Main menu

Miscellaneous chart updates

As equities continue to "melt up," boosted by continued signs that the economy likely is growing at a 3-4% rate and not at risk of another recession, Treasury yields remain extremely low, priced to a lot of bad news that has yet to materialize. The market's apparent belief that the Fed can keep interest rates at extremely low levels for years to come, despite the fact that the economy is doing Ok, is being challenged. In my view the resolution is going to come sooner or later in the form of sharply higher Treasury yields. Higher Treasury yields at this point would be unmitigated good news for the economy, but of course very bad news for the Treasury market.

The recently-released household balance sheet data for the Q4/11 didn't show much change from previous reports, mainly because the stock market was relatively flat last year. But with stocks up almost 10% so far this year, household financial assets have probably risen by almost $3 trillion, boosting net worth to some $61 trillion, only $4 trillion shy of the 2006 highs.

As of Q3/11, household financial burdens had fallen significantly since their pre-recession highs. This is largely due to deleveraging, rising incomes, and lower borrowing costs. Households have materially improved their financial health, making the economy more resilient to possible future shocks.

The Eurozone crisis is slowly fading away, as reflected in this chart which shows the ratio of the Vix index to the 10-yr Treasury yield. Today's record-setting Greek debt restructuring—which forced bondholders to accept a 70% writedown—was so widely anticipated that markets received the news with total aplomb. I'm reminded of my assertion last summer that the eventual resolution of the Eurozone sovereign debt crisis would end up being a non-event similar to Los Angeles' "Carmageddon."

This chart of the dollar's inflation-adjusted value against other currencies is arguably the best measure of the dollar's relative strength available. As of the end of January, the dollar was only only slightly higher than its all-time lows. Dollar weakness is also reflected in strong gold and commodity prices. A weak dollar may be helping U.S. exports, but it is also contributing to inflation, and it reflects genuine concerns in the market about the long-term outlook for the U.S. economy. If the Fed is at all concerned about the long-term health and purchasing power of the dollar, then today's weak dollar is an indicator that there is essentially no more room for quantitative easing. Moreover, there is no more need for further quantitative easing, given the many signs that the economy is making forward progress.

Continued improvement in the labor market

According to the Establishment Survey, the private sector has been adding jobs at a 2.1% annualized pace over the past six months. That's about what we saw in the 2004-2007 period, but it's nothing to get excited about. However, according to the Household Survey, the pace of growth has been a very impressive 4%. I'm inclined to go with the Establishment Survey on this one, since it looks to me like the Household Survey is simply catching up to the Establishment Survey after growing more slowly over the past year or so. In any event, it remains the case that the economy is creating a decent number of jobs, and the outlook therefore continues to improve, even though the unemployment rate is still very high (8.3%).

One thing that stands out in today's report is the recent growth of the labor force (the number of people either working or looking for a job). As the first chart above shows, we've gone from a shrinking labor force to one that is growing at its long-term average (about 1% a year) in the past six months or so. The upturn is just barely noticeable in the second chart, but it's there. The flat-line behavior of the labor force over the past 3 years has been the most unusual characteristic of this recovery. Because they were either discouraged about getting a job, and/or satisfied with collecting generously-extended unemployment benefits and food stamps, today there are some 5 million people sitting on the sidelines that would normally either be looking for a job. If they all decided to get back into the labor force tomorrow, the unemployment rate would skyrocket. If they slowly decide to come back, then that will have the effect of keeping the unemployment rate unusually high for quite some time, and that seems to be what will most likely happen.

From a global perspective, corporate profits are not unusually high

I've showed this chart many times over the past several years, usually in the context of how impressive the growth in profits has been since the late 1990s, and usually with the observation that despite all this profits growth, equity prices are almost unchanged. To be specific: since October 1999, corporate profits after taxes have increased 160%, yet the S&P 500 index is unchanged. Many readers and analysts have argued that this is no anomaly, since the market is simply figuring that corporate profits will soon revert to their mean relative to GDP (6%); that the burst of profits in recent years is only transitory. My own valuation models confirm this: I think the market is priced to the assumption that Treasury yields rise significantly and corporate profits decline to 6% of GDP in the next 3-5 years. I've argued that since this is such a pessimistic assumption, there is plenty of room to be optimistic. Skeptics have argued that corporate profits can't possibly remain as strong relative to GDP as they are today, much less continue to increase, and that they must decline significantly in the years to come.

Now, reader "WimpyInvestor" has asked a question that bears looking into: "if US corporations are serving global customers, then shouldn't the denominator be changed to Global GDP?" And indeed I think he is right. The increasing globalization of world commerce has brought with it spectacular opportunities for companies to expand their addressable market. Apple is a prime example, since it can sell the same iPhone all over the world, and the global cell phone market is now over 6 billion in size, compared to less than a billion not too many years ago. Hollywood is another example of an industry that can now sell its products to billions of customers, whereas the movie-watching market was less than a billion a decade or so ago. It no longer makes sense to compare the profits of U.S. corporations to U.S. GDP, since that arbitrarily limits the effective size of the market our corporations operate in. It's time to go global in our thinking. Never before have companies been able to market their products so easily to such a huge and rapidly growing global market.

And so I've put together the above chart, which compares the same measure of corporate profits (after-tax adjusted corporate profits according to the National Income and Product Accounts, which includes income from foreign sources) to World GDP as calculated by the World Bank. (I've made a conservative estimate of world GDP for 2011.) Now we see that corporate profits aren't really so high after all. When we consider that many U.S. corporations now have significant exposure to global markets, profits relative to world GDP are only slightly higher today than they have been on average over the past 50 years. A reversion to the mean might occur over the next two years without any decline at all in nominal profits; for example, profits could continue to increase by 5% a year, but global GDP is likely to increase by even more (e.g., nominal GDP growth in China and India is likely to be in double-digit territory).  

I think this adds up to one more, and very good, reason to think that the U.S. equity market is being way too pessimistic in its outlook for corporate profits.

The jobs picture keeps improving

As these two charts show, there is no sign whatsoever that the economy is weakening. Weekly unemployment claims are down very close to levels that one would expect to see during a business cycle expansion. Corporate layoffs are down to a trickle, relatively speaking. If there's anything missing, it's that hiring activity is still relatively subdued, but we'll learn more about that tomorrow. In any event, there is no reason why the economy can't growth at a 3-4% pace given these numbers. While that won't do much to bring down our sky-high unemployment rate (which has been depressed by the staggering number of discouraged workers who have given up looking for a job), and it won't close our 13% output gap, it is better, I think, than what the market has been looking for, and that's why it pays to be optimistic.

The equity market has been priced to bad news from the economy, and so it has been forced to rally as the economic fundamentals gradually improve, as the chart above suggests.

The biggest change on the margin

These two charts represent what is arguably the biggest thing that is changing in the U.S. economy these days. Not only is the price of natural gas declining significantly, but it is getting cheaper relative to crude oil by leaps and bounds. And it's all thanks to new drilling technology (fracking) that has resulted in huge new natural gas discoveries and production in the U.S. It's probably impossible to imagine all the ramifications of this for the U.S. economy, but they are surely going to be very significant. When a relatively clean source of energy becomes suddenly abundant and extremely cheap, it is bound to be disruptive in more ways than one can imagine, and it is bound to result in a stronger economy in ways that we have yet to imagine. If there is any reason to be optimistic about the future of the U.S. economy, this is arguably the best.

The new iPad looks incredible

With a retina display, a faster processor, a great camera, 4G LTE, iMovie, and iPhoto, this new tablet is going to be a must-have for just about everyone. iPhoto plus the retina display alone is reason enough for every photographer in the world to own this gem. I can't wait to get my hands on one, and will be ordering it asap.

Full disclosure: I am long AAPL at the time of this writing.

Mixed news today

ADP's estimate of February private sector job gains came in about as expected, but they also issued revisions to past data that had the effect of increasing prior estimates to bring them more into line with BLS data. As the chart above suggests, ADP's estimate doesn't point to any surprising strength in the BLS number to be released tomorrow, so the market's current guess of 225K is probably reasonable. A number like that would be similar to what we have been seeing in recent months, and is neither impressive nor disappointing.

Q4/11 unit labor costs were revised sharply higher in today's BLS release. As this chart suggests, unit labor costs are now adding to the economy's overall inflation rate (the GDP deflator being the broadest measure of inflation available), rather than subtracting. 

Higher unit labor costs mean that the productivity of labor is declining. Businesses typically squeeze more productivity out of their workforce in the wake of recessions. But you can't increase productivity without limit, and it looks like we are now in that phase of the business cycle when businesses start having to pay more to expand their output; fortunately, that's not hard to do when corporate profits are at record highs. 

But more importantly, as the chart above suggests, declining productivity (blue line) is typically associated with rising inflation (red line). We've probably seen the high in productivity gains, so we've probably also seen the low in inflation, and we should expect to see inflation continue at current levels or (more likely, given accommodative monetary policy and a weak dollar) move gradually higher. 

Credit spread update

My last post on this subject was in mid-January, and my main points then were that 1) although credit spreads were still elevated, this did not imply a risk of imminent recession, and 2) high-yield bonds were still attractive since yields were a little over 8%. Since then, spreads have come down somewhat, but they are still at levels that prevailed at the onset of the last recession, as shown in the chart above. Yields have come down to record-low levels, but as I argue below, they remain attractive.

One crucial point I made back then is still valid today: the reason spreads are elevated is not because default risk is rising or of great concern, it's because Treasury yields have collapsed. In other words, the market is priced to the expectation that the whole economy is going to be in miserable shape in coming years, not that any one sector is necessarily more risky than another. As the two charts above show, A1 industrial spreads today are substantially above the levels of the mid-1990s, but yields are orders of magnitude lower (1.54% today).

A similar pattern can be seen in the above chart, which compares 2-yr swap spreads to the yield on 5-yr generic High Yield Credit Default Swaps. Swap spreads are about as low as they get, which tells us that systemic risk in the financial markets is very low and liquidity is very high, yet spreads on HY CDS are still quite elevated. As before, I would argue that the still-elevated level of junk spreads is not an indicator of impending recession, as it has been in the past. Rather, it presents the high-yield investor with a conundrum which is undoubtedly contributing to keeping spreads as high as they are: do you buy HY debt for the attractive spread, or do you sell HY debt because yields are so low?

As this next chart shows, junk bond yields are now at all-time lows (7.1% today). The cost of borrowing for the typical "risky" company has never been cheaper. Ordinarily, this might be a signal for investors to sell junk bonds, but since the alternative sources of yield are also at record lows, and the spread from high-quality to junk yields is still quite high, the rationale for exiting the junk bond market is weak. The Fed is leaving investors with little choice but to move out the yield curve and accept more risk, since the incremental rewards to doing so are significant. In contrast, high-quality yields offer very little to the average investor, but they are a boon to the average high-quality borrower.

Geithner covers for corruption on Pennsylvania Avenue

Charles Kadlec has an excellent essay, "Geithner Covers for Corruption on Pennsylvania Avenue," in the recent issue of Forbes. He makes it quite clear that, contrary to Geithner's assertion in his recent WSJ op-ed, the recent financial crisis had its origins not in a lack of regulation, but in extensive meddling by the federal government in the housing and lending market over many years. The last thing we need is more federal oversight and intervention in free markets. An excerpt:

[Kadlec to Secretary Geithner:] First, your essay glosses over the central role the federal government played in creating the crisis. In particular, the government through Fannie Mae and Freddie Mac directed $5.2 trillion of capital to increase the supply of mortgages. In addition, it passed a law that required banks to make billions of dollars in loans to individuals that were unlikely to pay off the loans, in the end with 0% down.
In 1998, Fannie Mae announced it would purchase mortgages with only 3% down. And, in 2001, it offered a program that required no down payment at all. Between 2001 and 2004, subprime mortgages grew from $160 billion to $540 billion. And between 2005 and 2007, Fannie Mae’s acquisition of mortgages with less than 10% down almost tripled. These loans are now known as “subprime” and “alt A” loans. At the time they were made, Fannie Mae and Freddie Mac encouraged their issuance by lowering their standards and buying them up from the now vilified mortgage brokers, S&Ls, banks and Wall Street investment banks.
Second, your claim that increased regulatory oversight would have prevented the crisis requires a credulous belief in the wisdom and courage of those in power. Regulators with all of the necessary powers have failed in their most basic task of preventing fraud including Bernie Maddoff’s Ponzi scheme, and now the still unexplained disappearance of $1.6 billion of customer money at MF Global. Yet, you ask us to believe tens of thousands of pages of new regulations will somehow empower you and other elite public servants to prevent another financial crisis?
As we know now, you and the other members of the Federal Open Market Committee in 2006 did not grasp the implications of the then faltering housing market for the general economy or the health of the banking system. As a consequence, you and your colleagues did not use the powers you had to head off the financial crisis when there was still plenty of time to act.

The self-regulatory check normally provided by markets on activities that are likely to lose money — lenders backing away — was simply blocked by the government’s intervention in the capital markets. As you must know, six top executives of Fannie Mae and Freddie Mac have been charged by the Securities and Exchange Commission with securities fraud for hiding the size of the purchases of low quality mortgages from the market.
This activity was not due to a lack of regulation or oversight as you claim. Both companies are under the direct supervision of a federal regulator and Congress. At the time these loans were being purchased by these two Government Sponsored Enterprises, their actions were defended by many in Congress who, led by Senator Chris Dodd and Congressman Barney Frank, saw such reckless lending as a successful government initiative.

Eurozone update: more improvement on the margin

With 2-yr swap spreads being key indicators of systemic risk and liquidity in the banking system, it is nice to see that U.S. spreads are back to what might be termed "normal," as the second chart shows; the U.S. has effectively decoupled from Eurozone risk. It's also nice to see that Eurozone swap spreads continue to decline on the margin (first chart), even though they remain quite high. The ECB's ongoing efforts to inject liquidity into the banking system with its 3-yr LTROs have added much-needed stability to the banking system, which in turn allows the economy to function and buys time so that market participants can redistribute risk. But of course this does nothing to alleviate the underlying problem, which is too much debt in some Eurozone economies, and too little ability to service that debt, absent some major structural reforms (e.g., big cuts in government spending and entitlement programs). Still, it is progress.

The Fed's efforts to provide dollar liquidity to the Eurozone have also been helpful, as reflected in the decline of Euro Basis Swaps, which in turn have proved to be a leading indicator of systemic risk in general. As the chart suggests, we should see some further decline in Eurozone swap spreads in coming months.

2-yr Italian and Spanish yields have declined significantly as a result of the improved liquidity conditions in the Eurozone. Ireland has benefited as well, but most of the improvement in the prospects for Ireland is due to painful but bold decisions last summer to implement needed fiscal reform (e.g., cutting spending). Greece of course has already defaulted, and Portugal remain quite likely to follow in its footsteps.


This chart, which includes data as of Jan. 31, 2012, shows that despite all of the ECB's liquidity injections, growth of the broad money supply in the Eurozone is not necessarily worrisome at all. Indeed, this chart suggests that the slowdown in M2 growth since the end of 2008 has been simply a reversal of the much faster growth in prior years. It's not surprising to see the slow growth in Eurozone M2 in recent years, since we know that money has been fleeting Eurozone banks for the relative safety of U.S. banks, and that has shown up as faster M2 growth in the U.S. (As a curiosity, I would note that the long-term growth of both Eurozone and U.S. M2 has been very close to 6% per year.) As has been the case with the Fed, the ECB has simply been supplying liquidity on demand, functioning as a "lender of last resort," which is proper. This has been carried out by effectively swapping bank reserves for longer-dated bonds of various sorts, thus satisfying an intense desire for liquid, safe assets. There has been no massive "printing" of money to date, which is why inflation remains relatively tame.

Service sector continues to grow

The February ISM Service Sector survey reflected decent growth across the board. Nothing in these charts even hints at weakness.

As a counterweight to the relatively weak showing for January capital goods orders, I offer this chart of January factory orders ex-defense, a much larger category. Orders were down 1% in January from December, but up a solid 8.6% over the previous 12 months, and up at a 5.7% annualized pace over the previous six months.

As we see more and more signs of continued growth (albeit growth that is less than we would normally expect to see given the depths of the recent recession), the burden of proof increasingly is shifting to the shoulders of the bears, especially those who are predicting an imminent recession or a substantial setback in the economy's ongoing expansion. Just because the economy is not as strong as it "should" be at this point in the business cycle is not reason to believe that it is at risk of rolling over into another recession. Moreover, Fed governors should be feeling increasingly uneasy with numbers of this sort, since they are not weak enough to warrant an ultra-expansionary monetary policy that promises to be in place for years to come.