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.

Commercial real estate still strong

A quick update on the health of the commercial real estate market, which remains quite good. According to the folks at CoStar, their composite (equal weighted) price index rose a staggering 17.5% in the 12 months ended June, 2017. Price gains were strongest in the lower-priced, secondary and tertiary markets. Gains in higher-priced and larger markets were a solid 5% over the same period.


Impressive.

Tuesday, August 1, 2017

No boom, no bust

My reading of the economic and financial tea leaves is that the economy continues to grow at a sub-par pace (about 2%), just as it has for the past 8 years. I don't see evidence of a coming boom, nor of an imminent bust. I think the market expects roughly the same thing; it's not priced to either a boom or a bust, just more of the same. Dull.

Here are a baker's dozen charts, with the latest updates, to flesh out the story:


The chart above is one of my enduring favorites. It shows that the ISM manufacturing index does a pretty good job of tracking the growth rate of the economy. What's especially nice is that the index comes out with a relatively short lag of just a week or two, whereas we usually have to wait months to get a read on the economy. What it's saying now is that GDP growth in the current (third) quarter is likely to be in the range of 2-4% annualized. That won't necessarily mean that the underlying pace of growth is picking up though; it's more likely that some faster reported growth in the current quarter which will make up for the relatively weak growth of recent quarters. Such is the volatile nature of GDP stats.



The two charts above are encouraging, since they show that global economic activity is likely picking up. US manufacturers are seeing relatively strong overseas demand, and Eurozone manufacturers have experienced a significant improvement over the past year or so, after years of weak activity.


The chart above shows that US manufacturers are at least somewhat optimistic about the future of their businesses, since many reportedly plan to increase hiring activity in the months to come.


The chart above shows that the ISM manufacturing index does a pretty good job of predicting corporate revenues. For months now, the ISM index has been telling us that revenues per share for the S&P 500 were likely to increase, and they have indeed in increased by over 5% in the 12 months ended July. 


Not surprisingly, faster growth of revenues has gone hand in hand with increased profits. Trailing 12-month earnings per share (earnings on continuing operations) were up over 9% in the year ending July. No wonder the stock market continues to edge higher. Profits and prices are both at all-time highs and rising.


The current trailing PE ratio of the S&P 500 is just over 21, according to Bloomberg's calculation of earnings from continuing operations. That's a good deal above its long-term average of just under 17, but it's not impossibly high. The inverse of the PE ratio—the earnings yield on stocks—is still a healthy 4.7%.


The chart above subtracts the yield on 10-yr Treasuries from the earnings yield on stocks. Equity investing still gives you a yield that is substantially higher than the risk-free yield on Treasuries. It's not always thus. In fact, during periods of robust growth and strong stock markets—such as the 1980s and 1990s—the earnings yield on stocks was usually less than the yield on Treasuries. When investors are confident and the economy is strong, investors are willing to accept a lower yield on stocks because they expect to more than make up for that with capital gains (i.e., rising share prices). The situation today is quite the opposite: a positive equity risk premium suggests that investors are skeptical of the ability of earnings to grow, and are thus willing to accept a lower yield on Treasuries in exchange for their increased safety.


Not all is rosy, however. As the chart above shows, the dollar has taken quite a hit since the "Trump bump" of last November. It's down about 10% in the past 8 months, in what is surely a sign that the world has become a lot less excited about the growth prospects of the US economy.


The chart above provides more evidence that the market doesn't expect the US economy to be very strong going forward. The current real Fed funds rate—the best indicator of whether monetary policy is tight or not—is about -0.25%. The current 5-yr real yield on TIPS (a good indicator of what the market expects the real funds rate to average over the next 5 years) is only 0.11%. This means the market doesn't expect the Fed to do much more in the way of tightening for the foreseeable future. And that, in turn, means the market holds out very little hope for any meaningful improvement in the US economy.


The chart above suggests there is very little reason to expect a recession for the foreseeable future. Every recession for the past half century has been preceded by a monetary tightening sufficient to raise real short-term rates to at least 3-4%, and to flatten or invert the Treasury yield curve. We're a long way away from either of those conditions today. The Fed is relatively easy, and is not expected to tighten much, if at all, because the economy is not expected to improve much, if at all. 


The chart above compares the 2-yr annualized growth of real GDP to the 5-yr real yield on TIPS. I use a 2-yr measure for GDP to "edit out" the quarterly fluctuations which are more due to statistical vagaries than to any real change in the economy's strength. The chart suggests that the current level of real yields is a sign that the market thinks the economy is still likely on a 2% growth trend. (The latest revision to GDP boosted growth during the 2014 -2015 period, but reduced it in the past two years. That is consistent with my repeated observations that the trend growth rate of jobs has slipped in the past year or so from 2.0% to 1.6-1.7%.)

Another not-so-rosy-sign is construction spending, which has softened and dipped year to date. This could just be a pause that refreshes, but in a worst case scenario—if this weakness continues—it could be an early warning sign of another recession. I doubt that is the case, since mortgage originations and home sales are still relatively healthy, but if you want something to worry about, here it is.


I highlighted this chart a few weeks ago, noting that the stability of China's foreign reserves this year is a healthy sign that the yuan has moved to a level that is balancing capital flows (forex reserves under a floating-pegged currency regime such as China's are a direct measure of net capital flows). The yuan has appreciated a bit more of late, a sign that the situation in China is improving on the margin (more money wants to get in than out). Good news from overseas is always good news for the US, especially for a major player like China.

To sum up: I see no sign of excessive optimism or pessimism in market prices. The market's expectations are for a dull economy to remain dull and for inflation to remain relatively low. 5-year expected inflation, according to TIPS and Treasury prices are 1.7%. There is no compelling reason to worry about a recession, or to get excited about a boom. The market is thus "vulnerable" to signs of emerging weakness or increased strength. If we get a decent tax reform package, look for optimism to emerge. If we don't get tax reform, the downside risk is likely not significant, since reform expectations have not been priced in. Fortunately, we have had some meaningful reform in the area of regulatory burdens so far this year, and this should give the economy enough of a lift to keep things on an even, 2% growth trajectory or maybe slightly better. 

Saturday, July 29, 2017

Easy healthcare fixes

Congress has once again failed to fix the problem of healthcare—a problem exacerbated (but not created) by Obamacare. Arguably, the main reason for this failure is the fact that trying to manage the healthcare industry by government fiat is impossible. It's manifestly impossible for any collection of politicians and bureaucrats, no matter how smart or how well-intentioned, to design a healthcare system that covers pre-existing conditions, expands access, improves services and lowers costs. The best and most efficient healthcare system can only be achieved by a freely-functioning market that is not burdened by government meddling, subsidies, regulations, or mandates.

The best way to "fix" healthcare is to get the government out of the business of "fixing" healthcare. Steve Horwitz has a few simple suggestions that would go a long way to improving  the healthcare industry. (Big HT to Mark Perry!)

If you want to really reform health care and make it cheaper and provide easier access, you can start with the following, after you end the ACA:
1. End the tax-favored treatment of employer-provided insurance
2. End the limits on interstate competition in the insurance market
3. End the community standards legislation
4. Tort reform
5. Deregulate the supply side of the market by loosening or ending licensing provisions and the AMA's monopoly on the supply of physicians.
6. Encourage the development of more walk-in clinics and other ways of avoiding third-party payment.
7. Encourage health insurance to be actual insurance for major medical problems, not third-party payment for health maintenance
8. Expand the use of pre-tax dollars in health savings accounts
There are surely more. But all of these have been on the table as alternatives for years. They would work from both the supply and demand side to accomplish the goals of lower cost and higher quality care.

It would not guarantee universal coverage, but the cost of covering everyone is that you give up on lowering cost and will eventually have to ration supply. You cannot have lower costs, expanding supply, and universal coverage. At best, pick two.

While this would help a great deal, it doesn't address the problem of the poor, the unfortunate, and those with pre-existing conditions. Fortunately, there are ways to solve this problem, as I discussed in this post—as John Cochrane has proposed, we should raise taxes to directly support charity care and subsidies, instead of using the system of cross-subsidies that so greatly distorts things today.

I posted the chart below a long time ago, and it bears repeating:


Since the consumers of healthcare are for the most part not the ones who pay the bill, there is no price discovery, there is no transparency, and there is no way for competition to work effectively to reduce prices and improve services. We must get rid of the third party payer problem if we want to have any chance of improving the healthcare industry. That can be accomplished very easily by changing the tax code: for example, let everyone deduct the cost of healthcare insurance. Since WW II, the government has allowed only employers to deduct the cost of healthcare insurance. This created a powerful incentive for everyone to get as much healthcare insurance as possible (insurance that covers not just major expenses but also very minor expenses) from their employer. And it's now the case that almost 90% of all money spent on healthcare is spent by someone other than the person receiving healthcare services.

Suppose we did the same thing for food. Suppose we said as a society that food was a universal right; that it would be inhuman to not provide quality food for everyone. Suppose we made food a single payer commodity—let everyone have access to food and have the government pay for it all. What incentive would there be for producers to supply all the things people want and in the right quantities? Why would anyone buy what are now the cheap cuts of beef? Think of the amount of food that would go to waste in people's refrigerators. Soon there would be shortages of food, and the inevitable result would be the rationing of food. Single payer for anything can never be a good solution. History is littered with failed experiments in single payer, aka socialism.

It is immoral to declare a "right" to healthcare, because by doing so we make anyone who works in the healthcare field a slave of everyone else. No one should have the right to the services of someone else—to argue otherwise is to condone slavery, and ultimately to empower the government at the expense of the liberty of all.

Fixing healthcare isn't really all that difficult. What's difficult is accepting the reality that government can't fix healthcare except by drastically reducing its influence on the healthcare market. We don't need a government healthcare fix; we need to restore market forces to the healthcare industry.


Thursday, July 20, 2017

Global green shoots

If you want bad news and arguments for why the market is due to collapse any day now, just spend a few hours reading Zero Hedge or browsing the media and punditry. Very few observers these days are willing to pound the table for stocks, considering they have been rising for more than 8 years and are hitting new highs almost every day. Is there anyone who isn't dismayed that Trump and the Repubs haven't been able to repeal and replace Obamacare after years of trying? Is there anyone who is confident that Trump and the Repubs will succeed in massively lowering tax rates? I don't see any evidence that the market is pricing in a stronger economy: 5-yr real yields on TIPS are a mere 0.15%, a level that suggests the market is priced to sluggish growth for as far as the eye can see. And then there are the geopolitical risks. The chances of North Korea dropping a nuclear bomb somewhere are frighteningly high, and China seems bent on expanding its ocean domain. And of course, the Fed is in tightening mode, and tight monetary policy has been the precursor of every recession in modern times.

Yet amazingly, despite the obvious problems out there, complacency reigns: the Vix Index and the MOVE index (the bond market's version of the Vix) are both down to all-time lows. Isn't it scary that the market is moving higher at a time when there are so many troubling things going on and complacency is rampant? Anyone in his right mind would be concerned, no?

Investors are on the horns of a dilemma: it's tough to be bullish, but it's also expensive to be bearish. The earnings yield on stocks is still quite high relative to the yield on cash and bond market alternatives; so hiding out in cash means giving up a lot of precious yield. But almost $9 trillion in bank savings deposits paying almost nothing says that there are lots of people who are reluctant to take on market risk. Indeed, when I look at the market, I see more evidence of caution than I do of exuberance. Bill Miller, a long-time friend and former colleague, maintains that the market is still in a "safety bubble" after the shock of 2008. I've long observed that real yields on TIPS are miserably low, and for that matter nominal yields on sovereign bond markets nearly everywhere are very low. So it's not at all obvious that the market is running on fumes.

Amidst all the worries, however, there are actually some encouraging developments. Call them global green shoots. The U.S. may be stuck in slow-growth mode, but the rest of the world is looking better on the margin. Some charts follow which help flesh out the story:


China is pulling back from the abyss, after scaring the bejesus out of nearly everyone two years ago (check out the "Walls of Worry" chart below), when it looked like their stock market and economy were tanking. As the chart above shows, real GDP growth now looks to have stabilized in a 6-7% range.


As the chart above shows, China's forex reserves have been stable for most of this year, after having plunged from $4 trillion to $3 trillion over the previous two years. The fact that the yuan has stopped falling suggests that the central bank has managed to maneuver the yuan to a level that is balancing capital flows. This further suggests that the fundamentals in China has improved significantly in the past two years. Capital inflows and outflows are about equal these days. (The level of forex reserves is a direct result of net capital flows; reserves decline when outflows exceed inflows, and vice versa.)


Due to the yuan's strength and relative stability against the dollar, inflation in China is virtually identical  to inflation in the US, and it has been for a number of years. This further suggests that the Chinese currency could remain relatively stable against the dollar going forward. What's good for China is good for the world.


As the chart above shows, the Chinese stock market has been trending higher for the past 18 months after the bursting, beginning in mid-2015, of what in hindsight looks like a huge speculative bubble. Now that the dust of that bursting has settled, we see that the Shanghai Composite has actually kept pace with the S&P 500 over the past four years. This is a problem? On the contrary.


The Eurozone has been struggling for many years and continues to struggle. Since the beginnings of our bull market in March, 2009, Eurozone stocks have underperformed their US counterparts by over 30%, as the chart above shows.


But as the chart above shows, Eurozone industrial production now is outpacing US industrial production.


Eurozone ISM manufacturing surveys confirm that the industrial side of the Eurozone economy is regaining its health. And the Euro is strengthening on the margin of late, another sign that the outlook for Europe is not as gloomy as it used to be.


Industrial metals prices are up strongly in nearly every currency over the past 18 months. This is an excellent sign that global economic activity is picking up.



Emerging market stocks have been doing exceedingly well in the past 18 months, as the charts above show. In dollar terms, the Brazilian stock market has more than doubled and the MSCI emerging market equity index (second chart) is up some 50% since early last year. It's not that emerging economies are booming; rather, it's that the outlook has improved from dismal to maybe Ok. Emerging economies are also being bolstered by stronger commodity prices: the CRB Spot Commodity index is up 20% in the past 18 months.


The current PE ratio (using 12-month trailing earnings from continuing operations) of the S&P 500 is just under 22. That's well above its long-term average, but is that a sign of unwarranted exuberance?


Not necessarily. Earnings are growing, as the chart above shows. 12-month trailing earnings are up more than 7% in the past year, and we see positive earnings surprises almost daily.


The current earnings yields on stocks (the inverse of the PE ratio) is 4.6%. That means that if earnings held steady at current levels and if companies paid out all their earnings, the dividend yield on stocks would be 4.6%. The chart above compares the earnings yield on stocks to the yield available on risk-free 10-yr Treasuries. It's unusual for stocks to yield a lot more than risk-free bonds, as they do today. By this measure stocks look cheap. About as cheap, in fact, as they were in the late 1970s, when the world was terrified of stocks. When the stock market is fueled by optimism, as it was in the 1980s and 1990s, the yield on stocks is typically less than the yield on bonds. People are willing to accept a lower yield on stocks because they expect that stock prices and dividends (and earnings) will rise in the future.


The chart above shows yields on a variety of different investments, from Treasuries to mortgage-backed securities to corporate bonds, REITs and emerging market debt. The yield on stocks stacks up quite favorably to the alternatives, and that again is unusual. If the market were optimistic, the yield on stocks would be much lower than the yield on less risky alternatives. Put another way, when the yield on stocks is relatively high, thus the price of stocks is by inference relatively low.


Shown above is an update of one of my favorite charts. The equity market rally which began last November has been driven in no small part by a decline in fear and uncertainty, coupled with a belief that the economy is likely to continue to be relatively sluggish but also relatively stable (which is reflected in a modest rise in 10-yr Treasury yields since November).


The chart above shows the implied volatility of stocks and bonds. Both are now at new lows: that means the stock and bond markets have never been so unconcerned about the future. In a sense, the capital markets appear to be pretty sure that nothing much is going to happen to the economy for the foreseeable future: growth is going to remain modest, inflation is going to remain relatively low, and the Fed is not likely to upset the applecart. In addition, the market seems pretty sure that earnings are not going to increase, and are more likely to be flat or to decline.

To sum it up, although the market is priced to mediocrity (sluggish growth, flat to lower earnings), the global green shoots are hinting that the future may be a bit more exciting. If Trump and the Repubs manage to pull off a successful tax reform, then things could get really exciting.

Thursday, July 13, 2017

Fiscal policy dreaming

The Federal government last month passed a dubious milestone, having spent $4 trillion over the previous 12-month period for the first time ever. That works out to over $11 billion per day. To make matters worse, the budget deficit is once again on the rise, as spending is outpacing revenues. The budget deficit is now running over $700 billion per year, or roughly 3.4% of GDP, up from a post-recession low two years ago of $411 billion, or about 2.2% of GDP.

Although we obviously need to rein in spending, it would also be smart to cut taxes, particularly corporate taxes. The Feds collected $300 billion from corporations over the past year, which was less than 15% of adjusted corporate profits (according to NIPA figures) in the year ended last March. A relative handful of corporations reportedly hold well over $2 trillion in profits they refuse to repatriate—they've already paid tax once on that money overseas, why pay another 35% for the "privilege" of repatriating the money? If corporate income taxes were lowered, say, to 15%, the Feds might wind up doubling corporate tax collections (15% of $2 trillion) overnight as those profits were repatriated, and everyone would be thrilled. Most importantly, however, a much lower corporate tax rate would most likely result in a reverse wave of corporate inversions—the U.S. would instantly become the most attractive place on earth to do business! With companies rushing to repatriate profits and new companies rushing to relocate here, it's a safe bet that employment would surge and individual income taxes would surge as well. What's not to like about that?

Just about everyone—on both sides of the aisle—agrees that corporate income taxes are too high. Why is this such a hard problem to fix? It's the lowest-hanging fruit out there. Instead, the Republicans are struggling with healthcare reform, which is not something that government can easily achieve. The healthcare industry responds weakly (and mostly negatively) to politician's ministrations, but it would surely respond powerfully and productively if the heavy hand of government were removed altogether. Free markets always beat administered markets. The proper role of government might be limited to administering subsidies to the poor and the unfortunate among us, but then again that's what charity is for. I've always believed that private charities work far better than government bureaucracies at taking care of the sick and the poor. I have more discussion of this in a recent post.


In the 12 months ending June 2017, federal spending totaled just over $4 trillion, while revenues were $3.3 trillion. Spending is rising at a 6-10% pace, whereas revenues have been stagnant for the past 16 months.


The weakness in revenues can be traced to individual and corporate income tax collections. Payroll taxes have been rising at a steady 5-6% pace for the past several years, in line with the growth in jobs and incomes. Wealthy individuals and corporations can minimize their taxes by postponing income, accelerating deductions, and avoiding the realization of capital gains, but working stiffs have no way of avoiding their monthly FICA deductions. The anticipation of future cuts in income taxes is likely having a big adverse impact on federal tax collections these days, and it's not helping the economy to grow either. Best to get this done ASAP, GOP!


The chart above shows the evolution of the federal budget deficit. We were staring into the abyss in 2009, with a staggering deficit $1.5 trillion, which was more than 10% of GDP. Things look better now, but federal finances are once again deteriorating on the margin.


The chart above shows the long-term trends in spending and revenues as a % of GDP. If anything is out of line, it's spending, which is running above its postwar average and is accelerating on the margin. All that's really needed is to slow the growth in spending and apply a good dose of tax-cutting, which would likely boost the economy and tax collections as well, much as we saw in the late 1990s. Spending restraint and growth are the sweet spots that Congress needs to be hitting.

Friday, July 7, 2017

Another jobs nothing burger

As I said two months ago about the April jobs number (April jobs: a nothing burger), today's June jobs report doesn't change the big picture at all, even though it was touted as an upside surprise (+222K vs. +178K). The best that can be said about the jobs market is that the rate of growth of private sector jobs—which was roughly 2% by the end of last year but which has slowed to 1.7% of late—has stopped declining. With jobs growth of 1.7% and productivity of 0.5% or so, real GDP is likely going to average a little over 2% for the foreseeable future. Which is what it has been doing since mid-2009. These two charts tell you all you need to know about the jobs market:


Private sector jobs are the ones that really count. They've increased by about 175K per month over the past year. That's substantially less than the 240K per month we enjoyed in the 1997-99 period. And the rate of growth has been trending downward at a modest rate over the past year or two.


The best jobs growth we've seen over the past 15 years or so was just over 2% per year. Currently, private sector jobs are growing at a 1.7% pace. Nothing to write home about, but not exactly a disaster either. 


The reason this has been a tepid recovery is that we've had weak jobs growth on top of very weak productivity growth, and both are explained by a dearth of productive investment. To be sure, corporations have generated significant profits in the current recovery, but most of those profits ended up funding the federal government's voracious appetite for debt. I explained this three years in this post.

What happened to all the profits? Almost all of the most incredible surge in profits in modern times was squandered by our government, flushed down the Keynesian drain.

Thursday, July 6, 2017

A 16-chart review of the outlook

Blogging's been light of late, mainly because there hasn't been much going on. The economy is still growing at a disappointing pace, inflation is still relatively low and stable, and the equity market is no longer cheap but neither is it overly optimistic. It's encouraging to see the progress that Trump has made towards reducing regulatory burdens, but it's disappointing to see that his major legislative initiatives (tax and healthcare reform) are bogged down in Congress. I wish he had chosen the low-hanging fruit (reducing the corporate tax rate) first, rather than tackling the very messy and complicated task of repealing and replacing Obamacare. Reducing the corporate tax rate is something just about everyone understands must be done, and it would have already unleashed a wave of new investment in the economy, and that in turn would have made all the other reforms easier on the margin. Fortunately, it's still too early to rule out some major policy developments which could significantly improve the economic outlook. If there's a silver lining to the cloud of sub-par growth, it's that the economy has tremendous upside potential—if Trump's pro-growth policy promises become reality.

In recent months there have been some negative developments in the economic outlook (a slowdown in housing starts, car sales and jobs), but those have been outweighed, in my view, by a variety of positives (tight credit spreads, strong ISMs, rising industrial commodity prices, rising real yields, and increased global trade). I review these below in 16 updated charts.

Meanwhile, my major worry continues to be North Korea, since it is difficult to see how we can find a non-violent resolution. As one wag put it, we've been kicking the can down the road for decades, and we've finally run out of road. A nuclear attack somewhere in the world is now more likely than it has been for decades. One well-placed EMP bomb, moreover, could wreak massive, incalculable destruction in any of the world's highly developed economies.


Housing starts weakened considerably in recent months, and have now been flat for the past few years. The continued rise in builder sentiment suggests that the slowdown is likely to prove temporary. In the meantime, mortgage rates remain historically low, so housing affordability is not a negative. 


Car sales have also weakened of late, and have been flat for several years. One likely explanation is that the advent of ride-sharing services has sapped demand for car rentals, which in turn has depressed sales of new cars to rental fleets.



Notwithstanding the slowdown in housing and autos, the labor force continues to expand, albeit at a slower pace. The growth of private sector non-farm payrolls has slowed from a 2% pace last November to a 1.6% pace as of May. Slower jobs growth is disappointing, but there is no sign at all that employers are shrinking their workforce: unemployment claims remain very low, and corporate layoffs have rarely been lower than they were last month. As long as jobs keep growing, families keep growing and cars keep wearing out, it's reasonable to think that housing and car sales are likely to experience at least modest growth going forward.

The June ISM Manufacturing Index was strong, and it suggests that second quarter GDP growth is likely to be substantially better than first quarter. The Atlanta Fed currently estimates Q2/17 growth to be about 2.7%; combined with first quarter's 1.4% growth, that would average out to 2% for the first half, which is right in line with the economy's growth trend over the past 8 years. Ho-hum. 


Export orders are one area of strength, and that jibes with a widely observable global pickup in trade so far this year. It's hard to overestimate how important global trade is to prosperity.


The all-important service sector continues to look healthy as well.


As the chart above shows, industrial metals prices have increased over 50% since early last year. Industrial commodity prices in general are up over 25% during the same time period. All of this despite the fact that the dollar has been roughly flat for the past two years. This strongly suggests that global economic activity is picking up, not inflation.


2-yr swap spreads, excellent indicators of market liquidity and systemic risk, are at optimal levels in the US and are only modestly elevated in the Eurozone. This further suggests that financial fundamentals are healthy, and the economic outlook is likely improving.


5-yr Credit Default Swap spreads are an excellent and highly liquid proxy for the financial health of corporations. These spreads are at relatively low levels, and that in turn belies concerns that corporations may be over-leveraged or that the economic outlook may be deteriorating.


Real yields on 5-yr TIPS continue to inch higher, suggesting that the outlook for the economy is improving. I posted at greater length on this subject here.


C&I Loans, shown in the chart above, were flat for the past 8 months or so, but the latest data showed a resumption of growth. It remains unclear whether the pause—which interrupted six years of steady and strong growth—was a sign of a restriction in lending or a decline in the demand for credit. In any event, the lack of growth in business lending does not appear to have had any obvious impact on the economy.


With the recent release of Q1/17 data, we see that households' financial burdens (see chart above) remain relatively low and stable. The federal government and businesses in general have been leveraging up, but not households.


PE ratios today are about 25% above their long-term average, according to Bloomberg (using earnings from continuing operations as the E and the S&P 500 index as the P). One could argue that this shows that stocks are moderately over-valued.


But if you look at PE ratios in the context of the current yield on risk-free bonds, then stocks are still cheap. The chart above subtracts the yield on 10-yr Treasuries from the earnings yield (the inverse of the PE ratio) of the S&P 500. The typical stocks offers an earnings yield that is about 230 bps higher than the yield on 10-yr Treasury bonds. That is unusual, since equities have a higher expected return (being much more risky) than Treasuries. This can only mean that the market is very distrustful of the ability of corporations to continue to growth their earnings. That's been the case throughout the current bull market, and it was the case in the late 1970s, when stocks were in the throes of a major bear market. In other words, the market is hardly exuberant these days.


If anything stands out as worrisome, it's the fact that the market does not appear to be very worried at all. The Vix/10-yr ratio, my favorite indicator of the market's nervousness about the prospects for growth, remains relatively low.