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The big news is a weaker yen (update)

Six weeks ago I noted that one of the biggest changes on the margin was the sharp decline of the Japanese yen and the equally sharp rise of the Japanese stock market. This meme is still alive and well, and here are some updated charts:


Since the end of last September, the yen is down almost 20% vs. the dollar. According to my calculation of its Purchasing Power Parity, the yen is still somewhat overvalued, but much less so now that it was just a few months ago. A very strong yen represents a deflationary force that was suppressing the growth of Japan's export sector, a key part of the economy. So a less-strong yen should be good news for the Japanese economy, since the yen has been appreciating on and off for the better part of the past 30 years.


Since mid-November, the Japanese stock market is up 40%. It is still quite low from an historical perspective (recall that the Nikkei 225 hit a high of 40,000 at the end of 1989), but now much less so.


This chart compares the value of the yen with the level of the Nikkei 225. Note that the correlation has been quite high for years now. A chronically stronger yen (as shown by the declining red line) has corresponded with a weaker stock market. Now things seem to be changing, and in a big way, thanks to new leadership from Prime Minister Abe which seeks to stimulate growth by relaxing Japan's notoriously-tight monetary policy.

If "Abenomics" does prove beneficial to Japan's economy, as the stock market suggests, this will also be good news for the rest of the world.

Jobs report better than expected

The February payroll report was better than expected, better even than the ADP report suggested. Private sector jobs are growing at about a 2% rate, which is enough to bring the unemployment rate down over time. If productivity retains its long-term average growth of 1% per year (it was only 0.5% last year), this points to real GDP growth of 3%. That's not enough to close what I estimate to be the economy's 13% output gap, but it's sure better than stagnation.



February nonfarm payroll gains were much stronger than expected (236K vs. 165K), and private sector  payroll gains were even stronger (246K vs. 170K), as the public sector continues to shed jobs. Since the low in early 2010, the private sector has generated 6.35 million jobs. We're still a long way from where we should be—it would take maybe an additional 5-7 million jobs to put the economy back on its long-term growth track—but the progress is undeniable.


Jobs growth in the private sector actually has been running at about a 2% rate on average for almost two years now, which is about the same pace as we saw in the mid-2000s.


The thing about this recovery that has been different from all others is the extremely slow rate of growth of the labor force: those who are either working or looking for work. As the chart above suggests, some 5-6 million people have "dropped out" of the labor force, presumably because they have given up looking for a job. That explains a lot of the decline in the unemployment rate.


Regardless of whether the unemployment rate is understated (overstating the economy's health) or not, the fact remains that there has been a significant increase in the number of jobs over the past three years. Unemployment has clearly declined, and as usually happens during recoveries, government spending as a share of GDP has also declined. These are two very welcome developments. The recovery is proceeding in typical fashion, even though it's been a very sluggish recovery.


The stock market rally is fully justified by the ongoing—albeit slow—recovery in the economy. The chart above compares the decline in weekly unemployment claims (inverted, as a proxy for the economy's underlying health) to the S&P 500. Nothing unusual here at all. Claims are getting back down to "normal" levels, and the stock market today is only 2% shy of regaining its former high.

I don't think monetary policy has had much to do with the economy's recovery. The Fed has responded to the market's intense demand for safe-haven assets by buying $1.7 trillion of Treasuries and MBS, effectively swapping bank reserves (which are functionally equivalent to 3-mo. T-bills) for bonds. They haven't "printed" much more money than usual, and the fact that inflation has not soared is good evidence that they haven't done too much.


But as the chart above shows, inflation expectations are now picking up. The difference between the yield on 5-yr TIPS and 5-yr Treasuries is now 2.58%, which is the market's expectation for the average annual inflation rate over the next 5 years. This measure of inflation expectations has rarely been this high since TIPS were first issued in 1997.


The chart above shows the yield on 30-yr T-bonds. Note that since QE3 was officially announced in early November, yields are up about 50 bps. Yes, even thought the Fed has been buying bonds and trying hard to push long-term bond yields down, yields have instead risen. This is the paradox of Quantitative Easing: if it works (by stimulating inflation expectations), then it won't be able to do what it was intended to do (depress long-term yields). In other words, the Fed's failure to artificially depress long-term yields is good evidence that it has been successful.

It's becoming increasingly obvious that we no longer need more Quantitative Easing. QE3 is overstaying its welcome.

Household net worth recovering nicely

According to the Federal Reserve's calculation of households' balance sheet, household net worth at the end of last year recovered to its highest level since the onset of the 2008-2009 recession. Net worth is still about 8.5% below its pre-recession highs after adjusting for inflation, however, but at this rate (net worth rose 9% last year) we could see a new high in net worth in both nominal and real terms by the end of this year. Equities are already up over 8% year to date.


The recovery since late 2007 has been healthy in every respect: equity valuations are up, savings are up, real estate values are up, and liabilities are down. Households have deleveraged and built up their savings, and the recovering economy has boosted equities and, more recently, housing prices.


According to Radar Logic, housing prices rose over 13% last year.

The recovery may have been slow and agonizing for many, but it is for real. The U.S. economy has gone through tremendous adjustments that have enabled it to resume a normal and healthy path of growth.

Still no sign of a recession



Weekly claims for unemployment continue their downward trend, and announced corporate layoffs remain low. These two indicators strongly suggest that the economy continues to avoid another recession; their is no apparent deterioration in the labor market. Indeed, it is still the case that conditions are improving: the number of people receiving unemployment insurance is down 22% from a year ago. There are 1.5 million fewer people "on the dole" today than there were a year ago, and those people have an added incentive to look for and accept a new job.

As long as the economy avoids a recession and continues to grow, albeit relatively slowly, the rationale for holding large sums in safe, conservative assets (e.g., cash, cash equivalents, and short-term Treasury securities) becomes weaker and weaker. On the margin, more and more people are going to want to reduce their holdings of low-risk assets and increase their holdings of risk assets; this shift in the appetite for risk is a large part of what is driving riskier asset prices higher these days.

ADP jobs report stronger than expected

ADP released yet another set of revisions to its projection of the change in private sector payrolls that is reported by the BLS. As the chart below shows, ADP's numbers now track the BLS numbers fairly closely. If that track record continues, we are likely to see the BLS change in private payrolls, to be released Friday, come in a bit stronger than the 170K that is currently expected, since ADP's February number was somewhat stronger than expected (198K vs. 170K). Regardless, it is likely that jobs are growing by something like 150-250K per month, nothing to get very excited about, nor anything to worry about.


Bankruptcies fall by half

Bankruptcy filings through January of this year continued a dramatic downtrend nationwide. Total U.S. bankruptcy filings were down 51% from their peak in early 2010, while filings in California's Central District were down 52% from their early 2011 peak. At this rate, bankruptcy filings will be back to something close to a "normal" rate by this time next year. It all adds up to persuasive evidence of a significant improvement in U.S. economic fundamentals. 



Argentine peso blues



The Argentine peso is headed for yet another big devaluation. The government has been propping up the peso by restricting people's ability to sell it, and by selling its holdings of foreign reserves, which are down 20% in the past two years. It's foolishly attempting to convince the public that inflation is only 10% when in reality it is closer to 30%. But currency in circulation is growing by almost 40% per year, and to judge by the decline in the unofficial "blue" peso rate (see chart above), demand for the peso is in free-fall, at the same time the government is running the printing presses 24/7. Inflation is thus likely to accelerate, even as the economy slows, thanks to ill-advised import limitations, currency controls, and unofficial capital flight. It's a recipe for yet another big devaluation disaster, and the only question is when, not whether it will occur. The fuse is short and getting shorter by the day.

If you're traveling to Argentina, you'll want to take plenty of $100 bills with you so you can exchange them for pesos at the "blue" rate (about 8) at hotels and restaurants (the government says it's illegal to do this, but demand for dollars is so high you shouldn't have much of a problem). Otherwise, if you use a credit card or ATM you will be exchanging dollars for pesos at the official rate (currently 5). That's a huge difference: on the "blue" market your dollar buys 60% more pesos than it does at the official exchange rate.

I've seen this movie so many times in my 40 years' experience with Argentina that it is like watching a slow-motion train wreck. If I've learned anything, it's that you can never underestimate the ability of the Argentine government to screw things up. The incompetence and corruption of the government is endemic and criminal.

Stocks for the long haul

With the Dow Jones Industrial Average today reaching a new all-time high, it's appropriate to step back and put this achievement in a long-term context. What we see is that stocks have delivered about a 7% annualized price return for those willing to be very patient and adopt a buy-and-hold strategy. Including dividends, the S&P 500 has delivered a total annualized return of just over 11% since 1950. 



UPDATE: Here is a chart of the S&P 500 in real terms, using the CPI. The CPI has risen at a 3.7% annualized pace since 1950, and subtracting that from the 6.8% trend lines in the second chart above, we get a 3% real annualized trend, which not coincidentally happens to be very close to the economy's annualized growth rate over this same period.


Service sector continues to grow moderately

According to the February ISM survey of the service sector, business activity remained moderately healthy. The composite index was actually a bit stronger than expected (56 vs. 55). The employment subindex rose to a relatively high level, suggesting somewhat stronger economic growth in the months to come. Importantly, there is no evidence in these figures of any weakness or impending recession, and no sign either of any deflationary threat. On balance, this is a "steady as she goes" report that is moderately encouraging. Conditions in the Eurozone service sector remain somewhat depressed, however. 





The "sequester" doesn't cut spending at all

If there is one explanation for why the equity market is rising despite the onset of what those on the left are calling a draconian cut in goverment spending, it is that the "sequester" that was triggered the other day doesn't cut spending at all. It merely slows the growth of government spending by a tiny amount. Dan Mitchell of the Cato Institute did a good job of illustrating this in a post a month ago, titled "Exposing the Absurdity of Washington's Anti-Sequester Hysteria."


He notes: "As you can see from this chart, the sequester will 'cut' spending so much that the budget will grow by 'only' $2.4 trillion over the next 10 years."

Even with the sequester, federal government spending will rise this year, and it is scheduled to rise every year for as far as the eye can see. This is a "cut" only in the Alice in Wonderland world of budget-speak.

Investors are usually smart enough to see through the smoke and mirrors, and what they see is a slowing in the growth of government spending: something that is badly needed and long overdue, but nevertheless a step in the right direction.

As a reminder of where we stand when it comes to federal spending, I repost the following two charts:



The battle that is being waged to slow the growth of government spending has actually been going on for the past four years, so this latest skirmish is nothing new. As the second of the above two charts shows, federal spending has already shrunk considerably relative to the economy, but it remains historically very high. If the very high levels of federal spending in the past four years failed to create a robust economy, then lower levels could arguably be a much-needed stimulus. Government spends money less efficiently than the private sector, so shrinking the size of government gives the private sector more breathing room and that in turn should create a stronger, healthier economy. It's a slow process, but we are making progress.

End the corporate income tax

Richard Rahn, a clear, level-headed thinker, wrote a nice article in The Washington Times last week titled "Ending the Corporate Tax." I like it because it neatly summarizes all the pros (which are few) and cons (which are many) on the issue of whether corporations should be taxed, in a way that just about anyone can understand. It's an important issue, especially as Washington these days is torn between those who want more taxes to fund even more government and those who want less government and lower taxes, while the most pressing concern is finding the best way to foster a healthier economy with more jobs. Here's an excerpt:

Economists dislike the corporate income tax because it reduces productive labor and capital and is an additional tax on income that has already been (or will be) taxed. Politicians love the tax because it is largely invisible to most voters.

If a corporation has to pay higher income taxes, it will have less money for research and development, expansion and job creation. The money invested in corporate stocks has already been taxed at least once when it was earned, and it will be taxed again when it is paid out in dividends or sold for a capital gain. How many times should the same income be taxed?
Ask yourself, who is likely to spend the money in a way that will bring more human satisfaction and create more jobs — corporate executives trying to make money by producing goods and services people want, or politicians and government bureaucrats trying to enhance their own power?
As most good economists and knowledgeable others understand, the world would experience a better allocation of resources and more job creation if the corporate income tax was abolished. Fights over which jurisdiction gets to tax and how much it can tax would disappear. The so-called revenue loss would be made up by taxes on the dividend and capital gains increases, and by the extra economic growth and employment that would result from ending the corporate tax.

Sterling update: still somewhat expensive

Last Friday I suggested that the dollar was still very weak against a large basket of currencies. This post focuses on the dollar's value vis a vis the British Pound.


The green line in the above chart is my calculation of the Purchasing Power Parity of the dollar/sterling exchange rate. This is the rate that in theory would make prices equal between the two countries. At this rate U.S. tourists to the U.K. would find that on average goods and services cost about the same there as in the states. The rate is calculated by using a base year for the exchange rate (i.e., a period during which prices where roughly equivalent between the two countries) and adjusting that rate by the difference in inflation over time between the U.S. and the U.K. The PPP of the pound has been falling over the entire period of the chart, which means that inflation in the U.K. has been higher than inflation in the U.S. So the PPP value of the pound must fall in order for prices to remain equal (i.e., the weaker PPP value of the pound offsets the higher nominal prices in the U.K.).

As a rule of thumb, significant deviations between the value of a currency relative to its PPP value reflect stronger/weaker demand for the currency, which in turn is related to confidence in a country's fiscal and monetary policies, and/or the outlook for the economy.

Currently, I estimate that the pound is about 10-15% overvalued relative to the dollar. If I'm right, that means that goods and services cost about 10-15% more in the U.K. than they do in the U.S. This is down significantly from the 40% overvaluation of the pound in late 2007. The dollar was weak against almost all currencies back then, and it had been falling for the previous 5 years. The Euro was also quite strong at the time, and Eurozone equities had outperformed U.S. equities for 5 years running. As I see it, the world was much more optimistic about the future of Europe at the time than about the future of the U.S. Today the world is losing its enthusiasm for Europe as the list of things to worry about (relatively high public debt/GDP ratios, relatively high tax rates, large unfunded pension liabilities, sovereign debt defaults, a potential breakup of the ECU, the inability of most states to cut back on excessive public sector spending) lengthens. Meanwhile, things haven't been as bad in the U.S. as had been expected.

If the U.K.'s troubles prove to be deep-seated, intractable, and worse than the troubles still plaguing the U.S., then the pound is likely to fall further against the dollar. In a worst-case scenario, there is little reason why the pound couldn't again approach parity with the dollar, as it almost did in 1985. For the time being, I'd be reluctant to be long the pound vis a vis the dollar. U.S. investors would be wise to ensure that any investments they have in Europe or the U.K. are not exposed to currency risk. U.K. investors might want to leave the currency exposure of any U.S. investments unhedged.