Braking and Accelerating in China (excerpt)

The Chinese have a very high savings rate, widely estimated to be 40%-50% of their income. A rough proxy for the amount of saving is M2, which rose to a record $21 trillion during May. It is up $2 trillion y/y and $12 trillion over the past five years.

The PBOC’s monetary policies have channeled most of those deposits into loans that expanded industrial capacity and funded property development. Now there is a glut of these, which is weighing on economic growth. Yet as I discussed yesterday, China’s banking regulators are set to scrap the country's longstanding loan-to-deposit ratio requirement, which is currently 75%. That move could inject another $1.1 trillion into the economy.

Over the past seven months, Chinese investors have poured money into the stock market seeking better returns, thus inflating a speculative bubble, which may be starting to burst already. Helping to burst the bubble are regulators intent on keeping a lid on margin lending by shadow banks. The 6/25 FT reported that official margin lending totaled $354 billion as of Wednesday’s close, up nearly 5.5-fold from a year earlier. However, this officially sanctioned margin lending, which is tightly regulated and relatively transparent, is only the tip of the iceberg for Chinese leveraged stock investing.

Unregulated margin leverage can reach 5:1 or higher, with no limits on which shares investors can buy. The funds come mainly from wealth management products (WMPs) sold by banks and trust companies. These are structured deposits that banks market to customers as a higher-yielding alternative to traditional savings deposits. Regulators moved to limit the availability of shadow margin debt on Saturday, June 13, triggering panic selling on Monday, June 15.

This past Saturday, China’s central bank cut its benchmark lending rate to a record low and lowered reserve-requirement ratios for some lenders. In the fourth reduction since November, the one-year lending rate was reduced by 25 basis points to 4.85%. The one-year deposit rate will fall by 25 basis points to 2%, while reserve ratios for some lenders, including city commercial and rural commercial banks, will be cut by 50 basis points. The PBOC was clearly worried about a meltdown in the stock market.

Today's Morning Briefing: Central Bank Credit & Credibility. (1) Are central banks losing control? (2) Given global turmoil, US stocks may be more attractive again. (3) BOJ pumps up liquidity, but fails to ramp up production. (4) Japan’s forward earnings still rising to record highs. (5) Chinese savings glut. (6) As China’s margin debt regulators step on brakes, PBOC steps on monetary accelerator. (7) Wealth management products may be China’s weapons of mass financial destruction. (8) ECB stimulates bank lending a little bit. (9) How much does Greece owe ECB? (10) Not cool: Dudley compares Greece to Lehman. (11) Liftoff or back off? (12) Fist fight between IMF and BIS. (More for subscribers.)

US Consumers Still Consuming (excerpt)

I have often said that betting against the US consumer is usually a bad bet. When we are happy, we spend money. When we are depressed, we spend even more to release the dopamine in our brains’ pleasure center. That helps us feel better. We were born to shop!

I have to admit that I was starting to doubt American shoppers earlier this year. Forgive me, please. Retail sales were anemic during the first four months of the year despite the windfall from lower gasoline prices. I reckoned that perhaps the savings from lower fuel costs was offset by higher out-of-pocket medical expenses attributable to Obamacare. In addition, rent inflation has been rising faster than overall CPI prices, reducing consumers’ spendable dollars for other goods and services.

Well, never mind: Retail sales jumped 1.2% during May, and the previous two months were revised higher. On Friday, we learned that personal consumption expenditures (PCE) jumped 0.9% during May, with upward revisions during April (0.1% from 0.0%) and March (0.6% from 0.5%). Real PCE rose 2.1% (saar) during Q1, and probably rose by about 3.0% during Q2.

On a year-over-year basis, real PCE rose 3.4% through May. Real disposable personal income rose 3.5%, with real wages and salaries rising 4.8%. Over the past three months through May, real consumer spending rose 2.8% (saar), led by solid gains in durable goods (9.8) and nondurable goods (2.9) but a middling increase in services (1.7).

Today's Morning Briefing: Standard of Living at Record High! (1) The last act of the Greek drama? (2) Dopamine and consumer spending. (3) Winter’s cabin fever set stage for spring spending splurge. (4) Real pay per worker at record high. (5) Real consumption per household is at record high. (6) Corporations prefer to buy back shares, pay dividends, acquire competitors, and cut expenses. (7) The logic of deals. (8) Not much inflation. (9) Why is PCED inflation lower than CPI version? (10) Yet another Chinese fire drill. (More for subscribers.)

The Productivity Puzzle (excerpt)

There is something very odd about the productivity numbers. They don’t make much sense. Productivity growth seems awfully weak given all the news articles about robots, automation, drones, the Internet of Things, and all the apps that are enabling everyone to work more efficiently.

The real output of the nonfinancial business (NFB) sector recovered from the last recession during Q4-2011, when it first exceeded the previous cyclical peak. Since then through Q1-2015, it is up 10.3%. Over this same period, NFB productivity is up only 2.3%. In other words, an 8.0% increase in hours worked accounted for most of the increase in output. On a y/y basis, real NFB output has been hovering around 3% since mid-2010. Over the same period, hours worked has been growing around 2%, while productivity has been rising around just 1%.

My hunch is that the output of the services-producing industries may be undercounted. Alternatively, productivity may be particularly weak in these industries. The easiest and best productivity gains in services-producing industries may have been gotten, and extracting more out of them is getting harder to do. Here are the relevant data points:

(1) The ratio of real GDP for goods to goods-producing payroll employment was at a near-record high of $267,810 per worker during Q1 (saar), up 1.7% y/y. The similar ratio for services rose to $81,372 per worker, down 0.1% y/y.

(2) Since the start of the data in 1947, the goods-producing “productivity” ratio is up a whopping 908%, while the comparable rate for services is up only 77%.

Today's Morning Briefing: Everyday Low Price. (1) EDLP. (2) Walmart stuffing labor costs down supply chain. (3) Is the Phillips Curve right about wage inflation, but wrong about price inflation? (4) S&P 500 Hypermarkets & Super Centers are getting squeezed. (5) Other retailers still showing upbeat metrics. (6) Is there something wrong with the productivity stats? (7) Productivity ratio falling recently in services. (8) Global economy muddling along in the mud. (9) US economy still has some soft spots. (10) Eurozone’s M-PMIs more upbeat than actual production. (11) Submerging economies. (More for subscribers.)

US Housing: Good Foundation? (excerpt)

Sales of both new and existing homes rose last month. That always happens during the spring. However, the data are seasonally adjusted, and were relatively weak earlier this year. There is an encouraging development for the housing industry in recent household formation, suggesting a higher trend in sales.

The total number of new households increased by 1.4 million y/y through March. This growth rate has exceeded the 1.0 million mark since October 2014. That’s the good news. The bad news is that all the new households are renting rather than buying their homes. The total number of homeowners peaked at 76.5 million during Q4-2006. It was down to 74.0 million during Q1-2015. The number of households who are renters rose 9.3 million since Q2-2004 from 32.9 million to 42.2 million.

That trend has clearly benefitted landlords of multi-family units and given them an incentive to build more of them. However, housing starts of such units have been back to their previous cyclical high for over a year. There was a big jump in May’s building permits for multi-family units, which reflected a surge of applications to beat the expiration of a lucrative tax break in New York City.

Single-family housing starts has been hovering around 700,000 (saar) for over a year, well below previous cyclical highs that typically well exceeded 1.0 million units. New single-family home sales rose to a cyclical high of 546,000 units (saar) during May, but that’s closer to previous cyclical troughs than peaks.

Today's Morning Briefing: Household Formation. (1) Narrowing bull market. (2) Three outperforming sectors. (3) Health Care way ahead of the pack. (4) Seeking earnings growth. (5) No bargains. (6) Dollar and oil weighing less on earnings revisions. (7) More households, but they are all renting. (8) Housing starts and new home sales still well below previous cyclical peaks. (9) Existing home sales rising, but who is buying? (10) Focus on market-weight-rated S&P 500 Industrials. (More for subscribers.)

Is Gold Just Another Commodity? (excerpt)

Gold is widely viewed as among the best hedges against inflation. It rose dramatically from $287 an ounce on September 11, 2001 to a record high of $1,895 during September 6, 2011. It’s down 37% since then. Gold bugs figured that the war on terror would widen government deficits and that central banks would help by keeping credit conditions loose. The financial crisis of 2008 unleashed the major central banks to experiment with various forms of ultra-easy monetary policy including NZIRP and QE.

Yet inflation remained subdued. The price of gold seemed to break when gold bugs were disappointed by the metal’s failure to rally on Abenomics, specifically the latest round of extremely easy money from the BOJ. So they started to sell.

I’ve observed that the price of gold tends to coincide with the underlying trend in the CRB raw industrials spot price index. If so, then the trend in both is more likely to be flat to down than to be up, in my opinion, given my outlook of secular stagnation for the global economy. That’s neither a boom nor a bust, just more of the same.

Today's Morning Briefing: Inflation Still MIA. (1) Diminishing inflation. (2) Un-COLA. (3) The forces of disinflation remain intact. (4) Lots of liquidity, yet not much inflation. (5) Unit labor cost inflation remains subdued. (6) Weak productivity growth doesn’t jibe with record profit margin. (7) Is Yellen waiting for Godot? (8) Fed study says cost-push inflation is a myth. (9) Inflationary expectations trending downwards with commodity prices. (10) Is gold really an inflation hedge or just another commodity? (11) Inflation is obviously key to bond and stock valuations. (More for subscribers.)

The Long Expansion (excerpt)

The Index of Leading Economic Indicators rose 0.7% for the second straight month during May and is just shy of the previous record high during May 2006. Previously, I examined the Index of Coincident Economic Indicators (CEI) for some historical guidance on the longevity of economic expansions. Let’s update the analysis:

(1) It has taken 68 months--from January 2008 through October 2013--for the CEI to fully recover from its severe decline during 2008 and early 2009. The previous five recovery periods averaged 26 months within a range of 19-33 months.

(2) The good news is that the average increase in the CEI following each of those recovery periods through the next peak was 18.6%, over an average period of 65 months within a range of 30-104 months. If we apply these averages to the current cycle, then the CEI would peak in 48 more months, during March 2019, with a substantial gain from here.

(3) For now, let’s just enjoy the fact that the CEI is at a record high, and 4.3% above its previous cyclical high during January 2008. All four components of the CEI (payroll employment, real personal income less transfer payments, industrial production, and real manufacturing and trade sales) are at or near recent record highs.

Of course, this analysis simply establishes a benchmark for the average length of expansions. There is quite a bit of variability around this average. The question is whether current events and projected future developments are likely to trigger a recession well before March 2019 or well after. There are plenty of talking points for the debating team making the pessimistic case. For now, I remain on the optimistic team, and a secular bull, as I have been since March 2009.

Today's Morning Briefing: ‘Gradually’ Is the Word. (1) Yellen waves her magic wand again. (2) Fed’s tightening will be below normal. (3) Kansas City discussions focused on secular bull. (4) Secular stagnation is bullish. (5) Kicking the can down the road beats the alternatives. (6) So what could go wrong? (7) Tightening tantrum ahead? (8) Contrary indicator: the front cover of The Economist. (9) Updating the long expansion story. (10) Wage inflation may be heating up finally, but is that inflationary? (More for subscribers.)

Global Oil Supply Rising Faster Than Demand (excerpt)

Global oil demand rose to a new record high of 93.8 mbd based on the 12-month average through May. It’s been doing so since it recovered from the Great Recession ever since June 2010. It has been rising at a faster pace in recent months. It rose 1.2% y/y in May, up from a recent low of 0.6% during November 2014.

Does this suggest that global economic growth is picking up? I doubt it. More likely is that the drop in oil prices is boosting demand. That’s the way the price mechanism is supposed to work. While the upturn in demand has helped oil prices to rebound from their lows at the start of the year, there’s plenty of supply keeping a lid on them despite the fall in prices. Indeed, the ratio of demand-to-supply continued to fall in May as it has virtually every month since August 2013. I expect that the price of a barrel of crude will remain range bound between $46 and $68 (the year’s low and high in the nearby futures price) through the end of this year.

This suggests that the S&P 500 Energy sector isn’t likely to outperform the S&P 500. It might be a market performer at best. The sector isn’t cheap with a forward P/E of 24.7, although its forward earnings has stopped falling in recent weeks.

Today's Morning Briefing: Leading Sectors. (1) Three outperforming sectors: Health Care, Consumer Discretionary, and IT. (2) They aren’t cheap, but they can grow earnings. (3) Overall outlook for revenues and earnings growth is lackluster. (4) Industry analysts tend to be overly bullish about prospects for long-term growth. (5) Is the trend growth rate 10%, 7%, or 5%? (6) Investors are also optimistic given record-high PEG. (7) More upside for profit margins of some sectors. (8) Financial engineering can also boost earnings per share. (9) Why Goldman hates buybacks. (10) Lower prices boosting oil demand, but supply increasing faster. (11) Focus on market-weight-rated S&P 500 Energy. (More for subscribers.)

Here Comes Another Earnings Season (excerpt)

S&P 500 earnings rose 1.4% y/y during Q1. That’s not much, but industry analysts expected a drop of 4.0% at the start of that quarter’s earnings season. Among the sectors, the big loser was Energy. Excluding it, earnings rose impressively by 11.2% y/y. Here is the rundown of Q1’s earnings performance derby from best to worst: Financials (19.6%), Health Care (19.4), Information Technology (10.3), Consumer Discretionary (8.1), Industrials (5.5), Consumer Staples (4.0), Utilities (2.4), Materials (2.0), Telecommunication Services (1.8), and Energy (-59.7).

Q2 might also show underlying strength. Industry analysts are currently estimating that S&P 500 earnings will be down 4.5% y/y during the quarter. The latest analysts’ earnings consensus performance derby for the sectors is as follows: Financials (14.7%), Consumer Discretionary (7.1), Telecom (5.6), Health Care (4.1), Tech (3.0), Materials (1.2), Utilities (0.9), Industrials (-0.3), Consumer Staples (-2.9), and Energy (-63.8). Excluding Energy, the consensus currently anticipates a 4.8% gain in Q2 results.

Given that the price of oil crashed during the second half of last year, Energy earnings may continue to weigh on aggregate earnings during Q3, but have a diminishing impact from Q4 into next year. That’s assuming the price of oil won’t be dropping again anytime soon, as I do. That might be a bad assumption if the sanctions on Iran’s oil exports are lifted. I am also assuming that the trade-weighted dollar isn’t going much higher. That might be a bad assumption if Greece exits the Eurozone, which I am not expecting.

Today's Morning Briefing: Zigzag. (1) Another earnings season is around the corner. (2) Why do industry analysts cut their estimates? (3) We count 58 “earnings hooks” over the past 85 quarters. (4) The longest streak is the current one. (5) Will Q2 be as surprisingly strong as Q1, excluding Energy? (6) Joe slices and dices earnings. (7) With P/Es stretched, earnings matter more. (8) Health Care leads the pack. (9) US consumer indicators are mostly upbeat, while business indicators are mixed. (10) Focus on market-weight-rated S&P 500 housing-related industries. (More for subscribers.)

Eurozone Stocks Hit Air Pocket (excerpt)

This may very well be the week for a deal, or for no deal. The question is who will blink first in this dangerous game of chicken between Greece and its creditors. Global stock investors started to blink on April 13, when the EMU MSCI (in euros) hit the year’s high with a gain of 22.9% ytd. On Monday, it was down 9.4% from that peak and still up 11.3% ytd. So it continues to outperform the US, UK, and EM MSCIs. Interestingly, the latest selloff in the EMU MSCI has been remarkably widespread among the 10 sectors comprising the index.

The good news is that the forward earnings of the EMU MSCI has been recovering nicely over the 14 weeks through June 4. In addition, the region’s Net Earnings Revisions Index jumped to 4.0% during May, the highest since September 2010. Obviously, industry analysts either aren’t counting on a Grexit, or don’t expect it will matter much to their companies. The index remains relatively cheap, with the forward P/E at 15.1.

While numerous economic indicators show that the Eurozone’s economy is on an upswing, it’s a very anemic one based on the region’s measures of industrial production. Here is the y/y performance derby for the region and its four biggest economies: Spain (2.2%), Germany (1.3), Italy (0.1), and France (-0.1). That’s not much to get excited about. It’s not much better in some of the other European economies: Sweden (1.5), UK (1.2), and the Netherlands (-4.2).

Yesterday, one of our accounts asked me if Europe’s economy is strong enough to absorb the shock of a Grexit. I think so, but I wouldn’t bet the ranch on it. Keep in mind that the Eurozone’s recovery is weak despite the fact that the following six cylinders have all been firing: near-zero interest rates, QE, a weak euro, rising bank lending, soaring stock prices, and lower oil prices.

Today's Morning Briefing: Dead Reckoning.(1) Deduced reckoning. (2) Are investors in the same boat with Nicole Kidman? (3) Is the Greek play a tragedy or comedy? (4) In praise of kicking the can down the road. (5) Angela vs. Wolfgang. (6) Earnings finally recovering in Eurozone. (7) No wind in the sails of commodity, currency, and S&P 500 traders. (8) Eurozone’s economic recovery remains uninspiring. (9) China’s economy continues to struggle with excess capacity and PPI deflation. (10) Focus on market-weight-rated S&P 500 IT industries. (More for subscribers.)

Varieties of Valuation (excerpt)

In my ongoing research on valuation, I constructed a quarterly P/E series for the S&P 500 based on reported earnings from Q4-1935 through Q3-1988, and operating earnings since then. Its average is exactly 15.0. It was 18.5 during Q1-2015. It has been this high before and sometimes gone higher. A reversion-to-the-mean valuation model is bearish based on this measure of the P/E since it is currently higher than its mean.

Over 30 years ago, Jim Moltz, my mentor at CJ Lawrence during the 1990s, devised the Rule of 20. It states that for equities to be fairly valued, the P/E ratio plus the inflation rate has to be around 20. In April, the CPI inflation rate was minus 0.2% y/y, implying that the fair-value P/E should be 20.2, well above the trailing P/E. On the other hand, the core CPI was up 1.8% y/y, suggesting that 18.2 is the right valuation number.

Greg Donaldson, the chief investment officer of Donaldson Capital Management and a subscriber and friend of Yardeni Research, offers an interesting inflation-based analysis of the P/E in a 5/16 Seeking Alpha article titled “The Great P/E Debate: Are Stocks Overvalued?” Greg writes: “We do not find strong relationships between any of the widely followed indicators such as interest rates, GDP growth or earnings growth. We have found that inflation is the best predictor of P/E ratios at any given point in time.” He ran a regression of inflation (using the core PCED) on the earnings yield (E/P). He used it to calculate that the current P/E should be about 21 based on his model.

In addition to tracking the trailing P/E, I also monitor market-capitalization-to-sales and price-to-sales ratios. During Q1, the Fed’s Financial Accounts showed that the ratio of the market capitalization of all equities traded in the US (excluding foreign issues) to nominal GDP rose to 1.69, the highest since Q3-2000. The comparable ratio for the S&P 500 rose to 1.87 during Q1, also the highest since Q3-2000. The ratio of the S&P 500 to its forward revenues per share rose to a cyclical high of 1.82 in early June. Stocks are seriously overvalued according to these measures.

Today's Morning Briefing: Slice & Dice. (1) The valuation question again. (2) Waiting for the answer while stocks meander. (3) Earnings-led target of 2300 for the S&P 500 next year. (4) Reversion-to-the-mean model is bearish. (5) A 20 P/E isn’t irrational according to inflation models. (6) Fed model says either stocks are too cheap or bonds are too expensive. (7) Does revenues growth matter to valuation? (8) Price-to-sales models are bearish. (9) Retail sales data suggest soft patch is over. (10) Our in-house Gen Xer slices and dices generational demographics from A to Z. (11) “Love & Mercy” (+ + +). (More for subscribers.)

Abrupt Normalization in Bond Market (excerpt)

One simple model of the 10-year bond yield compares it to the growth rate of US nominal GDP on a y/y basis. While real GDP fell 0.7% (saar) during Q1 on a q/q basis, it was up 2.7% y/y, confirming that the quarterly result might have been distorted by faulty seasonal adjustments. Recent economic indicators confirm that the US economy continues to grow at a moderate pace. In any event, nominal GDP rose 3.6% y/y during Q1. That’s well above even the latest yield. In the Eurozone, real GDP rose 1.5% (saar) q/q during Q1. It was up 1.0% y/y, with nominal GDP rising 2.0%.

This suggests that the rebound in yields is an abrupt normalization relative to nominal economic activity. This happened in reaction to the ebbing of deflationary fears. Expected inflation in US 10-year TIPS is up from this year’s low of 1.54% on January 13 to 1.86% on Tuesday. In addition, growth prospects seem to be improving in the US and Eurozone. While the ECB is committed to its QE program through most of next year, the Fed is likely to respond by raising the federal funds rate later this year. Expectations that the Fed will soon start normalizing monetary policy is another explanation for the abrupt normalization of bond yields.

Today's Morning Briefing: Bond Bath. (1) Blondes vs. bonds. (2) Bonds vs. bunds. (3) Where do we go from here? (4) From abnormal to less abnormal. (5) Deflation fears ebbing. (6) A simple bond model. (7) Draghi deserves credit and blame. (8) Dudley says Fed policy is market dependent. (9) Tranquility in the commodity pits. (10) Riding the Age Wave. (More for subscribers.)

No Soft Patch for Small Business (excerpt)

The NFIB survey of small firms reports a series reflecting the net percentage of business owners saying that their earnings were higher over the past three months versus lower. It has been negative since the start of the data in January 1986. It jumped last month to -7%, the highest reading since October 2005. It’s up from the series’ record low of -47% during January 2009.

Not surprisingly, the 12-month average of the earnings series is highly correlated with the NFIB small business optimism index. When small business owners are optimistic because their earnings are improving, they tend to hire workers. Sure enough, the percentage of small companies expecting to increase employment is up to 11.6%, the highest since February 2008. The percentage of small firms with job openings is up to 25.4%, the highest since December 2001.

The latest NFIB survey noted: “Owners report that the labor market is, from an historical perspective, getting very tight. Owner complaints about ‘finding qualified workers’ are rising, job openings are near 42 year record high levels, and job creation plans remain solid. Over 80 percent of those hiring or trying to hire in May reported few nor no qualified applicants.” In an obvious dig, the report added that there’s not much the Fed can do to increase the supply of qualified workers.

Today's Morning Briefing: Small Business Is Big. (1) Jury is out on soft-patch verdict. (2) No soft patch for small business owners. (3) Businesses create jobs, not governments. (4) Small businesses lead the way. (5) Corporate profits lead employment and capital spending. (6) Hard to find qualified workers. (7) Capital spending improving, but lagging. (8) A real jolt in JOLTS. (9) SMidCaps vs. LargeCaps. (10) Falling oil prices have had bigger impact on earnings than rising dollar. (11) Margins getting squeezed among SMidCaps as they ramp up hirng. (More for subscribers.)

Trailing P/E Is On the High Side (excerpt)

As I noted recently, valuation, like beauty, is in the eye of the beholder. I think P/Es are high. Others disagree and say they can go higher given historically low inflation and interest rates.

I counter that low inflation rates are contributing to low revenues growth. Given record-high profit margins, total earnings aren’t likely to rise faster than total revenues. Low interest rates are offset by low earnings growth, in my opinion. I’ve constructed a quarterly P/E measure based on S&P 500 reported earnings from Q1-1960 through Q3-1988 and operating earnings since then when it first became available. Consider the following:

(1) Reversion to the mean. The average of this combined series is 16.2. The P/E was 18.5 during Q1, exceeding the average by 2.3 percentage points. Historically, readings of 20.0 or more have proved to be high and often followed by bear markets.

(2) Inflation and interest rates. There is a stronger inverse correlation between the CPI inflation rate and the P/E than between the 10-year Treasury bond yield and the PE. Arguably, they both justify still higher P/Es.

(3) Earnings growth. However, there is also a very good correlation between analysts’ consensus expected long-term earnings growth over the next five years for the S&P 500 and the P/E. The former suggests that the latter may be too high.

(4) Valuation and beauty. I come to the same conclusion as before: Valuation, like beauty, is in the eye of the beholder.

Today's Morning Briefing: Which Way Is the Wind Blowing? (1) Jefferson, Einstein, and Twain. (2) The weather will change. (3) Neither boom nor bust. (4) OECD paints a picture with some shades of grey. (5) China’s trade data confirm domestic weakness. (6) Eurozone on recovery road, as Greece can gets kicked down the road. (7) Japan isn’t getting much bang for all those yen. (8) Waiting for Thursday’s retail sales report. (9) Real exports are really OK. (10) Dead calm for US stocks. (11) Revenues growth outlook is neither hot nor cold. (12) Valuation vs. reversion to the mean, inflation and interest rates, and earnings growth. (More for subscribers.)

Is the Soft Patch Over? (excerpt)

The soft patch may be over. The latest batch of economic indicators is certainly more upbeat than previous ones. Most importantly, I am impressed with May’s 0.6% m/m increase in our Earned Income Proxy (EIP), which is highly correlated with wages and salaries in the private sector. It’s also highly correlated with retail sales excluding gasoline, though the two series have diverged so far this year, with the latter lagging the former.

A sharp rebound in May retail sales would confirm that the soft patch is over. May auto sales did rise to 17.8 million units (saar), the highest since July 2005. We still have some concerns that rapidly rising tenant rent and out-of-pocket health care costs may be offsetting some of the positive impact of our rising EIP. May’s retail sales will be reported this Thursday. An upbeat housing-related indicator was April’s Pending Home Sales Index, which rose to the highest level since May 2006. It tends to be a good leading indicator for existing home sales.

And, of course, there was plenty of good news in Friday’s employment report. Most impressively, full-time household employment rose by 630,000 during May, having risen 2.6 million over the past 12 months. While wage gains remain relatively subdued around 2% on a y/y basis, the latest three-month changes are mostly around 3%, on average, at an annual rate.

Today's Morning Briefing: Peter Pan. (1) By the shores of Lake Winnipesaukee. (2) Seven strategists and economists with seven opinions. (3) Consensus vs. contrary scenarios. (4) Kuroda says we can fly if we believe we can. (5) Japanese inflation close to zero again despite all the pixie dust. (6) Draghi plays Captain Hook. (7) Less deflation, more growth in Eurozone. (8) Dudley: On your mark, get set, wait. (9) Fed policy is market dependent too. (10) Is the US soft patch over? (More for subscribers.)

Has Profits' Share of National Income Peaked? (excerpt)

Profits’ share of national income is very volatile over the business cycle because it reflects the volatility of its two determinants that also fluctuate with the business cycle, namely revenues and the profit margin. The latter is the more volatile of the two and is highly correlated with profits’ share of national income. It has the same cyclical pattern as profits’ share of national income. They both rise rapidly during recoveries and expansions when revenues tend to rise faster than costs, which boosts the profit margin. They both tend to peak and fall near the tail end of expansions when costs, including payrolls and capital spending, start to outpace revenues. During recessions, profits plunge on an absolute and relative basis as revenues fall faster than costs, which also depresses profit margins.

The jury is still out on whether the profit margin has peaked, having risen to a record high of 10.4% during Q1 for the S&P 500. That will depend on whether companies will raise wages as they continue to expand their payrolls. It will also depend on whether the pace of capital spending picks up. So far, there’s not much evidence that these costs are taking off.

However, the profit margin can also get squeezed if revenues growth slows, which does seem to be happening. That’s because global economic growth is lackluster. Yesterday, the Organization for Economic Cooperation and Development lowered its forecast for world economic growth to 3.1% this year and 3.8% in 2016, down from its prediction six months ago of 3.6% and 3.9% growth, respectively. Furthermore, revenues growth has been hard hit by the drop in oil prices and the strength in the foreign exchange value of the dollar since last summer.

Today's Morning Briefing: What’s the Trend in Profits? (1) Why profits can’t grow faster (or slower) than GDP. (2) Profits’ share of national income may be peaking. (3) Profits are very pro-cyclical because so are revenues and profit margins. (4) Record high for S&P 500 profit margin. Can it go higher? (5) Two ways to squeeze margins: Higher costs vs. lower revenues. (6) The OECD cuts its estimate for world growth. (7) Profits cycle driving the business cycle. (8) Using the value of world exports as a proxy for global GDP. (9) Beware of false slowdown in world economic indicators measured in dollars. (10) Is 5% rather than 7% the new normal? (More for subscribers.)

China Remains Epicenter of Global Deflation (excerpt)

Monday’s WSJ included an article titled “Glut of Chinese Goods Pinches Global Economy.” The main point is that “China’s excess manufacturing capacity and slowing growth rate are … putting renewed downward pressure on prices.” I have been expounding on this theme for quite some time, so I obviously think the article is worth reading.

When China’s economy was booming, so did its demand for commodities. The result was the commodity super-cycle, which started in late 2001 after China joined the World Trade Organization on December 11 of that year. The super-cycle was briefly interrupted by the financial crisis of 2008. However, the Chinese government responded to it with a major fiscal stimulus program while the PBOC pumped lots of credit into the economy. Other governments and central banks did the same, but the Chinese led the way.

As a result, commodity prices soared again in 2009 through 2010. However, China’s factories turned expensive commodities into lots of cheap manufactured goods thanks to the availability of cheap labor. In other words, the trend in the so-called “China Price” was disinflationary, if not deflationary for the world economy. For the seven countries that report their CPIs by goods and services, durable goods prices have been falling steadily since the start of 2001: Eurozone (-1.7%), US (-12.5), UK (-13.7), Sweden (-21.6), Taiwan (-22.3), Switzerland (-23.9), and Japan (-43.7).

But China’s economic growth peaked during 2010, and labor costs started rising. The commodity super-cycle wasn’t so super, lasting just 10 years rather than 25-50 years. The subsequent drop in commodity prices since 2010 depressed commodity producers. Nevertheless, the China Price continues to fall as Chinese factories replace labor with automation. The 5/5 South China Morning Post included an article titled, “Building work starts on first all-robot manufacturing plant in China’s Dongguan.” A total of 1,000 robots will be installed at the factory, run by Shenzhen Everwin Precision Technology Co, with the aim of reducing the current workforce of 1,800 by 90% to only about 200.

To avert large-scale unemployment, the government continues to provide fiscal and monetary stimulus, which only worsens the excess capacity problem in manufacturing.

The WSJ article cited above reports, “Prices of all goods imported to the U.S. directly from China have fallen in 20 of the past 38 months, by 2.2% in all. For U.S. consumers, that is good news. But for policy makers and corporate executives, declining prices present a real challenge. The declines can sap profitability, deter investment and block wage growth, all of which are needed to help the world break out of its years of underwhelming growth.”

The article notes, as I have on a regular basis, that China’s PPI has declined on a y/y basis for 38 consecutive months. The PBOC has responded by easing credit conditions, which is likely to boost excess capacity by keeping “zombie” companies in business and by spurring even more capacity expansion.

Today's Morning Briefing: Blaming China. (1) No shortage of gluts thanks to China. (2) The epicenter of deflation. (3) Not so super super-cycle. (4) “China Price” remains deflationary as robots replace humans. (5) Deal or no deal? (6) Lots of big deals in healthcare, IT, and telecom. (7) Fed financing M&A mega-boom. (8) The fastest and easiest way to grow. (9) Challenging time for active managers. (10) Dividend-yielding stocks underperforming. (11) Focus on market-weight-rated S&P 500 auto-related industries. (More for subscribers.)

Sorting Out the Statistical Discrepancy in GDP (excerpt)

The US economy may not be booming, but it certainly isn’t doing as badly as suggested by the 0.7% (saar) drop in real GDP during Q1. By now, everyone is aware of the “residual seasonality” problem that has been weighing on Q1 growth rates. That includes the Bureau of Economic Analysis, which announced in a 5/22 blog post that it should fix the problem by the end of July.

Recently, I’ve noted that the problem can be overcome by simply calculating that real GDP rose 2.7% during Q1 on a y/y basis. This automatically eliminates the seasonal adjustment problem and shows that the economy continues to grow at a slow but steady pace. Real nonfarm business output, which excludes government spending, rose 3.5% y/y during Q1.

Furthermore, national income rose faster than GDP during Q1. In theory, these two should be identical. In practice, there is a statistical discrepancy, which rose to a record high of $328 billion (saar) during Q1. In other words, the economy looks better when the BEA adds up all the incomes than when it adds up all the demand data that are used to calculate national output.

Today's Morning Briefing: Neither Boom Nor Bust. (1) Jury is out. (2) Supply-side and demand-side perspectives on slowdown. (3) National and regional business surveys diverged in May. (4) Not much spring in consumer spending. (5) Meet the HENRYs, or high earners not rich yet. (6) Rising rents and health care costs squeezing consumers. (7) Meet the BBADs, or older Baby Boomers with adult dependents. (8) Building lots of new factories, or just a Gigafactory? (9) Record discrepancy between GDP and National Income. (10) Bond market’s latest economic assessment. (11) Lots of mixed PMIs in Asia and Europe. (More for subscribers.)

The Trend in Profits (excerpt)

The growth trend of corporate profits is determined by the growth trend of nominal GDP. My analysis shows that the trend of these variables has been 7% since 1960. Profits growth is much weaker during recessions and much faster during recoveries, but 7% has been the magic number for the trend. That seems to be the best we can expect in the coming years until the next recession. Given that valuation multiples are at their historical highs, 7% may also be the best we can expect in terms of annual capital gains in the stock market for the duration of the current bull market. That’s quite good compared to the bond yield and the inflation rate, which are both historically low.

On a cyclical basis, there is a strong correlation between the y/y growth rates of nominal GDP and S&P 500 revenues in aggregate. The correlation is even better with nominal GDP for goods. The two series do diverge often on a short-term basis, but have the same cyclical pattern. During Q1, revenues fell 2.5% y/y, while nominal GDP with and without services rose 3.6%. The recent plunge in oil prices had a bigger impact on S&P 500 revenues than on nominal GDP.

Over the past four and a half years, nominal GDP has been growing just under 5%, so it’s possible that this may be the new magic number for the trend growth in GDP, and therefore in profits. While there has been some recent chatter about the depressing impact of seasonal adjustment factors on Q1 real GDP, that distortion is eliminated simply by tracking the y/y growth rate, which has been relatively stable around 2.5% since mid-2010. In fact, while real GDP fell 0.7% (saar) during Q1, it was up 2.7% y/y! Meanwhile, inflation continues to decelerate in the GDP accounts. The GDP price deflator was up just 0.9% y/y during Q1, with the core rate also low at 1.1%. Again, put these trends together, and nominal GDP is growing below 5% rather than close to 7%.

Today's Morning Briefing: Probing Profits. (1) Profits measures: Take your pick. (2) We pick forward earnings. (3) Is the 7% trend still our friend for profits growth, or might it be 5%? (4) How much longer can profit margins break records? (5) Cash flow stalled at record high. (6) The government should fill potholes. (7) Assessing the soft patch in the oil patch. (8) Regional surveys add up to weak May. (9) Frightful freight index. (10) Signs of life in Eurozone’s corporate earnings. (More for subscribers.)