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Jobs and manufacturing point to continued growth

In my estimation, the market continues to underestimate the health of the U.S. economy. To be sure, this recovery still ranks as the worst in modern times. The unemployment rate remains very high. The labor force participation rate remains very low. The number of people working today is still 3 million less than at the peak in early 2008. It's no secret that the economy should be doing a whole lot better. However, the most important thing is what is happening on the margin. The bad news is that the rate of improvement has been disappointing; the good news is that the economy continues to add jobs at a decent pace, and there is no sign of any deterioration. The market is braced for a recession, but there is no sign of a recession; the economy continues to grow, albeit at a disappointingly slow pace.


For the past two years, the private sector has been adding jobs at a 2% pace: about 190K per month on average. That's the same pace as during the 2004-2006 period. According to this chart we are growing just as fast today as we were when the economy was reasonably healthy about 8 years ago. The difference, of course, is that given the depth of the recession we should have been growing much faster.


Both employment surveys show that the private sector of the economy has added a little over 6 million jobs in the past three years. At this pace, jobs will reach a new high within a few years. That will still leave many millions of people unemployed, so it's nothing to cheer. But things are nevertheless improving, not deteriorating. That's critically important, since the markets and the Fed are worrying that the economy is clinging to growth by the skin of its teeth. It's not. It's doing much better than that. Economies are not like airplanes: they don't have a "stall speed." Economies don't collapse if they grow too slowly, they just keep growing slowly.


The January ISM manufacturing report was a good deal stronger than expected (53.1 vs. 50.7). As the above chart suggests, it is reasonable to think that the economy is growing at a 2-3% pace given the health of the manufacturing sector. Things could be a lot better, but they are not getting worse.


As the above chart shows, manufacturing conditions in both the U.S. and the Eurozone are improving on the margin. To be sure, although the survey suggests that Eurozone manufacturing is still shrinking, the pace of deterioration has slowed. On the margin, the outlook is improving both here and in Europe.




Even in Japan the outlook is improving. The Nikkei 225 is up almost 30% since mid-November, thanks to declining deflation risk courtesy of a weaker yen. As the second chart above shows, the January manufacturing surveys in Japan, like in the Eurozone, show a reduction in the rate of deterioration.

It's never smart to let the perfect be the enemy of the good. The economy should be doing better, but it is improving, and that is a far cry from being at risk of recession. Things are likely to continue to improve, albeit slowly.

Markets (and the Fed and most other central banks) are too worried about how things should be better, when they should be encouraged that the outlook is slowly improving.

Avoiding recession is all that matters

When yields on risk-free assets are close to zero, it only makes sense to hold those assets if you need liquidity and/or are highly concerned about the potential for losses in other assets, most of which are yielding substantially more. From a macro perspective, the fact that significant assets are being held with virtually a zero yield can be interpreted as a sign that the market is very worried about a recession, since that is the one event most likely to create widespread losses in risky assets. 

This has been the case for most of the past 4 years (during which time the yield on 3-mo. T-bills has averaged about 0.1%), yet the economy has avoided a recession and the returns on almost all alternative assets have been astounding. The returns on cash have actually been negative in real terms, since inflation has averaged 2.2% a year over the past four years. Cash, the risk-free asset, has produced an annual loss of purchasing power of over 2% for four years running. The S&P 500 index, on the other hand, has produced annualized total returns of 16.8% for four years running.

With almost $7 trillion sitting in bank savings deposits earning practically nothing, and with tens of trillions invested in risk-free assets around the world, there are therefore many millions of people and investors who need a recession to justify their current asset allocation.

Are there any signs of a budding recession? None that I can see in the recent data.


Weekly unemployment claims are volatile around this time of the year since the seasonal adjustment factors can be large. The 4-week average of claims, which eliminates a good deal of this volatility, is now at a post-recession low. No sign here of any recession or even an economic slowdown, to judge by this relatively fresh and sensitive indicator of conditions in the jobs market.


No sign here either of a recession, to judge by the Challenger tally of announced corporate layoffs. There is no sign of any unusual downsizing.


Meanwhile, it's almost certain that a housing market recovery is well underway. As the above chart shows, the stocks of major home builders are up over 100% in the past 16 months, and they are up 270% since their recession low. Housing starts are up 77% since the beginning of 2011. 

The zero growth reported for the fourth quarter of last year was the result of a downsizing of defense spending and a slowdown in inventory accumulation. Reduced government spending is not necessarily a bad thing, since it frees up resources for the private sector. Inventory investment is quite likely to bounce back, having been depressed in recent months by the uncertainty of the "fiscal cliff" which has since been resolved.


All of this is being repeated on a global scale. The value of global equities has more than doubled since their early-2009 low. $25 trillion has been earned by the holders of those equities, compared to a loss on the purchasing power of the tens of trillions that was held in cash over the same period.

Investors are notorious for following the money rather than anticipating where the money will be made, and $25 trillion in gains ought to be enough to get a lot of people's attention. We may finally be at the point where the private sector stops trying to deleverage and begins to releverage; when investors stop taking money out of equity funds in order to add to bond funds; and when investors try to reduce their cash balances in favor of riskier assets. The Fed and all other major central banks have been trying very hard to make this happen, and it would be foolish to think they won't be successful. By keeping interest rates on risk-free assets extremely low, the Fed is trying to destroy the demand for those assets, and trying to encourage money to find its way into other more riskier asset classes. The money can't actually  leave cash, but the attempt by the private sector to reduce its cash exposure (and/or increase its borrowings) in favor of equities or real estate could unleash a powerful change in relative asset prices. Ultimately, the yield on cash will rise significantly, while the yield on other assets will decline as their prices rise.

All it takes for this to happen is to simply avoid a recession. 

The economic news is not worse than expected

Everyone realizes that the very weak GDP growth (-.5%) reported for last year's fourth quarter was an anomaly and not a harbinger of recession, the product of sharp defense cutbacks and an inventory slowdown. That's why stocks today are unchanged, and Treasury yields are actually up a bit. The Q4/12 news is old history, and growth is almost certainly going to be stronger in the current quarter, and that's what counts for now. 


Today's ADP forecast of January private sector jobs growth was better than expected (192K vs. 165K), and as the chart above suggests, this points to Friday's private sector jobs gain to also be a bit better than the 169K expected. To be sure, job gains of 190K aren't anything to get excited about, but they are surely welcome, and this goes a long way to explaining why the market didn't take the GDP report as unexpectedly bad news. The economy is most likely still growing, albeit slowly.


The economy's real problem is displayed in the chart above, which compares the path of actual GDP growth (blue line) to what the long-term trend has been (red). By my calculations, the U.S. economy is now about 14% below where it perhaps could have been if fiscal and monetary policies had been more growth-friendly (e.g., lower tax burdens, less government spending, reduced regulatory burdens) and less manipulative (e.g., no QE infinity, less income redistribution). That's a shortfall of $2.25 trillion, or about $7,000 of annual income per capita, or about $20,000 per family, and that is real money to most folks. It's taken the form of a very slow recovery in jobs; if this had been a normal recovery there could have been well over 10 million more jobs by now.

So even though the economy continues to grow, we are losing ground relative to where we should or could be. This is a national tragedy, but it's not a reason for financial markets to collapse.


10-yr Treasury yields are still only 2%, and 5-yr real TIPS yields are still firmly negative. As the chart above suggests, this implies that the market is braced for GDP growth to be miserable (as low as zero, possibly) over the next few years. With expectations like these, GDP growth of only 2-3% this year might actually turn out to be a positive surprise.

Today's FOMC announcement shows that the Fed shares the market's miserable expectations. Everyone, it seems, realizes that the U.S. economy is just not performing well, and there is little reason to expect any meaningful improvement for the foreseeable future.

If there is any silver lining to this cloud, it is the almost-universal agreement that we are stuck in a rut. When sentiment shifts so solidly to one extreme or another, the market becomes vulnerable to even the smallest sign that things are not conforming to expectations. When this might happen is anyone's guess, but I continue to believe that the economy is capable of exceeding the market's miserable expectations, which is why I remain invested in risk assets.

For all the glum news, it's not worse than the market expected, and that's good news.

Developments in China explain the end of gold's rise

Arguably, there have been three major developments in the global economy in the past decade: 1) the Chinese economy has posted 8-10% annual economic growth; 2) China's foreign exchange reserves have soared from $170 billion to $3.3 trillion; and 3) the price of gold has sextupled. It's likely that all three are related, and that the outlook for gold is diminished as a result. 


China's economic growth has been truly impressive. There has been huge progress and prosperity gains, thanks to the introduction of free market reforms and investment-friendly policy.



China's decision in early 1994 to peg the yuan to the dollar was a key factor driving China's growth, since it brought Chinese inflation rapidly down to the level of the U.S. The prospect of a stable currency not only reduced inflation and its multiple distortions, it also increased the market's confidence in China, and helped boost investment in the country since it all but eliminated foreign exchange risk. Indeed, since the yuan has only appreciated against the dollar since 1994, foreign investors benefited from strong Chinese growth and yuan gains. China was the boom of the century.

As the first of the two charts above shows, the huge capital inflows that helped China grow needed to be sterilized or accommodated by the Bank of China, otherwise they would have caused the yuan to soar, and that could have short-circuited China's ability to grow. Massive inflows of foreign capital seeking to benefit from rapid Chinese development essentially forced the BoC to buy over $3 trillion of foreign exchange, with a commensurate increase in the Chinese money supply. Converting capital inflows into yuan is the only way foreign capital could actually enter the economy, because you can't build a factory or hire workers with dollars—the dollars need to be converted to yuan, and it is the proper role of the BoC to buy those dollars and issue new yuan in the process. Yet despite massive forex purchases, which relieved pressure on the yuan to appreciate, the BoC still had to allow the yuan to float irregularly upwards. A stronger yuan helped to keep the inflationary pressures of rapid growth under control. 

As I explained in this post, it now appears that this process of forex purchases and yuan appreciation is at an end. This is a big deal. China's foreign exchange reserves have not increased for almost two years, and the yuan has been stable against the dollar for the past two or three months. Capital flows and trade flows appear to have reached some kind of equilibrium, just as Chinese and U.S. inflation have converged.


I find the above chart fascinating. It compares the rise in China's forex reserves with the rise in the dollar price of gold, both of which have been impressive to say the least. China's central bank started buying up capital inflows in earnest in early 2001, right about the time that gold was hitting a multi-year low. This came to an end in early 2011, as net capital inflows approached zero, and shortly thereafter gold peaked. Both forex purchases and the price of gold increased by many orders of magnitude over roughly the same period.

Is there a plausible explanation for the strong correlation between these disparate variables? I think there is, but I can't say so with authority.

Gold bugs (and some supply-siders) will argue that gold rose because both the Fed and the BoC were "printing money" with abandon. The global monetary base exploded during this period, so naturally gold rose—because the world was being flooded with fiat currency. Gold was the only port in an eventual inflationary storm.

But we know that Chinese and U.S. inflation rates are still relatively low. There has been over a decade of impressive expansion of bank reserves and yuan, but inflation has so far failed to show up—outside of some impressive strength in commodity prices.

Don Luskin, a good friend, got me started down the path to an explanation for how China's forex reserves are connected to the rise in the price of gold. He argues that the outstanding stock of gold is relatively fixed—growing only about 3% per year—but that the demand for gold has jumped by orders of magnitude since China, India, and other emerging markets have enjoyed explosive growth and prosperity gains. In other words, the number of potential buyers of gold has risen much faster than the supply of gold, so naturally gold's price has increased. This is not a story about massive money printing and hyper-inflationary consequences, it is a story about a one-time surge in the demand for the limited supply of gold.

And that surge in demand for gold stopped almost two years ago as China's capital inflows have settled down to more manageable levels. Since capital is no longer flooding into China, China's growth rate is subsiding. Instead of purchasing massive amounts of foreign exchange reserves, China will in the future be purchasing more goods and services from the rest of the world as its economy continues to expand. This is "organic" growth, not super-charged, foreign investment-led growth.


Meanwhile, as the chart above shows, gold prices in real terms have reached very high levels. Should it be surprising that demand for gold is no longer accelerating now that its price has reached historically high levels relative to other goods and services? Gold is very expensive relative to other things at today's prices. Demand has its limits. At the same time, the very high price of gold is undoubtedly stimulating all kinds of efforts to increase gold production, thus bringing supply and demand into balance. As we approach two years of relatively stable gold prices, it is reasonable to conclude that the heydays of gold are now a thing of the past.

To sum up, the slowdown in Chinese growth and the end to China's massive forex purchases are good signs that the boom in gold is over.

Modest improvement in capital goods orders


December capital goods orders exceeded expectations (+0.2% vs. -0.2%), and November orders were revised up a bit (+3.0% vs. +2.7%). This proxy for business investment has now reversed over half of the decline that occurred from December through July, and thus the threat of an investment-led slump in the economy has receded significantly. Businesses are not going on strike, but they remain cautious. As of the third quarter last year, after-tax corporate profits were up 30% from their pre-recession peak, yet capital goods orders are still 9% below their pre-recession peak. Business' lack of confidence in the future—as manifested in a reluctance to invest in line with gains in profits—is one of the main factors restraining the growth of the economy.

Shipments of capital goods have risen for the past three months, and so this component of GDP will be positive in the fourth quarter, after subtracting in the third quarter. It's not a whole lot to be excited about, but it is a positive change on the margin, and when a number of those add up, the economic outlook continues to improve, albeit gradually.

Durable goods orders, meanwhile, reached a new post-recession high in December, and are only 5% shy of their pre-recession peak.