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Credit spreads are moderately attractive

Corporate credit spreads today are at post-recession lows, which makes them much less attractive than they were four years ago. However, they are still above the levels that prevailed during the strong growth phases of the previous two business cycles. Spreads are thus only moderately attractive. Investment grades spreads offer only a modest cushion against an increase in Treasury yields, while high-yield spreads offer substantially more. Bear in mind that Treasury yields are likely to rise only to the degree that the economy and/or nominal GDP picks up, and in either case that would reduce the risk of defaults, thus providing a further cushion against higher Treasury yields. 


UPDATE: I think spreads at this level reflect a market that has lost a good deal of its pessimism, but is not necessarily optimistic or overly optimistic. High-yield spreads are still 200 bps above the lows of early 2007, when the economy was growing at a reasonable pace and the future looked OK, and the subprime mortgage crisis was still in its infancy. Investment grade spreads are only 60 bps above the 2007 lows.

Overcoming adversity

Russell Redenbaugh, a good friend of mine for the past 20 years or so, has been a great source of inspiration. He has triumphed over great adversity—losing his sight and the normal use of his hands—to become a successful investor, a world champion at jiu jitsu, and an influential voice in conservative political circles. I struggled with the loss of my hearing about 10 years ago, but that's nothing compared to what Russell has managed to accomplish. I consider him to be one of the smartest analysts and investors I know, and I feel privileged to have collaborated with him over the years.

In this video from a recent TED conference, he tells his story in 18 minutes. 

Capital goods orders looking better

A month ago, capital goods orders were looking disappointing. Today's release of April figures, which included a 2.5% upward revision to prior numbers and beat expectations (+1.2% vs. +0.5%), has returned this series to the "moderate growth" column. Capex orders are now up 2.6% over the past year, after fully recovering from a disturbing slump last summer.


This is encouraging, to be sure, but we will need to see better numbers than this if the economy is to do better than plod along at the 2% growth rate that has prevailed over the past few years. Businesses still remain quite cautious, and one need look no further than the significant uncertainties surrounding the impending implementation of Obamacare to understand at least in part why.

Nevertheless, the "recovery" in this series provides good support for the view that the economy continues to grow and that a recession is nowhere to be found. That is a critical point, since yields remain extraordinarily low from an historical perspective, and consistent with rather dismal growth expectations. If we could be confident that the economy could post 2% or better growth for the foreseeable future, yields would likely be substantially higher than they are today, since the Fed would almost surely have abandoned its zero interest rate policy stance.

Thoughts on Tim Cook's testimony

I can't help but note the media's bias which is exemplified by a Bloomberg article that implies that Apple has avoided taxes by "shifting income ...  to offshore tax havens."

Given that Apple has fully complied with all applicable laws, why should anyone presume that corporations have a duty or an obligation to maximize their tax liability? Corporations' duty is first and foremost to maximize shareholder profit. Without profit corporations cannot exist. If corporations fail to maximize their profit they are wasting scarce resources.

Are financial journalists ignorant of the fact that the incidence of corporate taxes falls almost entirely on consumers? The bulk of any tax on corporate profits must eventually be passed on to consumers in the form of higher prices, since corporations must earn a minimum return on equity in order to remain in business. Corporations benefit society most by adding value to scarce resources and satisfying consumer demands, not by paying taxes.

Are politicians and journalists arguing that we would all be better off if the government took a much larger share of Apple's profits? Show me one example in which the government utilizes scarce resources more efficiently than Apple and I might agree that Apple should pay higher taxes. But I am quite comfortable believing that Apple can more efficiently utilize scarce resources than the government, and that therefore Apple's tax burden should be as low as possible in order to advance the common good.

I'm with Rand Paul on this:

“I’m offended by a $4 trillion government bullying, berating and badgering one America’s greatest success stories,” the Kentucky Republican told the committee. “Tell me what Apple has done that is illegal?”
“If anyone should be on trial here, it should be Congress,” he insisted. “I frankly think the committee should apologize to Apple. I think that the Congress should be on trial here for creating a bizarre and Byzantine tax code that runs into the tens of thousands of pages, for creating a tax code that simple doesn’t compete with the rest of the world.”
Apple has amply demonstrated the absurdity of our tax code by borrowing $17 billion to avoid paying taxes twice on money it has earned overseas. Apple is essentially engaging in an arbitrage in which it will pay less than 2% a year in order to avoid paying 35% on any overseas profits it might otherwise repatriate. When such a huge arbitrage exists (otherwise known as a "wedge" to economists) it is a sign of markets and regulatory structures that are seriously dysfunctional and inefficient. This is a compelling argument for reforming our tax code and sharply reducing the corporate tax rate. At the very least, the U.S. corporate tax rate should be no higher than it is in majority of the countries in which our businesses compete, and we should never impose a tax on money that has already been taxed in another jurisdiction.

Corporations should be indifferent to repatriating money earned overseas; they should never be penalized for doing so.

In an ideal world, the corporate tax rate should be zero and there should be no deductions. If Tim Cook made any mistake in his testimony earlier this week, it was in being overly generous in suggesting a compromise in which the corporate tax rate would fall to 20%. If there must be a compromise, then tax reform should employ a static-revenue-approach in which a lowering of the corporate tax rate is offset by the elimination of deductions.

I'd like to think that Apple came out ahead in this congressional battle, if only because it has logic on its side. I'd also like to think that this has been very instructive for the electorate, and that it has therefore advanced the cause of tax reform.

An early end to QE3 is not something to worry about

Early last week I argued that the beginning of the end of QE3 was not scary, even though the Fed could start scaling back its asset purchases within a few months. Yesterday the Fed moved closer to doing just that, and it sent paroxysms of fear rippling through global equity markets. As I see it, this is simply an overreaction. The economy is not about to collapse just because the Fed buys fewer Treasuries and MBS. The Fed is going to be scaling back QE in response to an improvement in the economic outlook and there's nothing scary about that at all.

Reading the bond market tea leaves shows that bond market is rationally reflecting an improvement in the economic outlook, rather than any deterioration. This in turn suggests that the equity market selloff is overdone.


The chart above illustrates the biggest change to hit the bond market of late: a sharp rise in 5-yr real yields on TIPS. Since the beginning of April, 5-yr TIPS real yields are up over 70 bps, and that's a big deal.


The chart above compares the real yield on 5-yr TIPS to the 2-yr annualized real growth of the U.S. economy since 1997. As I've argued before, real yields on TIPS tend to track the market's expectations for economic growth. Real yields in the past two years have been negative because the market has been extremely concerned over the possibility of zero or negative growth going forward. It only makes sense to buy TIPS with a negative yield—thus assuring a loss of purchasing power—if you are really concerned that returns on risky assets could be much worse. The recent rise in real yields tells me that the bond market has now become less pessimistic about the prospects for U.S. economic growth, and that same change in sentiment can be found in Fed governors' recent statements. We aren't seeing more optimism, we are seeing less pessimism. The risk of bad things happening has declined, so it is less imperative for the Fed to continue its asset purchases.


The above chart shows 5-yr nominal yields on Treasuries and 5-yr real yields on TIPS, as well as the spread between the two—which is equivalent to the market's expected average annual inflation rate over the next 5 years. Real yields have risen much more than nominal yields, which have barely budged, and that is the result of declining inflation expectations, which are now down to just under 2%, only slightly below the 2.08% average of the past 16 years. Nothing scary at all here: inflation expectations have moderated a bit, and concerns over future economic growth have also moderated a bit. That change in sentiment can also be what's driving gold prices down from exceptionally high levels.


As the above chart shows, long-term inflation expectations have also moderated a bit, but they remain absolutely normal at 2.3%, considering that the annualized increase in the CPI over the past 10 years has been 2.4%. Nothing scary here: inflation expectations remain "well-anchored," as the Fed is wont to say, and there is no sign of deflation concerns either.


The above chart of the spread between 10- and 30-yr Treasury yields is a good measure of the slope of the yield curve, which remains just about as steep as it has ever been. A steep yield curve is a classic sign of a market that expects short-term interest rates to rise in the future, and as a corollary, a sign that the market considers the Fed's current monetary stance to be very accommodative (easy money today almost guarantees that monetary policy will have to tighten in the future). If the bond market were worried that Fed tightening could threaten the economy, then the yield curve would be a whole lot flatter.

By the way, the above chart also shows that the Fed's efforts to flatten the yield curve have not succeeded at all. As I explained last week, when a central bank's massive bond purchases produce a counter-intuitive result, that is a very good sign that monetary ease is working.



Meanwhile, high-frequency data such as weekly claims for unemployment continue to be consistent with an economy that is growing. Nothing to worry about here.


As the above chart of bank reserves shows, the magnitude of the Fed's latest round of asset purchases has been quite modest compared to what it was with QE1 and QE2. Tapering its purchases beginning in a few months will be equivalent to the Fed adding fewer drops to a relatively full bucket.

Consumer loan delinquencies hit a new low


Delinquency rates on consumer loans and credit cards fell to a new all-time low in the first quarter of this year.


Abstracting from student loans, which are growing at a (frightening) 20%+ annual rate and now make up some 20% of all consumer credit, banks have not aggressively expanded their consumer lending activities, as shown in the chart above. This presumably owes much to tighter lending standards and to consumers' desire to deleverage. But there has not been a wholesale curtailment of consumer lending that might explain declining delinquency rates. Falling delinquency rates thus are most likely a sign of improving consumer finances, prudent lending standards, and greater job stability.


If there is anything to worry about, it is the still-rapid expansion of student loans that began in early 2009 when the federal government essentially took over the student loan market. The other day I helped my daughter apply for a $20,000 student loan and it took her about 5 minutes online to qualify. Surprisingly easy. Probably too easy for most, and a likely source of future problems. With easy access to federally-provided credit, students are enabling colleges to continue charging what in many cases are exorbitant amounts.

Watch out for the seemingly-inevitable bursting of the higher education bubble. In the meantime, declining consumer delinquency rates are a healthy sign.