Overseas profits are not really overseas at all

If you read this:

Moody’s Investors Service’s Richard Lane today writes in a note to clients that the “surging” pile of cash of U.S. tech companies that is parked overseas reached $227.5 billion out of a total $457 billion at the end of the March quarter, just counting the holdings of the companies that have $2 billion or more in cash and liquid investments combined.

... you would be very tempted to think that U.S. companies with large overseas cash holdings are depriving the U.S. economy of much needed cash and investable funds. But you would be wrong.

When a U.S. corporation refrains from repatriating profits it has earned overseas, this does not necessary deprive the U.S. economy of those funds. That's because the decision to hold cash in overseas accounts is mainly an accounting and taxation issue, not a decision about where the cash should be invested. A great deal—most likely the vast majority—of the overseas-held profits of U.S. corporations is actually invested in U.S. banks, bonds, and equities. Apple and many other companies have investment shops in Nevada, among other places, where their overseas profits are managed. That cash is held in the name of a foreign company in order to avoid being double-taxed—first at the foreign location, then in the U.S. if the funds are repatriated. It is invested in much the same way that domestically-sourced profits are invested. If there is any "culprit" here it is the U.S. tax code, which insists on the double-taxation of foreign profits. Companies with foreign-sourced profits are quite sensibly trying to avoid that onerous taxation burden by leaving the money in their offshore entities. The only one being "deprived" of these foreign profits is the IRS, not the U.S. economy.

Reading the market tea leaves

What follows is a brief recap of what I think are the key indicators of market sentiment and their implications. Conclusions: markets are priced to very pessimistic growth assumptions; the risk of catastrophic failure has declined meaningfully; financial markets are for the most part liquid and functioning; risk-aversion is still extremely high; deep-seated fear and uncertainty have been replaced by a conviction that there is little hope for any meaningful growth in the global economy for the foreseeable future.

This first chart compares the Vix Index (a proxy for fear and uncertainty) with the S&P 500 (a proxy for the value of the U.S. equity market). Every major selloff in equities in recent years has been driven accompanied by a rise in fear and uncertainty. Fear and uncertainty have now declined to levels that are only modestly elevated, and equities are, not surprisingly, approaching their pre-recession highs.

However, profits as a % of GDP are now very close to their all-time highs, and are more than 40% above their pre-recession highs. The PE ratio of the S&P 500 is more than 20% below its pre-recession level. Therefore, it seems clear that the market is very pessimistic about the prospects for growth and profits in the years to come. 

The Vix index (a good proxy for the market's fear level) is still somewhat elevated, but it is much lower today than its prior peaks. Each episode of rising fear has resulted in an equity market selloff, and each time fear subsides, equity prices have risen. The current episode of declining fear is no exception. Currently, with 2-yr swap spreads firmly in "normal" territory and the Vix index not too far above its "normal" range of 12-15, .......

10-yr Treasury yields are at all-time lows. This not only reflects the market's fear that prospects for U.S. growth are dreadful, but also the global market's extreme risk-aversion.  

10-yr TIPS real yields are at all-time lows. Yet the difference between 10-yr nominal and real yields—the market's expected average inflation rate over the next 10 years—is 2.1%, which is only slightly below its 10-yr average. Despite the extremely weak recovery to date, and the economy's estimated 12% "output gap," inflation expectations have not turned negative. In fact, 5-yr, 5-yr forward inflation expectations embedded in TIPS and Treasury pricing are currently 2.6%; this in turn suggests that the risk of deflation is not a major concern for the market. That follows from the fact that the dollar is very close to all-time lows, the fact that Fed policy is both admittedly and in fact ultra-accommodative. 

Real yields on TIPS are heavily influenced by the economy's recent and expected growth potential. Investors who buy a 5-yr TIP with a real yield of -1% have the alternative of buying the S&P 500 index, so on a risk-adjusted basis (TIPS are default-free, whereas equities are not) they must be relatively indifferent to this choice, which in turn implies that expectations of real returns on equities are very low. If this chart is any guide, the -1% real yield on 5-yr TIPS suggests that the market expects zero real growth in the U.S. economy over the next few years and by inference, very low real returns on equities.

The Vix index is low, suggesting that the market is much less worried about the uncertainties of the future than it was just a few months ago. Since 10-yr yields are also very close to all-time lows, this suggests that the market seems relatively confident that the outlook for U.S. economic growth is dreadful. However, the prospect of very weak growth for the foreseeable future has not led to the catastrophically distressed valuations that we saw following the Lehman collapse and the past two outbreaks of Eurozone fears. Still, the ratio of the Vix to the 10-yr yield remains very high from an historical perspective, suggesting that valuations are still very distressed.

Despite the market's periodic attacks of fear in recent years, the gradual improvement in the economic fundamentals of the U.S. (in the case of this chart, the declining level of weekly unemployment claims) have provided support for the equity market. Eurozone fears are one thing, but so far the U.S. economy has proved to be quite resilient to any Eurozone contagion. As long as the U.S. fundamentals fail to deteriorate, Eurozone fears are likely to prove temporary and fleeting. 

2-yr swap spreads are good proxies for the degree to which banking systems face systemic failure. U.S. spreads today are firmly in "normal" territory, while Eurozone spreads have retreated significantly from last year's highs. 

This last chart compares Euro basis swap spreads (a measure of how difficult it is for Eurozone banks to get dollar funding) with 2-yr Eurozone swap spreads (a measure of systemic risk and the health of the Eurozone banking system). Both have declined this year by a substantial amount, thanks to aggressive efforts by the Fed and the ECB to supply much-needed liquidity to financial markets. Europe is not out of the woods yet, to be sure, but the risk of catastrophic failure has declined significantly. Liquid markets are the private sector's best chance to get things fixed, by distributing risk from those who don't want it to those who do. To judge from this chart, the Eurozone is making important progress. 

A tale of two jobs reports

The establishment survey of payrolls has been disappointing of late, finding an average monthly gain of only 105K new private sector jobs over the past four months. (I focus on private sector jobs because that's where the action is; the public sector workforce has been shrinking for the past three years due to budget cutbacks, and I view that as a good thing.) In contrast to the establishment survey, the household survey has registered a relatively strong average gain of 235K jobs over the same period. Since the jobs recovery began in early 2010, the household survey has registered about 5.1 million new private sector jobs, while the establishment survey has recorded 4.3 million. This discrepancy between the two surveys is large, and somewhat troubling. One survey says jobs growth is weak, the other says it is decent. Which one to believe?

The household survey is typically better at picking up new jobs in the early years of a recovery, since it is based on a sampling of the entire population, whereas the establishment survey only samples known businesses. So if there are lots of new businesses being formed, especially small ones, the household survey will find those but the establishment survey won't find them until a year or so from now when it is recalibrated to match IRS data. I'm inclined to trust the household survey more than the establishment survey right now, and so I conclude that the economy is still growing at a modest/moderate pace—nothing to get excited about, but nothing to get upset about either.

Another encouraging aspect of the June jobs report is that the labor force (all those with jobs plus those who are looking for jobs) is once again growing. Over the past year, the labor force has grown 1.1%, which is roughly its long-term average. Over the past six months, however, it's up at an annualized rate of 1.7%, and it has now reached a post-recession high. The overall growth of the labor force since the recession started is of course still miserable—the worst performance in modern times—but the change on the margin is now quite positive.

A weak dollar points to need for supply-side policies

The dollar is very weak, which is good evidence that monetary policy in the U.S. is very accommodative. But at the same time, the demand for Treasuries is very strong, which suggests that the market is extremely risk averse. What's needed is fiscal policy inspired by supply-side principles, not more monetary ease.

This chart shows the dollar's inflation-adjusted, trade-weighted value against a very large basket of currencies (over 100) and against a basket of major currencies. This is arguably the best the way to measure the dollar's value vis a vis other currencies. No matter how you slice and dice the numbers, the dollar remains at or near its lowest levels ever. A weak dollar measured against almost all currencies in the world is a prima facie evidence that dollars are in abundant supply relative to the supply of other currencies. There is no shortage of dollars; the Fed is not restricting the supply of the dollars, either intentionally or unintentionally. This observation can be confirmed by measuring the dollar's value relative to almost any commodity.

The price of gold and the value of the CRB Spot Commodity Index are both much higher than they were a decade ago when monetary policy was intentionally tight—whether measured in nominal or in constant dollars. It takes a lot more dollars today to buy these commodities.

The same can be said for the price of crude oil, which, although it has weakened some this year, is still very close to an all-time high in real terms.

In stark contrast, the extremely low level of Treasury yields tells us that the demand for Treasuries is extremely strong, and that Treasuries are relatively scarce. Real yields on 10-yr TIPS are negative, which means that those who buy TIPS today are willing to sacrifice 0.5% of the future purchasing power of the dollar per year in order to be sure of not losing even more by investing in other things. There are plenty of dollars in the world, but there is a relative shortage of risk-free, interest-bearing securities, and Treasuries are still the standard against which all other securities are measured.

How can Treasuries be in short supply if there is over $11 trillion of Treasury debt held by the public? (The Fed only holds about 10% of the Treasuries held by the public, hardly enough to make a significant difference in the relative supply of Treasuries.) The answer is that the demand for Treasuries is extremely strong, and that implies that the world is extremely worried that the return on alternative investments is likely to be very low—which can only be true if the prospects for economic growth are miserable.

In other words, it is almost certainly not the case that the prospects for growth are miserable because the Fed has not been generous enough with the supply of dollars. The Fed has increased the supply of bank reserves to such an extent that there are now $1.5 trillion of excess reserves—reserves that are not needed to back up bank deposits, and which are being held by banks because they are still very risk averse. If the Fed were to engage in yet another round of quantitative easing (which would involve the purchase of more Treasuries and the creation of more bank reserves), this would only exacerbate the relative scarcity of Treasuries, and would not likely do much if anything to increase the relative supply of dollars, which are already in abundant supply. More monetary ease could also exacerbate the problems already caused by an extended period of super-accommodative monetary policy, as the eminent John Taylor explains in his WSJ op-ed today:

... loose monetary policy was likely a big factor pushing up commodity prices. The current sharp slowdown in most emerging markets coincides with an inevitable bust of this easy-money induced boom, and the decline of foreign demand for American goods is now feeding back to the U.S. economy.

Indeed, one reason that global growth prospects are dismal is precisely because monetary policy has been so accommodative. Think about this: all currencies are weak relative to gold and commodity prices, not just the dollar. Central bankers can only do so much to stimulate growth, and they have probably done too much already. That might explain why the market's reaction to today's coordinated easing by the central banks of England, the Eurozone, and China was tepid if not negative. Enough with the easy money stuff, what we need is a reason to be genuinely confident about the future. In the absence of any clear vision in Washington or the Eurozone for fiscal policies that could accomplish that, what we are left with is a market that is extremely risk averse.

From my supply-side perspective, what's needed is fiscal stimulus that shrinks the relative size and scope of the public sector (yes, cutting government spending from its current lofty level is quite likely to be stimulative because it allows the private sector to more efficiently deploy the economy's scarce resources), reduces the burden of regulations, broadens the tax base, and lowers and flattens tax rates. We've had enough money printing and faux-stimulative Keynesian policies. Going forward, governments need to step back and give the private sector a chance to work its magic. Unfortunately, Romney only imperfectly understands this, while Obama believes in the exact opposite. The market is pointing politicians in the right direction, if they would only pay attention to its signals.

Service sector disappoints, but ADP beats

Today's news was mixed, with the biggest disappointment coming from the ISM service sector report. Other releases, however, were generally positive. Overall, I don't think this provides any new insights into the economy's health, but there is very little if any support here for the view that the economy is once again slipping into a recession. It's just more of the same: an economy growing at a disappointingly slow pace.

The ISM service sector survey (top chart) came in below expectations, and definitely looks weak; it might support the case for another recession. However, the employment index (second chart) picked up a bit. With a plunge in new orders driving the decline in the overall index, this might be a case of Eurozone-induced anxiety rather than any fundamental deterioration in the economic fundamentals.

The ADP employment report was quite a bit stronger than expectations (176K vs 100K). As the chart above suggests, this points to a payroll report tomorrow that could be stronger than the 100K expected. That would definitely rule out a recession.

Weekly unemployment claims were on the low side of expectations, and there is no sign that the downtrend that began over three years ago has come to a halt or reversed. Nonseasonally adjusted claims (chart above) were down over 13% from year-ago levels, and the 52-week average of claims continues to decline. No sign here of any incipient recession. Moreover, the total number of people receiving unemployment insurance has dropped by 1 million (over 15%) over the past year, and that means that the incentive to find and accept jobs continues to rise. 

The Challenger tally of announced corporate layoffs fell, and as the chart above shows, this index is quite low, showing no signs of any unrest in the corporate sector.

Apple has trounced MSFT

This is the most powerful evidence I've seen that Microsoft has been trounced by Apple. See the full story here.

UPDATE: Here is a chart which makes the same point from a different perspective. Apple's $574 billion market cap is now more than double Microsoft's.

Gloomy 4th at the beach

It's a "May-June gloom" day at Calafia beach today, unfortunately. Water temp 65º, cloudy skies, but decent surf. That hasn't stopped thousands of people from flocking to beach however. Here's a shot from near the San Clemente pier, which shows how one enterprising group has claimed a choice bit of beach front in order to watch the fireworks tonight—and furnished it with astroturf, patio furniture, and a gas BBQ!