the S&P 500 has not budged, on balance, over the past 12 years. As I've been arguing for a long time, the equity market looks very undervalued to me. Perhaps that's because, like the bond market (see my post from yesterday), the equity market believes the future will be very grim.


Note in this last chart how the NIPA measure of profits continues to be a leading indicator of accounting profits (which are used to calculate standard PE ratios). With strong profits growth likely to continue, it's hard to believe the equity market is going to remain at depressed levels for much longer.

Quick thoughts on Bernanke's speech

First, I like the way the market is reacting: higher bond yields, stronger equities, and a slight rise in inflation expectations. That's good, because higher bond yields and a stronger economy go hand in hand. If the economy grows by some reasonable amount, then we should expect to see lots more of this—much higher bond yields and a much stronger equity market.

Second, it's a shame that Bernanke could not muster the courage to blame profligate fiscal policy for the sluggish economy. At least he refrained from suggesting we need more spending.

Third, it's good that he is drawing a line in the sand on inflation. He will do anything to avoid deflation, but he won't even entertain the notion of trying actively (by raising the Fed's inflation target) to get inflation to rise. He wants strongly to maintain some semblance of price stability. That is reassuring to the markets. Building confidence in relative price stability is essential to help the economy recover. The market needs to know that Bernanke won't squander what the Fed has worked so hard to achieve since the inflationary 1970s.

A bond bubble?


Like many others, I remain fascinated by the rally in bonds that has taken the 10-yr yield to 2.5%, only 50 bps above its all-time lows which first occurred when the economy was mired in a decade-long depression and deflation. Is that the fate—depression and deflation—that awaits us today? How can we have ultra-low yields at a time when the federal deficit is gigantic and federal debt/GDP ratios are soaring? I have some thoughts and speculations.

One explanation would be that the market is simply priced to the expectation of deflation. But that hypothesis is not validated by TIPS spreads, because inflation expectations are still reasonably positive: a 1.4% CPI on average over the next 5 years, and 1.6% over the next 10 years (see next chart). Deflation was our expected destination at the end of 2008—TIPS spreads were flat to negative, and TIPS yields soared because deflation fears were so strong that nobody had any interest in the securities. But things are very different today, with 10-yr TIPS real yields of 1% reflecting very strong demand for TIPS.


So perhaps the explanation behind ultra low yields is simply that growth expectations are extremely low; after all, we know that the market has been obsessed with a double-dip recession for awhile, so perhaps a real doozy of a recession is being priced into 10-yr Treasuries—something like a depression but without the attendant deflation that we saw in the 1930s.

But that hypothesis is not convincingly validated by the corporate bond market, where spreads are trading at levels that are similar to or less than what we saw in advance of the (very mild) 2001 recession, and at levels that are an order of magnitude less than what we saw at the end of 2008, when a depression was indeed priced in.


So perhaps there is, in addition to weak growth expectations, an inordinate fear of the future: a fear of big tax hikes, and of a prolonged economic malaise caused by an overbearing state that absorbs the fruits of and smothers the private sector. Japan comes to mind, with its massive deficits, a debt/GDP ratio that has been well into triple digits for years, and sluggish growth. Perhaps it's the case that as debt approaches and exceeds 90% of GDP the economy simply loses much of its forward momentum, a thesis supported by the findings of a recent research paper by Rogoff and Reinhart. There's even some support for this thesis in our own history—muddled of course, by WWII—when federal debt surged to 120% of GDP in the early 1940s, even as 10-yr yields traded at 2% or so.


This last explanation appears to be the most satisfying, given the various signals available in our capital markets. Animal spirits are seriously lacking, thanks to a massive expansion in the size and role of the government, coupled with the host of uncertainties which surround the future course of monetary policy—for example, many observers argue today that the Fed has run out of ammunition to jolt the economy out of its (supposedly) current funk. If the market is scrambling to buy bonds yielding 2.5% or less, it only makes sense if market participants hold little or no hope for a better alternative in the foreseeable future on a risk-adjusted basis.

It also makes sense that today's almost-zero yields on cash, extremely low yields on risk-free bonds, and massive debt sales become in a sense a self-fulfilling prophecy. Low yields represent very low hopes and aspirations on the part of the private sector, while the bonds being sold and the money absorbed from the private sector by our federal deficit are being used to fund a level of spending and wealth redistribution such as we have never seen before. For those of us who believe the spending multiplier is much less than one, it makes perfect sense that a huge increase in spending can only result in a dismal return on investment—i.e., a moribund economy. Ultra-low yields on Treasuries thus reflect dismal growth expectations while at the same time virtually ensuring that growth will be disappointing.

We're not witnessing a bond bubble in the making, we're living in a statist nightmare. Bonds are not in a bubble, because they are priced rationally if you believe, as the market seems to, that the outlook for the future is grim.

The future, however, is not written in stone, and there is little reason—in my view—to expect that the current state of affairs is going to go on forever. But you have to be an optimist to venture outside the safe haven of ultra-low Treasury yields that only the pessimists are content to receive. Today's bond market will prove to be a bubble if and when the people take back control of government from the statists currently occupying the White House and running Congress. I believe they will, come November. If you don't, then go out and buy some of those Treasury bonds; you'll have plenty of company.

CRE update


I included this chart in yesterday's post (20 bullish charts), only to discover today that I had neglected to update the chart for the June release of the commercial property index, which declined 4%. I don't think that changes the interpretation of the chart however. My eyeball says that commercial and residential property prices have been flat to slightly up for the past year, and that's encouraging. You need stabilization and consolidation, and that's what we are seeing.

This would be a good place to note that the prices of commercial real estate-backed securities (CMBS) have been trending higher for the past several months. This is happening because property prices have stabilized at a time when the market was expecting further declines. In other words, defaults have been lower than expected.

Claims back on track




As I mentioned last week, the unexpected rise in weekly unemployment claims that rattled the market could have been due to the vagaries of seasonal adjustment. This week's unexpected fall in claims suggests that I was correct.

The top chart shows seasonally adjusted claims, while the bottom shows actual claims. Actual claims have fallen the past two weeks, and now the seasonally adjusted claims number is catching up. What happened last week was that actual claims did not fall as much as the seasonals expected, probably because they didn't rise as much as expected in July. Note also that the actual claims number has hit a new low for the year, and the continuing claims number has been trending down since peaking in June of last year.

By next week, we'll probably see the adjusted number fall a bit further, to show that claims are about where they've been on average since January. In short, all the hoopla over claims has been an exercise in futility, because there has been no real change in the underlying fundamentals of the labor market so far this year. The much-anticipated double-dip recession is still a no-show in the data.

20 bullish charts

Pessimism is rampant, and most of the articles and commentaries I see have some doom-and-gloom flavor to them; indeed, many pundits are already claiming to see a double-dip recession either in progress or as imminent. I think the "conservative" bull case—that the economy is growing at a sub-par trend rate of 3-4%, which will leave the unemployment rate uncomfortably high for some time to come—is not getting its fair share of the news. So here is my attempt to balance the scales: a collection of charts that to me point to ongoing economic growth, however mild that might be, with not a hint of a double-dip recession. All charts contain the latest data available, and they are shown in no particular order. I've discussed all of these in recent posts, so for long-time readers this just a recap of how I see things today.


Capital spending has grown at an impressive rate since the end of the recession, with no signs yet (assuming the July numbers contained a faulty seasonal adjustment, as I detailed in an earlier post today) of any slowdown. Strong capex reflects at least some positive degree of confidence on the part of businesses, and that is a leading indicator of future growth in the economy.


Industrial production is increasing at a very fast rate, with no signs of any slowdown. Most global economies also are experiencing a rapid recovery in industrial production. This is a good indication that the cutback in production that occurred in the wake of the financial crisis was sufficient to allow a substantial inventory drawdown. Now, with demand and confidence slowly returning, production must ramp up to avoid continued inventory drawdowns. Rising production supports increased confidence, leading to a virtuous cycle that all but guarantees further gains.


Commodity prices are up across the board. This likely reflects strong growth in global demand and/or accommodative monetary policies worldwide. Whatever the case, rising commodity prices all but preclude the deflation that so many are worried about, and rule out the existence of a double-dip recession.


Global trade is rebounding strongly. Rising exports are adding to U.S. GDP growth, while strongly rising imports reflect a healthy rebound in consumer demand, which in turn likely reflects a consumer that is in better shape than most give him/her credit for.



Credit spreads have been reliable leading indicators of recessions in the past. While it's true that spreads haven't tightened on balance over the course of this year, there is no sign of any rise in spreads that might foreshadow a return to recession. In any event, it's not unusual at all for several years to pass, following a recession, before spreads return to more normal levels. The behavior of spreads today—especially swap spreads, which are currently somewhat lower than what we typically see during periods of healthy growth—is fully consistent with an ongoing, albeit relatively sub-par, recovery.



The slope of the yield curve has been an excellent leading indicator of recessions and recoveries for many decades. The curve typically flattens or inverts in advance of recessions, but today it is still very far from being flat or inverted. The curve is strongly upward-sloping, which reflects easy money and expectations that monetary policy will eventually need to tighten as the economy improves. We've never seen a recession develop when the curve was this steep and monetary policy was this easy.


The fact that the demand for temporary and part-time workers is steadily increasing may not guarantee a continued recovery, but I think it argues strongly against a double-dip recession being underway.


Car sales are up strongly over the past year, reflecting underlying improvement in confidence and in consumers' financial health. Car sales had fallen so much and for so long that this created pent-up demand that has the potential to be self-perpetuating. Bears focus on the fact that sales are still at abysmally low levels, but the correct way to see this is as very positive change on the margin.


Large corporate layoffs are essentially a thing of the past. It's very likely that corporations have done all or almost all of the cost-cutting that they need to do. A big decline in layoffs is almost a necessary precursor to a new wave of hiring, and that's what we're getting set up for.


China and almost all emerging market economies are growing like gangbusters, and global trade is recovering nicely. What's good for emerging market economies is good for everyone, since the more they produce the more they can buy from us.


Corporate profits typically decline in the years leading up to a recession, but for the past 18 months they have been growing strongly—which in turn is typical of the early years of a recovery. Strong profits are the fuel for future investments in new job creating ventures.


Although key indicators of financial health—most notably the Vix index, which at 27 is still significantly above its long-term average—are not in perfect shape, neither have they deteriorated enough to foreshadow any significant deterioration in the health of our financial markets.



Key indicators of shipping activity suggest that at the very least, there is no sign of any slowdown underway in global trade volumes or demand.



The Bloomberg index of the stocks of leading home builders hit a low almost 18 months ago and has more than doubled since. Prices of residential and commercial real estate have been flat to somewhat higher for more than a year. At the very least this tells us that the worst of the bad news from a housing and construction standpoint has passed. Residential construction is at an all-time low of about 2.5% of GDP, so even if things get worse, it would have only a modest impact on the overall economy.


It is arguable whether the Leading Indicators actually lead the economy, or whether they are just good coincident indicators of the economy. But in any case, they aren't even close to a level that would suggest that the economy has deteriorated to any meaningful extent. Indeed, they are at a level which strongly suggests continued growth.


Last but not least, I offer this chart which shows how the ISM manufacturing index has done a pretty good job of reflecting the underlying growth rate of the economy as a whole. Although the index doesn't match up exactly with each quarter's GDP growth rate, the recent level of the index strongly suggests that growth is still in positive territory, and that a 3-4% growth expectation for the current quarter is not unreasonable.

Credit spread update




These charts use data from the Markit indices of credit default swaps, as of yesterday. Spreads have widened a bit over the course of this month, but when you put this in the context of the past few years, the widening is hardly noticeable. Is the recent widening a sign of emerging economic weakness (e.g., the dreaded double-dip)? I don't think so. The magnitude of the widening isn't big enough to signal anything other than random noise or subtle shifts in sentiment—there has been no significant or fundamental deterioration in the economic outlook at all this year, according to these figures. And the outlook remains dramatically better today than it was early last year.

Of course, these charts also show that the fundamentals of the economy are still much worse than what we would expect to see in a normal expansion—spreads are still substantially higher today than they were in early 2007. So the economy is doing much better than the market expected a year ago, but the economy is still far from being termed "healthy." I think the explanation for the relatively poor performance of the economy is not too difficult to pinpoint: it's fiscal policy, stupid—huge increases in government spending and regulatory burdens, coupled with huge uncertainty over the level of future tax burdens. We could argue about monetary policy, since it has created huge uncertainty about future inflation risk, but at this point monetary policy is a minor problem compared to fiscal policy. The Fed can't create growth out of thin air, but intelligent tax and spending policies can, by altering the incentives to working and investing.

The economy has been facing serious fiscal headwinds for the past several years. That's a bummer, to be sure. But if anything, the outlook for fiscal policy today is not as bad as it was a year ago. Cap and trade is dead, and it appears highly likely that the Democrats will lose enough seats in Congress this November to make regulatory gridlock a reality (and one devoutly to be wished). With a little luck, the November elections could result in outright reform of fiscal policy.

My point here is that the problem of bad fiscal policy is nothing new, and sensitive indicators of the economy's health (e.g., swap spreads and credit spreads) do not reflect any meaningful deterioration in recent months. All of the angst and hand-wringing over a double-dip recession might just be the growing realization that we have had a big fiscal problem on our hands for quite some time. If that's the case, then the hue and cry might actually be a good thing, since it could nudge policymakers and the electorate in a direction that might restore some common sense to Washington.

Yes, things are bad, but that's nothing new. What's important on the margin is how things are likely to change in the future, and whether those changes are being factored into today's prices.

July capital goods orders were very weak, but possibly misleading




July new orders for capital goods were down a steep 8%, much weaker than expected. Is this hard evidence of a double-dip recession? While it shakes my confidence, I think there is a good chance that the weakness is an artifact of poor seasonal adjustment. Both Brian Wesbury and our own "brodero" noted today the pronounced tendency of this series to drop on the first month of every quarter: "this is the eighth consecutive first month of the quarter (January/April/July/October) where machinery orders have dropped, with the typical decline being around 9%."

The top chart shows the raw (seasonally adjusted) data. The second chart uses a 3-mo. moving average, and it should be immediately obvious that this removes a lot of the noise in the raw data without changing its character or its signal. The third chart shows the 6-mo. annualized growth in the moving average.

Regardless of how you massage the data, the story remains the same: over the past year, the rebound in capital spending by U.S. corporations has been quite strong and is likely ongoing. This is an important indicator not only of business confidence, but also of the economy's ability to grow in the future, since capital spending is the raw material necessary for future productivity growth.

What double-dip?


No sign of a double-dip recession here. For more info, see Mark Perry's comments on this.

The stock/corporate bond disconnect



This chart compares the S&P 500 index with the price of HYG (a large high-yield index bond fund). The correlation of these two prices was an impressive 0.95 throughout the second half of last year. The correlation has since dropped to 0.67 over the course of this year, and in the past two months (since mid-June) the divergence has become noticeable: bond prices have tracked higher as equities have weakened (see chart below for a detailed look). Only a part of that divergence can be attributed to falling yields on government bonds—most of the divergence is explained by a tightening of corporate spreads which began in June.



This means that in the past two months the equity market has grown more pessimistic about the outlook for corporate earnings while the bond market has grown more optimistic about the outlook for corporate defaults. This is, to put it mildly, a curious development, since normally the outlook for earnings tracks the outlook for defaults quite closely.

How to explain this? Perhaps the equity market is too pessimistic, or the bond market is too optimistic. An optimistic interpretation, to which I'm partial given my bond-market background and experience, would say that the bond market is the leading indicator, especially at key turning points. There have indeed been times in the past when the bond market has led the stock market. For example, corporate bond spreads started tightening in earnest in the last two months of 2002, while the equity rally only really got underway several months later. Then, corporate bonds spreads (and in particular swap spreads) started widening in early 2007, but equities didn't start falling until much later that year.

I think this all adds up to one more reason to think that the equity market is much too gloomy these days. Earnings have been growing strongly, and there are plenty of signs that suggest that the economy is not falling into the double-dip recession so many seem to be calling for these days.

Why deflation is not in the cards





Deflation is when all prices fall relative to the unit of account—when the value of the unit of account rises relative to the prices of all goods and services. That is most certainly not the case today, as these three charts make clear.

Gold has risen steadily for the past 9 years against the dollar. Spot industrial commodity prices are only inches from making new all-time highs. And the dollar is very close to its lowest levels ever against a large basket of foreign currencies—which of course means that prices in other countries are historically high relative to our prices.

All you can reasonably say about prices today is that some prices are falling while many other prices are rising. We are seeing a lot of relative price changes, but we are definitely NOT seeing all prices decline. It is almost inconceivable that we could be on the cusp of an actual deflation when commodity and gold prices are soaring and the dollar is very weak against other currencies.

The closest we have been to an outright deflation was in the 2002-2003 period, and that's when the Fed first panicked at the prospect of deflation. Leading up to that period, we saw gold and commodity prices plunge, and the dollar soar against all other currencies. And the proximate cause of all that was a period of extremely tight monetary policy from 1995-2000. Today we have the exact opposite set of conditions. This is not a deflation.

The Bush/Obama $4.4 trillion spending boom

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From today's WSJ:


CBO's mid-year review largely reinforces the bad news we already knew—to wit, that spending has exploded since Democrats took over Congress in 2007, first with the acquiescence of George W. Bush and then into hyperdrive after Mr. Obama entered the White House.
To appreciate the magnitude of this spending blowout, compare CBO's budget "baseline" estimate in January 2008 with the baseline it released Thursday. The baseline predicts future spending based on the law at the time. As the nearby chart shows, in a mere 31 months Congress has added more than $4.4 trillion to the 10-year spending baseline. The 2008 and 2009 numbers are actual spending, the others are estimates. As recently as 2005, totalfederal spending was only $2.47 trillion.

This is the biggest problem facing our economy today: the huge and escalating increase in the size of government intervention in the economy. This is unsustainable, and I predict will not be sustained. The voters are sick and tired of this; the public sector at all levels of the economy is getting out of control, and it must be reined it. Stop the spending!!

Chicago Fed index reflects continued growth


No sign of a double-dip here.

Shipping update



These are the dog days of summer, with most of the financial types on vacation and the Labor Day weekend less than 2 weeks away. The beach here is beautiful but relatively uncrowded, perhaps due to the water temperature being an unusually cold 60-61ยบ. Since there's not much going on, I thought I would post update charts of shipping costs.

Contrary to the widely-held view that the U.S. and most global economies have taken a turn for the worse, the Baltic Dry Index has been moving steadily higher since mid-July. The Harpex Index was on a tear but has recently taken a breather. On balance, neither index is supportive of the notion that economies are headed towards a double-dip recession. In fact, I think it's entirely reasonable to assume from this and from other real-time measures of economic activity (e.g., commodity prices, railroad ton-miles, part-time staffing, truck fuel consumption) that most economies, including ours, continue to grow.

Tighter spreads on jumbo mortgages are a good sign


The prevailing rate on 30-yr fixed-rate mortgages hasn't changed much since early July, despite a 40 bps drop in 10-yr Treasury yields. This rising spread could be telling us that investors on the margin are unwilling to buy MBS that are yielding less than 3.5%. That would be a rational response to the ongoing decline in high quality bond yields—at some point you figure that yields are so low that the risk/reward of owning bonds at lower yields is just too high. Homeowners who lock in today's 4.7% 30-yr fixed rates can refinance almost without cost should rates fall further (to the detriment of investors), but they can laugh all the way to the bank for years and years if rates rise (also to the detriment of investors). That's because the duration of MBS bought today could extend hugely if rates start rising, resulting in outsized losses to MBS investors; MBS prices are going to be much more sensitive to rising rates than T-notes or T-bonds.

But the more important development in the past month or two is that the spread between jumbo and conforming mortgage rates has narrowed to about 40 bps. At the height of the financial market panic in late 2008, when 10-yr Treasury yields collapsed to a mere 2.05%, the spread was an outsized 170 bps. In "normal" times the spread tends to be about 20 bps.

When the spread between jumbo and conforming rates was super-wide, it was a sign of a dysfunctional bond market—lenders unwilling to lend at almost any price, and that was a big factor contributing to shut down the housing market. Now that the spread has come down to almost-normal levels it is a sign that the bond market has largely regained its footing. Yield-hungry banks and and investors spotted the huge incremental yield advantage of the jumbo sector and stepped in to fill the gap, offering loans to buyers of expensive homes. They have earned a substantial reward for doing so.

The bond market is operating more efficiently now, and that's a good sign, because it makes the economy healthier. And it also means that the housing market—particularly for high-end homes—has much better support.