Friday, May 3, 2019

Income Stagnation Is a Progressive Myth

The Progressives claim that—despite the (Old) New Deal, the Great Society, and Obamacare—the incomes of the vast majority of Americans have stagnated for three decades and that income distribution remains disturbingly unequal and must be fixed with more progressive taxes. Who would know better than Joseph Stiglitz? After all, he is a Nobel laureate in economics. In 1972, I took Stiglitz’s course on microeconomics in Yale’s PhD program. He gave me a good grade, so I like him.

In a 4/19 NYT article titled “Progressive Capitalism Is Not an Oxymoron,” he lamented: “Despite the lowest unemployment rates since the late 1960s, the American economy is failing its citizens. Some 90 percent have seen their incomes stagnate or decline in the past 30 years. This is not surprising, given that the United States has the highest level of inequality among the advanced countries and one of the lowest levels of opportunity—with the fortunes of young Americans more dependent on the income and education of their parents than elsewhere.”

Freshman Rep. Alexandria Ocasio-Cortez (D-NY) must have read Stiglitz’s article. She recently tweeted that “working Americans haven’t gotten a raise in 30 years despite unprecedented growth & living costs have exploded.”

That’s certainly a problem that needs to be fixed! But hold on: There would surely be a revolution in America if 90% of our citizens have suffered income stagnation or worse, as Stiglitz claims has happened for the past 30 freaking years—i.e., since 1989! Real GDP is up 110% since then, yet only 10% of Americans have benefitted, he claims. Is it possible that the great silent majority has enjoyed no improvement in standards of living since 1989? No freaking way, Professor!

I have taken deep dives into the data on standards of living and income inequality. Nowhere can I find a credible series that confirms a 30-year drought in standards of living for almost all Americans. Instead, the data show that Americans have never been better off. I’m not making a political statement, just a statement of facts (which, I acknowledge, do have political implications). Consider the following:

(1) The worst data series ever! Stiglitz must be relying on annual data compiled by the Census Bureau on real median household income (Fig. 1). I hate this series with a passion because it is an extremely flawed measure of income; yet it is widely used by Progressives to prove their claim of widespread and prolonged income stagnation. It is up only 13% since 1989 through 2017. The flakiness of this measure is confirmed by the modest 27% increase in real mean household income (which gives more weight to the rich) since 1989 despite a 52% increase in real GDP per household over this period.

In Chapter 7 of my book, Predicting the Markets, I discuss all the problems with the Census income measure in the last section, titled “Income stagnation myth.” It is woefully misleading, because it grossly underestimates Americans’ standards of living. It is based only on surveys that focus just on money income. On its website, the Census Bureau warns: “[U]sers should be aware that for many different reasons there is a tendency in household surveys for respondents to underreport their income.”

Furthermore, the Census measure of money income, which is used to calculate official poverty rates, is missing key noncash government-provided benefits that boost the standards of living of many Americans, including Medicare, Medicaid, the Supplemental Nutrition Assistance Program, and public housing. The Census series is a pre-tax measure of income. So it doesn’t reflect the Earned Income Tax Credit and the Additional Child Tax Credit that many low-income households receive from the government.

That’s insane: The government’s bean counters are excluding many of the beans provided by government programs designed to reduce income inequality. So the Census series will never show the progress made by Progressives’ pet programs, seemingly calling for more such programs to fix a “problem” that might have been mostly fixed by the existing programs already! (Software programmers call this phenomenon a “Do Loop,” which is to be caught in a series of actions that repeat endlessly.) Enough will never be enough. No wonder the Progressives love this series, while I hate it.

(2) Price deflator makes a big difference. The Census series uses the Consumer Price Index (CPI), which is based on an indexing formula that gives it an upward bias over time. That’s simple to fix by dividing the nominal version of the Census measures of median household income by the personal consumption expenditures deflator (PCED). Since 1989 through 2017, it is up only 7.4% using the CPI but up 21.5% using the PCED (Fig. 2). That blows away the income stagnation myth without much effort.

(3) Smaller households distorting income stagnation and inequality measures. Another problem with any income series on a per-household basis is that growth of the singles population (aged 16 and older) continues to outpace that of the married population. It’s been doing so since the start of the data in 1976 (Fig. 3).

What’s changed in recent years is that the former cohort exceeds the latter, as singles are getting married later in life and unattached seniors are living longer (Fig. 4). That means more single-person households, which tend to have lower incomes than married-couple households. That trend will weigh down both median and mean per-household incomes, exaggerating income stagnation and inequality.

(4) The true story is a happier one. While the political agendas of Joe Stiglitz and other Progressives rest on a flawed measure of income, plenty of other indicators tell a different story. Over the past 30 years, from March 1989 through March 2019, inflation-adjusted average hourly earnings of production and nonsupervisory workers is up 32%, using the PCED and a measure of wages that covers more than 80% of payroll employment (Fig. 5 and Fig. 6). That’s NOT stagnation!

Median measures of income are hard to find. However, the Bureau of Labor Statistics (BLS) has a quarterly series on pre-tax “median usual weekly earnings of full-time wage and salary workers” that starts in 1979 and is based on survey data. Dividing this series by the PCED shows that it is up 25% since the start of 1989 (Fig. 7). Clearly, American workers haven’t been reporting stagnant paychecks over the past 30 years to the BLS survey takers.

Finally, I believe that the best measures of standards of living are the disposable income and consumption series compiled monthly by the Bureau of Economic Statistics on a per-household basis. Deflated by the PCED, the former is up 61%, while the latter is up 67% from March 1989 through March 2019 (Fig. 8). Real GDP per household is up 54% over this period.

Admittedly, these alternative measures of standards of living are means rather than medians, but the rich don’t eat much more than the rest of us. There aren’t enough of them to make a significant difference to average measures of income and spending. IRS data for 2016 show that the so-called “1%” of taxpayers earning more than $500,000 in adjusted gross income included 1.3 million of the total 150.3 million returns filed that year. Furthermore, as noted above, there are fewer mouths to feed per household as the population of adult singles continues to grow faster than married couples.

(5) Bottom line. American households are enjoying record standards of living. Income stagnation is a myth. Income inequality isn’t a myth but an inherent characteristic of free-market capitalism, an economic system that awards the biggest prizes to those entrepreneurs who benefit the most consumers with their goods and services. Perversely, inequality tends to be greatest during periods of widespread prosperity. Rather than bemoaning that development, we should celebrate that so many households are prospering, even if a few are doing so more than the rest of us.

Thursday, April 25, 2019

S&P 500 Run, Forrest, Run!

Forrest Gump’s fans cheered him on during his remarkable roundtrip cross-country marathon by exhorting him to “Run, Forrest, run!” Similarly, bullish investors are cheering for the bull market in stocks with their gleeful chant, “Run, bull, run.” In this video podcast, I discuss why I believe that the bull market still has legs with revenues and earnings likely to keep it moving higher.

Sunday, March 24, 2019

Freaking Out Over Inverted Yield Curve

In this video podcast, I discuss why the stock market is freaking out over the inversion of the yield curve.

Thursday, March 21, 2019

Stock Market Singing: "The Sun Will Come Out Tomorrow"

In this video podcast, I discuss the odd weakness in real GDP growth and in the Economic Surprise Index during the first quarter of the past few years. I agree with Annie (and the stock market) that the sun will come out tomorrow.

Sunday, March 17, 2019

Disconnecting the Fed’s Dots (Melissa Tagg and Ed Yardeni)

Don’t look too closely at the Fed’s dot plot or you might miss the larger monetary policy picture, warned Federal Reserve Chairman Jerome Powell in a 3/8 speech titled “Monetary Policy: Normalization and the Road Ahead.” To make his point, he showed two unusual images: an unrecognizable close-up of a bouquet of flowers from impressionist painter Georges Seurat’s “A Sunday Afternoon on the Island of La Grande Jatte” and a very recognizable image of the full painting. Monetary impressionists may not be seeing the forest for the trees, to mix up the metaphor.

The Fed began issuing its Summary of Economic Projections (SEP) for the next three years and longer run back in 2007, specifically with the 10/30-10/31/07 Federal Open Market Committee (FOMC) meeting materials. Included in the SEP is the “dot plot,” which reflects each participant’s view of the appropriate federal funds rate trajectory “in the scenario that he or she sees as most likely,” according to Powell. The scenarios outline participants’ outlooks for the unemployment rate, the pace of real GDP growth, and the inflation rate.

Looking back at Figure 2 in the latest, 12/19 SEP, we see the median forecast for the federal funds rate envisioned would rise to 2.90% this year and 3.10% in 2020. The precision of these (median) point estimates in the dot plot is at odds with repeated warnings by Fed officials that the outlook is highly uncertain and that incoming data will dictate the appropriate policy response. We take Powell’s impressionist interpretation to mean that the Fed hasn’t had a clear enough view of what lies ahead to put much faith in the latest dots. Indeed, he seems to be questioning the usefulness of the entire exercise, and may be signaling its demise. Consider the following:

(1) Collateral confusion. This is not the first time that a Fed chair has provided Fed watchers with an art class on interpreting the Fed’s dot-based pictures of monetary policy. In his speech, Powell reviewed two previous instances. In 2014, the dots caused “collateral confusion,” according to the then Fed Chair Janet Yellen, when the markets misread the Fed’s intentions. She stated that what matters more than the dots is what is said in the FOMC Statement released after each meeting.

Similarly, former Fed Chairman Ben Bernanke once said that the “dots” are merely inputs to the Fed’s policy decision-making; they don’t account for “all the risks, the uncertainties, all the things that inform our collective judgement.”

(2) Bullard’s missing dot. Powell didn’t specifically mention him, but St. Louis Fed President James Bullard, a current voter on the FOMC, has questioned the usefulness of the dots for some time. Since 2016, Bullard has opted out of providing longer-run projections, the only participant to do so. He explained why in a paper, contending that switches among monetary policy “regimes”—and the possible future macroeconomic outcomes they may lead to—are not forecastable beyond 2.5 years.

(3) FOMC’s flexible course. Perhaps Bullard led the FOMC participants in an impromptu discussion about the dots during the January 29-30 meeting? According to the Minutes: “A few participants expressed concerns that in the current environment of increased uncertainty, the policy rate projections prepared as part of the Summary of Economic Projections (SEP) do not accurately convey the Committee’s policy outlook.” It was the first time that the minutes suggested that this subject had been discussed in a FOMC meeting.

These participants were concerned that “the public had misinterpreted the median or central tendency of those projections as representing the consensus view of the Committee or as suggesting that policy was on a preset course.” In other words: The public doesn’t understand impressionistic art, so let’s stop showing it to them!

(4) A suggestion. We are not fans of the dot plot. We think that a data-dependent approach is the most sensible way to run monetary policy. Nevertheless, the SEP does provide some useful insights into the heads of the Fed heads.

While the words of Fed officials along with the FOMC Statement and the Minutes help to paint the larger picture of monetary policy, it would also be helpful if the estimated probability of occurrence associated with each of the participants’ projections was indicated within the SEP.

(5) Spot off. Barring an unexpected inflation surprise, we are fairly certain that the Fed will continue to be patient and not raise rates until at least the end of the year. One thing we are absolutely sure of: We won’t be gazing at the Fed’s upcoming release of the dot plot for the 3/19-3/20 FOMC meeting for very long. We’ll take Powell’s advice and view it with a cursory glance and from a few steps back.

In any event, given that the dot plot hasn’t been spot on in a very long time, we won’t be upset if the Fed deletes the dots in the future.

Sunday, March 10, 2019

Happy Birthday to the Bull Market!

In this video podcast, I examine the prospects for the bull market that turned 10 years old on March 9. I also discuss potential peace and productivity dividends that may prolong the bull run.

Monday, March 4, 2019

Chauncey Gardiner on GDP, "There will be growth in the spring."

In this video podcast, I review the latest data on real GDP and discuss why it might continue to cruise along without a recession any time soon. I can safely predict that spring is coming for the economy.

Wednesday, February 20, 2019

Should Stock Buybacks Be Banned?


The Government Is Here To Help

Journalist H.L. Mencken famously observed: “The whole aim of practical politics is to keep the populace alarmed (and hence clamorous to be led to safety) by menacing it with an endless series of hobgoblins, all of them imaginary.” Ronald Reagan just as famously warned: “The nine most terrifying words in the English language are ‘I’m from the government, and I’m here to help.’” Rahm Emanuel summed it all up neatly when he said: “You never want a serious crisis to go to waste. And what I mean by that is an opportunity to do things that you think you could not do before.”

The corollary of Rahm’s Law is that the government will tend to create crises so that we will need more government to fix them. A case in point is stock buybacks.

Senators Chuck Schumer (D-NY) and Bernie Sanders (D-VT), who is running for president as a socialist, long for the good old days. They believe that our nation’s glory days can be restored by limiting corporate stock buybacks. They said so in a 2/3 NYT op-ed. According to the two senators, the 1950s-70s were a golden age for workers because “American corporations shared a belief that they had a duty not only to their shareholders but to their workers, their communities and the country that created the economic conditions and legal protections for them to thrive.” However, in recent decades, corporate managements and their boards of directors have become greedy, focusing on maximizing “shareholders earnings” at the expense of workers’ earnings. The result has been the “worst level of income inequality in decades,” they claim.

As proof, they offer the “explosion of stock buybacks.” From 2008-2017, corporations have boosted their earnings per share and the value of their stocks by spending close to 100% of their profits on buybacks (53%) and dividends (40%)—which the senators characterize as corporate “self-indulgence.” They bemoan that corporations haven’t been investing enough to strengthen their businesses or boost the productivity of their workers. So stock-holding managements have gotten richer at the expense of workers who don’t hold stock and haven’t benefitted from rising stock prices—thus exacerbating both income and wealth inequality. Adding insult to injury, “the median wages of average workers have remained relatively stagnant.” While the corporate fat cats are getting fatter on buybacks, workers “get handed a pink slip.”

The two senators, who have never managed any business, intend to fix this problem. They are planning to introduce a bill that will prohibit any corporation from buying back its shares unless it first provides a minimum wage of $15 an hour and a basic package of employee benefits, which presumably the bill will spell out. The senators recognize that corporations would respond by paying out more in dividends if they can’t buy back their shares. They promise more legislation to deal with that issue if necessary, maybe by amending the tax code.

Original Sin

I humbly offer our two senators a bit of good advice courtesy of Erasmus, from his essay In Praise of Folly: “Let not the wise man glory in his wisdom: the reason is obvious, because no man hath truly any whereof to glory.” I am from Yardeni Research, and I’m here to help.

Where shall I begin to expose the folly of the senators’ arguments? I’ll begin at the beginning:

(1) SEC eases the rules on buybacks. Not widely known is that for many years after the Great Crash of 1929, the Securities and Exchange Commission (SEC) viewed buybacks as bordering on criminal activity. That was the case up until the Reagan years, when the SEC began to ease the rules on buybacks under John Shad, chairman from 1981 to 1987. He believed that the deregulation of securities markets would be good for the economy.

In a widely read September 2014 Harvard Business Review article titled “Profits Without Prosperity,” William Lazonick, a professor of economics at the University of Massachusetts, argued that buybacks are effectively a form of stock price manipulation. The article was a big hit with progressive politicians like Senator Elizabeth Warren (D-MA), who is running for president.

(2) Bill Clinton inadvertently boosts stock compensation for top execs. Granted, some corporate executives are paid too much and spend too much time boosting their stock prices—purportedly under the banner of “enhancing shareholder value.” They claim that high compensation and rising stock prices (most of them are shareholders)incent them to work hard to manage their companies very well.

Ironically, many became even bigger shareholders after President Bill Clinton changed the tax code in 1993, when he signed into law his first budget, creating Section 162(m) of the Internal Revenue Code. This provision placed a $1 million limit on the amount that corporations could treat as a tax-deductible expense for compensation paid to the top five executives (this was later changed by the SEC under Bush to the top four execs). It was hoped that would put an end to skyrocketing executive pay.

The law of unintended consequences trumped the new tax provision, which had a huge flaw—it exempted “performance-based” pay, such as stock options, from the $1 million cap. Businesses started paying executives more in stock options, and top executive pay continued to soar. Liberal critics, notably Senator Warren, concluded that the 1993 tax-code change had backfired badly and that soaring executive pay has exacerbated income inequality.

(3) Buybacks don’t boost earnings per share. The widely believed notion that buybacks boost earnings per share by reducing the share count isn’t supported by the data S&P provides for the S&P 500 companies.

It’s true that from 2008 through 2017, S&P 500 companies repurchased a whopping $4 trillion of their shares, as the senators state in their op-ed (Fig. 1). However, the spread between the growth rates in S&P 500 earnings per share and aggregate S&P 500 earnings has been tiny since the start of the available data during Q4-1994 (Fig. 2).

To calculate per-share earnings, the S&P divides aggregate earnings by a “divisor,” which ensures that changes in shares outstanding, capital actions, and the addition or deletion of stocks in the index do not change the level of the price index (Fig. 3). From the start of 2008 through the end of 2017, it is down just 2.6%, or 0.3% per year on average. That certainly doesn’t support the notion that buybacks have reduced the share count meaningfully, thus boosting earnings per share.

The best explanation for this surprising development is that the S&P 500 companies are mostly buying back their shares to offset the dilution of their shares resulting from compensation paid in the form of stocks that vest over time, not just for top executives but also for many other employees.

So the latest bull market has been driven by rising earnings, but they haven’t been artificially boosted on a per-share basis by stock buybacks! Nevertheless, buybacks might have provided a lift to stock prices since the buybacks occur in the open market, while the issuance of stock as compensation has no immediate market impact, especially if not yet vested.

Rewarding Workers

What about the claim that corporations have been spending almost 100% of their profits on buybacks and dividends rather than expanding and improving their productive capacity and workforce? It is factually accurate (Fig. 4).

The problem is the claim’s underlying assumption that the biggest source of corporate cash flow is profits; rather, it is depreciation allowances. This is the corporate income that is sheltered from taxation to reflect the expenses incurred in replacing depreciating assets. It’s this cash that nonfinancial corporations (NFCs) mostly use for gross capital spending—which rose to a new record high during Q3-2018 and continues to rise in record-high territory (Fig. 5). Recent net capital spending by NFCs is comparable to levels in previous business-cycle expansions, though making such comparisons may understate the technological enhancements in current spending (Fig. 6).

Now I will consider the plight of all those workers whom Schumer and Sanders want to help:

(1) Record employment and quits. Granted, it took longer than usual for payroll employment to recover from the previous recession, which was among the worst since World War II. However, by May 2014, payroll employment did regain what was lost during the severe downturn. It too has continued to move higher, and hit 150.5 million during January, surpassing the previous cyclical peak during January 2008 by 8.8%. The unemployment rate has been running around just 4.0% since March 2018. Job openings is at a record high, exceeding the number of people unemployed since last March. The quit rate is around record highs, as workers have lots of alternative prospects for boosting their pay and their benefits.

(2) Record income and consumption per household. Perhaps one of the biggest myths of all about our economy is that real incomes have stagnated for most Americans over the past 15-20 years. Even Donald Trump often made this claim when he was running for president. This assertion is based on one widely followed and extremely flawed inflation-adjusted measure of median household income produced annually by the Census Bureau (Fig. 7). It is based on survey data, focuses just on money income, and is pre-tax.

From Q1-2000 through Q4-2017, real GDP per household rose 19.7%. Yet over this same period, the aforementioned income series, which is available only on an annual basis, rose just 2.2%. That’s stagnation for sure, and implies significantly worsening inequality. However, there are numerous other inflation-adjusted measures of household income and wages that are based on hard data and are broader in scope, including nonmoney government support programs like Medicaid, food stamps, and tax credits. They are up much more over the same period.

For example, real personal income per household is up 27.0% before taxes and 29.9% after taxes. Skeptics will instantly pounce on the fact that these are means, not medians. So they might be upwardly biased by the enormous incomes of the ultra-rich. I doubt that, as evidenced by real personal consumption per household, up 28.1%. The rich don’t eat much more than the rest of us. My basic assumption is that there aren’t enough of them—often dubbed the “1%” for a reason—to bias the mean series I’ve constructed for personal income and consumption.

(3) Record real wages and compensation. There can be no disputing the fact that real wages haven’t been stagnating at all, notwithstanding the assertions of the two senators who want to help workers. From the start of 2000 through the end of 2017, real average hourly earnings rose 17.3% (Fig. 8). I am using the series that applies only to production and nonsupervisory workers, who tend to be rich only if they win the lottery. They account for roughly 80% of all workers.

There’s more: Total real compensation—which includes wages, salaries, and benefits, per worker (using the household measure of employment)—rose 19.5% from the start of 2000 through the end of 2017, and was at a record high last year, as were all the other measures mentioned above (Fig. 9).

The Inequality Debate

A July 2016 working paper authored by a team of economists—three from the Bureau of Economic Analysis and one from the University of Michigan—created a median measure of personal income. The economists found that it grew by 4.0% from 2000 to 2012, while the Census’ median money income fell 6.2%. That’s certainly a significant difference! The study came to the following significant conclusion: “We show that for the period 2000–2012, inequality using personal income is substantively lower than inequality measured using Census Bureau money income, and the trends in both inequality and median income are different. This demonstrates the importance of using a national accounts based measure of income when examining the relationships between inequality and growth.” This extraordinary statement completely debunks using Census money income to measure not only income inequality but also the standard of living.

The data cited above strongly suggest that the standard of living of the average American household hasn’t stagnated, and has increased along with real GDP since 2000. If so, then income inequality hasn’t worsened much if at all since then. That doesn’t mean that there isn’t any income inequality, but rather that it is just as bad now as it was back then but no worse. Remember that inequality was an issue under President Clinton, who addressed it by capping cash compensation at $1 million for top execs in 1993.

The bull market in stocks undoubtedly has worsened wealth inequality since it started in early 2009. However, lots of Americans have benefitted from the bull market through their pension programs at work, including 401(k) plans and individual retirement accounts (IRAs). The latest data available from the Investment Company Institute show that in 2016 about 55 million American workers were active 401(k) participants. The value of their 401(k) funds was $5.6 trillion as of September 30, 2018. The Fed compiles quarterly data on the value of all IRAs, which rose to a record $9.3 trillion during Q2-2018, up $5.7 trillion since the start of the bull market (Fig. 10).

Room for Improvement

Progressives like Senators Schumer and Sanders want to reduce corporate cronyism. I wholeheartedly agree with them on that, and I have some ideas on how to do so, including limiting the number of boards on which an individual may serve and compiling a “crony scoreboard” to keep track. Corporate cronyism may become a bigger problem, in my opinion, because shareholders are losing their influence over corporate managers and boards as a result of the outflows from equity mutual funds into equity ETFs. Active managers exert more shareholder influence over corporate governance issues than do passively managed funds.

There is certainly room for improvement in corporate governance. On the other hand, I see no need for regulating buybacks. Most corporate managers are driven to make their companies as successful as possible, as evidenced by record earnings both on a per-share basis and in aggregate. America’s free-market capitalism continues to boost the prosperity of most Americans, in my opinion, without more help from the government.

Finally, let’s recognize that income and wealth inequality are inevitable consequences of a system of free-market capitalism. The rich do tend to get richer, especially when the rest of us also prosper along with them, since they benefit from consumers with more purchasing power to buy what their companies produce. Socialism does create more equality, but that’s because it tends to generate less growth for the economy and less prosperity for most people. Take your pick.

Friday, February 15, 2019

Lipstick on a Pig: US Federal Government Debt

In this video podcast, I review the latest developments in the US federal government's budget and I explain why I disagree with the proponents of Modern Monetary Theory who claim that deficits and debt don't matter as long as the government borrows in its own currency and inflation remains subdued.

Thursday, February 7, 2019

Bonds: Doing the Unexpected

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Last year, the 10-year US Treasury bond yield peaked at 3.24% on November 8 (Fig. 1). Last year, when the yield first rose above 3.00% on May 14, there was lots of chatter about how it was likely to rise to 4.00% and even 5.00%. Those forecasts were based on the widespread perception that Trump’s tax cuts would boost economic growth, inflation, and the federal deficits. In addition, the Fed had started to taper its balance sheet during October 2017, and was on track to pare its holdings of Treasuries and mortgage-related securities by $50 billion per month (Fig. 2). It was also widely expected that the Fed would hike the federal funds rate four times in 2018, which is what happened, and that the rate-hiking would continue in 2019 into 2020.

Furthermore, the Bond Vigilantes model, which correlates the bond yield with the y/y growth in nominal GDP, was bearish because the latter rose to 5.5% during Q3 (Fig. 3). But instead of moving higher toward 5.50%, the bond yield fell back below 3.00% and was at 2.70% on Tuesday.

What gives? The Dow Vigilantes screamed “no mas” at the Fed during the last three months of 2018, allowing the Bond Vigilantes to take another siesta. The Fed got the message, and the word “gradual” was first replaced with the word “patient” to describe the pace of monetary normalization by Fed Chairman Jerome Powell on January 4. The two-year Treasury yield, which tends to reflect the market’s year-ahead forecast for the federal funds rate, dropped down to that rate (at 2.38%, the midpoint of the 2.25%-2.50% range) on January 3 (Fig. 4 and Fig. 5).

Last year, I surmised that the bond yield might be “tethered” to the near-zero yields for comparable Japanese government bonds in Japan and bunds in Germany (Fig. 6). I also argued that based on my 40 years’ experience in our business, I’ve never found that supply-vs-demand analysis helped much in forecasting bond yields. It’s always been about actual inflation, expected inflation, and how the Fed was likely to respond to both. The most recent bond rally was mostly driven by a drop in the expected inflation rate embodied in the yield spread between the 10-year Treasury bond and the comparable TIPS (Fig. 7). The spread dropped 30bps since October 9, 2018 through Wednesday.

Meanwhile, the yield curve remains awfully flat, with the yield spread between the 10-year bond and the federal funds rate at only 36bps (Fig. 8). This suggests that Powell & Co. may pause rate-hiking for as long as the yield curve spread remains this close to zero. If they raise rates, they risk inverting the yield curve. That might stir up the Dow Vigilantes again.

So do federal deficits matter to the bond market? Apparently not. It’s all about inflation. If deficits boost inflation, then they will matter, as I see it.

Wednesday, January 30, 2019

Stocks: Something for Worriers

The S&P 500 is one of the 10 components of the Index of Leading Economic Indicators (LEI). The LEI stalled during the last three months of 2018—falling 0.3% in October, rising 0.2% in November, then falling again by 0.1% in December. The drop in stock prices accounted for much of that weakness. The rebound in the S&P 500 so far in January is a relief.

However, the selloff late last year and the partial government shutdown early this year depressed the expectations sub-index of the Consumer Optimism Index (COI) during January (Fig. 1). This is the average of the expectations components of the Consumer Sentiment Index (CSI) and the Consumer Confidence Index (CCI). That average is also one of the LEI indicators, and it has fully reversed the jump it took after Trump was elected president.

The good news is that the current conditions component of the COI remains at a cyclical high, edging down only slightly during January. That reflects the continued strength in the labor market. So does the 213,000 increase in ADP payrolls during January.

However, if you are a worrier, then you can certainly worry about the ratio of the current conditions and expectations components of the CCI, which tends to spike higher at the start of recessions, as it did this month (Fig. 2). It also tends to spike after a bear market has started (Fig. 3).

I expect that expectations will rebound along with stock prices, assuming that there isn’t another government shutdown in the offing. I also expect that an amicable resolution in the US-China trade talks will boost stock prices and consumer confidence.

Helping to boost sentiment for both stock investors and consumers is today’s decision by the FOMC to pause rate-hiking. Today’s FOMC statement didn’t include the 12/19 statement’s language that “further gradual increases” in interest rates were warranted. Instead, a more cautious approach was signaled: “In light of global economic and financial developments and muted inflation pressures, the Committee will be patient as it determines what future adjustments to the target range for the federal funds rate may be appropriate to support these outcomes.”

In a separate statement released yesterday too, the FOMC also signaled a more flexible approach to QT, i.e., the paring of the Fed’s balance sheet: “The Committee is prepared to adjust any of the details for completing balance sheet normalization in light of economic and financial developments.”

At 2681, the S&P 500 is now up 14.0% from the 12/26 low of last year, and is only another 9.3% gain away from its 9/20 record high of 2930. My year-end target of 3100 is looking more achievable.

Wednesday, January 9, 2019

On the Demographic Path to Human Self-Extinction

In Chapter 16 of my book Predicting the Markets, I observe that fertility rates have dropped below replacement rates around the world as a result of urbanization. Only in India and Africa are couples having enough babies to replace themselves. Humans are on a demographic path of self-extinction.

Leading the way has been Japan. I have often described the country as the world’s largest nursing home. That distinction undoubtedly will soon belong to China. All around the world, nursing homes will be bulging with more occupants, while the maternity wards will have lots of vacant cribs.

The economic consequences of these demographic trends will be slower growth and subdued inflation, if not outright deflation. That means that interest rates most likely will remain historically low for a very long time. That could be positive for the valuation multiples that investors are willing to pay for the stocks of companies that are able to grow their earnings at an above-average rate. It should also be very positive for the stocks of companies that are able to grow their dividends in this demographically challenged environment.

A global shortage of workers should stimulate more labor-saving and labor-replacing technological innovations. The result should be faster productivity growth. That should give a lift to real wages that should offset some of the slowdown in employment growth attributable to labor shortages.

The scenario I just sketched isn’t a forecast. It is a description of exactly what has been happening in Japan. The forecast is that most of the rest of the world will follow suit. Japan is the poster child for the rest of us who aren’t having enough babies to replace ourselves. Consider the following:

(1) Japan. On a 12-month basis, the number of deaths in Japan exceeded the number of live births for the first time during July 2007 (Fig. 1). On this basis, during July of this year, deaths exceeded live births by a record 351,000 (Fig. 2). The situation has been exacerbated by a record low of only 586,700 marriages over the past 12 months through July (Fig. 3).

So Japan’s population has been falling in recent years and rapidly aging. The percentage of the population that is 65 or older has increased from 25.2% at the start of 2014 to 28.2% at the end of last year (Fig. 4). Yet the total labor force has actually been rising gradually over the past few years (Fig. 5). That’s because the labor force participation rate has been moving higher (Fig. 6). The problem is that more Japanese women have been entering the labor force and not getting married, which depresses the number of births. If that continues, the number of births will remain depressed.

These demographic trends go a long way toward explaining why Japan’s inflation rate remains near zero, despite the ultra-easy monetary policies of the Bank of Japan, which has been targeting a 2.0% inflation rate since January 22, 2013 (Fig. 7). Older people and fewer children aren’t conducive to home-building, car-buying, or the consumption of other durable goods.

(2) China. The demographic profile of China isn’t as geriatric as Japan’s, but it is heading in the same direction, accelerated by the government’s one-child policy that was in force from 1979 through 2015 (Fig. 8). For the first time ever, the percentage of seniors in the population, at 6.6%, matched the percentage of children under five years old during 1998 (Fig. 9). By the middle of this century, the former is projected by the UN to rise to 26.3%, while the latter falls to 4.6%.

Young married adults who have no siblings must accept the burden of taking care of four aging parents. Now that the government has declared that couples can have more than one child, many are likely to be overburdened having even one child.

As I’ve noted in recent months, all this is weighing on Chinese real retail sales growth, which has been on a downtrend for the past several years (Fig. 10).

(3) United States. The good news in the US is that the fertility rate is in line with the replacement rate. However, the demographic trends are heading in the wrong direction. Young people are staying single longer. Newly married older couples are likely to have fewer children than younger couples. The cost of college education is also a downer for many couples, forcing them to consider how many children they can afford.

The proof is in the maternity wards. Over the past 12 months through March, live births in the US totaled 3.84 million, the lowest since November 1997 (Fig. 11). Over the same period, the number of deaths totaled a record 2.36 million. So births exceeded deaths by 1.48 million, the lowest reading on record, dating back to December 1972 (Fig. 12).

Meanwhile, as the Baby Boomers age, they are turning into minimalists. They don’t need their big houses anymore. They don’t need minivans to take the kids to soccer practice. The Millennials are natural-born minimalists, for reasons I have reviewed in the past on many occasions.

I don’t view this as necessarily bad news for the US economy. Rather, I see these demographic trends as reducing the likelihood of an economic boom, which reduces the likelihood of a bust. The business-cycle expansion should continue, and inflation should remain subdued.

Tuesday, January 1, 2019

Video Podcast: Is the Fed Done?

Today is January 1, 2019. I wish you all a healthy, happy, and prosperous New Year! In this video, I discuss why the new year is likely to start with some downbeat economic data that should cause the Fed to pause hiking interest rates. Regional business surveys conducted by five of the Fed district banks were very weak during December. That explains the recent drop in the 10-year Treasury bond yield below 2.70%. The 2-year Treasury yield tends to be a good one-year leading indicator of the federal funds rate, and is currently predicting no change this year. Are the implications bearish or bullish for the stock market?

VIDEO