Tuesday, December 20, 2016

Votes of Confidence

Once again, the election results demonstrate that “It’s the economy, stupid!” Stock investors are certainly giving the President-elect not only the benefit of the doubt but a big tailwind for his economic program, as the market capitalization of the S&P 500 has increased by $1.0 trillion since Election Day to a record high. In fact, the votes of confidence since that day have been overwhelmingly positive, suggesting that Trump may have unleashed some animal spirits that might very well boost economic growth. Consider the following:

(1) Financial stocks. Leading the way among the S&P 500 sectors has been the Financials sector. In the past, leadership by this sector tended to be bullish for the overall market. REITs were removed from this sector on September 19, so it hasn’t been weighed down by their relative weakness. Instead, the sector has soared as the yield curve has steepened and credit spreads have narrowed. Financial stocks have also been buoyed by the prospect of less government regulation.

Here is the S&P 500 sector performance derby since Election Day through Friday of last week: Financials (17.2%), Telecom Services (10.8), Energy (10.3), Industrials (7.7), Materials (7.0), S&P 500 (5.5), Consumer Discretionary (5.3), Health Care (2.0), IT (2.0), Real Estate (0.5), Consumer Staples (-0.9). and Utilities (-1.2). (See table.)

(2) Credit markets. In my meetings with our accounts in Toronto and Chicago last week, I opined that November 8 might have marked the end of the New Normal, or secular stagnation, and comeback of the Old Normal. That’s certainly reflected in the 10-year US Treasury bond yield, which jumped to 2.60% on Friday, up from 1.88% on Election Day.

So far, the credit markets aren’t signaling that the backup in bond yields might cause a recession. On the contrary, the yield curve has steepened by 42bps since Election Day, based on the spread between the 10-year US Treasury bond and the federal funds rate. The yield curve spread is one of the 10 components of the index of leading indicators, and it usually turns negative before a recession. It had been narrowing prior to the election, but has turned more positive since then.

Another upbeat signal from the credit markets is that the spread between corporate bond yields and the 10-year Treasury yield continues to narrow after peaking during February. The spread widened significantly during the second half of 2014 and during 2015 on fears that the plunge in oil prices might trigger a financial contagion. Instead, it caused a recession that was contained within the energy sector, which has been recovering since early this year along with the price of oil. Most encouraging is that the corporate high-yield credit spread has narrowed from a peak of 844bps on February 11 to 363bps last Wednesday, the lowest reading since October 6, 2014.

(3) Business surveys. Among the most spectacular votes of confidence for a “New Morning” scenario for the US economy are December’s business surveys for the Fed’s Philadelphia and New York districts. The average of their two composite indexes jumped from 4.6 during October to 15.3 this month, the highest reading since November 2014.

The NFIB Small Business Optimism Index jumped from 94.9 during October to 98.4 last month, the biggest one-month increase since April 2009. The NAHB Housing Market Index rose this month to the highest reading since July 2005 thanks to a sharp increase in traffic of prospective home buyers. This is happening either despite the jump in mortgage rates or because of it as potential buyers scramble to purchase before rates go still higher.

(4) Consumer sentiment. As we noted last week, the Consumer Sentiment Index has increased from a 14-month low of 87.2 during October to 98.0 during the first half of December. At the end of the month, the final number will be reported in addition to the readings for December’s Consumer Confidence Index. November’s results for the latter showed that confidence was especially strong among survey respondents who are under 35 years old. If Trump can make young adults happier, maybe we will see an increase in household formation, marriages, babies, and home buying.

(5) Still ahead. There are still plenty of post-election surveys ahead, including those of the other three Fed districts that will be reporting their December business surveys. Business Roundtable conducts a survey of corporate CEOs. The quarterly index that is compiled from the survey is a leading indicator for capital spending.

The Q4 survey was taken between October 26 and November 16. However, CEOs remained cautious, as their Economic Outlook Index didn’t change much from Q3. “America’s business leaders are encouraged by President-elect Trump’s pledge to boost economic growth,” said Doug Oberhelman, chairman and CEO of Caterpillar Inc. and chairman of Business Roundtable. “We will work with the incoming Administration and Congress to enact pro-growth policies such as modernizing the U.S. tax system, adopting a smarter approach to regulation, investing in infrastructure and focusing on the education and training people need to thrive in the 21st century economy.”

He added, “It’s telling that for the fifth year in a row CEOs name regulation as their greatest cost pressure. We are encouraged by the promise of a renewed focus to usher in a smarter regulatory environment that promotes job creation and economic growth and also protects safety, health and the environment.”

Our sources among our institutional accounts tell us that many CEOs are becoming increasingly exuberant about the prospects for Trump’s policies. That should show up in the Q1 reading of Business Roundtable’s CEO survey and in better capital spending next year.

(6) Commodities & currencies. Remarkable votes of confidence since Election Day are also visible in the CRB raw industrials spot price index and the JP Morgan trade-weighted dollar. The former is up 3.3%, while the latter is up 4.7% since the election. The nearby futures price of copper is up 7.7% over this same period. In the past, a strong dollar tended to depress commodity prices.

So far, Donald’s Trumpland seems a bit like Alice’s Wonderland. In any event, financial and survey indicators suggest that while Clinton’s supporters may remain in mourning, it may very well be a new morning for the economy.

Wednesday, December 7, 2016

Corporate Taxes In Trump World

President-elect Donald Trump’s tax plan will be the “largest tax change” since Reagan, Steven Mnuchin told CNBC in a 11/30 interview. That was the day after Trump officially cast the former Goldman Sachs banker and Hollywood movie financier in the role of US Treasury Secretary. During the interview, Mnuchin confirmed the Trump campaign’s promise to cut the federal statutory corporate tax rate to 15% from 35%. In addition, overseas profits will be brought back to the US, he said, obviously referring to the one-time 10% repatriation tax that the administration intends to implement. Overall, cutting corporate taxes should stimulate spending and jobs, he argued. Mnuchin also emphasized that taxes are “way too complicated” and people spend “way too much time worrying about how to get them lower.”

That all sounds good to me, but there’s a catch. Trump’s corporate tax cut might not be as bold as suggested by the 20ppt reduction in the tax rate. That’s especially true if the tax code is simplified to close tax loopholes, as Mnuchin implies. Furthermore, there’s no guarantee as to how corporations will spend any of the tax benefits that are realized. Consider the following:

(1) Statutory vs. effective. The headline corporate tax rate of 35% isn’t what companies actually pay. That’s the statutory federal tax rate. It’s more meaningful to consider the corporate effective tax rate (ETR) after all credits and deductions are taken into account. A March 2016 Government Accountability Office report highlighted a range of ETR estimates by different methods, including one for profitable large corporations at just 14%. However, a more comprehensive ETR measure includes both profitable and unprofitable large corporations. And that was 25.9% of pretax net income in US federal income taxes, excluding foreign and state and local taxes. Obviously, however you slice it, the ETR is generally lower than the statutory rate.

My own measure of the ETR has come down significantly. It is simply corporate profits taxes divided by pre-tax corporate profits, with both series included in the National Income & Product Accounts. It has been trending down from its record high of 50.2% during Q1-1951 to its record low of 17.1% during Q1-2009. It drifted back up to 25.0% during Q3 of this year. It has almost always been below the top corporate tax rate.

(2) Simpler code? “Mr. Trump’s tax reform plan would boost incentives to work, save, and invest,” concluded a 2015 Tax Policy Center (TPC) study. That might be true. However, the study also footnoted: “It is unclear whether the 15 percent rate is a flat tax rate on all corporate income, or whether some form of graduated rate schedule is maintained.” And: “It is unclear which specific business tax preferences would be eliminated.” In other words, the ETR might not change all that much if the statutory rate change is combined with reductions to credits and deductions.

On 10/18, the TPC issued a revised analysis of Trump’s revised tax plan. It covered Trump’s policies as outlined in his speeches on 8/8, 9/13, and 9/15. It noted: “The revised framework, as set out in those speeches and campaign publications and statements, leaves many important details unspecified. We needed to make many assumptions about these unspecified details to analyze the plan.”

The revised plan seems to include the profits of pass-through businesses (e.g., sole proprietorships, partnerships, and S corps) in the 15% tax rate club along with other corporations--that is, instead of taxing owners at their regular individual income tax rates. (Different rules would apply to distributions to owners of “large” pass-through entities.) Both corporate and qualifying pass-through entities would have the option to deduct investments immediately as opposed to depreciating them under current law--a potential boon to investment spending. But then they wouldn’t get to deduct interest expenses. That might just apply to manufacturers, but TPC says it’s unclear. Some special interest deductions would also be repealed. And the corporate alternative minimum tax would be eliminated. (By the way, a 11/11 CFO.com article noted that Trump might have since backed off a bit from the 15% rate for pass-through enterprises.)

But again, a lot of open questions remain. That includes exactly what deductions and loopholes would be eliminated. The TPC observed in its revised appendix: “In his Detroit speech, Mr. Trump said his plan would ‘eliminate the Carried Interest Deduction and other special interest loopholes’ and in his New York speech that ‘special interest loopholes’ would be closed, but no specific provisions are identified. The fact sheets on tax reform indicate that the plan ‘eliminates most corporate tax expenditures’ [i.e., deductions] except the research credit.”

It seems unlikely that such a massive corporate tax rate reduction would be formally proposed without the corresponding elimination, or reduction, of more deductions. With that, Trump would still be able to keep his 15% campaign promise without adding potentially unsustainable sums to the deficits and debt. Keeping a lid on deficits and debt would be especially important in the near term before any economic benefit resulting from the tax breaks would occur. Mnunchin did say in his interview that some of the lost tax revenue from corporations would be made up on the personal income side.

(3) US versus them. A comparison of the US ETR relative to other countries obviously is important for considering US competitiveness. When measured on the basis of effective rather than statutory rates, the US corporate tax rate becomes much closer to other countries’ rates. A 2014 Politifact article reviewed several studies of the ETR across different countries. It noted: “[W]hereas the statutory rate is relatively straightforward and uncontroversial, different, reputable organizations have published very different estimates of the effective tax rate that corporations pay.” An often-cited 2014 study by the Congressional Research Service had the US effective rate at 27.1%, which was slightly lower than the OECD weighted average of 27.7%.

(4) Laffer effect. By the way, Trump tax critics argue that his plan will balloon the federal deficits and debt. However, back in 1978, economist Arthur Laffer argued that cuts could be revenue-neutral in the long term as economic activity grows. Gene Epstein updated the case for the Laffer effect in a 11/26 Barron’s article. He tested the concept using a statistical run originated by a couple of Cato researchers. He concluded: “The results not only confirmed the Laffer effect but if anything, showed that a decline in the corporate tax rate seems to bring a rise in revenue, rather than a fall. In other words, instead of being revenue-neutral, the proposed cut might even be revenue-positive.” He added: “Meanwhile, the boost to economic activity would be palpable.”

Tuesday, November 29, 2016

We Are All Populists Now

The February 6, 2009 cover story of Newsweek was titled “We Are All Socialists Now.” I reread it over the weekend, and was floored by the first paragraph:
On the Fox News Channel last Wednesday evening, Sean Hannity was coming to the end of a segment with Indiana Congressman Mike Pence, the chair of the House Republican Conference and a vociferous foe of President Obama’s nearly $1 trillion stimulus bill. How, Pence had asked rhetorically, was $50 million for the National Endowment for the Arts going to put people back to work in Indiana? How would $20 million for "fish passage barriers" (a provision to pay for the removal of barriers in rivers and streams so that fish could migrate freely) help create jobs? Hannity could not have agreed more. "It is … the European Socialist Act of 2009," the host said, signing off. "We’re counting on you to stop it. Thank you, congressman.”
Jon Meacham, the author of the piece, concluded, “Whether we want to admit it or not--and many, especially Congressman Pence and Hannity, do not--the America of 2009 is moving toward a modern European state.”

Now Pence is the VEEP-elect and Hannity is one of the favorite journalists of POTUS-elect Donald Trump. None of them are socialists. However, they are all now self-proclaimed populists. I’m not sure what the difference is, since both socialists and populists tend to advocate strong government intervention to help the common man, the little guy, and the forgotten man.

In his speech after Tuesday’s election, Donald Trump referred to America’s “forgotten men and women” who propelled him to victory. They are the blue-collar workers in the manufacturing towns of the Rust Belt and the hollowing coalfields of Appalachia. These people feel left behind by progress, laughed at by the elite, so they put their faith in the billionaire businessman who promised to Make America Great Again.

In a fireside chat over the radio on April 7, 1932, Franklin Delano Roosevelt used the phrase “forgotten man” to promote his New Deal: “These unhappy times call for the building of plans that rest upon the forgotten, the unorganized but the indispensable units of economic power, for plans like those of 1917 that build from the bottom up and not from the top down, that put their faith once more in the forgotten man at the bottom of the economic pyramid.”

Given that both Trump and Hillary Clinton promised to spend lots of money on infrastructure to create good-paying jobs, maybe we are all Keynesians now too. By the way, Nixon never said, “We are all Keynesians now.” What he did say was, “I am now a Keynesian in economics.” Milton Friedman was also misquoted on this subject. What he actually said was: “In one sense, we are all Keynesians now; in another, nobody is any longer a Keynesian.”

In any event, VEEP-elect Mike Pence is a Keynesian now who supports Trump’s $1 trillion of spending on infrastructure. So is Steve Moore, one of the founders of supply-side economics. He recently declared himself to be a populist now.

Before turning to the future, let’s stay in the past and try to see what Trump saw when he ran into all those forgotten people he met on the campaign trail. Here are some relevant observations:

(1) Exhibit A against China. In researching the causes of the productivity slowdown during the current economic expansion, I ran a chart of the Fed’s indexes for manufacturing industrial production and capacity. They both are available monthly since the late 1940s. Both have been on uptrends since the start of the data until about 2001, when both started moving sideways. China entered the World Trade Organization (WTO) on December 11, 2001.

While manufacturing production reflects the ups and downs of the business cycle, manufacturing capacity has a long history of relatively stable growth. In fact, on a year-over-year basis, the former tends to turn negative, while the latter had remained positive until it turned slightly negative for the first time from September 2003 to October 2004, and again from August 2008 to November 2011. Capacity growth averaged 3.9% from 1949 through 2001. From 2002 through 2015, it averaged just 0.4%.

If we were all populists now, I would argue that this is Exhibit A confirming that US companies stopped expanding their capacity in America ever since China entered the WTO. Instead, they invested in factories in China or outsourced to Chinese factories to produce goods that now are imported into the US rather than made here by American workers.

(2) Smacking productivity. If we were all populists now, I would challenge the argument made by Globalists that Americans have lost jobs as a result of labor-saving technological innovations, rather than the migration of jobs to Chinese workers. I would counter that this notion isn’t supported by the flat trends in manufacturing production and capacity since 2001. Technological innovation should expand manufacturing capacity and boost labor productivity. Yet nonfarm business productivity growth has been extremely weak during the current economic expansion. Over the past 20 quarters (five years), it is up only 0.7% per year on average. It has never been this weak during an economic expansion!

Not surprisingly, there does seem to be a good correlation between the growth in manufacturing capacity on a y/y basis and the five-year growth trend in productivity. The latter tends to grow fastest during or soon after a period of fast growth in capacity. This makes sense to us. If companies aren’t expanding capacity at home, then domestic productivity is likely to suffer.

(3) Whacking real incomes. If we were all populists now, I would also note that productivity drives the standard of living, which by some measures seems to have stagnated for years. That jibes with the high correlation between the 20-quarter growth rates in productivity and real hourly compensation in the nonfarm business sector. The latter is up just 1.0% per year on average, among the slowest five-year growth rates since the start of the data in the early 1950s.

(4) Blaming foreigners. If we were all populists now, I would support the view that free trade hasn’t been fair trade by observing that our merchandise trade deficit was $724 billion over the past 12 months through September. That is below its record high of $851 billion during October 2008. However, excluding the petroleum trade deficit, which has narrowed dramatically in recent years, the merchandise deficit, at $670 billion over the past 12 months through September, remains near recent record highs.

Now let’s round up the usual suspects. Over the past 12 months through September, our trade deficit has been as follows among our major trading partners: China ($350 billion), Eurozone ($128 billion), Japan ($69 billion), and Mexico ($63 billion). In terms of product categories, the US is running merchandise trade deficits over the same period in autos ($199 billion), non-auto capital goods ($69 billion), and non-auto consumer goods ($389 billion). China currently accounts for 48% of the US trade deficit. Mexico accounts for just 9% of it.

(5) The case for Globalization. At the risk of getting tar and feathered by the populists, allow me to make the case for Globalization. (These are my own views, so my associates at YRI should be held harmless.) For starters, the US quarterly balance-of-payments accounts show that the US trade deficit in goods, which was $751 billion over the four quarters through Q2-2016, was partially offset by a sizable trade surplus in services of $251 billion.

In any event, the horses may already be out of the barn. Only 8.5% of payroll employment is now attributable to manufacturing, down from 10.3% 10 years ago, 14.3% 20 years ago, and 17.5% 30 years ago. Bringing factory jobs back to the US may bring them back to automated factories loaded with robots. Even Chinese factories are using more robots.

The standard of living hasn’t stagnated in the US. That notion has been promoted by the President-elect, and other populists, who have observed that real median household income has been virtually flat since 1999, though it did jump 5.2% during 2015. Previously on several occasions, I questioned the accuracy of this data series, which is based on survey (micro) data, is limited to money income, is pre-tax, and is pre-noncash entitlements. Macro data based on tax returns and other fact-based sources, on real personal income, disposable personal income, and consumption per household all remain on rising trends and are at record highs. While my data are averages (means) rather than medians, I doubt that there are enough rich people to seriously distort my numbers, especially for real mean consumer spending per household.

The main argument for free trade is that it lowers prices for consumers since imported products must be cheaper to make overseas than at home. Everyone is a consumer, so everyone benefits from lower prices. Studies have shown that it would be much cheaper to provide income support and retrain workers who have been harmed by Globalization than to impose prohibitive tariffs to force production to come home, thus reducing the standard of living of all consumers, who must pay higher prices for domestically produced goods.

Business Insider published an article on 11/27 that was titled “Here’s what 5 of your favorite products would cost if they were made in the US.” The price of iPhones could more than double. Jeans would cost more than $200. The price of sneakers might also double. TV prices might not go up much since transportation costs would be lower for domestically produced units, but solar panel prices would be much higher.

The election results clearly show that there are many people who feel that they have been harmed by Globalization. They may not realize that they have also benefitted from it through lower prices on the goods they purchase. It is unlikely that prohibitive tariffs will bring back manufacturing jobs paying much higher wages. Those days are probably gone. The best hope is that Globalization increases incomes, consumption, and standards of living around the world, thus leveling trade imbalances.

Thursday, November 17, 2016

Is Trumponomics Inflationary?

Trumponomics is a mix of demand-side and supply-side economics. The former tends to be inflationary, while the latter tends to be disinflationary. That’s in theory. In practice, we will all find out together what the net result of mixing things up like this will do to inflation. On the demand side, President-elect Trump proposes to spend $1 trillion on infrastructure over the next 10 years. On the supply side, he proposes to slash the corporate tax rate. He also intends to reduce income tax rates on personal incomes, which can have both inflationary demand-side and disinflationary supply-side effects.

I think that on balance, the disinflationary supply-side effects will offset some, but not all, of the inflationary demand-side effects of Trumponomics. That certainly should greatly reduce the risk and fears of deflation. If so, then the 35-year bull market in bonds might have ended on July 8 of this year when the 10-year yield bottomed at a record low of 1.37%. It is already back up to 2.23%.

Much of that backup was attributable to the perception that no matter who won the presidency, there would be more fiscal stimulus. Now that Trump has won, that’s become a virtual certainty. After all, Don the Builder’s specialty is building things. Now let’s consider the various inflationary and disinflationary forces that are likely to be unleashed by Trumponomics, focusing on the data that will be especially important to monitor to assess how all these vectors will add up:

(1) Globalization vs. protectionism. Since the end of the Cold War, I have argued that Globalization is inherently disinflationary. Now we are starting to see headlines such as “Goodbye, globalization.” It appeared at the top of a 11/13 Business Insider story that mentioned a cautionary note Bridgewater sent to clients on Friday, which warned, “The political backdrop looks negative for globalization.” Crispin Odey, another hedge fund manager, wrote in a recent note to clients, “Globalisation, competition, internationalism are now firmly in the retreat. Inflation and protectionism promise a future which is not as kind to financial assets as QE and deflation has been.”

Protectionism can be inflationary, as long as it doesn’t trigger a depression, which would be deflationary. The Smoot-Hawley Tariff of June 1930 caused a depression and a collapse in commodity and consumer prices. I recently have observed that the Reagan administration pursued policies that seemed protectionist at the time. Our major trading partners were pressed to adopt fairer trade practices in exchange for free trade with the US. The US economy continued to grow, and inflation remained subdued. I think that will be the outcome of the current protectionist wave. So I expect that Globalization will survive the latest challenges.

(2) Labor market. In a November 4 speech, Federal Reserve Vice Chairman Stanley Fischer said that in his view “the labor market is close to full employment.” He added that it wouldn’t take much by way of job gains to maintain the unemployment rate near 5%. That’s because he expects that the labor force participation rate will continue to decline due to the “likely drag from demographics.”

Specifically, he said that job gains of as low as 65,000 to 115,000 would be “sufficient to maintain full employment.” Even if participation rates were to remain unchanged, Fischer said a range of 125,000 to 175,000 job gains would prevent “unemployment from creeping up.” Nonfarm private payroll employment gains averaged 210,200 per month over the past five months through October.

The unemployment rate has been around 5% since last fall. Strong labor market indicators were also evident in the latest Job Openings and Labor Turnover Survey (JOLTS) and National Federation of Independent Business (NFIB) reports through September and October, respectively. According to both surveys, the rate of job openings exceeds levels during two of the past three cyclical peaks. Layoffs fell to the lowest on record, while quits were near a record high during September. Not surprisingly, quits are highly correlated with the Consumer Confidence Index, which has been lagging but could jump higher now that the elections are over.

This all points to higher wage inflation. The Atlanta Fed’s median wage growth tracker shows that “job switchers” enjoyed a wage gain of 4.4% y/y during October versus 3.6% for “job stayers”. Average hourly earnings for all private industry workers rose 2.8% y/y during October, the highest since June 2009.

Trumponomics could put more upward pressure on wages given that most labor market indicators suggest that the economy is at full employment. There is already a shortage of construction workers that will be hard to fill, unless Trump allows special work visas for construction workers from Mexico! (See the 9/21 WSJ article titled “How an Immigration Downturn Has Contributed to the Construction-Worker Shortage.”)

(3) The dollar, oil, and other commodities. The soaring dollar and falling oil prices should help to moderate inflationary pressures in the labor market. The JP Morgan trade-weighted dollar is now up 24% from its low on July 1, 2014. That, along with OPEC’s inability to agree on production cuts, is depressing the price of oil. Trump’s commitment to “lift the restriction” on the US energy industry could very well drown the cartel in oil.

On the other hand, the CRB raw industrials spot price index is soaring. However, it is doing so as the dollar is doing the same, which is unprecedented. It is also extraordinary to see that inflationary expectations have jumped since the election, while the dollar has soared. In any event, the strong dollar is bound to put downward pressure on nonpetroleum import prices.

(4) Productivity. Over the past couple of years, there has been a widening consensus that secular stagnation is here to stay. I’ve been there too. Keynesian economists, like Larry Summers and Stanley Fischer, have argued that the only way out is more fiscal spending. Supply-siders have championed less government and tax cuts as the only sure way to revive growth. I’ve sided with the latter camp. Now Trump is proposing to do all of the above.

If he succeeds in boosting real economic growth, it might not be inflationary if it is based on productivity. I have argued that productivity has a demand side as well as a supply side. The productivity of the most efficient widgets factory in the world will be zero if demand for widgets is zero. Better economic growth could very well prove that the supply side of productivity can deliver more output, thus limiting inflation.

Thursday, November 10, 2016

Another Relief Rally

“Happy Days Are Here Again” is a song copyrighted in 1929 by Milton Ager (music) and Jack Yellen (lyrics). I wonder if the lyricist is related to Fed Chair Janet Yellen? The song was featured in the 1930 film “Chasing Rainbows.” The lyrics are very upbeat: “Happy days are here again / The skies above are clear again / So let's sing a song of cheer again / Happy days are here again.”

The happy tune became the campaign song for Franklin Delano Roosevelt's successful 1932 presidential campaign. It was played at the Democratic National Convention that year, and went on to become the Democratic Party's unofficial theme song for many years. The song is also associated with the repeal of prohibition, which occurred shortly after FDR was elected and was greeted with signs saying “Happy days are beer again.”

Monday was a happy day, with the S&P 500 rising 2.2%, breaking the previous nine-day losing streak. The market continued to advance on Tuesday (Election Day) and again on Wednesday. The financial press said that Monday’s action reflected increasing odds that Hillary Clinton would be the next President. Wednesday’s action meant that the market was looking forward to Donald Trump in the White House. Or maybe investors are just relieved that the election is over.

This could all be the beginning of yet another relief rally, which has been the modus operandi of the current bull market. (See our S&P 500 Panic Attacks Since 2009.)

In any event, the latest relief rally also reflects lots of recent good economic news that hadn’t been discounted because of the political uncertainties hanging over the market as the elections approached.

The latest earnings data are mostly happy news. Once again, we are seeing a happy hook in Q3’s blended earnings of actual and estimated results for the S&P 500. It has increased by $1.28 per share over the past three weeks to $31.00 during the 11/3 week. There’s also a significant upward hook for the S&P 400, while the S&P 600 continues to flat-line near the lows for the quarter.

So now the Q3 earnings growth rate for the S&P 500, which was slightly negative at the start of the earnings season, is plus 3.3%. The growth rates for the S&P 400 and S&P 600 currently are 5.0% and 6.7%.

Thursday, November 3, 2016

US Economy: Full of Beans?

In the movie “Casablanca,” Humphrey Bogart tells Ingrid Bergman, “Ilsa, I’m no good at being noble, but it doesn’t take much to see that the problems of three little people don’t amount to a hill of beans in this crazy world.” Apparently, the US exported a hill of soybeans during Q3. A surge in soybean exports after a poor soy harvest in Argentina and Brazil helped to shrink the US trade deficit during the quarter, boosting real GDP growth.

I prefer to track the trend in GDP by monitoring the y/y growth in this key indicator of economic activity. Real GDP continues to grow in the US, though it is doing so at a slower pace. While it rose 2.9% (q/q saar) during Q3, up from 1.4% during Q2, it was up only 1.5% compared to a year ago. That’s below the 2% “stall speed” that led to recessions in the past. However, this time has been different, so far. Economic growth has been fluctuating around 2% since Q1-2011 without actually stalling. Let’s have a closer look at the latest numbers:

(1) Government is no longer a drag. From mid-2010 through mid-2014, real GDP excluding federal, state, and local government spending rose mostly around 3.0% on a y/y basis. However, since Q4-2015, real GDP growth has been below 2.0% with and without government spending. In other words, government spending has stopped weighing on growth over the past year.

(2) Energy recession is over. Of course, the biggest drag on growth since the second half of 2014 has been the recession in the oil patch. Real GDP spending on mining exploration, shafts, and wells structures plummeted 67% from Q4-2014 through Q3 of this year. This is very similar to the plunge in the mid-1980s, when the oil business fell into a recession yet the overall economy continued to grow. This series is highly correlated with the US rig count, which seems to have bottomed at the beginning of this year.

The energy recession also depressed demand for trucks and railcars to transport fracking materials and crude oil. That has been reflected in the 10% y/y drop in real outlays on transportation equipment. This category of capital equipment had soared to record highs over the previous few years. While there may be more downside in this series, it was encouraging to see sales of medium-weight and heavy-weight truck sales rebound sharply during September.

Meanwhile, the energy recession hasn’t depressed capital spending elsewhere. Real spending on industrial equipment, information processing equipment, software, and R&D all edged up, remaining in record-high territory during Q3.

(3) Obamacare may be weighing on consumers. Consumer-spending growth slowed from 4.3% (q/q saar) during Q2 to 2.1% during Q3. This series, which is also available monthly, showed a solid y/y gain of 2.6% during August. However, that was down from a recent peak of 4.0% during January 2015. An increasing drag on overall consumer spending may be Obamacare. The Affordable Care Act has driven up costs throughout the entire health care system. Out-of-pocket spending on deductibles and copays has risen sharply. Since consumers can’t predict their health care needs, this also creates a great deal of uncertainty and anxiety about how much should be set aside for these increasingly unaffordable out-of-pocket expenses.

Another possible drag on consumer spending is that the economy may be at full employment. While job openings are at a record high, finding workers with the skills to fill the openings is getting harder. So employment growth could slow because of a labor shortage. That should, in theory, boost wages, but it hasn’t happened yet.

(4) Inventory drag over for now. Real inventory investment has been a negative contributor to real GDP growth for the past five quarters through Q2. During Q3, it contributed 0.61ppt of the quarter’s annualized growth in real GDP. Again, I suspect that the energy recession may have weighed on inventories since mid-2014, when the price of oil took a huge dive. That effect may finally be behind us.

(5) More than just a hill of beans. The soybean-driven export growth spurt is likely to reverse in Q4, though exports of capital and consumer goods have been growing strongly in recent months. Overall exports increased 10% (q/q, saar), the biggest rise since Q4-2013. As a result, trade contributed 0.83ppt to GDP growth after adding a mere 0.18ppt in Q2. The strength of the dollar and slow global economic growth suggest there won’t be any more upside surprises in exports anytime soon.

(6) Waiting for the Millennials. During one of my meetings in Boston at the end of last week, I was asked what might cause a sustainable upside surprise in real GDP growth. I responded that I am waiting for the Millennials to get married, move to their own homes in the suburbs, and have kids. I may be waiting for a while. There’s some, but not much, evidence that they’ve started to settle down the way the Baby Boomers did.

(7) The bottom line. So my central premise is that the slowdown in real GDP growth since mid-2014 was mostly attributable to the energy recession, which seems to be over. If so, then the economy should resume growing at its stall speed of 2% without stalling into a recession.

Wednesday, October 26, 2016

Yellen Has Many Questions

Ever since the FOMC’s last rate hike at the end of last year, Fed Chair Janet Yellen has sided with the committee’s doves who believe that there is no rush to hike again. They might have to settle for one rate hike before the end of the year. However, three of them (Yellen, FRB-NY President Bill Dudley, and FRB-Minneapolis President Neel Kashkari) recently have said that the economy has “room to run.” In effect, their new mantra is “Hysteresis”!

To my knowledge, Yellen used this word for the first time in a public presentation during her keynote speech at the 60th Economic Conference hosted by the FRB-Boston on October 14 and 15. The conference’s theme was “The Elusive ‘Great’ Recovery: Causes and Implications for Future Business Cycle Dynamics.” The word popped up four times in the text of Yellen’s remarks and two times in the footnotes and references. (Prior to that, it appeared only once, in a footnoted reference, in her speech at Jackson Hole titled “The Federal Reserve’s Monetary Policy Toolkit: Past, Present, and Future.”)

The term as used by macroeconomists means that a severe downturn in demand during a recession could have a depressing impact on supply. If so, then “strong economic conditions can partially reverse supply-side damage after it has occurred, then policymakers may want to aim at being more accommodative during recoveries than would be called for under the traditional view that supply is largely independent of demand,” according to Yellen.

While she did say that more research is needed, she also seems to like the concept since it dovetails with her dovish view that the economy has room to run. She devoted a paragraph in her speech to the possible positive effects of “temporarily running a ‘high-pressure economy,’ with robust aggregate demand and a tight labor market.” Here is what she said:
One can certainly identify plausible ways in which this might occur. Increased business sales would almost certainly raise the productive capacity of the economy by encouraging additional capital spending, especially if accompanied by reduced uncertainty about future prospects. In addition, a tight labor market might draw in potential workers who would otherwise sit on the sidelines and encourage job-to-job transitions that could also lead to more-efficient--and, hence, more-productive--job matches. Finally, albeit more speculatively, strong demand could potentially yield significant productivity gains by, among other things, prompting higher levels of research and development spending and increasing the incentives to start new, innovative businesses.
The title of all six papers presented during the conference ended with question marks. While Fed Chair Janet Yellen’s keynote address didn’t do the same, the text of her prepared remarks had 19 question marks related to her topic, which was “Macroeconomic Research After the Crisis.” Now without any further ado, here are the numerous questions Yellen asked economists to answer in her latest speech:

(1) “The first question I would like to pose concerns the distinction between aggregate supply and aggregate demand: Are there circumstances in which changes in aggregate demand can have an appreciable, persistent effect on aggregate supply?

(2) “My second question asks whether individual differences within broad groups of actors in the economy can influence aggregate economic outcomes--in particular, what effect does such heterogeneity have on aggregate demand?

(3) “My third question concerns a key issue for monetary policy and macroeconomics that is less directly addressed by this conference: How does the financial sector interact with the broader economy?

(4) “What is the relationship between the buildup of excessive leverage and the value of real estate and other types of collateral, and what factors impede or facilitate the deleveraging process that follows?”

(5) “Does the economic fallout from a financial crisis depend on the particulars of the crisis, such as whether it involves widespread damage to household balance sheets?”

(6) “How does the nature and degree of the interconnections between financial firms affect the propagation and amplification of stress through the financial system and overall economy?”

(7) “[M]ost importantly--what can monetary policy and financial oversight do to reduce the frequency and severity of future crises?”

(8) “[I]s the persistent increase in the personal saving rate that we have observed since the collapse of the housing bubble primarily a result of a sustained shift toward more prudent underwriting standards by lenders? Is it something that will ultimately prove transitory once households finish repairing their balance sheets or become more confident about their future prospects for employment and income?”

(9) “My [next] question goes to the heart of monetary policy: What determines inflation?

(10) “Does the reduced sensitivity [of inflation to the labor market] reflect structural changes, such as globalization or a greater role for intangible capital in production that have reduced the importance of cyclical swings in domestic activity for firms’ marginal costs and pricing power? Or does it perhaps reflect the well-documented reluctance--or, alternatively, limited ability--of firms to cut the nominal wages of their employees, which could help to explain the relatively moderate movements in inflation we saw during and after the recession?”

(11) “Ultimately, both actual and expected inflation are tied to the central bank’s inflation target, whether that target is explicit or implicit. But how does this anchoring process occur? Does a central bank have to keep actual inflation near the target rate for many years before inflation expectations completely conform? Can policymakers instead materially influence inflation expectations directly and quickly by simply announcing their intention to pursue a particular inflation goal in the future? Or does the truth lie somewhere in between, with a change in expectations requiring some combination of clear communications about policymakers’ inflation goal, concrete policy actions to demonstrate their commitment to that goal, and at least some success in moving actual inflation toward its desired level in order to demonstrate the feasibility of the strategy?”

(12) “Do U.S. monetary policy actions affect advanced and emerging market countries differently? Do conventional and unconventional monetary policies spill over to other countries differently? And to what extent are U.S. interest rates and financial conditions influenced by easing measures abroad?”

Clearly, she had lots of questions. In her speech, Yellen inadvertently confirmed the sad state of macroeconomic “science” and raised some serious doubts about whether the FOMC understands the economy well enough to manage it with monetary policy. Yellen might have been asking the wrong crowd for answers to her questions. Everyone at the conference was a macroeconomist. She really needs to be asking micro-economists many of the questions pertaining to consumer and business behavior. Demographers might have some relevant thoughts. Focus groups representing Americans with all sorts of different backgrounds might provide more down-to-earth insights.

Maybe the world’s economy would work better and make more sense if there were fewer macroeconomists trying to manage it. Could it be that many of the problems that confound macroeconomists result from too many of them meddling with the economy as policymakers? That’s a question that no one asked at the conference, though one economist did suggest that doing less meddling should be considered as an option.

Wednesday, October 19, 2016

Fiscal Policy: Cooking the Books

As ultra-easy monetary policies seem to be losing their effectiveness around the world, more economists are calling for more fiscal stimulus. Gaining altitude is the notion of “helicopter money”--i.e., that fiscal authorities should ramp up infrastructure spending with financing provided by the central banks. The problem is that the major central banks have been financing government deficits, which already are quite large but seem to have also lost their stimulative mojo. Let’s focus on the US:

(1) Measuring up the deficit. America’s taxpayers may need to hire a forensic accountant. There is a huge discrepancy between the official federal deficit, which totaled $587 billion through September, and the $1.05 trillion 12-month change in federal debt held by the public over the same period. In the past, these two ways of measuring the deficit have been nearly identical, as they should be. The previous exception was a large divergence in late 2008 related to accounting for TARP.

Apparently, a whole bunch of perfectly legit accounting maneuvers, which have gained currency recently, account for the discrepancy. An expert on fiscal matters explained them to me, but accounting was never my strong suit. Nevertheless, the bottom line is that the deficit is best measured as the change in debt.

(2) Lots of US and foreign helicopters. But wait: There are more accounting shenanigans, as you probably know. While Donald Trump has been trumpeting that the federal debt is $20 trillion, it’s actually $14.2 trillion excluding the $5.3 trillion held by the government itself. However, that’s because the Treasury issues mostly nonmarketable securities to government trust funds as a way to plunder their surpluses. There are no surpluses. There are just more IOUs that will have to be covered by more taxes or more borrowing in the future.

But wait: If we consolidate the Fed’s holdings of $2.5 trillion in US Treasuries into the government’s account, then the debt actually held by the public is $11.7 trillion. In my opinion, the Fed’s holdings amount to helicopter money since it has been used to finance some of the deficits. The claim by a few Fed officials in recent years that they haven’t been monetizing the debt is--how can I put this delicately?--an Orwellian distortion of the truth.

But wait: Foreign central banks have also, in effect, monetized some of the US federal debt thanks to the role of the dollar as the leading reserve currency in the world. At the end of September, they collectively owned $2.8 trillion of US Treasuries. We are clearly dependent on the kindness of strangers.

(3) Not shovel ready. The American Recovery and Reinvestment Act of 2009 (ARRA) was supposed to boost the US economy by financing spending on public infrastructure that was presumably “shovel ready.” Apparently, there weren’t many such projects available. Census Bureau data on public construction put in place show that it peaked at a record high of $325 billion (saar) during March 2009 and drifted down to a low of $263 billion near the start of 2014. In August of this year, it was still 17% below the record peak.

Again, we should hire a forensic accountant to see what happened to all the ARRA money before we waste a bunch of helicopter money. By the way, there may already be a shortage of construction workers in the US, so we may need to ask Mexican construction workers to come back if the government actually succeeds in boosting construction.

Thursday, October 13, 2016


Last week, in his 10/5 WSJ “Heard on the Street” column, Justin Lahart had a closer look at the “cyclically adjusted price-earnings,” or CAPE, ratio developed by Robert Shiller and John Campbell in the 1990s. Shiller became a superstar in our business when he argued in his 2000 book titled Irrational Exuberance that his ratio, which is based on 10-year trailing earnings, was signaling irrational exuberance just as stocks started to plunge. Then again, just about every other valuation metric on the planet was sending the same signal. In any event, the ratio is signaling trouble again.

Previously, I’ve described judging valuation as similar to judging contestants in a beauty contest. Both are subjective judgments. Valuation judgments can be quite different depending on the metrics used to make a determination. There are lots of alternative options. I look at them all.

I am not a fan of valuation measures based on trailing earnings, especially if they trail over the past 10 years. I believe that the stock market is forward looking and discounts analysts’ consensus expectations for earnings over the year ahead. More specifically, I use S&P 500 12-month forward consensus expected operating earnings, which is a time-weighted average of analysts’ expectations for the current year and the coming one. While the forward P/E of the S&P 500 isn’t as alarming as Shiller’s CAPE ratio, stocks aren’t cheap using almost any valuation metric other than the Fed’s Stock Valuation Model, which has been showing that stocks have been increasingly undervalued relative to bonds since 2001. (See our new and improved FSVM.)

In his column, Lahart often provides excellent analyses of the stock market. In his latest piece, he observed that:
[CAPE’s] advantage is that it corrects for extreme good times and bad times by valuing share prices based on 10 years of earnings, rather than one year. … The CAPE is now at 27. That is about where it was in 2007, before the financial crisis, and it is well above its 50-year average of 20. The only times the CAPE has been higher were during the 2000 bubble and bust, and just prior to the 1929 crash, according [to] the data compiled by Mr. Shiller.
(Hence, the title of this piece, which is also a play on the 1962 movie “Cape Fear” with Robert Mitchum and the 1991 remake with Robert De Niro.) Let’s have a closer look:

(1) Measuring earnings. Lahart reported:
Mr. Shiller uses S&P 500 earnings under generally accepted accounting principles, or GAAP. That is probably the best measure of earnings because it avoids many of the tricks that companies use to flatter their numbers. The problem is that GAAP isn’t a stable concept, and has been revised multiple times. In 1993, for example, banks were required to mark to market a greater portion of their holdings. In 2001, accounting rule makers changed the rules on goodwill.
Wharton Professor Jeremy Siegel says that both changes lowered GAAP earnings.

The WSJ constructed an alternative CAPE ratio using quarterly data on total after-tax US profits from the National Income & Product Accounts (NIPA) accounts, presumably because this measure is compiled using “a consistent standard over the decades.” I compared aggregate S&P 500 reported earnings, which is the GAAP measure, to the NIPA after-tax corporate profits based on tax returns. The former is annualized but not seasonally adjusted, while the latter is both annualized and seasonally adjusted. I compared them since Q1-1964, when the S&P data start.

When I take the ratio of the S&P measure to the NIPA measure of profits, I don’t see the impact of the accounting changes mentioned above. The ratio has been volatile but has fluctuated around 50% without any pronounced structural shifts along the way since the start of the comparison.

(2) CAPE of good hope. Next, the WSJ analysis used Fed data on the total value of US stocks rather than the value of the S&P 500. I prefer to use the same measure excluding foreign equities trading in the US when we use these data for the comparable valuation measures we construct. Foreign equites held by US residents as a percentage of their total equity holdings was relatively flat around just 1% from 1952 through the mid-1980s. Then it soared to peak at 21.1% during Q2-2008. It has been hovering around 20% since then. Foreign equities should be excluded from the numerator of the ratio, because their profits are not included in the NIPA profits.

The WSJ measure of the CAPE ratio is less fearsome than Shiller’s version:
As of the end of the second quarter, according to the latest data available, the corporate-profits CAPE was at about 19--just above its 50-year average of around 17. By contrast, it was 39 at its peak during the tech bubble and 24 at the market’s peak in 2007.
That’s a relief. It would be even lower using the total value of equities traded in the US excluding foreign issues.

(3) Short trail. I can’t bring myself to compare the value of the stock market today to earnings over the past 10 years. Instead, let’s look at my ratio of the value of equities excluding foreign issues divided by the NIPA profits measure on a quarterly basis rather than on a 40-quarter trailing basis. During Q2-2016, it was 18.0. The record high was 36.5 during Q1-2000, while the record low was 4.7 during Q4-1978. Its current reading does match previous cycle highs excluding the irrational exuberance peak of Q1-2000.

Given that inflation and interest rates are lower than at any time since we can calculate this ratio, it seems to suggest that stocks are fairly valued rather than seriously overvalued. That’s about the same conclusion that Lahart came to with his version of the 10-year trailing CAPE ratio.

(4) Tobin & Buffett ratios. The CAPE ratio certainly isn’t a novel measure of valuation. It is highly correlated with the Q ratio devised by Professors James Tobin and William Brainard in 1968 at Yale University. The concept is simple: It is the ratio between a physical asset’s market value and its replacement cost. When applied to the overall stock market, a ratio exceeding 1.0 suggests stocks are overvalued, while a ratio below 1.0 suggests they are undervalued.

Measuring that ratio seems like a huge challenge. However, the Fed’s Financial Accounts of the United States has a quarterly series starting in 1952 that tracks Tobin’s Q for nonfinancial corporations. It is highly correlated with the ratio I constructed inspired by Lahart and Shiller, though mine is based on quarterly profits rather than 10-year trailing profits.

My ratio is also highly correlated with the Buffett ratio, which is the market value of US equities excluding foreign issues relative to GNP. I’ve found that the Buffett ratio is also highly correlated with the ratio of the market capitalization of the S&P 500 divided by S&P 500 revenues. I can get a more real-time read on these simply by tracking the S&P 500’s forward price-to-sales ratio.

(5) Looking forward. The S&P 500’s forward P/E (based on forward operating earnings) was 16.6 during September. That isn’t much higher than its 13.8 average since 1979, when the data begin. However, that’s well below Q2’s 21.1 P/E based on four-quarter trailing operating earnings, and 23.9 based on four-quarter reported earnings.

Had enough yet? On balance the most widely followed valuation measures all show that the market is somewhere between fairly valued and overvalued. However, bear markets are caused by recessions, not overvaluation. Recessions cause earnings to fall, which causes stock prices to fall even faster, thus depressing valuations. In my opinion, the stock market can remain overvalued as long as earnings continue to grow. That’s particularly likely now given that both inflation and interest rates are at historical lows.

Meanwhile, S&P 500 forward earnings rose to a record high during the first week of October. The same can be said for the S&P 600, while the S&P 400 edged down from its record high two weeks ago.

Wednesday, October 5, 2016

Just Say No!

For many years, there has been a recurring pattern of banks getting into all sorts of trouble. That’s because bankers are playing with other people’s money (OPM). They either have no, or very little, skin in the game. So they have a tendency to take more risk than they should. Just like power, OPM can corrupt some people. I don’t have any reason to believe that any of the major central bankers is corrupt, but their access to and excess with the OPM they control is a drug, i.e., it’s their opium.

When they were first established, central banks were tasked with providing an elastic currency that met the seasonal ebbs and flows of money demand. They were also supposed to provide liquidity when financial crises occurred from time to time to make sure they didn’t turn into full-blown financial contagions. They certainly were not mandated to manage the economy with the aim of keeping the labor market near full employment and stabilizing inflation around a fixed and near-zero target. Most of them originally were run by commercial bankers and lawyers, who tended to be conservative and weren’t trained to manage the economy in any case.

That changed in recent years, and now the major central banks have been overrun by macroeconomists in the policy committees, with large staffs of more macroeconomists. They’ve all been trained to manage an economy, and firmly believe that’s their job and they can do it. The leading proponent of that view in the United States is, of course, the leader of the Fed, namely Fed Chair Janet Yellen.

Central bank leaders are convinced that without their ongoing and expanding ultra-easy monetary policies--relying increasingly on so-called “unconventional” monetary tools--the global economy would have sunk into a depression following the financial crisis of 2008. Of course, they’ve been disappointed that the pace of economic growth has been subpar and that inflation remains below their 2% targets. However, they argue the counterfactual--namely, that were it not for the forward guidance, quantitative easing, and negative interest rates they implemented once their official interest rates had fallen to zero (the dreaded “lower bound”), there would have been a terrible outcome. They never consider the alternative counterfactual that their unconventional policies might be one of the main causes of global secular stagnation.

Last Thursday, in a video conference (start listening at the 9:05 time mark) with bankers in Kansas City, Yellen crossed the line, in my opinion, when she suggested that the Fed should be authorized by Congress to buy corporate bonds and stocks. After all, she noted, the Bank of Japan (BOJ) has been buying corporate bonds and stocks for a while, and the ECB has been buying corporate bonds since June of this year. That’s true, but how’s that working so far?

Not so good. The BOJ just can’t seem to stop the forces of deflation. In August, Japan’s CPI was down 0.5% y/y, while the “core core” rate was up only 0.2%. Japanese industrial production rose 1.5% m/m during August, but is actually down 5.1% from January 2014, despite Abenomics. In the Eurozone, the headline CPI inflation rate was only 0.4% during September, according to the flash estimate, while the core rate was 0.8%. Eurozone industrial production fell 1.1% m/m in July, and was down 0.5% y/y, the weakest since November 2014. On the other hand, Germany’s Ifo Business Confidence Index rose smartly during September, though the survey was taken before Deutsche Bank hit the fan. European banks are sitting on too many nonperforming loans, which is weighing on their willingness to lend, notwithstanding all the efforts by the ECB to encourage them to do so.

Yellen graduated from Yale with a Ph.D. five years before I did the same, in 1976. We both learned from Professor James Tobin, the chairman of both our dissertation committees, about the “Portfolio-Balance Model.” The idea is that assets are substitutable for each other. So if the Fed buys government bonds, reducing their supply, that will drive more demand into other bonds as well as equities. The resulting increase in wealth then should stimulate spending. (My Ph.D. dissertation was titled “A Portfolio-Balance Model of Corporate Finance.”)

In her talk last Thursday, Yellen said:
Now because Treasury securities and, say, corporate securities and equities are substitutes in the portfolios of the public, when we push down yields--let’s say on Treasuries--there’s often and typically spillover to corporate bonds and to equities as well [such] that those rates fall or that equity prices rise, stimulating investment. But we are restricted from investing in that wider range of assets. And if we found--I think as other countries did--that [we] had reached the limits in terms of purchasing safe assets like longer-term government bonds, it could be useful to be able to intervene directly in assets where the prices have a more direct link to spending decisions.
Got that? If the Fed runs out of Treasuries, “it could be useful” to buy corporate bonds and stocks. Spoken like a true central monetary planner. She would like to add that option to the Fed’s toolkit just in case the other tools used to tinker with the economy don’t work. She is very blunt about her willingness to distort our capital markets because they clearly aren’t working well enough on their own to achieve the Fed’s goals.

How can capitalism survive in the US if the capital markets are completely distorted by the Fed? The economy certainly doesn’t seem to be getting any lift from all the distortions that have occurred in the Treasury bond and money markets caused by the Fed’s policies since the financial crisis of 2008. Intervening so broadly in the capital markets is bound to disrupt the process of creative-destruction that is integral to capitalism. It will keep zombie companies in business, which would be deflationary and reduce profitability for well-run competitors. Investors won’t get to determine the winners and losers if the Fed buys simply to prop up stock prices. Depending on the circumstances, the “Yellen put” might result in a speculative bubble.

In short, it’s an insane idea. But the BOJ and the ECB are doing it, so why can’t we do it too? Could it be that they are insane? They certainly aren’t doing anything to revive capitalism’s animal spirits. Both the Eurozone and Japan have relatively inferior capital markets compared to the vibrant ones in the US. That’s one of the main reasons why the US economy is outperforming them. They still depend too much on their banks for financial intermediation. Their banks have been broken for a long time, and the flat-yield curve and negative interest-rate policies of the BOJ and ECB certainly aren’t helping their banks.

Yellen concluded her response saying:
But while it’s a good thing to think about, it’s not something that is a pressing issue now, and I should emphasize that while there could be benefits to, say, the ability to buy either equities or corporate bonds, there would also be costs as well that would have to be carefully considered in deciding if it’s a good idea.
I think it would be a very bad idea.

On Friday of last week, just by coincidence (or maybe not), Larry Summers floated exactly the same idea. The 9/30 Bloomberg reported:
Among the proposals that deserve “serious reflection" is the purchase of a “wider range of assets on a sustained and continuing basis,” Summers said in a lecture at a Bank of Japan conference in Tokyo Friday. “I’m not prepared to make a policy recommendation at this point,” he told reporters later. ...

Japan has “engaged in that type of transaction to much greater extent than other countries,” Summers said, pointing out among its initiatives the BOJ’s purchases of exchange-traded funds. “It is something that economic logic suggests should be considered in other places where the zero lower bound is a potentially important monetary policy issue,” he said, referring to the perceived lower limit for benchmark rates set by central banks.
Got that? It’s “economic logic.” Maybe so, but that too certainly hasn’t worked for Japan so far. The BOJ started buying ETFs during October 2010 at a modest rate of roughly 450 billion yen per year. That was doubled to an annual 1 trillion yen in April 2013 and increased again to 3.3 trillion in October 2014. The BOJ’s Monetary Policy Committee literally doubled down at its July 28-29, 2016 meeting, raising the ante to 6 trillion yen. BOJ purchases are averaging 2.9% of daily trading values now.

The Japan MSCI stock price index (in local currency) entered a bear market in mid-January and remains 22.6% below last year’s high. The stock market isn’t getting a lift from the government’s stock purchases because the yen has appreciated 24% since last year’s low. If the stock market is falling despite the BOJ’s faster pace of purchasing ETFs, what’s the point?

Summers acknowledged, “There are obviously important political and economic questions associated with government ownership of companies.” He said, “Some critics could term such a policy as ‘socialism.’” Sign me up for that club of critics! It’s certainly not capitalism, which would be gravely damaged in the US, as it has been in both Japan and the Eurozone by the half-baked interventions of the BOJ and ECB in the capital markets.

Interestingly, “What Assets Should the Federal Reserve Buy?” was the title of an article by two economists at the Federal Reserve Bank of Richmond, which first appeared in the bank’s 2000 annual report. (Hat-tip to Mike O’Rourke.) Back then, there was serious concern that the US Treasury would be running large budget surpluses and would pay off all of the outstanding federal debt in a matter of a few years. (Hard to believe, but true.) The authors didn’t specifically mention equities, but they strongly warned against the Fed buying private-sector securities for numerous good and obvious reasons. Summers and Yellen should read the article. Here is just one relevant excerpt:
There would be costs associated with assessing asset value and creditworthiness, whether the Federal Reserve hired staff to make those judgments internally or hired independent portfolio management. Further, the extension of even a small amount of Federal Reserve credit to a particular entity might be interpreted as conferring a preferential status enhancing that entity’s creditworthiness. The status of a particular asset or loan could deteriorate while in the Fed’s portfolio, requiring it to be sold, or not rolled over, in order to avoid taxpayer losses. It might be difficult, however, for political or bank supervisory reasons, for the Fed to sell such an asset or call such a loan.

Wednesday, September 28, 2016

Persistent Profits Recession?

The Q3 earnings season starts early next month. There is already some chatter about the profits recession persisting for the sixth quarter in a row. I am in the camp that believes that it ended during Q2 and comparisons should turn positive during the second half of this year into next year. Let’s see what I may or may not be missing:

(1) Profits recession: A bottom? The 9/25 WSJ featured an article on this subject titled “Profit Slump for S&P 500 Heads for a Sixth Straight Quarter.” According to the story: “The third quarter was supposed to be when earnings growth returned to U.S. companies. Not anymore. Companies in the S&P 500 are now expected to report an earnings decline for the sixth consecutive quarter in the coming weeks, according to analysts polled by FactSet. That slump would be the longest since FactSet began tracking the data in 2008.”

I use S&P 500 actual operating earnings and analysts’ consensus operating earnings expectations data compiled by Thomson Reuters. On a year-over-year basis, earnings have been falling for the past four quarters through Q2-2016. Earnings are down 2.9% since they peaked in Q4-2014. However, the most recent low in this series occurred during Q1 of this year when earnings were down 11.7%, suggesting that might have been the bottom of the recession, though the y/y comparisons remained negative through Q2.

(2) Revenues: An upturn? My optimistic spin on earnings is supported by S&P 500 revenues, which declined on a y/y basis from Q1-2015 through Q4-2015. However, the actual level of revenues admittedly has been volatile in a flat range (though near recent record-high territory) since mid-2014, when the price of oil started to plunge.

(3) Analysts’ consensus: Another hook? The Thomson Reuters data confirms the WSJ story, which is based on FactSet data. The Q3 consensus estimate turned negative on a y/y basis recently, and was -0.8% last week. However, as I have noted going into every earnings season since the start of the bull market, actual results often tend to exceed downwardly revised estimates just before the earnings season begins. Let’s call it the “earnings hockey stick.” The average hook in the stick since Q2-2009 through Q2-2016 has been 4.8%. There wasn’t one quarter over this period with a negative surprise.

The positive surprise for Q2-2016 was 3.6%. It won’t take that much of a positive surprise to produce a positive y/y comparison for Q3-2016.

(4) Forward earnings: What really matters. I believe that the stock market discounts forward earnings, i.e., the S&P 500 12-month forward consensus expected operating earnings. It is a time-weighted average of analysts’ earnings estimates for this year and next year, and is usually a good year-ahead leading indicator of actual earnings. When the earnings season starts in October, forward earnings will give a weight of only 3/12 to this year’s estimate and 9/12 to next year’s estimate.

Doing this calculation using weekly data shows that the S&P 500 forward earnings has rebounded nicely since the spring of this year and is back at $129.20 per share, near the record highs of 2014. That’s because it is converging to the current estimate of $133.57 for 2017. I just added 2018 consensus estimates to our numerous earnings charts. Analysts are currently predicting $147.49 per share for 2018. While those numbers are bound to be revised downward over time, as typically occurs, there’s certainly no profits recession in the analysts’ earnings outlook for the next couple of years.

Wednesday, September 21, 2016

Inflation: Healthy & Unhealthy

Bob Wiley, the anxiety-prone obsessive-compulsive character played by Bill Murray in “What About Bob?,” tells his psychiatrist, played by Richard Dreyfuss, “There are two types of people in this world: those who like Neil Diamond, and those who don’t.”

Previously, I’ve often argued that there are two kinds of deflation. In a period of good deflation, consumer prices fall as a result of competition, technological innovation, and productivity. Consumers’ purchasing power increases and they spend more, which results in more demand and more jobs. The standard of living improves.

Bad deflation typically occurs after a prolonged period of easy credit. The stimulative impact of easy credit is increasingly dampened by the burden of accumulated debt, which weighs on demand. Meanwhile, supply is plagued by too much capacity as easy money allows the living-dead “zombie” producers to stay in business. Zombies are very sociable. They create more zombies as profitable companies become unprofitable competing with them. Debt servicing becomes more onerous as the profits recession is exacerbated by falling prices. A dangerous deflationary spiral is often triggered by the bursting of speculative bubbles that had been inflated by easy money.

There are also two kinds of inflation. There’s the kind that stimulates demand by prompting consumers to buy goods and services before their prices move still higher. The other kind of inflation reduces the purchasing power of consumers when prices rise faster than wages. That variety of inflation certainly doesn’t augur well for consumer spending.

During the 1960s and 1970s, price inflation rose faster than interest rates. The Fed was behind the inflationary curve. So were the Bond Vigilantes. However, wages kept pace with prices because unions were more powerful than they are today, and labor contracts included cost-of-living adjustments. Back then, the University of Michigan Consumer Sentiment Survey tracked rising “buy-in-advance” attitudes. Those attitudes remained particularly strong in the housing market through the middle of the previous decade. On balance, inflation stimulated demand more than weighed on it. Borrowing was also stimulated.

Today, the major central banks would like to revive buy-in-advance attitudes, along with inflationary expectations, to boost demand for goods and services. For various reasons, the central bankers have failed to increase their inflation measures back up to their 2.0% targets. Despite several years of ultra-easy monetary policy since the financial crisis of 2008, the ECB’s preferred measure (i.e., the headline CPI) has been under 2.0% since February 2013, and was up only 0.2% y/y through August. The BOJ’s preferred inflation measure (i.e., “core” inflation excluding only food) has been under 2.0% since April 2015, and was 0.5% through July.

In the US, there is some confusion about whether Fed officials are targeting the headline or the core PCED inflation rate. In the past, they all seemed to focus on the core rate excluding food and energy. More recently, even individual FOMC participants have mentioned both as worth monitoring. In any event, both remain below the Fed’s 2.0% target, with the headline at 0.8% and the core at 1.6%.

A few Fed officials believe that the core is close enough to 2.0% to hike the federal funds rate again soon. Others say that having stayed stubbornly below 2.0% for most of the time since October 2008, what’s the rush to raise rates? This afternoon, we will all find out whether the doves or the hawks won the debate at the latest meeting of the FOMC.

Both sides are missing an important development on the inflation front. The variety of inflation that the US is experiencing isn’t the kind that stimulates economic growth. On the contrary, it has been led by rising rents, and more recently by rising health care costs. It is very unlikely that buy-in-advance attitudes cause people to rent today because rents will be higher tomorrow, or to rush to the hospital to get a triple-bypass today because it will be more expensive tomorrow! Higher shelter and health care costs are akin to tax increases because they reduce the purchasing power available for other goods and services. Consider the following:

(1) The rent is too d@mn high! Tenant rent accounts for 5% of the core PCED and 10% of the core CPI. In August, it was up 3.8% y/y in the CPI, well ahead of the increase in the core rate. That can’t be good for consumers’ purchasing power given that a record 37% of all households were renters during Q2-2016. The tenant-rent data are used to construct owners’ equivalent rent (a very strange concept, indeed!), which accounts for 13% of the core PCED and 31% of the core CPI. It was up 3.3% y/y during August, the highest pace since June 2007. Why would anyone at the Fed think that’s a happy development, since it doesn’t really have any effect one way or the other on anyone, because what homeowners rent their homes from themselves!?

(2) Obamacare’s stealth mission almost accomplished. Of course, 100% of households rely on our health care system. August’s CPI had some really bad news on this front. There were big increases in health care prices as the overall health care index jumped 1.0% m/m (the most since February 1984) and 4.9% y/y (the highest since January 2008).

It’s not clear why the surge occurred during August, but it may be related to the expansion of healthcare coverage under Obamacare. There has certainly been an increase among the population with pre-existing conditions, which has significantly boosted costs for all. Many conservatives always suspected that Obamacare was designed to fail so that the government would have to save the day with a nationalized single-payer system.

By the way, one of the main reasons that the CPI inflation rate exceeds the PCED rate is because the latter doesn’t include health care spending paid for by the government through Medicaid and Medicare. Nevertheless, when August’s PCED is released on September 30, it may very well hit the Fed’s 2.0% target thanks to rapidly rising rents and health care costs. For the man and woman on the street, congratulations to the Fed will not be in order. However, I won’t be surprised if Fed officials jubilantly declare: “Mission accomplished!”

Thursday, September 15, 2016

Slip Sliding in the Oil Patch

China’s latest economic indicators showed some strength. However, that strength hasn’t shown up in commodity prices. China’s industrial production and real retail sales rose 6.3% and 9.3% y/y through August. While those growth rates were a bit better than expected, they remain close to recent cyclical lows in both series.

The CRB raw industrials spot price index rebounded earlier this year from last year’s plunge. It has been meandering sideways since the spring. The index includes the price of copper, which is highly correlated with the growth rate in China’s industrial production. Both remain in their downward trends of the past few years.

Like the CRB index, the price of a barrel of Brent crude oil recovered earlier this year after plunging by 76% from mid-2014 through early 2016. It has been hovering between $42 and $52 since mid-April.

In many ways, the price of oil is the tail that’s wagging the dog. It is highly inversely correlated with the trade-weighted dollar. Causality probably runs both ways, so a weaker (stronger) oil price seems to put upward (downward) pressure on the dollar. That may be because oil exporters have fewer (more) dollars to convert to other currencies when the price is weak (strong).

Of course, there is a feedback effect from the dollar to oil and other commodity prices. The CRB raw industrials spot price index, which doesn’t include oil, tends to strengthen (weaken) when the dollar is weak (strong).

For now, I foresee the choppy sideways actions of the dollar, oil prices, and other industrial commodity prices continuing through the middle of next year. The Fed’s process of gradually normalizing interest rates is turning out to be very gradual, which should keep the dollar from moving higher given that it is up 19% from its low on July 1, 2014. On Monday, Fed Governor Lael Brainard said that the Fed/US econometric model shows that such an increase is equivalent to a 200bps hike in the federal funds rate. In other words, the foreign exchange market has already done much of the Fed’s work.

Nevertheless, if the oil market’s fundamentals push the price of oil back down again, the dollar could move still higher and depress other commodity prices. So let’s review the latest developments in oil’s supply and demand:

(1) Inventories. The combination of weak demand and increased OPEC output pushed oil inventories in developed nations to a record 3.1 billion barrels in July. Yesterday, the International Energy Agency (IEA) predicted that the surplus in global oil markets will last for longer than previously estimated. So world oil stockpiles will continue to rise through 2017, resulting in a fourth consecutive year of oversupply. Just last month, the IEA predicted the market would return to equilibrium this year.

(2) Supply. The IEA’s revised estimates of the supply/demand oil balance on Tuesday followed a similar revision by OPEC on Monday. The 9/12 WSJ reported: “In its closely watched monthly report on market conditions, OPEC said non-OPEC members like the U.S., Russia and Norway will produce about 190,000 barrels a day more than expected in 2016, a sign that production outside the cartel has remained resilient despite low prices. By 2017, the cartel’s data suggests that oil supplies will outstrip demand by an average of about 760,000 barrels a day, over three times higher than OPEC predictions made just last month.”

(3) Strategic petroleum reserve. In August, the US Department of Energy released its “Long-Term Strategic Review of the U.S. Strategic Petroleum Reserve.” It said that instead of the nearly 700 million barrels the US currently stockpiles, an SPR around 530-600 million barrels would be more appropriate. Much has changed since the SPR was set up in the aftermath of the 1973 oil embargo. The US is one of the largest oil producers in the world, so energy security isn’t as important.

(4) US production. That all seems very bearish for oil prices. However, keep in mind that lower oil prices probably will continue to reduce oil production in the US. Arguably, the new swing producer in the oil market is now the US rather than Saudi Arabia. The weekly US oil rig count seems to be a very good 18-month leading indicator of weekly oil field production in the US.

Production is down 11.5% from a recent high of 9.6mbd during the week of July 3, 2015 to 8.5mbd during the week of September 2, 2016. The rig count has rebounded slightly in recent weeks, but remains down sharply from the peak of late 2015. The implied drop in US oil production could provide some bullish support to offset the bearish factors highlighted in the IEA and OPEC reports.

Meanwhile, US gasoline demand over the past 52 weeks through the 9/2 week rose to 9.3mbd, matching the previous record high during 2007.

On the other hand, Apache found lots more oil last week. The 9/7 WSJ reported: “Apache Corp. said it has discovered the equivalent of at least two billion barrels of oil in a new West Texas field that has the promise to become one of the biggest energy finds of the past decade. The discovery, which Apache is calling ‘Alpine High,’ is in an area near the Davis Mountains that had been overlooked by geologists and engineers, who believed it would be a poor fit for hydraulic fracturing.”