Yield Curve Inversion

July 18, 2018

The yield spread between the 2-year and 10-year Treasury Note has narrowed to 25 basis points, its smallest spread since 2007.  This has many investors worried the narrowing spread will lead to an inversion of the yield curve (when short-term rates exceed long-term rates) – which throughout history has often occurred prior to a recession.

In reality, an inverted yield curve simply means long-term investors expect short-term rates to fall in the future.  A 2-year bond is just two 1-year bonds, one after another.  So if the 2-year yield is below the 1-year yield, then investors are saying the yield on the 1-year bond, one year from now, is expected to be lower.

For the record, an inverted yield curve does not cause a recession.  Typically, the yield curve inverts because the Fed drives short-term interest rates too high and over-tightens monetary policy.  It’s this tight monetary policy that causes the recession, the inversion is a symptom of the bigger issue.  Investors, realizing the Fed is too tight, push long-term rates down because they expect the Fed to reduce short-term rates in the future.  It’s the overly-tight Fed that causes both the recession and the inverted yield curve.

This is why we do not believe the current narrowing yield spread signals looming recession.  The Fed is far from being tight.  Short-term rates remain well below the pace of nominal GDP growth, and even below many measures of inflation.  As a result, rates are likely to rise in the future, not fall.  If anything, the 10-year Treasury note appears overvalued – possibly in a bubble (meaning yields on the 10-year Treasury are far too low).

But just like most overvalued markets, investors seek ways to justify it.  In 1999, despite weak – or no – earnings growth, the US stock market became massively overvalued.  By our measures, over 60% above fair value.

This has now apparently happened to the Treasury market. Justification for low yields include low foreign yields, an imminent recession, and a belief the Fed is (or will soon become) too tight.

Nominal GDP (real growth plus inflation) grew 4.7% in the four quarters ending in March, and looks to have grown even faster in the four quarters ending in June.  At 2.83%, the 10-year Treasury note yield is 187 basis points below nominal GDP growth.  For comparison, over the past 20 years (1997-2017) – the 10-year Note yield averaged just 43 basis points less than nominal GDP growth.  In other words, today’s spread is substantially – and we think unsustainably – larger than its 20-year average. 

Nominal GDP growth is a good proxy for a “natural or neutral” rate of interest because it’s the average rate of growth in the economy – a reasonable proxy for investment returns.  Some companies grow much faster than GDP, some grow much slower.

If interest rates are well below nominal GDP, then companies growing less than average are encouraged to borrow.  But this makes no economic sense.  It’s “malinvestment”…investment that hurts growth and slows the creation of wealth.  In other words, interest rates today are well below levels justified by fundamentals.

More importantly, the economy is accelerating, and the Fed is chasing both rising real growth and rising inflation.  Even if the Fed lifts rates to 3.5% by the end of 2019 (which would require six more rate hikes at the current pace), the Fed will still not be tight relative to nominal GDP growth.  So, the odds of a recession in the next few years remain very low even if we get a technical inversion.

That said, we don’t expect the yield curve to invert in the near future.  It may.  But if it does, it just means that the bubble in long-term rates still exists.  At some point that will cease.  It won’t be pretty for long-term bond holders, but at least it should end the inversion-recession fears.

Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist

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From Strength to Strength

July 10, 2018

The US labor market is going from strength to strength.  Like with corporate earnings, June jobs data beat consensus estimates – up 213,000 – pushing the average monthly gain for the past year to 198,000 per month. 

Meanwhile the unemployment rate jumped from 3.8% to 4.0%.  Why?  Because the civilian labor force grew by 601,000.  We hate blowing one month’s data point out of proportion, but there is enough concurrent evidence out there to conclude that this gain in the labor force is a bullish sign for the economy.  It signals that fewer people are counting on the government for support.

There are two ways to shrink the welfare state.  One way is to directly cut welfare benefits. That’s a structural change that encourages work no matter where the economy is in the business cycle.  The other method is indirect: adopt policies that help the economy grow faster and let private sector opportunity pull people out of the government’s welfare system and back into the labor market.  Right now, that second method is taking hold.

The number of people getting Food Stamps (SNAP benefits, which stands for the Supplemental Nutrition Assistance Program) fell to 39.6 million in April, down 4.7% from a year ago and the lowest level since about 2010.  This isn’t because it’s harder to get food stamps, it’s because the rewards for work are rising.

In the second quarter of 2018, applications for Social Security disability benefits (SSDI) were down 2.3% from the same period a year ago.  That’s on top of a 6% decline for full-year 2017 from 2016.  And last year also saw 1.3% fewer workers collecting disability benefits than in 2016, the biggest annual decline since 1983.  This year, that number has continued to decline.  In other words, the job market is plenty strong enough to pull workers back into the private sector.

Although average hourly earnings are up a respectable, but not stellar, 2.7% from a year ago, hundreds of companies are paying “one-time” bonuses to their workers, either based on tax reform or as a way for companies to attract workers without raising their long-term costs, particularly in the trucking sector.  These bonuses are helping push down both the median duration of unemployment, and already low unemployment rates across education levels, sexes and races.

While unemployment rates by racial/ethnic categories are volatile from month-to-month (and why we prefer to focus on the trend), the black unemployment rate increased from a near record low in June, but the Hispanic jobless rate fell to 4.6%, the lowest for any month since the government started tracking the data in the early 1970s.  And for the past 12 months, the average unemployment rate for both blacks and Hispanics fell to the lowest levels ever recorded, dating back to the early 1970s.

None of this means the labor market is perfect.  It never is.  Back in the late 1990s, the participation rate among prime-age workers (age 25-54) reached a peak of 84.6%.  Right now, their participation rate is 82%.  But this is a double-edged sword…where some see imperfection, others see room for further growth.  Where some see a labor market that can’t get any better, others see opportunity.  

We fall in the second camp.  Extremely low unemployment rates and rising earnings mean that private sector employment is becoming increasingly more attractive than static government programs.  And with more workers moving into the private sector, it’s not hard to see better times for workers ahead.  The tax cut happened just over six months ago.  Deregulation is encouraging more business investment.  Corporate earnings continue to exceed expectations.  The job market looks set for even more strength.

Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist

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Bonds Misjudge the Future

June 19, 2018

We’ve always been skeptical that bond yields carry deep meaning about the future.  Low Treasury bond yields in recent years were said to be a signal of slower growth, or possibly a recession, ahead.  And the bond world said stocks were over-valued.

Clearly, the forecasted recession never came.  Not only is the economy accelerating, but the recovery is likely to become the longest on record.  And stocks have handily outperformed bonds.

Now, low bond yields are supposed to signal the Fed is getting close to being too tight.  Either too many rate hikes will cause a recession, or the Fed will hike rates only twice next year as the economy slows.  And, of course, the bond world says this too is bad for stocks.

We see at least two mistaken beliefs that are influencing bond bulls these days.  The first mistake is that the Fed will lift rates only once or twice in 2019.  We believe four rate hikes are more likely, with more to follow in 2020.  The reason is simple.  Nominal GDP is accelerating, and likely to grow at a rate of 5%+ over the next few years.

But four rate hikes of 0.25% in 2019, after two more in 2018, will only push the federal funds rate near 3.5%.  History (in 1969, 1973, early 1980s, late 1980s, 2000, and 2007) shows that, in order for the Fed to create a recession, it needs to push the federal funds rate above nominal GDP growth.  Right now, the Fed is chasing growth, and bond markets are underestimating how much rates must rise before policy becomes “tight.”

This, we believe, has pushed the long-term bond market into what appears to be a bubble.  At a 2.92% yield, the implied Price-Earnings (PE) ratio for the 10-year Treasury Note is 34.2, with zero chance of an increase in earnings in the next 10 years.

That doesn’t sound like a very good investment to us.  Real GDP is likely to grow at a 3% rate this year, while consumer prices should rise 2.5%.  In other words, nominal GDP – total spending in the US economy – will rise by 5.5% in 2018, which means revenue at the “average” company will grow at that pace, as well – double the yield on a 10-year Note.

Corporate profits are growing even faster than GDP – most likely 20%+ this year – and hundreds of companies have raised dividends in the past year.  The PE ratio of the S&P 500 is 21 based on trailing twelve months’ earnings, and less than 17 on forward earnings.

Yet, even with all that data in front of them, many bond investors are convinced the 10-year yield is likely to decline in the next year, making long-term bonds a slightly more palatable investment.

Instead, it looks like the bond market is acting like the stock market in 1999, when our capitalized profits model said stocks were 62% overvalued.  But, like all bubbles, a vast majority of investors still believed stocks could go higher.  Obviously, they were wrong.

The second mistake animating the bond market is the belief that the narrowing spread between the federal funds rate and the IOER (Interest Rate on Excess Reserves) signals a developing shortage of reserves – a sign of tight Fed policy.

Yet, there are still $1.9 trillion in excess reserves in the banking system – which contradicts any belief that Fed policy is remotely close to being tight.  There are very few banks that actually trade federal funds, because they simply don’t need them. 

Meanwhile, the Fed has been doing reverse repos with institutions (like Fannie Mae and Freddie Mac) because it is not allowed to pay them interest on reserves.  What has happened is that those reserves (the Fannie/Freddie kind) have now been mostly drained from the system, which means the difference between these short-term rates is narrowing.  This is not a sign of a lack of bank reserves, just that excess liquidity outside of the banking system is getting tighter and more competitive.

As a result, the IOER is becoming the most important short-term rate in the monetary system.  Today, at 1.95%, it is still too low.  The key question is whether the Fed can pay banks enough not to lend out that money, even as accelerating growth creates more profitable opportunities to lend.  If the Fed can do that – pay banks not to lend – then excess reserves are not a sign of easy money.  But, lending rates are still much higher than IOER, and banks have excess capital as well.

In other words, the Fed is nowhere near “tight,” and the market is mis-pricing both growth and inflation risks to bond yields.  Rates look far more likely to rise than fall.

Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist

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Is 2020 the Year for Recession?

June 14, 2018

According to former Fed Chair Ben Bernanke, the U.S. economy will get a Wile E. Coyote surprise in 2020.  You know, just when everyone thinks he caught the Roadrunner, Wile notices he has run straight off a cliff, plummets seemingly forever before hitting the bottom in a cloud of dust, and then, just for spite, an anvil lands on his head.

In other words, Bernanke sees a 2020 recession looming.  Other analysts are saying it, too.  And whenever they do, they get their name in the headlines. Scaremongering attracts attention.

But there is good news here: The Pouting Pundits of Pessimism don’t think the crisis starts tomorrow.  No longer does some exogenous crisis event – say, Brexit, or Grexit, student loan defaults, etc., – threaten imminent collapse.  Now, the recession doesn’t happen for another two years. 

Another interesting detail: the new problem is that the economy is growing too fast.  Remember when analysts used to say, “since the economy is growing less than 2% annually, it means a recession is coming”?  Now, Bernanke says the U.S. applied stimulus (in the form of a tax cut) “at the very wrong moment,” with the economy already at full employment.  In other words, real GDP growth is too strong, so the Fed will over-tighten and a recession is inevitable.

Now we agree that a recession is coming – someday.  Recessions are a fact of life, like death and taxes.  But predicting one in 2020 – and being right about it – is like reading tea leaves, it’s pure chance.  No one, and we mean no one, can honestly see that far in the future – not with the clarity expressed by these dated forecasts.

No one knows exactly what the Fed will do, not even the Fed.   Let’s say they follow their forecasts, raising fed funds to 3.5% in 2019. That alone doesn’t tell us if policy is “tight.”

While most recessions are caused by an excessively tight Fed, we don’t think the Fed is too tight until it drives the federal funds rate close to, or above, the rate of growth in nominal GDP.  Over the past five years, nominal GDP has averaged about 3.9%.  Which means if the Fed were to raise the funds rate by 0.25% three more times in 2018 and four times in 2019 (reaching 3.5%), and if nominal growth slowed to 3.5%, the Fed would be tight at that point. A recession would be possible.

However in the past year, nominal GDP growth has accelerated to 4.7%, and next year it could be as high as 6%.  That means a 3.5% federal funds rate would not be restrictive.  The Fed would have to raise rates faster and farther than any forecast we have seen in order to be “tight” going into 2020. At the same time, there are still at least $1.9 trillion in excess bank reserves.  Until those reserves are eliminated, no one knows if raising rates can actually cause a recession. 

We do have one major worry.  Government spending is rising rapidly, and the deficits this spending creates will put pressure on politicians.  If they were to raise tax rates, this could cause potential problems for U.S. growth.

But the bottom-line remains: the U.S. is not facing an imminent threat.  That’s why doom and gloomers have shifted to forecasting future recessions, not looming crises.  But we think it’s not going to be the economy that gets an anvil on its head in 2020.  More likely, it’ll be investors who believe in the recession forecast.

Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist

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Jobs, Jobs, Jobs

June 5, 2018

In over thirty years of watching the economy we’ve seen recessions, recoveries (both slow and fast), panics, lulls, and boomlets.  But we’ve rarely seen a job market this strong.

Everything is hyper-politicized these days, and we get accused of playing politics all the time. But what we care about deeply, what drives our focus, is the growth that creates opportunities for individual skills to shine in service to others. The development of assets – both physical and intellectual – to build for the future.  But it all starts with work, and there are now more Americans working than ever before – over 148 million, to be precise.

Nonfarm payrolls grew 223,000 in May and are up 2.4 million in the past year.  Civilian employment, an alternative gauge of jobs that better measures small business start-ups, grew 293,000 in May and is up 2.3 million in the past year.

And, importantly, it’s the private sector driving growth, not government.  Government jobs are up a total of 21,000 in the past year.   Meanwhile, manufacturing payrolls are up 259,000 in the past year, the fastest twelve-month increase since 1998.  If technology is supposed to be killing employment in manufacturing, I guess they didn’t get the memo.

No matter how you slice it, things look good.  

But we’re not done. The unemployment rate dropped to 3.8% in May, tying the lowest reading since 1969.  We think we’re headed lower, forecasting a 3.2% rate by the end of 2019 with a chance for a 2-handle on the unemployment rate sometime in 2020.

May also saw the black unemployment rate fall to 5.9%, the lowest reading since record keeping started in the early 1970s.  Black employment is up 3.5% per year in the past two years, versus a 0.9% per year gain for whites.  As a result, the gap between the black and white unemployment rates is now only 2.4 percentage points, the smallest gap on record.

Let’s keep it going. In the past twelve months, the average jobless rate among those without a high school degree is 6.0%, also the lowest on record (going back to the early 1990s).

Still, people bemoan wage growth.  We’ve never thought average hourly earnings (which do not include irregular bonuses, commissions, or tips) are a good measure of living standards.  “Real” (inflation-adjusted) average hourly earnings are up just 0.2% from a year ago and up 7.2% from the start of the last recession.  But, again, this does not include the one-time bonuses many companies paid after the tax cut was enacted late last year.

In addition, there’s evidence that the Labor Department’s measure of wage growth is being held down by the retirement of older, more highly paid Baby Boomers, while new-hire Millennials are just beginning to climb the compensation ladder.  So while average hourly earnings for all workers are up 2.7% (not adjusted for inflation), if you take out new entrants and retirees, wage gains are up 3.3% in the past year.  We expect this to accelerate, pushing overall wages higher as well.

It’s a tight labor market, with initial claims at the lowest level ever as a percent of total employment and wages rising fast enough to pull people off the disability rolls and back into the job market.

This will help improve the low labor force participation rate.  Participation among prime-age workers – those 25-54, who are either working or looking for work – was 81.8% in May, the same as the average for the past year.

To put that in perspective, that’s higher than it ever was before 1986.  The averages by decade are 67.4% in the 1950s, 70.0% in the 1960s, 74.2% in the 1970s, 81.1% in the 1980s, 83.7% in the 1990s, and 83.1% in the first decade of the 21st Century.  Even the all-time high for any twelve-month period, back in 1998-99, was 84.2%, not substantially higher than it is today.

So, while participation is down from when the U.S. population was younger on average, it’s way up compared to the 1950s-60s, which many view as a strong period for the labor market.

Back in the 1950s and 60s, redistribution of income was well below today’s levels.  If the U.S. really wants more people in the labor force it must either reduce government benefits for not working or wait for the private sector to raise wages enough to pull people off government programs. With the recent strength in the labor market, the latter seems more probable.  Tax cuts and deregulation will keep the job market strong.   

Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist

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Higher Rates Won’t Cause Debt Spiral

May 31, 2018

For decades, investors have feared the national debt growing to unsustainable levels and destroying the US economy.  Back in 1981, the public debt of the federal government was $1 trillion; today it’s more than $21 trillion.  At some point, their theory goes, additional debt is going to be the fiscal straw that breaks the camel’s back.     

The problem with this theory is that, in spite of the record high debt, the net interest on the debt – the cost to government to satisfy interest payment obligations – was only 1.4% of GDP last year, hovering near the lowest levels in the past 50 years. 

One reason net interest remains so low relative to GDP is that the government itself owns about $6 trillion of the debt, and this doesn’t even include the debt owned by the Federal Reserve.  So, the “net debt,” also known as the “publicly-held debt,” is roughly $15 trillion.    

The other reason, of course, is that interest rates have been very low.

So now – the pessimistic theory goes – with interest rates rising, it won’t be long before interest costs spike upward, meaning the government will have to borrow just to pay the interest on the debt. They envision a debt spiral like Greece faced a few years back, but with no one big enough to bail us out.

But the pessimists are wrong again, here’s why:

Today, the average interest rate on the publicly-held debt is roughly 2%.  So, let’s say at the close of business on Tuesday the entire yield curve moves up to 4%.  And let’s also assume that the following morning the Treasury Department rolls over the government’s entire debt complex at that new higher rate of 4%, even though the average maturity of the outstanding debt is about six years.

Doubling the interest rate to 4% would mean net interest relative to GDP would double as well, going from 1.4% to 2.8%.  That certainly wouldn’t be pleasant, but it’d be no different than the average net interest on the national debt from 1981 through 1999. Then, as now, the US government was fully capable of issuing new debt and paying its bills without putting the economy at risk.    

Don’t get us wrong.  We’re not happy about the federal debt being so high.  In fact, we’d prefer it to be much lower.  We’re just explaining that the higher interest rates we’re likely to see in the next few years are not going to generate a fiscal crisis. 

Even better would be if the federal government took steps to lock-in what are still relatively low borrowing costs by lengthening the debt, issuing a higher share of 30-year Treasury bonds, introducing 50s, and even considering 100-year debt. If Belgium, Austria, Ireland, Mexico, and even Argentina can sell 100-year debt, so can we.   But even if no changes are made, investors should scratch a debt spiral off their list of worries. 

Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist

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Why Not 50?

May 22, 2018

Asking if the Federal Reserve will lift the federal funds rate on June 13 is like asking if Las Vegas Golden Knights goalie Marc-Andre Fleury, who has stopped 94.7% of the shots against him in the 2018 Stanley Cup playoffs, will stop the next one.  It’s a virtual lock.

And everyone knows the rate hike is almost guaranteed to be the very same 25 basis point (bp) increment the Fed has used six times in the current rate hiking cycle, starting in December 2015.  In fact, that’s the same 25 bp increment the Fed used consistently between June 2004 and June 2006, totaling seventeen drip-drip-drip rate hikes in all.  That campaign lifted rate 425 bps total, every one of which was telegraphed.  Rates moved from a starting point of 1% to a peak of 5.25%.

We need to go all the way back to May 2000 to find a meeting at which the Fed raised rates by 50 bps – the final rate hike of that cycle – after a series of 25 bp hikes that started in mid-1999.  In other words, the Fed has become comfortable and predictable with 25 bp moves, which seems to be all about not getting blamed for any kind of short-term market turmoil.

So why not raise by 50 bps?

Everyone knows the Fed will lift rates by at least another 50 bps this cycle.  The federal funds futures market puts the odds of the Fed raising rates by less than 50 bps this year at 6.6%.  We’re sure the odds would be even lower if we included 2019.  That’s as close to a sure thing a Marc-Andre Fleury.

So, if the Fed is going there anyhow, why not get there sooner?  Why not get to a neutral monetary policy more quickly?  Why be so predictable?

Raising rates by 50 bps this early in the cycle isn’t going to make monetary policy tight.  Right now, nominal GDP (real GDP growth plus inflation) is up 4.8% in the past year and up at a 4.4% annual rate in the past two years, well above the current federal funds target of 1.625%.  The 10-year Treasury yield is about 145 bps above the funds rate.  Meanwhile, the banking system is chock full of excess reserves and a record amount of capital.  Congress and executive agencies are moving to undo some of the excess regulations on the banking system, there are no major bubbles in the financial system, and corporate balance sheets are in fantastic shape.

Add in an unemployment rate of 3.9%, well below the Fed’s consensus view that its long-term average will be 4.5%.  Plus, the PCE deflator, the Fed’s favorite inflation measure, is already up 2% from a year ago and, given the recent rise in oil prices, should hover persistently above 2% for the rest of the year.

One of the key problems with “forward guidance” and gradually lifting interest rates on a predictable schedule is that it’s too predictable.  It’s like clockwork.  At present, everyone thinks they can predict the movement of future short-term rates with little to no risk.  Which is exactly what happened in the previous decade.  By telegraphing every move, the financial system could use simple spreadsheets to build a strategy for taking advantage of 25 bp moves at every meeting.  This led to a complacency and a willingness by many players to take on excessive risk.  In many ways, this is the same thing President Trump complained about with our military – always telling the world exactly what we would do and when we would do it.

To be precise, we’d like to see the Fed raise rates by 50 bps in June.  Then, using its dot plot and press conference, the Fed could signal more rate hikes to come while also, by going 50 bps at this meeting, signal that timing is always on the table.    In other words, the Fed would probably raise rates by a total of 100 bp this year, but the average level of short-term rates in 2018 would be slightly higher than if it moved only 25 bps at a time.  This would move long-term rates higher sooner as well.

Surprising the market would not be the end of the world.  Back in September, the Bank of Canada surprised with a rate hike and lived to tell the tale.  Canadian equities are up since then.  And the Canadian dollar is up, as well.

Once again: we’re not holding our breath waiting for the Fed to surprise the market.  The most likely outcome on June 13 is yet another 25 bp rate hike.  But if the Fed really wants to prevent the kinds of imbalances that built up before the last recession, it should consider introducing some upside uncertainty into the path of short term rates.

Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist

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Labor Market Strength

May 15, 2018

The US labor market has rarely been stronger.

Recent figures from the Labor Department show US businesses had a total of 6.550 million job openings in March versus 6.585 million people who were unemployed.  That’s a gap of only 35,000 workers.  By contrast, this gap never fell below 2 million in the previous economic expansion that ended in 2007, and stood at 638,000 in January 2001, at the end of the expansion that started in mid-1991 and ran through early 2001.

Of course, these figures have to be put in context.  The measure of unemployed workers doesn’t include “discouraged” workers, for example, nor does it include part-time workers who say they want full-time jobs.  And it’s not like all the unemployed have the skill sets needed for the job openings that are available.

Still, the negligible gap between the number of job openings and the number of unemployed who are pursuing work shows that the demand for labor is intense.

Reports on jobless claims show companies are clinging to their workers.  In the past four weeks, the average pace of initial jobless claims has been the lowest since 1969; meanwhile, continuing claims have averaged the lowest since 1973.

And new jobs continue to be created.  In the past year, nonfarm payrolls are up an average of 190,000 per month, matching the pace of the year ending in April 2017.  As a result of this continued job creation, the jobless rate has dropped to 3.9% in April, the lowest since the peak of the internet boom in 2000.

Assuming a real GDP growth rate of 3.0% this year and next, we think the jobless rate will finish 2018 at 3.7%.  That would be the lowest rate since 1969.

Then, in 2019, the jobless rate should drop to 3.2%, the lowest since 1953.  Beyond that, continued solid growth could realistically push the jobless rate below 3.0%.

Maybe it’s optimism about the labor market that’s behind President Trump’s recent tick upwards in popularity and the GOP’s better performance in the “generic” ballot, which measures whether potential voters are inclined to support Republicans or Democrats in House races this November.  Either way, it doesn’t seem like an environment that favors a tidal wave of change for the Democrats this fall.  The odds of the GOP keeping the House are rising, and the GOP looks more likely to gain Senate seats than lose them.

Although some still bemoan slow growth in wages, April average hourly earnings were up a respectable 2.6% in the past year.  And that doesn’t include the kinds of one-time bonuses that have become more widespread since the tax cut was enacted in late 2017.

The biggest blemish on the labor market is that the participation rate – the share of adults who are either working or actively looking for work – is still low by the standards of the last forty years.  After peaking at 67.3% in early 2000, the participation rate has declined to the current reading of 62.8% in April.

This drop is mainly due to three factors: the aging of the Baby Boom generation into retirement years, overly generous student aid (which has reduced the willingness of young Americans to work), and disability benefits that are too easily available.  Hopefully, the coming years will see policymakers find ways to tighten rules on disability while limiting student aid to truly needy students who are taking economically useful coursework.

But even if these changes don’t happen, look for more good news – and an even stronger labor market – in the year ahead.

Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist

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Don’t Compare Stocks to GDP

May 7, 2018

The bull market in U.S. stocks, which started on March 9, 2009, gets little respect.  Those who have been bullish, and right, are mocked as “perma-bulls,” while “perma-bears,” who have been repeatedly wrong, are quoted endlessly.

We don’t have enough fingers and toes to count the number of times a recession has been predicted.  Brexit, Grexit, adjustable rate mortgages, student loans, the election of Donald Trump, tapering, rate hikes, a 3% ten-year Treasury yield, Hindenberg Omens, Death Crosses, and two fiscal cliffs are just a few of the seemingly endless list of things that were going to end the bull market.  (And the pouting pundits of pessimism are never held accountable for erroneously spreading fear.)

One staple of the bearish argument, and the one we want to discuss today, is that corporate profits have grown faster than GDP.  This, the bears have claimed for years, can’t last.  The argument is that there will be a reversion to the mean, profit growth will slow sharply and an overvalued market will be exposed.  A close cousin to this argument is that stock market capitalization has climbed above GDP, signaling over-valuation.

Both of these arguments make fundamental mistakes:  first, about the relationship between GDP and profits; second, about the correct measurement of GDP.

The economy is a combination of the public sector and the private sector.  Most people think direct government purchases of goods and services, which were 17.2% of GDP last quarter, represents the full impact of government on the economy.  But total Federal, State and Local spending (which adds in entitlement spending, welfare, and government salaries), as well as the cost of complying with government regulations, raises the number to 45% of GDP.  And because the private sector pays for every penny of government spending, resources directed by the government are significantly larger than just purchases.

There is little doubt that the growth rate of productivity in the private sector is much stronger than in the public sector.    In fact, it is probably true that productivity growth in the public sector is negative – directly, and indirectly – through the burden of regulatory costs.  If 55% of the economy (private spending) experiences strong productivity, but 45% of the economy (the public sector) experiences negative productivity, overall GDP and productivity statistics are dragged down. 

In other words, secular stagnation is a figment of the average – government has grown too big and is a drain on the economy.  Yes, private sector growth (and profits) can grow faster than GDP.  It’s not a bubble, it only looks like a bubble when looking up from the hole government has created.

The second important point is that GDP is a flawed measure of economic activity.  It tracks final sales, but not “total” economic activity.  A new car may cost $42,000, but the total amount of economic activity to build and sell that car (the total of all the checks written between businesses and consumers) is significantly more than the final cost of the car.  Much business-to-business activity is not captured directly in GDP.

Mark Skousen has pushed for years for the Bureau of Economic Analysis to publish “Gross Output (GO),” which includes all economic activity.  And in Q4-2017 GO was $34.5 trillion, nearly double the $19.7 trillion reading for GDP.

If you really want to compare the market cap of U.S. corporations to the correct measure of economic output, it is much more logical to compare it to Gross Output, not GDP.  By that measure the market cap of the U.S. stock market is still well below overall economic activity.

The real issue here is that investors should care little about GDP.  No one buys shares of GDP.  Investors buy shares of companies, and profits are proof that productivity is strong in the private sector.  Government distorts the picture, showing both a secular stagnation and “bubble” that don’t really exist.

Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist

Approved For Public Use

3% – Why It Doesn’t Matter

May 1, 2018

Just a few weeks ago, the Pouting Pundits of Pessimism were freaked out over the potential for the yield curve to invert.  They’ve now completely reversed course and are freaked out over a 3% 10-year Treasury note yield.

All this gnashing of teeth is driven by a belief that low interest rates and QE have “distorted” markets, created a “mirage,” a “sugar high” – a “bubble.”

These fears are overblown.  Faster growth and inflation are pushing long-term yields up – a good sign.  And, yes, the Fed is normalizing its extraordinarily easy monetary policy, but that policy never distorted markets as much as many people suspect.  Quantitative Easing created excess reserves in the banking system but never caused a true acceleration in the money supply.  That’s why hyper-inflation never happened and both real GDP and inflation remained subdued.  Profits, not QE, lifted stocks.

And our models show that low interest rates were never priced into equity values, either.  We measure the fair value of equities by using a capitalized profits model.  Simply put, we divide economy-wide corporate profits by the 10-year Treasury yield and compare these “capitalized profits” to stock prices over time.  In other words, we compare profits, interest rates, and equity values and determine fair value given historical relationships.  The lower the 10-year yield, the higher the model pushes the fair value of stocks.

Because the Fed held short-term rates so low, and gave forward guidance that they would stay low, they pulled long-term rates down, too.  As a result, over the past nine years, artificially low 10-year yields have caused our model to show that stocks were, on average, 55% undervalued.

In other words, stocks never priced in artificially low interest rates.  If they had, stock prices would have been significantly higher, and in danger of falling when interest rates went up.

But we have consistently adjusted our model by using a 3.5% 10-year yield.  Using that yield today, along with profits from the fourth quarter, we show the stock market 15% undervalued.  In other words, we’ve anticipated yields rising and still believe stocks are undervalued.  A 3% 10-year yield does not change our belief that stocks can rise further this year, especially with our expectation that profits will rise by 15-20% in 2018.

The yield curve will not invert until the Fed becomes too tight and that won’t happen until the funds rate is above the growth rate of nominal GDP growth.  Stay bullish.

Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist

Approved For Public Use