Federal budget update

Federal spending and revenues continue to follow a semi-virtuous path: revenues are inching higher, thanks to a modestly-growing economy, more people working, and slightly higher incomes; and spending growth remains very low, thanks to fewer people receiving unemployment benefits, and a Congress that has been gridlocked for most of the past three years.

As the chart above shows, revenues have risen from $2 trillion in 2009 to $2.4 trillion over the past 12 months, while spending has increased by only $0.1 trillion from 2009 to the past 12 months. As my good friends Art Laffer and Steve Moore note in their op-ed in today's WSJ, this supports Obama's claim to have overseen an extended period of very slow growth in federal spending. But it is ironic that Obama should take pride in the slow growth of spending under his administration when he continues to be among the most vociferous proponents of increasing government spending. They argue, and I would agree, that if Obama were to pursue policies that reduce spending further, without raising taxes, the economy would be much stronger going forward.

The first of the above three charts shows spending as a percent of GDP. One of the best things to happen as a result of relatively flat spending over the past few years is that the size of government has shrunk by two percentage points of GDP. This is a step in the right direction, since as Moore and Laffer remind us, and as Milton Friedman argued long ago, "government spending is taxation ... government can't tax an economy into prosperity. Friedman made it clear time and again that restraining government spending stimulates the economy by liberating private resources." Excessive spending can be financed by selling debt, but ultimately it must be paid for by higher taxes. So it's not so much the size of the deficit that is important, but the magnitude of spending, especially as a percent of GDP. The good news is that we have been moving in the right direction in recent years, and as a result, the deficit has receded from a scary 10.4% of GDP to 7.7% currently (by my estimate). Spending is still very high relative to GDP, however, higher than at any time since WW II, and that continues to be a burden that is slowing economic growth. 

Blogging has been light

... since our trip to The Hamptons and now New York City kept me tied up much more than I expected. 

Until I can find some time to do something substantial, I recommend an excellent and thoroughly provocative essay by Victor Davis Hanson, "The Liberal Super Nova." Liberals likely will be offended, but at the very least I would argue that he has shed light on a very important shift in the political winds in this country. 

From Greece to Italy to California to Wisconsin to Obama’s Washington, the verdict is in: the democratic statist model of trying to provide cradle-to-grave benefits, administered by an elite technocratic class, using demonization to bully the opposition and redistribute income, not only does not work, but cannot ever work.

Household balance sheets continue to improve

The Fed has released its Flow of Funds data for the first quarter, and there are several notable developments, as summarized in the chart above. For starters, households have been deleveraging since 2007 (reducing net debt by almost $1 trillion), yet the economy has failed to implode as the doomsters were predicting. Financial assets have made a full recovery back to their 2007 high, thanks mainly to a $1 trillion addition to savings deposits and a rally in the equity and corporate bond markets. The value of households' real estate holdings has recovered to 2010 levels, but is still down over $6 trillion from the 2006 highs. Finally, despite all the turmoil of the past decade (housing market collapse, financial market collapse, worst recession in generations, slowest recovery in generations), households' net worth has risen at an annualized rate of just over 4% since 1997, almost double the rate of inflation.

This is a testament to the resilience and inherent dynamism of the U.S. economy. We have managed to weather almost unimaginable storms; most households have endured wrenching and painful adjustments; nevertheless, things are getting back to where they should be, slowly but surely, thanks to hard work and savings. A good deal of this progress has come despite the headwinds of excessive government spending and regulation, despite extreme gyrations in monetary policy, and despite the huge growth in federal borrowing which has raised fears of a significant increase in future tax burdens. If monetary and fiscal policy can get back to a more stable, sustainable and predictable path in the future, and I think they can, then the outlook will brighten even more. (See John Taylor's excellent summary of what needs to be done here.)

Continued progress on the claims front

Weekly claims for unemployment came in as expected, and they were almost exactly what they have been averaging so far this year, so there hasn't been much progress in this area for awhile. But considering all the hand-wringing about the U.S. getting a case of recession contagion from the Eurozone, it's very good news: no sign at all of any deterioration in the U.S. economy as of last week. The good news here is that there's no bad news.

Meanwhile, there continues to be significant progress in the number of people receiving unemployment insurance: 1.26 million fewer people today are "on the dole" than were a year ago, and that's an impressive decline of 18.3%. And it's ongoing, especially since more and more people are going to be exhausting their "emergency claims" benefits in the months to come. This represent a positive change on the margin in the incentives that people have to find and accept a new job, and changes in incentives can be powerful factors affecting the evolution of the economy.

What TIPS tell us about the outlook for growth

I've asserted several times in the past that the real yield on TIPS is a good proxy for the market's outlook for real economic growth, but I've never done a good job demonstrating that with charts. So I had an inspiration and came up with the following set of charts which I think does a reasonably good job. As I said last month, the extremely low (actually negative) level of real yields on TIPS tells us that the bond market is very pessimistic about the prospects for economic growth. Here are some ways to understand why that is so, and in the process to gain an understanding of just how cheap equities might be.

The chart above compares the 2-year annualized real growth of GDP to the real yield on 5-yr TIPS. What I'm trying to show here is that there is a correlation, albeit not very tight, between the level of real yields and the general strength of the economy. In the late 1990s and early 2000s, real yields on TIPS were fabulously high, as was optimism about growth. I remember thinking at the time that the markets were priced to the expectation that the economy would grow at 4-5% for a long time. Since then, the economy suffered two recessions, and is still in the midst of the most disappointing "recovery" in modern times. Not surprisingly, the real yield on TIPS is as low as its ever been. Most TIPS yields are in fact negative, which means that investors are willing to lock in a negative real yield on default-free TIPS just for the privilege of knowing they won't lose any more than that, presumably because they expect that real yields could be even more negative on risky assets. The chart is suggesting that TIPS are priced to the expectation that real economic growth will be zero at best for the next two years, and that would undoubtedly lead to some very negative real returns on equities and corporate bonds.

I've showed this next chart many times over the past several years, always remarking that since the earnings yield on equities has been higher than the yield on BAA corporate bonds, this means the market is extremely pessimistic. Investors would rather accept a lower, fixed rate on corporate debt in order to have first dibs on earnings (which the market suspects will be in short supply in the future), rather than enjoy a higher earnings yield and the potential price appreciation that comes with being an equity owner.

This last chart ties real yields on 5-yr TIPS to the earnings yield on equities. The real yield on TIPS is inverted, in order to show that a lower real yield (and as the first chart suggests, a lower expectation for real economic growth) goes hand in hand with a higher earnings yield on equities. Real yields are very low and equity earnings yields are very high for the same reason: the market is very fearful that a recession and/or a period of prolonged economic stagnation awaits us. The market is unwilling to believe that the record-high level of corporate profits will last. The market is priced to the expectation that the economy will be very weak and profits will collapse. While that may prove to be the case (the market is sometimes, but not always, right), it is nevertheless a very pessimistic way of looking at things. I think it reflects the mood of investors that have been "once burned and now twice shy." I think emotions are running high and valuations may therefore be unreasonably low.

Looked at another way, if the economy ends up doing anything better than a recession, then valuations will most likely improve. You don't need to be a raging optimist to like the market, you just need to be less pessimistic than the market.

More on forward inflation expectations

Contrary to a recent post on Zero Hedge which notes that 5-yr, 5-yr forward inflation expectations according to Bloomberg's calculations have turned negative for the first time ever, I have updated my chart using Bloomberg's calculations of this variable (USGG5Y5Y Index, for those interested). Rather than falling to unprecedented lows, forward inflation expectations have now risen to their highest level since last August. My own calculations of this rate confirm Bloomberg's numbers, so I'm at a loss as to how ZH got the story backwards.

In any event, as I noted in a previous post, it is very interesting that forward inflation expectations are rising at a time when 10-yr Treasury yields have plunged. Moreover, it's very interesting that this has happened while gold has fallen, commodities have fallen, and the dollar has risen. It suggests that the driving force behind collapsing Treasury yields (and this includes the sovereign debt of the UK, Germany, and Japan as well) is a budding global panic over the likelihood of a global recession, accompanied by fears that this will all end with currency debasement (particularly of the Greek variety) and thus higher inflation. Investors apparently have an insatiable appetite for risk-free, yield-bearing assets, because they fear that everything else will be negative, while at the same time reasoning that eventually (some years in the future) governments will resort to even more monetary stimulus that will reignite inflation. It's a curious state of affairs, to say the least.

Jon Hilsenrath's story that broke late today has contributed to the rising inflation fears today, since he reports that the Fed is once again considering another round of easing. I'm still having difficulty understanding how more Fed easing could solve the problem of insolvent PIIGS, and I note in this regard that 2-yr Eurozone swap spreads are not signaling any sudden or acute shortage of liquidity. Furthermore, it seems to me that another round of QE would only exacerbate what appears to be an acute shortage of high-quality sovereign debt (e.g., Treasury notes and bonds, plus the bonds of the UK, German, and Japanese governments, all of which are trading at extremely low yields).

What this suggests, of course, is that monetary policy easing is the wrong response to the problem at hand. We don't have a shortage of liquidity, we have a failure of policymakers to understand that in order to improve the health of the world economy, we need to shrink Big Government just about everywhere. More liquidity injections may be necessary to keep banks functioning and markets liquid, but for now they can't fix the underlying problem which is more spending than private sectors can afford to bear.

On the bright side, Scott Walker's solid victory in today's Wisconsin election is one more marker on the long road to smaller government, and that's good news.

U.S. vs. Eurozone update

As I mentioned in yesterday's post, which explained why the problems that plague the U.S. economy have little to do with a lack of Fed easing, " the Eurozone is the epicenter of the world's growth and financial concerns." We have yet to see any clear signs of a significant weakening of the U.S. economy, but there is no lack of such signs in the Eurozone.

This chart compares the Institute for Supply Management's survey of the manufacturing sector for the U.S. and for the Eurozone. Note how the Eurozone was doing somewhat better than the U.S. prior to the 2008 recession, but how severely the Eurozone has underperformed since. See more on this underperformance here, where I argue that this underperformance is a good proxy for the losses that have resulted from lending to countries (e.g., the PIIGS) that don't have the ability to service their debts. It's very likely that the Eurozone (with the notable exception of Germany) has been in a recession for most of the past year.

This chart compares the ISM indices for the Service Sector in the U.S. and in the Eurozone. Here we see the same pattern as with the manufacturing sector; the sovereign debt crisis is impacting everything in the Eurozone, while the U.S. continues with its relatively sluggish recovery. (As Robert Barro so ably notes in yesterday's WSJ, this "recovery" is arguably not a recovery at all, since real growth over the past year or so has been below the economy's 3% potential, thus leading to an ever-widening gap between where the economy is today and where it could be if economic conditions and policies were better.)

So most Eurozone economies probably have been in a recession for awhile, and maybe that has contributed somewhat to the slow growth of the U.S. economy. But the U.S. economy is still not even flirting with a recession based on the ISM indices, and although jobs growth is disappointing it is still positive. As the chart above suggests, we would have to see the ISM manufacturing index fall below 47 (it's currently at 53.5) before we could see recessionary conditions. The service sector index does not yet have enough data to make a similar comparison, but the current U.S. service sector reading is 53.4, which is enough above the 50 level to suggest continued expansion.

Just because the Eurozone is in a recession does not doom the U.S. economy to a similar fate.