Thursday, September 12, 2019

US Bond Yields Made in Germany

Another round of central bank easing is underway. So why are bond yields rising?

The 10-year US Treasury bond yield rose from a recent low of 1.47% on 9/4 to 1.72% on Tuesday (Fig. 1). The record low was 1.37%, hit on 7/8/16 just after the Brits voted to leave the European Union (EU). The risks of a no-deal Brexit have eased in recent days, though it still could happen next month. A hard Brexit could cause the bond yield to retest its recent low.

In any event, the main reason that the US bond yield has moved higher in recent days has more to do with Germany than the UK. The 10-year German government bond yield has risen from a recent record low of -0.71% on 8/30 to -0.54% Tuesday. Reuter’s reported: “Germany’s 30-year government bond yield briefly rose into positive territory on Tuesday for the first time in over a month, lifted by expectations for fiscal stimulus and caution over the scale of stimulus the European Central Bank might deliver this week.”

During a parliamentary budget debate on Tuesday, Germany’s Finance Minister Olaf Scholz said that Germany can counter a possible recession with a big stimulus package. On Monday, Reuters reported that Germany was considering creating a “shadow budget” to boost public investment above and beyond limits set by its national debt rules, sparking a bond sell-off.

European Central Bank (ECB) President Mario Draghi has been lobbying for fiscal policy to turn more stimulative to support the ECB’s ultra-easy monetary policies. Germany has resisted doing so and even questioned whether the ECB’s asset purchase program could legally buy sovereign bonds. Germany’s fiscal and monetary conservatives might be starting to waver as a result of Germany’s intensifying manufacturing recession, with factory orders and production down 5.6% and 4.8% y/y through July (Fig. 2).

Last year, when there was widespread bearishness in the bond market, with some predicting that the US yield would rise from 3% to 4%-5%, I observed that the US bond yield might be “tethered” to the comparable German and Japanese yields, which were barely above zero. This year, both have dropped solidly below zero.

During the Q&A portion of his 7/25 press conference, Draghi pleaded for more fiscal stimulus, especially from Germany:

“What’s hitting the manufacturing sector in Germany and [elsewhere in Europe is] an idiosyncratic shock. Here what becomes really very important is fiscal policy. [T]he mildly expansionary fiscal policy is supporting activity in the euro area. But if there were to be a significant worsening in the Eurozone economy, it’s unquestionable that fiscal policy … becomes of the essence. … I started making this point way back in 2014 in a Jackson Hole speech: monetary policy has done a lot to support the euro area … but if we continue with this deteriorating outlook, fiscal policy will become of the essence.”

Thursday, September 5, 2019

From FOMO to FONIR

I visited with our accounts in Atlanta and Chattanooga recently. They seemed relatively calm. Most of them believe that the US economy can continue to grow for the foreseeable future. So they aren’t freaking out about the recent inversion of the yield curve. However, they are somewhat anxious about the prospect of negative interest rates in the US, though they think it is a remote possibility. Consider the following:

(1) US bond yields stand out. We discussed in our meetings the expectation that the Bank of Japan (BOJ) is likely to keep its official policy interest rate at -0.10% for the foreseeable future, as it has since 1/29/16, while the Governing Council of the European Central Bank (ECB) is likely to lower its official deposit rate, currently -0.40%, deeper into negative territory at its 9/12 meeting (Fig. 1). The ECB is widely expected to resume quantitative easing at that meeting as well (Fig. 2).

Such expectations have driven the 10-year German government bond yield down to -0.70% on Monday from 0.24% at the start of this year. At 1.50% on Friday, the 10-year US Treasury bond yield is literally outstanding compared to the comparable yields available overseas: UK (0.34%), Japan (-0.27), Sweden (-0.34), France (-0.40), Germany (-0.70) (Fig. 3). The negative-interest-rate policies (NIRPs) of the ECB and BOJ are increasing the amount of negative-interest-rate bonds (NIRBs) around the world.

(2) Dividend & earnings yields stand out. The rationale for remaining bullish on US stocks seems to be shifting from TINA (there is no alternative) and FOMO (fear of missing out) to FONIR (fear of negative interest rates). These fears are inherently bullish for stocks and continue to overcome the bearish fear that an inverted yield curve is predicting an impending recession, i.e., FOIYC (fear of inverted yield curve).

A few of the accounts with whom I met recently noted that the 10-year US Treasury bond yield at 1.50% is below the S&P 500 dividend yield, at 1.90% during Q2-2019 (Fig. 4). That is one very good reason why they remain mostly fully invested in the stock market. I observed that the forward earnings yield of the S&P 500, at 6.06% during August, is even more outstanding compared to the bond yield (Fig. 5).

(3) Performance derby. The 119bps drop in the US bond yield since the beginning of the year certainly has benefited dividend-yielding stocks. The S&P 500 sectors that tend to have lots of dividend-paying companies have outperformed those that tend to have fewer of them: Information Technology (28.0% ytd), Real Estate (26.0), Consumer Discretionary (20.3), Communication Services (20.0), Consumer Staples (19.0), Utilities (17.6), Industrials (17.4), S&P 500 (16.7), Financials (12.6), Materials (11.9), Health Care (4.6), and Energy (-0.5) (Fig. 6).

FONIR should continue to benefit dividend-yielding stocks. Their high valuation multiples reflect investors’ willingness to pay up for these stocks, as evidenced by the relatively high forward P/Es of the S&P 500 sectors with lots of dividend payers: Real Estate (44.0), Consumer Discretionary (21.2), Information Technology (19.6), Consumer Staples (19.6), Utilities (19.4), Communication Services (17.4), Materials (16.9), S&P 500 (16.8), Industrials (15.4), Health Care (14.8), Energy (14.7), and Financials (11.4) (Fig. 7).

(4) Real yields. During July, the US bond yield averaged 2.05%, while the CPI inflation rate was 1.80%. So the inflation-adjusted bond yield was close to zero, at 0.25% (Fig. 8). During August, the bond yield fell below the inflation rate. In other words, in real terms, bond yields are entering negative territory. Meanwhile, the real earnings yield of the S&P 500, using reported earnings, remained solidly in positive territory during Q2-2019, at 3.02% (Fig. 9). The real forward earnings yield of the S&P 500 was 4.03% during July (Fig. 10).

Wednesday, August 28, 2019

Trump's Game of Chicken

President Donald Trump seems to be playing simultaneous games of chicken with Fed Chair Jerome Powell and Chinese President Xi Jinping. Last Friday, he raised tariffs again on US imports from China and ordered US companies to leave China. He also said that Fed Chair Jerome Powell is a greater enemy than Xi. Trump’s game plan is to create more uncertainty about trade, thus increasing the risks for US economic growth so that the Fed will have to respond with more interest-rate cuts. At the same time, he hopes that Xi will relent by agreeing to a trade deal that is good for the US economy.

Games of chicken are often reckless and dangerous, with dire consequences. The S&P 500 tumbled 2.6% on Friday. In the classic movie “Rebel Without a Cause” (1955), Jimmy (played by James Dean) agrees to a “chickie-run” to settle a dispute with Buzz, the leader of a local gang. Both race stolen cars toward the edge of a cliff. The first to jump out of his car is branded a “chicken.” Jimmy flings himself out an instant before the cars reach the edge of the cliff. Seconds into the race, Buzz discovers that his jacket is stuck on the door handle. So he goes over the cliff and dies.

The question for all of us is whether Trump is Jimmy or Buzz. Is Trump trumping Powell and Xi or is Trump trumping Trump?

Our 7/11 Morning Briefing was titled “Powell Gets Trumped!” I wrote: “President Donald Trump wants the Fed to lower interest rates. Fed Chair Jerome Powell claims that the Fed is independent and won’t bow to political pressure. Yet Trump has figured out the perfect way to force the Fed to lower interest rates. All he has to do is keep creating uncertainty about US trade policy. In his congressional testimony yesterday on monetary policy, Powell mentioned the trade issue eight times in his prepared remarks.”

Sure enough, the Fed lowered the federal funds rate by 25bps on 7/31. However, that afternoon, Trump said that it wasn’t enough and that he wants more easing right away. Trump was quick to attack the Fed’s decision. He tweeted: “What the Market wanted to hear from Jay Powell and the Federal Reserve was that this was the beginning of a lengthy and aggressive rate-cutting cycle which would keep pace with China, The European Union and other countries around the world. … As usual, Powell let us down, but at least he is ending quantitative tightening, which shouldn’t have started in the first place—no inflation. We are winning anyway, but I am certainly not getting much help from the Federal Reserve!”

The very next day, Trump trumped Powell again by creating more uncertainty about trade when he said that the US will impose a 10% tariff on an additional $300 billion worth of Chinese imports next month. The new tariff comes on top of the 25% levy that Trump already has imposed on $250 billion worth of Chinese imports—so the US will be taxing nearly everything China sends to the US. Trump added that the tariffs could be raised to 25% or higher if the talks drag on further without any significant progress, but he allowed that alternatively they could be removed if a deal is struck.

Then on 8/14, stocks rebounded after the Trump administration de-escalated its trade war with China. The 10% tariff would be delayed until 12/15 on imports from China of cellphones, laptop computers, toys, and other items. No reason was given. Trump trumped Trump.

In our 8/7 Morning Briefing, I wrote: “What does Trump want? He wants to win another term on 11/3/20. What does Xi want? He wants Trump to lose. They both know that. Xi is president for life, so he figures he can easily outlast Trump, though having to deal with Trump through 2024 would be more challenging than through 2020. Trump must know that even if he gets a deal with China before the election, that won’t mean much if he loses. He seems to be talking up the scenario of a post-election deal, perhaps believing that timing will yield a better deal from the Chinese, assuming he wins a second term.”

I concluded in that commentary: “Trump must figure that he needs the Fed to lower interest rates while he waits for the Chinese to come around on trade, hoping to strike a deal after the elections.” Trump’s game is to trump Powell before he trumps Xi.

By the way, Bill Dudley is apoplectic about Trump's game of chicken. Dudley served as president of the Federal Reserve Bank of New York and as vice chairman of the Federal Open Market Committee from 2009 to 2018. He revealed his antipathy for the President in a 8/27 Bloomberg View op-ed titled “The Fed Shouldn’t Enable Donald Trump.”

He wants the Fed to fight fire with fire: “I understand and support Fed officials’ desire to remain apolitical. But Trump’s ongoing attacks on Powell and on the institution have made that untenable. Central bank officials face a choice: enable the Trump administration to continue down a disastrous path of trade war escalation, or send a clear signal that if the administration does so, the president, not the Fed, will bear the risks—including the risk of losing the next election.”

In other words, the Fed shouldn’t offset the uncertainties caused by Trump’s trade policies with lower interest rates, even if that leads to a recession. The Fed should refuse to meet its legal mandate to maintain full employment and price stability rather than enable Trump.

Dudley is essentially calling for the Fed to overthrow the President in the coming election: “There’s even an argument that the election itself falls within the Fed’s purview. After all, Trump’s reelection arguably presents a threat to the U.S. and global economy, to the Fed’s independence and its ability to achieve its employment and inflation objectives. If the goal of monetary policy is to achieve the best long-term economic outcome, then Fed officials should consider how their decisions will affect the political outcome in 2020.”

I am almost speechless. Dudley may be calling on the Fed to join the resistance and to fight fire with fire, but that would be playing with fire for the Fed. Welcome to the New Abnormal, where everyone loses their minds! Trump has the amazing ability to make sane people go insane. (For more on this, Google search “Trump Derangement Syndrome.”)

Wednesday, August 21, 2019

Bonds In Neverland

The negative interest rate policies of the European Central Bank (ECB) and the Bank of Japan (BOJ) have created a Neverland in the global fixed-income markets. An 8/18 Bloomberg story reported: “The world’s headlong dash to zero or negative interest rates just passed another milestone: Homebuyers in Denmark effectively are being paid to take out 10-year mortgages. Jyske Bank A/S, Denmark’s third-largest lender, announced in early August a mortgage rate of -0.5%, before fees. Nordea Bank Abp, meanwhile, is offering 30-year mortgages at annual interest of 0.5%, and 20-year loans at zero.”

A 7/29 story in The Washington Times reported: “The latest estimates are that approximately 30 percent of the global government bond issues are now trading in negative territory. Last week, Swiss 50-year borrowing costs fell below zero percent, which means that Switzerland’s entire government bond market now trades with negative yields. Earlier in the month, Denmark became the country to have its entire yield curve turn negative.”

During 2018, when the 10-year US Treasury bond yield was rising toward last year’s high of 3.24% on 11/8, there was much chatter about its going to 4%-5%. For example, on 8/4 at the Aspen Institute's 25th Annual Summer Celebration Gala, JP Morgan Chase Chief Jamie Dimon warned that the 10-year US Treasury bond yield could go much higher: “I think rates should be 4% today. You better be prepared to deal with rates 5% or higher—it's a higher probability than most people think.”

At the time, the bears worried about mounting federal deficits, resulting from the tax cuts at the beginning of the year, at the same time that the Fed was on track for more QT. In addition, there was mounting evidence that inflationary pressures were building, with some related to Trump’s tariffs.

In my 8/8/18 daily commentary, I wrote: “So why isn’t the US bond yield soaring? The bulls respond that trying to forecast the bond market using flow-of-funds supply-vs-demand analysis has never worked. It’s fairly obvious that US bond yields are tethered to comparable German and Japanese yields, which are near zero, and are likely to remain there given the stated policies of both the ECB and BOJ to keep their official rates near zero for the foreseeable future.”

The tether has gotten tighter since last year’s peak in the US bond yield on 11/8. Since then, the US bond yield has dropped 164bps to 1.60% on Monday, while the comparable German and Japanese yields are down 111bps to -0.65% and 36bps to -0.23%, respectively.

Now consider the following related developments in the US bond market:

(1) Tipping into negative territory. The 10-year TIPS yield dropped to zero on Monday, suggesting that the nominal yield reflects only inflation expectations with no real yield. The TIPS yield could be about to turn negative, as it did in 2012.

(2) Real rates and productivity. Why should the real bond yield be negative or even zero? The most widely accepted notion is that the real bond yield should be related to the growth rate in productivity, which is the economy’s real return, arguably. The correlation between the two—using averages over five-year time periods—is not compelling, though. In any event, productivity growth has been turning up over the past few years. Productivity has been growing faster in the US than in the other G7 economies.

(3) Demography is destiny. The geriatric trend in global demographic profiles does support a case for negative nominal and real interest rates if the trend leads to a combination of slow growth and deflation. That’s if deflation reduces the value of assets purchased today with debt. Negative interest rates on that debt might reflect the voluntary self-extinction of the human race attributable to the collapse of fertility rates around the world. Dwindling populations, particularly of younger people, will put downward pressure on real asset prices, because there will be less demand for the goods and services they provide in the future.

Friday, August 16, 2019

Yield Curve Inverts: Head for the Hills?

The stock market tanked on Wednesday, August 14 because the yield spread between the 10-year US Treasury bond and the 2-year Treasury note turned negative. Such an inversion of the yield curve is widely viewed as a reliable leading indicator of economic recessions. In fact, it is one of the 10 components of the Index of Leading Economic Indicators. But so is the S&P 500, which remains close to its recent high but would fall sharply if stock investors become convinced that a recession is imminent.

Not only did the stock market react badly to the latest yield-curve inversion, but so did President Donald Trump, who tweeted: "CRAZY INVERTED YIELD CURVE! We should easily be reaping big Rewards & Gains, but the Fed is holding us back."

An inverted yield curve has predicted 10 of the last 7 recessions. In other words, it isn't as accurate a predictor of economic downturns as widely believed. It can be misleading.

In our recently published study "The Yield Curve: What Is It Really Predicting?," we concluded that inverted yield curves do not cause recessions. In the past, they’ve predicted credit crunches caused by Fed tightening. So investors on the lookout for a recession should instead pay attention to credit availability. Recession-watchers should keep an eye on bank credit metrics—specifically, net interest margin, charge-offs and dividends, and business loans. Right now, those metrics aren’t signaling a credit crunch. In our study, we observed:

“One widely held view is that banks stop lending when the rates they pay in the money markets on their deposits and their borrowings exceed the rates they charge on the loans they make to businesses and households. So an inverted yield curve heralds a credit crunch, which inevitably causes a recession. …The widely held notion that a flat or an inverted yield curve causes banks to stop lending doesn’t make much sense. The net interest margin, which is reported quarterly by the Federal Deposit Insurance Corporation (FDIC), has been solidly positive for banks since the start of the data in 1984.”

Credit remains amply available. The Fed has been back in easing mode since the end of July, when the federal funds rate was cut by 25bps. Fed officials are likely to respond to the inversion with more rate cuts.

Our study includes a “Primer on the Yield Curve,” based on “Dr. Ed’s” book Predicting the Markets (2018). It also includes several useful charts for gleaning more insights into the relationships of the yield curve to the economy and to financial markets.

Monday, August 5, 2019

The Great Inflation Delusion

The Fed, the European Central Bank (ECB), and the Bank of Japan (BOJ) came up with lots of headline-grabbing shock-and-awe programs over the past 10 years in reaction to the Great Financial Crisis. Over time, they seemed to lose their effectiveness and ability to shock or awe.

Nevertheless, the US economy had improved sufficiently by 2014 that the Fed terminated Quantitative Easing (QE) in October 2014 and started very gradually to raise interest rates in late 2015. However, by the end of July 2019, the Fed was lowering the federal funds rate again. The ECB terminated its QE at the end of 2018 and was expecting to raise interest rates by mid-2019. However, by July 2019, the ECB signaled that it would most likely lower its deposit rate further into negative territory in September, and that more QE might be ahead. The BOJ has yet to even consider normalizing monetary policy, and continues to expand its balance sheet. By the summer of 2019, the major central banks seem to have run out of new tricks.

The central bankers have been fighting powerful forces of deflation. With all the liquidity they’ve provided, they have succeeded in averting outright deflation. However, the Fed, the ECB, and the BOJ haven’t succeeded in pushing inflation in their countries up to their 2.0% targets. Inflation remains awfully close to zero and too close to its border with deflation.

In my opinion, the central bankers are trying to fix problems that can’t be fixed with ultra-easy monetary policies. They are trying to fight the four forces of deflation: Détente, Disruption, Debt, and Demographics. I call them the deflationary “4Ds.” Let me explain:

Détente. Détente occurs after wars. Such periods of peacetime lead to globalization with freer trade, which means more global competition in markets for labor, capital, goods, and services. Wars, in effect, are trade barriers. The end of the Cold War marked the beginning of the current period of globalization.

Competition is inherently deflationary. No one can raise their price in a competitive market because it is capped by the intersection of aggregate supply and demand. However, anyone can lower their price if they can cut their costs by boosting productivity. The incentives to do so are great because that’s a sure way to increase market share and profits.

History shows that prices tend to rise rapidly during wartime and then to fall during peacetime. War is inflationary; peace is deflationary. The CPI for the US is available since 1800. It spiked sharply during the War of 1812, the Civil War, World War I, and World War II. During peacetimes, prices fell sharply for many years following all the wars listed above, except for the peace so far since the end of the Cold War in 1989. (Of course, there have been local wars since then, and all too many terrorist attacks, but none that has substantially disrupted commerce.) Prices still are rising in the United States, though at a significantly slower pace than when the Cold War was most intense.

During wartimes, global markets are fragmented. Countries don’t trade with their enemies. They face military obstacles to trading with their allies and friends. Commodity prices tend to soar as the combatants scramble to obtain the raw materials needed for the war effort. A significant portion of the labor force has been drafted and is in the trenches. The upward pressure on labor costs and prices often is met with government-imposed wage and price controls that rarely work. Entrepreneurs, engineers, and scientists are recruited by the government to win the war by designing more effective and lethal weapons.

Peacetimes tend to be deflationary because freer trade in an expanding global marketplace increases competition among producers. Domestic producers no longer are protected by wartime restrictions on both domestic and foreign competitors. There are fewer geographic limits to trade and no serious military impediments. Economists mostly agree that the fewer restrictions on trade and the bigger the market, the lower the prices paid by consumers and the better the quality of the goods and services offered by producers. These beneficial results occur thanks to the powerful forces unleashed by global competition during peacetimes.

As more consumers become accessible around the world, more producers around the world seek them out by offering them competitively priced goods and services of better and better quality. Entrepreneurs have a greater incentive to research and develop new technologies in big markets than in small ones. The engineers and scientists who were employed in the war industry are hired by companies scrambling to meet the demand of peacetime economies around the world. Big markets permit a greater division of labor and more specialization, which is conducive to technological innovation and productivity.

My war-and-peace model of inflation simply globalizes the model of perfect competition found in the microeconomic textbooks. The single most important characteristic of this microeconomic model is that there are no barriers to market entry. Anyone can start a business in any industry. In addition, there are no protections against failure. Unprofitable firms restructure their operations, get sold, or go out of business. There are no “zombies,” i.e., living-dead firms that continue to produce even though they are bleeding cash. They should go out of business and be buried. These firms can only survive if they are kept on life support by government subsidies, usually because of political cronyism.

The microeconomic model of perfect competition predicts that the market price will equal the marginal cost of production. An increase in demand might temporarily increase profits, but that would stimulate more production among current competitors and attract new market entrants. If demand drops such that losses are incurred, competitors will cut production, with some possibly shutting down if the decline in demand is permanent. New entrants certainly won’t be attracted.

So no one firm or group of firms can set the price. Both producers and consumers are “price-takers.” No one has enough clout in the market to dictate the price that everyone must receive or pay. The price is set by the “invisible auctioneer,” who equates total market demand to total supply at the market’s equilibrium price, which is determined by the marginal cost of production.

Profits are reduced to the lowest level that provides just enough incentive for enough suppliers to stay in business to satisfy demand at the going market price. Consumer welfare is maximized. Obviously, there can’t be excessive returns to producers in a competitive market. If there are, those returns will be eliminated as new firms flood into the excessively profitable market. Firms that try to increase their profits by raising prices simply will lose market share to firms that adhere to the market price. That’s a good way to go out of business.

This microeconomic textbook model of perfect competition seems to be much more relevant in explaining deflation and disinflation during periods of globalization than any macro model. Globally, there have been fewer barriers to market entry because of the end of the Cold War. This is certainly true geographically. It is also true in other ways. For example, a potential barrier to entry in some industries is the availability of financing. Technology is especially dependent on venture capital. Low interest rates and booming stock markets around the world since the early 1990s provided plenty of cheap capital—too much, in some cases.

Disruption. Competitive markets facing worker shortages will tend to stimulate productivity via technological innovation. Technology is inherently disruptive across a wide range of businesses. That’s all very deflationary. Clearly, there is a tremendous incentive to innovate and use technology to lower costs. Firms that do so gain a competitive advantage that allows them to have a higher profit margin for a while. That’s especially true if their advantage is sufficiently significant to put competitors out of business. However, some of their competitors undoubtedly will innovate as well, and there is always the possibility of new entrants arriving on the scene with innovations that pose unexpected challenges to the established players.

Debt. The forces of deflation that had been mounting since the end of the Cold War were held back by rapid credit expansion around the world. Central banks were lulled by the decline in inflation and the proliferation of prosperity following the end of the Cold War into believing that they had moderated the business cycle. Indeed, they attributed this achievement to their policies rather than to globalization, and they dubbed it the “Great Moderation”—which presumably started during the mid-1980s but ended abruptly with the “Great Recession” in 2008. So they provided lots of cheap credit and enabled lots of borrowing by households, businesses, and governments.

The central bankers simply ignored the implications of soaring debt. Their macroeconomic models didn’t give much, if any, weight to measures of debt. Perversely, their easy monetary policies reduced the burden of servicing previous debts, which could be refinanced at lower rates, allowing borrowers to borrow more. By declaring that they had moderated the business cycle, the central bankers encouraged debtors to be less cautious about the potential dangers of too much leverage.

Around the world, governments borrowed like there was no tomorrow. In the United States, buyers bought homes with no money down and “liars’ loans,” where credit was granted without a formal credit check. In the Eurozone, banks lent to borrowers in Portugal, Ireland, Italy, Greece, and Spain (the “PIIGS”) as though they had the same credit ratings as German borrowers. That turned out to be a very bad assumption. Emerging market economies likewise could borrow on favorable terms despite their often spotty credit histories.

These credit excesses all hit the fan in 2008, and the consequences were clearly deflationary. The Great Moderation turned into the Great Recession. To avert another Great Depression, the central banks of the major industrial economies scrambled to flood the financial markets with credit. So far, their ultra-easy monetary policies have succeeded in offsetting the natural, peacetime forces of deflation. Of course, central bankers existed in the past when deflation prevailed but monetary theory and operating procedures were primitive. Today’s central bankers claim that this all proves they are better than ever at managing the economy with monetary policy. I hope they’re right, but I’m not convinced.

Demography. Demographic profiles are turning increasingly geriatric around the world. People are living longer. They are having fewer children. As a result of widespread urbanization, children no longer provide the benefit of labor in rural economies. Instead, they are a significant cost in urban settings. Economies with aging demographic trends are likely to grow more slowly and have less inflation.

Governments with aging populations are bound to borrow more. Governments challenged by rising dependence ratios—with the number of retiring seniors outpacing the number of young adult workers—don’t have much choice but to borrow money to meet their funding gaps. Debt accumulated for this purpose is likely to weigh on economic growth rather than to stimulate it.

The 4Ds combined tend to weigh on economic growth and are inherently deflationary. This explains why unconventional ultra-easy monetary policies have become conventional over the past 10 years. The central bankers are doing more of the same and getting the same disappointing result. Like Sisyphus of ancient Greek mythology, every time they push the boulder up the hill, it comes rolling back down.

Central bankers tend to be macroeconomists who were taught in graduate school that inflation is a monetary phenomenon. They were also taught to hate deflation as much as inflation. That’s why the major central banks have all pegged 2.0% as their Goldilocks inflation target, not too hotly inflationary or frigidly deflationary.

But surely, they must have learned over the past 10 years that inflation isn’t a monetary phenomenon after all. They must realize that the four powerful forces of deflation are microeconomic in nature.

In a speech in July 16 speech in Paris, Fed Chair Jerome Powell acknowledged in passing that inflation may not be solely a monetary phenomenon: “Many factors are contributing to these changes—well-anchored inflation expectations in the context of improved monetary policy, demographics, globalization, slower productivity growth, greater demand for safe assets, and weaker links between unemployment and inflation. And these factors seem likely to persist.”

He also acknowledged that these factors collectively may continue to keep the “neutral rate of interest low,” i.e., too close to zero, which is the dreaded “effective lower bound.” He concluded: “This proximity to the lower bound poses new complications for central banks and calls for new ideas.”

The problem is that the central bankers have run out of new ideas (and policy tools), so they keep trying the same old ones. Their delusion is that doing more of the same (i.e., ultra-easy monetary policy) should boost inflation to 2.0%. Maybe they should just give up on the notion that deflation is a bad outcome of the 4Ds and admit that they are trying to fix a problem that monetary policy cannot fix.

If they persist in their delusion and their ultra-easy monetary policies, the outcome will continue to be asset price inflation, especially in global equity markets. That’s fine, until it isn’t.

Monday, July 1, 2019

Embezzelcoin

In late 2017, when bitcoin was soaring toward a record-high price of $18,961 on 12/18/17, a distant relative asked me what I thought about the cryptocurrency. He had bought one bitcoin when it was around $4,000 in mid-2017. I said it reminds me of digital tulips. “What do you mean?,” he responded. He is a Millennial who had never heard of the Dutch Tulip Bubble from 1634-38. I explained what happened back then and noted that the bubble was mostly confined to Amsterdam, whereas the bitcoin bubble is global.

Of course, some bitcoin fans believe that bitcoin has a legitimate role in a portfolio as a hedge against the madness of central banks. I concede that point. However, as we saw last year, it can crash, which is what it did on its way back down by gut-wrenching 83% from the high of $18,961 on 12/18/17 to a low of $3,224 on 12/14/18. But now it’s back up to $11,171. It certainly is volatile and hardly a stable store of value, which makes it a very poor candidate to replace more stable forms of money.

Some of this volatility may be attributable to the illegitimate uses of bitcoin. I’ve noticed more news stories this year about hackers planting ransomware on the computer systems of small city governments in the US. They successfully extort tens of thousands of dollars in exchange for the software key to unlock the frozen computer systems. Payment has to be made in bitcoin.

In June, Riviera Beach, a city in Florida, paid hackers $600,000 in bitcoin with the hope of having its systems restored. Also during the month, Lake City, Florida facing a ransomware demand, authorized the payment of $490,000 in bitcoin to a hacker in order to regain access to its phone and email systems. At the end of the month, the village of Key Biscayne confirmed it had been hit by a cyberattack, though it wasn't clear if it was related to ransomware.

Cities and small businesses are becoming more popular targets for hackers, who recognize frequently unsophisticated systems. According to FBI estimates, there were 1,493 ransomware attacks in 2018, with victims paying a total of $3.6 million.

In my book, Predicting the Markets (2018), I wrote:

I’m particularly intrigued by the impact of bitcoin and other cryptocurrencies on our monetary system. Blockchain, the software that runs these digital currencies, is allowing banks to eliminate clearinghouse intermediaries in their transactions and to clear them much more rapidly. Smartphone apps allow consumers to use these digital devices to deposit checks and make payments. These innovations could reduce employment and bank branches in the financial sector, much as Amazon is doing in the retail space. Central bankers are scrambling to understand the implications of bitcoin and blockchain. In time, central banks likely will incorporate these technologies into their operations, perhaps spawning bitdollars, biteuros, bityen, etc.
I concluded:
Libertarians might long for a day when central banks are replaced by a monetary system based on a digitized currency that is unregulated by governments. I doubt that the central monetary planners will allow that to happen. But who knows? Technology has disrupted major industries. Maybe it will disrupt central banking!
The International Monetary Fund (IMF) is studying cryptocurrencies. The 6/27 IMFBlog is titled “Five Facts on Fintech.” It reviews the findings of a report titled, "Fintech: The Experience So Far." Based on its research, countries generally foresee the emergence of crypto assets backed by central banks. The study surveyed central banks, finance ministries, and other government agencies in 189 countries. More specifically:
The survey reveals wide-ranging views of countries on central bank digital currencies. About 20 percent of respondents said they are exploring the possibility of issuing such currencies. But even then, work is in early stages; only four pilots were reported. The main reasons cited in favor of issuing digital currencies are lowering costs, increasing efficiency of monetary policy implementation, countering competition from cryptocurrencies, ensuring contestability of the payment market, and offering a risk-free payment instrument to the public.
Increasingly, at the top of the list for the central bankers is the need to improve cybersecurity in the payments system. Banning cryptocurrencies that are not officially backed by central banks undoubtedly will be considered. Whether this is even feasible is a matter for future discussion.

Sunday, June 16, 2019

Running Out of Workers?

I am not convinced that the demand for labor was hard hit by Trump’s escalating trade war during May. Granted, payroll employment was weak last month, rising just 75,000 (Fig. 1). That compares poorly to the average gains of 186,250 per month during the first four months of this year and 223,250 per month during 2018.

The problem may be that all the anecdotal evidence of labor shortages is actually constraining the growth of payrolls. Perhaps we really are finally running out of workers, or at least those with the appropriate skills and geographic proximity to fill job openings. Consider the following:

(1) Openings. There certainly are plenty of job openings. They totaled 7.45 million during April, exceeding the number of unemployed workers by a record 1.6 million (Fig. 2).

(2) The most. Here were the industries with the most job openings during April: professional and business services (1.241 million), health care and social assistance (1.244 million), and leisure & hospitality (1.004 million) (Fig. 3). Those are roughly the same levels of openings as a year ago, when the job market was also widely deemed to be tight.

(3) The biggest. The biggest increases in job openings compared to a year ago have been in some of the most cyclical industries: construction (404,000, up from 258,000), durable goods manufacturing (322,000 up from 288,000), state & local government excluding education (359,000, up from 339,000), transportation, warehousing & utilities (373,000, up from 348,000), and financial services (365,000, up from 328,000) (Fig. 4).

(4) The least and the one big loser. Interestingly, neither mining & logging (33,000) nor information technology (131,000) is looking for very many workers. Job openings in retail trade fell from 1.032 million a year ago to 837,000 during April (Fig. 5).

(5) Labor force. Last year, the labor force increased 217,000 per month on average (Fig. 6). During the first five months of this year, it is down 119,000 per month on average. This must be exacerbating labor shortages.

(6) NILFs. The problem is that senior Baby Boomers (65 years old and older) are retiring and dropping out of the labor market faster than 25- to 64-year-olds are entering the labor market, while most members of the 16-24 cohort are still in school (Fig. 7).

Over the 12 months through May, the total number of people not in the labor force (NILFs) increased 428,000, with senior NILFs up 1.1 million, younger adult NILFs down 137,000, and student NILFs down 440,000.

(7) Small business owners. The report reviewing May’s NFIB small business survey showed that the demand for labor by small business owners remains strong. Last month, 38.0% said that they have job openings, which continues the readings in record-high territory (Fig. 8). The net percentage increasing hiring over the next three months was 21.0%, near previous cyclical highs. However, the percentage complaining of few or no qualified applicants for their job openings was 54.0%.

Twenty-five percent of all owners cited the difficulty of finding qualified workers as their Single Most Important Business Problem, equaling the record high. Fourteen percent of all firms reported using temporary workers. In construction, 59% had openings, and 93% of those openings were for skilled workers. No wonder that construction payrolls rose only 4,000 during May.

The NFIB survey’s job-openings series is highly inversely correlated with both the national unemployment rate (at just 3.6% in May) and the percentage of respondents who say that jobs are hard to get in the Consumer Confidence survey (at only 10.9% in May) (Fig. 9 and Fig. 10). All these indicators portray a labor market that’s been very tight through May, when payrolls rose much less than expected.

(8) Productivity to the rescue? Does it really matter whether payroll employment growth slows because we’ve run out of workers or because demand for workers is weakening? Either way, wages and salaries growth will slow and depress consumer spending and GDP growth. In our opinion, better productivity growth may have started to offset the supply constraints that are slowing payroll gains. Businesses will still have demand for their goods and services and will do what they can to produce more by boosting productivity.

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.