- The deleveraging process has ended, but overall credit growth remains low.
- The culprits are the housing sector--and the Fed.
- Low growth supports current bond and equity valuations.
Thursday, August 21, 2014
The US economy has begun to dig out from the post-Lehman deleveraging process, but the current level of overall credit growth is anemic. (I am using the Fed’s flow of funds data series from FRED.)
Total Credit Growth
Total credit was growing at 10% before the Crash, contracted in 2009-10, and is now growing at 3.5%, which is low enough to be acting as a drag on money growth and the recovery. This is mainly due to the low level of activity in the mortgage sector.
Household credit was growing at 11-12% pre-crash and then contracted for four straight years: 2009-12. Only last year did the contraction end, and growth is now de minimis. The mortgage sector has not recovered from the collapse of the housing bubble. This is the main drag on growth today.
Corporate credit was growing at 14% before Lehman, contracted in 2009-10, and has since recovered to a healthy 9% growth rate. Business is not starved for credit. This is a major positive for overall growth.
During the bubble, the financial sector was growing in the low teens, then contracted very sharply, and has not yet resumed growth. Like housing, the financial sector has not yet recovered from the crash.
Pre-crash, federal debt was growing at a modest 3%. During the crash, it grew very rapidly (2009). Following the Fiscal Cliff, federal debt growth has fallen to 6% which is neither contractionary nor stimulative. One could say that government finance has normalized at “neutral”.
I believe that the current low level of overall credit growth is acting as a drag on the Fed’s monetary policy by countering the Fed’s efforts to grow M2. Larry Summers has suggested that the US economy can only grow rapidly during credit bubbles. I don’t agree. I would reformulate that to say that the nominal economic growth rate will tend to grow at the nominal rate of aggregate credit growth. You can’t have economic growth without credit growth, but it need not become a bubble. We don’t need 12% household credit growth to achieve 6% NGDP growth; we can make by with household credit growth in the mid-single digits.
At present, aggregate credit growth is stalled at 3.5%. If it can accelerate (i.e., if housing and/or inflation can pick up) then I would expect to see the benefits of the quantity equation, resulting in higher nominal growth. Of course, that is almost a tautology. It would appear that everything hinges on the bugaboo of the bubble years: house price appreciation and the availability of mortgage credit.
I do not mean to contradict monetarism or to absolve the Fed of its unwillingness to accelerate money growth. I am only saying that by handcuffing itself the Fed is making the economy hostage to the housing market. The growth rate of the nominal economy is within the control of the Fed, if it is prepared to reflate. The Fed’s ongoing satisfaction with inadequate inflation means that we are swimming on our own. At present, neither the government nor the Fed are providing any stimulus.
We are looking at an economic dashboard where almost every dial is on LOW: credit growth, money growth, velocity, inflation, nominal growth. This suggests to me that the outlook for inflation and bond yields remains low. This in turn supports current stock and bond valuations, and it explains why the bond market yawned when the FOMC minutes were published. The fact that the Fed is plotting to reverse QE is deflationary, not inflationary. In fact, I am reminded of the monetary fiasco of 1937-38, when the Fed hit the brakes much too soon. The FOMC continues to be “Austrian Lite”. Monetarism is nowhere to be found.
Bottom line: current bond and stock prices are supported by the low trajectory of credit and money growth.
Tuesday, August 12, 2014
Friday, August 1, 2014
- The market selloff was prompted by noise rather than real data.
- On a YoY basis, the signals remain in range.
- There is no call for higher bond yields.
- Stocks remain cheap to bonds.
Once again, the bond market has demonstrated that it has a higher IQ than the stock market. Three numbers came out (second quarter growth, the July employment report, and the second quarter employment cost index) which spurred fears of higher inflation and interest rates, prompting a 500-point selloff in the DJIA. The bond market reacted much more calmly because bond investors study the data rather than reacting to a headline.
The data indicates that nothing has happened that would lead to higher interest rates. One can grow old quickly if he annualizes single data points. Annualized growth and employment data have a high noise to signal ratio when observed in isolation. I much to prefer to view the data on a year-on-year basis. This removes most of the noise and makes the trend visible and intelligible. On a YoY basis, there is no real news in the latest data.
Economic growth remains low, with NGDP growing at 4% and RGDP growing at 2.4%. Nominal growth at 4% is abysmal for an economy in recovery. In the post-inflation era (1983-2006), the economy often grew at 6-7%, which left plenty of room for 4% real growth. With 4% nominal growth, the post-Crash output gap will never close. We are in a new era of low money growth, steadily declining velocity, low inflation and low growth. This is not a promising environment for higher interest rates. Yes, the Fed is winding down QE. If that has any impact on money growth (doubtful), it will be negative, which means deflationary. So the end of QE is a reason to buy bonds, not to sell them.
Next, the employment data. Employment grew by 1.9% in July on a YoY basis, and by 1.8% on an annualized basis. This is within the range of employment growth since the recovery began. It is not a spike. There is no employment boom.
The employment cost index (all civilians) rose by 3% on an annualized basis, but by only 2.1% YoY. The 3% annualized rate is the highest since the Crash, but the 2.1% YoY rate is still within range. And price inflation? Core PCE inflation for June was 1.5%, which remains 25% below the Fed’s target.
So, in sum, there is very little news when you extract the headline-grabbing noise in the most recent data. We are on a stable path of low growth and low interest rates.
Tomorrow, Professor Aswath Damodaran will publish his estimate of the equity premium for today at the closing bell. It should be quite a bit higher than it was on July 1st (5.45%), given the selloff. I expect it to approach 6%, which is historically high and means that we are being paid a lot of money to hold stocks versus bonds.
Investment Conclusion: Don’t panic. Buy stocks.
Wednesday, July 30, 2014
[Parts of this post are plagiarized from the Wikipedia entry for ‘Liquidity Preference” for which I offer no apology. I vouch for the correctness of what I have plagiarized.]
In macroeconomic theory, liquidity preference refers to the demand for money, considered as liquidity. The concept was first developed by John Maynard Keynes in his book The General Theory of Employment, Interest and Money (1936) to explain determination of the interest rate by the supply and demand for money. The demand for money as an asset was theorized to depend on the interest foregone by not holding bonds. Instead of a reward for saving, interest, in the Keynesian analysis, is a reward for parting with liquidity.
According to Keynes, demand for liquidity is determined by three motives:
- The transactions motive: people prefer to have liquidity to assure basic transactions, for their income is not constantly available. The amount of liquidity demanded is determined by the level of income: the higher the income, the more money demanded for carrying out increased spending.
- The precautionary motive: people prefer to have liquidity in the case of social unexpected problems that need unusual costs. The amount of money demanded for this purpose increases as income increases.
- Speculative motive: people retain liquidity to speculate that bond prices will fall. When the interest rate decreases, people demand more money to hold until the interest rate increases, which would drive down the price of an existing bond to keep its yield in line with the interest rate. Thus, the lower the interest rate, the more money demanded (and vice versa).
The liquidity-preference relation can be represented graphically as a schedule of the money demanded at each different interest rate. The supply of money together with the liquidity-preference curve in theory interacts to determine the interest rate at which the quantity of money demanded equals the quantity of money supplied.
Monetary velocity is a function of the liquidity preference. When investors and businesses expect bond prices to fall, they maintain large cash holdings. When they expect bond prices to rise, they draw down their cash and invest in bonds. Today, velocity is low because of a high liquidity preference caused by the trauma of the Crash, and the perception that bond and stock prices are “too high”. In other words, a big part of M2 is not for transaction balances, but is rather a savings vehicle. This is exacerbated by the fact that the yield curve is low and flat. The opportunity cost of holding money is very low by historical standards. Going forward, market volatility should support low velocity, whereas a continued bull market should--at some point--begin to reduce the liquidity preference. Higher interest rates would also raise the opportunity cost of holding cash, and would increase velocity. Velocity will remain low until nominal growth returns to historical levels, which could be a long time.
Economic growth has been retarded by the increase in the liquidity preference which has meant declining velocity in the face of growth in the monetary aggregates. The liquidity preference is a function of nominal interest rates, which are very low. The opportunity cost of holding cash versus bonds is minimal. The economy needs a much steeper yield curve, and it’s not going to happen.
- Both nominal and real growth remain subdued.
- There are no signs of acceleration.
- The bond market has over-reacted.
On a YoY basis, RGDP is growing at 2.4% and NGDP is growing at 4%, far below the growth rates of the Clinton and Bush years. The low level of real growth reflects the low level of nominal growth, because you are not going to have 4% real growth along with 4% nominal growth. Nominal growth should be at least 6.5% if we ever wish to see 4% real growth again. The core problem is that the Fed’s 2% inflation target is much too low; and the FOMC has tolerated below-target inflation since the Crash.
Given that the economy has been stalled for the past four years, and given that the Fed is in the process of withdrawing stimulus, there is no reason to expect higher growth or inflation. Bond yields are unlikely to rise substantially against such a backdrop, and today’s selloff will prove to be a blip.
The economy is not accelerating at a pace that should raise bond yields. Low bond yields sustain the wide equity premium (5.4% according to Aswath Damodaran).
Sunday, July 27, 2014
- Both the Right and Left see Yellen as a radical departure from her predecessors.
- But she is just another Bernanke and she won’t upset the apple cart.
- We can expect to see nothing radical coming out of the FOMC in the foreseeable future.
Janet Yellen has recently been getting a lot of attention in the media from both the Right and the Left.
On the Left, the New Yorker recently published a profile by Nicholas Lemann which painted Yellen and her economist husband in liberal if not leftist colors: “Yellen is notable not only for being the first female Fed chair but also for being the most liberal since Marriner Eccles.” Lemann reports that Yellen’s Nobel Prize winning husband, George Akerlof, called the Bush Administration “the worst government the U.S. has ever had in its more than 200 years of history”.
Lemann, who does not appear to be a close student of economics (“Economic management sounds technical, but it also has the quality of a powerful fable”), gets a bit confused when trying to make the case that there are “liberal” and “conservative” monetary policies. He tries to paint Milton Friedman as a conservative and Yellen as a liberal, when in fact they are both monetarists. Lemann is groping for the monetarist vs Austrian dichotomy, but he doesn’t have command of the scholastic nomenclature. In any case, he paints the Democrat Yellen as being to the left of the Republican Bernanke, and says that this has profound policy implications.
On the Right, Peter Schiff (a conservative hard-money pundit) recently published a column in which he takes the Lemann interview and runs with it. His column is a broad-ranging indictment of the new chairman as a dangerous liberal, leftist and inflationist: “She is very different from any of her predecessors in the job. Put simply, she is likely the most dovish and politically leftist Fed Chair in the Central Bank's history...She does not seem to see the Fed's mission as primarily to maintain the value of the dollar, promote stable financial markets, or to fight inflation. Rather she sees it as a tool to promote progressive social policy and to essentially pick up where formal Federal social programs leave off.”
Schiff deplores QE, saying that it “has prevented the government from having to raise taxes sharply or cut the programs she believes are so vital to economic health”, while “pushing up prices for basic necessities such as food, energy, and shelter”. He says that, as a liberal, Yellen focuses exclusively on employment: “Yellen clearly sees jobs as her top priority. Any hope that she will put these priorities aside and move forcefully to fight inflation when it officially flares up should be abandoned.” He expects her to pursue radically stimulative policies.
Obviously, a big part of the problem here is that not a lot of pundits understand monetarism (or Keynesianism). There is a strong desire to cast the FOMC as a battleground between the right and the left, much like the Supreme Court where there are “Democratic” and “Republican” justices. This analysis founders, of course on the fact that many “Republican” economists are monetarists, such as Friedman, Greenspan, Bernanke and many others, and that Republican presidents have nominated many monetarists to the Board of Governors.
The sad fact is that, despite the hopes of the Left and the fears of the Right, Yellen is another Bernanke, a radical monetarist who abandons all of his core beliefs the day he first sits down in the chairman’s seat. Lemann is wrong that Yellen will speed up growth, and Schiff is wrong that she will cause inflation. I hope that both of their predictions prove true, but I’ll bet two-to-one against it.
Bernanke had the best shot we will ever see of implementing radical reflationary policies, and he failed. He recanted almost everything he had preached as an academic about price-level targeting and the need to do whatever is necessary to oppose deflationary forces. If Bernanke couldn’t do it, in face of the Great Recession, there is no way that Yellen is going to do it.
That is because the #1 job of the Fed chair is not to grow the economy, but to maintain consensus in the committee and credibility on Capitol Hill. If Yellen were to form a growth caucus on the FOMC and ram through policies intended to get the economy moving again, the GOP would would pass legislation which would remove policy discretion and perhaps even the employment mandate. Such bills have already been introduced. This may happen even if Yellen stays on the reservation, but the probability would rise exponentially if she allowed inflation to hit 4%, which is now defined as hyperinflation.
Yellen and the monetarists know that, were they to incite such legislation, the future policy consequences could be dire. So they won’t. Instead we will see the end of QE, continued interest on excess reserves, and increasing pressure to “normalize" the Fed’s “bloated” balance sheet, despite the fact that money growth has been declining for the past two years, inflation has been below target and--most recently--both nominal and real growth have been negative.
Because the Fed will not pursue reflationary policies, inflation, inflation expectations and bond yields will remain very low, while the wide equity premium will persist until stock prices go materially higher.
Wednesday, July 16, 2014
- Many pundits are predicting stronger growth and higher bond yields.
- They are misreading the monetary data.
- The FOMC is withdrawing stimulus in the face of slowing growth.
- The outlook is for low money growth, low inflation, low nominal growth and low bond yields.
- This is bullish for both stocks and bonds.
There is a growing chorus among the economic pundits that the economy is picking up steam, that monetary policy should “normalize”, and that bond yields “will have to normalize”. This consensus is not supported by the data.
Nominal growth, inflation and bond yields are artifacts of monetary policy. Monetary policy today is restrictive and becoming more so. If the quantity equation holds, then we won’t be seeing any pickup in nominal growth that could justify higher bond yields. Anyone who thinks that the first quarter growth numbers were caused by “winter” isn’t looking at current monetary policy. (This may come as a shock to Al Gore, but the government still seasonally adjusts the quarterly GDP data.)
The bottom line for the economic outlook is that the Fed is withdrawing stimulus in the face of falling growth. This is not a monetarist Fed; it is a hawkish Fed. While the FOMC is not as Austrian* as the ECB, the Austrian hawks on the FOMC have an effective veto over any policies intended to stimulate inflation and nominal growth--due to the institutional priority placed on consensus and “credibility”.
Despite the fact that both Bernanke and Yellen are dovish monetarists, the policy mix that we are seeing today and can expect to see in the future is Austrian Lite, which is a compromise between monetarism and Austrianism. We are going to get a continuation of low inflation, low nominal growth, and low bond yields. We will not see again the high levels of nominal and real growth that we saw during the Greenspan years. That is, not unless there is a radical change in the composition of the FOMC.
There is nothing to stop the Fed from raising the funds rate, since this is within its complete control. But the impact of a rate hike in a weak economy is deflation and lower bond yields. A higher funds rate will not raise bond yields; it will just flatten the curve and create a recession.
What is the policy stance of the FOMC today? Judging by its actions, as opposed to its palaver, the policy stance is to target an inflation rate below 2%, to grow the money supply in the mid-single digits, and to tolerate abysmal levels of nominal and real growth. In other words, Austrianism Lite. The policy is restrictive; the brakes are on. This is not monetarism.
Bush and Obama appointed dovish monetarists to the chairmanship, hoping for good growth and low unemployment. But the minute a dovish academic walks into the Eccles Building, he stops being an economist and becomes a consensus-seeking, controversy-avoiding "manager". The monetarists are institutionally captured, no matter what they truly believe about economics. The real job of the Fed chair is institutional credibility and continuity, not growth or other humanitarian desiderata. The last thing that a Fed chairman wants to be called is "controversial". This is analogous to the job of the chief justice: retain credibility and respect.
The post-crash FOMC has not completely ignored its full employment mandate, but mainly pays it lip service. It’s slogan (like that of the ECB and the pre-Abe BoJ) is “We’re doing all that we can do and monetary policy is not a panacea”. They are “creating the conditions” for recovery, but take no responsibility for making it actually happen. They are defying the quantity equation. I can only wish that Milton Friedman were still around to be able to explain to Bernanke and Yellen that the pace of nominal growth is within the control of the Fed. Friedman did not put the quantity equation on his license plate because he didn’t believe in it.
So today we have 6% money growth, falling velocity and dangerously low nominal growth. In the face of that data, the Fed has decided to end its balance sheet expansion. The FOMC has declared victory and now plans to do nothing further. So why in the world should we expect nominal growth and bond yields rise in such circumstances? Let’s look at what the bond market thinks: 10-year yields have fallen from 3.0% to 2.6% this year. That does not suggest that the bond market expects a pickup in nominal growth let alone higher yields. Why would falling bond yields lead people to expect higher bond yields? Why would falling growth lead people to expect accelerating growth? It’s as if the data didn’t exist.
We are living in a “new era” of slow money growth, low inflation, low nominal growth and low bond yields. Since low bond yields support high stock PE multiples, this news is bullish for both stocks and bonds, but stocks will continue to outperform bonds (because the equity premium is so high).
*Austrianism is the belief that the optimal policy of the monetary authority is price stability, rather than moderate nominal growth or full employment. (Paul Ryan, Rand Paul and Paul Gigot are Austrians.) Austrians reject the quantity equation (money growth = nominal growth) as simplistic and meaningless. They believe that if the central bank delivers price stability, the economy will grow at its “natural” pace and that growth should not be stimulated with "monetary steroids". They believe that recessions naturally occur and naturally correct without fiscal or monetary stimulus, and they recommend supply-side measures such as regulatory reform and lower taxes. This philosophy (once espoused by Herbert Hoover and his gang) has created 12% unemployment in the Eurozone, a shrinking nominal economy in Japan for two decades, and U6 unemployment in the US of 12% five years after the Crash.
Thursday, July 3, 2014
- The June employment numbers are noise.
- Employment growth remains slow.
- There is little risk of an inflation shock.
How should we interpret the strong employment growth figures for June? Does it suggest that the economy is accelerating, or even overheating? My answer is no to both. Employment growth remains slow, and the economy is not overheating.
Between 2003 and 2008, total employment grew from 130 million to 138 million. Over the next two years the economy shed 8 million jobs and employment returned to 130 million. Since 2010, the economy has added back the 8 million jobs that were lost in the recession, and we are just above where we were six years ago. It has been a long and painful recovery, which reflects poorly on the stewardship of the FOMC (which consistently ignores its full employment mandate).
Since the Crash, employment on a YoY basis has been growing at between 1.5% and 2.0%. The June number, on a YoY basis, remains within range at 1.8%. On an annualized basis, monthly employment growth during the recovery has averaged below 2%, with a range between 0.6% and 3.3%. The June growth number was 2.5%, well within range. There is thus not a lot of information content in the June number; I see it as noise, just like the shrinkage of the economy in 1Q14.
The economy and employment (nominal) continue to be stuck in second gear, growing far below the levels achieved before the Crash. I attribute this to the combination of sluggish money growth (~6%) and the slow recovery of the credit cycle. For the economy to accelerate to escape velocity will require faster money growth (9%) and much stronger housing activity. In other words, the economy has not yet recovered from the trauma of 2008.
There is still substantial slack in the labor market. The participation rate has not recovered at all. The broad measure of unemployment (U6) is at 12%, far above the 8% level before the Crash. Ten million workers have no jobs. Therefore, I would be very surprised if the June employment number has any effect on monetary policy. The Fed has not yet achieved full employment, nominal growth remains very slow, and capacity is not constrained. What would change the Fed’s mind would be a sustained rise in core inflation, but I don’t expect this given the economy’s weakness and the slack in the labor market. (The employment cost index grew at a 0.6% annual rate in 1Q14.)
The big drop in nominal GDP in 1Q14, and the big spike in employment in June are both noise. Nothing has changed: inflation remains low and the Fed is unlikely to tighten in the foreseeable future. For the capital market, this means that there is very little risk of an inflation spike that would cause stock and bond prices to decline. We are living in a new world of permanently slow growth and low interest rates.
Wednesday, July 2, 2014
- The stock market remains attractively valued.
- The equity risk premium remains high by historical standards.
- The size of the premium reflects the low yields on offer in the bond market.
At the beginning of each month, Professor Aswath Damodaran at NYU publishes his estimate of the implied equity risk premium as of the first day of the month. His estimates go back to 1961. Today he published his estimate for July 1, 2014, which is 5.4%. How should we interpret this number?
The 53-year range for Damodaran’s ERP is 2.0% to 7.7%, and the eyeball median is between 3% and 4%. Since the Crash, the range has been between 4.4% and 7.7% (the all-time high, set in March 2009 and again in October 2011) . The current number is the highest it has been since last October.
My personal view is that when the ERP is above 4%, the stock market offers an adequate risk premium, and when it is below 4% it is less compelling and more risky. The all-time low was set in 1999 at 2.0 %. The stock market was highly overvalued at that time, and it took 15 years for the real S&P 500 index to return to its 1999 high.
Fernando Duarte and Carlo Rosa at the New York Fed published a paper on the ERP in January: “The Equity Risk premium: A Consensus of Models”. The authors concluded that:
- There is broad agreement across models that the ERP has reached historical heights [as of mid-2013] even when the models are substantially different from each other and use more than one hundred different economic variables. [Note: today’s ERP is only slightly below the level in mid-2013.]
- The ERP is high at all foreseeable horizons because Treasury yields are unusually low at all maturities. In other words, the term structure of equity premia is high and flat because the term structure of interest rates is low and flat. Current and expected future dividend and earnings growth play only a minor role.
- A high ERP caused by low bond yields indicates that a stock market correction is likely to occur only when bond yields start to rise.
- We should no longer rely on traditional indicators of the ERP like the price- dividend or price-earnings ratios, which all but ignore the term structure of risk-free rates.
- The current high levels of the ERP are unusual in that we are not currently in a recession and we have just experienced an extended period of high stock returns. During previous periods, the ERP has always decreased during periods of sustained high realized returns. It is unusual for the ERP to be at its present level in the current stage of the business cycle, especially when expectations are that it will continue to rise over the next three years.
- Our analysis provides evidence that is consistent with a bond-driven ERP: expected excess stock returns are high not because stocks are expected to have high returns, but because bond yields are exceptionally low.
The key take-away from their paper is that the stock market offers an attractive risk/return relationship not because of expected earnings growth, but instead because low interest rates justify a high PE ratio. A simple way to look at it is to compare the PE of the 10-year Treasury bond with that of the S&P 500. The current PE for the bond market is 40x, while the PE for the stock market is 20x--even though corporate earnings grow and bond interest doesn’t.
One might argue that both stocks and bonds are overvalued, perhaps due to the zero funds rate and quantitative easing. However, I see no evidence that bond yields are artificially low. Bond yields are historically low because inflation expectations are historically low. Despite “unprecedented monetary stimulus”, both expected and observed inflation have remained low.
Admittedly, the bond and stock markets are vulnerable to an inflation shock, but I don’t expect one. Money growth remains in the mid-single digits, velocity continues to decline, overall credit growth is modest, and nominal growth is at a recessionary level. Higher oil prices are deflationary, not inflationary.
I am aware of the argument that “true” inflation is much higher than reported, but this requires a level of paranoia that is neurotic and not analytic. Inflation is low, which is why the prices of gold and silver have been falling for almost three years. Not only is price inflation low, but also wage growth is currently flat.
The stock market has offered investors a historically high risk premium since the Crash. While the current premium is below the all-time highs following the Crash, it remains elevated at all horizons and does not depend upon expected earnings growth. Higher inflation and bond yields would reduce the premium, but I see the risk of an inflation shock as low. Consequently I believe that the stock market remains attractively valued at current prices.