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.

Corporate profits continue strong

Today's first revision to Q2/13 GDP growth (which was revised up from 1.7% to 2.5%) brought with it the first look at corporate profits for the quarter, and the news was excellent. After-tax corporate profits rose to a new all-time of $1.68 trillion, up 7% from a year ago. This is actually within the realm of astonishing if one considers that this measure of profits (arguably the best measure of "true" or economic profits) has increased 218% since the first quarter of 2000 (when the S&P 500 hit its peak for the year), yet the S&P 500 is up only 7.5% since then. With the benefit of hindsight we know that stocks were grievously overvalued in 2000—but that can hardly be the case today.

Note how strong corporate profits have been since 2000, despite the current sluggish recovery (actually the weakest recovery in history).

The chart above provides a long-term perspective on how corporate profits behave relative to nominal GDP.

Relative to nominal GDP, corporate profits today are just shy of an all-time high.

Using the methodology explained in my post last week, the chart above shows the PE ratio of the stock market using the NIPA measure of after-tax corporate profits instead of trailing 12-month earnings. This suggests that stocks currently are trading about 25% below their historical average PE. This is also astonishing since PE ratios tend to track interest rates inversely (i.e., PE ratios tend to be low when market interest rates are high, and vice versa). 10-yr Treasury yields are still extremely low from an historical perspective, yet PE ratios are quite low from the same perspective. This suggests that the market has hardly any confidence in the ability of corporate profits to maintain current levels. Instead, it seems like the market is priced to the expectation that corporate profits will "mean revert" to their long-term average of 6-6.5% of GDP.

But as I've argued before, it is not necessarily the case that corporate profits have to, or are likely to, revert to some historical mean relative to GDP. U.S. corporations are increasingly operating in a rapidly-expanding global economy and marketplace. As the chart above suggests, corporate profits relative to global GDP are still fairly close to their long-term average. Thus there may be little reason to think that profits need to decline significantly or that they are at unsustainably high levels today.

NIPA profits and reported earnings tend to track each other over time, with NIPA profits tending to lead trailing earnings. This suggests that reported earnings are likely to continue to grow.

At the very least, the news on corporate profits provides solid support to the current level of equity valuations. Viewed from an optimistic perspective, stocks would appear to have lots more upside potential and could be considered significantly undervalued.

How scary is Syria?

The Obama administration has been busy preparing the world for a likely and imminent attack (most likely via drones and/or cruise missiles) against Syria in retaliation for Assad's use of chemical weapons on his people. Markets are nervous.

Things could certainly get worse, if, for example, Iran carries out its threat to attack Israel in retaliation for a U.S. attack against Syria. But for now, let's let key market-based indicators tell us how scary the current situation is:

The Vix index of implied equity volatility has jumped to almost 17, its fourth-highest level this year. Earlier this month it sat at a relatively tranquil 12.

But from a multi-year perspective, today's jump barely registers.

Comparing the Vix Index to the 10-yr Treasury yield shows the current threat to be more substantial than just looking at the Vix in isolation. That's because 10-yr Treasury yields are still quite low from an historical perspective—which is symptomatic of a pretty weak economic outlook. Markets are nervous and the economy is weak, so that is more threatening than if the market were equally nervous but the economy were stronger. Still, the current Vix/10-yr ratio pales in comparison to the level registered during other major events in the past two decades.

The chart above shows Bloomberg's calculation of the PE ratio of the S&P 500. It's down today because everyone is nervous, but it's only a bit less than its long-term average of 16.6. That's neither over- nor significantly under-valued.

On balance, it would appear that the market today is saying that while the Syria issue is certainly something to worry about, it is not likely to have much of an impact on the economy.

We'll soon know if the market has correctly estimated the gravity of the Syria situation.

Housing recovery slows down

It's nice to see housing prices clearly on the rise, as shown in the chart above. It's about time, considering that housing has suffered through a four-year consolidation after three years of a terrifying decline. Housing starts collapsed, falling by more than 75% from early 2006 through 2009. Dramatically lower prices and an almost-complete halt to new construction were necessary to "fix" the oversupply of homes, and enough time has now passed to think that the process of recovery is finally underway.

But as the chart above shows, the pace of improvement is slowing. The chart shows nonseasonally adjusted prices for 2011 (red), 2012 (orange) and 2013 (white). Prices this year are not following the typical seasonal pattern we've seen in other years—there has been some weakness of late (April and May). This has probably continued, since we know that new mortgage applications have dropped a little over 10% in the past two months, mainly in response to a sharp increase in mortgage rates. It's going to take several months for the market to adjust to the new reality of higher interest rates.

On an inflation-adjusted basis, the recent rise in home prices has been only slightly more than necessary to make up for the past several years' worth of inflation. We're seeing a recovery in nominal prices, but only a modest rise in real prices from the nominal lows of 2009. I doubt we're going to see any actual weakness in the housing market, but the recovery has lost some of its steam, so improvement in the months to come will likely be much less exciting.

20 optimistic charts

I continue to believe that the market is dominated by pessimism rather than optimism. Or, if you will, that there is a shortage of optimism.

What follows are some 20 or so charts, in random order, which highlight optimistic developments in the economy and financial markets which I believe are underappreciated. They paint a picture of an economy that is stronger and more durable than the skeptics seem to believe. There's still plenty of room for improvement, to be sure, but there are few if any signs of deterioration.

Banks have increased their lending to small and medium-sized businesses by almost $400 billion in less than 3 years. This reflects increasing optimism on the part of banks (who are more willing to lend) and on the part of businesses (who are more willing to borrow). There are undoubtedly many businesses that have been unable to obtain loans for worthwhile projects, but their number is definitely declining on the margin. One of the key factors holding the economy back in recent years is a lack of confidence; banks have been reluctant to lend, and businesses have been reluctant to borrow. This is all symptomatic of the deleveraging that has been the national pastime for most of the current recovery but which is slowly fading away.

Consumers have also been working to deleverage, and it shows in the three charts above. Delinquency rates on credit cards and consumer loans in general have fallen to the lowest level in recent history, while credit card loan chargeoff rates have plunged to levels rarely seen in the past. Households' financial burdens (monthly payments as a % of disposable income) have fallen to their lowest level in many decades. Consumers on average are in much better financial health these days than they have been for a long time.

Credit spreads are excellent indicators of the health of corporate balance sheets and cash flow. Spreads today are very near their post-recession lows, which marks significant progress from the terrifying heights of the past recession. But spreads are still substantially higher than they have been at their previous lows. We've made great progress, but there is still room for improvement. It's worth noting that even with the current scare over the approaching "tapering" of QE, credit markets reflect absolutely no increase in systemic risk. Investors and analysts may be spooked by tapering, but the bond market is behaving as though it is going to be a non-event. 

The number of people receiving unemployment insurance has been declining steadily and significantly for over four years. There are 1.15 million fewer people "on the dole" today than there were a year ago, and that's a sizable reduction of over 20%. This is creating healthier incentives in the workforce, since it means many of the unemployed have a stronger incentive today to find and accept a job.

Mortgage rates are up sharply in the past few months, but they are still extraordinarily low from an historical perspective. While this raises the bar for new homebuyers, most are still in good shape to qualify, as the second of the above charts shows. A typical family earning a median income today still has about 66% more income than needed to qualify for a conventional loan for a median-priced house.

The above chart shows Bloomberg's Financial Conditions Index, a composite of a variety of key indicators of financial market health (e.g., implied volatility, general liquidity conditions, credit spreads). This index is now at a new high. Healthy financial markets are necessary for a healthy economy, but not sufficient, of course. We are still lacking in the confidence department, and government is still placing excessive regulatory and tax burdens on the economy. That's terribly unfortunate, but having healthy financial fundamentals does mean that the right combination of growth-oriented policies could unleash a new wave of economic growth.

Several months ago, I noted that one of the biggest changes on the margin was the rise in real yields. That's still the case today, and the above three charts help explain why. The big rise in real yields has tracked closely with the decline in gold prices (see the first of the three charts above), and that tells me that the market's appetite for "safe assets" has declined. Gold is the classic refuge from geopolitical and monetary uncertainty, and its decline tells us that the world is worried less about the possibility of a Fed-induced hyperinflation. The measure of the decline in real yields I've used is 5-yr TIPS, because they are another type of "safe asset": default-free, relatively short-term in nature, and immune to inflation. Rising real yields are the flip side of declining demand for TIPS. A decline in the demand for safe assets mirrors an increase in the world's confidence, and that bodes well for future growth.

As the second chart above shows, real yields have a strong tendency to inversely track the earnings yield on stocks. Very low real yields and very high earnings yields are symptomatic of a market that is deeply pessimistic about the prospects for economic growth and corporate profits. The recent reversal thus marks a key improvement in the market's outlook for the future.

The third chart above shows how real yields tend to track the economy's growth rate. Very high real yields are typically found at times when economic growth is very strong, and low real yields are symptomatic of weak growth. The recent rise in real yields means the market is now somewhat less pessimistic about the future.

The world still agonizes over U.S. budget deficits, but the above charts document the huge improvement there has been in the just the past few years on this front. Most of the improvement has come from stable and even declining levels of federal spending, since that shrinks the burden of government and gives the private sector more breathing room. Strong growth in revenues has also contributed, but that is more symptomatic of an improving economy (e.g., more jobs, higher incomes, higher profits) than it is of higher tax rates. It all adds up to a huge reduction in the burden of the deficit, from a high of over 10% of GDP to the current level of just over 4%. This is very positive for the future, since it dramatically reduces the likelihood of the need for higher tax rates and even opens up the possibility of tax rate reductions.

Swap spreads are critically important and sensitive indicators of systemic risk. Currently below 20 bps, they signal very healthy financial market conditions and an almost complete absence of systemic risk.

Architectural billings have been increasing for most of the past year, a clear sign that the economy has recovered enough confidence to once again begin major construction projects. The improvement here is still in its infancy, however, but that does nothing to take away from the importance of this development.

Mortgage rates typically follow the yield on 10-yr Treasuries. The spread between the two averages about 80-100 bps, and that's pretty close to where we are today. Mortgage rates have jumped along with Treasury yields, but both are still very low from an historical perspective. The recent rise in rates is very unlikely to snuff out economic growth; it's much more likely to be symptomatic of the economy's improving (though still relatively weak) economic growth fundamentals. Interest rates tend to be driven by economic activity, not the other way around. Three cheers for higher rates!

Since late last year, Japan's monetary policymakers have been making a concerted effort to reverse the deflationary forces that have plagued its economy for decades. This shows up first in a substantial devaluation of the yen. That this is a positive development shows up in the sustained rise in equity prices which has accompanied a weaker yen. What's good for Japan is going to be good for the whole world.

Thanks to new fracking technology, U.S. production of natural gas has soared and the price of natural gas has plunged, both in nominal terms and relative to the cost of oil. Since natural gas is not readily exportable, this has given energy-intensive U.S. industry a key low-cost advantage relative to overseas producers that is likely to endure for at least the next few years.

Contrary to what so many bears seem to believe, I think these charts provide convincing evidence of an economy that is gradually improving. There is nothing fictitious about the data here, and most of the charts use market-based data that is not subject to revision or faulty seasonal adjustment factors. This is real.

Stocks are up because the economy continues to expand

Capital goods orders are notoriously volatile from month to month, so I have long preferred to look at a 3-month moving average of the series, which is shown in the chart above. July orders for this proxy for business investment fell 3.3% from June, but the 3-mo. moving average is at a new all-time high and is up at a 8.8% annualized rate over the past six months.

The much-broader category of factory orders has also been notching new highs, up almost 8% in the year ending June. To the extent factory orders are a good proxy for the physical side of the economy, it validates the performance of the equity market—stocks are rising because the economy is expanding.

The amount of freight hauled around by the U.S. trucking industry is another proxy of sorts for the size of the physical economy. As the chart above shows, truck tonnage also validates the recent rise of the equity market, shown here in real terms. Note how both this and the preceding chart show that equity valuations were way out of line (i.e., too high) compared to the expansion of the economy in the the late 1990s and early 2000s. Not so today: no sign here of "irrational exuberance." The market is up because the economy is expanding.