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So. California bankruptcy filings plunge


My son-in-law, a lawyer specializing in bankruptcies, points me to some rather surprising information: bankruptcy filings in California's Central District (So. California less San Diego county), home to some 19 million people, were down by over 30% in the 12 months ended June 2012. You can see the data in the chart above. Looks to me like things have improved rather decisively in the past year. Well, they've "improved" in the sense that the news is a lot less bad. But that's still welcome progress.

Federal budget update



These charts summarize the current state of the Federal government's finances. The best thing to be said is that revenue growth has outpaced spending growth since the end of the recession, with the result that the deficit has declined both in nominal terms and as a percent of GDP. The worst thing, however, is the deficit is still $1.23 trillion dollars over the past year. In the "thank goodness for small favors" department, spending as a percent of GDP has dropped from a high of 25.3% in 2009 to 23.5% today. That's still higher than during the peak of the early Reagan years, however.

One other thing to note is the dismal performance of revenues in recent years. They have risen, but at a very slow pace, and that is almost entirely due to the fact that the recovery has been miserably slow; the tax base is still way below where it was pre-recession.

The best way to fix the deficit is to keep revenues from rising in nominal terms (as has been the case since mid-2009), and find ways to boost employment. Allowing the Bush tax cuts to expire for those earning over $250K, as Obama has proposed, won't do anything to achieve that goal. More likely, it would retard the growth of employment since taxes on capital would rise significantly, hurting small business owners and entrepreneurs the most. Soaking "the rich" for a few extra dollars has a payoff that is much lower than the payoff of an increase in the size of the workforce.

The euro comes back to earth


The euro has fallen almost 15% in the past year against the dollar, and it is off almost 25% from its 2008 all-time highs. Is this a disaster? Hardly. As the chart above shows, the euro is now worth almost exactly what it has averaged against the dollar since its inception in 1999.


As this next chart suggests, just about the same can be said for the euro's purchasing power relative to the dollar. On an inflation-adjusted basis, the euro today is worth only slightly more (about 6%) against the dollar than its average over the past 40 years. (The green PPP line is my estimate of the euro/dollar exchange rate that would equilibrate prices between the U.S. and the eurozone. When the actual exchange rate trades above its PPP value, then prices in Europe are higher than in the U.S. Today's rate suggests that a U.S. tourist to the eurozone will find that prices are only about 6% higher on average than they are in the U.S.)


It's interesting that despite all of the huge and well-publicized problems plaguing the eurozone today, the euro is not undervalued, at least against the dollar. However, both the dollar and the euro are very weak—and, I would argue, undervalued—relative to gold, as the chart above suggests (I have created a synthetic euro back to 1978, based on the value of the DM, with the idea that the euro is basically an extension of the DM). Over the past 35 years, the yen has held its value against gold far better than either the euro or the dollar. From a long-term perspective, the dollar and the euro have been tracking each other fairly well against gold and against inflation-adjusted prices.

What this suggests is that if you believe that really bad things have yet to happen in the Eurozone, then shorting the euro vis a vis the dollar is not such a bad idea, since the euro's value today does not appear to be distressed at all.

The big drop in claims is probably temporary


Weekly unemployment claims came in way below expectations (350K vs. 372K), but this likely has more to do with faulty seasonal adjustment factors than with any significant improvement in the labor market. On an unadjusted basis, claims actually rose by 70K, to 440K. So what happened is that the increase in actual claims—due to scheduled layoffs in the auto sector—was less than the seasonal factors expected. Actual claims were almost 15% below the level of a year ago, but there's a chance we'll see adjusted claims tick back up in a few weeks once this seasonal noise is past. Nevertheless, it remains the case that there is nothing about claims that points to any deterioration in the labor market or in the health of the economy.


As an aside, this next chart shows that as a percent of the people working, claims as of last month are fairly low when viewed from an historical perspective. Even when the economy was booming in the mid-80s, a bigger percentage of the workforce was getting laid off than today. That's not to say the economy is healthier today, but rather that there would appear to be less uncertainty today about what the future holds for those who have a job. 

17 reasons the U.S. is not in recession

The folks at ECRI, led by Lakshman Achuthan, say that the U.S. economy is in a recession. We won't know for sure for quite a while, and the answer may depend on what one's definition of a recession is, but I'm willing to say we aren't in a recession, and I've got some charts and reasons to back me up. 17 charts, in fact.


This chart shows the real Fed funds rate, arguably the best measure of how "tight" monetary policy is. Every recession in the past 50 years has been preceded by a significant tightening of monetary policy, as the Fed tries to slow the economy and/or reduce inflation pressures. A high real funds rate pushes up borrowing costs all across the yield curve. This in effect starves the economy of funds, and shuts off weaker borrowers from credit. Today, however, conditions are the exact opposite. The Fed is actively encouraging borrowing by keeping real borrowing costs extremely low and supplying almost $1.5 trillion of excess reserves to the banking system to make sure there is no shortage of money.



The slope of the Treasury curve has traditionally been an excellent indicator of where the economy is in the business cycle. The curve is usually flat or negative in advance of recessions, and then flips to being very positive in the early years of a recovery. The first of the two charts above shows the difference between 2- and 10-yr Treasury yields, which is arguably the best measure of the yield curve's slope. The difference is usually very low or negative prior to recessions, because Fed policy is tight, pushing up short-term rates relative to longer-term rates. When the Fed becomes exceedingly tight, the market begins to sense that the economy is slowing down, and that in turn leads to expectations that the Fed will soon begin to lower rates; that causes the curve to flatten since short-term rates are projected to be lower in the future. Today the curve is still positively sloped by a decent amount, which means that the market expects the Fed to raise rates in coming years as the economy gradually improves. The second of the two charts above combines the real funds rate and the slope of the Treasury curve to show that every recession in the past 50 years has been preceded by a very high real funds rate and a negatively-sloped Treasury curve. Taken together, these two indicators suggest that the odds of a recession are very low.


Credit spreads are a good measure of how risky corporate debt is perceived to be. Credit spreads tend to rise in advance of recessions, because the Fed is restricting credit and making borrowing costs high. Moreover, the market senses that tight money is likely to slow the economy, and that puts weaker borrowers at greater risk of default. Swap spreads are arguably the best credit spread to focus on, because swap spreads have tended to be leading indicators of systemic risk and are direct indicators of the health of the financial system. In the chart above we see that swap spreads are very low, suggesting that the economy is not facing any unusual risks, the banking system is quite healthy, and there is no shortage of liquidity. Credit spreads are a little high, but this is mainly due to the fact that Treasury yields, the benchmark against which all credit yields are measures, are unusually low. The yield on A1-rated Industrial paper today is at an all-time low of 1.44%. Clearly, the market is not at all concerned about the health of these companies.


Credit Default Swap spreads, such as shown in the chart above, are very good and liquid measures of the average default risk of a large number of large corporate borrowers. Here again we see that spreads are somewhat elevated, but still far lower than they were during the last recession. Indeed, they have been trading around current levels for most of the past few years. On the margin, they have been declining, which would suggest that the risk of a recession has been receding of late.



Residential construction has moved in and out of slumps at the same time as the broader economy in every business cycle in the past 50 years. The recent housing slump was the worst and longest-lived, but it has finally reversed. Housing starts are up 48% from their recession lows. The beginnings of a housing recovery are also evident in the fact that both residential and nonresidential construction spending are beginning to turn up.





As of May, industrial production in the U.S. showed no signs of deterioration, having risen at a 4.7% annualized rate over the past six months, and rising 4.6% over the past year. Subtracting the output of utilities, manufacturing production is up at a 6.1% annualized pace over the past six months. The ISM survey of the manufacturing sector has been weak in recent months, but the index is still consistent with growth in the overall economy of 2% or so. (see second chart above) As of June, the ISM survey of manufacturing  employment showed no signs of any weakness; indeed, it registered a relatively strong 56.6. If manufacturing conditions were deteriorating, the majority of firms would not be planning to expand employment.


The establishment survey of private sector employment has been relatively weak in recent months, but the household survey has been relatively strong. Neither survey shows any signs of turning down. The economy is weak, to be sure, but if employment continues to grow then I doubt this will prove to be a recession.



First time claims for unemployment have only ticked up marginally over the past few months. There is a lot of seasonal noise in this series, but no reason so far to suspect that the labor market is deteriorating, and that is confirmed by the Challenger tally of corporate layoffs, which is quite low.


Commercial & Industrial Loans outstanding continue to rise at double-digit rates. Banks are relaxing lending standards, and companies are willing to borrow, a good sign of rising confidence, and a clear sign that credit conditions, which have been very restrictive, are improving.


Consumer confidence tends to be a lagging indicator, and it remains quite low. Recessions tend to catch nearly everyone by surprise, especially consumers. Note how confidence is typically high going into a recession. Recessions happen when the future fails to turn out as expected; companies expand only to find that their market has shrunk; consumers borrow and spend, only to find that they've lost their job; builders build, only to find that there are no buyers. But with nearly everyone still quite pessimistic about the future, it is unlikely that businesses or consumers are "over their skis" and vulnerable to a slowdown. Caution still reigns.



Consumers have been deleveraging over the past several years, another sign of caution. As of last March, credit card delinquency rates continued to decline at a fairly impressive pace. Consumers have pulled back, and their balance sheets are healthier as a result. Households' financial burdens are about as low as they have been in the past 30 years. This effectively provides a cushion against recession.

There is no way to be sure about this, I'll admit. Plus, much of the data in these charts is a month or so old, and subject to revision. (Financial data such as interest rates and swap spreads, however, are as of today.) But I think the preponderance of the evidence suggests that the U.S. economy continues to grow, albeit at a relatively slow pace. Moreover, we have yet to see any of the classic hallmarks or leading indicators of recession such as we have seen in the past (e.g., tight Fed policy, rising swap spreads, rising unemployment claims, a flat yield curve, too much confidence).

Financial conditions are actually quite normal


This chart adds to my comments yesterday about reading the market tea leaves. The chart is Bloomberg's calculation of "financial conditions" and it uses the Vix index and swap spreads—two of my favorites—as key ingredients. What it is saying now is that financial conditions are very close to "normal." That's remarkable, given the raging concerns across the pond over the possible default of major countries and the possible collapse of one of the world's major currencies.


This next chart compares the Bloomberg Financial Conditions Index (white line) to the S&P 500 index (orange line). Note that the two move almost in lockstep, with a correlation of 0.94. What that tells me is that even though the economy is muddling along at a 2% growth rate, as long as financial conditions don't deteriorate, there is upward pressure on the prices of risk assets. We see the same relationship between the Vix and the S&P.

Tranquil conditions at the very least serve to nudge investors in the direction of yield, which in the case of the S&P 500 is substantial: the earnings yield on the S&P 500 is currently over 7%, and earnings have grown 11% over the past year. The world simply can't pass up positive yields if conditions don't deteriorate. Which is another way of saying that the market is priced to some very pessimistic assumptions; if those assumptions aren't confirmed by reality, then risk asset prices are likely to rise.


Meltzer: monetary policy is not the problem

Allan Meltzer has always been one of my favorite economists, perhaps because we think alike on so many issues. His op-ed in today's WSJ ("What's Wrong With the Federal Reserve") is a good example of his clear-thinking approach to complex issues:

Consider the response to last week's employment report for June—a meager 80,000 net new jobs created, and an unemployment rate stuck at 8.2%. Day traders and speculators immediately clamored for additional monetary easing. Even the president of the Federal Reserve Bank of Chicago joined in.
To his credit, Mr. Bernanke did not immediately agree. 
But he failed utterly to state the obvious: The country's sluggish growth and stubbornly high unemployment rate was not caused by, nor could it be cured by, monetary policy. Market interest rates on all maturities of government bonds are the lowest since the founding of the republic. Banks have $1.5 trillion in cash on their balance sheet in excess of their legally required reserves—far more than enough to meet any unsatisfied demand for loans that bankers regard as prudent. 

For those that missed it, this echoes my thoughts in a post last week. 

Overseas profits are not really overseas at all

If you read this:

Moody’s Investors Service’s Richard Lane today writes in a note to clients that the “surging” pile of cash of U.S. tech companies that is parked overseas reached $227.5 billion out of a total $457 billion at the end of the March quarter, just counting the holdings of the companies that have $2 billion or more in cash and liquid investments combined.

... you would be very tempted to think that U.S. companies with large overseas cash holdings are depriving the U.S. economy of much needed cash and investable funds. But you would be wrong.

When a U.S. corporation refrains from repatriating profits it has earned overseas, this does not necessary deprive the U.S. economy of those funds. That's because the decision to hold cash in overseas accounts is mainly an accounting and taxation issue, not a decision about where the cash should be invested. A great deal—most likely the vast majority—of the overseas-held profits of U.S. corporations is actually invested in U.S. banks, bonds, and equities. Apple and many other companies have investment shops in Nevada, among other places, where their overseas profits are managed. That cash is held in the name of a foreign company in order to avoid being double-taxed—first at the foreign location, then in the U.S. if the funds are repatriated. It is invested in much the same way that domestically-sourced profits are invested. If there is any "culprit" here it is the U.S. tax code, which insists on the double-taxation of foreign profits. Companies with foreign-sourced profits are quite sensibly trying to avoid that onerous taxation burden by leaving the money in their offshore entities. The only one being "deprived" of these foreign profits is the IRS, not the U.S. economy.

Reading the market tea leaves

What follows is a brief recap of what I think are the key indicators of market sentiment and their implications. Conclusions: markets are priced to very pessimistic growth assumptions; the risk of catastrophic failure has declined meaningfully; financial markets are for the most part liquid and functioning; risk-aversion is still extremely high; deep-seated fear and uncertainty have been replaced by a conviction that there is little hope for any meaningful growth in the global economy for the foreseeable future.


This first chart compares the Vix Index (a proxy for fear and uncertainty) with the S&P 500 (a proxy for the value of the U.S. equity market). Every major selloff in equities in recent years has been driven accompanied by a rise in fear and uncertainty. Fear and uncertainty have now declined to levels that are only modestly elevated, and equities are, not surprisingly, approaching their pre-recession highs.


However, profits as a % of GDP are now very close to their all-time highs, and are more than 40% above their pre-recession highs. The PE ratio of the S&P 500 is more than 20% below its pre-recession level. Therefore, it seems clear that the market is very pessimistic about the prospects for growth and profits in the years to come. 


The Vix index (a good proxy for the market's fear level) is still somewhat elevated, but it is much lower today than its prior peaks. Each episode of rising fear has resulted in an equity market selloff, and each time fear subsides, equity prices have risen. The current episode of declining fear is no exception. Currently, with 2-yr swap spreads firmly in "normal" territory and the Vix index not too far above its "normal" range of 12-15, .......


10-yr Treasury yields are at all-time lows. This not only reflects the market's fear that prospects for U.S. growth are dreadful, but also the global market's extreme risk-aversion.  


10-yr TIPS real yields are at all-time lows. Yet the difference between 10-yr nominal and real yields—the market's expected average inflation rate over the next 10 years—is 2.1%, which is only slightly below its 10-yr average. Despite the extremely weak recovery to date, and the economy's estimated 12% "output gap," inflation expectations have not turned negative. In fact, 5-yr, 5-yr forward inflation expectations embedded in TIPS and Treasury pricing are currently 2.6%; this in turn suggests that the risk of deflation is not a major concern for the market. That follows from the fact that the dollar is very close to all-time lows, the fact that Fed policy is both admittedly and in fact ultra-accommodative. 


Real yields on TIPS are heavily influenced by the economy's recent and expected growth potential. Investors who buy a 5-yr TIP with a real yield of -1% have the alternative of buying the S&P 500 index, so on a risk-adjusted basis (TIPS are default-free, whereas equities are not) they must be relatively indifferent to this choice, which in turn implies that expectations of real returns on equities are very low. If this chart is any guide, the -1% real yield on 5-yr TIPS suggests that the market expects zero real growth in the U.S. economy over the next few years and by inference, very low real returns on equities.


The Vix index is low, suggesting that the market is much less worried about the uncertainties of the future than it was just a few months ago. Since 10-yr yields are also very close to all-time lows, this suggests that the market seems relatively confident that the outlook for U.S. economic growth is dreadful. However, the prospect of very weak growth for the foreseeable future has not led to the catastrophically distressed valuations that we saw following the Lehman collapse and the past two outbreaks of Eurozone fears. Still, the ratio of the Vix to the 10-yr yield remains very high from an historical perspective, suggesting that valuations are still very distressed.


Despite the market's periodic attacks of fear in recent years, the gradual improvement in the economic fundamentals of the U.S. (in the case of this chart, the declining level of weekly unemployment claims) have provided support for the equity market. Eurozone fears are one thing, but so far the U.S. economy has proved to be quite resilient to any Eurozone contagion. As long as the U.S. fundamentals fail to deteriorate, Eurozone fears are likely to prove temporary and fleeting. 



2-yr swap spreads are good proxies for the degree to which banking systems face systemic failure. U.S. spreads today are firmly in "normal" territory, while Eurozone spreads have retreated significantly from last year's highs. 


This last chart compares Euro basis swap spreads (a measure of how difficult it is for Eurozone banks to get dollar funding) with 2-yr Eurozone swap spreads (a measure of systemic risk and the health of the Eurozone banking system). Both have declined this year by a substantial amount, thanks to aggressive efforts by the Fed and the ECB to supply much-needed liquidity to financial markets. Europe is not out of the woods yet, to be sure, but the risk of catastrophic failure has declined significantly. Liquid markets are the private sector's best chance to get things fixed, by distributing risk from those who don't want it to those who do. To judge from this chart, the Eurozone is making important progress.