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Slow growth is not necessarily bad news


Second quarter GDP growth was slow to begin with, and has now been revised to even slower (1.3% vs. 1.7%). That's a relatively modest downgrade (the number is annualized, so the downward revision to the level of GDP was only about 0.1%), but it's pretty slow growth, both in real and in nominal terms.


Since the U.S. economy has enjoyed an annualized growth rate of 3% or so for over 50 years leading up to the last recession,  the current recovery is downright miserable. By my calculations, the economy is about 12% smaller than it should be. If the economy were growing at its long-term trend, national income would be about $2.1 trillion higher than it is today. That's a lot of lost jobs and lost tax revenue. Weak growth is thus the principle source of our ongoing $1 trillion plus annual deficits.

Despite all the disappointing news, though, it's nothing that the market hasn't expected, and that is an important thing to note. Abysmally low Treasury yields are symptomatic of a market that expects very weak growth for as far as the eye can see, and by the looks of these charts, we're on track for exactly that.



One very bright spot in this otherwise dim picture is corporate profits, which have grown at an impressive rate over the last decade, despite the slowdown in overall economic growth. Corporate profits are now close to an all-time high, both in nominal terms and relative to GDP. Despite this excellent news, most observers look at the top chart and argue that profits are mean-reverting to nominal GDP; since they have averaged 6.2% of GDP for the past 50 years, the current level (9.5%) is unsustainably high and must inevitably decline. But as the second chart suggests, the market is priced to just such a decline, because PE ratios are significantly below their long-term average. (This chart uses a normalized S&P 500 index as the "P" and after-tax corporate profits from the National Income and Products Accounts for the "E".) In other words, the market seems quite confident that future profits are going to be much weaker than current profits.( The 12-mo. trailing S&P 500 PE ratio is currently 14.7, which is also substantially below its long-term average of 16.6.)


I look at the above chart, in contrast, and argue that it is no longer meaningful to compare corporate profits to our domestic economy at a time when the U.S. economy is more integrated than ever before with a global economy that is growing quite rapidly (e.g., China and India). When you compare corporate profits to global GDP, the current level is unremarkable and therefore sustainable. Consequently. it seems reasonable to conclude that the market is very pessimistic and therefore valuations are quite attractive. Assuming, of course, that we are not on the cusp of another substantial recession. I think that even a continuation of today's disappointingly slow growth could be enough to move equity prices higher—the market can only ignore record profits for so long. As long as we avoid a recession, the market is likely to move higher, albeit modestly. Should we get a meaningful pickup in growth next year, however, then Katie bar the door.

Business investment is disappointing


If capital goods orders are a good proxy for businesses' confidence in the future, then the outlook for future growth is not very promising. This chart is just about the only one I follow that paints a clear picture of a slowdown. Some argue that the decline in capex this year is payback for the expiration of favorable tax treatment this year, but I note that the weakness has only been noticeable in the past three months (June-August). This lends support to those who argue that business investment has declined because businesses are losing confidence in the future, and that the looming fiscal cliff at the end of this year likely has been the catalyst for mounting concern. Whatever the case, declining business investment means less growth in the future—because investment is the seed corn of future productivity gains.

I would add that this somewhat gloomy investment outlook confirms the message of 1.6% 10-yr Treasury yields: the market's collective wisdom calls for very slow growth for the foreseeable future. Pessimism still trumps optimism in today's market.

Claims: steady but slow progress



As the top chart shows, the 4-week moving average of weekly claims for unemployment is 374K, and that is also the average of this series so far this year. As the second chart (of unadjusted claims) shows, claims are still in a downtrend, with current claims running about 8-9% below those of the prior year. So although claims have been flat so far this year, there is reason to think they will exhibit a decline as the year progresses. That adds up to modest, but continuing improvement in labor market conditions on the margin.


The number of people receiving unemployment insurance continues to decline, down 19.8% from a year ago. Today, 1.25 million fewer people are receiving unemployment checks than were a year ago. That adds up to a significant change in the margin, and the trend looks to be accelerating, if anything.

No sign here of any emerging recession, none at all. It's steady and slow as she goes.

The housing market deal of a lifetime


This chart of the yield on current coupon FNMA collateral and 10-yr Treasury yields, and the spread between the two, is good evidence that the Fed has finally managed to distort market pricing. MBS spreads are now almost zero—implying that FNMA MBS are as rock-solid and as attractive as Treasuries. Which of course they aren't. Mortgage-backed securities have nasty characteristics that Treasuries don't: when yields fall, their duration shortens (because homeowners can prepay their mortgages), and when yields rise, their duration extends (nobody will ever want to prepay a 30-yr mortgage with a 3% rate). That's called negative convexity, and that's one big reason why MBS yields are almost always higher than Treasury yields. Investors require an extra yield on MBS to compensate for their erratic cash flow risk. Not to mention, of course, that they don't have an explicit U.S. government guarantee.



If MBS spreads remain near zero, then 30-yr fixed rate conforming mortgages (orange line in the first chart above) could fall to 2.25%. (Over the past 15 years, the average spread between FNMA collateral and 30-yr conforming mortgages has been about 60 bps, which when added to today's 10-yr yield of 1.62%, gives you an idea of just how low conforming mortgage rates could go.) At that outstanding, almost unimaginable level, everyone who doesn't own a home should be willing to stand in line outside a bank for however long it takes to qualify for a mortgage, and then turn around and buy just about any home on the market. The Fed has succeeded in creating the housing market's biggest "blue plate special" of all time. Come and get it! A once in a lifetime opportunity to lock up unbelievably low fixed-rate financing and buy a home at a price that's not going to last much longer.

The one thing standing in the way of what should be a stampede of new home buyers is that it's not so easy to qualify for a loan. Banks have been loaded to the gills with reserves, and thus able to make an almost unlimited number of new loans, but they haven't—because they are still very risk-averse. You need 20% down to qualify, and your credit scores need to be good, and your employment solid. Not everyone can qualify, and many can't.

Regardless, this is a situation that can't last for very long. When market prices are distorted artificially, powerful arbitrage forces are set in motion. Large institutional investors are going to want to sell their MBS holdings at what could be record-setting high prices. Yields going forward are paltry, downside risk is enormous, and upside potential is extremely limited. The Fed's promise to buy $40 billion per month of MBS could be swamped by the decision of money managers to lighten up on their MBS holdings, which are measured in the many trillions of dollars. In other words, the big decline in MBS yields could quickly reverse, because the Fed can't permanently distort the yield on a market that is many trillions of dollars in size by buying a paltry $40 billion per month.

Meanwhile, those who can get loans are going to be putting that money to work in the housing market, and that's one reason why prices are firming in many parts of the country. The new mentality: buy now, before prices go higher. (Banks with tons of REO on their books will be thinking: no rush to sell now, maybe prices will go higher. Homeowners who are currently underwater will be thinking: maybe I can hold out a little bit longer and things will get better. It all adds up to less selling pressure and more buying pressure and the outcome can only be higher prices.)

And of course, banks are at some point going to be relaxing their lending standards. If they don't do it on their own initiative, then you can bet some politician is going to figure out a way to force them to. There is a precedent for this sort of thing in the U.S., after all, and that's one reason we got the housing market bubble.

Commodities update


As this chart shows, non-energy spot commodities (CRB Spot, white line) have been rather strongly correlated with equity prices (S&P 500, orange line) this year. Are equities and commodities rising because the economic fundamentals are improving? Or is it because monetary policy has become easier?

That's a tough call, but I'm inclined to think that commodities are up mainly because the economic fundamentals are improving, and easier monetary policy is acting as a tailwind. If the action were all about monetary policy, then gold should have been rising and the dollar should have been falling beginning in early June. However, the dollar didn't start weakening until August, and that was also when gold started rising.


This next chart puts the recent commodity price action in a long-term perspective. The bounce in prices since last June has been relatively modest, and that fits in the context of a modest improvement in the economic fundamentals. Stocks are not on a moonshot by any stretch. If anything, what we have seen in recent months is a very minor improvement on the margin in economic fundamentals that has received a modest boost from easier monetary policy.

Housing update


Median home prices for existing single-family homes rose 10.2% in the year ending August. This is one more (and impressive!) indication that the housing market is recovering. The chart above shows the prices in constant dollar terms, and they are up 8.4% in the past year. The chart also suggests that housing prices in real terms have found solid support at levels reached earlier this year. Mark Perry has charts and data for median home prices for new single-family homes: "The median sales price for new homes surged by almost 17% from a year earlier to $256,900 in August, the highest median price since March 2007."

The housing market news is getting to be pretty impressive.

The iPhone 5 is a beauty


Came back from a trip last night (that's why blogging has been somewhat light) and found my new iPhone 5 waiting for me. First overwhelming impression: it's so light! Actually, it's 20% lighter than the 4S, even though its screen is bigger. Nevertheless, it feels just as solid. Next thought: this phone is gorgeous. The design has been purified; it's hard to see how it could be better. Could a future phone be any lighter or more compact? Hard to believe; what will they do to improve on this? It's faster all around. The camera takes much better pictures in low light (the biggest defect with previous iPhones was lousy indoor shots). The screen is perfect. I love the new charger plug; the other one looked clunky, this one looks svelte, just like the phone.

I think anyone who picks up this phone and compares it to any other on the market will be immediately smitten by its looks, its simplicity, and its functionality. No other screen can compare. The software "just works," and everything is smoothly integrated. iCloud syncs everything hassle-free. How can so much technology be packaged into such a small and beautiful enclosure?

Apple is going to sell this phone as fast as they can make them. It's going to be another blockbuster.

Full disclosure: I remain long AAPL at the time of this writing.

More evidence of a housing recovery



The Radar Logic series of housing prices (nsa) is up 3.7% in the year ending July, and it is essentially unchanged for the past three years. The Case Shiller measure of housing prices (sa) is up 1.1% over the past year, and hasn't changed much either over the past several years. That's three years of almost flat prices, with the important change on the margin being to strengthen, albeit modestly. For over six years the housing market has been adjusting, painfully, to new realities, and increasingly it appears that the adjustment process is complete. Prices have found a new equilibrium.


Using the Case Shiller data for 10 large metropolitan areas, and comparing that to the BLS' calculation of owner's equivalent rent, we get the same story: housing prices and rents have come back into alignment; the adjustment process is largely complete.

However, the current level of prices may not be a true equilibrium, because mortgage rates, which determine the "cost" of a house for many people, are extraordinarily low. If getting a mortgage were to be made somewhat easier (it's still difficult, as my daughter can attest), demand for housing could increase significantly, boosting prices even as banks increased their sales of foreclosed properties. Even now there are bidding wars in some markets, and some houses in my daughter's neighborhood are selling for full price just one or two days after listing.

Weekend must-read (2)



Leslie Michelson: Doctor to the 1% (and Maybe Someday to You), WSJ. Excellent discussion of how true healthcare innovation can only happen as the result of market-based incentives, and never from a top-down regulatory approach. Some excerpts:

In a world in which 98% of the conversations are about cost containment, it's a joy ... to have somebody who's focused on enhancing quality only.

... the health-care delivery system, to the extent it qualifies as a system, "has no quality control, no integration, no coordination." Doctors "tend to operate in an independent and isolated way, and even specialists who've been treating the same patient for years and years typically never, ever speak to one another."

Since businesses are the customers [in the current system], not the individuals who change jobs every three years on average, insurers "act rationally" and don't invest in services with "short-term costs and long-term payback." ... the better option is for businesses to convert to cash vouchers so their workers can buy portable policies. Right now, there is "no meaningful information about the quality of care, virtually no information about price, and no sensitivity to price," but that would change if the insurance industry built "an enduring relationship with consumers ... "

... why, circa 2012, should HR departments be selecting and administering one or two or three plans for a thousand or a hundred thousand workers and their dependents? You don't need a Ph.D. in economics to understand that you will guarantee suboptimization."

Universal coverage is never as universal as its proponents want it to be, and it usually results in a double- or triple-tier system as the upper-middle classes flee. Then the medical ethicists condemn the disparities based on ability to pay that their own programs helped to create.

... if your aspiration is to provide everyone the highest quality of care, then you have precluded yourself from providing anyone with the highest quality of care. As an economic, structural, societal matter, it's impossible to achieve.

"Innovations such as ours have to start at the high end, because you have to figure out how to do it. And then you figure out how to systemize it and take the costs down and deliver to the mass market."

Americans ... are "extremely good at buying things." But they don't know how to buy health care ... . "The entire engine of American consumerism is missing in health care. What a preposterous thing."

The last two sentences are the most powerful. And by the way, the guy who is doing this is a Democrat.

Weekend must-read

A Capital Gains Primer, WSJ op-ed. This is a timely and valuable discussion of why capital gains taxes should be as low as possible (and preferably zero). When Clinton says that tax rates like Romney's won't help the economy, he is making two grievous mistakes: he fails to understand why tax rates on capital must be low, and he assumes that government is able to manage the economy's scarce resources better than the owners and creators of those resources. Here's a quick summary of the key points in the op-ed:

Amid sluggish growth that has prompted the Federal Reserve into unlimited monetary easing, it is hard to imagine a worse time to raise the tax on capital investment. None other than Lord Keynes wrote that "the weakness of the inducement to invest has been at all times the key to the economic problem."
First, under current tax rules, all gains from investments are fully taxed, but all losses are not fully deductible. This asymmetry is a disincentive to take risks. A lower tax rate helps to compensate for not being able to write-off capital losses. 
Second, capital gains aren't adjusted for inflation, so the gains from a dollar invested in an enterprise over a long period of time are partly real and partly inflationary. 
Third, since the U.S. also taxes businesses on profits when they are earned, the tax on the sale of a stock or a business is a double tax on the income of that business. 
The main reason to tax capital investment at low rates is to encourage saving and investment.