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More optimism, or less pessimism?


The University of Michigan's May Index of Consumer Confidence turned out to be much higher than expected (79.3 vs. 77.8), and the headline sounded breathless: "Consumer confidence rose in May to the highest level since October 2007 as Americans became more upbeat about the prospects for employment."

I think there is another way to interpret this. Rather than seeing the rise in confidence as a sign of growing confidence in the future, I see it as a sign that Americans are become somewhat less concerned about the future. After all, the May reading was similar to or even lower than what we have seen during several past recessions. In other words, for most of the period from 1983 through 2006, a reading of 79.3 would have been considered shockingly low. Optimism is still in very short supply these days.

Slow progress, but not a recession, and that's bullish

When analyzing incoming economic data, it is important to view it from the perspective of the market's expectations. In my view, the extremely low level of Treasury yields (and the same goes for sovereign yields in most developed countries) is a strong sign that the market's growth expectations are dismal at best, and downright dreadful at worst. Similarly, price/earnings multiples on the S&P 500 of 13.4 and forward multiples of 12.2, at a time when corporate profits are at all-time highs, both in nominal terms and relative to GDP, can only mean that the market is expecting a significant decline in future earnings, which in turn is likely only if the economy is on the verge of another recession. Moreover, when there are $6.3 trillion of retail savings deposits earning almost zero at a time when earnings yields on equities are 7.5%, one is forced to conclude that a significant portion of the population is still in the grips of fear. In short, both the bond and stock markets are priced to the expectation of an imminent recession that could prove substantial.

With that said, today's economic releases reflect an economy that is improving, but only slowly. Is that something to worry about? No, because even a slow-growing economy is much better than what the market is expecting. In that light, today's news is a reason to be bullish.


The level of weekly unemployment claims has been choppy of late, but shows no sign of any deterioration in the economy. As the above chart suggests, the recent correction in equity prices is just that, a correction; the market was worried that the rise in claims in early April was a harbinger of another recession, but as it turns out it was most likely just an artifact of seasonal adjustment problems. Non-adjusted claims have been low and flat for the past several months, and last week's number was down 13% from a year ago, so on balance claims are still pointing to a slowly improving labor market. In the absence of any actual deterioration, stocks are likely to turn back up.


The number of people receiving unemployment insurance continues to decline, and is down 17% from a year ago. This is a positive indicator, since it means that those who are still looking for jobs have a greater incentive to find and accept job offers. And of course, it also reflects the fact that the ranks of the employed continue to expand, albeit relatively slowly.


New orders for capital goods, a proxy for business investment, have shown almost no growth since last summer. This is disappointing, since it would be much better to see continued increases. But it is not a sign of recession, and at worst it simply reflects what might be termed a economic "soft patch."


Swap spreads are good indicators of systemic risk, and they can also be good leading indicators of overall economic conditions. In the chart above we see that spreads in the Eurozone are quite elevated, and that makes sense given the ongoing difficulties with sovereign default risk. U.S. spreads have inched higher, but are still well within the range of "normal." Europe is having problems, but the U.S. has so far been unaffected, even though the market continues to worry about contagion risk.


As this chart of credit default swap spreads shows, the market is still quite worried about the risk of corporate default risk. Spreads today are at levels that we saw at the beginning of the last recession, and this is a clear sign that the market is priced to a recession, even though we have yet to see any signs of a downturn.


As a reminder, the chart above shows the trailing PE ratio of the S&P 500. At 13.4 today, it is approximately equal to what it was at the end of 2008, when the market fully expected a multi-year global recession/depression and years of deflation.


And as another reminder, this chart shows after-tax corporate profits as a % of GDP. We've never seen anything close to this good. The market's current PE ratio can only imply the expectation that profits are going to collapse, and that would only occur if the economy lurches into another recession.


Skeptics will be quick to point out that corporate profits are likely to exhibit mean-reverting behavior relative to GDP, and so today's very high level almost guarantees that profits are going to significantly underperform in the years to come—and thus the market is correct in assigning a very low multiple to current earnings. My rebuttal comes in the chart above, which shows that as a % of world GDP, corporate profits today are not unusually high at all. The globalization of most large corporations has brought significant advantages to U.S. business. Firms that can address a significantly larger global market can expect to earn profits that far exceed what was possible when U.S. firms were limited to just the U.S. market. Think Apple, which appears to have doubled its share of the booming Chinese smartphone market in just the past quarter.

The U.S. news may not be very exciting these days, but it is far better than the market's expectations. Thus I think it pays to remain bullish, even in the face of the "fiscal cliff" that is approaching at year end. The world is rapidly learning that lots of government spending does little or nothing to boost an economy, and that less government intrusion in the economy is much better for growth than boosting taxes. (See my previous post for more on this.) I think it will be very difficult for anyone in Congress to argue convincingly for allowing a big increase in tax burdens to occur starting January 1st. And I don't see a constituency in favor of ramping up government spending either. I note that Congressional gridlock has already resulted in a significant decline in the federal budget deficit as a % of GDP in recent years (from 10.4% to 7.4%), and a welcome decline in federal spending as a % of GDP (from 25.3% to 22.7%).

Good and bad austerity

I've been a friend and admirer of David Malpass for a long time, even though we have not always agreed on the outlook for the economy. Today, David has a very nice op-ed in the WSJ, "Greece's False Austerity," that makes a critical distinction: austerity that shrinks the public sector is good, while austerity that imposes increased burdens on the private sector is bad. This is excellent advice for Greece, just as it is for the U.S. Some excerpts:

The conflict between growth and austerity is artificial and framed to favor bigger government. Growth comes from economic freedom within a framework of sound money, property rights, and a rule of law that restrains government overreach. Businesses won't invest or hire as much in an environment where governments dominate the economy. Thus, government austerity is absolutely necessary for economic growth in both the short and long run. 
Economics has often ignored the critical distinction between austerity for the government and government-imposed austerity on the private sector. In the former, governments which are over-budget sell assets, restrain their hiring, and limit their mission to essentials. That's growth-oriented austerity. 
In the private-sector version of austerity, governments impose new taxes and mandates on the private sector while maintaining their own personnel, salaries and pensions. That's the antigrowth version of austerity prevalent in Europe's austerity programs.Many economic models, including the U.S. Congress's budget scoring system and Keynesian stimulus, ignore national debt levels and disregard whether spending decisions are made by the private sector or the government. This creates the absurd result that an economy in which the government spends and invests increasing amounts—even 100% of GDP—has the same projected growth rate as an economy where the government spends and taxes less. 
As the U.S. struggles with tax reform, deficit reduction and the year-end fiscal cliff, it will be critical to distinguish between reforms that downsize the government and reforms that downsize the private sector and put the dollar at risk. One approach points to growth, the other to Greece.

UPDATE: The Centre for Policy Studies yesterday published a study of 28 OECD countries that finds "that the size of government as a proportion of GDP is a major influence, controlling for other factors, on a country's rate of economic growth. If you want growth, scaling back the state should be an aim whether you have a deficit or not." Furthermore, the study finds that "other things equal, countries with small governments and with small tax burdens grow faster," and "pupils in small-government countries achieve significantly better results in reading, math and science than those in big-government countries."

The good news is spreading: cutting back on bloated government spending is not austerity, it is one of the best ways to stimulate an economy.

How natural gas stimulates the economy

Mark Perry has a post today which makes a very important point: thanks to new fracking technology, natural gas has become abundant and very cheap; this in turn has created savings of $350 billion for end-use customers over the past three years, many thousands of new jobs, and it promises to revolutionize manufacturing in this country in coming years. In short, one new idea (how to get natural gas out of shale) has allowed the U.S. economy to produce much more energy with a given amount of resources, and abundant and cheap energy has allowed consumers and companies all over the country to devote more of their scarce resources to other purposes. This is how jobs are created, not by increased government spending or artificially stimulating demand, but by producing more with less effort. Growth comes from increased production, increased productivity, and increased investment. As F. Say famously said, supply creates its own demand. I can think of no better way to illustrate why the supply-side view of how the economy works is better than the Keynesian demand-side view.


Here's an updated chart of natural gas prices. Prices are up this month, but are no higher than they were 15 years ago, and only slightly higher than they were 20 years ago. Oil prices, of course, are 4.5 times higher today than they were 20 years ago.


Relative to oil, natural gas prices have literally collapsed. Relative to oil, natural gas prices have fallen by roughly 80% compared to the late 1990s. We have only just begun to see the impact of this incredible development on the U.S. economy's ability to grow.

Obama's tipping point

I think we have seen the tipping point at which Obama's reelection prospects begin what could be a relentless decline. His policies were arguably the main reason the economy has done so poorly in recent years, and now we begin to see that the real problem is his total lack of understanding about how economies and markets work, compounded by an amazingly inept campaign. Romney should have no trouble convincing a majority of voters that he will be a better steward of the economy. Jennifer Rubin, an outstanding political observer writing for the Washington Post, makes this chilling point in her blog post today:

I confess that not in my wildest dreams did I imagine President Obama’s campaign would be so awful. Oh sure, I knew it would be “awful” in the sense of going negative, being disingenuous and blaming everyone for his failings. But I was taken by surprise by how “awful,” in the sense of incompetent and ham-handed, it has been. 
Virtually every gambit and issue (“war on women,” gay marriage, and now Bain) has gone haywire, arguably inflicting more damage to Obama than to Mitt Romney. 
Either Obama is preying on the public’s ignorance in a transparent effort to distract them from his rotten record, or he’s economically illiterate, soaked in the rhetoric of the left with no real feel for the American economy. (These are not mutually-exclusive explanations.)

Obama is at best an empty suit and ignoramus when it comes to our economy.

This chart of Obama's chances of winning reelection needs no further explanation:


UPDATE: As of June 4th, this prediction seems to be on track:


More signs of a housing upturn


Existing home sales in April were close to expectations, but as this chart shows, the pace of sales has been improving: sales are up 14% since last July.


It's also nice to see that prices are bottoming/improving as well; this chart shows the median price of existing single family homes, adjusted for inflation. Over the past year, real prices have jumped about 8%. The chart also suggests that real home prices have found support at levels that have prevailed over long periods. In short, the housing bubble has burst and prices have finally returned to sensible levels. The repricing of the U.S. housing stock has allowed the market to clear; we've seen the worst, and now things are beginning to improve on the margin.


But not only have prices become reasonable from an historical perspective, the cost of purchasing a home relative to median family incomes has now fallen to record-low levels, as shown in the chart above of housing affordability.

The evidence is becoming very strong that at the very least we have seen a bottom in the residential housing market.

Euro update

With the world's worst fears dominated by events unfolding in the Eurozone, and with the euro's continued existence a key question, I offer some charts which perhaps provide some useful perspective. Despite all the fears of cataclysmic outcomes, the euro has actually strengthened vis a vis the dollar since its 1999 inception, and the euro today is trading about 10% above its purchasing power parity relative to the dollar by my calculations. This suggests that the ECB has been doing a pretty good job of defending the euro—better even than the Fed.


The euro today is slightly higher against the dollar than it was at its inception. It's been a long roller-coaster ride, but I see nothing here that would point to an imminent collapse. What seems more likely is a further gradual decline of the euro vs. the dollar.


The euro (using the DM as a proxy going back prior to the inception of the euro) has been trending higher against the dollar for the past 40 years, primarily because inflation in Europe has been lower than in the U.S. Purchasing power parity theory conforms with this experience; the currency with lower inflation should outperform, over time, the currency with higher inflation (the inflation differential between the U.S. and the Eurozone is reflected in the green line on the chart). The inflation differential that has favored the euro is ultimately the result of tighter monetary policy in Europe. The gap between the blue and green line suggests that the euro is about 10% "overvalued" against the dollar, which means that an American tourist in Europe is likely to find that most goods and services cost about 10% more in Europe than they do in the U.S. By the same logic, European tourists to the U.S. are likely to find that things are about 10% cheaper here.

The ECB can take credit for maintaining the purchasing power of the euro even as the world's demand for euros has weakened as a result of the Eurozone crisis, even as the world's demand for safe-haven currencies has been intense, and even as the Eurozone financial crisis has required the ECB to inject massive amounts of liquidity to shore up its banking system. But the strains are showing, and I think the euro is likely to weaken some more.


This chart shows the price of gold in the world's three major currencies. Here again we see that the dollar has lost purchasing power against the euro (because the price of gold has risen more in dollar terms than it has in euro terms). The yen has been the strongest currency of all for the past several decades; the price of gold in yen today is still less than it was at the gold's peak in the early 1980s.

The dollar is weak against the great majority of the world's currencies, and the Fed's Real Broad Dollar Index shows indeed that the dollar is very near its all time lows. But the euro's resilience in the face of great adversity, and the dollar's rather extreme weakness in general, don't mean the dollar is doomed. I've been arguing for awhile that the dollar was likely to rise this year against other developed currencies, because I think the economy is going to end up doing better than expected, and I continue to believe a stronger dollar is likely. The ECB is going to have a tough time maintaining its tight-fisted stance (relative to the dollar, that is), since the Eurozone financial system is still far from being out of the woods, and the Bank of Japan already is making a real effort to keep the yen from appreciating further. If the ECB and the BoJ have to further expand their balance sheets to achieve their goals, this could result in additional supplies of euros and yen relative to the dollar, thus supporting the dollar's value in a relative sense. And if the U.S. economy continues to beat expectations, then demand for the dollar could strengthen, and that in turn could provide a tailwind for the Fed's efforts to drain liquidity as the economy improves.