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Strong equity fund inflows




Domestic equity funds experienced their largest monthly inflow in the past six years, according to preliminary figures tallied by the Investment Company Institute (top chart). This follows six years during which equity funds experienced huge and almost relentless outflows. Has the tide finally turned? Are investors now finally becoming bullish after four years of strong equity gains? Perhaps, but if this is the beginning of the return of bullish sentiment, it likely has a long way to go before it runs out of gas.

Commercial real estate recovery is very impressive




The recovery in commercial real estate is now almost four years old. As the top chart shows, commercial property prices are up decisively in recent years. As reported by CoStar, its Value Weighted Index was the first to turn up due to strength in the high-end sector of property market. But now the equal weighted index is starting to catch up, a sign that the recovery is broadening.

The second chart shows the price action for Vanguard's REIT fund, whose price has risen 215% from its March '09 low. On a total return basis, this fund has trounced the S&P 500, gaining 287% vs. 142% since the March '09 lows.

Thanks to panic-induced selling in late 2008 and early 2009, commercial real estate and related prices reached incredibly depressed lows. This represented one of the buying opportunities of a lifetime. If the economy merely avoids another recession, commercial real estate is likely to continue to deliver attractive returns relative to the almost-zero yield on cash.

Full disclosure: I am long VNQ at the time of this writing.

Continued improvement in the labor market



Initial jobless claims last week were less than expected, but the 4-week moving average (chart above) was roughly unchanged. Compared to this time last year, claims are down a little over 5%. What we have here is a picture of a jobs market that has been slowly but steadily improving for the past four years. There is as yet no sign at all in this very timely indicator of any deterioration in the economy.


Meanwhile, the number of people receiving unemployment insurance continues to decline significantly on a seasonally adjusted basis. As of two weeks ago (this data comes out with an extra week's delay) there were 18% fewer people collecting unemployment checks than there were a year earlier, almost 1.3 million fewer. This continues to be one of the most significant changes on the margin in today's economy. More and more people have an increased incentive to find and accept jobs, and that brightens the economic outlook.

The economy may not be generating a lot of new jobs, but it is most certainly improving and not deteriorating, and that is a powerful message for investors. Why? Because the market in aggregate is still braced for a recession.

With guidance and encouragement from the Fed, the market is priced to the assumption that the U.S. economy will be very weak for the foreseeable future, and remains at risk of a relapse. That is the only possible interpretation of 0.27% 2-year Treasury yields, 2.03% 10-yr Treasury yields and -1.63% real yields on 5-yr TIPS. Investors are willing to accept nominal yields that are close to zero and negative real yields on TIPS (which effectively guarantee a loss of purchasing power) because they fear that nominal and real returns on alternative asset classes could be much worse.

The Eurozone economy is one source of recession risk, since it has shrunk for the past 5 quarters, and has not experienced any net growth for the past six years. So far, though, weakness in the Eurozone has been more in the nature of a headwind for the U.S. economy than an obstacle to growth.

Another potential source of weakness and concern is the looming spending sequester. The actual "cuts" to spending will be almost trivially small, however, and only strike fear into the hearts of committed Keynesians. Supply-siders like me see any shrinkage in the size of government as a reason to cheer, given that spending is still substantially above its long-term average relative to the economy. A smaller government means less "crowding out" of the private sector. It means the private sector will be able to keep more of the money it generates, and that in turn means a more efficient and healthier economy on the margin.

As I mentioned last month, avoiding a recession is all that matters. As long as the economy continues to expand, even if only by a little, the returns to owning risk assets will tower over the returns to safe assets like cash, TIPS, and Treasuries.

A good rule of thumb


"Whenever you find yourself on the side of the majority, it is time to pause and reflect."
-Mark Twain

Retail sales post modest growth



Retail sales rose modestly in January, probably due to the expiration of the payroll tax holiday. Total sales are up 4.4% in the past year; excluding autos, they are up 3.6%. Nothing very exciting going on here, but nothing awful either.


Adjusted for inflation, retail sales have recovered completely from their recession slump, having risen almost 17% from their 2009 low. But they are still well below where they could have been, had this been a normal recovery.


The retail sales "control group" shown in the chart above removes the most volatile items: autos, building materials, and gasoline stations. That makes it easier to see what's happened to sales and the economy. For 16 years sales grew at about 5% per year on average. Then came the recession, and sales have yet to recover any of the ground lost relative to their long-term trend. Ever since the recession ended in mid-2009, sales have been about 10% below where they might have been if this had been a typical recovery. That "gap" amounts to almost $600 billion per year in "lost" retail sales (the control group averages about 65% of total retail sales).


As the chart above shows, one thing that happened to make this recovery different was the loss of roughly 10 million workers from the labor force. For decades, the labor force (those working plus those looking for work) rose about 1% per year, in line with population growth. Then came the recession in 2008, and the labor force stopped growing. Today we have about 10 million fewer people in the workforce than we would have had if the 1% long-term trend were still in place. Where did they go? Many undoubtedly just gave up looking, and many of those were probably young and inexperienced workers who were priced out of the market because of increases in the minimum wage. Some became disabled: there are 1.6 million more disabled workers today than there were at the end of 2008. With 16 million more people receiving food stamps today than at the end of 2008, some are finding it a bit easier to give up looking for a job, especially when several family members are collecting food stamps at the same time. 

With jobs hard to get here, but conditions in Mexico improving (the Mexican stock market is now 35% above its pre-recession high), the U.S. is receiving far fewer immigrants looking for work. The Pew Hispanic Center estimates that net migration from Mexico is now zero or negative. Without immigration to supplement the declining rate of U.S. population growth, our labor force growth cannot sustain its long-term trend. A shortage of immigrants—also the result of our decision to issue no more than 520K immigrant visas a year—is likely a significant and overlooked factor behind our sluggish growth.

Reducing or eliminating minimum wage laws and opening our doors to all immigrants willing to work could go a long way to revitalizing the U.S. economy. 

Giving businesses new incentives to expand could also make a big difference. Reducing or eliminating the corporate income tax could accomplish wonders in that regard. As it is, our corporate income tax is the highest in the developed world. Reducing the tax on business would almost certainly result in more businesses locating here and expanding. More businesses and more opportunities likely would entice millions to re-enter the labor force.

The problem with the minimum wage


This is the best illustration I have ever seen of the fundamental problem with government setting a "minimum wage." As Mark Perry notes in a fascinating post on the subject, only about 2% of the 135 million people with jobs today earn the minimum wage or less. If the minimum wage is set too high, then younger and inexperienced workers never get a chance to work, because employers can't afford to hire someone that is expensive but has no experience or talents or a track record of success.

UPDATE: Keith Hennessy adds some meat to this argument.

Financial conditions continue to improve


Bloomberg's Financial Conditions Index is now at a post-recession high. This index incorporates a variety of measures of market liquidity, credit spreads, implied volatility, systemic risk, and equity performance. These are important economic and financial market fundamentals, and they thus augur well for the future health of the economy.

Federal budget continues to improve



One of the great, largely-untold stories of the past three years is the ongoing and substantial improvement in the federal budget. Thanks to very slow growth in spending and a decent rise in revenues, the budget deficit has declined from a high of $1.47 trillion in late 2009 to $1.03 trillion in the 12 months ended January 2013. Relative to GDP, the deficit has dropped from a high of 10.5% to 6.7%. This was achieved despite no increase in tax rates (and in spite of a 2-year payroll tax holiday), despite no announced budget cuts, and despite the Senate not having once passed a budget. Three cheers for Congressional gridlock, and a hearty "well done" to an economy that has managed to grow despite all the headwinds it has faced!


Looked at another way, the burden of the federal deficit has dropped by a very impressive 36% in the past three years. More important, perhaps, is that the burden of government spending has dropped by 10% over the same period. These rank as significant improvements in the underlying economic fundamentals of the economy, since they allow the private sector to keep more of its earnings. The private sector is much better at spending money than the government, so getting government out of the way and out of our pockets is a good thing.

Over the past year, federal revenues have grown by over 9%, mainly because the economy has been adding jobs. Even taking into account the surge in revenues in December, which was driven in large part by accelerated income and dividend payouts designed to avoid the threat of higher taxes in 2013, revenues had been rising at a 7-8% pace for most of last year, while spending in the 12 months ended January 2013 was up only 0.4%.

If current trends were to continue, the budget would be balanced within 7 years or so, without the need for budget cuts or higher taxes.

The problem, of course, is that these trends are not likely to continue, unless we get real healthcare and entitlement reform. Healthcare costs are going to rise enormously if and when Obamacare is implemented, and social security benefit payments are going to outstrip receipts unless the retirement age is increased, benefit increases are limited to the increase in inflation, and payouts are means-tested.

But for the time being, things are getting better, and that's good news that is not widely understood.