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Federal finances continue to improve

The federal budget outlook is still dismal, but—believe it or not—there has been substantial progress. Federal spending in the past three years has increased by a total of only 1.5%, while federal revenues have increased by a total of 22.7%, despite a 2-year payroll tax holiday and no increase in tax rates!


The chart above shows the 12-month running total of federal spending and revenues. Note that since the end of 2009, spending has been almost flat, while revenues have increased steadily. Congressional gridlock gets the credit for slowing spending growth, while the economy's ongoing recovery—regardless of how unimpressive it has been—gets the credit for boosting tax revenues. It is unfortunate that President Obama has placed so much importance on increasing tax rates for the rich in order to address the still-yawning budget gap, when tax revenues have been rising quite impressively without any assistance from higher rates. Economic recovery has once again proven to be the best source of tax revenues for the federal government. The public has not gotten this message.


This next chart shows spending and revenues as a % of GDP. Note that simply stopping the growth of nominal spending is enough to bring about a fairly impressive decline in the burden of government (i.e., spending as a % of GDP). No actual cuts are needed to effectively shrink the size of government.


This chart puts the current situation in a long-term historical perspective. Note that spending as a % of GDP is still substantially higher than its post-war average, whereas revenues are only slightly below their post-war average. In order to achieve a balanced budget, this strongly suggests that the heavy lifting of policy should be focused on restraining the growth of spending while promoting economic growth. Higher tax rates are not needed. Unless, of course, President Obama's intention is to permanently increase the size of government, and increasingly it looks like it is.


We are very fortunate as a nation that the federal deficit has declined significantly in the past three years, from a high of 10.5% of GDP in late 2009 (a level that was clearly unsustainable) to less than 7% today. 7% is still very high, but it is not unsustainably high and it is on a downward trajectory.


As this next chart shows, gains in federal revenues have accreted throughout the year. Every month in 2012 showed higher revenues than the same month in prior years.


This next chart shows how there is a fairly reliable correlation between the level of government spending, as a percent of GDP, and the unemployment rate. A stronger economy reduces the need for spending of the "social safety net" variety, that much is clear. What is perhaps not so clear nor well documented is that as the relative size of government shrinks, this allows the private sector to keep more of the fruits of its efforts, and this strengthens the economy while increasing employment and reducing unemployment. This chart fairly screams its message: if we want the economy to get stronger, we need to cut back on the relative size of government! Bigger government brings with it a weaker economy, while smaller government opens up the possibility of a stronger economy. To put it another way, the private sector can spend money more efficiently and more productively than the public sector. Shrinking the public sector allows the private sector to expand, and that in turn results in more productivity and more growth.


Federal debt held by the public (including the debt that has been "purchased" by the Fed, but excluding the debt that is owed to social security and other trust funds) is now $11.6 trillion, or about 72.5% of GDP. Total debt is now $16.4 trillion, about 103% of GDP. 


At the current rate, the burden of federal debt held by the public (i.e., debt as a % of GDP) will have increased by almost 25% of GDP during President Obama's first term. That handily eclipses the increased debt burden under the two terms of President G.W. Bush (15.3%) and the two terms of President Reagan (15%).

One way to look at equity prices


Here's one way of putting the equity market rally in long-term perspective. By this measure, equities on average gain almost 7% a year (plus dividends), and they have plenty of room left on the upside. The market was way too optimistic in 2000, but now appears to be right in the middle of its historic range.

Stocks gain despite equity fund outflows

For a long time, my thesis has been that the equity market was moving higher despite all the bad news and despite the very negative assumptions embraced by the capital markets. Stocks are not riding a wave of optimism; if anything, stocks are up because the future hasn't turned out to be quite as bad as the market had expected. Mutual fund flows continue to confirm this.


According to data compiled by ICI, there has been an impressive exodus of investors from domestic equity funds over the past several years, and there is no sign that this is getting any better.


Bond funds, in contrast, have been growing like Topsy ever since the crash of 2008. Investors continue to shun equity funds in favor of less risky bond funds, a clear sign that negative sentiment prevails. 

Labor market conditions continue to improve

Now that the dust of the Sandy storm has settled, we find that seasonally adjusted layoffs early this year were a bit below the average of the past year. There is no sign of any deterioration in the labor market; on the contrary, the trend over the past year has been and continues to be one of gradual improvement.


The 4-week moving average of claims last week was very close to its post-recession low. Nonseasonally adjusted claims last week were actually 14% lower than they were a year ago.


Compared to the size of the workforce, the current level of claims is historically lo, as the above chart shows.


But thanks to generous extensions of unemployment insurance and the exodus of 5 million or so from the labor force, the percent of the labor force receiving unemployment compensation remains historically high, even though it has declined significantly in the past two years.


This is one problem area of the labor market: 2 million people are still being paid unemployment insurance via the Emergency Claims provision after exhausting their regular state benefits. The other problem, of course, is that the pace of hirings has been lackluster. The fiscal cliff deal extended the emergency claims provision for another year; otherwise it would have now expired.

The avalanche

We have a spending problem, not an under-taxation problem.


Predictions for 2013

First, a review of last year’s forecast.

I thought the economy would continue to experience a “sub-par” recovery, burdened by numerous headwinds (e.g., excessive government spending, great monetary policy uncertainty, increased regulatory burdens, fears of a Eurozone sovereign debt crisis), and grow by only 3-4%. It now looks like it managed to grow by about 2.5%. That’s not a grievous miss, however, since I thought that the market was priced for even weaker growth. Importantly, I thought the downside risks of Eurozone defaults were greatly exaggerated, and that proved to be correct.

I predicted that CPI inflation would be about 3%, but instead it will probably turn out to be a bit less than 2%. I didn’t think the Fed would need to resort to another round of Quantitative Easing, but they did. Treasury yields failed to rise as I expected, but they were roughly unchanged for the year, despite additional Fed bond purchases.

I predicted a stronger housing market, and it improved significantly by almost any measure. Mortgage spreads tightened instead of widening as I expected, because the Fed opted to expand its purchases of MBS. Commodity prices failed to rise as I thought, but on balance they were roughly unchanged. I expected gold prices to be very volatile and probably down for the year, but they ended up with a gain of 7%—a clear miss. The dollar didn’t rise as I thought, but it was essentially unchanged.

My worst mistake: a belief that the electorate would vote in favor of less government, lower and flatter taxes, and a simpler tax code. Thanks to the results of the November elections and the recent fiscal cliff deal, we are now burdened by the prospect of more government, higher and more progressive taxes, and a more complex tax code. Regulatory burdens will increase.

Arguably, the misses and near-misses noted above were trumped by my investment recommendations. I thought equity returns would be 10-15%, and the S&P 500 enjoyed a 16% total return for the year, even though the growth in corporate profits slowed as I expected. Emerging market debt (+22%), investment grade debt (+11%), junk bonds (+12%), and REITs (+17%) all did very well, as predicted. Throughout the year I reiterated my view that cash should be avoided at all costs, and that was indeed a good call. Anyone who avoided cash, no matter what they chose to invest in, was rewarded. In the end, risky assets did well because the economy did better than expected.

Now let’s turn to the future.

This year I will eschew point forecasts, since the real purpose of forecasting is to put oneself on the correct side of what the market is expecting. If the market expects no growth or a recession, then any forecast that calls for growth greater than zero is likely to be rewarded if the economy fails to stagnate or decline. That was the case last year, and I think it will be the case again this year.

For the 5th year in a row, I think the economy is likely to do better than the market is expecting, even though growth is likely to be less than what it would be if this were a normal recovery following a deep recession. I think the market is quite fearful that growth this year will be either zero or negative, and I base that on my observation that yields on safe-haven, risk-free assets (e.g., T-bills, Treasuries) are extremely low, yields on inflation-indexed, risk-free assets (e.g., TIPS) are negative, forward interest rates are priced to the expectation that the Fed will not raise short-term rates meaningfully for at least 2-3 years, equity PE ratios are below average even though corporate profits are at record highs, and high-yield spreads are still quite elevated.

A quick glance at key indicators—e.g., very low swap spreads, a positively sloped yield curve, negative real yields, relatively low levels of unemployment claims, flat industrial production but decent ISM readings, strong auto sales, strong residential construction gains, and continued growth in jobs—rules out an imminent recession. Going forward, monetary policy is almost certain to be non-threatening this year. Although fiscal policy has tightened—in the worst way, through higher taxes instead of reduced spending—on the margin it’s not a huge problem (things could have turned out a lot worse), and the negative impact is likely to be absorbed by the economy’s inherent dynamism, the continued growth of jobs, and ongoing gains—albeit modest—in productivity. On balance I think the economy can generate some modest growth this year despite the ongoing headwinds.

If there is a silver lining to the cloud of big government that darkens the outlook for the economy, it is that we will have a divided government for at least the next two years. The House can effectively block any big new spending initiatives, and if spending can continue to shrink relative to GDP, then this will give the private sector some badly needed breathing room.

The Fed’s aggressively accommodative monetary policy has pushed up inflation expectations over the past year or so, but I note that current inflation remains relatively subdued. Regardless, I continue to think the odds favor inflation that is higher than expected. Since Treasury yields are still extremely low, they offer a very unattractive risk/reward profile, with downside risk greatly exceeding upside potential. Although the yield on TIPS would rise in line with inflation, higher inflation would likely push Treasury and TIPS real yields higher, thus depressing TIPS prices and damping total returns; in short, TIPS are expensive inflation hedges given the very low level of real yields. Treasuries just don’t have much appeal in this climate.

As was the case last year, if the economy simply avoids a recession and manages to grow, I think those who avoid cash will be rewarded. The yield on just about any risky asset is substantially higher than the almost-zero yield on cash, and this becomes compelling as long as disaster fails to strike. Equity yields at 7% simply tower over the yield on cash. If there is any obvious caveat it would be for investment grade corporate debt, since spreads are relatively tight and the sector is thus exposed to the risk of rising Treasury yields. High yield debt, in contrast, still offers attractive spreads, and any pressure from higher Treasury yields (which would only come if the economy strengthens) would likely be absorbed by declining default risk.

Households have almost $7 trillion in bank savings deposits as a hedge against another recession. But since savings deposits yield almost nothing, then as more time passes without a disaster, at least some may feel that their savings could be put to better use in other asset classes or simply spent. Any attempt by households to redeploy their savings would put upward pressure on other asset prices, and possibly fuel an increase in the growth of nominal GDP. This is the wild card to watch.

The dollar remains very weak, so it’s more likely to strengthen, especially if the economy does better than expected. Gold remains a very risky asset at these lofty levels, and I think it is priced to a lot of very bad things (e.g., very high inflation, geopolitical risks) that have yet to happen, so again I’m not a fan of gold. Commodity prices, however, do have some upside potential after consolidating over the past year, and they have tailwinds such as easy money and ongoing growth in the global economy. Real estate stands out as the cheapest and most attractive inflation hedge, and commercial real estate offers some decent yields to boot. Equities are a decent inflation hedge as well.

Inflation expectations are rising

For the past 15 months, the inflation expectations embedded in TIPS and Treasury bond prices have been moving higher, most likely in response to the Fed's increasingly accommodative policy stance. 10-yr Treasury yields—already quite unattractive relative to current inflation—are thus at serious risk of moving higher, regardless of the Fed's determination to keep them low. Fortunately, this is not something to worry about.


As this first chart shows, Treasury yields and inflation began to diverge in the latter half of 2011; yields fell as inflation rose, an unusual development that could be explained by the Fed's insistence that the economy was so weak that extremely low short-term interest would be required for at least the next several years.


Treasury yields are now about the same as inflation (roughly 2% each), which means that real yields are essentially zero. As the chart above shows, this is a very unusual condition. Since 1960, the real yield on 10-yr Treasuries has averaged about 2.4%, and real yields on Treasuries have only been below zero for about 8 of the past 52 years. Notably, real yields were negative for a good portion of the 1970s, a period notorious for its accommodative monetary policy and relatively high and rising inflation.


The above chart shows the real yield on 3-mo. T-bills, which is a good proxy for the Fed's effective monetary policy stance: high real yields mean policy is tight, while low or negative real yields mean policy is very easy. Monetary policy has rarely been as accommodative as it is today. If the 1970s are a guide, we should thus expect inflation and inflation expectations to be on the rise today.


The chart above shows Bloomberg's calculation of the "breakeven inflation rate" for 5-yr TIPS and Treasuries. This is effectively the bond market's assumption for what consumer price inflation will average over the next 5 years. (If future inflation equals breakeven inflation, then an investment in TIPS or Treasuries of comparable maturity will deliver the same total return.) As you can see, inflation expectations have risen from a low of 1.4% in September 2011 to just over 2% today.


Of course, it's possible that the bond market could be wrong. As the chart above shows, the bond market sometimes can be very wrong about inflation. This chart is just a longer-term version of the one above it. Note that 5-yr inflation expectations at the end of 2008 were -.78%. In the four years since then, the CPI instead has averaged 2.2%. So the bond market was way underestimating inflation back then, and it could be underestimating future inflation today.


This next chart shows the bond market's expectation for what the CPI will average over the 5-yr period beginning 5 years from now. Forward-looking inflation expectations, by this measure, have risen from a low of 2% in September 2011 to now just over 3%.


This chart shows the market's expectation for what the CPI will average over the next 10 years. It's essentially a combination of the 1st and 3rd charts in this series. By this measure, long-term inflation expectations have risen from a low of 1.7% in September 2011 to 2.5% today. That's not at all unusual, because the CPI has averaged almost 2.5% over the past 10 years. So although the market's antennae have picked up a sense of rising inflation, it's not yet something to be terribly concerned about. Unless, that is,  you own Treasuries that are now promising to deliver negative real returns in coming years. And unless the bond market is once again underestimating future inflation.


This last chart compares 5-yr forward inflation expectations to the level of the S&P 500. Both inflation expectations and equity prices have moved together over the past 15 and also for the past 27 months, which suggests that the Fed's accommodative policy stance at the very least is driving the market's outlook for nominal growth. Both equities and bonds are assuming faster nominal growth—driven by higher inflation.

Going back to the very first chart, it seems clear that 10-yr yields are unusually low relative to current inflation. The rest of the charts make it very clear that inflation expectations are on the rise and that at this point there is no reason to believe that inflation will fall. If the gap in the first chart is unsustainable, and I think it is, then it is thus very likely to close with 10-yr yields moving higher.

Once again, I take this opportunity to repeat that the current very low level of Treasury yields only makes sense if you view them from the perspective of a market that is extremely worried about future economic growth. Investors are so risk-averse and so worried about the future that they are willing to forgo earning a positive real yield—and accept a negative real yield—in exchange for the perceived safety of Treasuries.

The Fed is laying the foundation for higher yields with its accommodative policy stance, since inflation and inflation expectations are unquestionably higher. What will end up delivering higher yields is the return of confidence. As the market overcomes its fears and as risk-aversion declines, Treasury yields will rise; investors will attempt to shift out of Treasuries and into more risky assets, causing relative prices to change. Higher yields will thus be symptomatic of an improving economic outlook and rising investor confidence. They will not therefore pose a threat to the economy, and thus are not something to worry about. The sooner they arrive, the better, in fact. And when they do, we'll likely see higher equity prices to boot.

Winter at Calafia Beach

(click to enlarge)

I took this photo a few days ago with my iPhone 5. Winter is the most beautiful time of the year for So. California beaches. Catalina Island is visible in the center horizon.