Apple continues to innovate

On Wednesday I joined millions of people in downloading Apple's new and greatly improved operating system for mobile devices, iOS 7. After playing with it for awhile, I can say I'm delighted. It's like having a brand new phone. And it's not just me; in just two days, a significant portion of Apple's installed base has upgraded to iOS 7. A much greater percentage of Apple phones are now running the newest software than is the case with Android-based phones. It is reasonable to expect that, as Apple claims, iOS 7 will be the most popular mobile software in the world before too long, because the vast majority of iPhones and iPads being used today are eligible for the upgrade, and it is relatively easy to do. The same is not true of Android phones, only a fraction of which can use the latest version of Android.

The new software represents a complete overhaul, adding hundreds of new features and capabilities, all with a fresh new look. One new feature, Activation Lock, means a stolen iPhone becomes useless; the phone cannot be reactivated without a user's Apple ID and password, and Apple requires all passwords to be relatively complex. The camera software is now easier to use, with added editing features. Font sizes can be increased or decreased. Developers now have 1,500 new APIs to play with, opening the door to even more innovation.

Meanwhile, Apple's new iPhone 5S comes with a 64-bit processor (a first for the smartphone market), and a fingerprint scanner, both of which will be hard for competitors to copy in a short time frame. Plus, a new camera sports a bigger aperture, larger pixels, a new dual flash, and software capabilities not found in any camera. Reviewers almost universally consider the 5S to be the best smartphone on the market. Initial reports suggest the iPhone 5S is selling like hotcakes. The cheaper 5C is likely to do very well in overseas markets.

Within the next month or so, Apple is likely to introduce a new generation of iPads, and Apple already dominates the tablet market. Tablets are replacing laptops and desktops all over the world.

Apple has over $100 billion in cash, equivalent to more than $110 per share, and it pays a 2.6% annual dividend—which represents only 10% of its current cash holdings. Backing out the cash, AAPL trades with a trailing PE of 9 and a forward PE of 9.2, which means that the market is pretty confident that Apple's best days are behind it, and there is little chance that earnings will continue to grow. That's a pretty pessimistic assessment of a company that has revolutionized and created entire industries (e.g., smartphones and tablets), and that continues to deliver high quality and innovative products to a global market with significant growth potential.

You don't have to be a wild-eyed optimist to like this stock.

Full disclosure: I am long AAPL at the time of this writing.

Jobless claims are very low, what's lacking is new hiring

The number of first-time claims for unemployment has been artificially depressed in recent weeks due to computer system overhauls in two states, but the trend in claims has not likely changed: it's down, and the level of claims is about as low as it's ever been (first chart above). Meanwhile, the number of people receiving unemployment insurance has rarely been so small. The labor market may be plagued by a dearth of new positions, but it is certainly not plagued by too many layoffs. Indeed, today the chances of a worker being laid off are about as low as they have ever been (second chart above).

The number of people who continue to receive unemployment insurance has not been materially affected by computer problems, and that too continues to decline. In the past year, the number has shrunk by 22%, or 1.12 million, and it is getting very close to pre-recession levels. In this aspect of the workforce, the economy has managed to stage an almost-complete recovery.

Very few observers pay much attention to the so-called Leading Economic Indicators, but the truth is that they haven't done such a bad job. They may not be very leading, but they have consistently turned down during every recession and risen during every growth cycle. As of August, they were up over 4% from a year ago, and that is consistent with a growing economy and very little chance of recession.

The chart above shows the level of the index, and I have highlighted how similar the past 13 years have been to the period from 1965 to 1982, during which time the stock market suffered from miserable  performance, falling 62% in real terms (see chart below). It's been a miserable recovery this time around, but the stock market is in much better shape, perhaps because we have not had a big problem with inflation like we did back in the 1970s.

All in all, it looks like economic conditions are gradually improving. All that's needed to convert this miserable recovery into a robust recovery are more "animal spirits." Businesses need to regain more confidence (so that they are more willing to invest in new plant and equipment and hire more workers), and a good way to help businesses regain confidence would be for regulatory and tax burdens to be lightened, and for monetary policy to become more rules-based.

How much higher should interest rates be?

We're leaving paradise today, so in the absence of time I offer this chart which makes a statement about the level of inflation and interest rates over the past decade. Inflation and inflation expectations are one of the most important determinants of interest rates.

From 1993 through early 2011, Treasury yields tracked core inflation quite closely, and interest rates were always somewhat higher than inflation, just as theory would predict. But from early 2011 through April of this year, that wasn't the case: interest rates moved down while inflation rose, and interest rates fell below the level of inflation (and real interest rates entered negative territory).

Most observers seem to believe that interest rates were abnormally low because of the Fed's QE program. But as the chart above shows, interest rates actually rose each time the Fed bought large quantities of bonds.

I've argued that interest rates fell to unusually low levels because the world expected U.S. economic growth to be very weak, and feared that another recession was on the horizon. Interest rates have moved higher of late because the outlook for the U.S. economy has improved somewhat.

The recent jump in rates appears to be the first step in restoring the normal relationship between interest rates and inflation. Rates are still relatively low, however; if inflation remains at current levels and the economic outlook continues to improve (e.g., the market begins to price in growth expectations of 3% or better), then short- and intermediate-term interest rates should and could rise by another 100 bps. 10-yr Treasury yields could rise by another 50 bps or so.

Demand for safe assets beginning to decline

I first introduced this chart a few months ago. I think it's a good way to track the world's demand for safe assets. Gold is the classic "safe asset," being both durable and traditionally a refuge from monetary and political risk. 5-yr TIPS are also a "safe asset" since they are default-free, their price is relatively stable, and they offer protection from inflation. As the chart shows, the real yield on TIPS has correlated inversely with the price of gold for most of the past six years. (Another way to say this is that the price of TIPS, which moves inversely to their real yield, has correlated positively with the price of gold.) Both prices have been moving down of late, which I think tells us that the world's demand for safe assets is beginning to decline, after having risen substantially for more than 5 years.

If gold and TIPS are at the cutting edge of the demand for safe assets, then they could be leading indicators of the demand for other safe assets, such as cash, currency, bank savings accounts, and short-term bonds. So far, there is little, if any, evidence that demand for these other safe assets is declining.

U.S. currency in circulation is growing at about a 7% annual rate, or about the same pace it's averaged for the past 4-5 years. There's no sign of any slowdown in the growth rate of currency, and I note that the world's demand for dollars has been relatively stable over this same period.

Similarly, there is no sign of any slowdown in the growth of M2, arguably the best measure of "money." For the past two years, M2 has grown at a 6.5-7% pace, which is only slightly above its long-term average.

Bank savings deposits have been growing at an 11-12% annual pace since the Lehman crisis in Q3//08. The pace of growth has slowed a bit in recent months, but is still relatively strong at 9-10%. Demand for the safety of bank savings deposits is still strong.

After four years of strong and virtually uninterrupted gains, taxable bond funds have experienced significant outflows in the past several months. This is a sign that the world is less anxious for the relative safety of bonds, and this reinforces the message of TIPS and gold.

To judge from this collection of charts, any decline in the world's demand for safe assets is still in its early stages.

The unhurried way of life

This is the reason that blogging has been light this past week. We're at our favorite spot in paradise: the Napili Kai Beach Resort in Maui. Their motto is "the unhurried way of life," and indeed it's hard to do anything but relax and enjoy the beauty.

The incredible shrinking budget deficit

Since hitting a high of $1.478 trillion in February 2010, the U.S. federal budget deficit has plunged by 54% to a new, post-recession low of $679 billion in the 12 months ended August 2013. Two factors accounted for the bulk of the decline: federal outlays have declined (both in nominal terms and relative to GDP) and revenues have grown. Virtually no one expected the budget outlook would improve so quickly and so dramatically. Since the decline in spending is without post-war precedent, whereas the rise in revenues is fairly typical of recoveries, the real surprise here is the degree to which spending has declined.

As the chart above shows, there has been no growth in federal spending since the recession ended in mid-2009. Federal revenues, on the other hand, have been rising almost continuously since late 2009. 

Relative to GDP, spending has declined by over 15%, from 24.4% of GDP to 20.6%, while revenues have increased by almost 17%, from 14.2% of GDP to 16.5%. The budget deficit is now a mere 4.1% of GDP, down from a high of 10.2%. In less than 3 years, the federal budget outlook has gone from dire to almost normal. It's nothing short of astonishing.

And despite the unprecedented and almost completely unexpected shrinkage of federal spending, the economy has been growing and the unemployment rate has been declining. Far from precipitating another recession, as Keynesians would have argued just a few years ago, our incredibly shrinking public sector has coincided with a meaningful improvement in the economy. (Yes, I know that the employment situation is still miserable, but it's undeniable that things have improved.)

It's tempting to conclude that the massive fiscal "stimulus" of 2009 was bad for the economy, while the unwinding of that "stimulus"in recent years has been good. (We can't know for certain, of course.) But at the very least, this is a very important example of the Law of Unintended Consequences, which loves to thwart the best intentions of politicians: government spending doesn't always do what it is expected to do.

As I've explained before, this is very good news. As Milton Friedman taught us, spending is taxation, so the big decline in spending means that the expected burden of future taxation is far less today than it was thought to be just a few years ago. This is equivalent to a dramatic reduction in the headwinds facing the economy. It's also a big reduction in the level of uncertainty that has plagued the economy for the past several years. In a supply-side model, this is a good reason to be optimistic about the future, since declining tax burdens and reduced uncertainty should prove to be fertile ground for much-needed new investment.

It may be too much to hope for, given that the healthcare exchanges are supposed to open for business in less than 3 weeks, but I continue to believe that Obamacare will never see the light of day. It's terribly unpopular, more and more unions are against it, the exchanges aren't ready, and the deferral of the employer mandate opens the door to massive fraud unless the individual mandate is also postponed. Even if the exchanges open and the individual mandate takes effect on January 1st, it is inevitable that Obamacare will fail to achieve its objective, all the while creating unpleasant and unintended consequences for tens of millions of citizens. From the very beginning, it was clear that there was almost a zero chance that the government could re-engineer and restructure one-sixth of the U.S. economy in a way that would work to the benefit of the majority of the people. It was hubris to the max, and as such, virtually guaranteed to fail.

If the implementation of Obamacare is delayed, this would result in another boost (by reducing expected tax and regulatory burdens) for the U.S. economy.

The message of rising yields is very good

Over the past year, both Treasury yields and stocks have risen significantly, and therein lie some important messages. One, that the Fed's QE program has totally failed to lower Treasury yields; yields are up despite the Fed's monthly purchases of $85 billion of Treasuries and MBS (MBS yields are actually up much more than Treasury yields since the Fed started its current QE program). Two, that the Fed was never able to control or artificially lower Treasury yields—the market controls the level of Treasury yields. Three, that the Fed never did distort or artificially depress yields, and never did artificially "stimulate" the economy. Four, that rising interest rates are not bad for stocks. Five, that interest rates and stocks are rising because the underlying economic fundamentals are improving—even though this remains the most miserable and weakest recovery in U.S. history. 

It's also very important to note the message of TIPS. Real yields on TIPS have risen a bit more than nominal yields on Treasuries, which means that the market's inflation expectations have declined a bit. That's another way of saying that the rise in Treasury yields has been dominated by a rise in real yields, not by a rise in inflation or inflation expectations. Higher real yields confirm the message of stocks: what has been happening over the past year is an improvement in the economic fundamentals. Even though (I repeat) this remains the most miserable and weakest recovery in history.

UPDATE: Reader "Sil Sanders" notes that it's not obvious from my charts and my explanation (admittedly brief) above that QE has failed to keep rates low. For a more complete explanation, see my post from last month, "Why QE was a successful failure." The chart below is an updated version of one of the charts from that post:

As I said back then, 10-yr yields ended up higher at the end of each QE program, and were unchanged at the end of Operation Twist. Yields only fell during periods when the Fed was not engaged in buying bonds—surely a counterintuitive result.

As I argued in the post linked above, and on many other occasions (here, here, here, and here), the only result the Fed could hope to achieve with QE was to raise, not lower rates, by responding to the world's demand for safe assets and thus alleviating a potential liquidity shortage which likely would have led to a weaker economy. As I've argued many times in the past, interest rates are fundamentally determined by the market's perception of economic growth and inflation. The chart above shows how real yields on TIPS tend to track the economy's growth rate, and the chart below shows how nominal yields track inflation.

I would argue that it makes much more sense to view the decline in yields over the past 5-6 years as a response to the market's expectation that economic growth would be very weak and inflation very low, rather than as the result of the Fed's bond purchases, which after all only represented a small fraction of the outstanding amount of bonds and MBS. That same logic, combined with a modest decline in inflation expectations in recent months, argues that the recent rise in yield is therefore the result of the market's improving expectations for economic growth in the years to come. As the second chart above shows, however, current 10-yr yields suggest the market now feels comfortable with economic growth of about 1% per year. Not too long ago, 10-yr yields were consistent with growth expectations of zero or even a modest recession. Even with the recent and rather impressive rise in 10-yr yields, the market's outlook for future economic growth is still quite modest.

One final point: if I'm right, and QE never artificially lowered rates nor directly stimulated the economy, then the "tapering" and eventual reversal of QE should not pose any threat to the economy as so many seem to fear, so long as the Fed's efforts have satisfied the world's demand for "safe assets."

Interest rates are up because the economy is stronger

Within the past 4-5 months, 10-yr Treasury yields have jumped by 140 bps, and 10-yr TIPS real yields have shot up by almost 190 bps. Most observers attribute this huge repricing in the Treasury bond market to the anticipation of a sooner-than-expected tapering of the Fed's Quantitative Easing bond purchases, and the rise in short-term rates which will inevitably follow. While that's a fair description of what's happened to market psychology, the more important driver of higher yields is simply the fact that the economic fundamentals have improved considerably.

The above chart shows my interpretation of the intrinsic value of 10-yr TIPS. Real yields that are guaranteed by the U.S. government are a very special animal: nowhere else can you find a fail-safe real return on your money. When real yields were deep in negative territory not too long ago, it was a sign that investors were so worried about the prospects for the economy (and the real profits to be found in alternative investments) that they were willing to forgo any chance of a positive real return. TIPS became extremely expensive because fear was rampant. Now TIPS are approaching what might be considered "fair value" territory. Investors' fears are subsiding, and confidence in the future is returning. This is extremely important because one of the hallmarks of this recovery has been a lack of confidence.

The chart above compares the real yield on 5-yr TIPS to the growth rate of the U.S. economy. Normally, the two ought to bear some resemblance to each other. When the economy was booming in the late 1990s, real yields were 4% because they had to compete with the very strong real returns that investors expected from alternative investments. Today, real yields are returning to levels that suggest the market now believes the economy can grow by 2% a year. That's hardly impressive, but it is a lot better than zero.

We've seen plenty of evidence of a stronger economy in recent months: corporate profits are very near record highs, both in nominal terms and relative to the economy; employment is rising at a fairly steady pace of 190K per month; weekly claims for unemployment have fallen to very low levels; car sales continue to increase at double-digit rates; and conditions in the manufacturing and service sectors have improved, both here and abroad. Federal revenues are up almost 13% in the past year, and they have risen at a 15% annualized pace in the six months ending in July; tax revenues don't rise like this unless there is some real improvement in jobs, incomes, capital gains, and corporate profits.

What's not to like about this? Weekly claims have fallen steadily for four years and are now down to very low levels. Businesses have trimmed just about all the fat they had. Labor market conditions have improved dramatically.

Car sales have been rising at strong double-digit rates for the past four years, and have almost returned to pre-recession levels. This is a picture of a powerful V-shaped recovery. Car sales have exceeded all expectations, and that in turn has caused manufacturers to ramp up production, hiring, and purchases of materials and parts. There are ripple effects from this that have benefited many sectors of the economy already. Housing starts have experienced a similar double-digit recovery in the past two years.

The service sector of the U.S. and Eurozone economies has experienced some surprising strength in recent months. The Eurozone is clearly pulling out of its 2-year recession, and the U.S. economy appears to have regained a surprising amount of strength.

Meanwhile, despite all these signs of improvement, the equity market is still plagued by doubts. The Vix Index rose from 12 to almost 17 recently, while the S&P 500 index dropped 4% from its all-time high. High-yield bonds have shed over 5%, leveraged bond and preferred equity funds are down 15-20%, equity REITS plunged almost 20%, and home builders' stocks gave up 10-25%. Taken at face value, these indicators suggest that the market believes rising interest rates will short-circuit any nascent improvement in the economy and derail the housing recovery that began some two years ago.

This is the sort of "good news is bad news" thinking that is symptomatic of a market that suffers from a shortage of optimism. It's also rather short-sighted, since we know that the economy has been very strong in the past when interest rates were far higher than they are now.

The market's concerns are undoubtedly rooted in long experience with business cycles: e.g., booms are followed by busts, and falling rates are followed by rising rates. But we are still in the very early stages of the current business cycle expansion, and therefore these concerns arguably are premature. After all, it's still the weakest recovery ever, and it will take at least another year or so before the number of jobs exceeds its early 2008 high. And although the Fed seems likely to begin its "tapering" operation soon, the Fed is likely to wait until at least next year before starting to raise short-term interest rates. If the economy should sputter as the market seems to fear, then the Fed could easily postpone any plans to tighten. At this juncture, there is little to fear from the upcoming changes to monetary policy because there is as yet no reason for the Fed to take any dramatic actions; inflation is under control, economic growth is still relatively modest, and the dollar has enjoyed a modicum of support in recent years.

If the market is making a mistake, it's in thinking that low interest rates are stimulative, and high interest rates are depressing; that interest rates are the tail that wags the dog. In reality, however, the economy is the dog that wags the interest rate tail. Low interest rates are symptomatic of a weak economy, and high interest rates go hand in hand with a strong economy, just as low inflation results in low interest rates, while high inflation pushes interest rates higher. I've detailed before why it is that the Fed's QE is not stimulative; it's primary purpose has been to satisfy the world's demand for safe assets. As the demand for safe assets declines, and as confidence returns, then it is entirely appropriate for the Fed to first taper and then reverse its QE program. The market is now realizing this, and that is why interest rates are up. It's not scary, it's a breath of fresh air.

ISM manufacturing report encouraging

The August ISM manufacturing report beat expectations (55.7 vs. 54), and was generally strong. As the chart above suggests, this is consistent with an acceleration of economic growth in the current quarter relative to the second quarter's 2.5% growth, possibly to something in the range of 3-4%. This is quite encouraging, even if it means that the recovery is still only modest and sub-par.

Export orders were relatively strong (top chart), and this suggests that conditions overseas are improving. As the second chart above shows, conditions in the Eurozone are indeed improving. As the third chart shows, manufacturing conditions in China also have improved, albeit only marginally. Nevertheless, this is a positive, since the world has feared that conditions in China are deteriorating. China's economy is probably growing at a 7% rate; although that is only modest by Chinese standards, it is still more than twice the growth rate of developed economies. A growing China is supportive of global growth in general.

The prices paid component of the ISM report shows neither inflation nor deflation concerns.

The employment sub-index was marginally positive, and still reflects a business climate that is lacking in confidence. Although business conditions are improving, things could be a whole lot better.

As I've noted dozens of times in the past several years, swap spreads are good leading indicators of economic health; a healthy financial system is, after all, a necessary condition for a healthy economy. As the above chart shows, Eurozone swap spreads have indeed been excellent leading indicators of Eurozone manufacturing activity. Swap spreads are still somewhat elevated in the Eurozone, but they are declining on the margin, suggesting that manufacturing activity is likely to continue to improve.

Finally, the new orders sub-index was quite strong in August, and that augurs well for manufacturing activity in the coming months.

It is ironic—but symptomatic of a market that is still lacking in optimism—that risk assets should be struggling of late despite the relatively widespread improvement in the global growth outlook. The logic driving the market these days seems to be that better-than-expected news means higher-than-expected interest rates, and that in turn means that growth will be worse than expected in the future. I don't buy it (I think higher interest rates in today's environment imply stronger growth in the future), but that seems to be the current mood of the market: good news is somehow bad news.