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Used car prices continue to rise


The ongoing rise in used car prices—with temporary setbacks due to the trauma of recessions—is remarkable, especially since so many seem to assume that the high level of unemployment and the tremendous amount of "resource slack" in the economy (GDP is running about 10% below its full-employment trend level, by my calculations) make inflation practically impossible and deflation something to worry about.

I remain convinced that inflation is a monetary phenomenon and has nothing to do with resource slack or the level of unemployment. What few prices there are that are declining—mostly housing-related—are simply proof that the economy is still in the process of shifting resources from one sector (e.g., construction and housing-related areas, where there was obvious over-building) to another (e.g., mining, which is booming these days because the global economy is expanding rapidly and monetary policies are accommodative). That shift is signaled and driven by a comparable shift in relative prices. Housing prices decline, commodity prices rise; people leave the construction sector and move to the mining sector as a result. If car prices keep rising like this, pretty soon it will be obvious that there is a shortage of new cars being produced; look for more robust gains in new car sales and production in the months and years ahead.

For more color on the used car picture, I recommend reading Mark Perry's post.

Exports surge in October


October exports are old news, but it's nice to see that they rose 3.2% for the month, much more than expected. Exports had slowed down over the summer, and that was potentially worrisome; now we know that it was just temporary. Over the past three months exports are up at a 15.6% annualized rate, and they are up 15% over the past twelve months. Double-digit export growth has resulted in an almost-complete recovery from pre-recession levels. At these growth rates, exports will likely make new highs by the end of this year, and will contribute significantly to Q4 GDP growth.

Budget update: continued improvement




Although the November federal deficit was larger than expected, these charts show that key measures of Washington's finances continue to show gradual improvement. The budget is still in terrible shape, of course, with a $1.3 trillion deficit over the past 12 months that comes to just under 9% of GDP. But the encouraging signs are that revenues are picking up, having increased 6% over the past year, and at a 10% rate over the past three months. This is resulting—finally—in a modest rise in revenues as a % of GDP. If the economy continues to grow and improves just a little, then revenues should continue to rise relative to GDP even if the Bush tax rates are extended indefinitely. Another encouraging sign is that spending growth has already slowed rather dramatically; spending in the past 12 months was actually 0.5% less than it was a year ago. Spending has increased at a 4.2% annualized rate in the past 3 months, but that is less than the likely increase in nominal GDP.

We don't need higher tax rates to balance the budget, we need an extended period of much slower growth in spending. If revenues were to continue growing at the rate of the past six months, and if spending were to be frozen at current levels, the budget would be balanced within 5 years, with revenues and spending likely to be about 19% of GDP. That would put us back to the levels that prevailed, on average, for most of the postwar period.

UPDATE: To clarify a very important point, higher tax rates are not necessary to raise substantial new revenue. Revenues are already rising at a decent clip, and they should continue to do so as the economy grows and adds new jobs. Thus, it is fallacious to argue that extending the Bush tax cuts represents a "cost" in the form of foregone revenue; or that extending the tax cuts will increase the deficit.

Households will benefit if interest rates keep rising



Based on the household balance sheet data released today by the Fed (see my prior post for more details), I have estimated how the data could be disaggregated for the above chart. The picture hasn't changed much over time, but the message is still meaningful: rising interest rates on balance are good for the household sector. If the economy continues to recover, regardless of whether the Fed discontinues QE2 or not, interest rates should rise and that should be a net benefit to consumers.

Households have significantly more exposure to floating rate assets (e.g., time deposits, CDs, money market funds) than to floating rate debt (e.g., adjustable rate mortgages). That means that falling interest rates really cut into the income of retired folks, but rising interest rates are a direct benefit to households since that increases household income. As interest rates rise, the increase in interest income received greatly exceeds the increase in interest paid out.

As for exposure to fixed rates, households suffer somewhat from higher interest rates, since they have about 20% more exposure to fixed rate assets (mainly in the form of bonds whose price would decline as prices rise), than they do to fixed rate debt (mainly in the form of fixed rate mortgages that are immune to higher interest rates). However, this loss would be only on a mark-to-market basis, since cash flows would be largely unaffected.

Households' balance sheet recovery is encouraging


Today the Federal Reserve released its estimate of U.S. households' balance sheet as of the third quarter. As the chart above shows, household net worth has increased since the end of the recession, thanks mainly to the recovery in the price of financial assets (higher stock prices and higher bond prices). Real estate values have slipped a bit from the levels of early last year, but this has been offset by a decline in debt. So the big picture here—aside from the regrettable fact that net worth is still about $11 trillion shy of its 2007 high—is one of a noticeable shift in relative prices: financial asset prices have increased relative to real estate values since the end of the recession. Is this unprecedented or unsustainable? Not at all, as the next chart shows.


This chart compares the annualized rate of inflation (on a 3-yr rolling basis) to the ratio of households' holdings of tangible assets as a % of total assets. The chart (or one like it) was originally created by John Rutledge in the early 1980s to show how inflation impacts the prices of tangible and financial assets. Easy money, and the rising inflation that follows, reward those who own real estate and tangible assets in general (e.g., commodities) and penalize those who own financial assets (because interest rates rise), so it's not surprising that we saw a big upturn in tangible asset prices relative to financial assets in the late 1970s as inflation rose. By undermining the demand for money, rising inflation boosts the prices of non-money "things," while it erodes the value of money itself. By the same logic, it was not surprising that the big decline in inflation in the 1980s saw a big reversal of that relative price shift, as financial asset prices boomed and real estate values rose only modestly.

Curiously, however, while the housing boom of the 2000s caused a surge in real estate values relative to financial assets, we didn't see much of an increase in inflation. That may explain why the real estate boom ended up a bust: inflation never got enough momentum to boost incomes, so rising home prices soon became unaffordable, and that was the root cause of the subsequent price collapse.

Another thing that strikes me about this chart is the fact that the ratio of tangible to total assets has come back down to a level that prevailed in the low-inflation 1960s, up until the inflation of the 1970s hit. 

In a similar vein, Calculated Risk has a nice chart (below) which shows that household net worth as a % of GDP has come back down to levels that prevailed in the early 1960s, and close to the trend level that has prevailed since 1952, after surging briefly in 2000 (the dot-com boom) and 2005-06 (the housing boom). Bubbles can get surprisingly big and last longer than one would think, but eventually they burst. I would argue that from these two perspectives (net worth as a % of GDP and the ratio of tangible to financial assets), there has been enough price adjustment in recent years to restore some semblance of equilibrium once again. In other words, there is no a priori reason to expect a significant further deterioration in real estate prices or net worth, especially with monetary policy being so accommodative that it could begin encouraging another rise in real estate prices (and here I note that commodity prices are at all-time highs and rising), but not yet so accommodative that it is likely to destroy financial asset prices via double-digit interest rates.

Unemployment claims fall again



On a seasonally adjusted basis, weekly unemployment claims have been falling for the past two months, and are now down by one-third from last year's recession high. The only reason claims are falling, however, is that firms are not laying off as many people in the runup to the holiday season as they normally would be: actual claims rose by 70K last week. We can only hope that this means firms are being run leaner and meaner than usual (which would help explain why profits have been so strong), and that this may give way to more hiring if and when the economy picks up next year.

More good news from the housing market


Applications for new mortgages rose again last week, and are up almost 30% from the July lows, in a good sign that the housing market is unlikely to suffer another relapse and may even be putting in a bottom.


Meanwhile, mortgage rates have jumped from their lows, and are going to be rising further, since the yield on Fannie and Freddie MBS has shot up 100 bps from the early October lows. Will this kill the housing market? I doubt it. Rates are still very low from an historical perspective. If anything, the recent rise in rates is likely to stimulate mortgage demand: "get it before the price goes higher." Plus, rising rates in general are symptomatic of improving economic fundamentals.

QE2's days are numbered


Since the end of August, when the Fed first began to hint that QE2 was in the works, yields on 30-yr T-bonds have jumped 95 bps, driving the price of the long bond down by almost 15%. 30-yr bond yields led the way initially—because the market figured the Fed couldn't artificially depress their prices, and QE2 would make all bonds less attractive by increasing inflation—but now 10-yr yields are up 80 bps from their August lows. Over the same period, stocks have jumped 16%. That's pretty amazing, considering that one of the main objectives of QE2 was to depress long-term bond yields in order to stimulate the economy.

The only way to understand this paradoxical development—Fed purchases of bonds have caused their price to fall, and rising bond yields seem to be improving the economic outlook—is to see it as the market's way of telling the Fed it will be making a big mistake if it forges ahead with QE2. The Fed can't depress 10-yr yields if inflation is rising and the economy is on the mend. QE2 needs to be shut down, and the sooner the better.

Why? Because it has served its real purpose, which was to drive a stake through the heart of persistent deflation fears. Bond yields had fallen to very low levels by August, signaling that the market was very concerned not only about the economy but also about the potential for deflation (see the chart below for my interpretation of the significance of different levels of 10-yr Treasury yields). If successful, QE2 would have vanquished those fears, and bond yields would rise as a result. Well, in a sense it's already happened. The Fed convinced the market that it would stop at nothing to defeat deflation, and that's all that was needed. To carry through with QE2 would be redundant and run the risk of generating too much inflation.


The Fed should pay attention to these important market signals. We don't need more QE2. The economy is doing OK, and Obama's tax deal—though far from perfect—should provide enough incentives to the private sector to result in stronger growth next year. The dollar is very weak and gold prices are very high; forward inflation expectations have risen from 2% to almost 3%; and commodities are on a tear. The Fed should begin to worry about getting too much of what it professes to want with QE2.

Junk bond default rates have plunged

Today Moody's announced that "the trailing 12-month global speculative-grade default rate dropped to 3.3% in November 2010. A year ago, the global default rate stood much higher at 13.6%." Moreover, Moody's is now forecasting that this same default rate "will fall to 2.9% by the end of this year before declining further to 1.8% by November 2011." "Measured on a dollar volume basis, the global speculative-grade bond default rate remained unchanged at 1.4% from October to November. Last year, the global dollar-weighted default rate was noticeably higher at 19.6% in November 2010."

The improvement in just the past year is remarkable: "A total of seven Moody's-rate corporate debt issuers have defaulted in November, which sends the year-to-date default count to 52. In comparison, a total of 257 defaults were recorded in the comparable time period last year."

Here's the reason behind the improvement: "Corporate defaults are falling as profits surge, the economy recovers and debt markets allow even the riskiest borrowers to raise record amounts of cash. Junk-rated companies have sold $97.8 billion of bonds globally since September, putting issuance on pace to beat the record $99.8 billion raised in the third quarter, according to data compiled by Bloomberg."




The above chart shows the average yield on junk bonds, currently 8.2%. The dramatic decline from the unheard-of-before peak of 25% is simply breathtaking. This improvement also owes much to accommodative monetary policies all around the world. Easy money is a debtor's best friend, as they say.




This next chart shows the spread on high-yield CDS, which also shows dramatic improvement—and, more importantly, room for more, especially since default rates continue to decline. To date, the generous spreads on junk bonds have helped insulate this market from the rather dramatic increase in Treasury yields. Since the end of August, when QE2 was first floated, 10-yr Treasury yields are up over 60 bps, yet junk bond yields have fallen by about 30 bps.

Even if 10-yr yields rise further—as I expect they will, since the economy is continuing to grow and Obama's long-awaited decision to go bipartisan on the issue of taxes should impart some genuine growth stimulus to the economy, and forward-looking inflation expectations have risen from 2% in August to almost 3% today—I note that junk yields traded around current levels back in the first half of 2007, when 10-yr Treasury yields were over 150 bps higher than they are today. To pass up 8% yields on junk bonds in favor of cash yielding almost zero is equivalent to saying that all h*ell is going to break loose at any moment.

Full disclosure: I am long TBT and long various high-yield mutual funds at the time of this writing.

Assessing the market's assumptions

In order to have a view on whether the market is attractive or not, it's essential to consider the assumptions that are reflected in market pricing. What follows is a review of a variety of key market-based indicators that provide insights into the assumptions the market is making about the future. Taken together, these indicators suggest that the market is still quite cautious and concerned about the future. Nowhere is there any indication that the market is priced to optimistic or rosy assumptions about economic growth, inflation, interest rates or corporate profits. Indeed, most indicators reflect a market that is already discounting a deterioration in corporate profits, sharply rising yields, and/or higher corporate tax rates. What this suggests is that if the future turns out to be less problematic than the market is expecting, then there is still a lot of upside potential in equity prices.


This chart compares the spread on 5-yr swaps (a measure of the credit risk of generic AA-rated banks) to the spread on 5-yr A1 Industrial corporations (a measure of the credit risk of generic industrial corporations). Swap spreads have been trading at "normal" levels for most of this year, but industrials are still trading at levels that are elevated in an historical context. This means that the market still worries (not a lot, but more than it would if the outlook were healthy) about the viability of large industrial corporations over the next several years. 


This chart compares spreads on high-yield bonds to spreads on investment grade corporate bonds. Credit spreads are a good measure of the perceived default risk of corporate debt, and are generally correlated to the health of the economy—spreads tend to rise around recessions, and fall during recoveries. As the dashed green lines show, the current level of spreads is substantially above the levels that have prevailed during economic expansions. This implies that the market is still quite skeptical of the economy's ability to thrive.


Credit default swaps tell a similar story to that of credit spreads in general: the market's perception of default risk is still substantially higher than it was prior to the onset of the 2008 recession.


In theory, the price of a stock is the discounted present value of its future after-tax profits, and thus a function of three variables: interest rates, tax rates, and profits. Therefore, there should tend to be an inverse correlation between the level of yields and the price of a stock; the higher the level of yields, the greater the discount on future cash flows, and vice versa. This chart shows how the value of stocks (the blue line, which is the ratio of the S&P 500 index to nominal GDP) compares to the level of 10-yr Treasury yields (the red line, which is shown with the y-axis inverted). When yields were low and relatively stable in the early 1960s, the economy was strong and stocks were well-priced. As yields rose in the 1970s, stock prices fell relative to GDP, and subsequently rebounded as yields declined in the 1980s and 1990s. Since 2000, however, yields have continued to decline, but stock valuation has fallen. This implies that stocks are priced to the assumption that yields will rise, future after-tax profits will decline, and/or tax rates will rise significantly.


This chart compares actual market capitalization (using the S&P 500 as a proxy) with a theoretical measure which capitalizes current after-tax corporate profits using the 10-yr Treasury yield as a discount factor. This model of equity valuation has worked pretty well for many decades, but has clearly broken down in recent years. One interpretation for this is that the market expects yields to rise, profits to fall, or tax rates to rise, or some combination of the three. However you look at it, though, the market is priced to some pretty big and unpleasant assumptions.


The VIX index of implied equity option volatility is a good measure of how nervous the market is. It typically peaks during market crises, as noted in the above chart. Today the Vix is trading around 18, which is substantially higher than the 10-12 level which has prevailed during periods of relative tranquility. This implies that the market is still pretty nervous, and that the future is still clouded by uncertainty (e.g., fears that tax rates will rise, government regulatory burdens will rise, and/or that the economy will suffer a relapse).


This chart compares the level of the S&P 500 with the Vix index (which is inverted, to show that a lower level of risk typically corresponds to a higher level of equity prices, and vice-versa). The Vix has returned to its pre-crisis levels, but the equity market has not, despite there having been a full recovery in corporate profits (in fact, after-tax corporate profits are currently at an all-time high).  This suggests that the market is still discounting profits at a higher-than-normal rate because of a general lack of confidence in the future.


This is a chart of the market's expectation for the level of the Fed funds rate one year in the future, as derived from Fed funds futures contracts. Currently, the market expects the funds rate to average just under 0.3% in Dec. '11. This implies that the market assigns a very high probability to the Fed keeping the funds rate target at 0.25% for all of next year. That, in turn, is likely to happen only if the economy remains relatively weak and inflation remains very low.


This next chart compares the yield on long-term BAA corporate bonds (blue line) with the earnings per share (i.e., earnings yield) of the S&P 500 (red line), as of Nov. '10. Earnings yields are now noticeably higher than corporate bond yields, a good indication that equity valuations are relatively cheap. (Normally, corporate bond yields should be less than earnings yields, since bonds are senior in the capital structure to equities and thus less risky.) After-tax earnings on the S&P 500 stocks now represent a "yield" of just under 7%, which also happens to be the average of the past 50 years. Corporate bond yields, in contrast, are currently 5.7%, which is 300 bps less than their average of the past 50 years. If it weren't for the market's expectation that after-tax earnings are very unlikely to maintain current levels, much less increase, stocks would be considered an incredible bargain by historical standards. Which is another way of saying that the market is assuming that profits will deteriorate and/or corporate tax rates will rise.


Gold traditionally has been a refuge from political, monetary, and economic risks. That it is trading at all-time nominal highs and close to all-time real highs is evidence that the market's perceived level of risk is unusually high.