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Car sales disappoint, but remain very strong


May sales of autos and trucks came in below expectations (13.7M vs. 14.5M). That makes a total of five series released today—all traditionally volatile on a month-to-month basis—that have been weaker-than-expected (payrolls, unemployment, manufacturing, construction, and auto sales). It's a "perfect storm" of weak news coming on a Friday, amidst escalating tensions in the Eurozone, and so it's no wonder the market sank.

But back to autos. In the past three years, auto sales have risen at an annualized rate of no less 11.7%, even counting May's 4.5% decline from April. That's weak? On the contrary, we have just seen two years of fabulous, double-digit growth in a sector of the economy that was fighting for its life just threee years ago. No one would have dared predict back then that sales would be this strong today.

In any event, the larger trend (see chart above) is much more important than the month-to-month fluctuations. It's very important to remember that the reported number is a seasonally adjusted annualized sales rate, so a rather small change in actual monthly sales, or a slight error in the seasonal adjustment factors, can result in big swings in the reported number. If you were to extrapolate each monthly swing in this series into the future and trade on that basis, you would be whipsawed to death inside of one year.

Going into today's releases, this market was on tenterhooks, fearful that the economy was on the verge of sinking into another recession. It could be mere coincidence that five series came out on the weak side of expectations, or it could be that the economy has lost some forward momentum. It's also important to reflect on the approaching fiscal cliff, which as Larry Kudlow notes is contributing greatly to the market's unease:

If all the Bush tax rates go up, incentives will go down and liquidity will leave the system. You can’t pick up a newspaper these days and not find a story about how the fiscal cliff is elevating uncertainty and slowing U.S. growth. House Speaker John Boehner asked Obama for help in extending the Bush tax cuts this summer. But Obama said no. Instead, he wants to raise marginal tax rates on successful upper-income earners, capital gains, dividends, estates, and many successful corporations.

Where’s the corporate tax reform that would lower rates and broaden the base and end the double-taxation of the overseas profits of American companies? A business tax cut would help enormously, but it’s nowhere in sight. Obama is too busy trashing Bain Capital profits and Romney’s business career, both of which, by the way, have recently been praised by former president Bill Clinton. (It was Clinton, you might recall, who lowered investment taxes and presided over an economic boom.)

The larger trends, however, remain intact: jobs are growing, incomes are rising, sales are rising, layoffs are declining, manufacturing is doing pretty well, and residential construction has turned up after 5 years of decline. The economy doesn't change on a dime, and not even 5 disappointing reports in one day can disprove that.

Oil price update


Crude oil prices have fallen rather sharply since late February, down almost 25%. This is likely the result of oil production being up, demand being a little softer than expected, and crude oil inventories reaching a new all-time high (but only 3% above their year ago levels). In other words, crude production responded to the high prices we saw earlier this year by increasing, and demand responded by weakening. Consumers are now breathing a little easier as prices decline to a new clearing level.



Gasoline is still pretty expensive, but the good news is that it's going to get cheaper, as suggested by the second chart above. This chart compares the price of wholesale gasoline futures (white line) with retail gasoline prices at the pump (orange line). Note how retail prices lag futures prices, which is what you'd expect. With the recent declines in futures prices, we can expect gasoline prices at the pump to fall to $3.30/gal. or less in coming weeks; that would represent a decline of at least 15% from the early April highs, and possibly more before all the dust settles. It was just a few months ago that the market fretted over the possibility that rising gasoline prices would amount to a significant headwind to growth, but now that risk is fading.


Meanwhile, the huge decline in natural gas prices in recent years is acting as a big stimulus for the economy, transforming entire industries as they switch from more expensive energy sources to very cheap natural gas.

Construction spending is picking up



It continues to look like the bottom in the construction sector occurred just over a year ago. Spending on residential and nonresidential construction is up 6% and 7%, respectively, in the past year. Total construction spending is up at a 5% annual rate in the past six months.


After it's worst slump ever, residential construction spending is now growing faster than the rest of the economy. The gains are still minimal, but the important thing is that we have turned the corner and conditions are now improving, albeit slowly. Construction will once again be contributing to GDP growth, and that should be the case for many years to come, given its recent steep decline and the ongoing growth in the population: lots of catch-up to come here.

Manufacturing sector still healthy



The May ISM manufacturing report was about in line with expectations, and it didn't change the meme: the manufacturing sector continues to do better than the rest of the economy. As the top chart shows, the current level of the ISM index is consistent with economic growth of at least 2% or better. As the second chart shows, the employment index is actually very high from an historical perspective. So manufacturing continues to expand, and the prospects for future growth remain relatively bright. Nothing to get concerned about here, and no signs of any deterioration.

Jobs growth still moderate

It's been more than 30 years that I've been following the monthly employment report, and I've never understood why it is that the market places so much importance on a single number. Especially since that number can and most likely will be revised significantly in the future, it is subject to seasonal adjustment factors that are never completely accurate, and it is volatile from month to month. I've also never understood why the market focuses on just the establishment survey of jobs and almost completely neglects the household survey. Both have their problems, and sometimes they can diverge a lot, but over time they tell the same story, only from different perspectives. I've found that looking at both surveys can be very useful, and I make a point of doing that on this blog. The household survey is especially important to follow in the early years of a business cycle expansion, because it can pick up the growth of small start-up companies which aren't covered at all by the establishment survey until future revisions which match the survey data to tax records.

I also try to focus just on the growth of jobs in the private sector, since that is where the real action is. It makes even more sense these days, since state and local governments have been shedding jobs. In my view, the public sector has gotten way too big, and cutting it back is not only necessary but actually quite healthy, since it leaves more room for the more-productive private sector to grow. 




According to the establishment survey, private sector jobs growth has been disappointedly low for the past two months: about 85K on average. But according to the household survey, private sector jobs growth has averaged 160K for the past two months. As the charts above suggest, the household survey has enjoyed some pretty impressive growth this year, following a period of fairly slow growth. The household survey is finally doing what it usually does, which is to lead the establishment survey. (Since the low water mark in early 2010, the household survey shows a gain of 5.2 million jobs, while the establishment survey shows a gain of 4.3 million.) I think the household survey should get the benefit of the doubt here, and that's why the title of the post says that jobs growth is still "moderate" rather than disappointingly low. 


The unemployment rate ticked up last month, in part due to renewed growth in the labor force. The labor force is still way below trend, however, since some 5 million people have stopped looking for jobs, either because they have retired or have given up finding one. But if you look closely at the chart above, you will see that the labor force actually has been growing in fits and starts since last summer, and that is a positive sign. If the economy continues to slowly improve and the labor force continues to slowly expand, the unemployment rate is not likely to decline further, and could in fact rise some more, at least until the pace of jobs growth starts picking up.


So I think the market's reaction to today's news has been excessively pessimistic. I don't see convincing signs of deterioration in the outlook; I see an economy that continues to grow at a sub-par pace, and that's been the case for the most of the past three years.

Eurozone default losses are water under the bridge

Forget all the talk about PIIGS defaults and a possible Eurozone banking and/or currency crisis. The losses from lending to Greece, Portugal, Spain, etc., are water under the bridge. The real issue is that Eurozone economies have been doing poorly for many years, thanks to excessive and unproductive spending and bloated governments.


As the chart above shows, the U.S. equity market has been outperforming its Eurozone counterpart ever since 2001. 


This chart quantifies the outperformance, by showing the ratio of the S&P 500 to the Euro Stoxx index since 2001. U.S. equities have outperformed by an astounding 125% since the Eurozone glory days of early 2001. (Correcting for the fact that the Euro has appreciate vis a vis the dollar by some 37% since then, U.S. equities have still outperformed by an impressive 63%.) Europe's underperformance relative to the U.S. would be the equivalent of many trillions of dollars of foregone income. 


It's only been in the last year or two that this outperformance has really gathered speed. The chart above shows the ratio of the two equity indices from the beginning of last year. Here we see that U.S. equities have outperformed by over 40%. (And correcting for the Euro's depreciation against the dollar over this period, US equities have outperformed by over 50%.)

My point here is that the concerns over the eventual size and impact of Eurozone defaults is misplaced. The losses resulting from the profligate borrow-and-spend policies of Greece, Spain, Italy, Portugal, etc., have already occurred in an economic sense. The losses began to accrue from the moment these countries took advantage of the strong euro to borrow money that was used to support lavish lifestyles for public sector employees, corporate cronies, and other beneficiaries of income redistribution. Very little of the money went to productive purposes, so there is nothing to show for it.

It's wise to remember that debt is a zero-sum game in an accounting sense. When Greece declares default, its creditors must take the hit to their bottom line, but the Greek government wins because it has relieved itself of the need to make interest and debt repayments. In the real world, Greece's creditors began losing money many years ago as Greece squandered the money it borrowed. For many years, Europe collectively diverted massive amounts of scare resources to the Southern Eurozone countries, and the money and the resources were consumed rather than invested, so there is nothing to recover.

The real losses are shown in the charts above, and they have manifested themselves in more than a decade of serious economic underperformance. This is the elephant in the room, not the potential impact of PIIGS' defaults on the Eurozone banking system.

Given the degree of Eurozone underperformance, I would be tempted to buy Eurozone equities, but only if and when the PIIGS governments decide to address their true underlying problem. They need to radically cut back the size and scope of their governments, and at the same time eschew any effort to raise taxes to close their funding gaps. Raising taxes only serves to validate the size of government; instead, government must be shrunk to fit the ability of the private sector to afford. This will of course be difficult, since Europe has long been addicted to Big Government, and Big Government will not consent to go into rehab until it has exhausted all other efforts at reform. So I don't see it happening soon, but I'll be watching closely, as will all other serious investors.

And of course, all of this is a timely lesson for the U.S. Our problem is not a shortfall of revenues, it's an excess of unproductive spending.

Corporate profits continue to impress

With today's release of revised first quarter GDP statistics comes the first estimate of corporate profits for the first quarter. I've been highlighting this measure of corporate profits, which comes from the National Income and Product Accounts (NIPA), and adjusts for inventory valuation and capital consumption allowances, for quite some time, since it is 1) based on corporate profits as reported to the IRS, not on profits as reported according GAAP rules (and thus provides what might be termed "true economic profits"), 2) it uses a consistent methodology for measuring corporate profits going back to 1958, and 3) it is an annualized and seasonally adjusted number that arguably provides a more current estimate of profits than the traditional one-year trailing measure of profits that is used to calculate PE ratios. (HT to Art Laffer, who has been making these arguments for as long as I can remember.) 



As the first two charts show, total after-tax, adjusted corporate profits in the first quarter fell 4% from the previous quarter, from $1.576 trillion to $1.511 trillion, but they remain extraordinarily strong relative to nominal GDP. First quarter profits were up 4% from a year ago.


Using the NIPA measure of corporate profits as the "E" in P/E ratios, and using a normalized S&P 500 index as a proxy for the "P" of all corporate equities, I derive an alternative measure of the P/E ratio for the entire corporate sector of the U.S. economy. According to this measure of equity valuation, equities are almost as cheap as they have ever been. Another way to appreciate how cheap equities are is to consider that over the past 20 years, corporate profits have increased 340%, while the S&P 500 index has increased only 250%. Since the end of 2008, by which time corporate profits had collapsed, through the end of this year's first quarter, corporate profits doubled, but the S&P 500 only rose 60%. Clearly, prices have not kept up with the growth of profits.


Even using the standard methodology (dividing the S&P 500 index by one-year trailing earnings), equities look to be relatively cheap: today's PE ratio is 13.2, which is 15% less than they average of the past 50 years.


Although total corporate profits fell 4% in the first quarter, the profits of nonfinancial domestic corporations surged to a new high; thus, the weakness in total profits came mainly from the financial and international sectors, and the strength came from the domestic operations of non financial corporations.


Once again I feature this chart, which I think is very important to bear in mind. Many will argue that since corporate profits are at extremely high levels relative to GDP, they are very likely to mean-revert to their long-term average at some point. That would involve an extended period of very weak or negative growth in profits, and that is enough to given any equity bull nightmares. But in a sense a big drop in profits has already been priced in, because current PE ratios today are substantially below average; it's as if the market already expects to see a mean reversion in profits.

As the above chart suggests, corporate profits relative to world GDP are not unusually high at all, and any mean reversion here would be relatively minor. I think there is a strong case to be made that it no longer makes sense to compare corporate profits to U.S. GDP, since the U.S. economy is much more integrated into global commerce than ever before. One proof of that is in the chart below; in the past 30 years, U.S. exports of goods and services have grown 2 and a half times faster than GDP. More and more companies are able to market their products all over the globe, and the global market (e.g., India, China) has grown by leaps and bounds in the past decade. More and more companies are finding that the market for their products and services has grown by much more than the U.S. market, so it is not surprising that profits have grown far more than nominal GDP. Going forward, corporate profits are likely to average much more than 6% of GDP.

Labor market news is mixed


Weekly unemployment claims last week were slightly higher than expected (383K vs. 370K), but that is well within the normal level of "noise" for this series. At worst, this could be a sign that the downtrend in claims is slowing; still, the unadjusted claims number was down 10.6% from a year ago, and that is a good thing.


This chart highlights what is arguably the most important (and positive) change on the margin in the labor market: the ongoing and significant decline in the total number of people receiving unemployment insurance. Over the past year, that number has declined by 17.6%; 1.22 million fewer people are receiving unemployment compensation checks today than were a year ago. This is significant because it creates meaningful changes in the incentives of workers looking for jobs—when you are no longer paid to be out of work, you are more likely to be searching harder and more likely to accept an offer that you might otherwise have turned down. Tracking changes in incentives is key to understanding the important changes on the margin in the economy. Moreover, we are likely to see more of this in the weeks and months to come, since a growing number of people will be exhausting their eligibility for emergency claims.


The May ADP estimate for private sector jobs growth was a little disappointing (133K vs. 150K), but it suggests that the BLS estimate of payroll changes in May will be up from April's level. Expectations call for the BLS to announce an increase of 160K for May, which is indeed better than April's 130K, but that would still reflect rather tepid jobs growth.

On balance, nothing to get really excited about, but then again there is nothing in these numbers to suggest that the economy is getting worse.

What record-low Treasury yields tell us



As shown in the top chart, 10-yr Treasury yields have never been lower than they are today (1.62% as I write this). Ordinarily, you would expect low Treasury yields to be a sign of low inflation and/or low inflation expectations, but this time around, that's not the case. As the second chart shows, forward-looking inflation expectations, as derived from the pricing of TIPS and Treasuries, are near the upper end of their 15-year historical range and have been rising of late. Forward inflation expectations are slightly higher than the increase in the CPI over the past year (2.3%), and about equal to the average annual increase in the CPI for the past 20 years. In other words, inflation and inflation expectations are alive and well, so the decline in nominal Treasury yields must be symptomatic of something other than inflation. It's also worth noting that real yields on 5-yr TIPS are -1%, and this means that investors are happy to lose 1% of their annual purchasing power in exchange for the privilege of avoiding what they fear will be even bigger losses on just about everything else over the next 5 years. 

The only explanation that fits these facts is that the market is behaving as if economic growth is going to be severely depressed, but without having any negative impact on inflation. That alone is very unusual, since the biggest hit to growth in recent memory (the 2008-9 recession) also produced the lowest inflation expectations ever: 5-yr, 5-yr forward inflation expectations plunged to almost zero in late 2008. This makes sense, however, since the biggest thing happening on the margin is the sovereign debt crisis that is roiling the Eurozone. Europeans are extremely worried about a collapse of the Euro and a return to individual currencies (particularly the Drachma). The collapse of the Euro could bring with it a financial crisis like we saw in the wake of the collapse of Lehman Bros. in 2008, which in turn resulted in a sudden and deep global recession. Plus, it goes without saying that any spin-offs from the Euro are almost certain to result in substantial devaluations, and big devaluations invariably bring with them big increases in inflation.

So the threat of a euro breakup has raised fears of a deep recession accompanied by rising inflation, and with those fears in mind, 10-yr Treasuries yielding less than 2% look like a fabulous safe haven. Europeans are piling into Treasuries since they look like the only lifeboat that's likely to survive. Investors should understand that when the price of safety is extremely high, as it is today, then buying Treasuries in the expectation of making a profit will only work if the future ends up being even more catastrophic than what the market currently expects. By the same logic, buying anything risky in the expectation of making a profit will work as long as the future is less catastrophically bad than is currently expected. In other words, you don't need a robust economy to make money taking risk these days, you just need an economy that avoids disaster. Even a measly 2% real rate of growth in the U.S. economy would be like manna from heaven for investors in risky assets.


So how to explain the fact that, in the face of tremendous uncertainty and expectations of continued inflation, the price of gold (see above chart) has declined by 18% in dollar terms since last September? 

My answer to that rather difficult question is that the market is beginning to realize that the massive central bank easings that we have seen over the past 5 years have not been nearly as inflationary and destructive as the market had feared. At $1900/oz., gold prices had incorporated enormous quantities of fear that have not yet been justified by reality. The future, in other words, has turned out to be much less dire than expected. 


Even after its sharp decline since September, gold has risen by an annualized 14.6% since its low 13 years ago. That's a far cry from Apple's 45% annualized return over the same period, but it beats just about anything else you could hope to have owned. Gold has been priced to very traumatic conditions for quite some time. In real terms, gold today is worth about one-third less that it was at its very brief peak in mid-January 1980, which marked the worst of double-digit inflation fears and a collapsing dollar. But compared to its value at the end of January 1980, gold today is only down 19% in inflation-adjusted terms. In short, gold today is priced at levels that are roughly equivalent to the conditions that prevailed in early 1980, when the world feared recession, a collapsing dollar, and a continuation of double-digit inflation. Conditions might not be all that much better today, but they are almost surely no worse. 


In inflation-adjusted terms and against a broad basket of trade-weighted currencies, the dollar is actually a bit weaker today than it was in early 1980, but inflation and inflation expectations are significantly lower. 

If I had to sum up what all this means, I would say that the evidence of market prices points to a very high level of fear, uncertainty and doubt among global investors. Today's record-low 10-yr Treasury yield is just the latest sign that investors are consumed by fears. When emotions reach such heights, as they did in the early 1980s and in late 2008/early 2009, investors willing to bear risk stand a good chance of being rewarded, provided the future turns out to be less awful than the market expects. 

Housing price update


According to the seasonally adjusted Case Shiller index, housing prices actually rose a bit (about 0.2%) in the first quarter of this year. According to the non-seasonally adjusted Radar Logic data, prices rose about 3%.


As the chart above suggests, the rate of decline in housing prices has moderated quite a bit in recent years.


Adjusted for inflation, the Case Shiller data for 10 large metropolitan areas shows that prices declined about 3% in the first quarter. Real home prices by this measure are still about 10% higher today than they were in 1990. But since the cost of a mortgage in 1990 was about two and a half times higher than it is today, and real disposable incomes have increased over 70% since 1990, housing prices are best thought of as being incredibly cheap.


This chart compares the rise in home prices as measured by Case Shiller, and the BLS' estimate of the rental equivalent of home prices has been. Housing prices and rents have come back into line.

All the evidence to date suggests that there has been a major pricing adjustment in the U.S. housing market, and that this has been sufficient to clear the market. Anecdotal reports from a number of areas in the country now suggest that activity and prices are beginning to pick up. While we may see a bit more softness in these indices before they turn up (bear in mind that they are produced with a lag of at least three months), prospective homebuyers would be wise to view the glass as half full rather than half empty (i.e., prices are more likely to be higher a few years hence than lower).

Good advice from "Spengler"

David Goldman, a long-time supply-side friend, seems to have found his stride channeling Spengler. His most recent article, Lessons from Europe's Winners and Losers, is a fresh look at the problems of the Eurozone. Germany is doing things right, and the Southern Europeans are doing things wrong. There will be large bankruptcies, but the world is not going to end:

Don’t believe the reports that a new Lehman-style financial crash is in the offing. What’s going to happen is much less dramatic. In 2008 no-one knew how to value Wall Street’s liabilities (for example, AIG’s famous guarantees on subprime securities). Now the full extent of the problem is known to everyone. It’s just a negotiation now over who gets knackered. And the answer, by one means or another, is the southern Europeans.
Spain probably has to spend the equivalent of 20% of GDP bailing out its bankrupt banks. It won’t quite bail them out: the $85 billion of subordinated debt of the banks — two-thirds of which is owned by individuals — will be vaporized, so Spaniards will lose a good deal of their savings. If Spain has to reduce debt payments to creditors like Greece, other European banks (mainly French) will get hung out to dry just like the Spanish banks. Their subordinated debt will vaporize, and the French will lose a large part of their savings. It’s easy to fix a financial crisis when you can put the damage back to individuals, insurance companies and pension funds. A lot of Europeans will get poor, fast. And the Chinese, or the Germans, or the Canadians, or someone with ready cash will come in and recapitalize the bankrupt banks. The Germans will be left with a lot of loans to the European Central Bank. They’ll live with it.

This reminds me of my Carmaggedon analogy, in which I argued that the PIIGS debt crisis was fundamentally different from the financial crisis of 2008, mainly because it's so much easier to understand what's at stake:

... back then the market found it almost impossible to value the thousands of often obscure and arcane mortgage-backed securities that were tied to many millions of homes whose prices were tumbling at different rates all over the country. With the PIIGS crisis, we are dealing with only a handful of borrowers who have issued fairly straightforward debt securities. 

I also argued that this time around the markets have had plenty of time—years—to get adjusted to the idea that there will be large debt write-downs in Europe. With so much advance warning, and with relatively transparent facts and securities to deal with, it is very unlikely that we will see a collapse of the Eurozone or the global banking system; lots of pain and anguish, to be sure, but not a collapse. 


That's why Eurozone swap spreads are not soaring, and are well below last year's highs. There are still problems in Europe, but they don't spell the end of the world as we know it.

The clamor in Europe these days is all about who is going to get stuck ("knackered," as David so crudely puts it) with the losses. As I pointed out last July, from an economic point of view the losses happened long ago. The losses happened when "the feckless Greeks, Spaniards, and Italians used the euro system to borrow money to pay themselves more than they are worth," as David notes. The money was borrowed and wasted. This is a true economic loss: scarce resources were used for no productive end. This loss cannot be erased, and it has already been reflected in several years of lost Eurozone output, declining living standards, and high unemployment. The only thing we don't know yet is who will be left without a chair when the Eurozone music stops. 

If Greece follows the leave-the-euro-and-return-to-a-devalued-Drachma route, then the losses will be shared by the entire Greek private sector, and the government will be the sole winner (devaluations are essentially a quick and dirty way for the government to collect taxes from the private sector). If Greece stays in the Euro, then sooner or later the government will have to shrink and the salaries and benefits of lots of Greeks will need to be cut. Either way, it's all about who will have to bear the loss, not whether there will be a loss.

The sooner the Europeans realize that they can't make the losses go away, the sooner their economy can get back on its feet.