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The recovery in consumer spending

The top chart shows the level of real personal consumption expenditures over the past 40 years, while the bottom chart shows the year-over-year change in real spending. In inflation-adjusted terms, spending has increased about 150% since 1970, with the apparent trend (green line) being about 3.3% per year annualized. Real spending over the 12 months ended November '10 rose 2.8%, half a percentage point below its long-term average growth rate.

The level of real spending now exceeds the peak of late 2007, so we've already had what might be called a "recovery" of sorts. But to get back to our 3.3% long-term growth path (we're about 8% below that path currently), real spending would need to increase by more than 3.3% per year. A 5% annual increase in real spending would get us there in just over 5 years. That sounds almost impossible in today's climate, but it would be consistent with the economy's demonstrated ability to bounce back from adversity over and over again, and it would give us growth approaching that of the heydays of the Reagan boom in the 1980s. And although nobody seems to be giving the consumer much credit these days, real consumer spending is already up at 4.3% annualized rate over the past three months.

What would a full recovery to trend growth look like? Well, if Congress can slow the growth of federal spending, broaden the tax base by eliminating deductions, and reduce and flatten tax rates, I'd be willing to bet we would enjoy a handsome recovery in the years to come, and it's not impossible at all.

Business investment remains strong

The 3-mo. moving average of capital goods orders (my preferred measure, since it removes some obvious seasonal distortions in the reported data) moved higher in November, the 18th consecutive month of gains that add up to a 17% annualized rate of growth—very impressive indeed. To be sure, growth has slowed of late (about 11% annualized over the past six months), but it still remains above average. It remains the case that these numbers reflect growing confidence on the part of businesses, and portend stronger economic growth in the months and years to come. Business investment is still less than it was a few years ago, but accumulated profits keep piling up, and that could drive many years of stronger capital spending.

Unemployment claims continue to improve

Both of these charts show seasonally adjusted first time claims for unemployment. The top chart takes the long view using a 4-week moving average, while the bottom chart zooms in on the weekly numbers for the last 5 years. Claims are now down 37% from their early 2009 high, and it would only take a 20% decline from here to get claims down to the levels that prevailed in 2006-2007. Dare it be said that we are beginning to see signs of actual strength in these numbers? Perhaps, but for now the main thing driving adjusted claims lower is that actual claims are not declining as they usually do at this time of the year. But no matter how you spin the numbers, I think it's safe to say there has been some genuine improvement in the economy in recent months, and that is one more reason to think that Q4 GDP growth could come in much stronger than Q3.

Further reflections on QE2

As the chart above shows, 30-yr Treasury yields and equity prices have been moving higher ever since the end of August, which happens to be when the Fed first began to float the idea of QE2. Proponents of QE2 say this proves their case—that QE2 was needed and has been effective. Opponents of QE2 say just the opposite, that this proves QE2 was unnecessary and has been ineffective. The truth probably lies somewhere between.

Supporters of QE2 argue that QE2 has given the economy a boost (witness the 20% rise in equity prices since QE2 was first floated) and it has vanquished deflation fears (as reflected in the almost 100 bps rise in long bond yields, plus the rise in 5-yr, 5-yr forward breakeven inflation expectations from 2% to almost 3%—see chart below). Boosting the economy and raising inflation expectations was exactly what QE2 was meant to do, so it has worked.

So far this makes sense, but it doesn't jibe with the Fed's claim that QE2 would boost the economy by depressing bond yields and keeping borrowing costs low. Since QE2 actually go underway in early November, Treasury yields haven't fallen at all—they've actually risen a lot—and corporate borrowing costs have also risen. According to Merrill Lynch, yields on investment grade bonds have risen about 60 bps since the Fed began its QE2 purchases of Treasuries, while yields on high-yield bonds have risen about 30 bps. That's not a lot, in the great scheme of things, but it's hard to see from these facts how QE2 has stimulated the economy. For more detail on how Quantitative Easing has worked so far, please see this post.

But it does make sense that if a government program were successful in stimulating the economy, then we would expect to see higher bond yields, since a stronger economy almost always goes hand in hand with higher bond yields—especially since bond yields were extraordinarily depressed last summer because of concerns that the economy was slipping into a double-dip recession. But are higher bond yields proof that Fed purchases of Treasuries are stimulating the economy? Not necessarily.

An alternative explanation—one that I and others have been advancing—is that QE2 was never necessary, and has been counterproductive, since all it has done is to push inflation expectations up, weaken the dollar, and boost commodity prices. What was really necessary back in August was for the Fed to convince the world that deflation was no longer a risk. The fear of deflation had been a drag on confidence and animal spirits ever since late 2008, when deflation expectations first became firmly embedded in TIPS prices. As I mentioned quite a few times, fear and uncertainty have played a major role in the recent recession and recovery, so anything which reduced investor fears would likely improve the economy's prospects. Deflation fears have surely worried many of the FOMC governors, especially Bernanke, and those fears have generated some contagion among the wider public. If QE2 has been successful, it is because it has raised inflation expectations and thus all but vanquished the fear of deflation, not because it has stimulated the economy.

Deflation was always more of a theoretical rather than a real risk, since while some measures of inflation were sliding perilously close to zero in recent months, others were rising (e.g., the GDP deflator was -0.3% in Q4/09 but rose to 2.0% in Q3/10). Similarly, although housing prices have been plunging, commodity prices have been soaring; we are nowhere near a deflationary situation, which is defined as a general decline in the overall price level. Plus, key indicators of liquidity conditions last summer were suggesting an abundant supply of dollars: the dollar was demonstrably weak, while gold and energy prices were rising, and swap spreads were very low.  What was needed was some positive shock to investors' confidence about in the future, not more dollars in circulation.

Another reason to think that QE2 wasn't necessary is that it didn't actually get approved until October and wasn't implemented until the first part of November, yet equity prices started rising the day after the idea of QE2 was first floated, and commodity prices were rising strongly by late July. We've only just begun to see a meaningful amount of Treasury purchases, and little if any evidence of unusual expansion in any measures of the money supply. In short, the evidence supports the notion that the economy was doing fine before QE2 started, and QE2 has not had any demonstrable impact on the economy beyond raising inflation expectations and eliminating deflation fears. As the charts below show, M2 growth has only been 4.5% annualized over the past six months, and 3.6% annualized over the past two years.

What this all means is that while QE2 may well have made a positive contribution to the economy to date, there is a risk that it could create a good deal of fear and uncertainty in the future. The Fed is creating hundreds of billions of new bank reserves that are sitting idle. Should banks decide to put them to work, no one knows whether the Fed can reverse course fast enough to prevent a true eruption of inflation.

Fear subsides, prices rise

I must have shown this chart at least a dozen times since late 2008, but it is so important that repetition is justified. (Here is a post from May '09 as an example) The main message here is that fear was the key driver of the 2008-2009 recession: fear of a global depression, fear of a global banking collapse, fear of deflation, and fear of a huge increase in future tax burdens thanks to an equally huge increase in the size of government. Fear drove us to the brink of what was expected to be an awful depression, and the reduction of fear is putting us back on a growth track.

The correlation between fear (represented by the red line, the Vix index inverted) and equity prices that is evident in this chart speaks for itself. The Vix has now returned to its pre-recession levels, and equity prices are on track to do the same, though the S&P 500 will need to rise another 25% to recover its previous highs.

Fears have been assuaged relentlessly since March '09. Swap spreads narrowed sharply. Credit spreads narrowed sharply. Signs of a recovery displaced expectations of a depression. Public reaction to the stimulus plan was mixed. Obama's popularity began declining, and the implementation of his agenda started facing headwinds. The Fed took strong action to expand the money supply. Financial markets began healing instead of collapsing. Commodity prices and gold prices started rising. Global trade got back in gear. Since the recession ended 18 months ago, the economy has proven the skeptics wrong more than once, and the forces of recovery have been working steadily behind the scenes, albeit slowly. Housing stopped collapsing and started stabilizing. A sea-change in the mood of the electorate resulted in a huge change in the congressional balance of power; the private sector now has a friend in Congress, and capital once again is held in high regard. More recently, a major increase in tax burdens was avoided, and a gargantuan omnibus spending bill went down in flames.

Short-term interest rates have been essentially zero for two years now. Investors, faced with the steep cost of safety (i.e., accepting a zero return for the safety of cash) have been realizing that the risks were not as great as they once feared, and they have been slowly deploying their cash hoards. Fearful investors have climbed countless walls of worry along the way, only to see the prices of risk assets moving higher. Consumers have been slowly drawing down their cash hoards, with the result that retail sales have now made a complete recovery. The next shoe to drop will be when corporations begin deploying their immense cash hoards to fund expansion plans and new hiring.

 It's hard to see how this self-reinforcing process of recovery can be derailed.

Amazing factoid

According to The Economist, "sometime in the next few months, the number of mobile phones in use will exceed 3.3 billion, or half the world's population. No technology has ever spread faster around the globe: the mobile phone took less than two decades to reach this degree of penetration."

HT: Glenn Reynolds

Taking the pulse of uncertainty

As I gear up for making another round of fearless forecasts (due out next week), it's important to first take the market's pulse. In this post, I consider how uncertain the market is concerning the outlook for the future. This chart compares the implied volatility of equity options and bond options. Implied volatility is a good measure of now much uncertainty the market perceives in the future, since it is a measure of how expensive options are (buying options is a way to reduce your risk exposure when you are unsure about the future). I also note that when uncertainty is highest, this tends to correspond to or signal market extremes. For example, the peak in the MOVE occurred in early Oct. '08, about three months before 10-yr Treasury yields hit their post-Depression low of 2.06%. The peak in the Vix occurred a few weeks later, preceding the equity market's ultimate bottom in early March by just over four months. The Vix was trading over 20 for about a year prior to the market's 2000 peak, meaning that a lot of people were nervous that prices were moving too high, and that turned out to be the case.

The Vix index is now trading at just about the lowest level we have seen since before the great crash of 2008. It's still higher than what we would expect to see in relatively calm conditions (e.g., 10-14), but not by much. Thus it would seem that the market is not greatly concerned about the outlook for the market or the economy. To be sure, optimism is in short supply these days, but when you combine today's skeptical market with implied volatility that is only moderately elevated, the result is like a sort of "consensus" that things aren't going to be greatly different in the future than they have been in the immediate past, namely: economic growth that is plodding, unspectacular, and insufficient to make much of a dent in the unemployment rate. The outlook for tax rates has been resolved, and that certainly helps reduce uncertainty, but there are still large uncertainties surrounding fiscal policy at the federal, state and local levels, and the still-unresolved debt crisis in the eurozone.

The MOVE index (the implied volatility of Treasury debt options) has risen in recent months, but it is still substantially lower than it has been for most of the past three years. This is to be expected, given the recent surge in yields on Treasury debt (10-yr yields are up almost 100 bps since October), and it is proportional in magnitude to what we saw when 10-yr yields surged 160 bps in the first few months of 2009. The most uncertain thing in the financial markets at this point would thus appear to be the future level of Treasury yields. I would note here that despite their recent rise, Treasury yields in general are still very low from an historical perspective. The only time in modern history that they have been lower, in fact, is during the Depression and deflation of the 30s and 40s. In my view, the rise in implied Treasury volatility is not sufficient to signal a market that has gone to an extreme (i.e., it does not suggest that yields are vulnerable to a reversal). I think the rise in yields reflects a market that has shifted its focus from one of expecting a double-dip recession to one that is trying to judge how strong or weak the expansion is likely to be.

A return to something characterized as more "normal" can be seen in the Bloomberg Financial Conditions index (below), which is "the number of standard deviations that current financial conditions lie above or below the average of the 1994-June 2008 period." Reduced uncertainty and volatility are generally supportive of economic growth, since at the very least they remove artificial barriers to growth. The return of "normal" conditions to the financial markets is a reflection of the return of both liquidity and confidence, and that is supportive of growth going forward, but not a guarantee.

I think this all paints a picture of a market that has ruled out a double-dip recession and an economic boom, but a market that assumes that a continuation of relatively slow growth (given the stage of the business cycle) is likely. This same outlook can also be found in the Fed funds futures market, where prices imply that the Fed is quite unlikely to raise the Fed funds rate before December of next year—thus ruling out a boom and assuming the continuation of slow growth that requires lots of help from monetary policy.

Reviewing my 2010 forecast

The first prediction I made a year ago was a no-brainer and absolutely right: I would never again get everything right. Of 11 other predictions I made a year ago, 6 were correct, 3 were wrong or mixed, and 2 were dead wrong. My biggest mistake was in thinking that the Fed would would begin raising rates this year in response to an improving outlook for growth.

Inflation will continue to trend slowly higher. Wrong/mixed. Inflation as measured by the CPI in fact trended lower over the course of last year, falling from 1.8% (year over year) from November '09 to 1.1% in November '10. But inflation as measured by the broadest possible measure—the GDP deflator—trended higher, from 0.2% year over year in Q3/09 to 1.2% in Q3/10.

The economy will grow 3-4% over the course of the year. Probably correct. Real GDP in the four quarters ending Sep. '10 was up 3.24%, and growth for 2010 will be 3% or better if Q4/10 annualized growth comes in above 4%. Most forecasts are calling for an upward revision to Q3 growth, and a relatively strong print for Q4 growth, so I think my lower bound growth forecast will hold.

The Fed will end up raising rates sooner and/or somewhat more aggressively than the market currently expects. Dead wrong. The Fed kept short-term rates close to zero for the entire year, and has given no sign at all that it intends to raise rates in the near future.

Residential construction activity is likely to slowly but gradually improve over the course of the year. Housing prices on average are likely to post modest gains as well. Wrong/mixed. Housing starts fell modestly over the course of last year, but have been relatively flat since early 2009. Prices, according to the Case Shiller data, were roughly unchanged. Compared to the consensus a year ago—which I think called for more bad news from the housing market—my optimism was not egregiously misplaced.

Interest rates on Treasury bills, notes and bonds should rise significantly over the course of the year, with 10-yr T-bond yields exceeding 4.5%. Dead wrong. T-bill rates rose, but only by a few bps over the course  of the year, 2-yr Treasury Note yields fell 40 bps, 10-yr yields fell about 50 bps, and 30-yr yields fell about 20 bps.

MBS spreads are likely to widen over the course of the year. Correct. MBS spreads rose from 70 bps a year ago to about 85 bps today. However, the rise in spreads was not enough to significantly detract from the generous total returns that MBS investors enjoyed for the year.

Credit spreads are likely to decline gradually over the course of the year. Correct. Spreads rose in the first half of the year, but ended the year with a net decline. Both investment grade and high-yield bonds enjoyed very strong performance as spreads declined and default rates plunged. 

Equity prices should be at least 10-20% higher by the end of the year. Correct. As of this writing, the S&P 500 is up about 12% year to date (with a total return of almost 15%), and the NASDAQ is up 17%. The going wasn't easy, however, with equities suffering a major setback in the second quarter after a strong first quarter.

Commodity prices will continue to work their way higher over the course of the year. Correct. The great majority of commodity prices registered strong gains for the year. 

Gold prices are likely to spike one more time to a new high this coming year. Correct. Gold rose from $1100 to $1400/oz., setting a new record high.

The dollar is likely to rise at least modestly against most major currencies, and it should be able to hold near its current levels against most emerging market and commodity currencies. Mixed. The dollar eked out a 3% gain against major currencies, but fell moderately against most emerging market and commodity currencies.