It’s a bull market

The US economy continues to show signs of a robust expansion. Net capital formation is rising (as a percentage of GDP) as it is wont to do during a boom. In layman’s terms net capital formation is the net growth in physical assets used in the production of goods and services, after allowing for depreciation.

Net Capital Formation

The Wicksell spread has turned positive. When return on investment (we use nominal GDP growth as a surrogate) exceeds the cost of capital (reflected by low investment grade Baa bond yields) that encourages new investment and economic expansion as in the 1960 – 1980 period on the chart below.

Wicksell Spread

Real bond yields, reflected below by Baa yields minus core CPI (blue line) on the chart below, are also near record lows. Low real returns on bonds support high stock earnings multiples.

Real Bond Yields

Fed Chairman Powell summed up the situation in a speech on Tuesday this week:

…Many of us have been looking back recently on the decade that has passed since the depths of the financial crisis. In light of that experience, I am glad to be able to stand here and say that the economy is strong, unemployment is near 50-year lows, and inflation is roughly at our 2 percent objective. The baseline outlook of forecasters inside and outside the Fed is for more of the same.

This historically rare pairing of steady, low inflation and very low unemployment is testament to the fact that we remain in extraordinary times. Our ongoing policy of gradual interest rate normalization reflects our efforts to balance the inevitable risks that come with extraordinary times, so as to extend the current expansion, while maintaining maximum employment and low and stable inflation.

The biggest risk is that investors get carried away and drive earnings multiples sky high, but gradual rate increases from the Fed and the threat of tariff wars appear to be keeping animal spirits in check.

Capital spending on the rise

Just released July 2018 manufacturers’ new orders for capital goods, excluding defense and aircraft, show that the recovery is gathering speed.

Manufacturers New Orders: Capital Goods excluding Defense & Aircraft

Any fears that easy money has undermined capital budgeting restraints — and that the economy is entering the final heady stages of a boom before the bust — can be dispelled by adjusting the above graph for inflation.

Manufacturers New Orders: Capital Goods excluding Defense & Aircraft adjusted for Inflation

Adjusting manufacturers orders by the GDP implicit price deflator shows that the recovery in capital spending has barely started and is a long way from the excesses preceding the Dotcom crash and the GFC.

Australian households are spending more than they are earning | ABC

Interesting chart from Stephen Letts at the ABC:

Thomson Reuters: Australian Consumption v. Disposable Income

Household consumption is growing at a faster rate than disposable income, with savings rates (net savings / disposable income) falling. This is clearly unsustainable. Savings rates, which include compulsory super contributions, fell to just 1.0% in Q2, with savings outside of super being rapidly eroded.

That relationship is even more unsustainable now house prices are falling, according to Deutsche bank’s Phil Odonaghoe.

“Strengthening housing wealth accrued by the household sector has been an important factor supporting the decline in saving. With house prices now falling, that support has been removed.”

From Households are now spending more than they are earning — and that’s not sustainable | Stephen Letts | ABC.

Hat tip to Macrobusiness.

Does the yield curve warn of a recession?

There has been talk in recent months about the narrowing yield curve and how this warns of a coming recession, normally accompanied by a graph of the 10-year/2-year Treasury spread which fell to 0.22% at the end of August 2018.

Yield Differential 10Year minus 2Year

I have always used the 10-year minus the 3-month Treasury spread to indicate the slope of the yield curve but, although this shows a higher spread of 0.71%, both warn that the yield curve is flattening.

Yield Differential 10Year minus 3Month

Is this cause for alarm?

First of all, what is the yield curve? It is the plot of yields on Treasuries against their maturities. Long maturity bonds normally have higher yields than short-term bills, to compensate for the increased risk (primarily of interest rate changes). If you tie your money up for longer, you expect a higher return. That is a rising yield curve.

A steep yield curve is a major source of profit to banks as their funding is mostly short-term while they charge long-term rates to borrowers, pocketing the interest spread.

The Fed sometimes intervenes in the market, however, restricting the flow of money to the economy, to curb inflation. Short-term rates then rise faster than long-term rates and the yield curve may invert — referred to as a negative yield curve.

At present we are witnessing a flattening yield curve, as short-term rates rise close to long-term rates.

A recent paper from Michael D. Bauer and Thomas M. Mertens at the San Francisco Fed concludes that a narrow yield differential has zero predictive ability of future recessions:

In light of the evidence on its predictive power for recessions, the recent evolution of the yield curve suggests that recession risk might be rising. Still, the flattening yield curve provides no sign of an impending recession. First, the evidence suggests that recession predictions based on the yield curve require an inversion (Bauer and Mertens 2018); no matter which term spread is used to measure its shape, the yield curve is not yet inverted. Second, the most reliable summary measure of the shape of the yield curve, the ten-year–three-month spread, is nearly 1 percentage point away from an inversion.

I was pleased to see that Bauer and Mehrtens find the 10-year/3-month Treasury spread more reliable than other spreads in predicting a recession within 12 months, with 89% predictive accuracy. They also refer to another study that came to a similar conclusion:

Engstrom and Sharpe found that their short-term spread statistically dominated the 10y–2y spread, and our findings are consistent with this result.

But both studies conclude that a negative yield curve (when the yield differential is below zero) is a reliable predictor of recessions. And Bauer and Mehrtens observe that, while the 10 year/2 year spread is less accurate, it is still a reliable predictor.

Are we just 22 basis points away from a recession warning? Let’s weigh up the evidence.

First, a negative yield curve is a reliable predictor of recessions. In the last 60 years, every time the 10-year/3-month spread has crossed below zero, a recession has followed within 12 months. There is one arguable exception. In 1966 the yield differential crossed below zero, the S&P 500 fell 22% and the NBER declared a recession, but they (the NBER) later changed their mind and airbrushed it out of history.

Yield Differential 10Year minus 3Month

Second, while there is strong correlation between the yield curve and recessions, the exact relationship is unclear.

The most convincing explanation is that bank interest margins are squeezed when the yield curve inverts. When it is no longer profitable for banks to borrow short and lend long, they restrict the flow of new credit. Credit is the lifeblood of the economy and activity slows.

That was clearly the case in the lead up to the 2008 crash, but why are net interest margins of major US banks now widening?

Bank Net Interest Margins

The flow of credit also slowed markedly before the 1990/1991 recession but did not ahead of the last two recessions.

Bank Net Interest Margins

And growth in the broad money supply — zero maturity money (MZM) plus time deposits — accelerated ahead of the Dotcom crash and 2008 banking crisis.

Broad Money Supply: MZM plus Time Deposits

Third, consider the Wicksell spread. Swedish economist Knut Wicksell argued in his 1898 work Interest and Prices that the economy expands when return on capital is higher than the cost of capital, with new investment funded by credit, and it contracts when the expected return on capital is below the cost of capital.

I was first introduced to Wicksell by Neils Jensen, who uses the Baa corporate bond yield as a proxy for the cost of capital and nominal GDP growth for the return on capital. Neils argues that the economy is near equilibrium when the Wicksell spread is about 2.0% — when return on capital is 2.0% higher than the cost of capital.

Wicksell Spread: Nominal GDP Growth compared to Baa Corporate Bond Yield

The above graph shows that 1960 to 1980 was clearly expansionary, with nominal GDP growth exceeding the cost of capital (Baa corporate bond yield). But the last almost four decades were the opposite, with the cost of capital mostly higher than the return on capital. Only recently has this reversed, suggesting a new expansionary phase.

One could argue that low-grade investment bond yields are a poor proxy for the cost of capital, with rising access to equity markets in recent decades. Also that nominal GDP growth rate is a poor proxy for return on capital. If we take the S&P 500, the traditional method of calculating cost of equity is the current dividend yield (1.8%) plus the dividend growth rate (8.0%), giving a 9.8% cost of capital. If we take the current S&P 500 earnings yield of 4.0% (the inverse of the P/E ratio) plus the earnings growth rate of 15.1% as the return on capital (19.1%), it far exceeds the cost of capital. You can understand why growth is soaring.

New capital formation is starting to recover.

New Capital Formation

Fourth, Fed actions over the last decade have distorted the yield curve. More than $3.5 trillion of Treasuries and mortgage-backed securities (MBS) were purchased as part of the Fed’s quantitative easing (QE) strategy, to drive down long-term interest rates. In 2011 to 2012, the Fed also implemented Operation Twist — buying longer-term Treasuries while simultaneously selling shorter-dated issues it already held — to further bring down long-term interest rates. Long-term rates are still affected by this.

In addition, Fed efforts to shrink their balance sheet may further distort the yield curve. The Fed has indicated that it will not sell Treasuries that it holds but will not reinvest the full amount received from investments that mature. If we consider that short-term Treasuries are far more likely to mature, the result could be that the maturity profile of the Fed’s Treasury portfolio is getting longer — a further extension of Operation Twist by stealth.


A flat yield curve does not warn of a coming recession. A negative yield curve does. Both the 10-year/2-year and 10-year/3-month Treasury spreads are reliable predictors of a recession within 12 months, but the 10-year/3-month spread is more accurate.

The correlation between the yield curve and recessions is strong but the actual relationship between the two is more obscure. Links between the yield curve, bank net interest margins, bank credit growth and broad money supply growth are more tenuous, with lower correlation.

Also, return on capital is rising while cost of capital remains low, fueling strong capital formation. The economy is starting to grow.

Fed actions, through QE, Operation Twist, and even possibly steps to unwind its balance sheet, have suppressed long-term interest rates and distorted the yield curve. While the yield curve is still an important indicator, we should be careful of taking its signals at face value without corroborating evidence.

Lastly, we also need to consider the psychological impact. If the market believes that a negative yield curve is followed by a recession, it most likely will be. Beliefs lead to actions, and actions influence outcomes.

Treat yield curve signals with a great deal of respect, and be very wary of how the market reacts, but don’t mindlessly follow its signals without corroboration. The economy may well be entering a new growth spurt, with all its inherent dangers — and rewards.

I contend that financial markets never reflect the underlying reality accurately; they always distort it in some way or another and the distortions find expression in market prices. Those distortions can, occasionally, find ways to affect the fundamentals that market prices are supposed to reflect.

~ George Soros

Bullish US GDP numbers

The Bureau of Economic Analysis (BEA) reports that real gross domestic product (real GDP) increased at an annual rate of 4.1 percent in the second quarter of 2018. This is an advance estimate, based on incomplete data and is subject to further revision.

Real GDP for Q2 2018 Annualized

While the spurt in quarterly growth is encouraging, I find annualized quarterly figures misleading and prefer to stick to the annual rate of change from the same quarter in the preceding year. Annual growth still reflects an improving economy but came in at 2.8 percent, more in line with the estimate of actual hours worked on the chart below.

Real GDP for Q2 2018 YoY

Personal consumption figures tend to decline ahead of a recession, so an up-tick in all three consumption measures is a positive sign for the US economy. Expenditures on durable goods is especially robust, suggesting growing consumer confidence. Non-durable expenditures are holding up, while services, which had been declining since a large spike in 2015, are maintaining at still strong levels.

US Personal Consumption

There is no sign of the US economy slowing. Continued growth and positive earnings results should encourage investors.

S&P 500 and Nasdaq relief

June average hourly earnings growth came in flat at 2.74% for Total Private sector and 2.72% for Production and Non-supervisory Employees. This suuports the argument that underlying inflation remains benign, easing pressure on the Fed to accelerate interest rates.

Average Hourly Earnings Growth

The S&P 500 rallied off its long-term rising trendline. Follow-through above 2800 would suggest another primary advance with a target of 3000.

S&P 500

The Nasdaq 100 respected its new support level at 7000, signaling a primary advance. The rising Trend Index indicates buying pressure. Target for the advance is 7700.

Nasdaq 100

The Leading Index from the Philadelphia Fed is a healthy 1.51% for May. Well above the 1.0% level that suggests steady growth (falls below 1.0% are cause for concern).


Our estimate of annual GDP growth — total payroll x average weekly hours worked — is muted at 1.91% but suggests that earnings growth will remain positive.

Real GDP Estimate

Personal consumption figures for Q1 2018 show growth in consumption of services is slowing but durable goods remain strong, while nondurable goods are steady.

Consumption to Q1 2018

Declining consumption of nondurables normally coincides with a recession but is often preceded by slowing durable goods — below 5.0% on the chart below — for several quarters.

Consumption to Q1 2018

Conclusion: Expect further growth but be cautious of equities that are vulnerable to escalating trade tariffs.

We live in a global economy, but the political organization of our global society is woefully inadequate. We are bereft of the capacity to preserve peace and to counteract the excesses of the financial markets. Without these controls, the global economy, is liable to break down.

~ George Soros: The Crisis of Global Capitalism (1998)

Be Data-driven not Fear-driven

A few months ago, markets feared a nuclear war on the Korean peninsula. Those fears have now largely dissipated but been replaced by fears of a massive trade war with China. There is always a small probability that our fears may be realized but most market fears are not.

Unless you want to follow in the footsteps of some media-driven forecasters, and anticipate ten of the next two recessions, you need to focus on the data and not on your fears.

I have always used Fedex as a bellwether of economic activity in the USA. Shipments of goods are an excellent barometer of the economic climate — and closely tied to quarterly earnings which in the long-run drive prices.


Unfortunately Fedex stock price is likely to become less reliable over time as an indicator of economic activity, with the entry of a new competitor: Amazon.

But Fedex produces excellent quarterly statistics of parcel shipments which remain a useful gauge of economic conditions.

Fedex Express Parcel Statistics

Parcel shipments for the quarter ended May 31, 2018 are up 1.1% on the same quarter in 2017. And the annual average is rising. Not fantastic but a step in the right direction, suggesting that earnings for the next quarter will improve.

The S&P 500 is testing its long-term rising trendline. Respect of support at 2700 would suggest another advance. Breakout above 2800 would strengthen the signal.

S&P 500

The Nasdaq 100 retraced to test its new support level at 7000. Bearish divergence on the Trend Index hints at selling pressure. Breach of support would warn of another test of primary support at 6300. Lengthy consolidation would be likely. Respect of 7000, while less likely, on the other hand, would signal a fresh advance.

Nasdaq 100

Discount the obvious, bet on the unexpected.

~ George Soros

12 Charts on the Australian economy

Australian GDP grew at a robust 3.1% for the year ended 31 March 2018 but a look at the broader economy shows little to cheer about.

Wages growth is slowing, with the Wage Price Index falling sharply.

Australia: Wage Price Index Growth

Falling growth in disposable income is holding back consumption (e.g. retail spending) and increasing pressure on savings.

Australia: Consumption and Savings

Housing prices are high despite the recent slow-down, while households remain heavily indebted, with household debt at record levels relative to disposable income.

Australia: Housing Prices and Household Debt

Housing price growth slowed to near zero and we are likely to soon see house prices shrinking.

Australia: Housing Prices

Broad money growth is falling sharply, reflecting tighter financial conditions, while credit growth is also slowing.

Australia: Broad Money and Credit Growth

Mining profits are up, while non-mining corporation profits (excluding banks and the financial sector) have recovered to about 12% of GDP.

Australia: Corporate Profits

But business investment remains weak, which is likely to impact on future growth in both profits and wages.

Australia: Investment

Exports are strong, especially in the Resources sector. Manufacturing is the only flat spot.

Australia: Exports

Iron ore export tonnage continues to grow, while demand for coal has leveled off in recent years.

Australia: Bulk Commodity Exports

Our dependence on China as an export market also continues to grow.

Australia: Exports by Country

Corporate bond spreads — the risk premium over the equivalent Treasury rate charged to non-financial corporate borrowers — remain low, reflecting low financial risk.

Australia: Non-financial Bond Spreads

Bank capital ratios are rising but don’t be fooled by the risk-weighted percentages. Un-weighted Common Equity Tier 1 leverage ratios are closer to 5% for the four major banks. Common Equity excludes bank hybrids which should not be considered as capital. Conversion of hybrids to common equity was avoided in the recent Italian banking crisis, largely because of the threat this action posed to stability of the entire financial system.

Australia: Bank Capital Ratios

Low capital ratios mean that banks are more likely to act as “an accelerant rather than a shock-absorber” in times of crisis (2014 Murray Inquiry). Professor Anat Admati from Stanford University and Neel Kashkari, President of the Minneapolis Fed are both campaigning for higher bank capital ratios, at 4 to 5 times existing levels, to ensure stability of the financial system. This is unlikely to succeed, considering the political power of the bank sector, unless the tide goes out again and reveals who is swimming naked.

The housing boom has run its course and consumption is slowing. The banks don’t have much in reserve if the housing market crashes — not yet a major risk but one we should not ignore. Exports are keeping us afloat because we hitched our wagon to China. But that comes at a price as Australians are only just beginning to discover. If Chinese exports fail, Australia will need to spend big on infrastructure. And infrastructure that will generate not just short-term jobs but long-term growth.

Life left in US stocks

According to market pundits, the latest stock sell-off was fueled by concerns over rising bond yields and slowing growth for Caterpillar (CAT).

From CNBC:

….Caterpillar shares reversed lower during the call, when Chief Financial Officer Brad Halverson said first-quarter adjusted profits per share will be the highest for the year because of increased investment later in 2018.

“We expect the targeted investments for future growth to be higher over the remaining three quarters,” Halverson said. “The outlook assumes that first-quarter adjusted profit per share will be the high-water mark for the year.”

Caterpillar (CAT)

The stock fell 6.2% on Wednesday, ignoring the earnings report:

In the earnings report, the Illinois-based machinery manufacturer raised its 2018 profit outlook by $2 a share over the previous quarter, to a range of $10.25 to $11.25 per share. The rosier guidance exceeds a Reuters analyst survey that expected a range of $8.39 to $10.60 a share. The company cited better-than-expected sales volume as the main driver of its improved full-year guidance.

Since when has “better-than-expected sales volume,” upward earnings revision and increased new investment been a bear signal? The market is unusually jittery at present, focusing on any semblance of bad news and ignoring the good.

Even concern over rising bond yields is nothing new.

10-Year Treasury Yields

10-Year Treasury yields are testing resistance at 3.0%. Breakout would complete a double-bottom reversal, warning of a bear market in bonds as yields rise. But rising long-term rates are not bad news for stocks, especially when off a low base as at present. I would go so far as to say that, over the last 20 years, rising 10-year yields have been bullish for stocks. The chart below compares annual percentage change in 10-year Treasury yields and the Russell 3000 Total Market index.

10-Year Treasury Yields and Russell 3000 Index 12-Month Rate of Change

There is plenty more good news that the market seems to be ignoring.

First quarter 2018 corporate earnings have so far impressed. According to S&P Indices, 117 stocks in the S&P 500 had reported results by the morning of April 24th. Of those, 91 (77.8%) beat, 10 (8.5%) met and 16 (13.7%) missed their estimates. Misses are largely concentrated in Materials ( 3 of 5), Industrials (4 of 26) and Consumer Discretionary sectors (5 of 13).

Freight activity remains strong, signaling a reviving economy.

S&P 500

Wages growth remains tame, with average hourly earnings of production and non-supervisory employees increasing at an annual rate of 2.42%. Growth above 3.0% would warn that underlying inflation is rising and the Fed will be forced to tighten monetary policy. But that does not appear imminent.

S&P 500

Muted wages growth allowed corporate profits (the blue line below) to rebound after a threatened down-turn.

S&P 500

Consumption has recovered. Per capita consumption of non-durable goods is recovering after a flat spot in 2017, consumption of durable goods has been rising since 2016, while services remain strong.

S&P 500

In financial markets, risk premiums on corporate bonds (Baa minus Treasuries) have declined to below 2.0%, suggesting a healthy credit outlook.

S&P 500

Bank credit is recovering after faltering in 2017.

S&P 500

The yield curve is flattening as the Fed gradually raises interest rates. A flat yield curve is not a threat. Only if it inverts, when the yield differential (gray line on the chart below) falls below zero, is the economy at risk of falling into a recession. Growth in the money stock (green MZM line on the chart below) has slowed but remains healthy.

S&P 500

The Fed has committed to shrinking its $4 trillion investment in Treasuries and mortgage-backed securities (MBS) run up by quantitative easing (QE) between 2009 and 2014. So far the decline has had no impact on financial markets as bank excess reserves on deposit at the Fed are declining at a similar rate. The effect is that net assets (Fed Assets minus Excess Reserves) are holding steady at $2.4 trillion.

S&P 500

The Philadelphia Fed’s Leading Index remains healthy at above 1.0 percent.

S&P 500

And our estimate of real GDP is rising (2.14% in March 2018), suggesting that the economy is recovering from its flat spot in 2016/2017.

S&P 500

Valuations are high and investors are jittery but the bull market still appears to have further to run.

How long will the bull market last?

US markets are clearly in a bull phase, with the Dow, S&P 500 and Nasdaq making strong gains. A rising Freight Transport Index highlights the broad up-turn in economic activity.

Freight Transport Index

Low corporate bond spreads — lowest investment grade (Baa) minus 10-year Treasury yield — and VIX below 15 both reflect bull market conditions.

Bond Spreads

Real GDP is growing around a modest 2 percent a year. Low figures are likely to continue, with annual change in hours worked (total payroll * average weekly hours) falling to 1.2 percent in September.

Real GDP

Money supply (M1) growth recovered to a balmy 7 percent (p.a.) after a worrying dip below 5 in early 2016.

M1 Money Stock

The Fed may be reluctant to tighten monetary conditions but will be forced to act if inflation starts to accelerate. Annual growth in hourly wage rates turned above 2.5 percent in September, signaling underlying inflationary pressure.

Average Hourly Wage Rate - Annual Growth

Another dip in M1 below 5 percent growth would warn that monetary conditions are tightening. From there, it normally takes 12 months to impact on the broad market indices.

M1 Money Stock and Fed Funds Rate

At this stage it looks like another 2 years of sunshine before the storm. But one false tweet and we could face an early winter.