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The jobs report wasn't as bad as the headlines suggest

As the above chart shows, the ADP did a pretty good job of tracking the BLS estimates of job growth up until about a year ago. The January ADP estimate of private sector job gains failed once again to come even close to the figure compiled by the Bureau of Labor Statistics. Plus, the BLS estimate came in much weaker than expectations (+50K vs. +145K). Despite these disappointments, however, this wasn't a bad jobs report. A good deal of the variance can be attributed to very bad weather in January and to the quirks of seasonal adjustments and benchmark revisions to the population estimate. Calculated Risk has a nice discussion of this here. With improving weather we are likely to see much bigger job gains in the months ahead.
As this next chart shows, even with all the problems that depressed job gains in January, the two key measures of jobs are both reporting the same rate of growth over the past year: about 1.25% annualized. That's sluggish, but it should be picking up over the course of this year, and over time that should be enough to reduce the unemployment rate. It was also nice to see an outsized gain of 49K manufacturing jobs, the biggest monthly gain in 10 years, confirming the strength that has been showing up in the ISM manufacturing surveys.

As the chart above shows, the public sector continues to shed jobs, which is actually good news since it means that state and local governments are tackling their budget problems by cutting costs. The public sector has suffered from excessive bloat for years now, and a cutback was long overdue. Expect this trend to continue.
Finally, the best part of the report was a big and unexpected drop in the unemployment rate.  It's still high, but it should be working its way lower over the course of the year. If it is slow to decline, at least part of the reason will be that with an improving economy, the number of people wanting to work will probably increase, and that will add to the number that are considered to be unemployed.

The bond market is getting restless


This chart shows 10-yr Treasury yields since the beginning of last year. Note that yields reached a high of 4.0% in early April, right before several bearish announcements (the Gulf oil spill and the downgrade of Greek debt) triggered a wave of concerns that eventually gave us the economic "soft patch" which lasted through late summer. An economic slowdown, coupled with a lot of hand-wringing over the prospects of a Eurozone financial crisis, pulled yields down to a dismal 2.4%. Then we had talk of QE2 reviving the economy, then we had rising inflation expectations as a result of QE2, then we had a string of economic releases (e.g., falling unemployment claims, strong exports, strong capex, strong car sales, strong corporate profits) that gave credence to the idea that the economy was actually accelerating. 10-yr yields appeared to have been capped at around 3.5%, however, with the support of continued QE2 purchases from the Fed and the market's belief that the economy's upside growth potential was limited.

That latter notion is what is being challenged in the past several days. 5- and 10-yr Treasury yields are breaking out to new high ground as the market begins to realize that the economy is growing, not struggling, that commodity prices continue to rise unabated, bank loans are accelerating, money supply measures are registering 6% and more, and the Fed may be overstaying its welcome with QE2. Besides, who wants to own Treasuries that pay 3.6% or less when nominal GDP growth—the rate at which corporate profits tend to rise over time—could be 5-6% or more? Bottom line: Treasury yields need to be more in line with expected nominal GDP growth, and QE2 purchases can't change that reality. Rising yields are an excellent sign, therefore, that the economy is picking up.

The real problem with Egypt—lack of property rights

I highly recommend the article by Hernando DeSoto in today's WSJ, "Egypt's Economic Apartheid." His research has uncovered a huge source of poverty of misery in many countries around the world, and unfortunately not much has been done to fix these problems. The word needs to get out. Some excerpts:

It is worth noting some of the key facts uncovered by our investigation and reported in 2004:
Egypt's underground economy was the nation's biggest employer. The legal private sector employed 6.8 million people and the public sector employed 5.9 million, while 9.6 million people worked in the extralegal sector.
As far as real estate is concerned, 92% of Egyptians hold their property without normal legal title.
We estimated the value of all these extralegal businesses and property, rural as well as urban, to be $248 billion—30 times greater than the market value of the companies registered on the Cairo Stock Exchange and 55 times greater than the value of foreign direct investment in Egypt since Napoleon invaded—including the financing of the Suez Canal and the Aswan Dam.
Without clear legal title to their assets and real estate, ... entrepreneurs own what I have called "dead capital"—property that cannot be leveraged as collateral for loans, to obtain investment capital, or as security for long-term contractual deals. And so the majority of these Egyptian enterprises remain small and relatively poor. The only thing that can emancipate them is legal reform. And only the political leadership of Egypt can pull this off.

Food price inflation


It seems that almost every commodity on the planet is rising in price, and foodstuffs are no exception. This chart shows the price of an index based on hides, steers, lard, butter, soybean oil, cocoa, corn, wheat and sugar—pretty basic stuff. Since hitting bottom in Aug. 2000, food prices according to this index have risen almost 300%, or a little more than 10% per year. The dollar has lost about one-third of its value since the low in food prices, so food prices have risen by less than 10% a year for most other currencies, but regardless, food prices are hitting new highs these days in almost every currency in the world, with the exception of the Japanese yen and the Australian dollar.

Key indices point to a stronger economy and more inflation this year


This week's data have included two back-to-back "blowout" numbers, both from the Institute for Supply Management. Activity in both the service and manufacturing sectors is really picking up, and more than expected. Today we learned that almost two-thirds of service sector companies—comprising the lion's share of the economy—report seeing a pickup in business activity. And as is the case with the manufacturing sector, a majority of businesses are hiring new workers, and a large majority report paying higher prices. All the numbers from both sides of the economy have moved up significantly in recent months. At this rate, it would appear inevitable that the economy is going to enjoy stronger growth and more inflation this year than last year. Once again, today's reports should be ringing alarm bells at the Fed, where FOMC governors should be realizing that the time to take your foot off the accelerator is way before you need to start applying the brakes.

Estimating Friday's jobs number


I have always hated the fact that the monthly jobs number ends up being so important. Whatever the number is that is announced this Friday by the BLS is almost sure to be revised significantly, up or down, in the months and years to come, as BLS eventually reconciles its estimates to actual data based on IRS tax receipts. Sometimes the revisions can be of an order of magnitude in size.

It's also the case that the ADP monthly estimate of the number of private sector jobs gained or loss has lost a lot of credibility in the past year or so, since it has ended up grossly underestimating the number of jobs that the BLS has reported. You can see this in the chart above, where the red line has been consistently higher than the blue line for most of the past year.

So are both these numbers so flaky that it is not worth paying attention to them? Only time will tell, but in any event you have to take them with several grains of salt at least. Both can be wrong.

Nevertheless, it is tempting to get a little excited about the relatively large January jobs gain that is being projected by ADP in their release today (+187K), since estimates for the BLS number are only +140K, and 200K jobs per month is an important threshold number since that is what is required—if it persists for a sufficient period—to bring down the unemployment rate. ADP overestimated job gains last month by a lot, but that was the only time they had overestimated the BLS number in over a year. What if ADP once again is underestimating the BLS number? If they are, then Friday's payroll number could be a welcome surprise to the upside.

I wouldn't want to put much stock in these speculations, however. As anyone knows who has followed at this data over the years, trying to predict monthly jobs numbers is fraught with difficulties, and the value of the exercise, even if one is right, can be negated months later by revisions to the original data. I only mention this because it is tempting, and because there are other indicators which are pointing to a substantial pickup in jobs numbers going forward (e.g., declining unemployment claims, stronger-than-expected corporate profits, stronger leading indicators, strong growth in capex, strong growth in commodity prices, strong export growth, strong car sales).

Economic Outlook (Part 7) -- Forecast Summary

Part 1 (overview) of this 7-part series, which is taken from a recent presentation I made at UCLA, can be found here. Part 2 (monetary policy) can be found here. Part 3 (fiscal policy) can be found here. Part 4 (economic fundamentals) can be found here. Part 5 (market fundamentals) can be found here. Part 6 (commodity watch) can be found here.


Political winds continue to shift in favor of fiscal austerity, with a strong emphasis on cost-cutting rather than higher taxes. This may add to short-term anxiety (Keynesians will argue that austerity is a negative for growth), but will ultimately prove beneficial (reduced government spending frees up scarce resources for the more efficient private sector).


Inflation will trend slowly higher.


Real growth will average 4% or better.


The Fed will raise rates sooner than the market expects (only one 25-bps tightening is expected by the end of this year).


Residential construction will slowly improve.


10-yr Treasury yields will rise to 4.5% or more.


MBS spreads will widen as yields rise. 


Credit spreads will hold current levels or continue to narrow. 


Equity prices will rise 10-15%. 


Commodity prices will post moderate gains.


The dollar will rise against most currencies.


Markets are still pricing in a lot of bad news, and there are a number of serious concerns weighing on sentiment (e.g., fiscal policy, monetary policy). As the US economy continues to grow in spite of these concerns, and policy uncertainties are resolved favorably, there is lots of room for improvement in asset prices. 

Corporate layoffs remain very low


The Challenger, Gray & Christmas tally of publicly-announced corporate layoffs remains unusually low. For some time now, this has been telling us that corporate America was quick to make the necessary adjustments in the wake of the financial crisis by cutting staff. This has contributed to improve overall productivity and keep corporate profits strong, and it also means that corporations are "lean and mean" and will likely have to increase hiring activity as the economy continues to expand. All in all, a very reassuring indicator.

Economic Outlook (Part 6) -- Commodity Watch

Part 1 (overview) of this 7-part series, which is taken from a recent presentation I made at UCLA, can be found here. Part 2 (monetary policy) can be found here. Part 3 (fiscal policy) can be found here. Part 4 (economic fundamentals) can be found here. Part 5 (market fundamentals) can be found here.




Real oil prices have once again exceed the early 80s highs, but that doesn't necessarily mean another recession. 




Conservation and technology have significantly reduced the amount of energy required to fuel economic growth. Even though energy is more expensive now than ever before (with the brief exception of mid-2008), today we spend about one-third less of our incomes on energy than we did in 1982, because we use less of it in our daily lives. 




The rebound in commodity prices reflects stronger global growth and accommodative monetary policy. Rising gold and commodity prices is likely a precursor to a rise in the general price level. 




In real terms, the rebound in commodity prices has taken them back to their 1970 levels. Easy money seems like a primary cause. Easy money typically encourages people to invest in physical goods that hold their value over time, while tight money reverses that tendency, encouraging people to invest in financial and productive assets. 


The across-the-board strength of commodity prices is an excellent indicator of healthy global growth, but also warns us that monetary policy (both in the US and abroad, since commodities are rising in all currencies) is playing an important role, and this is a portent of rising inflation. 

Car sales rise 16%


January auto sales didn't increase from December, but weak January numbers have been the norm for several years, despite this series being seasonally adjusted. Over the previous 12 months, a better comparison, sales were up over 16%. The auto industry is finally enjoying a decent recovery. From the ugly depths of Feb. '09, sales are up 34%.

Yield curve slope hits another new high


The spread between 2- and 30-yr Treasuries reached another new, all-time high today of 401 bps. As this chart suggests, it's not unusual for the yield curve to steepen coming out of a recession. This is typically driven by Fed easing, as the Fed attempts to provide more money to help the economy recover, and to compensate for the higher demand for money that usually follows in the wake of recessions. One side effect of a steeper yield curve is that this becomes fertile ground for bank earnings. Today, banks can borrow from the Fed at 0.25% and, if they choose, buy 30-yr Treasuries, thus helping to fund the federal deficit while also earning 3.75% net interest on the trade. If the mark-to-market risk of 30-yr Treasuries (which currently have a duration of 17.4, and thus stand to lose about 17.4% of their value if yields rise 100 bps) is too much, then banks can buy 10-yr Treasuries (which the Fed is supposedly going to be backstopping for the next 5 months, and which have only half as much price risk as 30-yr Treasuries) and pick up 3.25%.

In effect, what this says is that the Fed is greasing the skids for a lot of folks and a lot of banks and businesses. Corporate profits are already close to record highs, so it is not too hard to understand why the equity market is up 25% since the end of August.

The next shoe to drop will be a pickup in inflation. Recall that the CPI rose from a low of 1% in mid-2002, as the 2-30 slope passed 300 bps on its way to 360 bps in mid-2003, to reach a high of 4.7% in Sep. '05.

Economic Outlook (Part 5) -- Market Fundamentals

Part 1 (overview) of this 7-part series, which is taken from a recent presentation I made at UCLA, can be found here. Part 2 (monetary policy) can be found here. Part 3 (fiscal policy) can be found here. Part 4 (economic fundamentals) can be found here.




Swap spreads are an excellent proxy for systemic risk (the lower the spread the lower the risk), and they have also tended to be good leading indicators of the direction of other markets. In this chart they suggest that the yield on high-yield bonds is likely to remain relatively stable or perhaps decline a bit further. 




Treasury yields are primarily determined by inflation, but the economy's growth potential can also be an important factor (as was the case in late 2008 when 10-yr yields plunged due to widespread fears of an economic collapse). In this chart, the bond market appears to be saying that we have seen the low in inflation, and that both inflation and real growth are picking up. 




Credit spreads still reflect a degree of caution, suggesting that the market is not overly optimistic. Spreads in general are still significantly higher than what we might expect to see if the economy were healthy and financial conditions were normal. 




The Vix index is a good proxy for the market's fear, uncertainty and doubt. Fears have played a major role in the financial crisis, and this chart suggests we haven't yet returned to normal. That, in turn, suggests that there is still substantial upside potential left in the equity market. 


Key measures of market fundamentals show that while there has been substantial improvement over the past two years, we are still short of returning to what might be termed "normal" conditions. This suggests that the prices of risky assets are not overvalued and that the market is not overly optimistic. 

Economic Outlook (Part 4) -- Economic Fundamentals

Part 1 (overview) of this 7-part series, which is taken from a recent presentation I made at UCLA, can be found here. Part 2 (monetary policy) can be found here. Part 3 (fiscal policy) can be found here.
I included this same chart in an earlier post today, but it is worth repeating. The manufacturing sector is doing very well these days, and judging from past correlations, strength in the ISM indices is pointing to 4-5% growth in the overall economy. This is in line with my expectations of 4-5% growth this year.




Corporate profits are very strong relative to GDP. I note that the S&P 500 today is at a level that was first reached in Mar. 1999. Since then, corporate profits have doubled. Another notable fact about profits is that they have far outstripped corporate investment (proxied by capital goods orders in the next chart). Corporations are now sitting on a mountain of cash worth more than $1 trillion. As confidence in the future returns, that means there is the potential for a huge new wave of investment and growth.




Business investment is up 15% over the past year. This reflects increased confidence on the part of businesses, and promises stronger growth in the future by increasing worker productivity.




This model of the valuation of stock prices, which is derived from one developed by Art Laffer in the early 1980s, and is similar to the "Fed model" of equity valuation, suggests that equities would be fairly priced today if one were to use a 6% 10-yr Treasury yield and assume that corporate profits are going to decline to 6% of GDP. In other words, the model is saying that the market is priced to some very pessimistic assumptions, and therefore could withstand lots of bad news.


The manufacturing sector is enjoying robust growth, corporate America is fabulously profitable, and there is a mountain of profits waiting to be reinvested, yet the equity market seems very reluctant to accept that this is a genuine recovery.

ISM manufacturing report very strong

The January ISM manufacturing survey indices came in much stronger than expected. This is  almost what one could call a blowout report, since it leaves no doubt that conditions in the manufacturing sector are improving significantly. As the top chart suggests, the overall index is consistent with GDP growth of at least 4-5%, which is what I'm expecting to see as the year unfolds.


The employment index hasn't been this strong since early 1973.


The export orders index has been volatile in the past year, but January was very strong and there is no indication of any deterioration. The New Orders index was also very strong, rising back to levels not seen since the economy surged in the second half of 2003. The Prices Paid Index was also strong, as 81.5% of the respondents reported paying higher prices. This very strongly suggests that deflation is a thing of the past, and it should be ringing alarm bells at the Fed. Nothing about this report fits the Fed's narrative of an economy that desperately needs massive monetary stimulus with no need to worry about any inflationary consequences.

Economic Outlook (Part 3) -- Fiscal Policy

Part 1 (overview) of this 7-part series, which is taken from a recent presentation I made at UCLA, can be found here. Part 2 (monetary policy) can be found here.




Federal tax receipts are now rising at double-digit rates, which is typical following a recession, as incomes and profits rise and more people go back to work. The federal budget could be balanced in 5 years if spending just stops growing.




Deficits of 9% or more of GDP are a serious drag on the economy. Government spending is the problem, more so than the deficit. When government spends money it does so much less efficiently than the private sector, thus squandering the economy's scarce resources. Contrary to popular (Keynesian) thinking, large deficits are not stimulative, they are contractionary. Reducing government spending would likely provide a big boost to the economy, since it would reduce the future expected burden of taxation and it would make the economy more efficient and productive.




There is no necessary connection between tax rates and tax revenues. In this chart, we see that a huge reduction in top tax rates (from 90% prior to 1955, to 28% in the late 1980s) did not reduce tax revenues as a % of GDP at all. Lower rates coupled with fewer deductions and a broader tax base are far more efficient ways of collecting taxes. Reducing the top marginal rate for as many people as possible is the best way to use the tax code to encourage work, investment, and risk-taking.



The level of federal debt has correlated negatively to interest rates for most of post-war history. Interest rates are primarily determined by the rate of inflation, which is the purview of the Fed. Only recently has the Fed been engaged in monetizing the federal deficit, and not coincidentally, there are signs that the level of debt and interest rates are more positively correlated now than at any time in the past. Should inflation rise, interest rates will likely follow, and the combination would make the debt burden much more serious than it already is.

Economic Outlook (Part 2) -- Monetary Policy

Part 1 (overview) of this series, which is taken from a recent presentation I made at UCLA, can be found here


Federal reserve monetary policy hasn't been this easy/accommodative since the inflationary 1970s. Short-term real borrowing costs are negative, a policy that is designed to erode the demand for money, expand the money supply, and push inflation higher.


The Fed has exploded its balance sheet in order to accommodate an explosion of money demand. If the Fed hadn't done this then we probably would have suffered from a deep recession/deflation.


The velocity of M2 money is likely to rise as money demand falls and confidence returns, boosting nominal GDP. Velocity fell sharply a few years ago as confidence collapsed and money demand soared. Things are just beginning now to reverse.


The growth rate of most measures of the money supply has averaged about 6% per year for many years. There is no obvious sign yet that the Fed's quantitative easing has had any impact on the growth of the money supply. Taken in isolation, this would suggest that the Fed's provision of reserves has been just enough to satisfy the market's demand for reserves and to accommodate a modestly growing economy.


The dollar is very weak—about as weak as it has ever been—and this reflects very accommodative monetary policy and deep concerns about the future of the U.S. economy.


Low real yields from the Fed and a very steep yield curve all but guarantee a continued recovery. Every post-war recession has been preceded by high real yields (tight money) and a flat or inverted yield curve.


Thanks to QE2, the fear of deflation has again all but disappeared. Inflation expectations now are close to the average of what we have seen in normal times.


The rise in Treasury yields poses no immediate threat to the housing market. Mortgage rates are still very low from an historical perspective. The combination of very low borrowing costs, rising real incomes, and a 35% decline in the real, average cost of housing prices in recent years has left homes more affordable than at any time in more than a generation.

Economic Outlook (Part 1) -- Overview

This morning I spent some time with members of UCLA Anderson Prof. Bill Cockrum's Student Investment Fund. I believe this is the 5th or 6th year I have done this, and I always look forward to interacting with this group as they begin the difficult task each year of formulating an economic outlook and a coherent investment strategy. I thought it might be worthwhile to break down my presentation to them in several parts, with a minimum of words and a maximum of charts. Most of the charts and themes have been covered here in other posts, but I think it helps to put it all together in an illustrated, narrative form.

Overview
Formulating an investment strategy first requires an understanding of what the market is expecting. If your view of the world is the same as the market's then you can't expect to do much better than just investing passively in the market. But if you think the market is misjudging things, then that opens up opportunities for gains by over- or under-weighting different market sectors and individual stocks or bonds.

Many people use opinion polls or surveys of bullish and bearish sentiment to judge whether the market is cheap or rich. I think it's better to look at the market itself; I think there are a variety of market prices that provide good insight into the assumptions that are driving the market. The things I look at tell me that the market is still quite concerned about the future—there are lots of walls of worry, in other words. I think many of these concerns are too pessimistic, therefore I am generally optimistic and bullish.

Monetary policy is a source of great concern, since the Fed is in uncharted waters. Three years, ago, if you had told just about any economist in the world that the Fed was about to purchase well over $1 trillion worth of securities in a relatively short time span, they would have reacted with forecasts of imminent hyperinflation, but only after protesting that such a scenario was virtually impossible in the first place. But it has happened, and nobody knows yet what the endgame is going to be. So far there hasn't been any overt inflation problem, but there is a lot of action in the gold and commodity markets that might be precursors to a general rise inflation.

Fiscal policy is also a great source of concern, since federal spending relative to GDP has expanded by some 25% in just a few years, and will be as large or larger a share of the economy for the foreseeable future unless big changes are made. The problems with a surge in spending are many: higher spending, if left unchecked, sooner or later will require higher tax burdens, and higher expected tax burdens automatically depress the present value of all risky assets. Higher spending also means a weaker economy, since government spends money much less efficiently (and many times with wild abandon and rampant corruption) than the private sector.

Credit spreads have narrowed a lot, but they are still well above the levels we might expect to see in times of a normal, healthy economy.

The implied volatility of equity options (e.g., the VIX index) is still well above levels that we might expect to see during times of economic and financial tranquility.

The dollar is as weak as it has ever been. Surely that reflects great concern on the part of US and global investors over the future of the US economy.

Gold prices have soared to over $1300/oz. Surely that also reflects great concern over the political and financial future.

Commodities are up strongly, across the board. This reflects not only a strong global economy but there appears to be a significant monetary component to rising commodity prices, as investors stock up on physical assets out of fear that money may lose its value.

10-yr Treasury yields of 3.4% only make sense if the market in aggregate holds a very dim view of the US economy's ability to grow. Given the widespread belief in the Phillips Curve, a very weak growth outlook for the US economy compels one to believe that inflation is going to be very low for a considerable period. So Treasury yields are a clear sign that the market believes US growth will be sluggish for a very long time. 2-yr Treasury yields of 0.6% are an unambiguous sign that the market believes the Fed when it says that short-term interest rates will be very low for a very long time, and that will be the case only if the economy is weak for a long time.

In short, the market is generally pessimistic about a lot of things, leading me to the conclusion that equities are attractively priced if one believes that the problems facing us are not insurmountable.

The federal deficit is a big problem, but a solution is far from impossible. Just holding spending constant would balance the budget within 5 years. Social security is a big problem, but most of the problem could be addressed by raising the retirement age and indexing benefits by using the CPI instead of nominal wages. Healthcare is a big problem, but simply changing the tax code to allow everyone to deduct medical expenses would go a long way towards making the healthcare market more efficient and cost effective.

The November '10 elections made it clear that the people are demanding big changes from Congress, with the number one message being "stop the spending." Given the extreme to which the situation has gone in so many areas, the time is ripe for some fundamental and positive changes in the direction of fiscal policy.

QE2 update


The latest data from the Fed reveals only a modest uptick in the Monetary Base, the measure of that part of the total money supply that is completely controlled by the Fed (bank reserves plus currency in circulation). The uptick to date doesn't yet equal the size of the Fed's QE2 purchases, and the base today is only $40 billion higher than it was at this time last year. Other measures of the money supply (M1, M2) tell a similar story: there has been no unusual growth in the amount of money in the economy. This means that a) a good portion of the Fed's QE2 purchases to date have only served to offset other factors that have subtracted reserves, and b) the extra reserves created by the Fed's QE2 purchases of Treasuries are for the most part still being held voluntarily by banks (i.e., the financial system is still risk-averse enough to want to accumulate safe assets like reserves that pay only 0.25% annual interest). In short, QE2 has not resulted in a flood of new money, but instead has served mainly to satisfy the world's demand for safe haven assets.


It's also the case that one of the stated reasons for doing QE2—to reduce long-term interest rates in order to boost the economy—has at best a mixed record. Treasury bond yields are up sharply since late August when the idea of QE2 was first floated. Yet despite higher bond yields, the economy has picked up and the equity market has enjoyed a substantial rally.

If QE2 hasn't resulted in any new money flows to the economy, and Treasury bond yields are sharply higher, can QE2 still be given credit for somehow stimulating the economy? Perhaps it deserves some credit, if only because it has all but erased investors' fears of deflation, and any reduction of uncertainty improves confidence and that in turn leads to more investment and risk-taking. But perhaps the economy was improving on its own by the time QE2 got underway. Stay tuned as we continue to monitor these important monetary developments.