Thursday, December 14, 2017

The Fed is not yet a problem

Yesterday the FOMC raised its short-term interest rate target to 1.5%, as expected, and indicated that it expects to gradually raise this target to 2.25% over the next year or so. Markets received the news with barely a ripple. Inflation expectations and the value of the dollar haven't budged for months, swap and credit spreads remain quite low, and while the yield curve has flattened in the past few months, it remains reasonably positively-sloped. The market seems to agree with the Fed that it won't need to raise rates by much more than 75 bps for the foreseeable future. We can thus conclude that the Fed and the market are in general agreement about the outlook, and that the outlook calls for only a modest pickup in growth with continued, relatively low and stable inflation.

Despite recent and prospective rate hikes, it's important to note that the Fed is not yet "tight," and monetary policy today is probably best described as "neutral." The economy has been picking up a bit of late, optimism is up, and the demand for money consequently is softening. The Fed is correctly offsetting these developments with a minor boost to short-term rates designed to bolster the demand for money.

Chart #1

The Fed's record on inflation speaks for itself: for the past 10 years, consumer price inflation has averaged 1.8% with impressively low variance. As Chart #1 shows, the average level, range and variability of CPI inflation in the current decade is lower than in any other decade in the past century. (To read the chart, the red bars show the range of year over year readings in the CPI, The yellow line represents the annualized rate of CPI change over each decade, and the blue bars represent the average plus or minus one standard deviation.) Abstracting from energy prices, which have been extraordinarily volatile in recent decades, the ex-energy CPI has averaged 1.7% in the past year, 1.8% for the past 5 years, 1.8% for the past 10 years, and 2.1% for the past 20 years. On the inflation front, things haven't been this good for generations, and the Fed deserves credit for doing a great job.

Chart #2

An important part of the Fed's mandate is to maintain the dollar's purchasing power. As Chart #2 shows the dollar today is pretty close to its long-term average against other currencies, after adjusting for inflation. A relatively stable dollar vis a vis other currencies is one important way to ensure the dollar maintains its overall purchasing power.

Chart #3

As Chart #3 shows, the market's expectation for inflation over the next 5 years is currently 1.8%. That is just about exactly the prevailing rate of inflation in recent years, and very much in line with historical experience. Although some worry that this is below the Fed's "target" of 2%, I think most economists and consumers would prefer 1.8% to 2%. 

Chart #4

As Chart #4 shows, the real yield on 5-yr TIPS has a strong tendency to track the economy's underlying trend rate of growth, for which I use the 2-yr annualized change in real GDP. Real yields have been rising slowly and very gradually in recent years, suggesting the market is pricing in a modest increase in real growth. Real growth has averaged about 2.2% per year for most of the current recovery, but the market now seems to be pricing in something in the range of 2.5-2.8% growth over the next year. That also happens to be in line with the FOMC's forecasts. I note also that the Atlanta Fed is now projecting 3.3% annualized growth for the current quarter, which would result in a 2.7% annual rate of growth for the current year.

This is encouraging, of course, but as I argued last week, the market is not yet pricing in a significant boost to growth from the pending tax reform package.

Chart #5

As Chart #5 shows, 2-yr swap spreads are quite low. This strongly suggests that market liquidity conditions are excellent, systemic risk is low, and the economic fundamentals are generally rather healthy. That's not surprising, actually, since the Fed has yet to withdraw a significant amount of bank reserves from the system, as it did in prior tightening cycles. 

Chart #6

As Chart #6 shows, Credit Default Swap Spreads are also quite low. These instruments are very liquid, and are excellent proxies for short- to medium-term credit risk in the corporate bond market. Conditions look pretty good right now. 

Chart #7

Chart #7 tells the same story by showing indices of credit spreads in the broad market for corporate bonds of investment grade and high-yield ratings. The market has a good deal of confidence in the outlook for the economy.

Chart #8

As Chart #8 shows, all postwar recessions have been preceded by a significant tightening of monetary policy (as evidenced by a sharp rise in the real Fed funds rate) and a flattening of the yield curve (as evidence by a negatively-sloped Treasury curve). Currently, inflation-adjusted short-term rates are close to zero, which is hardly punitive. And while the yield curve has flattened substantially, it is still reasonably positive. Taken together, these two conditions suggest that the Fed is at least a year or two away from delivering monetary policy tight enough to begin to hobble the economy.

Chart #9

Chart #9 focuses on the outlook for the real yield curve (which also has inverted prior to past recessions), by comparing the current real funds rate (blue) to what the market expects that real rate to average over the next 5 years (red). Although the real yield curve is rather flat, it is not inverted, and real yields are not projected to be very high. Indeed, both the Fed and the market expect that the Fed funds rate will be increased only modestly, in line with a modest pickup in real growth.

Chart #10

Chart #10 shows a big-picture view of the nominal Treasury yield curve, as represented by 2- and 10-yr Treasury yields and the spread between the two. I note that the current spread (54 bps) is about the same as we saw in the mid-1990s, when the economy was quite healthy.

Chart #11

Chart #12

As Charts #11 and #12 show, over the past year there has been a significant slowdown in the growth of bank savings deposits. I take this as a sign that the demand for money has dropped meaningfully. Savings deposits have paid almost nothing in the way of interest, but demand for them was incredibly strong in the years following the Great Recession. The appeal of savings deposit was not their yield, but their safety. Now, even though they are yielding more than zero, demand for them has dropped. People are no longer so interested in safety. It's not surprising that equities have done very well for the past year; as the public has attempted to pare its holdings of cash in favor of riskier assets, the price of cash has risen and the yield on equities has declined (i.e., short-term rates have increased as equity yields have decreased). The Fed would be irresponsible to not raise rates given this important shift in the demand for money. 

Chart #13

Chart #14

As Charts #13 and #14 show, there has been a significant increase in confidence in the past year, both among consumers and small business owners. This increase in confidence is fully consistent with the slowdown in the growth of savings deposits. On the margin, people are deciding to put money to work rather than stashing it away in banks.

Chart #15

The counterpart to a slowdown in the demand for money is an increase in the velocity of money. Chart #15 illustrates how we may have seen the peak in money demand. Going forward, even if the supply of money in the economy grows at a slower pace, rising velocity should ensure that nominal, and perhaps also real GDP growth, should pick up. We are seeing that already in Q3 and Q4 GDP, and it should continue, especially if tax reform passes.

Conclusion: If tax reform passes in anything like its current form, the economy is quite likely to pick up by more than the market and the Fed are expecting. That's because tax reform will directly increase the incentives to invest, and that in turn means more jobs, more productivity, and higher wages. This also implies that 10-yr Treasury yields are going to have to rise by more than the market currently expects, if only because real yields should rise as the economy's real growth potential increases. Tax reform thus spells very bad news for the long end of the Treasury market. However, it's also true that rising market yields could (and should) put downward pressure on equity multiples. Thus, even though the economy strengthens and corporate profits increase, the rise in equity prices going forward could be modest rather than meteoric. 

Friday, December 8, 2017

No jobs boom yet, but...

The November jobs data were slightly better than expected (+221K vs. +195K), but from a big-picture perspective, jobs growth remains at best moderate. Private sector jobs, the ones that count, are increasing at a 1.6-1.7% annual rate, as they have been for most of the past year. Ho-hum. However, small business optimism looks strong, particularly in regard to future hiring plans. Small businesses are almost sure to be the main engine of jobs growth going forward, so this is very good news.

Chart #1

 Chart #2

As Charts #1 and #2 show, there hasn't been any change in the underlying rate of growth of private sector jobs for most of the past year. Indeed, the pace of hiring this year has been slower than it was in prior years.

 Chart #3

However, there has been a significant improvement among small business owners, as Chart #3 shows. An index of future hiring plans in November posted its strongest reading in the 44-year history of the survey. This suggests that Trump's efforts to reduce regulatory burdens, coupled with a strong expectation of reduced future tax burdens, have already produced positive results.

As I mentioned earlier this week, though, the market has still not priced in a stronger economy. Optimism is building, but the market is still in a "show-me" frame of mind.

UPDATE: Today (Dec. 12, '17) the overall Small Business Optimism Index was released, and it was also impressive, surging to a level that is just shy of that which occurred at the dawn of the boom years which followed the Reagan tax cuts:



Thursday, December 7, 2017

Wealthier and wealthier

Today the Fed released its quarterly estimate of household net worth. Things just keep getting better and better. Household net worth as of Sept. 30 was almost $97 trillion, having risen $7.2 trillion over the past year (+8%). As in recent years, gains have come mostly from financial assets (up $18 trillion since late 2007), plus real estate (up $2.4 trillion since the peak of 2006), offset by only a minor increase in debt (total liabilities rose from $14.5 trillion in 2008 to $15.4 trillion). Further details in the charts below:

Chart #1

Chart #1 summarizes the evolution of household net worth. 

Chart #2

Chart #2 shows the long-term trend of real net worth, which has risen on average by about 3.5% per year over the past 65 years. Is this a great country, or what? I note also that recent levels of net worth do not appear to have diverged at all from long-term trends. That wasn't the case in 2007 however, when stocks were in what we now know was a valuation "bubble."

Chart #3

Chart #3 shows real net worth per capita. The average person in the U.S. today is worth almost $300,000, and that figure has been increasing on average by about 2.3% per year for the past 67 years. Regardless of who owns the country's wealth, everyone benefits from the infrastructure, the equipment, the computers, the offices, the homes, the factories, the research facilities, the workers, the teachers, the families, and the brains that sit in homes and offices all over the country and arrange the affairs of the nation so as to produce almost $20 trillion of income per year.

Chart #4

Chart #4 shows that households have been extremely prudent in managing their financial affairs since the Great Recession. Household leverage (total debt as a % of total assets) has declined by fully one-third since its Q1/09 high. Leverage is now back to the levels which prevailed during the boom times of the mid-80s and 90s. Of course, while households were busy strengthening their finances, the federal government was doing just the opposite: the burden of federal debt more than doubled from June '08 to September '17 (i.e., federal debt owed to the public rose from 35% of GDP to 75% of GDP).

Tuesday, December 5, 2017

Tax reform is priced in, but not a stronger economy

The S&P 500 keeps setting new record highs, we're on the cusp of a major tax reform, and the economy is showing signs of perking up. Pessimists fret that we're in another bubble that could pop at any moment, while optimists believe the economy has lots of upside potential. I'm still in the latter camp, though I do acknowledge that it's tough to find much that is cheap these days. In any event, what the market seems to be ignoring is that the kind of tax cuts we're about to experience—which are unprecedented in their focus on businesses—are very likely to lead to a business investment boom, and that in turn is likely to result in more jobs, more productivity, and higher wages and salaries in the years to come.

The S&P 500 is up about 24% since the week before Trump won last year's election. Half of that gain is due to increased earnings on continuing operations, while the other half is due to a rise in the multiple the market is willing to pay for a dollar's worth of those earnings (i.e., PE ratios). Over that same period,  5-yr Treasury yields have jumped by about 80 bps (from 1.3% to 2.4%), and real yields on 5-yr TIPS have jumped 65 bps (from -0.33% to +0.33%), implying a meaningful increase in real growth expectations but only a modest rise in inflation expectations.

Both the bond and the stock market have thus undergone some significant price adjustments that are consistent with an improved economic outlook. Investors expect more growth (as seen in rising real yields) and rising after-tax profits (as evidenced by higher PE ratios). So: is the market now pricing in an economic boom because of the likely passage of Trump's tax reform? Or is the market just pricing in the boost to future after-tax earnings that would result from a sizeable reduction in corporate income taxes (from 35% to 20%)? The way I read the market tea leaves, the market has little doubt that tax reform will pass, and that it will in turn boost after-tax corporate profits. But as yet I see no convincing evidence that the market is pricing in a substantial increase in economic growth rates—almost certainly not of the magnitude which the Republicans are touting (i.e., 3% or more). So we're faced with a mixed bag of market expectations: good news for profits and equity investors, but not much reason to cheer for the man on the street. That's missing the forest for the trees.

Outside of the Republican booster community and supply-side economists, I see very few who expect real GDP growth to rise significantly in coming years. Left-leaning commentators argue that the tax reform being pushed is very unlikely to do anything outside of lining the pockets of big business and the wealthy. A recent Bloomberg article, "Supply-Siders Still Push What Doesn't Work" argues that what has really been holding growth back is not high taxes and heavy regulatory burdens, it's an aging population that is still nursing the wounds to confidence it suffered in the Great Recession of 2008-09. It's not hard to deploy statistics in a way that bolsters your argument, as the Bloomberg article does, but there are some facts in the historical record which should be incontestable: the tax cuts that occurred during the Reagan and Clinton eras boosted economic growth considerably, while the massive fiscal spending "stimulus" of the Obama years failed miserably. (see charts below)

As I argued a year ago, the only good thing about the American Recovery and Reinvestment Act of 2009 was that it served as a laboratory experiment to test the value of the government spending multiplier. ARRA boosters argued that it would kick-start the recovery and deliver strong growth for years to come. Unfortunately, the results were the exact opposite of what was expected by the Keynesians. Why? Because the ARRA was all about income redistribution. It did nothing to change the incentives to work and invest:

Fully 63% of the "stimulus" spending was income redistribution in disguise (i.e., tax benefits and entitlements). And if you reclassify things such as education, housing assistance, and health as transfer payments, then over 75% of the $840 billion allocated to "stimulus" was essentially income redistribution. Only 8%—$65.5 billion—went for transportation and infrastructure (i.e., the "shovel-ready" projects that would put American back to work). Not a dime went to increase anyone's incentive to work harder or invest more.
The ARRA was a laboratory experiment in the power of the government spending multiplier to grow the economy by "stimulating demand." It ended up proving that the multiplier is way less than one. American taxpayers borrowed $840 billion only to learn that the payoff was only a small fraction of the additional debt incurred. We wasted almost a trillion dollars of the economy's scarce resources, and that's a big reason why the recovery has been so disappointing. If we had instead "spent" the money on lowering tax rates for everyone (e.g., we could have eliminated corporate taxes for three years with the ARRA money spent) in order to give them a greater incentive to work and invest, the results could have been dramatically better. The tax cuts might even have paid for themselves in the form of a stronger recovery over time.

Income redistribution does nothing to change the long-term growth path of the economy. It takes investment, risk-taking, and working harder and more effectively to boost growth. Incurring debt to finance spending is a waste of the economy's resources, but incurring debt to finance productive investment can lead to a real payoff. Indeed, that was the lesson we learned from the ARRA: excessive spending financed by debt can weaken the economy.

The principle virtue of the Tax Cuts and Jobs Act about to be passed by Congress is that it significantly increases the after-tax rewards to business investment by slashing corporate income tax rates and by allowing immediate expensing of capital investments. This automatically lowers the hurdle rate for all investment projects, and thus it should lead to a significant increase in investment, jobs, and incomes over time. The TCJA  has its faults, unfortunately, and these center on measures which produce only one-time gains in after-tax income (e.g., increases in the standard deduction and the child credit which do nothing to reward new investment, harder work, or risk-taking). But on balance it is very pro-growth.

The TCJA differs importantly from the Reagan tax cuts in the early 1980s, since the latter focused almost exclusively on lowering individual income tax rates. Reagan gambled that cutting tax rates on individuals would eventually lead to a stronger economy since everyone would have an incentive to work harder and invest more. But by focusing directly on the investment side of the economy, the TCJA could prove even more effective than the Reagan tax cuts.

The charts that follow illustrate the various ways in which the economy is already perking up, and they also illustrate why I think the market has yet to price in a stronger economy as a result of the passage of the TCJA.

Chart #1

 Chart #2

Charts #1 and #2 illustrate the substantial recent upturn in US industrial & manufacturing production, and how that has been accompanied by a significant pickup in Eurozone industrial production. We're seeing a coordinated acceleration in global manufacturing and output, which is a nice tailwind to enjoy.

Chart #3

Chart #3 suggests that housing starts have lots of upside potential, especially considering the strong levels of builder sentiment. By eliminating or limiting the mortgage interest deduction (which subsidizes housing and thus makes housing more expensive than otherwise), the TCJA could make housing more affordable for the middle class and thus stimulate more housing supply. A dramatic increase in the standard deduction would render the loss of the mortgage deduction moot for a whole swath of the population.

Chart #4

As Chart #4 suggests, the ISM manufacturing report is consistent with GDP growth exceeding 3% in the third quarter. The Atlanta Fed's GDPNow index currently predicts fourth quarter real growth of 3.2%. That would put real growth for the year at over 2.7%, which is comfortably above the 2.2% annualized growth rate of the current business cycle expansion. This is very encouraging.

Chart #5
 
Chart #6

Chart #5 shows a substantial recent slowdown in the growth of Commercial & Industrial Loans (a proxy for bank lending to small and medium-sized businesses). Ordinarily, this would be disturbing since it could be the result of a severe tightening in lending standards. But as Chart #6 shows, banks have little reason to tighten lending standards since delinquency rates on all loans and leases are at record lows. This suggests that the slowdown in lending reflects caution on the part of business borrowers, and that is not necessarily a bad thing. Relative to GDP, C&I Loans are about as high as they have ever been.

Chart #7

Chart #8

Chart #7 illustrates the incredible and lasting strength of corporate profits over the past decade. Chart #8 uses this measure of profits (derived from income tax data supplied by businesses to the IRS and compiled into the National Income and Product Accounts) to show that current PE ratios are not excessive by historical standards. Yes, PE ratios are above average, but profits have been way above average for a long time, so the market is not necessarily in bubble territory. I wrote more extensively on this issue here.

Chart #9

Chart #10

Chart #9 looks at the 2-yr annualized growth rate of GDP since 1970. I use this measure in order to smooth out the typically volatile nature of this series on a quarterly and annual basis. It should be easy to see how strong growth was during the mid- to late-1980s, following the Reagan tax cuts. It also illustrates the impressive strength of the economy in the late 1990s, during which time the capital gains tax rate was cut. Chart #10 illustrates how sensitive capital gains tax collections are to changes in the capital gains tax rate. Capgains realizations surged in advance of the big hike in the capgains rate in late 1986, and surged again as the rate was cut during the late 1990s. Lower tax rates can indeed boost tax revenues, while the threat of higher rates can crush tax revenues.

Chart #11

It is noteworthy that the current equity risk premium, illustrated in Chart #11, has remained relatively high in recent years. This suggests investors have been very reluctant to price in a stronger economy. Risk premiums were much lower in the boom years of the 80s and 90s.

Chart #12

Chart #12 shows how weak business investment has been in the past decade, despite the extraordinary level of corporate profits shown in Chart #7. A dearth of business investment has been at the root of the economys sluggish performance over the past decade. That is why the TCJA, which boosts incentives for business investment, could be so important—it directly addresses the problem that has plagued the economy for years. And by lowering business income tax rates here relative to other countries, it could act as a magnet for international capital flows.

Chart #13

Chart #13 shows the 5-yr annualized growth in productivity, highlighted by presidential terms. The Bloomberg article cited above showed the annual growth in output per hour on a year over year basis. This measure of productivity is naturally volatile, so measuring it over longer periods makes it easier to see the big trends. Output per hour isn't the same total labor productivity, however, which is shown in Chart #13, and in any event changes in productivity are one thing while growth in the overall economy (which includes productivity and the number and hours of people working) is another. Regardless, the very weak growth of GDP and productivity in the Obama years is pretty good proof that the policies pursued during the Obama years were not conducive to growth or prosperity. The second half of the Clinton years, in contrast, rank right up there with the Reagan years, all of which featured tax rate reductions.

Chart #14

Chart #14 shows nominal and real rates on 5-yr Treasuries, plus the difference between the two, which is the market's expectation for consumer price inflation over the subsequent five years. Inflation expectations haven't changed much in the past few decades, and currently average about 1.8% per year for the foreseeable future, which is very much in line with what inflation has averaged in recent decades.

Chart #15

Chart #15 compares the real yield on 5-yr TIPS (red line) with the real Fed funds rate (the Fed's target for overnight rates minus the rate of inflation as measured by the PCE Core deflator). Think of the red line as the market's expectation for what the blue line will average over the next 5 years. Note that the real yield curve inverted (i.e., the blue line exceeded the red line) prior to each of the past two recessions. That happens when the Fed becomes so tight that the economy begins to weaken and the market begins to assume that the Fed will be cutting rates in the future. Currently, the real yield curve is still positively sloped. If anything stands out here, it is the market's belief that the Fed is going raise rates only a few more times in the years to come. If the economy picks up steam, however, the Fed is going to be raising rates by a lot more than that.

Chart #16

As Chart #16 shows, the level of real yields on TIPS (blue line) tends to track the economy's real rate of growth over time. That's only logical, since very high real yields can hardly be generated by a weakly-growing economy, whereas a strongly-growing economy, such as we had in the late 1990s, can produce very positive real yields on a variety of asset classes. The current level of real yields in the bond market is consistent with real economic growth rates that are roughly 2%, which is what we've seen over the recent business cycle expansion. If real growth rates were to ratchet up to 3% or more per year, I would bet lots of money that real yields on TIPS would rise to at least 1-2%. With stable inflation expectations, that would imply 5-yr Treasury yields of almost 3-4%, substantially higher than the current 2.2% rate on 5-yr Treasuries. Bond investors need to brace for sharply higher yields if I'm right about the impact of the TCJA.

Chart #17

Chart #17 suggests that nominal yields on 5-yr Treasuries are unusually low given the current level of core inflation. This reinforces the fact that stronger real economic growth would necessarily lead to substantially higher nominal Treasury yields.

As should be obvious from the last two charts, Treasury yields are quite low compared to where they would probably trade if the economy were to prove much stronger than currently expected as a result of tax reform. 

To sum up: the rally in equity prices is evidence that the market is pricing in the passage of tax reform. But the continued low level of real and nominal Treasury yields is evidence that the market has yet to price in the stronger economic growth that is likely to result from tax reform.

UPDATE: I'm adding my chart of GDP growth vs its long-term trend in order to give some broader context to this discussion, and to add to some discussion of the subject of "potential" GDP in the comments section.



Thursday, November 16, 2017

AAPL still looks good

I've been a fan of Apple's ever since I bought the stock about 15 years ago. I've had a number of posts on Apple over the years, all of which have been bullish. I'm still optimistic about Apple's prospects, even as it approaches the $1 trillion capitalization mark.

I got my new iPhone X a few days ago, and it is by far the most beautiful and exciting of all the iPhones I've ever had (and I've owned every model they've made). Face ID is surprisingly fast and seamless (and accurate!), the display is much larger and a pleasure to look at, the build quality is superb, the battery life is much longer, the camera is much better, and the gestures that replace the home button are powerful and easy to use, not to mention it's wicked fast. It costs more than its predecessor (iPhone 8), but it delivers much more at the same time. Since my digital life revolves around this little jewel, I'm happy to pay extra, and I'm sure tens of millions of others will feel the same way. Apple can no longer be accused of not innovating. Its flagship product has leapfrogged the competition, and it's become the "apple" of everyone's eye.

The iPhone X is going to set sales records. Face ID is almost surely coming to Apple's entire product line over the next year, and that will very likely trigger a wave of upgrades. But the market, believe it or not, is still not convinced that Apple's best days lie ahead. Apple's cash-adjusted PE ratio today is less than 17, giving it an earnings yield of 6%. That implies, in my judgment, that the market still suspects Apple will have a hard time increasing earnings. If expectations were solidly behind continued earnings gains, Apple's PE ratio would be a lot higher. Following are some nifty charts which tell the story.

Chart #1

Wow. One of the Great American Success Stories, told in one chart. (Note the y-axis is done with a semi-log scale.)

Chart #2

If the market were wildly optimistic about Apple, it would be tough to recommend the stock. But as the chart above shows, Apple's PE ratio has been below 20 for the past seven years, even as its stock price as more than quadrupled. As I've suggested in my prior posts, the market has consistently under-appreciated Apple's ability to grow. And that still looks to be the case, with the S&P 500 trading at a PE of just under 22 (using earnings from continuing operations), and Apple's PE trading at more than a 10% discount to that. If you adjust for the mountain of cash that Apple has sitting offshore, Apple's PE ratio is trading at almost a 25% discount to the broad market.

Chart #3

As the chart above shows, Apple's earnings haven't grown nearly as fast in recent years as its stock price. In the past 5 years, earnings per share have grown over 45%, while the stock price has more than doubled. The way I see it, the market has become a lot less pessimistic about Apple's prospects in the past 5 years, which is why Apple's PE ratio has increased from a meager 10 in early 2013. But the market is still cautious.

Chart #4

Is a $1 trillion capitalization reasonable? Apple is not outrageously priced compared to other companies, as Chart #4 shows. Microsoft today is only $250 billion behind Apple's current market cap, and most of what MSFT sells is software and services. This chart is a great David vs. Goliath story, with once-tiny Apple leapfrogging its gigantic former rival. 20 years ago the market thought MSFT would control the entire PC market within a few years. Today Apple has made tremendous gains, but they still don't have a majority of smartphone sales, nor a majority of PC sales. There's plenty of room for Apple to grow.

Chart #5

One final note: I could be wrong, but it strikes me that Apple has set an important precedent with the pricing of iPhone X. Prior to this, Apple (and most of its competitors) routinely brought out better, faster, and more capable products for the same price as what was being replaced; customers were thus getting more and more power and features for the same price. Now, for the first time, a hi-tech computer product has come out that is not only better but more expensive. Apple has demonstrated pricing power in an industry that has suffered from 20 years of deflation. You can see that in Chart #5 above.

The BLS uses what is called "hedonic pricing" to calculate that personal computer and peripherals have effectively fallen continuously over the past 20 years—if you get more of something for the same price as before, its price has effectively fallen. The index in the chart has fallen by more than 96% over the past 20 years. But it should also be apparent that the rate of decline has been slowing ever since the early 00s. In the initial heydays of PCs, prices fell 35% a year; then 20% per year; then 10% per year. In the past 12 months, prices have fallen by a mere 3.3%. The pricing and the success of the iPhone X may be among the first signs that in coming years you can expect to pay more in order to get more when it comes to computers.

Full disclosure: I am long AAPL at the time of this writing, and have no plans to sell in the near future.

Wednesday, November 15, 2017

The yield curve is not a red flag

In the past week or so I've see more and more people worrying about the flattening of the Treasury yield curve. I've also seen breathless stories about how the nation's malls are emptying, subprime auto loan defaults are surging, and student loans are defaulting. While these are all disturbing developments, a lot of other things will need to happen before the economy is at risk of falling into another recession. In that regard, I note that credit spreads are still relatively low, swap spreads are very low, real yields are very low, inflation and inflation expectations are right where they should be, and the financial system has tons of liquidity.

The following charts put some meat on my argument, and all contain the most up-to-date data available as of today.

Chart #1

The first chart sums it all up: it's Bloomberg's index of all the factors that contribute to financial market conditions. By this measure, financial conditions are about as good as they get. The following charts drill down into these factors to see how they stack up and what they mean.

Chart #2

The chart above is one of my favorites. It shows that two things have preceded every recession since 1960: real interest rates (blue line) have risen sharply, and the Treasury yield curve has gone flat or inverted (red line). That's another way of saying that the Fed has been the proximate cause of every recession in modern times. They have tightened monetary policy to such an extent that the economy just couldn't take it anymore. Until 2008, when Quantitative Easing started, the Fed tightened policy by withdrawing bank reserves from the financial system. Banks need reserves to back up their deposits, so when reserves become scarce they must pay more to get the reserves they need: this pushes up short-term interest rates. It also results in a general scarcity or shortage of liquidity. Rising rates and tighter liquidity conditions start eroding the economy's underpinnings. The economic and financial fundamentals deteriorate until people are forced to sell and panic ensues.

Chart #3

This time around, however, things are VERY different. Because of Quantitative Easing, the Fed can't tighten like they used to. They can't even begin to make bank reserves scarce enough to forces short-term rates higher. As Chart #3 shows, there are about $2 trillion of excess reserves in the system: way more than banks need to back up their deposits. The Fed gets around this by paying interest on reserves, which it never did before. In the old days banks always wanted to minimize their reserve holdings because they paid no interest. Nowadays banks don't worry so much, because reserves pay interest that is close to what T-bills pay; reserves are an asset today, whereas they were a deadweight loss before. By increasing the rate it pays on reserves, the Fed directly impacts all short-term interest rates without there being any shortage of liquidty.

So this tightening cycle that we are now in will be very different from past tightening cycles, because it will be a long time (years) before the banking system approaches the point at which bank reserves become scarce—the Fed is going to unwinding its balance very slowly. The Fed can "tighten" by raising short-term interest rates, but they can't create a shortage of liquidity like they did before. So it's not surprising that despite higher short-term interest rates and a flattening of the yield curve, there is as yet no sign that financial market conditions are deteriorating, as the following charts demonstrate.

Chart #4

Chart #4 shows the 40-year history of the Treasury yield curve. The bottom two lines show the yields on 2- and 10-yr Treasuries, while the top line (blue) shows the difference between the two (i.e., the slope of the yield curve). Here we see that flatter and inverted curves are always the result of short-term interest rates rising by more than long-term interest rates. That's the Fed in action. We also see that the yield curve can be fairly flat, as it is today, for many years before a recession hits (e.g., the mid-90s). To really squeeze the economy, you need not only a flat curve but much higher interest rates and a shortage of liquidity.

Chart #5

Chart #5 shows the real yield curve in action. Real yields are the true measure of how high or low interest rates are. A 10% yield in a 10% inflation environment is not a big deal, but a 10% yield in a 2% inflation environment is a killer. The blue line is the Fed's real short-term interest rate target. Currently it is about zero, or it will be next month, when the Fed will almost surely announce that the rate it pays on reserves will rise to 1.5%. That's just a tiny bit less than the underlying rate of inflation (1.6%), according to the PCE core deflator, which is the Fed's preferred measure of inflation. (PCE Core inflation is typically about 30 to 40 bps less than CPI inflation.)

As the chart also shows, the front end of the real yield curve is pretty flat. What that means is that the market doesn't expect the Fed to tighten much more after the December meeting. The 5-yr real yield on TIPS is effectively the markets' expectation for what the real Fed funds rate will average over the next 5 years. Note that prior to the last two recessions the real yield curve inverted: the blue line rose above the red line. That meant that the market expected the Fed to start lowering interest rates in the foreseeable future, because the market sensed that monetary conditions were beginning to undermine the economy's fundamentals. That's not the case today.

Chart #6

2-yr swap spreads are among my most favorite indicators, because they have been good leading indicators of economic conditions. In normal times, swap spreads are 10-30 basis points. Today they are 18 bps. Just about perfect. That means that liquidity is abundant and systemic risk is low. The financial markets are not worried at all about widespread defaults or a liquidity squeeze. The Fed hasn't tightened at all, by this measure.

Chart #7 

Chart #8

As charts 7 and 8 show, credit spreads are fairly low. Despite the news of defaults in certain sectors of the economy, investors by and large are not worried much about widespread defaults. This also tells us that the Fed hasn't really tightened at all. Corporations can borrow as much as they want without having to pay onerous interest rates.

Chart #9

Finally, Chart #9 shows that the market's expectation for consumer price inflation over the next 5 years is 1.85%, just a bit shy of the Fed's professed target of 2%. That's plenty good enough for government work, as they say. The Fed has delivered 2% CPI inflation (annualized) for the past 20 years, and the market fully expects more of the same. Nobody is worried that the Fed is going to have to tighten unexpectedly.

Until we see the yield curve actually invert, until we see real yields move substantially higher, until we see swap and credit spreads moving significantly higher, and until inflation expectations move significantly higher, a recession is very unlikely for the foreseeable future.

UPDATE: I'm adding my oft-used chart that shows the "Obama Gap," which illustrates how dismal the economy's rate of growth has been over the past 8 years, compared to what it was for the previous 40+ years. You'll find some discussion of this subject in the comments section if you're interested.