Thursday, January 11, 2018

Worrying about rising confidence

Confidence is high and risk-taking is on the rise, and that is something to worry about. It's not because equity prices are soaring and therefore downside bubble-popping risks are greater. It's because more confidence and a greater willingness to take on risk mean that the demand for money is declining, but the Fed—at least for now—is reluctant to move aggressively to offset the decline in money demand by boosting short-term rates and draining excess reserves. As Milton Friedman taught us years ago, inflation is a monetary phenomenon which results from an excess of money relative to the demand for it. Today we have declining money demand at a time when the supply of money remains abundant (e.g., $2 trillion of excess bank reserves) and interest rates remain very low. It's likely that because of this we are seeing the early signs of rising inflation in the form of higher prices for sensitive assets such as gold and commodities, and a decline in the value of the dollar.

Here's what we know so far: The boost to confidence began just over a year ago, coincident with the surprise election of Donald Trump, who promised to take radical measures to boost the economy by cutting tax and regulatory burdens. Confidence at both the consumer and small business levels promptly surged. The growth of bank savings accounts began to slow, the dollar began to decline, and gold began to rise—all such changes being symptomatic of declining money demand and the rational result of rising confidence. Now, in the past month or so, inflation expectations as embodied in TIPS and Treasury prices have risen from about 1.8% to 2.0%.

None of this is as yet scary or off the charts, but it is worrisome. It's not too late for the Fed to step up the pace of its rate hikes and reserve draining operations, but since the market is not expecting this to happen, the reality of an unexpected rise in interest rates would be at the very least a headwind for the equity market and/or fodder for selloffs and consolidations. And if the Fed doesn't react with faster rate hikes and more reserve draining, then inflation could become embedded and difficult to tame—and before too long we'd be worried about another recession.

I'm not saying we're on the cusp of disaster. What I'm saying is that we now have accumulating evidence and reason to be concerned about the risk of rising inflation and higher interest rates. It's great news that the economy is doing better and tax reform has passed; there is every reason to believe that the economy is headed for at least several years of much stronger growth. But the coast is not completely clear.

In a best-case scenario, I'd like to see the bond market signal the Fed that higher rates are warranted. The collective wisdom of the bond market is arguably better than that of a handful of Fed governors. One key thing to watch for is higher real yields, since that would be an indication that the market is pricing in stronger growth, and stronger growth and higher nominal and real yields go happily hand-in-hand. So far, however, real yields remain quite subdued. To date, the move to higher yields is concentrated in the nominal space, and that means that rising inflation expectations—not stronger growth—are what's driving yields higher.

Here's the evidence of declining money demand:

Chart #1

Small business optimism (Chart #1) surged almost immediately following the November '16 elections. It's now about as high as it has been in decades. One reason for increased business optimism is undoubtedly the huge reduction in regulatory burdens that the Trump administration has managed to achieve in one short year. Under Trump's leadership, there has been a one-third reduction in the number of pages in last year's Federal Register compared to Obama's last year, and the number of rules in the 2017 Federal Register was the lowest since records were first kept in the mid-1970s. And that low figure of course includes all the rules that Trump issued to get rid of other rules, so the reality is even better than the numbers suggest. (HT: Warren Smith)

Chart #2

As Chart #2 shows, consumer confidence began rising to healthy levels a few years ago. It's not yet at extremely high levels, but it is significantly better now that it was during most of the recovery years.

Chart #3

Chart #4

Charts #3 and #4 are the most important of all the charts in this post. What they show is a significant reduction in the growth of bank savings deposits in recent years. The slowdown accelerated in the past year, as growth rates fell from 8% in late 2016 to 3% in late 2017. Savings accounts in the current business cycle have been excellent indicators of money demand because they have paid extremely low rates of interest; no one has put money in a savings account in order to get huge interest rate rewards. What they are looking for is safety and liquidity. Yet despite paying almost nothing, bank savings account more than doubled in the past 9 years. This can only be because people had an overwhelming desire to keep their money safe while they increased their holdings of money. But now, people are becoming less and less risk averse, and the demand for cash and cash equivalents (like savings accounts) is declining in favor of increased demand for equities and other risky assets. With more confidence comes less desire for safety and a greater desire to take on risk.

Chart #5

Chart #5 shows how the public's desire to hold on to money increased dramatically beginning in the Great Recession. Think of M2 as a proxy for the amount of cash and cash equivalents the average person wants to hold, and nominal GDP as a proxy for the average person's annual income. The ratio of M2 to GDP peaked about six months ago, after reaching an all-time high, because there was a huge move on the part of the public to boost their stores of safe cash and cash equivalents. Since it's apparent that the public wants to shed some of its cash holdings, the only way that can happen is if there is a faster increase in nominal and real GDP. The extra amount of money that could be shed could translate into trillions of dollars of additional real and nominal GDP.

Chart #6

Chart #7

Chart #6 shows an index of industrial metals prices, which have increased by almost 17% since the beginning of 2017. This undoubtedly has a lot to do with improving global growth fundamentals, as well as the decline in the value of the dollar, shown in Chart #7 (the dollar has dropped over 10% since early last year vis a vis other major currencies).

Now a look at how inflation expectations are rising. They've increased of late, but over the past year they haven't changed much and current expectations are not out of line with historical experience:

Chart #8

Chart #9

Chart #8 shows the evolution over the past year of inflation expectations for the next 5 years. The top portion of the chart shows nominal yields for 5-yr Treasuries and the real yield on 5-yr TIPS. The difference between the two—the market's expected average annual rate of inflation over the next 5 years—is shown on the bottom panel. Note that current inflation expectations are about 2%, which is modestly higher than the 1.6% average rate of CPI inflation over the past 10 years and modestly lower than the 2.15% average over the past 20 years. Current expectations are not out of line with the past, but they are near the high end of past trends. Chart #9 shows the same analysis for 10-yr Treasuries and 10-yr TIPS. Note also that over the past month or so, real yields have been relatively flat, while nominal yields have risen: that is what happens when the market expects inflation to rise but economic growth to remain modest.

Chart #10

Chart #10 compares the year over year rate of core CPI inflation and the 5-yr Treasury yield. It suggests that if future inflation averages 2%, as the bond market currently expects, then we might expect the 5-yr Treasury yield to rise from their current level of 2.3% to about 3.5% (with 5-yr real yields on TIPS moving up from their current 0.3% to 1.5%). Those moves are significantly higher than what the bond market is currently expecting. Put another way, the current level of Treasury yields is still unusually low given a 2% inflation world.

Chart #11

Chart #12

Charts #11 and #12 give you historical context for the relationship between 10-yr Treasury yields and inflation. More often than not, 10-yr yields trade at least 1-2 percentage points higher than the annual rate of inflation. Currently, 10-yr Treasury yields are about 2.5%, whereas the current trend of CPI inflation is about 2%. Were things to get back to "normal," in a 2% inflation world we might therefore expect to see 10-yr yields at 3.5% to 4%.

So there is plenty of justification for yields to move higher by much more than the market expects.

The only thing keeping yields from rising significantly is the market's belief (as evidenced by 5-yr real yields of only 0.3%) that the economy is still stuck in a "new normal" rut; that due to capacity constraints and demographics, it would be very difficult for the economy to grow by much more than 2% per year for the foreseeable future.

This year will prove whether the "new normal" view will prevail, or whether significant tax and regulatory reform will unleash a new wave of growth. My money is on faster growth and higher interest rates. Faster growth will be very welcome, but higher interest rates will hurt, and they could very well keep future equity gains at modest levels (by putting downward pressure on PE ratios) even as the economy improves. So even though the economy looks set to surprise on the upside, it doesn't necessarily follow that equity valuation will also surprise on the upside.

Tuesday, January 9, 2018

Manufacturing is off to a strong start

Last week brought the good news that the December ISM manufacturing index exceeded expectations (59.7 vs. 58.2), while the new orders subindex hit a 14-yr high. Some impressive charts:

Chart #1

Chart #1 compares the ISM manufacturing index to quarterly annualized GDP growth. The two tend to move together. As the chart suggests, the recent strength of the manufacturing index is consistent with very strong GDP growth in the fourth quarter. The market is expecting to see something on the order of 3%, but this chart says it could be 4% or better.

Chart #2

Chart #2 compares US manufacturing to that of the Eurozone. Both have been unusually strong of late. It's very likely that the world is in the midst of a relatively strong, synchronized growth phase.

Chart #3

Chart #3 shows the New Orders subindex of the ISM manufacturing survey. It's rarely been this strong. 

Chart #4

Not surprisingly, equity markets continue to do very well, both here and abroad, as Chart #4 shows.

Sunday, December 31, 2017

Predictions for 2018

One year ago I expected to see an improving economy and further gains in equity prices, and I sure got that right. Stocks are up big-time and GDP growth has accelerated somewhat. But I worried, as I have every year for the past 8 years, that the Fed might be slow to react to rising confidence and declining money demand, and that this could set off a bout of rising inflation. Fortunately, I got that wrong yet again, since inflation has remained in a comfortable 1.5 - 2% range. For the past two years I've liked emerging markets, and they have done quite well. Last year I didn't much care for gold or commodities, but they have done well thanks to a weaker dollar—which I didn't see coming. So it's a mixed bag for calls, but last year's 19.4% rise in equity prices goes a long way to making up for a few smaller losses. In any event, take the following with suitable grains of salt. I've been bullish and right (on stocks) for so long now that it makes even me nervous.

All throughout 2017 the world worried that Trump and the Republicans were going to prove incompetent. Was Trump crazy? Could he actually govern? Could the Republicans abolish Obamacare as promised? Could they pass tax reform? Turns out they did a pretty good, if far from perfect, job. Obamacare is being dismantled, beginning with the elimination of the mandate. Tax reform could have been better, but it achieved its main objective: to stimulate investment. Meanwhile, hidden behind the distractions of tweet storms and faux pas, Trump has accomplished a major reduction in federal regulatory burdens. This can really make a difference over the long haul, and it may already be contributing to faster growth.

Thinking back, Obama in his first year got a $1 trillion dollar stimulus package designed to boot-strap the economy by redistributing income (see my analysis here). The result was the slowest recovery on record; Obama ended up borrowing some $8 trillion to no avail, since nothing he did was aimed at increasing the market's desire to invest, work harder, or take risk. Trump in his first year got a $1.5 trillion (CBO-scored "cost") stimulus package designed to boost the economy by increasing the after-tax returns to business investment. I'm betting the results of Trump's tax reform will be much better than expected, but the market is not yet willing to make that same bet, and that is the point of departure for all predictions of what is to come.

If 2017 was about just one thing, it was the ability of the Republicans to pass meaningful tax reform. The market spent most of the year handicapping the odds of tax reform, and it would appear that it is now mostly, if not fully, priced in. The tax reform package boils down to a one-time 20% boost to after-tax corporate profits (by cutting the corporate income tax rate from 35% to 21%), and that's pretty much what we have seen happen to equity prices this past year.

If 2018 is going to be about just one thing, it will be whether boosting the after-tax rewards to business investment results in a stronger economy. Beginning in 2009, Obama and the Democrats gambled that a massive redistribution of income would boost demand and thus boost the economy, but they lost. They ended up flushing $8 trillion down the Keynesian toilet. Trump and the Republicans are now gambling that a significant increase in the after-tax rewards to business investment will boost the economy. Only time will tell, but there are already hints of a stronger economy in the data: e.g., capex is up, industrial production is up, business confidence and the ISM indices are up, and industrial metals prices are up. It's likely that the current quarter could mark the first time we've enjoyed three consecutive quarters of 3% or more growth in over 12 years.

I think the meme for 2018 will be this: waiting for GDP. If the economy shows convincing and durable signs of stronger growth, more investment, more jobs, and rising productivity, then the Republicans' gamble will have paid off. If not, the Democrats will have carte blanche to take control of Congress and oust a sitting president.

From my supply-sider's perspective, we now have the essential ingredients for a stronger economy in place. Tax incentives are correctly aligned to encourage more business investment; regulatory burdens are being slashed, business confidence is high, and the Fed is not a threat for the foreseeable future. Swap and credit spreads are low, as is implied volatility, and that tells us that liquidity is plentiful and systemic risk is low. The fact that the rest of the world is also doing better as well is just icing on the cake.

But, argue the skeptics, won't businesses just use their extra profits to buy back shares and increase their dividends, making the wealthy even wealthier without creating any new jobs? This oft-repeated allegation is an empty argument, because it ignores one key thing: what do those who receive the money from buybacks and dividends do with it? John Cochrane explains it in this brief excerpt (do read the whole thing):

Suppose company 1 gets a tax cut, doesn't really know what to do with the money -- on top of all the extra cash the company may already have -- as it doesn't have very good investment projects. It sends the money to shareholders. Well, what do shareholders do with it? (Hint: track the money.) They most likely roll the money in to other investments. They find company 2 that does need the money for investment, and send it to that company. In the end, they only consume it if nobody has any good investment ideas.
The larger economic point: In the end, investment in the whole economy has nothing to do with the financial decisions of individual companies. Investment will increase if the marginal, after-tax, return to investment increases. Lowering the corporate tax rate operates on that marginal incentive to new investments. It does not operate by "giving companies cash" which they may use, individually, to buy new forklifts, or to send to investors. Thinking about the cash, and not the marginal incentive, is a central mistake.

In other words, what some companies do with their extra cash is immaterial. What matters is that tax reform has increased the marginal incentive to invest—for the entire economy—by reducing tax rates and by allowing the immediate expensing of capex. On the margin, investment now has become more attractive and more profitable in the US, and this will almost certainly result in more investment (some of which is likely to come from overseas firms deciding to relocate here), which in turn means more jobs, more productivity, and higher real incomes. As I explained a few years ago, productivity has been the missing ingredient in the current lackluster recovery, and very weak business investment is one reason that productivity has gone missing. A pickup in investment is bound to raise productivity, which is the ultimate driver of growth and prosperity.

So it's clear to me that tax reform is a big deal, because it's very likely to boost the long-term growth trajectory of the US economy by a meaningful amount. Surprisingly, however, the market does not appear to share that view. Why else would real yields still be miserably low (e.g., 0.3% for 5-yr TIPS)? Why else would the market expect only a modest increase (0.75% or so) in the Fed's target funds rate for the foreseeable future? The current Fed target is 1.5%, while 2-yr Treasury yields, which are the market's expectation for what that rate will average over the next two years, are only 1.9%. As for real yields, the current Fed target translates into a real yield—using the PCE Core deflator—of roughly zero, while the yield on 5-yr TIPS says the market expects that rate to average only 0.3% over the next 5 years. If the economy really gets up a head of steam (e.g., real growth of 3% or more per year), I can't imagine the Fed wouldn't raise rates by more than the market currently expects, and I can't imagine nominal and real yields in general won't be significantly higher than they are today. The last time the economy was growing at 4% a year (early 2000s), 5-yr TIPS real yields were 3-4%.

Yet the Fed is the one thing I worry about, which is nothing new. The Fed has been responsible for every recession in recent memory, because each time they have tightened monetary policy in order to reduce inflation or to ward off an expected increase in inflation, they have ended up choking off growth. They are well aware of this, however, so they are going to be very careful about raising rates as the economy picks up steam. But as I've explained many times before, the Fed's worst nightmare is a return of confidence. More confidence in a time of surprisingly strong growth would almost certainly reduce the demand for money; if the Fed doesn't take offsetting moves to increase the demand for all those excess reserves in the banking system (e.g., by raising the funds rate target and draining bank reserves) the result would be an unwelcome rise in inflation. Inflation is a monetary phenomenon: when the supply of money exceeds the demand for it, inflation is the inevitable result. And higher inflation would set us up for the next recession.

On balance, I think it's quite likely the economy is going to improve, and surprisingly so. Ordinarily that would be great news for the equity market, since a stronger than expected economy should result in stronger than expected profits. But the market is still cautious, so good news is going to be met with increased skepticism: if the Fed raises rates as the economy improves, the market will worry that higher rates will increase the risk of recession. And even if the Fed is slow to raise rates, the market will see that as a sign that inflation is likely to move higher, and that would in turn increase the odds of more aggressive Fed tightening and eventually another recession. In short, we're probably going to see the market climb periodic walls of worry, just as it has for the past several years.

Risk assets should do well in this environment, given time, but there will be headwinds. Rising Treasury yields will act to keep PE ratios from rising further, so equity market gains are likely to be driven mainly by stronger-than-expected earnings. At the same  time, higher bond yields will make it easier to people to exit stocks (very low yields today make being short stocks very painful).

Emerging market economies are so far behind their developed counterparts that they have tremendous upside potential in a world that is increasingly prosperous, but a stronger than expected US economy is likely to boost the dollar, which in turn would put pressure on commodity markets and the emerging economies that depend on them.

I continue to believe that gold is trading at a significant premium to its long-term, inflation-adjusted price (which I estimate to be around $600/oz.) because the world is still risk-averse. So a stronger US economy and a stronger dollar would spell bad news for gold. Who needs gold if real yields and real growth are rising?

In order to judge whether things are playing out in a healthy fashion, it will be critical to periodically assess the status of the world's demand for money—particularly bank reserves, of which there are over $2 trillion in excess of what is needed for banks to collateralize their deposits. If banks' demand to hold excess reserves declines faster than the Fed's willingness to drain reserves and/or raise the interest rate it pays on reserves, then higher inflation is almost sure to rear its ugly head. Signs of that happening would likely be seen in rising inflation expectations, a falling dollar, a steeper yield curve, and/or rising gold and commodity prices.

The world is on the cusp of a new chapter of stronger growth, led by US tax reform. The US economy has plenty of upside potential, given the past 8 years of sub-par growth and a significant decline in the labor force participation rate and lingering risk aversion. Tax reform can and should unleash that underutilized potential and boost confidence. The future looks bright, but there are, of course, lots of things that could go wrong (e.g., North Korea, the Middle East, Trump's ego, the Fed) so if and as the world becomes less risk averse, an investor would be wise to remain cautious, since very few things these days are obviously cheap. On the other hand, Treasuries, and bond yields in general, look very low and should thus be approached with great caution.