Thursday, April 13, 2017

Market-based chart updates

There are lots of things going on in the world, with the most significant, in my view, being the threat of nuclear war in/with North Korea, followed by deteriorating US-Russia and Mideast relations. On the domestic front, Trump has yet to make meaningful progress on an alternative to Obamacare or on tax reform, but he has made important progress with most of his nominees. However, if we don't get substantial progress on healthcare and taxes before year end, the economy could weaken as uncertainty mounts and people delay income and investment decisions. In the meantime, the nascent rebound in the manufacturing sector and the likelihood of improving corporate profits should sustain the economy for the next several months; but for now, the economy continues to plod along and markets are less than enthusiastic about the future.

What follows are updates of some of the more important charts—all based on market-driven prices—that I am following. These tell us what the market is thinking, as expressed in the prices of the dollar, gold, real and nominal interest rates, equity prices, volatility, swap and credit spreads, and commodity prices. As I read the charts, the market seems relatively unperturbed by all the turmoil, and hopeful that better times lie ahead. This in turn makes the market vulnerable to any shortfall vis a vis expectations, so now is one of those times to be cautiously optimistic rather than gung-ho.

If the US economy were a company, then the value of the dollar would be a good proxy for its relative attractiveness and its future prospects. The chart above shows two of the best measures of the dollar's value, on an inflation-adjusted, trade-weighted basis. By either measure, the dollar is moderately above its long-term average We can infer from this that the Fed has not printed more dollars than the world wants, though it might be guilty of supplying too few. On the other hand, it would appear that the dollar is one of the currencies in most demand, and that is encouraging since it means the US is attracting investment, and investment is the seed corn of future growth.

The chart above illustrates the tendency of commodity prices to move inversely to the value of the dollar (note that the dollar axis is inverted). In the past few years, however, both the dollar and commodity prices have moved higher. This is worthy of attention. I think it tells us that the rise in commodity prices has little or nothing to do with a monetary reflation (because a plentiful supply of dollars tends to boost the prices of most things (aka inflation), but rather more to do with a general strengthening of the global economy at a time when the US economy is expected to be one of the engines of stronger growth. Again, this is encouraging. 

The chart above shows the very strong correlation between industrial commodity prices and emerging market equities. That makes sense, because emerging market economies tend to specialize in the production of raw materials. I believe the rise in commodity prices reflects a general strengthening of global economies, so what's good for commodities is good for just about everyone, especially emerging markets. And as I pointed out in December 2015, emerging markets and commodities had been severely beaten up and prospects for their recovery were bright.


For years I've been amazed at the correlation between gold and TIPS prices, as shown in the chart above (note I use the inverse of the real yield on TIPS as a proxy for their price). The common denominator of both markets is the way they serve to protect people from risk. TIPS are a good hedge for inflation, they are default-free, and they are the only asset that guarantees investors a real rate of return if held to maturity. Gold, on the other hand, is a classic port in a storm for just about anything that makes people nervous about fiat currencies or government excesses. Gold and TIPS have been in a rough holding pattern for the past several years. Declines in gold and TIPS would likely coincide with improvements in the global economic outlook. That they have not yet fallen meaningfully is therefore a good sign that markets are still somewhat risk averse and less than optimistic.

It's almost always the case that stocks tend to weaken as fears tend to rise, as shown in the chart above. But the current level of fear and uncertainty (as reflected in the ratio of the Vix index to the 10-yr Treasury yield) is still quite modest compared to what we've seen in recent years. The Trump era seems to have brought with it a calming effect on global markets. 

Swap spreads are some of the best coincident and leading indicators of financial market and economic health. Spreads have been rising for the past year or so both in the US and in the eurozone, so that could be a sign of deteriorating economic and financial fundamentals. I've tended to dismiss the current rise in US swap spreads, however, because they are still within what we consider to be a "normal" range (20-35 bps); if anything, they were exceedingly low at the end of 2015 and only now have recovered to more normal levels. Eurozone swap spreads have moved substantially higher, however, and that is cause for concern. My guess is that eurozone swap spreads are elevated because of concerns that France could pull a "Frexit," and this could undermine the stability of the euro and the eurozone economy. This risk is not trivial, and is not one to dismiss lightly—unless you believe (as I do) that the demise of the eurozone would not be necessarily a bad thing. For the moment, I note that credit default spreads on French debt are declining (i.e., the market is worrying less about a Frexit since the political left seems to be ascendant for the moment), but this still bears watching.

 Speaking of credit default spreads, the chart above shows that they are relatively low here in the U.S., and that further suggests that systemic risks are low and markets are relatively confident about the future.

One persistent and salient feature of the past 6-7 years has been Treasury yields in the US that are very low relative to inflation, as the chart above shows. Some observers dismiss this with the argument that the Fed is keeping interest rates artificially low, but I'm not a buyer of that line of thinking. I think Treasury yields are very low because markets still have a palpable degree of risk aversion, and are thus willing to pay a lot for the protection of Treasuries. We see this same phenomenon all over the developed world: sovereign yields are unusually low. Most investors have a choice between holding Treasuries and holding riskier assets; that the price of Treasuries is unusually high relative to other assets (e.g., the earnings yield on the S&P 500 is substantially higher than the yield on 10-yr Treasuries) must therefore mean that investors are very distrustful of the outlook for the economy and for corporate profits. In other words, very low Treasury yields are a strong and reliable indicator of a market that is less than optimistic, to say the least. Show me an optimistic/enthusiastic market, and I'll show you nominal Treasury yields that are much higher than they are today.

 The difference between nominal and real yields is a measure of the market's inflation expectations. In the chart above we see that inflation expectations over the next 5 years (the green line) are 2%, and not surprisingly, that is what the CPI has averaged over the past few decades. Markets are not concerned about rising or falling inflation right now; it's steady as she goes. Kudos to the Fed for having managed monetary policy surprisingly well over the years.

The chart above is my attempt to show that the level of real yields on TIPS can and does tell us a lot about the market's expectations for real economic growth. Real growth has averaged about 2% during the current expansion, and 5-yr TIPS yields have averaged about zero. You can invest in the economy and expect to get an average real return of 2%, or you can invest in TIPS and earn a guaranteed zero real rate of return. Guaranteed real rates of return should always be less than expected real rates of return, should they not?. If and when TIPS yields rise significantly, this will be a good indicator that the market is expecting economic growth to accelerate. For now, it may be the case that the market is buoyed by Trump expectations, but to judge from TIPS yields, there is little or no evidence of much optimism.

The chart above shows the 6- and 12-month growth rates of private sector jobs in the US. If anything, jobs growth has slowed over the past few years, from just over 2% to currently about 1.7%. The manufacturing sector looks to be picking up, but the overall economy remains on a sluggish growth trend that of late has been declining modestly on the margin. No sign here of a Trump bump, and it's premature to expect one: we need to see meaningful tax and regulatory reform (or solid reasons to expect such) before getting excited.

Wednesday, April 5, 2017

The two major sources of our healthcare problem

As I noted two weeks ago, the problem with Obamacare is that "it attempted to rejigger a huge fraction of the U.S. economy, and that is something that is virtually impossible to accomplish in a successful fashion by government diktat. Only a freely functioning market economy can make something so huge and so complex work in an efficient manner." So the solution is to restore a freely functioning market to the healthcare industry. That sounds easy, but the complexities involved with undoing Obamacare are nearly intractable, and that is what has bogged down Congress' attempts to repeal and replace.

When faced with very complex problems, the best solution involves simplifying things as much as possible. Fortunately, John Cochrane has taken a giant step in that direction with his recent post. He has come up with what he refers to as the "two original sins" of healthcare regulation. These two sins explain most if not all of the problems that we face with healthcare today. 

The first original sin appeared in the 1940s, when the government agreed to allow companies to deduct the cost of health insurance, but neglected to allow individuals to do the same. (I've discussed this in a number of posts over the years.) This made health insurance provided by employers much cheaper than health insurance purchased by individuals. Not only that, but it created a strong incentive for employers to offer health insurance which covered a whole lot of things; and why not, if the costs were uniquely deductible by companies? Not surprisingly, the vast majority of us today get our health insurance either from our employer or the federal government, and most of the healthcare policies offered (or mandated) today cover all sorts of trivial expenses—it's like buying car insurance that includes oil changes. As a result, only 10.5% of healthcare expenses are paid for out of pocket, while the vast majority of expenses are paid for by third parties—consumers don't know what medical services really cost, and they don't care, so free market forces are absent. This tax distortion is also largely responsible for the problem of portability, since employees can't take their insurance with them when they change or lose their job. We could fix this problem easily by simply changing the tax code to allow everyone to deduct their healthcare insurance costs. 

The second original sin, Cochrane argues, is that "Instead of straightforwardly raising taxes in a non-distortionary way (a VAT, say), and providing charity care or subsidies -- on budget, please, where we can see it -- our political system prefers to fund things by forcing cross subsidies. Medicare and medicaid don't pay what the service costs, because we don't want to admit just how expensive that service is. So, large hospitals make up the difference by overcharging you and me instead." 

Instead of levying a tax designed to cover the cost of healthcare for the unfortunate among us, we have chosen instead to use a system of cross subsidies:

Cross-subsidies are dramatically less efficient than taxes. Cross-subsidies cannot stand competition. Low prices, efficiency, and innovation in the provision of services like health care come centrally from competition, and especially disruptive competition. With no competition -- especially no entry by new doctors, hospitals, clinics, insurance companies -- costs spiral up. As costs spiral up, the cost of the charity care spirals up. As that spirals up, the size of the cross-subsidies spirals up. As that spirals up, the need to restrict competition spirals up.

Read the whole thing.

ADP report not a blockbuster

Lots of hoopla today about the "blowout" ADP employment report. Yes, it greatly exceeded expectations (+263K vs +185K), but lost in the shuffle was the fact that the prior month's number (+298K), which was a true blockbuster, was revised down to +245K. As the chart below shows, what we're left with is nothing out of the ordinary. The economy is still on a moderate growth path, but it is probably getting stronger bit by bit, thanks to a revival in the manufacturing sector.

As the second chart above shows, there has been a burst of employment growth in the manufacturing sector in recent months. This is where the strength in the ADP comes from. It also corroborates other reports that show manufacturing is rebounding after sustaining an oil patch-related setback.

As the chart above shows, the service sector—which employs almost 10 times as many workers as the manufacturing sector—shows only modest improvement over the past year. It's too early to get excited about substantially stronger growth in the broad economy. There's excitement in manufacturing, but it's a very small piece of the GDP pie. 

Service sector industries do not have particularly impressive hiring plans, as the chart above suggests.

Nevertheless, it's still the case that the economic fundamentals have improved somewhat over the past year, particularly in the Eurozone, which had languished for a long time.

In order to get really excited, we're going to have to see Trump pull off a significant reform of the U.S. tax code. I'm still optimistic in that regard, but it's not going to happen soon.