Friday, May 30, 2014

Deflation is a no-show thanks to easy money and rising wealth

We now have the CPI and the Personal Consumption Deflator for April, and they show that inflation is running comfortably in the middle to the upper half of the Fed's desired range. As evidence, I offer the following charts that compare the year over year and 6-mo. annualized rates of inflation according to these two measures, using both the total and the core (ex-food and energy) versions of each:

In the 12 months ended April, the CPI rose 1.96%, and the core CPI rose 1.83%.

In the 6 months ended April, the CPI rose at an annualized rate of 2.13% and the core CPI rose at an annualized rate of 1.94%. This suggests that inflation pressures have increased a bit of late. Which of course runs counter to the prevailing belief that weak economic growth—such as we had in the first quarter—suppresses inflation. This further suggests that the Fed's model of inflation, which is grounded in the belief that a lot of excess capacity (e.g., a relatively high rate of unemployment and a relatively large "output gap") effectively inoculates the economy against rising inflation, may be faulty. I side with the monetarists on this: inflation comes from an excess of money.

Some years ago, the Boskin Commission found that the CPI tended to overstate inflation by as much as 1% a year. The BLS has since tinkered with and improved their methods, and more recently the CPI has tended to register about one-half of a percentage point higher than the more robust and generally more accurate Personal Consumption Deflator. In line with this, we see that the PCE deflator rose 1.62% in the 12 months ended April, and the core PCE deflator rose 1.42%, both being about half a point lower than their CPI counterparts.

Over the past six months, the PCE deflator has risen at an annualized rate of 1.59%, while the core PCE deflator rose at an annualized rate of 1.46%. 

I like to round things off and generalize, so I conclude from the eight measures of inflation shown above that inflation is running somewhere in the range of 1.5% to 2.0%, and that it has picked up slightly in recent months. This is not alarming, but it does not lend much support to the Fed's aggressively accommodative monetary policy stance. Why do they have the pedal to the metal when inflation is running comfortably in the middle to upper half of their target range? 

At the very least we can conclude that deflation is nowhere to be found in the official inflation stats. Whereas some of them were flirting with sub-1% inflation last year, that is no longer the case.

The above chart is arguably the best measure of the dollar's value against other currencies. As it shows, the dollar currently is relatively weak against most of the world's currencies: about 12% below its long-term average. A weak dollar is symptomatic of an oversupply of dollars relative to the demand for dollars, and that is the equivalent to a strong anti-deflation tonic. You don't get deflation when there is a lot of extra money floating around. You're more likely to see signs of positive and/or rising inflation with a weak currency.

Steve Ballmer's shockingly large bid of $2 billion for the Clippers suggests that there is a lot of money out there chasing relatively few sports assets. Could this be a harbinger of a generalized increase in prices in the future? I wouldn't be surprised if it proves to be. Financial markets have done exceedingly well over the past 5 years. Not only is there a relative abundance of dollars, there is now a relative abundance of savings and wealth.

Despite near-zero interest rates, U.S. banks have taken in $3.3 trillion in savings deposits since late 2008. This is symptomatic of strong demand for the relative safety of money and money equivalents. Strong money demand has effectively neutralized the Fed's easy money stance to date. Put another way, the Fed has engaged in QE in order to satisfy the world's seemingly insatiable demand for money. 

As I've explained before, strong deposit inflows have provided banks the wherewithal to purchase the $2.9 trillion of bonds that they then sold to the Fed as part of its Quantitative Easing efforts. To date, it would appear that the public is content to hold $7.3 trillion in bank savings deposits yielding almost nothing, and the banks are content to sit on $2.6 trillion of excess reserves yielding only 0.25%. But if and when the demand for all that near-zero-interest paying money starts to decline, the public's desire to reduce their cash holdings could result in a significant increase in the price of things (e.g., real estate, commodities, cars, vacations) they would rather hold instead. In short, there is a lot of money sitting on the sidelines that could serve as the fuel for higher inflation and faster nominal GDP growth. All it takes is a decline in the demand to hold the huge stock of money and money equivalents that exist today.

The first chart above shows Bloomberg's calculation of the market cap of exchange-traded U.S. equities, currently about $23 trillion, up from just $8 trillion a bit over five years ago. The second chart shows the market cap of all global equities, currently $64 trillion, which is up from $26 trillion just five years ago. The third chart shows the huge gains in the net worth of U.S. households, which have been fueled almost entirely by gains in financial assets. These add up to some very impressive gains in money and wealth. Perhaps the Ballmers and near-Ballmers of the world are feeling like they'd rather have some concrete possessions instead of all that money in their brokerage account. Ballmer's aggressive bid for the Clippers may be a sign that money demand is beginning to weaken.

As the chart above shows, the bond market is anticipating that CPI inflation over the next 5 years will average 2.0% per year (expected inflation is derived by subtracting the real yield on TIPS from the nominal yield on Treasuries of similar maturity). That's a pretty sanguine outlook, considering that the CPI has risen at an annualized rate of 2.3% over the past 10 years, and 2.1% over the past 5 years. 

So far, so good: some signs here and there that money demand is beginning to weaken and there is a surplus of money developing, but no sign yet of any worrisome increase in inflation. But it seems to me that the pressures for higher inflation are building. It may take awhile for inflation to show up in the official statistics, but for now there are growing signs of an abundance of money and wealth, and the beginnings of a weakening in the demand for money that tip the balance in favor of higher inflation in the future.

As I noted last year, the Fed's real objective with Quantitative Easing is to destroy the demand for money. They want to weaken the public's and the banks' demand to hold on to money balances and their equivalent by making cash a poor investment compared to other assets. They don't mind seeing equity prices rise, as that ought eventually to encourage people to take on more risk. After all, this has been a recovery dominated by risk aversion. The Fed wouldn't mind seeing inflation rise above 2%, and they probably wouldn't take corrective action until it got to 3%. But that's a dangerous game, since, as Milton Friedman taught us, the lags between monetary policy and the economy are long and variable.

Don't let quiescent inflation and a weak economy lull you into a complacent view of the future of inflation, and don't worry about deflation. Think instead about the weak dollar, a weakening in the demand for money, and very strong financial markets. 

Thursday, May 29, 2014

The big picture is not very scary

The U.S. stock market has been rising for more than five years; the S&P 500 has delivered a total return of 217% since early March, 2009. Today the S&P 500 reached a new all-time high of 1920. You can hear the nail-biting, especially since Q1/14 real GDP notched negative with today's revision. Are we near the end of one of history's great stock market rallies? I don't think so.

These two charts help put things in perspective. The big picture is that the natural tendency of stock prices is to rise, which they have been doing for a very long time; that should hold as long as the economy is able to expand and inflation avoids negative territory. Economic growth is almost assured given ongoing growth in the population and in the number of jobs, and the Fed has taken extraordinary measures against an extended outbreak of deflation. As the top chart shows, stocks tend to rise, on average, about 6-7% per year in nominal terms (plus dividends). As the second chart shows, stock prices tend to rise about 3% per year in real terms (plus dividends). Prices are in the upper half of their long-term trends, but it's not what you might call "scary-overvalued." There is still plenty of room on the upside before historical precedents are violated.

This is also a plug for "buy and hold" investing. It's near-impossible to call the highs and lows with enough exactitude to make a fortune. But's it's easy to buy stocks when no one wants them—as was the case from late 2008 to early 2009—and hold on for the long haul.

The message of the first two charts—that stocks are a little above their long-term average growth path—is confirmed by the chart above. The 12-mo. trailing PE ratio (according to Bloomberg) of the S&P 500 is now 17.6, which is about 6% above its 55-year average of 16.6. By this measure, stocks are somewhat "overvalued," but not be a significant amount. Moreover, if you consider that Treasury yields are still historically low (the PE ratio of the 10-yr Treasury, which currently yields 2.5%, is 40), it's not unreasonable at all for PE multiples on equities to be above average. Show me an investor who prefers 10-yr Treasuries to equities today, and I'll show you an investor who expects corporate profits to plunge. Absent a plunge in profits, equities could handily outperform Treasuries, even on a risk-adjusted basis.

One negative quarter does not make a recession

Real growth in the first quarter was revised down to -1%, more than expected (-.5%).  The economy shrunk by about $40 billion in the first quarter, which in the great scheme of things is equivalent to a rounding error. These things happen occasionally, as you can see in the chart below. It hasn't been a jolt to the equity market because it was most likely only a temporary dip in economic activity.

The thing to focus on is not the weak first quarter, which is almost certainly weather-related, but the indicators that show the economy is very likely continuing to grow at a 2-3% pace. As a supply-sider, I think the things that drive growth are changes in work, output, incentives, and investment. A quick look at key indicators of the supply-side of the economy shows everything still pointing up.

First-time claims for unemployment last week fell to just about their lowest level ever: 300K. If the economy were unraveling, businesses would be stepping up the pace of firings. Instead, the pace of layoffs is about as low as it has ever been. 

With the expiration of "emergency" unemployment benefits early this year, there has been a huge increase in the incentive for the unemployed to find and accept a new job. In the past year, the number of people receiving unemployment insurance has dropped by almost half (-46%). So far this year, 2.2 million people have lost their long-term unemployment benefits. This is a significant change in incentives on the margin that will most likely work to strengthen the economy.

Industrial commodity prices have been rising for the past 8 months and are at relatively high levels from an historical perspective, suggesting that global industrial activity continues to improve.

U.S. manufacturing production rose at a 2.8% annualized pace in the first four months of this year.

The private sector added 840K new jobs in the first four months of this year. That works out to about a 2% annualized pace, which is in line with the trends of the past several years. With average productivity gains of about 1% per year, this pace of jobs growth can deliver 3% real growth over time.

Bank lending to businesses—presumably to finance expansion plans—is up at strong double-digit rates so far this year. Outstanding C&I loans have increased by $90 billion year to date (through mid-May), as shown in the chart above. Banks are more willing to lend and businesses are more willing to borrow; that's a good sign of rising confidence and a leading indicator of more jobs to come.

Capital goods orders—a good proxy for business investment—are up this year, and have been rising at about a 4% annual pace for the past year.

Corporate credit spreads are at post-recession lows. The bond market does not reveal any concerns about the future of corporate profits. Moreover, swap spreads, an excellent and leading indicator of systemic risk, are very near all-time lows.

First quarter growth was disappointingly slow, but that that was very likely just a temporary, weather-related dip in economic activity. Key indicators of current and future growth remain positive. Growth is likely to rebound in the current quarter.

Tuesday, May 27, 2014

Onward and upward

This is still the weakest recovery ever, but the economy continues to grow and conditions continue to improve. It's a sub-par recovery, as I've been predicting for the past 5 years, mainly because the private sector has been smothered by too much government spending and too many new regulatory burdens. Things could be a whole lot better, but that is no reason to be pessimistic about the future. Indeed, there are so many things that could be fixed for the better (e.g., major reform of the tax code, the reversal of Obamacare) that the case for optimism is still compelling. As I've said many times in recent years, the economy is growing in spite of all the "help" it has received from "stimulative" fiscal and monetary policy. Pessimists see it the other way around, of course, believing that if it weren't for all the government-sponsored stimulus the economy would be a total wreck.

What follows is a series of charts which make some important points about the ongoing improvement in the economy and the financial markets.

Capital goods orders have been lackluster for over a year, but today's release of April data contained some significant upward revisions to past data. A month ago, orders appeared to be essentially flat over the past year, but they now have a modest upward tilt. As the chart above shows, orders in real terms are still substantially below their 2000 high, but they are now at a new high in nominal terms. It's still the case that businesses are very reluctant to invest—despite record-setting profits—but at least we can say that investment in productivity-enhancing capital goods is expanding, albeit slowly. As an optimist, I look at this as a glass half-full: imagine how much stronger new investment could be if taxes on capital and regulatory burdens could be reduced. The November elections hold great promise for the future if they can tip the balance of policies in a more growth- and capital-favorable direction.

According to the Case Shiller data, housing prices have recovered almost half of what they lost from their pre-recession highs. The same goes for housing starts. The recovery is more modest in real terms, but it nevertheless continues. Every day the number of households suffering from negative equity declines. There is still plenty of upside potential in the housing market.

The market capitalization of global equity markets is now at a new all-time high, having gained $38 trillion from the March 2009 low. These are huge numbers, considering that the total market cap of the U.S. equity market is currently almost $23 trillion according to Bloomberg.

Pessimists don't get excited by the above chart, which shows that the implied volatility of equity options is very close to its historic lows. They worry that because the market is not very worried these days about something going wrong, it is vulnerable to bad news. As an optimistic, I prefer to think that the market is "vulnerable" to unexpected good news. Long-time readers may remember my post from August 2012, in which I posed the question "What if something goes right?" In retrospect it was quite prescient. I still think that is the right question to ask today.

The above chart of the PE ratio of the S&P 500 shows that multiples are only slightly higher than their long-term average (according to Bloomberg calculations). That lends strong support to the view that the market is far from being overly optimistic. There is still plenty of room for multiples to expand.

Consumer confidence is at a post-recession high, but as the chart above shows, it is still far below levels associated with healthy growth and widespread prosperity, such as we had in the late 1990s. Indeed, confidence today is at levels that in the past have been associated with the onset of recessions. There is still lots of room for improvement.

As the chart above shows, Eurozone equities have been rising in line with the ongoing recovery in  U.S. equities for the past two years. In fact, Eurozone equities have recorded outsized gains over the past two years: the total return on the S&P 500 is 51%, while the Euro Stoxx 50 index has posted a total return of 77%. The Eurozone may be lagging, but it is definitely improving. 

As an aside, I couldn't help but notice the proliferation of construction cranes and road repairs as we drove through almost 2,000 miles and 5 countries' worth of European countryside earlier this month. Things are definitely improving in Europe.

There will undoubtedly be setbacks along the way, but I see little reason to doubt that things can continue to improve, albeit slowly. Onward and upward.

Wednesday, May 21, 2014

Prague wins the prize

We're about to depart Prague, the most beautiful, charming, and friendly city we've seen on our travels—which are coming to an end. Here are some shots, all taken with my iPhone 5S:

Prague's best-kept secret is The Golden Well Hotel (U Zlate Studne), located just off the gardens of the Prague Castle. It's one of the nicest places we've ever stayed at, and it has views that are breathtaking. The photo above shows the view from the hotel's restaurant.

You can see the restaurant on the right side of this photo, taken from the castle gardens. The hotel has four floors of rooms, atop which sit two floors of restaurant. There is a door in the restaurant that takes you directly to the castle gardens, and from there a short stroll takes you into the castle proper.

The castle, seen here from the Charles bridge, dominates the city skyline. St. Vitus cathedral, built inside the castle walls, is gorgeous.

After touring the castle, we walked up the hill to the monastery, which offers panoramic views of the city and the river. It was such a nice day that we spent three hours sitting at a cafe admiring the view and sipping some local wine.

Friday, May 16, 2014

Forget about deflation risk

Producer price inflation in April was quite a bit higher than expected (+0.6% vs. +0.2%), and core (ex-food and energy) prices jumped 0.5%. April consumer price inflation, on the other hand, was about as expected. However, both the total and core versions of the PPI and the CPI now say that inflation in the past year has been at least 2%, whereas they were registering levels of less than 1% about six months ago, as shown in the following charts.

Could this be the beginning of a significant increase in inflation? Perhaps, but it's still premature to make that call, even though I've been worrying about rising inflation for the past five years. What it does say, however, is that deflation is a no-show. This is not the stuff of which deflations are made.

Fed monetary policy for years has been geared to fight the threat of deflation, and policy is still dominated by the fear of inflation being too low. Adding to the Fed's concerns were the still-sluggish rate of economic growth and the unprecedented "output gap" (i.e., idle capacity, which I estimate could be at least 10%) that is still growing despite 5 years of unprecedented monetary and fiscal stimulus. Conventional economic thinking would have thought this impossible, and conventional thinking today worries that the weak economy will surely exacerbate the threat of deflation, because we supposedly have too many goods and services (i.e., too much supply) chasing too few dollars (i.e., not enough demand).

Yet now we have inflation at 2% or more, at the top of the Fed's preferred 1-2% range, at a time when the Fed still has its metaphorical pedal to the metal. I have argued for years that the Fed hasn't really been printing money, so I don't think this metaphor is apt, but I've also noted that the justification for the Fed's massive bond purchases (the world's extraordinary demand for money and money equivalents) likely won't last forever. The recent pickup in inflation is one more sign that the demand for money may be easing, and if so, then the Fed's extraordinary supply of money may create an oversupply of money. If inflation starts to register 3% or more, (I'll take a bit of deflation any day rather than inflation of more than 2% a year) then that will have huge implications for monetary policy. The Fed is going to have to accelerate its tapering and shift into tightening mode, and interest rates are going to move higher across the board, by much more than the market currently expects. I'm not sounding the alarm yet, but it's a risk that can't be ignored, no matter how weak the economy's growth rate.

Weak economic growth does not inoculate an economy against inflation. On the contrary, inflation often thrives when growth is weak, and too much inflation can seriously debilitate an economy. I should know, since I lived in Argentina for four years in the late 1970s, during which time economic growth was abysmal and inflation lived in triple-digit territory. If the Fed responds to the threat of higher inflation in a timely and adequate fashion, there is no reason that should hurt the economy.

This business cycle has been a boon to economists, because it has destroyed the progressive myths that government spending and easy money can stimulate an economy. It has also destroyed the Phillips Curve theory that says that persistently high unemployment leads to low or negative inflation.

So now we await the dawning of a new era of public policy, one which I hope will be dominated by the belief that monetary policy and fiscal policy need to focus on delivering conditions that are optimal for the private sector to thrive: low marginal taxes, low and stable inflation, and low regulatory burdens. Washington needs to reduce marginal tax rates on businesses and individuals, while also eliminating deductions and subsidies. This shouldn't be too difficult, given the dramatic progress to date in reducing the budget deficit. Reducing regulatory burdens is also critical, since they impose a deadweight loss on the economy. It should soon become obvious to everyone that Obamacare is only making things worse, and that only by introducing market-based reforms can we improve healthcare.

Deflation is not a threat; Big Government is.

Tuesday, May 13, 2014

Trip notes

Our driving tour of Germany, Switzerland and Austria has been wonderful, though the weather turned a bit ugly on us yesterday and promises to remain so for the next several days. 

Yesterday we stumbled on the fantastic-looking headquarters of Red Bull, shown in the first shot above. It may be hard to see in the photo, but there are what appear to be large bronze bulls rampaging out of the building into a surrounding pool. It's located on the southeastern end of Fuschl lake—seen from the northwestern end in the second photo—which is about 10 miles east of Salzburg. The area is studded with gorgeous lakes and alpine peaks. 

Two days ago we made the obligatory visit to one of Europe's most incredible castles, Neuschawnstein, in southern Bavaria. My photo is the first of the two above, but as you can see from the professional photo, this place is situated magnificently (the photographer must have climbed into a pretty dangerous spot to capture that shot).

Three days ago we drove from St. Moritz to Merano, Italy, via the Swiss and Stelvio National Parks, and enjoyed one breathtaking vista after another. Here's a shot from a spot where we stopped to have some cheese, salami, and beer:

We ended up at the fabulous Castel Fragsburg hotel overlooking Verano, where I took this shot from the hotel's terrace:

Profits drive equity prices higher

Mark Perry's recent post on the relationship between corporate profits and equity prices reminded me that I haven't updated the above chart—which includes data beginning in 1959—for awhile. It's a basic demonstration of the fact that higher equity prices today are justified by the level of corporate profits.

The chart above shows how the measure of corporate profits in the first chart (after-tax adjusted profits from the NIPA accounts) compares to reported earnings per share. I discussed why the two appear to diverge in the past few decades here. NIPA profits rose 8% last year, and S&P earnings per share are up 6% in the year ending last April.

Sunday, May 11, 2014

The dollar doesn't get much respect

If I've learned anything from our (quite enjoyable) vacation driving around Europe, it's that the dollar doesn't go very far.

As the above chart shows, from a long-term perspective the dollar is trading at relatively low levels, in inflation-adjusted terms, against two broad baskets of currencies. It's comforting to see that it is still about 5% above it's all-time lows of mid-2011, but it is still over 10% below its long term average (96).

My calculation of the dollar's Purchasing Power Parity vis a vis the Euro is shown in the chart above (green line). This suggests that the Euro is about 20% overvalued against the dollar, which is another way of saying that things here in Europe cost on average about 20% more than they do in the states. My real-life experience this past week in Germany, Switzerland, and Austria confirms what my PPP model tells me. (I have been using this model, by the way, since the mid-1980s.)

The strength of the Euro is likely one reason that Eurozone inflation is quite low—low enough to draw the attention of the ECB, which appears to be gearing up for some kind of Quantitative Easing to forestall the alleged "risk" of deflation. With the ECB preparing to actively relax monetary policy at the same time as the Fed is preparing to begin tightening monetary policy (as soon as it finishes tapering QE3, which should happen by the end of this year), I think it's reasonable to assume that the dollar could enjoy some gains vis a vis the Euro over the next few years. The dollar could get a really serious boost if Washington could get its head out of the sand and pursue growth-oriented instead of business- and capital-unfriendly policies, but that awaits the outcome of the November elections at the earliest.

With the dollar generally weak against almost all countries these days (with the notable exception of the unofficial "blue" rate for the Argentine peso and the black market rate for the Venezuelan Bolivar, both of which are being crushed by a mountain of bad policies in general), I think it makes sense to engage in non-dollar investing on a mostly currency-hedged basis, because the long-term balance of risks favors, I believe, a stronger dollar.

Saturday, May 3, 2014

Credit spreads are very tight

Some measures of corporate credit spreads have reached their tightest levels in the past 23 years. Does this mean that optimism has peaked and it's time to sell? Not necessarily.

The chart above compares the yield on 5-yr A1-rated Industrial bonds with the yield on 5-yr Treasuries. The spread, or the difference between the two, is now 35 bps, which is very close to its lowest level (31 bps) in Bloomberg's recorded history, which was reached in March, 1997—four years before the next recession would strike. Like then, investors are willing to accept a very small premium in extra yield relative to a Treasury, in exchange for assuming the credit risk of the average A-rated Industrial issuer. This also implies a high level of confidence in the ability of those companies to make good on their obligations.

Confidence in bond-land is pretty high, but that doesn't mean a recession is just around the corner. It means that the economic and financial fundamentals for corporate cash flow are very positive and default risk is very low. That will change when another recession sets in, but something—other than tight credit spreads—will have to trigger it.

The chart above compares the spread to Treasuries of 5-yr A1 Industrial bonds and the spread
to Treasuries of 5-yr swap contracts, which can be thought of as representing the credit risk of AA-rated banks. Here you can appreciate how significant the recent decline in spreads has been.

Both swap spreads and credit spreads tend to rise in advance of recessions and decline in advance of recoveries. For now, they are very low and could decline a bit more. But when spreads are this tight, it doesn't pay to put a lot of your eggs in the corporate bond basket, especially of the investment grade variety. If the economy picks up, yields are very likely to rise and default risk is likely to decline further, but it can't go a whole lot lower than it already has. The current level of credit spreads and yields doesn't offer much (if any) cushion against the negative impact of rising yields. In other words, rising interest rate risk is now of much more concern to high-grade corporate bond investors than is default risk.

Blogging will be light for a few weeks

Tomorrow we leave for a tour of the Alps, starting and ending in Stuttgart, with a route that takes us through Zurich, St. Moritz, Merano Italy, Innsbruck, Munich, Salzburg, Vienna and Prague. We've never been to that part of the world, and its high time we did.

I suspect the world will not end nor even change significantly while we are gone, but I do hope to keep up with things and to post occasionally.

I also plan to test first-hand my theory that the Euro is about 20% overvalued relative to the dollar, as the chart above suggests.