Main menu

Federal budget update: modest improvement


The chart above tracks the rolling 12-month total of federal spending and revenue. From my perspective, the most notable thing to observe here is that spending has been relatively flat for the past three years. In fact, since the end of 2009, federal spending has increased by only 2%! Thanks largely to a deadlocked Congress, this "austerity" has brought spending down from a high of 25.2% of GDP in 2009 to 23.5% today. That still leaves the government commandeering a greater portion of GDP than at any time since WW II, but it is progress that cannot be denied, even by ardent conservatives. If Congress can keep this up we will eventually balance the budget without the need to raise anybody's tax rate.


The top chart also shows that federal revenues have been increasing fairly steadily since the end of 2009, and are now up by a total of over 18%! The chart above shows how monthly receipts have exceeded those of the prior year in most months this year. This is a natural part of every recovery, as incomes rise, the number of workers increases, and corporate profits rise. Revenues are still unusually weak for this stage of the business cycle, but that's mainly due to the very weak recovery and the still-large number of unemployed. The best way to boost revenues is to boost the economy.


Thanks to very slow growth in spending and the continued rise in revenues, the federal deficit has declined from a high of 10.5% of GDP in late 2009 to 8% as of last June. That's still painfully large, but it is below the 9% level that is said to be something like the point of no return—beyond which deficits can become destabilizing and the economy spirals downward.


According to my projections, by the end of this year outstanding federal debt held by the public (thus excluding debt the government owes itself, e.g., to social security) will reach approximately 75% of GDP. The chart above puts this into context, tracking the increase (red) or decrease (green) in the federal debt burden (best defined by comparing debt outstanding to GDP) by Presidential terms. Even though Obama can correctly claim to have overseen a very slow rate of growth in federal spending, he will have presided over the largest 4-year increase by far in the federal debt burden since WW II.

Romney makes the perfect VP choice

I've long been a big fan of Paul Ryan, so I am thrilled with Romney's VP choice. The Romney-Ryan ticket represents the single best hope for reforming our runaway government and reviving our sickly economy. If the people do not respond to this overwhelmingly in November, then the future of our country will be in serious doubt.

UPDATE: For a fairly comprehensive look at the origins of Paul Ryan's approach to policymaking, see  this article by John Podhoretz.

Exports continue to impress


U.S. exports have contributed significantly to economic growth in recent years. As the chart above shows, exports of goods (stuff actually made here) are at an all-time high, and have exceeded their 2008 high by 10.6%. Goods exports were up at an annualized rate of almost 8% in the first half of this year, despite the weakness in the Eurozone.


As the above chart shows, the U.S. economy continues to become more "internationalized." Exports are now at an all-time high relative to GDP, having grown 275% more than the economy as a whole since 1970. It should also be clear in this chart that the trade deficit has narrowed considerably, from a wide of almost 6% of GDP in 2005 to just over 3% today. Almost all of the improvement has come from increased exports. That is the right way to solve a deficit problem: grow.

Of course, the flip side to the narrowing of the trade gap is a reduction in the size of capital inflows. Foreigners are now less willing to invest the proceeds of their U.S. sales in U.S. financial assets, and more willing to purchase U.S. goods and services instead. If foreigners were to decide to completely stop lending money to or investing in the U.S., we would see our exports increase even more.

The good and bad news about unemployment claims


Unemployment claims continue to tell us that the economic fundamentals are gradually improving. On an unadjusted basis, the number of first-time claims is down almost 10% from a year ago. There is still no sign at all of a deterioration in the jobs market, and this all but rules out a recession. Claims keep falling, and the number of jobs keeps rising, and those are hallmarks of recovery. On an unadjusted basis, the number of people currently "on the dole" is down over 17% from a year ago. More and more people have an incentive to find and accept a job, and that is a very positive change on the margin.


Unfortunately, as the above chart shows, the portion of the labor force that is receiving unemployment compensation is still extremely high from an historical perspective. Congress was never more generous in its willingness to extend unemployment benefits in this business cycle, and the recovery was by far the worst in modern times. Could there be a connection between those two facts? Yes. When you pay people to not work, don't be surprised if you find that more people are not working. 5.66 million are still receiving unemployment checks today, substantially more than the 4.6 million who were receiving unemployment checks at the peak of the 1981-1982 recession. As a percent of the labor force, the number on the dole today is still far worse than most of the recessions of the past 30 years.

The bond/equity disconnect

Very low yields on Treasury securities—and on most developed country sovereign debt, for that matter—are symptomatic of a market that holds out very little hope for growth, and a market that believes that central bank accommodation for an extended period is necessary to (at worst) keep the economy from sinking into another recession or (at best) pump up growth a little. There has been a fairly good correlation between equity prices and interest rates because of this perceived connection between weak growth and low interest rates—until late last year, that is. In the U.S. we now see equity prices approaching post-recession highs, while bond yields are still extremely low. What does this mean? 


One possible answer is that even though equity prices are nearing a post-recession high, they are still depressed compared to earnings and thus reflect a market that is very reluctant to see any good news on the horizon. According to Bloomberg, the trailing 12-mo. P/E of the S&P 500 is now 14.2, and the expected P/E is now 13.1. Both those ratios are substantially below the 16.6 average P/E ratio over the past 50 years.



And P/E ratios are very low considering that corporate profits are very close to record high levels compared to GDP. Very low P/E ratios are thus best interpreted to mean that the market is very pessimistic in regard to the future potential of profits. In a sense, the market is priced to a significant decline in profits, and that would imply that the market believes that growth is going to be miserable in coming years. This market is not optimistic at all. It was extremely optimistic in 2000, as we now know, when P/E ratios were extremely high but corporate profits as a % of GDP were relatively low; back then the market was priced to a continuation of robust rates of growth for as far as the eye can see. Today, in contrast, the market is priced to doom and gloom.


As this last chart shows, the bond market is not entirely oblivious to the improvement in equity prices. The 5-yr, 5-yr forward breakeven inflation rate that is derived from TIPS and Treasury yields (the Fed's favorite measure of inflation expectations) has moved up more or less in line with a stronger equity market in recent weeks, and is now at a one-year high.

My interpretation of all this is that equity prices are improving not because the economy is getting stronger, but because the economy is not deteriorating to the extent reflected in bond yields. Since the economy is not getting materially stronger, the bond market still expects the Fed to stay on hold for a long time, and so Treasury yields remain extremely low. But now the bond market is sensing that the risk of a Fed overshoot—i.e., not reversing its accommodation in a timely fashion—is rising, and that means that inflation could be somewhat higher in the future than the market had been expecting. Treasury yields are not going to rise meaningfully (thus "catching up" to equity prices) unless and until the economy proves to be much stronger than it is currently perceived to be.

Risk of a near-term Eurozone collapse is way down

I have yet to see any meaningful steps taken by the PIIGS to rein in the size and scope of government, and thus I don't think the Eurozone crisis is a thing of the past. But the Eurozone, with the help of the ECB, has made great progress in reducing the risk of a near-term blowup. Markets everywhere are breathing a sigh of relief for what should prove to be more than a temporary, if not a complete, reprieve. 


U.S. swap spreads remain quite low, signifying that systemic risk is low, the financial system has plenty  of liquidity, and the outlook for the economy is likely to be improving, if only modestly. Eurozone swap spreads are still somewhat high, but they have declined significantly so far this year.


Euro basis swap spreads have been good leading indicators of this improvement, since they show that Eurozone banks are no longer having much difficulty in accessing dollar liquidity. This may also signify that capital flight out of the Eurozone is moderating. Taken together, these spreads show that liquidity in the Eurozone financial system has improved remarkably, and systemic risk has declined significantly. The likelihood of a near-term disaster is thus much lower. The Eurozone has bought itself a good chunk of time to work out its problems.


Zeroing in on individual countries, we see that 2-yr Spanish and Italian yields have dropped considerably in just the past week or so. They are not out of the woods yet, but the market is judging that near-term default risk has declined quite a bit.


5-yr CDS show a somewhat different story, since they are driven by the longer-term outlook. We don't see a whole lot of improvement of late, and that makes sense because these countries haven't yet fixed their underlying problems, even as they have made great strides towards remaining solvent for the near-term. Note how French 2-yr yields are almost zero, but French CDS are trading around 150 bps—even the long-term outlook for France remains somewhat suspect. For reference, I've included the current rate on generic 5-yr high-yield corporate CDS, which is trading around 550 bps. Spain, Italy, and Ireland are all considered to be about as risky as the typical junk bond. That sounds a lot worse than it really is, since junk bonds have been excellent investments in recent years, almost matching the total return on the S&P 500 since the rally started in early March 2009 (98% vs. 121%).