The Pace of Growth

May 19, 2019

by Steve Stofka

We are living in an economy that is fundamentally different than the ones our parents and grandparents grew up in. Some of us want a return to those days. More goods were made in the U.S.A. Each family spent more on food, clothing, furniture and the other necessities of life but the money circulated in our economy, not among the workers of Asia. Union membership was stronger but there were crippling strikes that affected the daily lives of many families. In 2016, the current President promised a return to those days of stronger but more erratic growth. Almost half of voters bet on him to undo the changes of the past several decades. Let’s look at some data that forms the bedrock of consumer confidence.

GDP is the most frequently used measure of the nation’s economic activity. Another measure, Final Sales of Domestic Product excludes changes in business inventories. In the graph below is a chart of the annual change in Final Sales after adjusting for inflation (Note #1). Compare the right and left rectangles. The economy of post-WW2 America was more erratic than the economy of the past thirty-five years (Note #2).

The two paces of growth

In the first 35 years following WW2, growth averaged 3.6%. Since the Financial Crisis there have only been five quarters with growth above 3%. Let’s include the annual change in disposable personal income (Note #3). That’s our income after taxes. Much of the time, the two series move in lockstep and the volatility in each series is similar.

However, sometimes the change in personal income holds steady while the larger economy drops into recession. A moderate recession in 1970 is a good example of this pattern.

1982 was the worst recession since the 1930s Great Depression. Unemployment soared to more than 10% but personal incomes remained relatively steady during the downturn.

In the 1990, 2000 and 2008 recessions, personal incomes did not fall as much as the larger economy. Here’s the 2008 recession. While the economy declined almost 3%, personal income growth barely dipped below zero.

In the last 35 years, annual growth in Final Sales has averaged only 2.8%, far below the 3.6% average of the first 35-year period. After the recession, the growth of the larger economy stabilized but the change in personal incomes became very erratic. In the past eight years, income growth has been 2.5 times more volatile than economic growth (Note #4). Usually the two series have similar volatility. In the space of one year – 2013 – income growth fell from 5% to -2.5%, a spread of 7.5%. In the past sixty years, only the oil crisis and recession of 1974 had a greater swing in income growth during a year! (Note #5)

When income growth is erratic, people grow cautious about starting new businesses. Banks are reluctant to lend. Despite the rise in home prices in many cities, home equity loans – a popular source of start-up capital for small businesses – are about half of what they were at the end of the financial crisis (Note #6). The Census Bureau tracks several data series for new business applications. One of these tracks business start-ups which are planning to become job creators and pay wages. That number has been flat after falling during the Great Recession (Note #7).

Census Bureau – see Link in Notes

Businesses borrow to increase their capacity to meet expected demand. Since the beginning of 2016, banks have reported lackluster demand for loans from large and medium businesses as well as small firms (Note #8). For a few quarters in 2018, small firms showed stronger loan demand but that has turned negative this year. This indicates that business owners are not betting on growth. Here’s a survey of bank loan officers who report strong demand for loans from mid-size and larger firms. While few economists predicted the last two recessions, the lack of demand for business loans forecast the coming downturns.

There is an upside to slow growth – less chance of a recession. Periods of strong growth promote excess investment into one sector of the economy. In the early 2000s, the economy took several years to recover from the money poured into the internet sector. The Great Financial Crisis of 2008 and the recession of 2007-2009 was a reaction to over-investment and lax underwriting in the housing sector. On the other hand, weak growth can leave our economy vulnerable to a shock like the heightening of the trade war with China, or a military conflict with Iran.

Can a President, a party or the Federal Reserve undo several decades of slow to moderate growth? None of us want a return to the crippling inflation of the 1970s and early 1980s, but we may long for certain aspects of those yesteryears. An older gentleman from North Carolina called into C-Span’s Washington Journal and lamented the shuttering of the furniture and textile plants in that area many decades ago (Note #9). Many of those areas have still not recovered. Another caller commented that the Democratic Party long ago stopped caring about the jobs of rural folks in the south. Contrast those sentiments about the lack of opportunity in rural America with those who live in crowded urban corridors and struggle to keep up with the feverish pace and high costs of urban housing, insurance and other necessities.  Two different realities but a similar human struggle.

/////////////////

Notes:

  1. Real Final Sales of Domestic Product FRED series A190RO1Q156NBEA
  2. Standard Deviation of first 35 years was 2.44. In the second 35-year period it was only 1.56.
  3. Real Disposable Personal Income FRED series DPIC96
  4. Since 2010, the standard deviation of economic growth has been .7 vs 1.75 for income growth.
  5. In the decade following WW2, people had similar large swings in income growth as the country and the Federal Reserve adjusted to an economy dominated by domestic consumption.
  6. Home Equity Loans FRED series RHEACBW027SBOG totaled $610 billion in the spring of 2009. It was $341 billion in the spring of 2019, ten years later
  7. Census Bureau data on new business start-ups
  8. Senior Loan Officer Surveys: Large and medium sized businesses FRED series DRSDCILM. Small businesses FRED series DRSDCIS.
  9. C-Span’s Washington Journal. C-Span also has a smartphone app.

Making Stuff

May 5, 2019

by Steve Stofka

This week I’ll review several decades of trends in productivity. How much output do we get out of labor, land, and capital inputs? Capital can include new equipment, computers, buildings, etc. In the graph below, the blue line is real GDP (output) per person. The red line is disposable (after-tax) income per person. That’s the labor share of that output after taxes.

As you can see, labor is the majority input. In the following graph is the share of real GDP going to disposable income.  In the past two decades, labor has been getting a larger share.

That might look good but it’s not. Since 2000, the economy has shifted toward service industries where labor does not produce as much GDP per hour. The chart below shows the efficiency of labor, or how much GDP is being produced by labor.

If labor were being underpaid, the amount of GDP produced per dollar of disposable income would be higher, not lower. On average, service jobs do not have as much leverage as manufacturing jobs.

A century ago, agricultural jobs were inefficient in comparison to manufacturing jobs. The share of labor to total output was high. In the past seventy years, the agricultural industry has transformed. Today’s farms resemble large outdoor manufacturing plants without walls and productivity continues to grow. In the past five years, steep price declines in the prices of many agricultural products have put extraordinary pressures on today’s smaller farmers. The increased productivity of larger farms has allowed them to maintain real net farm income at the same level as twenty years ago (Note #1). Here’s a graph from the USDA.

Although agriculture related industries contribute more than 5% of the nation’s GDP, farm output is only 1% of the nation’s total output. The productivity gains in agriculture have not been shared by the rest of the economy. Labor productivity has plunged from 2.8% annual growth in the years 2000-2007 to 1.3% in the past eleven years (Note #2).  Here’s an earlier report from the Bureau of Labor Statistics with a chart that illustrates the trends (Note #3). The report notes “Sluggish productivity growth has implications for worker compensation. As stated earlier, real hourly compensation growth depends upon gains in labor productivity.”

Productivity growth in this past decade is comparable to the two years of deep recession, high unemployment and sky-high interest rates in the early 1980s. The report notes “although both hours and output grew at below-average rates during this cycle [2008 through 2016], the fact that output grew notably slower than its historical average is what yields the historically low labor productivity growth.” Today we have low unemployment and very low interest rates – the exact opposite of that earlier period. Why do the two periods have similar productivity gains? It’s a head scratcher.

Simple answers? No, but hats off to Donald Trump who has called attention to the need for a greater shift to manufacturing in the U.S. economy. He and then Wisconsin governor Scott Walker negotiated with FoxConn Chairman Terry Gou to get a huge factory built in Mount Pleasant, Wisconsin to manufacture LCD displays, but progress has slowed. An article this week in the Wall St. Journal exposed the tensions that erupt among residents of an area which has made a major commitment to economic growth (Note #4).

If we don’t shift toward more manufacturing, American economic growth will slow to match that of the Eurozone. Along with that will come negative interest rates from the central bank and little or no interest on CDs and savings accounts. We already had a taste of that for several years after the recession. No thanks. Low interest rates are a hidden tax on savers. They lower the amount of interest the government pays at the expense of individuals who are saving for education or retirement. Interest income not received is a reduction in disposable income and has the same effect as a tax. Low interest rates encourage an unhealthy growth in corporate debt and drive up both stock and housing prices.

///////////////////

Note:

  1. USDA summary of agricultural industry
  2. BLS report on multi-factor productivity
  3. BLS report on declining labor productivity
  4. FoxConn LCD factory (March article – no paywall). Also, a recent article from WSJ (paywall) – Foxconn Tore Up a Small Town to Build a Big Factory—Then Retreated

Slow Growth

April 21, 2019

by Steve Stofka

Happy Passover and Happy Easter. Now that tax day is past, let’s raise our heads and look at long-term growth trends of real, or inflation-adjusted, GDP. For the past seventy years real GDP has averaged about 3% annual growth. In the chart below, I’ve charted the annual percent change in a ten-year average of GDP (GDP10, I’ll call it). As you can see on the right side of the graph, growth has been below average for the past decade.

In 2008, growth in the GDP10 crossed below 3%. Was this due to the Financial Crisis (GFC) and the housing bust? No. The GFC barely figured into the computation of the ten-year average. The housing market had been running hot and heavy for four to five years, but this longer-term view now puts the housing boom in a new perspective: it was like lipstick on an ugly pig. Without the housing boom, the economy had been faltering at below average growth since the 1990s tech boom.

The stock market responds to trends – the past – of past output (GDP) and the estimation of future output. Let’s add a series of SP500 prices adjusted to 2012 dollars (Note #1).

For three decades, from the late 1950s to the mid-1980s, the real prices of the SP500 had no net change. The go-go years of the 1960s raised nominal, but not real, prices. Investors shied away from stocks, as high inflation in the 1970s hobbled the ability of companies to make real profit growth that rewarded an investor’s risk exposure. From the 2nd quarter of 1973 to the 2nd quarter of 1975, real private domestic investment lost 27% (Note #2). In less than a decade, investment fell again by a crushing 21% in the years 1979 through 1982.

In the mid-1980s, investors grew more confident that the Federal Reserve understood and could control inflation and interest rates. During the next decade, investors bid up real stock prices until they doubled. In 1996, then Fed chairman Alan Greenspan noted an “irrational exuberance” in stock prices (Note #3). The “land rush” of the dot-com boom was on and, within the next five years, prices would get a lot more exuberant.

The exuberance was well deserved. With the Fed’s steady hand on the tiller of money policy, the ten-year average of GDP growth rose steadily above its century-long average of 3%. A new age of prosperity had begun. In the 1920s, investment dollars flowed into the new radio and advertising industries. In the 1990s, money flowed into the internet industry. Construction workers quit their jobs to day trade stocks. Anything less than 25% revenue growth was the “old” economy. The fledgling Amazon was born in this age and has matured into the powerhouse of many an internet investor’s dream. Thousands of other companies flamed out. Billions of investment dollars were burned.

The peak of growth in the ten-year average of GDP output came in the 1st quarter of 2001. By that time, stock prices had already begun to ease. In the next two years, real stock prices fell almost 50%, but investment fell only 12% because it was shifting to another boom in residential housing. As new homes were built and house prices rose in the 2000s, long-term output growth began to climb again.

From the first quarter of 2006 to the 3rd quarter of 2009, investment fell by a third, the greatest loss of the post-war period. In the first quarter of 2008, growth in the GDP10 fell below 3%. In mid-2009, it fell below 2%. Ten years later, it is still below 2%.

The Federal Reserve has had difficulty hitting its target of 2% inflation with the limited tools of monetary policy. There simply isn’t enough long-term growth to put upward pressure on prices.  Despite the low growth, real stock prices are up 150% since the 2009 lows.  A prudent investor might ask – based on what?

The supply side believers in the Trump administration and Republican Party thought that tax cuts would spur growth. In the first term of the Obama administration, believers in Keynesian counter-cyclical stimulus thought government spending would kick growth into gear. Faced with continued slow growth, each side has doubled down on their position. We need more tax cuts and less regulation, say Republicans. No, we need more infrastructure spending, Democrats counter. Neither side will give up and, in a divided Congress, there is little likelihood of forging a compromise in the next two years. The stock market may be waiting for the cavalry to ride to the rescue but there is no sign of dust on the horizon.

Economists are just as dug in their ideological foxholes. The Phillips curve, the correlation between employment and inflation, has broken down. The correlation between the money supply and inflation has also broken down. High employment but slow output growth and low inflation. Larry Summers has called it secular stagnation, a nice label with only a vague understanding of the underlying mechanism. If an economist tells you they know what’s going on, shake their hand, congratulate them and move to the other side of the room. Economists are still arguing over the underlying causes of the stagflation of the 1970s.

A year ago, I suggested a cautious stance for older investors if they needed to tap their assets for income in the next five years. The Shiller CAPE ratio, a long-term evaluation of stock prices, is at the same level as 1929. At current prices in a low growth environment, stock returns may  struggle to average more than 5-6% annually over the next five years.

//////////////////////

Notes:

  1. Adjusted for inflation by the Federal Reserve’s preferred method, the Personal Consumption Expenditures Price Index (FRED series PCEPI). Prices do not include dividends
  2. Real Gross Private Domestic Investment – FRED Series GPDIC1.
  3. A video of the 1996 “irrational exuberance” speech

Deepening Debt

December 2, 2018

by Steve Stofka

Each time the Federal Reserve raises interest rates, the President tweets out his disapproval. This week Fed Chair Jerome Powell indicated that interest rates increases might be slowing and the Dow Jones average jumped up more than 2% in a few hours (Note #1). Presidents don’t like rising interest rates because they contribute to a slump in housing and car sales, two relatively small pieces of the economy that create ripples throughout a community’s economy. Trump’s strategy relies on strong growth.

The passage of the tax law last December reduced Federal tax revenues, which contributed to a rising deficit. The gamble was that the repatriation of corporate profits plus a reduced corporate tax rate would spur higher GDP growth which would offset the falling revenues. It hasn’t so far.

Let’s get away from dollars and use percentages. Economists track the annual budget deficit as a percent of GDP. I’ll call it DGDP. Let’s say a family made $50,000 last year and had to borrow $1000 because they spent more than they made, their DGDP would be $-1,000/$50,000 or -2%. In a growing economy, the DGDP rises, or gets less negative. It falls, or gets more negative, as the economy nears a recession.

DeficitPctGDP

A DGDP below the 60-year average of -2.5% indicates an unhealthy economy and, by this measure, the economy has not been healthy since 2007. The DGDP was the same in the last year of Bush’s presidency as it was in the last year of the Obama presidency. By 2014, it had risen above -3% and rose slightly again in 2015 but fell again the following year.

In 2016, the last year of the Obama presidency, the DGDP was -3.13%. In the first year of the Trump presidency it fell slightly to -3.4%. As I said earlier, the administration and Congressional Republicans hoped the tax law passed at the end of 2017 would spur enough GDP growth to offset declining corporate revenues. So far, that has not happened. The 2018 budget year just ended in September. Preliminary figures indicate that the deficit will be 3.9% of GDP this year (Note #2). Some economists project a DGDP near -5% in 2019.

Japan’s economy for the past two decades strongly suggests that an aging population weakens GDP growth. The U.S. economy must flourish against that demographic headwind. By December this year, Social Security (SS) benefits will surpass the $1 trillion mark, equal to or surpassing SS taxes collected (Note #3). For years, the excess in SS tax collections has lessened the amount that the Federal government had to borrow from the public. Each year, the government has left an I.O.U. in the SS trust fund. The total of those IOUs is almost $3 trillion.

Now the Federal government faces two challenges: interest on the ever-growing Federal debt and the government’s need to borrow more from the public to “pay back” those IOUs. The interest on the debt will soon overtake defense spending. Politicians could reduce cost of living increases in SS benefits by indexing benefits to the chained price index, a flexible measure of inflation that assumes that human beings alter their consumption in response to changing prices. Benefits are currently indexed to the Consumer Price Index (CPI) whose fixed basket of goods never changes. The CPI overstates inflation, but seniors are sure to lobby against any changes that would reduce cost of living increases. Politicians are reluctant to face angry seniors who might boot some of them out of office at the next election.

Trump has a better alternative than strategically lowering benefit increases for the swelling ranks of retiring Boomers – increase SS tax collections. The only way to do that is jobs, jobs, jobs. Jobs that are “on the books,” that take out SS taxes with each paycheck; not the jobs of the underground economy that flourish in immigrant communities. More jobs to draw in the half million discouraged workers who are sitting on the sidelines of the job market (Note #4).

Jobs, jobs and more jobs take care of a lot of budget problems. Campaign strategist James Carville stressed that point to Bill Clinton during the 1992 Presidential campaign. Higher interest rates hurt the construction, auto and retail industries, and blue collar small business service industries. All of these are more likely to reach out and hire marginal workers.

The headwinds are more than demographic. The economy has been stuck in low for a decade. In the eleven years since the 3rd quarter of 2007, just before the 2007-2009 recession, real GDP has averaged only 1.6% annual growth (Note #5). That is barely above population growth. Sectors that were strong, housing and auto sales, have slowed. Housing sales have declined for six months. Auto sales have declined for 18 months. Fed interest rate policy has been very supportive but that is slowly being withdrawn.

The DGDP is one more indicator that we should already be in a recession or approaching one. A recession will add to the demographic headwinds, increase the annual budget deficit and swell the accumulated federal debt. Job growth must counter job loss due to automation. Good policies are those likely to add jobs. Bad policies are those that thwart job growth. It doesn’t matter how well intentioned the policies are. Good or bad for job growth is all that matters in the next decade.

Here’s why. Another credit crisis is building. Low interest rates transferred billions of dollars in interest from the savings accounts of older people to businesses and government, who were able to go on a borrowing binge. Defaults and delinquency on business loans will probably be the source of our next crisis. After that is the coming pension crisis in several cities and states. Let’s hope those two don’t hit simultaneously.

////////////////////
Notes:

  1. Within a day, interest rate futures that had priced in a 1/2% increase in the Fed Funds Rate during 2019 fell to just .3% for next year.
  2. Estimates of 2018 Fed deficit and GDP
  3. Social Security trustees’ summary report for fiscal year 2017.
  4. BLS series LNU05026645 discouraged workers. After ten long years, there are now as many discouraged workers as October 2008, just as the financial crisis sent the economy into shock. Within two years after the onset of the crisis, the number of discouraged workers had exploded 250%, reaching 1.25 million in October 2010.
  5. Real GDP: 3rd quarter 2007 – $15,667B. 3rd quarter 2018 – $18,672B. Constant 2012 dollars.

Taxes – A Nation’s Tiller

Printing money is merely taxation in another form. – Peter Schiff

 

August 12, 2018

by Steve Stofka

The Federal government does not need taxes to fund its spending, so why does it impose them? Taxes act as a natural curb on the price pressures induced by Federal spending. Taxes can promote steady growth and allow the government to introduce more entropy into the economic system.

During World War 2, the Federal government ran deficits that were 25% of the entire economy (Note #1) and five times current deficit levels as a percent of the economy. Despite its monetary superpowers, the government imposes a wide range of taxes. Why?

Using the engine model I first introduced a few weeks ago (Note #2), taxes drain pressure from the economic system and act as a natural check on price inflation. During WW2, the government spent so much more than it taxed that it needed to impose wage and price controls to curb inflationary pressures. Does it matter how inflation is checked? Yes.

When price pressures are curbed by law, people turn to other currencies or barter. During WW2, the alternative was barter and do-it-yourself. Because neither of these is a recorded exchange of money, the government collected fewer taxes which further increased price pressure in the economic engine. After the war was over and price controls lifted, tax collections relieved the accumulated price pressures. As a percent of GDP, taxes collected were 50% more than current levels.

For the past fifty years, Federal tax collections have ranged from 10-12% of GDP, but they are not an isolated statistic. What matters is the difference between Federal spending and tax collections, or net Federal input. During the past two decades Federal input has become a growing share of GDP.

FedSpendLessTaxPctGDP

During the past sixty years, that net input has grown 8% per year. The growth rates have varied by decade but the strongest rates of input growth rates have occurred when the same party has held the Presidency and House. Neither party knows restraint. The lowest input growth has occurred when a Republican House restrains a Democratic President (Note #3).

FedNetInputGrowth

Let’s compare net Federal input to the growth of credit. As I wrote last week, the Federal government took a more dominant role in the economy in the late 1960s. By the year 2000, net Federal input grew at an annual rate of 10.3%, over one percent higher than credit growth. During all but six of those years, Democrats controlled the House and the purse. During those forty years, inequality grew.

FedNetInputCreditGrowth

During the 1990s and 2010s, government should have increased its net input to offset the lack of credit growth. To increase input, the government can increase spending, reduce taxes or a combination of both. When GDP growth is added to the chart, we can see why this decade’s GDP growth rate has been the lowest of the past six decades. It’s not rocket science; the inputs have been low.

FedNetInputCreditGrowthGDPGrowth

A universe with maximum entropy is a still universe because all the energy is uniformly distributed. At a minimum entropy, the universe exploded in the Big Bang. Too much clumping of money energy provokes rebellion. Too little clumping hampers investment and interest and condemns a nation to poverty. As an act of self-preservation, a government adopts redistributive tax policies. Among the developed nations, the U.S. is second only to France in the percent of disposable income it redistributes to its people (Note #4).

A nation can either tax its citizens directly, or add so much net input that it provokes higher inflation, which taxes people indirectly through the loss of purchasing power. Of the two alternatives, the former is the more desirable. In a democracy we can vote for those who spend our tax dollars. Inflation is both a tax and an unmanaged redistribution of money from the poor to the rich. How so? Credit is money. Higher inflation rates lead to higher interest rates which reduce access to credit for lower income households, and give households with greater assets a higher return on their savings.

////////////////////////////////

Notes:
1. Federal Income and Outlays at the Office Management and Budget, Historical Tables

2. The “engine” was first introduced in Hunt For Inflation, and continued in Hunt, Part 2 , Engine Flow , and Washington’s Role.

3. Federal spending less tax collections grew at a negative annual rate during the Clinton and Obama administrations. Both had to negotiate with a hostile Republican House in the last six years of their administrations.

4. “U.S. transfer payments constitute 28.5% of Americans’ disposable income—almost double the 15% reported by the Census Bureau. That’s a bigger share than in all large developed countries other than France, which redistributes 33.1% of its disposable income.” (WSJ – Paywall) The OECD’s computation of the GINI coefficient is based on disposable personal income, which is calculated differently in the U.S.

Miscellaneous:

Average GDP growth for the past sixty years has been 3.0%. The average inflation rate has been 3.3%. The 60-year median is 2.6%. The average inflation rate of the past two decades have been only 2.1%.

A good recap of the after effects of the financial crisis.

 

Our Legacies

April 29, 2018

by Steve Stofka

Each generation bequeaths the benefits and costs of legislative programs to the following generations.  In the past one hundred years, Democrats have secured a dominant majority in the Congress three times. A dominant majority is one where one party controls the Presidency and both houses of Congress with a filibuster proof majority of sixty in the Senate (History of Shifting Political Power).

Each time, the Democrats have created an entitlement program, a legacy structured so that it would be difficult to undo when Democrats were out of power.  Under FDR in the 1930s, the Democrats created Social Security. Like all entitlement programs, coverage and benefits were expanded in the first ten years after creation of the program.

In the 1960s, LBJ and the Democrats created Medicare and Medicaid. Before these programs, the Federal government paid 11 cents of every health care dollar. In 2013, that 11 cents had grown to 26 cents (CMS history PDF).  As with Social Security, coverage and benefits were greatly expanded the first decade after creation. In 1960, the U.S. spent 5.1 cents for every $1 of GDP. OECD countries spent only 3.7 cents. By 2013, Americans spent 16.4 cents of each $1 of GDP, twice as much as the 8.7 cents spent by OECD countries.

For fifty years, the annual growth of health care spending was 50% more than the growth rate of the economy.  With a dominant majority after 45 years, Obama and the Democrats tried to pass single payer health care in 2009. Democratic politicians in conservative leaning districts balked at the idea. Obamacare was a compromise solution that has been compared by opponents and advocates alike to a Frankenstein contraption of legislation that needs to be fixed. Expansion was embedded in the legislation from the start through the Medicaid program.

When the BLS and Census Bureau compute the Consumer Price Index (CPI), a measure of inflation, they consider the shifting patterns of consumer spending. Since 2000, the Medical spending component of the CPI has doubled its share of the index to about 17%. Increased medical spending is affecting most American families. Regardless of one’s opinion of the solution, Obamacare was a compromised attempt to deal with this trend.

The American health care system is like the 50-year old cars in Cuba that have been patched together with duct tape and ingenuity. The system runs on policy payoffs to stakeholder groups and it will fail most of us because it cannot adapt to the extraordinary advancements in medical care. As technological changes accelerate in the coming decades, this cobbled together system born of World War 2 wage and price controls will grow ever more unwieldy.

Entitlement programs invariably cost a lot more than the designers calculate. Program benefits are easier to sell to voters than raising the funds to pay for them. Following December’s tax reform bill, the non-partisan Congressional Budget Office revised their ten year budget and deficit estimates.

For the past fifty years, the Federal government has collected an average of $17.40 for every $100 of GDP.  The CBO projects Fed revenue will be over $18.00. Here’s the problem: the Federal government has been spending $20.30, almost $3 more than it collects. That’s how the country has run up a debt of $20 trillion. It’s about to get worse. Because of increased Medicare and Medicaid spending, the CBO projects spending will increase to $22.40 for every $100 of GDP. A $3 shortage will soon turn to a $4 shortage. The interest on that steadily increasing debt? By 2023, almost $3, a sixth of what the government collects and more than the defense budget.

Nations can not declare bankruptcy.  Instead, they become failed states and descend into anarchy.  Venezuela has become a failed state and its people are fleeing the country.  Most of the institutions have failed.  Most of the daily necessities of life are in short supply. The government claims that it doesn’t even have the paper to print exit Visas.  Under the Maduro government, truth was the first to abandon the country.

The economy is strong yet Chapter 11 bankruptcy filings have reached the same level as April 2011 when there was talk of another recession. That year, the unemployment rate was still above 9% and housing starts remained at all-time lows. Then-President Obama and Republican House Majority Leader John Boehner battled over a budget compromise and the stock market dropped nearly 20%. In a strong economy like today, we should have lower levels of bankruptcy.

 

Smackdown

February 4, 2018

by Steve Stofka

We tell ourselves stories. Here’s one. The stock market fell over 2% on Friday so I sold everything. Here’s another story. After the stock market fell 2+% on Friday, the SP500 is up only 21% since 2/2/2017. Wait a second. 21%! What was the yearly gain just a few days earlier? 24%! Yikes! How did the market go up that much? Magic beans.

Here’s another story. Did you know that there has been a rout in the bond market? Yep, that’s how one pundit described it. A rout. Let’s look at a broad bond composite like the Vanguard ETF BND, which is down 4% since early September, five months ago.  The stock market can go down that much in a few days. Bonds stabilize a portfolio.

Two stories. Story #1. The Recession in 2008-2009 produced a gap between actual GDP and potential GDP that persists to this day. To try to close that gap, the Federal Reserve had to keep interest rates near zero for almost eight years and is only gradually raising interest rates in small increments.

Story #2. The Great Recession was an overcorrection in a return to normal. The GDP gap was closed by 2014. Here’s a chart to tell that story. It’s GDP since 1981. I have marked the linear trends. The first one is from 1981 through 1994. The second trend is an uptick in growth from 1995 to the present.

GDP1981-2018

What do these competing narratives mean? For two years the economy has been growing at trend. Should the Federal Reserve have started withdrawing stimulus sometime in 2015, instead of waiting till 2017? Perhaps chair Janet Yellen and other members were worried that the economy might not sustain the growth trend. A do-nothing incompetent Congress could not agree on fiscal policy to stimulate the economy.  The extraordinary monetary tools of the Federal Reserve were the only resort for a limping economy during the post-Recession period.

Ms. Yellen’s last day as Fed chair was Friday. She served four years as vice-Chair, then four years as chair. During her tenure, she was the most powerful woman in the history of this country. She was even-tempered in a politically contentious environment. She kept her cool when  testifying before the Senate Finance Committee.  A tip of the hat to Ms. Yellen.

////////////////

Performance

Vanguard recently released a comparison of their funds to the performance of all funds.

///////////////

Trump To The Rescue

by Steve Stofka

December 10, 2017

This blog post goes to what may be a dark place for some readers. The election of Donald J. Trump may have stopped a year-long slide into recession. I didn’t start out with that conclusion. I meant to point out some interesting correlations in the velocity of money. Yeh, yawn. By the time I was done, not yawn.

If I mention the change in the velocity of money, do you groan at the prospect of a wonky economics topic? Take heart. Anyone who has slowed down from 65 MPH on a highway to 15 MPH in rush hour traffic is familiar with a change in velocity.

The velocity of money measures the amount of time that money stays in our pockets. It signals the willingness of buyers and sellers to make transactions. When buyers and sellers can’t agree on price, transactions fall and the change in velocity goes negative. In the chart below, the change in the velocity of money (blue line) often has a similar pattern to the change in real GDP (red line).

VelocityVsGDP

Both recent recessions were preceded by declines in GDP growth and the speed of money. Following the financial crisis, the Fed began to inflate the money supply in a series of policies dubbed “QE,” or Quantitative Easing. In 2011, after two rounds of QE, the Fed worried that the recovery might stall out.

Let’s turn to the green square in the chart labelled Operation Twist. Obama and a do-nothing Republican Congress were at odds so there was little chance of Congress enacting any fiscal policy to come to the economic rescue. That task was left – once again – to the Federal Reserve to use its monetary tools.

In Congressional hearings, then Fed Chairman Ben Bernanke advised the Senate Finance Committee that the short term interest rate was already zero and the Fed was out of monetary tools. The Congress should step in with a stimulative fiscal policy. The Committee members somberly hung their heads. We are incompetent, they said, so the Federal Reserve will have to rescue the country.

If it expanded the money supply further, the Fed was concerned that they would spark inflation. In hindsight, that fear was unfounded, but none of us has the luxury of making decisions while looking in the rearview mirror. Economic identities like M*V = P*Q (notes at end) are just that – looking in the rearview mirror.

The Fed resurrected a monetary tool from the 1960s dubbed Operation Twist, after the dance craze the Twist (Fed paper).  Early Boomers will remember Chubby Checker. The Fed began selling the short-term Treasuries they owned and buying long term Treasuries. By increasing the demand for long term Treasuries, the Fed drove down long-term interest rates as an inducement for businesses and consumers to borrow. Despite the low rates, consumers continued to shed debt for another year. How effective was Operation Twist – maybe a little bit (Survey).

As the price of oil declined in late 2014 and the Fed ended yet another round of QE (QE3), there was a real danger of moving into a recession. Notice the decline in GDP growth (red) and money velocity (blue).

The downward trend barely reversed itself in the 3rd quarter of 2016, just before the election, but not by much.

MoneyGDPGrowth2013-2017

The election of Donald J. Trump and a single party controlling both houses of Congress kindled hope of a looser regulatory environment and tax reform. Only then did the speed of money turn consistently upward. But we are not out of the woods yet. A year later, in late 2017, money velocity is still negative. As I said earlier, buyers and sellers still cannot agree on price. There is a mismatch in confidence and expectations. Until that blue line turns positive, GDP growth will remain tepid or turn negative.

///////////////////

M*V = P*Q is an identity that equates money supply (M) and demand (V) to inflation (P) and output (Q).

 

 

Guessing the Future

April 23, 2017

Human beings have an ability to foretell the future, or at least some people think so.  A more accurate description is that we predict the likelihood of future events based on past patterns.  Index funds average the predictions of buyers and sellers in a particular market.

During the recovery most active fund managers have underperformed their benchmark indexes. Standard & Poors, the creator and publisher of many indexes, provides a quick summary in their SPIVA spotlight. In the past five years, 88% of active fund managers have underperformed the SP500.  In a random world, I would expect that 50% of active fund managers would beat the index, and 50% of managers would underperform the index because the index is an average of all those buy sell decisions.

The 1% higher fees charged by active fund managers contribute mightily to this underperformance. Using long term averages, we expect that a third of active fund managers would beat their benchmark index.  The current percentage is only 12%. It is likely that the law of averages will eventually exert its pull.

Index funds mechanically rebalance regularly. Let’s look at a real life example.  The pharmaceutical giant Johnson and Johnson is a member of both the SP500 and the smaller group of core stocks that make up the Dow Jones index.  This week the company  reported first quarter revenues that were below expectations, and sellers promptly knocked 3% off the stock price.  Because most SP500 index funds are market weighted, index funds that mimic the weighting of the stocks in the index would buy and sell stocks in the index to capture these changes.

Because index funds are averaging the decisions of all stock investors, they should underperform. After all, the index funds are buying those companies that everyone else is buying, and selling companies that everyone else is selling.  Index funds are buying high and selling low, creating a drag on performance that is overcome by the lower fees charged by these funds.

In an article last fall in the Kiplinger newsletter, Steven Goldberg makes the case for a mix of both index and active funds.  Research shows that active fund mangers do better when an index does poorly.  It’s worth a read.

The index fund giant Vanguard is featured in a NY times article. John Bogle founded Vanguard based on his thesis that a passive approach to investing and low fees would reward most investors over the long term.

///////////////////////

Correlation, not Causation

When the stock market crashed in 1929, the unemployment rate was less than 3%.  A booming economy during the 1920s lifted demand for labor, while severe immigration restrictions enacted in 1924 reduced the supply of workers.

Unemploy1929-1942

The unemployment rate was 6% when the market crashed in October 1987 and again in September 2008. There seems to be a weak connection between unemployment and severe market crashes.  However, there is a consistent correlation between the change in number of unemployed and the start of recessions.

UnemployChange

A yearly increase in the number of unemployed on a percentage basis indicates a fundamental weakness in the economy.  Sometimes, the change reverses as it did in early 1996, at the start of the dot com boom, or in the mid-eighties after a downturn in oil and housing exposed a banking scandal. These two periods are circled in blue in the graph above.

Often the economy continues to weaken, more people lose their jobs, GDP falters and the economy slides into depression.

Because we cannot rely on just one indicator as a warning signal, we can chart the amount of production generated by each person in the labor force.  The civilian labor force includes both those who are working and those who are actively looking for work.  A growth rate below 1% indicates some weakness.  Using both the change in unemployment and the change in production helps filter out some of the noise.

While production growth may be faltering, the current unemployment level is not worrying.

///////////////////////

Pay Attention to the Pros

Institutional buyers and sellers of Treasury bonds will usually let the rest of us know when they are worried about a recession.  In a middling to healthy economy, Treasury buyers will demand a higher interest rate for a longer dated bond.  Subtracting the interest rate on a shorter term two year bond from a long term ten year bond should be positive.  In a “normal” environment, a 10 year bond might have an interest rate of 3% and a two year bond an interest rate of 1%.  The difference of 2% would be expected.  However, a negative result indicates that buyers want more interest from short term bonds because they are more concerned about short term risks.  As we can see in the chart below, a negative result precedes a recession by 12 to 18 months.  The current difference shows no indication of concern.

Guessing the future is not divination, nor is it perfect.  Retail investors may not have the time or expertise to estimate future risk, but we can study those who make it their business to manage risk.

Economic Porridge

August 31, 2014

As summer comes to a close and the sun drifts south for the winter, the porridge is not too hot or too cold.

********************

Coincident Index

The index of Leading Indicators came out last week, showing increased strength in the economy.  Despite its name, this  index has been notoriously poor as a predictor of economic activity.  The Philadelphia branch of the Federal Reserve compiles an index of Coincident Activity in the 50 states, then combines that data into an index for the country.

This index is in the healthy zone and rising. When the year-over-year percent change in this index drops below 2.5%, the economy has historically been on the brink of recession.  The index turns up near the end of the recession, and until the index climbs back above the 2.5% level, an investor should be watchful for any subsequent declines in the index.

As with any historical series, we are looking at revised data.  When this index was published in mid-2011, the percent change in the index was -7% at the recession’s end in mid-2009.  Notice that the percent drop in the current chart is a bit less than 5%.  This may be due to revisions in the data or the methodology used to compile the index.

**************************

Disposable Income

The Bureau of Economic Analysis (BEA) produces a number of annual series, which it updates through the year as more complete data from the previous year is received.  2013 per capita real disposable income, or what is left after taxes, was revised upward by .2% at the end of July but still shows a negative drop in income for 2013.  While all recessions are not accompanied by a negative change in disposable income, a negative change has coincided with ALL recessions since the series began at the start of the 1930s Depression.

Many positive economic indicators make it highly unlikely that we are either in or on the brink of recession.  Clearly something has changed.  Something that has routinely not been counted in disposable personal income is having some positive effect on the economy.  In 2004, the BEA published a paper comparing the methodology they use to count personal income and a measure of income, called money income, that the Census Bureau uses.  What both measures don’t count in their income measures are capital gains.

Unlike BEA’s measure of personal income, CPS money income excludes employer contributions to government employee retirement plans and to private health and pension funds, lumps-sum payments except those received as part of earnings, certain in-kind transfer payments—such as Medicare, Medicaid, and food stamps—and imputed income. Money income includes, but personal income excludes, personal contributions for social insurance, income from government employee retirement plans and from private pensions and annuities, and income from interpersonal transfers, such as child support. (Source)

Analysis (Excel file) of 2012 tax forms by the IRS shows $620 billion in capital gains that year, about 5% of the $12,384 billion in disposable personal income counted by the BEA.  An acknowledged flaw in the counting of disposable income is that the total reflects the taxes that individuals pay on the capital gains (deducted from income) but not the capital gains that generated that taxable income.  Although 2013 data is not yet available from the IRS, total personal income taxes collected rose 16%.  We can suppose that the 30% rise in the stock market generated substantial capital gains income.

*************************

Interest

Every year the Federal Government collects taxes and spends money.  Most years, the spending is more than the taxes collected – a deficit.  The public debt is the accumulation of those annual deficits.  It does not include money “borrowed” from the Social Security trust fund as well as other intra-governmental debt, which add another third to the public debt.  (Treasury FAQ)  This larger number is called the gross debt.  At the end of 2012, the public debt was more than GDP for the first time.

The Federal Reserve owns about 15% of the public debt.  But wait, you might say, isn’t the Federal Reserve just part of the government?  Well, yes it is.  Even the so-called public debt is not so public.  How did the Federal Reserve buy that  government debt?  By magic – digital magic.  There is a lot of deliberation, of course, but the actual buying of government debt is done with a few dozen keystrokes.  Back in ye olden days, a government with a spending problem would have to melt down some of its gold reserves, add in some cheaper metal to the mix and make new coins.  It is so much easier now for a government to go to war or to give out goodies to businesses and people.

Despite the high debt level, the percent of federal revenues to pay the interest on that debt is relatively low, slightly above the average percentage in the 1950s and 1960s but far below the nosebleed percentages of the 1980s and 1990s.

As the boomer generation continues to retire, the Federal Government is going to exchange intra-governmental debt, i.e. the money the government owes to the Social Security trust funds, for public debt.  As long as 1) the world continues to buy this debt,  and 2) interest rates stay low, the impact of the interest cost on the annual budget is reasonable.  However, the higher the debt level, the more we depend on these conditions being true.

************************

Watch the Percentages

As the SP500 touched and crossed the 2000 mark this week, some investors wondered whether the herd is about to go over the cliff.  The blue line in the chart below is the 10 month relative strength (RSI) of the SP500.  The red line is the 10 month RSI of a Vanguard fund that invests in long term corporate and government bonds.  Readings above 70 indicate a strong market for the security. A reading of 50 is neutral and 30 indicates a weak market for the security. The longer the RSI stays above 70, the greater the likelihood that the security is getting over-bought.

Long term bonds tend to move in the opposite direction of the stock market.  While they may both muddle along in the zone between 30 and 70, it is unusual for both of them to be particularly strong or weak at the same time.  We see a period in 1998 during the Asian financial crisis when they were both strong.  They were both weak in the fall of 2008 when the global financial crisis hit.  Long term bonds are again about to share the strong zone with the stock market.

Let’s zoom out even further to get a really long perspective.  Since November 2013, the SP500 index has been more than 30% above its 4 year average – a relatively rare occurrence.  It happened in 1954 – 1956 after the end of the Korean War, again in December of 1980, during the summer months of 1983, the beginning of 1986 to the October 1987 crash, and from the beginning of 1996 through September 2000.

In the summer of 2000, the fall from grace was rather severe and extended.  In most cases, including the crash of 1987, losses were minimal a year after the index dropped back below the 30% threshold.  When the market “gets ahead of itself” by this much, it indicates an optimism brought on by some distortion.  It does not mean that an investor should panic but it is likely that returns will be rather flat over the following year.

The index rarely gets 30% below its 4 year average and each time these have proven to be excellent buying opportunities.  The fall of 1974, the winter months of 2002 – 2003, and the big daddy of them all, March 2009, when the index fell almost 40% below its 4 year average.

************************

GDP

The Bureau of Economic Analysis (BEA) released the 2nd estimate of 2nd quarter GDP growth and surprised to the upside, revising the inital 4.0% annual growth rate to 4.2%.  As I noted a month ago, the first estimate of 2nd quarter growth included a 1.7% upward kick because of a build up of inventory, which seemed a bit high.  The BEA did revise inventory growth down to 1.4% but the decrease was more than offset primarily by increases in nonresidential investment. A version of GDP called Final Sales of Domestic Product does not include inventory changes.  As we can see in the graph below, the year-over-year percent gain is in the Goldilocks zone – not strong, but not weak.

New orders for durable goods that exclude the more volatile transportation industries, airlines and automobiles, showed a healthy 6.5% y-o-y increase in July.  Like the Final Sales figures above, this is sustainable growth.

***********************

Takeaways

Economic indicators are positive but market prices may have already anticipated most of the positive, leaving investors with little to gain over the following twelve months.