Clouds and silver linings

Markets have been unusually nervous and volatile since late October, driven by fears of an escalating trade war with China, emerging weakness in European economies, tighter monetary policies from most major central banks, the post-election realities of a divided Congress, and a growing sense that the US economy is struggling and/or possibly staring a recession in the face. I've called it "global angst" in my current favorite chart (see Chart #16 below), "Stocks climb walls of worry."

Without doubt, things could be better than they are, but there are silver linings to a lot of the clouds. Business investment is relatively weak, but corporate profits are at record levels. The housing market and residential construction have softened, but this is being at least partially offset by the recent 40 bps decline in mortgage rates. Today's jobs number was disappointing, but jobs growth this year still is stronger than it was last year. The Fed says it plans to raise short-term rates in gradual fashion, but the market has priced out two of the tightenings it expected earlier this month (the market now expects only one more tightening in the next 12 months, and no more after that). The yield curve has flattened in some areas, but remains positively sloped, and real short-term interest rates are still very low (only slightly above zero). Inflation expectations have fallen below the Fed's target, but this is almost entirely due to a recent sharp drop in oil prices. None of this points to recession.

The problem is not the Fed, not deflation (or even low inflation), and not the yield curve. I think the main problem is a general angst that finds its strongest expression in the outlook for the US-China conflict. This creates uncertainty which acts as a headwind to growth and risk-taking in general.

Regardless, we are besieged by worries of all sorts these days. What follows are 16 charts which help put things in a useful perspective:

Chart #1

Chart #2

Chart #1 compares real and nominal 5-yr Treasury yields, and the difference between the two. Note how real yields (blue line) remain in a gradual uptrend: this is a direct reflection of the market's perception that the US economy remains healthy and is likely to continue growing at a 2.5-3% pace, in my estimation. Note also the recent decline in expected inflation: it's entirely due to the decline in nominal yields. And as Chart #2 shows, the decline in oil prices fully explains the drop in inflation expectations. No problems here.

Chart #3

Chart #3 shows two points on the real yield curve, which is the most important yield curve to watch (real yields are the true measure of how high or low interest rates are). The blue line is the overnight real rate, and the red line is effectively the market's forecast for what the blue line is going to average over the next 5 years. The time to worry is when the blue line exceeds the red line. There's still a healthy spread between the two.

Chart #4

Corporate credit spreads have widened a bit as oil prices have plunged. But as Chart #4 shows, credit spreads are still relatively tight, and the most important measure of spreads (swap spreads, because they tend to lead other spreads) remains very low. Swap spreads are also a good measure of financial market liquidity, and at today's levels they continue to suggest that liquidity is abundant. That's very important, since liquid markets allow for market participants to exchange risk freely. Note how the sharp rise in swap spreads priced the Great Recession; they got so high that the market was almost paralyzed, and that contributed significantly to the meltdown of mortgage-backed and other risky securities. Liquid markets can deal with all sorts of problems, just as free markets maximize economic efficiency.

Chart #5

Chart #5 shows the very impressive reduction in private sector leverage that has occurred since the end of the Great Recession. The average household today has very strong financial fundamentals, and that is effectively a buffer against negative shocks.

Chart #6

Nominal and real net worth of the private sector reached an all-time high as of the end of September: $109 trillion. As the above chart shows, recent increases in household net worth are very much in line with the long-term, inflation-adjusted historical trend. This was not the case with the asset price "bubble" that occurred prior to the Great Recession, and prior to the 2001 recession—markets and households got overextended. Note also the 10-fold increase in real net worth in the past 66 years! This is nothing short of breathtaking progress.

Chart #7

Chart #8

Chart #7 shows that the increase in private sector (household) net worth since 2008 has been driven mainly by rising stock prices and increased savings (i.e., financial assets). Real estate values and debt levels have increased only modestly. In turn, as Chart #8 shows, rising stock prices have been supported by rising corporate profits. It's not at all obvious that we are living in a bubble that threatens to pop.

Chart #9

The ISM manufacturing and service sector indices provide very timely insights into current economic activity. Both have been very strong of late. Chart #9 compares the ISM manufacturing index and quarterly GDP growth. The current strength in the manufacturing sector points to very strong economic growth overall, at least 4% for the current quarter. That contrasts significantly from the modest 2.4% Q3/18 growth rate projected by the NY and Atlanta Feds' forecast models.

Chart #10

As Chart #10 shows, hiring intentions in the all-important service sector (70% of the economy) are strong. This bodes well for future jobs growth.

Chart #11

Chart #11 suggests that the US manufacturing sector is outpacing Europe's handily; it also shows how much the Eurozone economy has suffered of late. That's not necessarily bad for the US, but it is another headwind to worry about.

Chart #12

As Chart #12 shows, the US service sector these days appears to be stronger than it has been for a long time. As with Chart #11, it also highlights the weakness in the Eurozone economy.

Chart #13

Today's release of the November jobs numbers was weaker than expected (+155K vs. 198K), but as Chart #13 shows, this series is notoriously volatile on a month-to-month basis. One month's data is hardly significant. I prefer to look at the 6- and 12-month averages. Private sector jobs growth averaged 180K per month in 2017, and so far this year it has averaged 200K: that's an 11% improvement!

Chart #14 

Chart #14 shows the 6- and 12-month rates of growth for the monthly private sector jobs numbers. Here we see the modest uptick in growth rates this year relative to last year. By these measures, private sector jobs currently are growing at a 1.8-1.9% rate, and that's only marginally less than the 2.0% average annual growth rate for the past 8 years.

Chart #15

Chart #15 shows the year over year growth rate of the labor force (the total of those working plus those looking for work). Today's 1.4% annual growth rate is substantially higher than 0.5% average growth rate we've seen since the economy bottomed in mid-2009.

Chart #16

Stock prices today are down a tad over 10% from their all-time highs of last September, as shown in Chart #16. That's mostly due to an increase in the market's worries (as measured by the ratio of the Vix index to the 10-yr Treasury yield), but it also reflects the fact that the economy has failed to accelerate as supply-siders (like me) had expected. Growth has picked up modestly in the past two years, but not as much as we would have liked to see considering how much deregulation and tax-cutting there has been in the interim.

China is the wild card these days, but it's also the case that for the next two years we're going to have a divided Congress that is unlikely to pursue a pro-growth agenda, and there are few signs, if any, that global growth is picking up.

The market has priced in a lot of slowdown expectations. According to Bloomberg, the current PE ratio of the S&P 500 is 18, and that's as low as we have seen since February '16. Today's equity premium (the difference between the earnings yield on stocks and the yield on 10-yr Treasuries) is 2.7%, and that's as high as we've seen since November '14. This rather substantial repricing of equities is a potential positive, since it makes taking risk more attractive, and that in turn helps offset the de-risking forces of uncertainty emanating from places like China and Congress. Clouds and silver linings.

The question confronting investors today is not whether the economy is going to slow down (that's priced in already); the question is whether it is going to slow down by a lot, and how certain one is of that future. In this regard I remain optimistic that things won't be as bad as the market already fears. That's been my position for the past 10 years, actually: always thinking that the market was too pessimistic in its assumptions about the future. 

The yield curve is not forecasting a recession

By now, most anyone who keeps up with financial matters knows that a flat or inverted Treasury yield curve is a good predictor of an impending recession. I've blogged extensively on this subject for almost 10 years. Recently, a few industrious pundits have found evidence that the front end of the Treasury curve is "close to flat." While it's hard to argue with their facts, an almost-flat curve is not the same as a flat or inverted curve. The latter occur only when the market looks into the future and sees good evidence that the Fed will no longer tighten policy and will very likely ease policy at some point. We're not there yet.

Here's a quick recap of where the yield curve stands:

Chart #1

Chart #1 shows us what the market has thought the target Fed funds rate will be in December of next year. One year ago, on the left end of the chart, the Fed funds futures market expected the funds rate to be 2.0% by December '19; it now expects the funds rate will be 2.7% by December of next year. That is essentially equivalent to two more Fed tightenings, from the current 2.25% to 2.75%. Currently the market does not expect the Fed to do anything more beyond December '19. "Two more rate hikes and the Fed is done" is the current meme. That implies that the economy is quite likely to continue growing for the foreseeable future, but not at a very impressive (nor worrisome) pace. Note that expectations for the future target rate have dropped by almost one tightening in past few weeks, and that in turn has been driven by news suggesting the economy is proving a bit weaker than previously thought. 

In any event, it's hard to get worried about a mere 50 bps increase in short-term interest rates for the foreseeable future.

Chart #2

Chart #2 looks at the front end of the real (inflation-adjusted) yield curve. This is arguably the only yield curve that really matters; real interest rates are the true measure of the cost of borrowing, not nominal rates. The blue line is the real Fed funds rate (the target funds rate (2.25%) less the year over year rate of inflation according to the Core PCE Deflator (1.8%), the Fed's preferred measure of inflation. The red line is the real yield on 5-yr TIPS (Treasury Inflation-Protected Securities), which can also be thought of as the market's forecast for what the real Fed funds rate will average over the next 5 years. This measure of the yield curve is still positively-sloped. Note that it has been inverted (i.e., when the blue line exceeds the red line) prior to the past two recessions. We're not there yet. This chart tells us that the market fully expects the Fed to tighten monetary policy further (by increasing the real funds rate), but not by much.

Chart #3

Chart #3 shows the most common and generally most-favored measure of the yield curve: the difference between 2-yr and 10-yr Treasury yields. The top portion shows the history of these two yields, while the bottom portion shows the difference between the two (i.e., the slope). Note first that the 2-10 slope quite often becomes flat or almost flat, and it does so sometimes many years in advance of recessions. It's almost flat now (20 bps), but that's hardly unusual during a period in which the Fed is raising interest rates.

Chart #4

Chart #4 effectively zooms in on Chart #3, showing the behavior of these yields and their spread over the past year. Note that this portion of the curve was actually a tiny bit flatter back in August than it is today.

Chart #5

 

Chart #5 is where things get more interesting. This shows the difference between 10- and 30-yr Treasury yields. This portion of the yield curve has been steepening since last July. Inversions in this portion of the curve have been reliable predictors of recessions, but we're definitely not there yet. To judge by this chart, a recession, if one is in the cards, might not occur for at least several years. And to judge by Charts #3 and #5, what is going on today in the yield curve is similar to what happened in the mid-1990s. Back then the economy was in the early innings of what would prove to be a very strong growth phase, which was followed by a mild recession in 2001.

In any event, it's possible, and likely, that good news on the global trade front could alter the bond market's expectations rather dramatically, resulting in a steeper yield curve and ultimately a stronger economy. 

Steady as she goes

Fed Chairman Powell yesterday made it clear that Fed policy is not a threat to the economy or to the market. He's not on the rate-hiking warpath, and he's not worried that the economy, which is growing nicely, is in danger of overheating. Not surprisingly, markets breathed a sigh of relief. The economic and financial market fundamentals are healthy, and the market's recent spate of worries are just that: worries.

Yesterday's release of the second estimate of Q3/18 GDP growth was largely unchanged from the first (+3.5%). If there's anything disappointing in the news, it's that the economy is not stronger, given that corporate profits are very strong. According to the latest NIPA data, after-tax corporate profits rose 19% in the year ending Sept. '18. According to GAAP (reported) profits, earnings per share for the S&P 500 rose over 22% in the year ending Oct. '18. Fabulous profits, indeed, but business investment remains moderate, and that is a big reason the economy is not stronger.

Trump has managed to reduce tax and regulatory burdens in impressive fashion, but his tweets and his tariff threats have created unnecessary distractions and unfortunate uncertainties, not to mention higher prices for an array of imported consumer goods. He's made America better, but not Great. Getting past the threat of trade wars, especially with China, will be the key to unlocking the future growth potential of the US economy, which remains Yuge. All eyes will be watching for the results of Trump's meeting with Xi in Buenos Aires later this week.

Chart #1

Thanks to plotting real GDP on a semi-log scale, Chart #1 makes it easy to see that the ongoing economic expansion has been the weakest in history. For many decades the economy averaged 3.1% annual rates of growth. But since the Great Recession ended in mid-2009, the economy has averaged only 2.3% annualized growth. Things have picked up a bit of late: in the year ending last September, growth was 3%. A decade of sub-par growth has created a potential GDP "gap" of at least $3.2 trillion. In the past year alone, the US economy has missed out on over $3 trillion in income—which averages out to over $20,000 per worker—that could have been earned if the economy had kept up with its previous trend.

Chart #2 

Chart #2 compares the 2-yr annualized growth rate of GDP with the real yield on 5-yr TIPS. There's a strong tendency for real yields to track the growth rate of the economy. Real yields began to rise just after the November '16 election, from -0.4% to 1% today. The outlook for the economy has improved, but we're still looking at moderate rates of growth in the 2.5-3% range. To get excited we'll need to see growth rates of 3-4%, and real yields of 2% or better. I remain optimistic that this will occur, but we aren't there yet. More confidence and more investment are what's needed, and a lower-tariff solution to our mounting China angst would be a wonderful tonic in that regard.

Chart #3

Chart #3 shows real gross private domestic investment. Like GDP, investment has been rising at a sub-par rate for the past decade. We need to see a lot more investment for the economy to get exciting. Chart #18 in my previous post shows a proxy for business investment—capital goods orders. They've been very unimpressive by historic standards. We've seen some nice improvement since late 2016, but this needs to continue.

Chart #4

Chart #5

Chart #6

Chart #4 compares after-tax corporate profits to nominal GDP, and Chart #5 shows the same profits as a percent of GDP going back 60 years. Corporate profits these days are close to their strongest levels ever relative to the economy, roughly 50% higher than their long-term average. Is it any wonder that the PE ratio of the S&P 500 (18.76 today, according to Bloomberg) is higher than average (16.85)? (see Chart #6)

Chart #7

If there is any message in the charts #4-6, it's that the market doesn't believe all this good news will last—despite record-level profits, valuations are only moderately above average. Chart #7 shows the risk premium that investors demand to hold stocks instead of risk-free 10-yr Treasuries. If PE ratios remained at today's level (18.75), and if corporations paid out all their profits in the form of dividends, then the dividend yield on stocks would be the inverse of the PE ratio: 5.33%. Yet if this were certain to persist, then only a fool would pass up stocks in favor of lower-yielding Treasuries. Instead, investors apparently figure that the corporate profits are likely to decline meaningfully relative to GDP. I made this same point three years ago and also seven years ago.

Chart #8

Chart #8 is one of my favorite recession-watch charts. Every recession has been preceded by a significant tightening of monetary policy, and that tightening can be measured by 1) a relatively high real Fed funds rate (2-3%), and 2) a flat or inverted Treasury yield curve. Currently the real funds rate is a bit less than 0.5%, and the yield curve remains positively sloped. Neither are threatening a recession, and neither is the Powell Fed. (I should note that the recent increase in the real funds rate is mainly the by-product of a decline in the PCE Core inflation rate.)

Chart #9

Finally, Chart #9 updates one of my favorites.