Main menu

Dramatic improvement in federal finances

Big changes that are unexpected have the power to dramatically affect markets, and that's been the story of the U.S. economy these past four years. The U.S. economy is in much better shape today than was expected four years ago, and the federal budget outlook is significantly better today than was expected four years ago. As a consequence, the expected future burden of federal taxes has declined, and the need for painful spending austerity has receded. All of this translates into very good news for risk assets, and goes a long way to explaining the equity market rally that began four years ago and continues today.

The first chart above shows federal revenues by month for the past four years. Revenues have been on a moderately rising trend since late 2009. Note, however, the huge increase in April 2013 revenues, the likely result of 1) higher taxes paid by those who accelerated income and capital gains realizations into the final months of 2012 in order to avoid an expected increase in taxes this year, 2) the end of the payroll tax holiday, 3) higher income taxes on the rich, and 4) ongoing growth in the U.S. economy which continues to lift personal income. The second chart above shows that the bulk of the April increase in federal revenues—about 70%—came from individual income tax receipts. That further suggests that a good portion of the April surge was a one-time occurrence, the result of accelerated income and capgains realizations late last year. Nevertheless, higher income taxes on the rich, and ongoing growth in the economy, personal incomes, and corporate profits, should continue to provide a marginal boost to revenues for the remainder of the year. 

April's revenue bonanza was equivalent to an annualized 0.42% of GDP, lifting 12-month revenues to 16.75% of GDP, which is about 2 percentage points better than the late-2009 low of 14.6%.

The main driver of higher revenues is simply the ongoing growth of the U.S. economy, which in turn has boosted incomes. corporate profits, and capital gains. The bigger story, however, is the huge decline in federal spending relative to GDP, which has fallen from a high of just over 25% to now just over 22%.  As the first of the above charts shows, this is all due to flat growth in federal spending; no actual cuts were necessary to reduce the burden of government spending by over 3 percentage points in just four years.

With spending flat and revenues up, the burden of the federal deficit has fallen by almost half, down from a high of 10.5% to 5.4% last month. In dollar terms, the 12-month deficit is down from a high of $1.47 trillion in 2009 to $856 billion as of April.

I'm reminded of my May 2009 post on how awful the federal budget outlook was, and in which I commented:

Let's be optimistic and assume the economy is already beginning to grow again, but it's hard to see a recovery in revenues that is much stronger than what we saw coming out of the 2001 recession. What was then the "jobless recovery" is going to be replaced by a recovery that has to climb a wall of higher taxes. That means that revenues probably won't turn up meaningfully for another couple of years. Meanwhile, we know that spending is on track to reach $4 trillion next year. The amount of debt that will need to be sold over the next few years is thus absolutely staggering.

... the prospect of massive Treasury supply is being ignored as a threat because that same supply will bring with it a massive increase in taxes, which will in turn keep the economy weak for the foreseeable future, which will in turn keep inflation low.

"Trillion-dollar deficits for as far as the eye can see" were the par for the course for most economic forecasts four years ago. Back then, hardly anyone was prepared to believe the U.S. economy was on the cusp of a recovery.

In a post in November 2008 I reasoned that "the current level of spreads on investment grade bonds implies that about 9% will be in default within five years, and fully 70% of speculative-grade bonds will be in default." As the chart above shows, high yield credit default swap spreads reached a peak of over 1800 bps in March 2009, a level which suggested that defaults over the next five years would be almost catastrophic. Today, just four years later, actual corporate bond default rates are historically low, and spreads on high-yield CDS have collapsed.

In the same November 2008 post I noted that "the stock market is assuming that corporate economic profits [will] decline by at least two thirds over the next few years. Any way you look at it, the pricing on corporate bonds and stocks today implies that the next several years will be the most disastrous in the history of the U.S." As we now know, instead of plunging, corporate profits are now almost double what they were at the end of 2008. Instead of years of deflation, we have had four years of relatively low and average inflation. Instead of an extended recession/depression, we have had four years of 2% annualized GDP growth.

In short, the future has turned out to be dramatically better than expected, and that is why risk assets are rallying. Moreover, with the very impressive improvement in federal finances, the specter of crushing tax burdens and wrenching austerity measures has receded significantly. Where once there was no hope whatsoever, there is now reason to be optimistic.

What's good for Japan is good for everyone

As I mentioned last January, one of the biggest things happening on the margin is the decline of the Japanese yen. It has now fallen to 101 yen/$, a level not seen since late 2008. The big decline of the yen marks what will most likely prove to be the end of Japan's deflation affliction, and it is causing a significant improvement in the economic fundamentals of the Japanese economy.

The chart above shows just how strong the yen was, having reached an all-time high against the dollar of almost 75 in late 2011. By my calculations, that made the yen approximately 50% overvalued vis a vis the dollar. For 40 years the yen had been rising (off and on) against the dollar, from almost 400 to 75: roughly a five-fold increase in its value. This was a near-constant source of pain for Japan's exporters, since they were continuously forced to cut costs in order to remain competitive in international markets. Now the deflationary pressure has been relieved, and in a rather big way. 

As this next chart shows, the value of the yen and the level of the Japanese stock market have been closely correlated for the past several years, especially since mid-November: the yen has dropped over 20%, from 79 to 101, and the Nikkei 225 has soared by 68%, marking one of the sharpest equity rallies in memory.

What's good for Japan is good for the U.S.: since mid-November the S&P 500 is up 20%. 

Gold is telling us that Japan's new monetary policy is not likely to be inflationary; since mid-November, gold in yen terms is up only 5%, while it has declined 15% in dollar terms. Indeed, gold's fall suggests that investors may be realizing that buying productive assets is likely to be more rewarding in the long run than speculating on commodity prices. 

The return of a more healthy growth outlook in Japan has already made equity investments in general more attractive than speculating in commodities, which are about flat since mid-November. As the chart above shows, the market cap of global equities is up 18% ($5.7 trillion!) since mid-November. The increase in the value of global equity markets since mid-November has been of the same order of magnitude as the value of the world's entire stock of gold, which is estimated to be as much as 175,000 tons, or roughly $8 trillion at today's prices.

The risk of recession is low and declining

Credit default swap spreads are coming back down to earth, and they are now at a new post-recession low. They are still higher than they were in early 2007, when markets were still unconcerned about the budding subprime mortgage crisis, but they are now lower than they were just prior to the onset of the Great Recession. Pessimism is thus receding, and I think that's what is pushing the prices of corporate bonds and equities higher, not excessive optimism. Not yet, at least.

Looked at another way, CDS spreads are telling us that the risk of a recession is declining meaningfully. As I've been saying for months now, avoiding recession is all that matters to investors. When cash yields nothing but risky investments yield a lot more, it only makes sense to remain in cash if you are very fearful of another recession or an onslaught of bad news. The economy is likely growing at a disappointingly slow pace, but it is nevertheless growing, and the risk of recession is low and declining. More and more investors are seeing the train leaving the station and they are increasingly anxious to not be left behind. As investors attempt to shift out of cash, they inevitably push up the prices of risk assets.

Fund flows show investors still cautious

With data as of last week, ICI's tally of equity fund flows shows no net inflows for the past two months, even as equity prices have hit new all-time highs. Bond funds, meanwhile, continue to enjoy strong inflows, even as bond yields remain very near all-time lows. Mutual fund flows thus reflect a market that is still dominated by caution.

The chart below is a reminder of just how low 10-yr Treasury yields are from a long-term historical perspective:

The chart below is a reminder that the real yield on TIPS tends to track the economy's health:

Negative real yields imply that investors have very pessimistic assumptions for economic growth over the next few years. This jibes with the dearth of equity fund inflows. There is a real shortage of optimism out there.