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Fear Nothing but Fear Itself

The famous old saying goes we have nothing to fear but fear itself.  However, today, it seems we have nothing to talk about but fear.

Statements on the current outlook for the economy and financial markets are filled with fear – “Trade War,” “Brexit Collapse,” or “Fed Failure.” Meanwhile despite these depressing headlines, the economy continues its upward trajectory. Progress is achieved in the face of fear.

The three main indicators of the macro economy – income, prices, and employment – are all showing continued gains. The nation’s income, or real gross domestic product (real GDP) rose 2.2% in the most recent quarterly report.[1] While this rate of growth is lower than the previous quarter, it is still healthy growth; well above the average growth rate over the past decade of 1.7% percent.

The price level in the overall economy is currently rising at an annual rate that policy makers of the 70s and 80s would have killed for. The Consumer Price Index (CPI) rose at annual rate of 1.9% in the most recent monthly report, better than the 2% rate the Federal Reserve has said is consistent with a healthy economy.[2]

Meanwhile, the US labor market is strong. The national unemployment rate, at 3.8%, is below what many economists consider normal.[3] Better yet, the number of job openings exceeds the number of unemployed workers.[4]

All this begs the question: What is there to be afraid of?

Economic theory and historical experience suggest there are at least two unresolved policy issues that could derail the positive economic environment; government debt and slowing international trade.

The US continues to have a relatively large amount of debt, and other major governments around the world continue to add to their outstanding debt.

Total federal government debt in the United States as percentage of GDP is at 104 %, compared to only 65% before the 2008 financial crisis.[1] In Europe, this number has risen from 60% to 92%, and in Japan it stands at 195%.[2]

Recently, a small group of economists have put forth arguments for why we should not care about the level of government debt in the United States. The so-called Modern Monetary Theory (MMT) claims those governments that borrow on their own currency can take on as much debt as they wish while inflation is low.

This group has a point, but it’s no free lunch. Classical economist David Ricardo (1772 – 1823) showed that government debt is just another form of taxation. When the public recognize taxes will be raised in the future in order to make payments of principal and interest on this debt, the current debt financing is equivalent to a tax.  That is, there is no real difference if the government taxes its citizens or borrows to finance current spending.

Therefore, it seems what the MMT proponents are arguing for is just another tax. An increase in government debt will affect the economy like any other tax. If governments continue to run budget deficits and borrow more, the economy will slow, just as it would with any new tax.

The second fearful factor is slowing trade.

In January the International Monetary Fund (IMF) cut its 2019 forecast for world economic output from 3.7% to  3.5%. This month the IMF cut it again to only 3.3%.[3] Both times the IMF analysts cited ongoing disputes over cross-border trade policy.

One of the most basic principles of economics is that trade makes everyone better off because it allows people to specialize in those activities in which they have advantages, both in skill and costs. Unfortunately, politicians often think about international trade as a contest – we must be losing if our imports exceed our exports. But the opposite is true: we benefit from trade because it allows for specialization.

These politicians want to manage trade, not open it or free it up. Not surprisingly, such a desire to control trade leads to “disputes”. While government officials are negotiating “deals”, business owners and managers hold back, waiting to see what happens. This uncertainty leads to slower growth.

More than a decade ago member governments of the World Trade Organization (WTO) launched negotiations for lower trade barriers around the globe, but nothing significant has been achieved.[1] Instead, the US and other governments have been negotiating regional trade pacts. Such agreements aren’t as beneficial as a global deal that would increase cross-border trade and help raise growth rates everywhere.

Perhaps all the “fear” talk is warranted. While the questions of government debt and trade policy remain unanswered, investors have reason to believe the economy will slow.

Corporate profits will decline in a slowing economy, but interest rates remain historically low. This means that while prices may not rise this year as much as they did last year, stocks are still a better way to protect purchasing power than bonds.

If we stay invested in stocks for the long run, we should fear nothing else – but fear itself.

Peter R. Crabb, Ph.D.

Professor of Finance and Economics

Department of Business and Economics

School of Business

Northwest Nazarene University

[email protected]

 

Dr. Crabb holds a Ph.D. in Economics from the University of Oregon and an MBA in Finance from the University of Colorado.  His research in economics and finance is published in the Journal of Business, the Journal of Microfinance, and the International Review of Economics and Finance, among others.  Dr. Crabb lives with his wife, Ann, and their four children in Canyon County, Idaho.  Dr. Crabb’s regular Financial Economics column is published by the Idaho Statesman. Previous work experience includes international trade, banking, and investments.

1 https://fred.stlouisfed.org/series/A191RL1Q225SBEA
2 https://fred.stlouisfed.org/series/CPIAUCSL
3 https://fred.stlouisfed.org/series/UNRATE
4 https://fred.stlouisfed.org/series/JTSJOL
5 https://fred.stlouisfed.org/series/GFDEGDQ188S
6 https://fred.stlouisfed.org/series/DEBTTLJPA188A, https://fred.stlouisfed.org/series/GCDODTOTLGDZSEMU
7 https://www.imf.org/en/Publications/WEO/Issues/2019/03/28/world-economic-outlook-april-2019
8 https://www.wto.org/

Where’s all this fear coming from?

As I discussed in my last market outlook, economists are fearful of, slow productivity growth. Such fear is not unreasonable given the importance of productivity to our standard of living over the long term.

However, some economic policymakers today are displaying a fear that is unwarranted – the fear that the strength of today’s labor market, as evidenced by a historically low unemployment rate, will lead to a high rate of inflation.

Consider the economic theories on which such concerns are based.

The idea that a government-controlled central bank can adequately control inflation through its policies on the amount of money in circulation or on deposit at banks began in earnest with the theories of John Maynard Keynes during the Great Depression.[1]

In his 1936 treatise, The General Theory of Employment, Interest and Money, Keynes explained how the fiscal and monetary policies of the government could possibly smooth out short-run fluctuations in the economy. When the economy slows, the government should step in and increase overall demand. When the economy is growing the government should do the opposite.

That is, government should buy when everyone is selling and sell when everyone is buying.

While Keynes’s theory was widely accepted, it was never fully implemented or tested.  That is, Keynesian economics is incomplete.

For example, Keynes proposed that governments run budget surpluses throughout periods of positive economic growth. Before 1930, the U.S. government had a budget surplus in two out of every three years. In the subsequent 82 years we have seen only twelve. Currently, government spending is rising faster than tax receipts; the exact opposite of what the theory calls for.

Monetary policy is any action undertaken by a central bank to influence the availability and cost of money and credit.  Through a myriad of different actions in our banking system the U.S. Federal Reserve can push interest rates higher so as to influence banks’ ability to provide credit.  If the banks respond to such incentives they may reduce lending, thereby reducing the likelihood that prices will rise.

But just as with fiscal policy, government policymakers have rarely followed Keynes’s monetary advice. In the early 1980s members of the Federal Reserve’s policymaking committee followed the lead of Chairman Paul Volcker and dramatically raised interested rates to counteract the inflationary policies of the day.

For these reasons and more there has yet to be a full test of the Keynes’s theory, and thus a complete understanding of how fiscal or monetary policy affects the real economy. In the eighteenth century, economist David Hume argued that monetary policy has no real effect on the economy.  This idea of monetary neutrality means that over time changes in the supply of money and credit affects only nominal variables, such as interest rates and exchange rates. Such changes have no effect, however, on real variables like income and consumption.

Some economists claim that the Fed’s actions do nothing but increase financial repression. Financial repression occurs when such actions channel funds from one area of the economy to another, often the government’s own debt. Under this theory, the low interest rate policy from the Fed these ten years has simply distorted the value of stocks and other financial assets while increasing the level of uncertainty in the overall economy.[2]

Regardless of all these academic debates, policymakers continue to follow a Keynesian model known as the Phillips Curve.[3]

Economist A. W. Phillips published a report many years ago that suggested a negative correlation between inflation rates and unemployment. According to the theoretical model behind this supposed relationship, when the Fed keeps interest rates too low the money supply expands too fast. The economy moves along the Phillips curve to a point of lower unemployment but at the cost of higher inflation.

So it is fear of inflation that is keeping policymakers up at night.

According to the minutes from their most recent meeting, Fed policy makers expressed the view that “the labor market has continued to strengthen and that economic activity has been rising at a strong rate.” From this observation they concluded “that further gradual increases in [interest rates] will be consistent with sustained expansion of economic activity…”[4] However, as noted above there is no certainty as to what effect such interest rate increases will have on the real economy.

So what is an investor to do if Keynes’s theory is incomplete and such policy concerns are unwarranted?  Keep your eye on the long-run goal! Don’t let the fears of some economists and some policymakers distract you.

We invest so as to secure a better future for ourselves and our families. We invest to provide a stable level of income in retirement or protect against health or other risks.

Over the long term, the current fiscal and monetary policies are likely to have little or no effect on the performance of my investments. As long as these policies don’t substantially deter businesses from investing in their operations and new products or services the US economy will continue to grow, even after adjusting for inflation. Historically, the only consistent hedge against inflation is stocks. The return on bonds tends to only match inflation.[5]

Fear in the financial markets is mostly unwarranted. Stick to your long-run investing plan.

[1] https://www.econlib.org/library/Enc/bios/Keynes.html
[2] http://www.imf.org/external/pubs/ft/fandd/2011/06/Reinhart.htm
[3] https://www.econlib.org/library/Enc/PhillipsCurve.html
[4] https://www.federalreserve.gov/newsevents/pressreleases/monetary20180801a.htm
[5] https://fred.stlouisfed.org/graph/?g=l4pF

Measuring Our Economy

We economists continue to earn our reputation as dismal scientists. By most measures, the US economy is strong, but economists continue to fret over how fast it will grow in the future.

Consider the numbers ….

The broadest measure of our standard of living, real gross domestic product (real GDP), grew 2.3 percent in 2017, up from only 1.5 percent in 2016.  In the most current estimates for this year, the U.S. Bureau of Economic Analysis (BEA) estimates that the economy is growing at an annual rate of 2.2 percent.

Meanwhile, the rate of inflation remains below historical averages. Through April, the U.S. Bureau of Labor Statistics (BLS) reports that the Consumer Price Index (CPI) is up 2.4 percent over the same period last year, compared to a 3.5 percent annual average since the end of World War II.

The third most widely studied measure of the overall economy is employment. The national unemployment rate now stands at only 3.8 percent, well below the historical average of 5.8 percent.  This figure is also well below the level economists consider normal.  A “normal” rate of unemployment is not an exact number but refers to the amount of unemployment the economy experiences when everyone is producing goods and services at their full potential. According to the Congressional Budget Office (CBO), US real GDP is just at, or slightly above, its potential.

Everything looks fine. So, what is there to fret about?

A key debate amongst economists today is whether or not our economy can continue to grow at 2 percent or higher each year with lower than normal productivity rates.

First, consider why the rate of real GDP growth matters. If the economy grows at 2 percent a year it takes approximately 36 years for the standard of living to double. The standard of living for just about every generation in America was twice that of their grandparents. But if the economy falls back to the rates last seen in 2016, it will take much longer for our kids to be better off.  The ultimate source of growth in our standard of living is higher productivity. Since World War II, the output per hour worked in the non-farm sector of the United States has grown at an average of more than 2 percent per year. Our standard of living is much better than our parents and grandparents because workers and businesses keep finding ways to produce more with less.

However, the rate of increase in productivity over the last decade has slowed to an average of only 1.2 percent per year. Lower productivity growth will show itself in slower economic growth over time.

So how can we improve productivity and keep growing at 2 percent or more per year?

Economic theory and historical experience show that productivity is determined by the amount of physical capital, human capital, and natural resources each worker has at his or her disposal, along with the technological knowledge to use all these resources. When businesses invest in these resources, and develop new technologies to use them, worker productivity grows faster.  Looking again at the BEA data, real Gross Private Domestic Investment has increased at an average rate of only 1.5 percent over the last decade, well below an average of 4.5 percent annually since the end of World War II.  We can’t expect to keep up the current 2 percent growth rate unless business investment picks up.

Over the course of last year, the stock market did well as the economy grew faster, but a continued rise is unlikely without continued business investment. Still, investors face limited choices. As I wrote in my last quarterly report, “stocks remain the better value over bonds or cash.”  Investors are continuing to seek the safety of U.S. government debt, keeping its yield low. The rate of return on a current 10-year Treasury note remains well below its historical average. The yield spread, or difference between the 2 and 10-year notes, is only 0.5 percent, or half its historical average.  The bond market is telling us to expect slow growth and low inflation ahead.

Over the past year or so, small company stocks have done well as growth picked up. But a slow growth economy, with low interest rates and low inflation, should favor large-capitalization stocks, particularly in the consumer staples and healthcare sectors.  Without more sustained investment, the consumer discretionary and industrial sectors are not likely to do as well.

Economists will always find something to fret about, but the economy is doing well, and all types of companies should profit from it. What we must hope for is a rise in business investment that keeps the economy growing at rates that make our children better off.

The views expressed here are those solely of the author and do not represent Northwest Nazarene University or Rathbone Warwick Investment Management.

Peter R. Crabb, Ph.D.

Professor of Finance and Economics

Department of Business and Economics

School of Business, Northwest Nazarene University

[email protected]

 

Dr. Crabb holds a Ph.D. in Economics from the University of Oregon and an MBA in Finance from the University of Colorado.  His research in economics and finance is published in the Journal of Business, the Journal of Microfinance, and the International Review of Economics and Finance, among others.  Dr. Crabb lives with his wife, Ann, and their four children in Canyon County, Idaho.

Dr. Crabb’s regular Financial Economics column is published by the Idaho Statesman. Previous work experience includes international trade, banking, and investments.

[i] http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm
[ii] http://fred.stlouisfed.org/series/CPIAUCSL
[iii] https://fred.stlouisfed.org/series/UNRATE
[iv] https://fred.stlouisfed.org/series/GDPPOT#0
[v] https://fred.stlouisfed.org/series/OPHPBS#0
[vi] https://fred.stlouisfed.org/series/GPDICI#0
[vii] https://fred.stlouisfed.org/series/T10Y2Y#0

 

 

 

 

 

 

 

 

 

 

Volatility is Back

It’s back! Volatility has returned to the financial markets.

The year got off to a calm start, but the stock market saw a return to larger daily price moves. Such volatility has many investors moving more funds to bonds or cash. Sounds reasonable! But economic conditions still favor stocks.

The primary way to measure risk, or uncertainty, in stocks and other financial instruments is to look at option contracts. These risk measurements are generally spoken of on Wall Street as Fear Indices.

The most famous is called the VIX.   The CBOE Market Volatility (VIX) is an index of stock option trading for the large, US-based companies in the Standard and Poor’s 500 Index. The VIX index reflects the cost of hedging risk through the sale or purchase of option contracts on the stocks of US companies. Option prices rise when the underlying stock prices move dramatically in one direction or another – reflecting greater uncertainty over what the price will be in the future.

As of the middle of March, The Chicago Board Options Exchange’s VIX index is at 17 percent, compared to an average daily rate of only 11 percent for all of 2017.  Statistically, this is a big difference. A 6 point rise reflects a large rise in expected risk.

The 17 percent value of the VIX index is a statistical measure called standard deviation. The VIX is saying over the foreseeable future we can expect to see stock returns deviate from their long run average by approximately 17 percent on an annualized basis. In terms of probability, a 17 percent deviation means there is about a 1-in-4 chance investors will be down over the course of the next year.

Therefore, stocks look more risky this year than last. But this rise in uncertainty comes at a time when things look very good in the real economy.

The three main indicators of our macro economy – income, prices, and employment – are all showing improvement. The nation’s income, or real gross domestic product (real GDP), is growing at a 2.5 percent annual rate based on the most recent report. This compares to only 1.5 percent growth in 2016.

According to the Congressional Budget Office (CBO), the US economy is now operating at its potential, meaning we are using all our workers and all our capital equipment fully. In theory, this means prices of goods and services should be rising more quickly.

The inflation rate, however, remains below long-run averages. As measured by the Consumer Price Index (CPI) index, inflation today is 2.3 percent, compared to an annual average of 3.3 percent since the 1980s.

Meanwhile, the labor market is strong. The national unemployment rate stands at only 4.1 percent, below the 4.7 percent rate which the CBO estimates to be normal.

If the economy is doing well why should stock prices be any more volatile? What’s the risk?

The financial market uncertainty seems to center on the fiscal and monetary policy of governments around the world.  What policies are changing that will hurt corporate profits and stock prices?

In terms of fiscal policy, most developed nations continue deficit spending, raising government debt levels. For monetary policy, central banks continue to hold bank interest rates below historical averages.

The US public debt situation is unchanged with total federal debt holding at just over 100 percent of GDP.  The debt levels of other major governments are growing even more (e.g., Japan).

Central banks around the world continue to support such government borrowing with relatively easy monetary policies, or liquidity in the banking system. High bank liquidity keeps interest rates below market equilibriums and creates uncertainty over the consequences of how fast central banks may raise rates.

Fortunately, classical economic theory and historical evidence show us that these two situations should not concern us. First, economist David Ricardo (1772 – 1823) showed when people expect taxes to be raised to offset the future payments of principal and interest on current debt, then today’s debt financing is equivalent to a tax.

That means there is no real difference if the government taxes its citizens or borrows to finance its spending. Thus, rising government debt levels shouldn’t affect corporate profits any more than current taxes. Companies have made good money even when governments run deficits.

Second, economist and philosopher David Hume (1711 – 1776) showed monetary policy has no real effect on the economy. Monetary neutrality is the theory that over time changes in the level of bank money and credit affects only nominal variables, such as interest rates and exchange rates. Such changes have no effect, however, on real variables like income and consumption.

Therefore, banks and other financial institutions may be at risk as interest rates rise, but most companies will see no harm. Households will even benefit from better returns on their savings.

With interest rates still below normal and the underlying economy humming along, stocks remain the better value over bonds or cash despite rising uncertainty. The near-term outlook for increasing household incomes and corporate profits remains strong.

The views expressed here are those solely of the author and do not represent Northwest Nazarene University or Rathbone Warwick Investment Management.

 

Peter R. Crabb, Ph.D.

Professor of Finance and Economics

Department of Business and Economics

School of Business, Northwest Nazarene University

 

[email protected]

Dr. Crabb holds a Ph.D. in Economics from the University of Oregon and an MBA in Finance from the University of Colorado.  His research in economics and finance is published in the Journal of Business, the Journal of Microfinance, and the International Review of Economics and Finance, among others.  Dr. Crabb lives with his wife, Ann, and their four children in Canyon County, Idaho.

Dr. Crabb’s regular Financial Economics column is published by the Idaho Statesman. Previous work experience includes international trade, banking, and investments.

[1] https://fred.stlouisfed.org/graph/?g=j3xN
[1] https://fred.stlouisfed.org/graph/fredgraph.png?g=hQ2F
[1] https://fred.stlouisfed.org/graph/fredgraph.png?g=j3iL
[1] https://fred.stlouisfed.org/graph/?g=iEWj
[1] https://fred.stlouisfed.org/graph/fredgraph.png?g=fVl5

On the Other Hand…

Depending on what news feed you use these days we should all be frightened. With the many comings and goings at the White House and tensions on the Korean Peninsula, you would think we should all be in a state of fear.

However, the economic data says otherwise. While the US economy is not growing at its potential, things still look rosy.

In previous outlook letters I expressed concern with the ongoing federal budget deficit and high outstanding public debt.  White House policy issues and international tensions aside, our economy is not living up to its potential because high-levels of public debt bring about slower economic growth.

Since the financial crisis ended in 2009 US real gross domestic product has grown at an average annual rate of only 2.1 percent, compared to an average of 3.1 percent over the prior six decades.[1] 

A one percent difference may not seem like much, but it has long-term consequences.  When the economy grows at 3 percent per year the living standards of the young are twice that of their parents.  But when the economy grows at only 2 percent it takes two generations before living standards double.  Slow economic growth leads to a “lost generation.”

This may be why we hear younger generations complaining about their prospects for a better life.

However, as we near the last quarter of 2017 economic and financial market indicators give a favorable economic outlook. Labor market conditions are strong, bond prices indicate low inflation expectations, and stock prices reflect good expectations for earnings growth.

At 4.3 percent, the U.S. unemployment rate is below what many economists consider normal. There is always some unemployment as new businesses start and old ones close, leading to displacement of some workers. Historically, a five percent unemployment rate is normal.

However, this below-normal rate has not been coupled with the normal rise in wages, and therefore living conditions. One explanation for this unusual result is that employees now receive more of their compensation in terms of benefits rather than wages. Over the past decade inflation-adjusted, total compensation has risen faster than the overall economy at 3.8 percent.[2]

The outlook for our cost of living, i.e. inflation, is also favorable. Interest rates on U.S. Treasury bills, notes, and bonds remain well below historical levels. The yield spread, or difference between rates on short-term and long-term US debt, predicts relatively low inflation for the next decade.[3]

Meanwhile, stock prices as measured by the Dow Jones Industrial Average are nearly 60 percent higher over the last decade. Higher stock valuations indicate expectations for either normal or higher than average economic growth.

So what should we be afraid of? 

The big caveat to the favorable economic conditions described above is the ongoing presence of financial repression.

Financial repression occurs when government authorities channel funds from one area of the economy to another, most often by using the government’s own debt. Since 2008, large US Treasury debt purchases by the Federal Reserve and the continuing federal government deficit have suppressed risk measures in the stock market and created a higher than normal level of uncertainty in the overall economy.

After their most recent meeting, the Federal Reserve’s Open Market Committee (FOMC) announced plans for ending the practice of reinvesting the proceeds of US Treasuries that mature. As the Fed reduces its portfolio of bonds over time interest rates should rise, which implies stock values should fall, all else being equal. However, the FOMC said that this process would be gradual.[4]

While the Fed keeps supporting bond prices foreign investors continue to push up stock prices. The most recent data on foreign investment shows that the US is a favored destination for capital. The value of foreign holdings of U.S. equity securities continues to rise while the value of US holding of foreign equity securities declines.[5]

Funds are flowing to the capital markets of the United States because the outlook for economic growth is worse elsewhere. Financial repression is even higher in Japan and Europe, while also rising in the developing markets of China and elsewhere.

Indicators in the U.S. labor, bond, and stock markets may all look good relative to historical averages, but a deeper look tells a different story. For conditions in these markets to improve, and economic growth return to its 3 percent long-run average, financial repression must decline.

When government spending and public debt start declining, the labor and financial markets will reflect a truly healthy economy.

The views expressed here are those solely of the author and do not represent Northwest Nazarene University or Rathbone Warwick Investment Management.

 

 

Peter R. Crabb, Ph.D.

Professor of Finance and Economics

Department of Business and Economics

School of Business, Northwest Nazarene University

[email protected]

 

 

 

Dr. Crabb holds a Ph.D. in Economics from the University of Oregon and an MBA in Finance from the University of Colorado.  His research in economics and finance is published in the Journal of Business, the Journal of Microfinance, and the International Review of Economics and Finance, among others.  Dr. Crabb lives with his wife, Ann, and their four children in Canyon County, Idaho.

Dr. Crabb’s regular Financial Economics column is published by the Idaho Statesman. Previous work experience includes international trade, banking, and investments.

 

[1] https://fred.stlouisfed.org/series/A191RL1Q225SBEA

[2] https://fred.stlouisfed.org/series/COMPRNFB

[3] http://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/default.aspx

[4] https://www.federalreserve.gov/newsevents/pressreleases/monetary20170726a.htm

[5] https://www.federalreserve.gov/econresdata/releases/secholdtrans/current.htm

 

 

 

Since the Election

It’s been said, “Elections have consequences.” The economic consequences of our most recent election are quickly becoming clear.

Following the vote in favor of now President-Elect Donald Trump investors responded with a sell-off in bonds and a rally in stocks. These financial market moves have a number of consequences.

First, investors with an undiversified portfolio felt the pain of this risky strategy. Since the financial crisis of 2008 many investors have loaded-up on bonds, moving away from traditional asset allocation strategies that keep the mix of stock and bonds relatively stable.

Since the election capital has moved from bonds to stocks. Stock mutual funds saw their largest inflow in two years and bond funds lost the most in over 3 years.[i]

The second consequence of the election is the economic outlook bond prices now predict. The US Treasury yield curve is both rising and steepening, raising expectations for both economic growth and inflation.

The yield curve is a graphical representation of the relationship between interest rates on government debt with different maturity dates. The yield (interest rate) on debt moves inversely with prices – when investors sell bonds, yields rise.

When the yield curve line moves upward for all maturities it indicates investors are selling out of bonds and moving capital to riskier assets. This suggests investors expect economic growth to improve, resulting in higher profitability for stocks and other risky assets.

The shape of the yield curve – upward sloping (long-term rates are higher than short-term rates) or downward sloping (long-term rates are lower than short-term rates) – depends on other factors. These factors can be classified into two general categories – expectations or liquidity concerns.

Expectations for future interest rates influence bond prices today. If the yield curve is currently flat – short-term rates and long-term rates are very similar – or downward sloping it is likely investors’ believe rates will be lower in the future. In this case, investors are buying more long-term bonds to capture the high current rates pushing their yield down (the yield on a bond and its price are inversely related). 

Conversely, if the yield curve is upward sloping, as we see now, investors expect future rates to rise. To capitalize on the expectation for higher interest rates investors sell long-term bonds and buy short-term bonds, respectively raising and lowering the yields on each.

A second factor that can explain the shape of the yield curve is investors’ perception of the risks of holding securities for longer periods of time. A preference for shorter term securities is called the liquidity premium and raises the relative yield on long-term securities. When the preference for short-term bonds becomes greater, investors sell current long-term securities and buy short-term securities, respectively raising and lowering the yields on each.

Since the election the yield curve has steepened slightly, but the slope is still smaller than it was at this time last year. The move upward for the whole yield curve and a still small slope suggests the second factor, liquidity concerns, may be declining. Therefore, the yield curve currently supports a better outlook for growth and profitability.

As always, we have to be cautious with financial indicators. The yield curve is not a perfect predictor of future economic conditions, and the Federal Reserve may be artificially holding this indicator down by continuing its bond buying programs. Nonetheless, the economic outlook has improved since the election.

 

What could go wrong?

Business investment, a necessary component of long-term economic growth is still weak and may not improve. Policymakers will need to use the election results as motivation for improving business conditions. Two key policy changes would help – tax reform and fiscal constraint.

Businesses want tax reform and less regulation. The current reliance on high corporate and personal income taxes distorts incentives and creates unnecessary administrative burdens. Small business owners facing higher individual income tax rates and more government oversight are discouraged from investing in their firms. Multinational corporations are keeping more of their earnings overseas to avoid the higher tax rates and additional regulations here.

Second, stimulus spending is unnecessary and counterproductive. Some economists claim the slow economic growth of late requires greater government spending. But the data on gross domestic consumption (GDP) does not support this contention. The biggest component of GDP, personal consumption expenditures, continues to grow and unemployment is at normal levels. Apparently, consumers don’t need the help.

More fiscal spending is just another tax. Economic theory and historical experience show that when people foresee that taxes will have to be raised to offset the future payments of principal and interest on new government debt, then today’s borrowing to finance new spending is equivalent to a tax. That is, there is no real difference between the government taxing its citizens or borrowing to finance its spending.

Financial market action since the election suggests the consequences of this election may be positive, but this could end up being just a short-term bump. The consequences of previous policy failures have yet to be corrected.

The views expressed here are those solely of the author and do not represent Northwest Nazarene University or Rathbone Warwick Investment Management.

Peter R. Crabb, Ph.D.

Peter R. Crabb, Ph.D.

Professor of Finance and Economics

Department of Business and Economics

School of Business, Northwest Nazarene University

[email protected]

 

Dr. Crabb holds a Ph.D. in Economics from the University of Oregon and an MBA in Finance from the University of Colorado. His research in economics and finance is published in the Journal of Business, the Journal of Microfinance, and the International Review of Economics and Finance, among others. Dr. Crabb lives with his wife, Ann, and their four children in Canyon County, Idaho.

Dr. Crabb’s regular Financial Economics column is published by the Idaho Statesman. Previous work experience includes international trade, banking, and investments.

 

[i] http://www.cnbc.com/2016/11/18/the-trump-trade-week-1-a-violent-rotation-with-a-bond-bloodbath.html

 

Throwing out the Playbook

Some coaches are throwing out their playbook.

I’m not talking football. Members of the Federal Open Market Committee (FOMC) of the US Federal Reserve are charged with the duty of “coaching” the economy, but are divided over what game strategies they should use.

The old economic playbook is known as the Phillips curve. In 1958, economist A. W. Phillips published a report detailing the negative correlation between inflation rates and unemployment in Britain. This empirical relationship was soon confirmed by other economists using US data.

According to the theory behind Phillips’ work, policymakers have a clear choice: how much inflation are they willing to tolerate in order to get people back to work?  If the Fed expands the money supply with low interest rates, as it has been doing now for nine years, it moves the economy along the Phillips curve to a point of lower unemployment, but at the cost of higher inflation.

The US national unemployment rate is now 4.9 percent, what economists generally consider normal. A “normal” rate of unemployment is not an exact number but refers to the amount of unemployment the economy experiences when everyone is producing goods and services at their full potential.

But as our economy moved to this normal unemployment, inflation has remained low in contrast to the Phillips curve model. Through July, the US Consumer Price Index (CPI) is rising at an annual rate of only 2.1 percent, very close to the historical average and the FOMC’s “inflation objective” of 2 percent annually. The economy is simply not producing the expected high inflation.

So maybe the game has changed. Minutes from the most recent FOMC meeting indicate that policymakers are divided on this question.

At their July meeting some FOMC members expressed the view that “labor market conditions were at or close to those consistent with maximum employment and expected that the recent progress in reaching the Committee’s inflation objective would continue.” This group then “judged that another increase in [interest rates] was or would soon be warranted, with a couple of them advocating an increase at this meeting.”

At the same meeting other FOMC members “concluded that the Committee should wait to take another step in [raising interest rates] until the data on economic activity provided a greater level of confidence that economic growth was strong enough to withstand a possible downward shock to demand.” These policymakers apparently think the game has changed.

Perhaps it’s the case that the old playbook never worked at all.

A decade after Phillips’ finding of a tradeoff between inflation and unemployment, economists Milton Friedman and Edmund Phelps showed that such policy tradeoffs were only good for a short period of time, if at all. These economists found that when the Fed lowered interest rates by increasing the rate of growth in the money supply there was no real effect on the economy. The Fed can’t do anything for the economy’s long-run unemployment rate.

Today, the economy is simply too weak for interest rates to change the incentives consumers have to buy goods and services, thus raising prices.  The strong force holding back growth has not changed – business conditions are uncertain.

The willingness of companies to invest and grow is being influenced by uncertainty at home and abroad. Fiscal challenges at both the federal and state level present an unclear picture for business investment, and weak economic activity around the globe suggests fewer opportunities for business expansion.

With the upcoming election in November the domestic concerns are unlikely to be resolved until sometime in 2017. This uncertainty clearly holds back many firms from investing in new products or new markets, which would expand output and economic growth.

There is also considerable economic uncertainty outside the US and more evidence that monetary policy is ineffective. The central banks of both Europe and Japan have lowered interest rates to below zero with little economic growth to show for it.

With a weak economy and uncertain outlook investors face limited choices. Prices for financial assets reflect the fact that the headwinds facing businesses have not improved. 

Investors continue to seek the safety of US government debt. In the last twelve months the yield on the 10-year Treasury note has fallen from around 2.1 percent to just over 1.5 percent. The yield spread, or difference between the 2 and 10-year notes, is only 0.8 percent, indicating the market expects very low inflation and economic growth ahead.

The bleak economic outlook outlined here may change next year if the outcome of the U.S. presidential and congressional elections brings more clarity for business owners. Business conditions need to improve, with more certainty over tax and regulatory policy.

To see real economic growth we need to throw out the monetary policy playbook altogether.

Peter R. Crabb, Ph.D.

Peter R. Crabb, Ph.D.
Professor of Finance and Economics
Department of Business and Economics
School of Business, Northwest Nazarene University
[email protected]

Dr. Crabb holds a Ph.D. in Economics from the University of Oregon and an MBA in Finance from the University of Colorado.  His research in economics and finance is published in the Journal of Business, the Journal of Microfinance, and the International Review of Economics and Finance, among others.  Dr. Crabb lives with his wife, Ann, and their four children in Canyon County, Idaho. Dr. Crabb’s regular Financial Economics column is published by the Idaho Statesman. Previous work experience includes international trade, banking, and investments. 

 

The views expressed here are those solely of the author and do not represent Northwest Nazarene University or Rathbone Warwick Investment Management.

 

Stick with Stocks

I’m sticking to it. About a year ago in this space I said we should “expect slow growth and low financial returns unless government spending and debt declines.”

Since this has held true it is hard to find good news in the financial markets. Nonetheless, investors need to stick with stocks as the alternatives look worse.

The only good economic news is that overall prices are rising slowly. Both consumer and producer prices are increasing at historically low rates. Even so, inflation may be reaching a level that policy makers consider too high, and they will therefore raise short-term interest rates higher this year. Such moves will hurt bond prices.

Speaking in Sacramento May 13, John Williams, President of the Federal Reserve Bank of San Francisco, said “inflation has been moving back up to our goal.” You heard that right, our monetary policy makers have a goal for inflation – they want the purchasing power of US currency to decline by about 2 percent per year.

Through April of this year the consumer price index rose at an annual rate of 1.1 percent, compared to 1.6 percent for all of 2015. The Fed’s preferred measure of inflation is called core PCE, defined as the rate of change in prices of personal consumer expenditures excluding food and energy. This inflation index rose 1.6% over the past 12 months.

Fed policy makers also have a congressional mandate to help the economy reach “full employment.” By many measures this goal has been met. The national unemployment rate, a little below 5 percent, is at the historical long-term average for the U.S.

Economists consider this rate “normal”, that is, we currently have a level of unemployment that we should expect in a dynamic economy. Despite this normal level of employment the Congressional Budget Office currently estimates that US real GDP is still about 2 percent below potential.

People are working but not producing as much as they could. Business and consumer demand must grow faster to close this gap.

To get a sense of why the economy is weak and prices are growing relatively slowly we have to consider what is holding back consumer purchases and business investment. The strong forces holding back demand have not changed – consumers have too much debt and business conditions are uncertain.

As of the end of 2015, U.S. households have $14.2 trillion in debt outstanding. This is the same level as the start of 2008, and remains 78 percent of the nation’s annual income. If we add to this the burden of government debt we can see why consumers are not willing to spend like they used to.

Consider now why business owners and managers are also not spending like they have in the past. For the first quarter of this year, gross domestic private investment grew at only 0.3 percent.

Business conditions reflect uncertainty at home and abroad. Questions regarding the policy outcomes of the upcoming presidential election, ongoing fiscal challenges at the state level, and slow economic growth around the globe all lead to lower overall business demand.

With a weak economy and uncertain outlook investors face limited choices. Prices for financial assets reflect the fact that the headwinds facing consumers and businesses have not improved much even though the stock market has bounced back from its fall at the start of the year.

Investors are continuing to seek the “safe-haven” investment of U.S. government debt. At 1.7 percent, the yield on the 10-year Treasury note is half of what it was before the financial crisis. Even very long-term bonds do not pay. The 30-year Treasury bond yields only 2.5 percent, also half of what it paid in 2007.

With an overbought bond market and ample supply of commodities keeping price gain potential low investors have little choice but to look at stocks. Despite the inherent greater risk in stocks over bonds there are sectors that should continue to do well in the current economic environment.

A slow growth economy with low interest rates and stable prices favors large-capitalization stocks in the consumer staples and healthcare sectors. Conversely, the continuing weak consumer demand does not favor the consumer discretionary and industrial sectors.

Further, investors would do well to stay globally diversified as economic growth is likely to pick up outside the U.S. first. Economists at the International Monetary Fund argue that “Emerging market and developing economies will still account for the lion’s share of world growth in 2016….”

Stick with the only investment that has the potential to overcome the Fed’s goal of destroying your purchasing power by 2 percent each year. Stick with stocks despite weak economic growth.

 

Peter R. Crabb, Ph.D.Peter R. Crabb, Ph.D.
Professor of Finance and Economics
Department of Business and Economics
School of Business, Northwest Nazarene University
[email protected]

Dr. Crabb holds a Ph.D. in Economics from the University of Oregon and an MBA in Finance from the University of Colorado.  His research in economics and finance is published in the Journal of Business, the Journal of Microfinance, and the International Review of Economics and Finance, among others.  Dr. Crabb lives with his wife, Ann, and their four children in Canyon County, Idaho. Dr. Crabb’s regular Financial Economics column is published by the Idaho Statesman. Previous work experience includes international trade, banking, and investments. 

[i]http://www.frbsf.org/economic-research/publications/economic-letter/2016/may/economic-outlook-springtime-is-on-my-mind-sacramento-speech/
[ii]https://research.stlouisfed.org/fred2/series/CPIAUCSL
[iii]https://research.stlouisfed.org/fred2/series/UNRATE
[iv]https://research.stlouisfed.org/fred2/graph/?g=3fEi
[v]https://www.federalreserve.gov/releases/z1/current/
[vi]https://research.stlouisfed.org/fred2/series/GPDI
[vii]http://www.imf.org/external/pubs/ft/weo/2016/01/pdf/c1.pdf

The views expressed here are those solely of the author and do not represent Northwest Nazarene University or Rathbone Warwick Investment Management.

“Safe Havens” in a Volatile Market

In the fifteenth century people used the phrase “safe haven” to speak of a place where fugitives went to get shelter or protection from their pursuers.  Today we speak of safe havens as places where investors put their cash when they don’t want to take risks. From what or who are these investors running?

Since the beginning of the year the financial markets have seen an increase in volatility over the previous year.  But this volatility may not be out of the ordinary. Investors may be running from something that isn’t really that dangerous.

Traditionally, in times of trouble and increased uncertainty about the economy investors moved capital from stocks to government bonds.  This safe haven investment is proving unhelpful this year.  While still a haven in that you are very unlikely to lose your investment principal, the returns on bonds are at all-time lows. Government bonds currently yield only 1 or 2 percent per year and have not risen in price even with the stock market declines we saw in January and February.

Another traditionally safe investment is precious metals. But here too, current returns are low. The price of gold is up for the year, but unchanged over the past twelve months.

In search of better returns some investors are turning back to real estate, despite large losses for this investing category during the financial crisis of 2008. As of late 2015, the S&P/Case-Shiller U.S. National Home Price Index was 5.3 percent higher year-over-year.[i]  According to the Society of Industrial and Office Realtors, commercial real estate prices are currently rising at about 7 percent per year.[ii]

Before shifting much capital to precious metals, real estate, or any other so-called “alternative investments”, investors should consider if the recent stock market volatility is really that bad.  Is the stock market response to slowing economic conditions and uncertainty surrounding the upcoming presidential election a reasonable adjustment or a sign of impending doom?

It turns out that a large drop in the value of stocks is consistent with only a small change in the forecasted growth rate of earnings.  To explain this, financial economists use a process called the dividend-discount method of stock valuation. Applying this model to today’s market shows the current situation is consistent with just a slightly lower expected growth rate.

Stock investors in the United States and other developed countries have historically earned a 10 percent return over the long-run. It’s not unreasonable to expect this return in the future, but if dividends are going to grow more slowly because the economy is slowing, our economic model predicts a fairly strong change in current prices.

Suppose, for example, a company currently pays a $1 annual dividend and has historically grown this dividend by 5 percent per year.  If investors are looking for a 10 percent long-run return the dividend-discount model then says this stock will sell for $20 ($1 divided by the expected return of 10 percent less the 5 percent growth rate).  Investors in this stock are earning a 5 percent current yield ($1/20) but getting another 5 percent in growth, for a total return of 10 percent.

Suppose now that things change and investors think the company can only grow dividends by 4 percent per year. The stock price has to fall to $16.83 in order to earn them the same 10 percent long-run return (($1/$16.83) + 4 percent = 10 percent).  So, a small reduction in the economic outlook for growth turns into a 16 percent drop in the stock price.  Since the economic outlook can change for many reasons we should expect 10 or 20 percent swings in stock prices relatively often.

And this is only half the story.  Compared to alternative investments, like gold and real estate, stocks aren’t all that risky.

Financial economists measure the investment risk in stocks, bonds, and other assets by their volatility; roughly the frequency and magnitude of price changes.  The statistical measure of this concept is called standard deviation.

Since 2006 the standard deviation of the return on stocks in the Standard & Poor’s 500 index is 14 percent using monthly price data.[iii]  Over the same period, returns on gold had a slightly higher standard deviation of 15 percent[iv], while the volatility in real estate was 22 percent as measured by the Wilshire US Real Estate Investment Trust index.[v] Metals and real estate are risky investments; that is, there is little protection in these so-called alternative investment classes.

So we can run to the investing haven of bonds and get a return that is currently below the rate of inflation, and never likely to be above it, or we can turn to the haven of metals and real estate and not be any safer.

Yes, the economic and political outlook is uncertain. But the greatest safety from whatever is pursuing your investment portfolio is simply the long-run value of stocks.

Peter R. Crabb, Ph.D.Peter R. Crabb, Ph.D.
Professor of Finance and Economics
Department of Business and Economics
School of Business, Northwest Nazarene University
[email protected]

Dr. Crabb holds a Ph.D. in Economics from the University of Oregon and an MBA in Finance from the University of Colorado.  His research in economics and finance is published in the Journal of Business, the Journal of Microfinance, and the International Review of Economics and Finance, among others.  Dr. Crabb lives with his wife, Ann, and their four children in Canyon County, Idaho. Dr. Crabb’s regular Financial Economics column is published by the Idaho Statesman. Previous work experience includes international trade, banking, and investments.

[i] http://us.spindices.com/indices/real-estate/sp-case-shiller-us-national-home-price-index
[ii] http://www.sior.com/resources/commercial-real-estate-index
[iii] https://research.stlouisfed.org/fred2/series/SP500
[iv] https://research.stlouisfed.org/fred2/series/GOLDPMGBD228NLBM
[v] https://research.stlouisfed.org/fred2/series/WILLREITIND
The views expressed are those solely of the author and do not represent Northwest Nazarene University or Rathbone Warwick Investment Management.

Economics is Full of Paradoxes

Economics is full of paradoxes. A paradox is a statement that contradicts itself or defies common sense. Most of the anomalies found in economics are named after the economists that first identified them. Examples include the Edgeworth Paradox, Leontief Paradox, or the Solow Computer Paradox.

Following the financial crisis of 2008 and 2009 economists started paying more attention to what is known as the Paradox of Thrift. This apparently bad outcome in the economy was first attributed to John Maynard Keynes by Paul Samuelson in Samuelson’s widely used economics textbook published in 1948.

The Paradox of Thrift says while saving more of current income may be good for the individual, it is bad for society as a whole.

Keynes believed recessions and periods of slow economic growth like the US has experienced over the past seven years cause households to save too much of their income. When everyone in a society is saving more, the effect is a large drop in demand, which in turn leads to low output and high unemployment. With a greater risk of losing work, households then save even more, leading to a downward cycle in the economy.

Keynes’ antidote for the problem is active fiscal and monetary policies that discourage savings. The idea is if we give people more money and keep interest rates low they will spend more and save less.

Perhaps not surprisingly, Keynes has many followers in government who have tried both fiscal policy and monetary policy with a vengeance. Federal government expenditures have increased 23 percent since 2008.[i] The Federal Reserve has facilitated a 46 percent increase in the money stock over the same period.[ii]

These Keynesian responses to a financial crisis and weak economy have been ineffective. Why? Keynes’ Paradox of Thrift doesn’t fit the current situation.

A key reason why Keynesian economic policy is wrong is due to the multiple ways households can save more of their income. Keynes expected households to hoard cash and other valuables, but today households are not holding onto their cash, they are using it to pay down debt.

A more precise theory for the current situation is Irving Fisher’s debt deflation. Fisher published his theory about the same time as Keynes, but the work received much less recognition.

Fisher predicted that when households start paying off debt in response to some crisis, assets will most often be sold at distressed levels (think housing foreclosure sales), and the velocity of money, or the frequency of its use, will decline.

The situation today more closely matches Fisher’s predictions over those of Keynes. Since the financial crisis household debt as a percent of income is down 17 percent and the velocity of money has dropped by a quarter.[iii]

Unfortunately, many politicians and monetary policy makers still see a problem here. Like the paradox of thrift, they see the lower debt level as good for the individual household but bad for society. Lower debt use and slower turnover of money leads to a reduction in demand for goods and services, thereby producing unemployment and a recession.

Like Keynes, Fisher said these negative consequences for society can only be counteracted by inflation. That is, their theories propose the economy will only stabilize or get back to growing if policymakers somehow get prices to rise.

The US Federal Reserve has been unable to produce this supposedly needed inflation. Overall prices have risen 10 percent since 2008, according to the Federal Reserve’s preferred measure of inflation, and the value of the dollar has risen. The Fed has flooded the market with dollars, but the dollar’s price is not falling. The US dollar has gained 19 percent in value relative to other major currencies like the Yen and Euro since 2008.iii

Fiscal policy did little, if nothing, to lift the economy out of the recession and despite all its efforts, the Federal Reserve has been unable to produce inflation. Like a coaching staff that finds themselves losing at halftime, politicians and the Fed should throw out this playbook.

Today’s fiscal and monetary policy is simply overburdening the economy with taxes.

Government spending needs to decline to reduce the tax burden more government debt has on future generations. The Fed needs to stop fighting world capital markets with the hope it will produce inflation. Inflation is a tax on our savings that just ends up hurting us in the long run.

Stop trying to fight a paradox that is not.  

Peter R. Crabb, Ph.D.Peter R. Crabb, Ph.D.
Professor of Finance and Economics
Department of Business and Economics
School of Business, Northwest Nazarene University
[email protected]

Dr. Crabb holds a Ph.D. in Economics from the University of Oregon and an MBA in Finance from the University of Colorado. His research in economics and finance is published in the Journal of Business, the Journal of Microfinance, and the International Review of Economics and Finance, among others. Dr. Crabb lives with his wife, Ann, and their four children in Canyon County, Idaho.

Dr. Crabb’s regular Financial Economics column is published by the Idaho Statesman.Previous work experience includes international trade, banking, and investments.

 

[i] https://research.stlouisfed.org/fred2/series/GEXPND
[ii] https://research.stlouisfed.org/fred2/series/MZMNS
[iii] https://research.stlouisfed.org/fred2/series/MZMV