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Balance sheet improvement continues


Today the Fed released its Q2/12 estimate of households' balance sheets. Although net worth slipped by $322 billion for the quarter, this was entirely due to the decline in the stock market. The rebound in equities since June has more than made up for the second quarter losses, so net worth today is almost certainly at a new post-recession high and closing in rapidly on pre-recession levels. Here's one surprising development: according to the Fed's estimates, the value of households' real estate holdings is no longer declining and in fact rose almost $800 billion in the first half of this year, while debt burdens are going nowhere. Altogether, this is a sustainable recovery, even though it is still painfully slow.

Still no signs of labor market deterioration



First-time claims for unemployment have averaged (on a seasonally adjusted basis) 375K per week this year, and the latest tally was 382K. The bottom line is that claims have been flat this year. No signs of any deterioration in the labor market, and no signs of any meaningful improvement either. The outlook for the economy remains rather dull and uninspiring. 


What has changed meaningfully, however, is the number of people receiving unemployment insurance. Over two million people have dropped off the dole so far this year. Since the ranks of the employed have increased only by 1.1 million this year, that means there are an additional one million people out there not working and not receiving unemployment compensation. Presumably, those folks are increasingly eager to get back to work. I count that as a positive change on the margin, since it means that employers ought to find it easier to hire people. The one ingredient that is missing, of course, is more employers willing to hire people. The problem is not that the economy is losing jobs, it is that the economy is not creating enough.

That's the sort of thing that can only be addressed by fiscal policy. The Fed pumping more reserves into a banking system that is already sitting on $1.5 trillion of excess reserves is not going to create more jobs. If the additional reserves are going to make a difference, banks have to decide that they are going to deploy those reserves; they need to lower their lending standards and seek out borrowers more aggressively. By the same token, borrowers need to be more willing to borrow. For both of those things to happen, we need more confidence in the future. That in turn must come from fiscal policy, which must somehow avoid the looming "fiscal cliff," and avoid raising marginal tax rates on those who are most able to create jobs (if you increase taxes on job creators, you are very likely to get fewer new jobs as a result).

In the meantime, the economy looks like it continues to grow slowly. That's disappointing, but it's a whole lot better than an economy that is slipping into another recession. Holding on to cash—there is a whopping $6.4 trillion sitting in bank savings deposits earning nothing—only makes sense if there is another recession around the corner; so every day that we avoid another recession is another day that holding cash becomes embarrassing. The Fed is trying very hard to encourage people to take on additional risk—to leave the comfort of cash by spending it or by investing in something, or to take on additional debt. So far they haven't been very successful, but the passage of time has. The longer we go without another recession, the more people are going to be encouraged to leave the comfort of cash and take on more risk.

So even though there is disappointment to be found in many areas, the economy is still likely to slowly improve. That's a good reason to reduce your cash holdings in favor of just about anything else (except Treasuries, where yields are so low that it would take an outright and painful recession to push them lower).

Eurozone recovery continues


2-yr swap spreads have declined dramatically this year, and that's an excellent indication that the Eurozone financial system is once again liquid and healthy. This in turn is a good sign that the Eurozone economy is likely to be improving in coming months (i.e., swap spreads are good leading indicators of financial and economic health).

We can't say that the Eurozone is out of the woods yet, since more than a few countries have yet to address their fundamental problem: excessive public sector bloat and chronic deficits. But with the health of the financial markets restored, there is hope that fundamental reform is in the offing.


The Euro Stoxx index is up over 20% since early June, another early sign that things are starting to improve on the margin. I note that with this index is trading at about 10 times expected earnings, it is fair to say that Eurozone markets are still suffering from deep pessimism. As in the U.S., the Eurozone equity market is being driven not by optimism, but by a slow decline in pessimism; conditions have not turned out to be as bad as the market had feared.

Still more signs of a housing recovery



The National Association of Home Builders asks its members to gauge their perceptions of current single family home sales and sales expectations for the next six months, and to rate traffic of prospective buyers. Scores from each component are then used to calculate a seasonally adjusted index where any number over 50 indicates that more builders view conditions as good than poor. The index is still under 50, so the majority of home builders still see poor conditions, but at the rate things are improving, we could see a majority rating conditions as good in a few months. 


This next chart shows an index of the stocks of major home builders, and it confirms that things have improved noticeably of late. The S&P 500 Homebuilders ETF (XHB) has doubled since its low of last October.


The mess we're in

Everyone should read today's WSJ op-ed by Shultz, Boskin, Cogan, Meltzer and Taylor: "The Magnitude of the Mess We're In." To their credit, they make no attempt to pin the blame for the mess on any party or politician. It should be clear that this is a bi-partisan mess we're in, and the Fed, presumably independent, is potentially a big part of the problem. It's just the facts, ma'am.

They also note that all is not yet lost, and the solutions are straightforward:

The fixes are blindingly obvious. Economic theory, empirical studies and historical experience teach that the solutions are the lowest possible tax rates on the broadest base, sufficient to fund the necessary functions of government on balance over the business cycle; sound monetary policy; trade liberalization; spending control and entitlement reform; and regulatory, litigation and education reform.

Both parties need to know this.

A friend asked me how it was possible for the market to be near all-time highs when the problems, as described in the article, are so big, so obvious and so potentially disruptive. My answer included the chart below.


Corporate profits are very close to all-time highs, both nominally and relative to GDP, yet PE ratios are below their long-term average. The market is not at all optimistic based on this metric. Indeed, I would argue that the market is priced to lots of bad news, at the very least to a big decline in profits in coming years. The article says the same thing in another way:

When businesses and households confront large-scale uncertainty, they tend to wait for more clarity to emerge before making major commitments to spend, invest and hire. Right now, they confront a mountain of regulatory uncertainty and a fiscal cliff that, if unattended, means a sharp increase in taxes and a sharp decline in spending bound to have adverse effect on the economy. Are you surprised that so much cash is waiting on the sidelines?

If the market is at all optimistic, it would be to the extent that it is not yet priced to death and destruction. The market assumes that somehow we will avoid a calamity. There is still time to fix things, and I would agree.