Monday, September 18, 2017

Big Picture charts

The global economy and global financial markets are huge, but just how huge? Answer: a lot bigger than most people realize. Here are some charts which help put things in perspective. They also show that what's going on today is not unprecedented nor extraordinary. As always, all the charts contain the most recent data available at the time of this post.


Global GDP is roughly $80 trillion, about four times the size of the US economy. As the chart above shows, the global economy supports actively traded bonds and stocks worth $132 trillion, of which about 40% are US-based. There's nothing unusual about any of this, considering that a typical US household has a net worth (stocks, bonds, savings accounts and real estate) equal to about three times its annual income. 




As the charts above show, the market cap of Non-US equities has grown at a much faster rate than US equities since 2004 (US equities have grown at a 5.4% annualized rate, non-US equities at a 8.9% annualized rate). US equities are now worth about 50% of the value of non-US equities, down from more than 80%. Non-US equities have suffered somewhat, however, due to the dollar's 5% rise (on a trade-weighted basis) over the period of these charts, but that's relatively insignificant in the great scheme of things.


The defining characteristic of the current US economic expansion is its meager 2.1% annualized rate of growth, which stands in sharp contrast, as the chart above shows, to its 3.1% annualized rate of growth trend from 1965 through 2007. If this shortfall in growth is due, as I've argued over the years, to misguided fiscal and monetary policies, then the US economy has significant untapped growth potential and could possibly be $3 trillion larger today if policies were to become more growth-friendly.


As the chart above shows, the value of US equities relative to GDP tends to fluctuate inversely to the level of interest rates. This is not surprising, since the market cap of a stock is theoretically equal to the discounted present value of its future earnings. Thus, higher interest rates should normally result in a reduced market cap relative to GDP, and vice versa. Since 10-yr Treasury yields—a widely respected benchmark for discounting future earnings streams—are currently at near-record lows, it is not surprising that stocks are near record highs relative to GDP. If the economy were $3 trillion larger, however, stocks at today's prices would be in the same range, relative to GDP, as they were in the late 50s and 60s. Valuations are relatively high, to be sure, but not off the charts nor wildly unrealistic.


As the chart above suggest, over long periods the value of US stocks tends to rise by about 6.5% per year (the long-term total return on stocks is a bit more due to annual dividends of 1-2%). The chart also suggests that the current level of stock prices is generally in line with historical trends. 


Adjusting for inflation, we see that stock prices tend to rise about 3% a year, and the current level is not unreasonably high, as it was in the late 1990s.


US equities have significantly outpaced Eurozone equities over the past nine years. That has a lot to do with the fact that the US economy has grown faster as well.


US households (i.e., the private sector) have a net worth that is approaching $100 trillion. That figure has been growing at about a 3.5% annualized rate for a very long time. The current level of wealth is very much in line with historical experience.


Adjusting for inflation and population growth, the average person in the US is worth almost $300,000. That is, there are assets in the US economy which support our jobs and living standards (e.g., real estate, equipment, savings accounts, equities, bonds) worth about $300,000 per person. We are richer than ever before, but the gains are very much in line with historical experience. (Note: the last two charts are based on Q1/17 data from the Federal Reserve. Data for Q2/17 will be released Sept. 21st, at which time I will be able to update these charts.)

Wednesday, September 6, 2017

A better PE ratio

This post is an update to a 4-yr old post titled "Equity valuation exercises." Back then I observed that stocks were fairly valued according to a standard measure of PE ratios (prices divided by 12-mo trailing earnings per share from continuing operations). But they looked to be quite undervalued if measured against the most recent quarterly annualized measure of after-tax, adjusted corporate profits that is produced in the National Income and Product Accounts (NIPA).

Art Laffer long ago taught me the value of using NIPA profits. This measure of profits is based on information supplied to the IRS, and it is then adjusted for capital consumption allowances and inventory valuation. It's been calculated the same way since 1947, and we can be reasonably sure it doesn't artificially inflate profits (who would overstate their profits to the IRS?); Laffer calls it simply "true economic profits." Using this measure, which is calculated quarterly, also gives us a more timely measure of profits, compared to using a 12-mo average of profits.

Here is a chart of PE ratios for the S&P 500 using trailing earnings per share, which suggests that stocks today are moderately overvalued:


And here is a chart of PE ratios for the S&P 500 using NIPA profits (I've normalized the result so that the long-term average is the same as the average for the standard measure of PE ratios), which suggests stocks are only modestly overvalued:


Both methods produce similar results, but the NIPA method suggests that PE ratios are only about 13% above average, whereas the standard method suggests PE ratios are about 28% above average.

For the curious, here is a chart that compares NIPA profits to 12-mo trailing earnings per share (the latest NIPA profits, released last week, are as of Q2/17, while EPS are as of August 2017):


In my 4-yr old post linked above, I discuss some of the reasons for the divergence in these two measures of profits that began around 1990 (e.g., changing accounting standards and changing taxation regimes). Those problems don't affect the NIPA measure of profits, which is why I tend to prefer them.



The two charts above compare NIPA profits to nominal GDP. Note how strong profits have been since the recession of 2001. Since the end of 2001, NIPA profits have almost doubled (+185%), while nominal GDP has increased by only 80%.

Over the years I've argued that this is at least in part due to globalization. Large and successful US corporations have been able to generate a much higher level of profits by selling into the rapidly expanding global market. Global GDP has increased 125% since 2001.

All things here considered, it's not surprising that stocks have done so well of late, and that PE ratios are moderately above their long-term average.

Tuesday, September 5, 2017

12 charts to watch

North Korea remains the biggest threat to world peace, but markets remain nonplussed. Gold prices have inched higher, but are nowhere near levels that would suggest panic buying. The dollar has declined about 10% so far this year, but it is still trading above its long-term, inflation-adjusted average value relative to other currencies. Stocks show no sign of any significant correction despite trading near record highs. Sovereign yields are uniformly low, but still comfortably above their all-time lows of mid-2016.

Is the market overly complacent? Overly optimistic? Absurdly cheap or expensive? A great buy on dips? "No" is the best answer to all these questions, in my view. Nothing obvious is staring us in the face. I'm with Howard Marks in thinking that now is not a time to take on oversized risks, but neither is it a time to cash in all your chips.


I've been fascinated by the above chart for years. Why is it that the prices of two unique assets—gold and 5-yr TIPS—have been tracking each other for the past decade? The best answer I've come up with is that both are havens of a sort—safe ports in a storm. TIPS protect you against inflation and default, gold protects you from systemic collapse. At current levels they tell us that although conditions today are somewhat better than they were 5 years ago, investors are nevertheless still paying a premium for safety. The long-term average, inflation-adjusted price of golds is somewhere in the range of $500-600/oz., by my calculations; and in normal times the real yield on TIPS would be expected to trade around 1% to maybe 2%. Both are priced to a premium these days, which suggests risk-aversion is still alive and well in today's market.


The chart above shows that the real yield on TIPS tends to track the trend growth rate of the economy. With a real rate today of zero, the TIPS market seems to be expecting real growth of the US economy to continue to average about 2% per year, which is what we've seen for the past 8 years.


The value of the dollar vis a vis other currencies rose following the November elections, but it has fallen by about 10% so far this year. As the chart above shows, the dollar is still above its long-term, inflation-adjusted average against two baskets of currencies. No big message here, but it seems to rule out excessive optimism and excessive pessimism.


The chart above shows how the market has reacted to major events in recent years. The recent reaction to the heating up of North Korean risk is rather tepid, and significantly less than other episodes of panic attacks.


Last week's release of the ISM manufacturing indices for August was very encouraging. The chart above suggests that the new-found strength of the manufacturing sector points to overall economic growth of at least 3-4% in the current quarter. The Atlanta Fed's GDP Now forecast for this quarter currently stands at 3.2%, a bit better than the second quarter's 3.0%.


The manufacturing employment index was very strong, suggesting that manufacturers see improving conditions and thus plan to ramp up their hiring plans.


The upturn in US manufacturing mirrors a similar improvement in the Eurozone. Synchronized recoveries are always welcome!


Based on past correlations, the strength of the ISM manufacturing index says that revenues per share of major US corporations are likely to remain strong for the foreseeable future. Coupled with near-record profits, this provides a reasonable basis for a continuing rally in equity prices.


Not all industries are looking up, however. The August report on car sales was decidedly weak, as the chart above shows. Construction activity has softened in recent months, and bank loans to small & medium-sized businesses have been flat for over six months. Their are pockets of strength and weakness, and that probably means no boom and no bust, as I noted last month.


The US may be stuck in slow-growth mode, but emerging markets are on fire. Measured in dollars, the Brazilian stock market has climbed 150% in the past 20 months. It's still far below its previous highs, however. Brazil is hardly booming, though, but the outlook has changed from dire to somewhat promising. This is one of those cases where the market was expecting a disaster which has failed to materialize. Regardless, emerging markets are riding the crest of two powerful waves: a weaker dollar and rising commodity prices. There is reason to be optimistic about the outlook down south, mainly due to ongoing improvement in the outlook for fiscal policies and politics in general.


Industrial metals prices are up 66% in the past 18 months. This strongly suggests that global economic activity is picking up.


The fact that the dollar is now weakening as commodity prices rise (which is their natural tendency) suggests that the rise in commodity prices may reflect a weakening in the demand for dollars at a time when their supply is abundant, and that is a classic recipe for rising inflation. It's premature to make a big rising inflation call, however, since the bond market continues to expect inflation to be relatively low, in the range of 1.5-2.0% for the foreseeable future. As I mentioned last week, this is something to worry about, not a reason to panic.

Wednesday, August 30, 2017

Something to worry about

Back in early 2014 I argued that the return of confidence was something to worry about, since that would mean reduced demand for money, and that in turn would make life difficult for the Fed. If the Fed didn't respond to declining money demand with sufficient vigor (e.g., by pushing interest rates higher and/or reducing excess bank reserves), that could sow the seeds of rising inflation and eventually lead to another recession. As I've noted many times on this blog, severe Fed tightening designed to combat rising inflation has been the proximate cause of nearly every recession in the past 50 years. Here's one such post, "How to know if Fed policy is a threat to growth."

My concern was obviously premature at the time, but it's been in the back of my mind ever since, and I'm starting to get worried again. Consumer confidence has jumped in the past year, and the demand for money has weakened more than at any other time in the current recovery. My concerns may again prove premature, but this is not a trivial issue and thus it bears close scrutiny.


According to both the Conference Board and the University of Michigan surveys, consumer confidence has risen significantly in the past year. It's not yet at all time highs, but it's certainly a good deal better that it has been for the past 8-9 years.


Small business optimism has surged since the November election. "Animal spirits" are on the rise.


First-time claims for unemployment relative to total payrolls have fallen to the lowest levels in recorded history. This means that the chances of a worker being laid off today are lower than ever before. Job security, in other words, has never been higher. And let's not forget that the unemployment rates has dropped to 4.3%, and it has rarely been lower in recent decades. It's not surprising, then, that confidence is rising and for good reasons.



As the two charts above show, the growth of bank savings deposits has slowed significantly in the past 6-7 months, after growing strongly ever since early 2009. Recessions and economic turmoil almost always make bank savings deposits attractive, especially relative to riskier alternatives. Demand for safety typically declines in the latter stages of an expansion, when people's appetite for risk rises in line with rising confidence. So it's normal for rising confidence to be reflected in slower growth of bank deposits.

Bank savings deposits in the past six months have risen at an annualized rate of only 2.5%—that's the lowest rate so far in the current business cycle expansion. Since bank savings deposits comprise comprise about two-thirds of the M2 money supply, slow growth in savings deposits has been matched by a slowdown in the growth of the money supply, which has registered annualized growth 5.3% over the past six months, down from the 6-8% rates of growth that have prevailed over the past six years. Declining growth in the money supply doesn't mean, however, that the Fed has been tightening—more likely it means that the demand for money has been weakening.


The above chart is arguably the most powerful illustration of how strong money demand has been in the past 8-9 years: the ratio of M2 to nominal GDP. Nominal GDP is a proxy for national income, and M2 is arguably the best measure of readily-spendable money. Think of this chart as measure of how much money the average person wants to hold relative to his annual income. It's risen from 50% prior to the Great Recession to 70% today. That's huge, and one of the defining characteristics of the current business cycle expansion—a massive increase in the demand for money.


People now have parked an unprecedented amount of their annual cash flow in retail money market funds, small time deposits, currency and bank savings deposits—and the bulk of the increased money holdings are in the form of bank savings deposits. What's even more impressive, however, is that none of these vehicles pays much in the way of interest. People are holding lots of money not because they like the return on money, but because of its safety.

This huge increase in the demand for money also explains why QE wasn't inflationary. The banking industry, faced with huge infusions of deposits, was happy to lend all that money to the Fed in exchange for the new bank reserves that the Fed created via its QE operations. People wanted more money, and banks wanted more reserves (banks were very risk-averse, just as most people were), and QE effectively accommodated that change in preference. If the banks hadn't wanted to lend all that money to the Fed, but instead to the private sector (and assuming the private sector had wanted to borrow a lot more), the result would have been a massive expansion in the amount of money in the economy, and a lot more inflation. But that didn't happen, thanks to increased money demand.

We now may be on the cusp of a reversal in the huge increase in money demand. With increased confidence, the public is becoming less desirous of accumulating money balances. The growth of bank savings deposits has slowed significantly, and it is now less than the growth of incomes. People may now be desirous of decreasing their holdings of cash relative to incomes. But since cash can't disappear, the public can only accomplish a reduction in their relative holdings of money by bidding up the prices of other things. Less demand for money means a lower price for money and a higher yield on money, plus higher prices for things and eventually higher nominal incomes. That's another way of saying that a decline in money demand is likely to result in an increase in inflation—unless the Fed takes offsetting measures.



Fortunately, the Fed is already in the process of accommodating this new shift in the demand for money. They have raised nominal and real interest rates on money (though the real interest rate on bank reserves is still less than zero), and they have allowed excess bank reserves to decline from a high of $2.7 trillion to now $2.2 trillion. But these are still baby steps.

I note the recent rise in gold prices (+15% year to date) and the decline in the value of the dollar (-9% year to date). Both are symptomatic of an excess of money relative to the demand for it, and thus they could be evidence that the Fed is falling behind the inflation curve.

Much hangs on just how much and how fast the public's demand for money declines, and how fast and how much the Fed is able to offset that by raising interest rates and reducing excess reserves in the banking system. So far things look OK, but it certainly pays to keep an eye on these developments.

Wednesday, August 23, 2017

No looming debt crisis

Perhaps it's the relaxation induced by 12 days on my favorite Maui beach. But try as I might—and I'm spending a few hours each day keeping abreast of economic, financial and political developments—I can't get concerned. The world seems to doing OK, the U.S. economy is still growing at a moderate pace (roughly 2% or so), financial markets display few signs of distress, and there is no shortage of analysts predicting bursting bubbles and general economic and financial mayhem.

President Trump is center stage, distracting the left and the MSM with his absurdities and his tweets, while slowly dismantling burdensome regulations, restoring the rule of law, rebuilding the military, and protecting American interests. We're still saddled with a mess of a healthcare system and an absurdly bloated and burdensome tax code, but even small victories in healthcare and tax reform could unleash significant upside economic potential. Big, stupid government has been a headwind to progress for many years, but the good news is that government is getting slightly less burdensome these days and there is hope that this can continue.

The charts in this post reinforce in part the message of an earlier post, No boom, no bust, by focusing on the absence of evidence of a looming credit crisis. If there's a problem in the credit sphere, it looks to be limited to student loans, and although it's hard dismiss this problem—which has created a huge burden for students and taxpayers—it's nice to know that student loans are no longer growing at breakneck speed.


Student loans grew at a frenzied 68% annual rate in the two years following Obama's 2009 decision to federalize the program and liberalize their issuance (virtually all student loans now come from the federal government). Since then they have grown 360% and now total over $1 trillion. This is problematic: according to the NY Fed, student loan default rates at the end of 2016 were 11.2%, up sharply from the 6.7% rate which prevailed in FY 2007. The good news is that student loans grew at a mere 4% annualized rate in the three months ending June '17. The problem is acute, but improving on the margin.

Whether we will avoid massive defaults and dislocations remains to be seen, but I wouldn't rule out a scenario in which taxpayers pick up the tab for hundreds of billions of defaulted and/or forgiven loans. Handing out mortgage loans willy-nilly is what led to the housing crisis, and it's likely we will see some kind of student-loan crisis in coming years. Fortunately, student loans are still a relatively small share of total credit: 28% of consumer credit, 11% of total home mortgages, and about 7% of total household liabilities. Unlike the housing crisis, in which trillions of flaky mortgages were used as collateral for trillions of financially-engineered securities which in turn were held by investors all over the world, the U.S. government is the one with the most exposure to loss—and these days, $1 trillion isn't a whole lot of money. A bursting of the student loan bubble is very unlikely to precipitate another global financial crisis.


With the exception of student loans, consumer credit has barely increased since 2007. Virtually all of the growth in consumer credit in the past 10 years has been in the student loan category.


C&I Loans, a good proxy for bank lending to small and medium-sized businesses, have grown a mere 2.4% in the past year, after years of double-digit growth. But the slowdown in bank lending to this sector is not necessarily problematic.


Relative to GDP, C&I Loans stopped growing a year or so ago, and are now beginning to decline. The fact that C&I Loans relative to GDP have rarely been higher than they were last year suggests that the slowdown in C&I Loan growth has more to do with a corporate sector that is satisfied with its current debt load than it does with a reluctance of banks to continue lending.

It's very important to understand that the current Fed "tightening" is fundamentally different from previous tightening episodes, thanks to QE. Before QE, the Fed raised rates by reducing the supply of bank reserves; this created a shortage of liquidity and resulted in higher interest rates. Reduced liquidity and higher borrowing costs eventually brought the economy to its knees by squeezing nearly everyone. This time around, the Fed is increasing short-term rates directly while keeping bank reserves relatively unchanged, and rates are still very low in both nominal and real terms. Bank reserves are still abundant (excess reserves today are about $2 trillion, whereas they were a mere $9 billion at the end of 2007), and thus it is not surprising that there is no sign of a shortage of liquidity in the banking system. Swap spreads are quite normal and credit spreads in general are relatively low. Nobody is getting squeezed by the Fed.


The delinquency rate on C&I Loans, as of June '17, was only 1.4%. Very few borrowers are getting squeezed these days. From an historical perspective, it's hard to see that banks are exposed to a collapse in business credit.


The delinquency rate on all bank loans and leases has rarely been lower than it is today. Bank credit totals almost $13 trillion these days, and in the past year this measure of credit has grown by about 4%. That's down from 7-8% annual growth a few years ago, but it's not by any means scary.


Household leverage has declined significantly since its 2008 peak. Household balance sheets are in pretty good condition these days. Compare today's leverage with the high levels that preceded the 2008 financial crisis.


Household financial burdens (monthly payments as a % of disposable income) have rarely been lower than they are today.

OK, it's time to get back to the beach and relax.

UPDATE: The Mortgage Bankers Association today released the Q2/17 mortgage foreclosure data. Foreclosures fell to a mere 1.29% of outstanding mortgages. Only 4.24% of mortgages were delinquent. Both of these numbers are very low. Homeowners are not being "squeezed" by mortgage rates, which have been very low for most of the past 5 years.



Thursday, August 10, 2017

The Nork Wall of Worry

Kim Jong-un is making today's headlines with his threats to attack Guam in short order and somewhere in the US at a later date—and to attack with nuclear weapons no less. He's also sparked a mini panic attack in global markets. But so far, markets have been quite blasé about the threat that North Korea poses. The chart below puts things in perspective, as of 7 am beach time:


Believe it or not, the threat of imminent nuclear hostilities is (so far) just a blip on the market's radar screen. About as big as the threat of a Frexit, but far less than Brexit, collapsing oil prices, or a Chinese economic implosion. If you want protection from a nuclear holocaust, options are still relatively cheap, with the Vix this morning trading around 14-15, up from a very low 10 a few days ago.

So either the market is ridiculously unconcerned, or the market rates the chances of a nuclear explosion as remote. Considering that the So. Korea stock market is down less than 4% in the past few weeks, it's probably the latter. (You would think Seoul has the most to lose if Kim Jong-un gets crazy enough to start pushing launch buttons.) I note as well that gold is up only 2% or so in the past week.

I'm not offering investment advice here, I'm merely laying some facts on the table.


It's also worth noting that industrial metals prices yesterday reached an 18-month high, having risen more that 60% from their January 2016 low, as the chart above shows. That's pretty impressive, and it suggests that global economic activity has definitely perked up.

I'm reminded of the fact that the recession of 2001 ended just a few months after the 9/11 attack. The US economy is amazingly resilient, and the global economy perhaps just as resilient.

Monday, August 7, 2017

Credit spreads tell a bullish story

Credit spreads—the extra amount of yield that investors demand to hold debt that is riskier than Treasuries—are uniformly low these days. That tells us that liquidity in the bond market is abundant, systemic risk is low, and the outlook for corporate profits and the economy is healthy. '


Swap spreads (see a short primer on swap spreads here) are arguably the bedrock and most important of all credit spreads. "Normal" spreads on 2-yr contracts are roughly 20-40 bps. At today's 25 bps, 2-yr swap spreads are perfectly normal. This tells us that bond market liquidity is relatively abundant. Fed tightening has not created a shortage of money, as it usually does in advance of recessions. It also tells us that systemic risk is perceived to be low. As the chart above suggests, swap spreads tend to be good predictors of conditions in the broader economy; spreads tend to rise in advance of recessions and decline in advance of recoveries.


As the chart above shows, swap spreads in the Eurozone are elevated. Conditions are not as healthy there as they are here. Eurozone spreads are not dangerously high, but they do reflect some systemic risk, which is likely related to the perception that the Eurozone still faces existential risks from countries thinking about "exiting" the Eurozone. Given the higher spreads in the Eurozone, it is not surprising that Eurozone GDP growth has been lagging that of the US for a number of years. Riskier markets tend to receive less investment—and consequently less growth—than less risky markets.


The chart above shows credit spreads as derived from the universe of bonds issued by US corporations: $6.3 trillion of investment grade bonds, and $1.3 trillion of high-yield (junk) bonds. Both spreads are relatively low, as you would expect them to be in a healthy, growing economy. They are not at record lows, but they are low enough to be impressive.


The chart above compares 2-yr swap spreads to high-yield corporate spreads. Here we see further evidence of how swap spreads tend to be good predictors of the health of the economy (HY spreads are particularly sensitive to the underlying health of the economy).


The chart above shows 5-yr Credit Default Swap spreads. CDS spreads are derived from generic contracts representing hundreds of large, liquid corporate bonds, so they are reliably good proxies for overall credit risk. Their message is the same as other credit spreads: conditions are normal, and thus the outlook for the economy and corporate profits is healthy.