2010 Economic Analysis

I am a top-down analyst.  My first instinct is almost always to look at the long term trends and patterns.  I’ll go back hundreds of years if I can.  Sometimes the easiest way to make money is to grab on to the “one big trend” and ride it.

2010 Annual Outlook

2010 Economic Outlook – A Strong First Half (12/28/09)

2010 Interim Econ Posts

Q4 Economic Growth – Be Happy, But Worry (1/31/10)

Reform the Tax Code Now (3/8/10)

The United States of Debt – Part I (5/26/10)

The United States of Debt – Part II: The Return of the US Consumer (9/2/10)

Manofthehouse.com Articles

Financial Planning with Purpose (10-15-10)

Get Rich, Slowly (10-28-10)

Dad-folio: The Essential Financial and Legal Tools Every Dad Must Own (11-11-10)

Is My House a Good Investment? (11-30-10)

Are You Your Biggest Investment? (12-19-10)

Where to Put Your Money: The Basics (12-29-10)

Simple Rules for Investing in Stocks (1-13-11)

Investing in Bonds – Keep it Simple (1-19-11)

You Need Skills to Pay the Bills (2-17-11)

Why the Fed Likes Inflation (And What it Means to You) (2-25-11)

Year End 2009 Market Update

In 2008 and 2009, I honed and refined my market valuation model for equities and bonds. It has been such a wild ride that it has been very hard to interpret. By just trying to ride the bucking bronco that was the financial market of 2009, I have actually learned a great deal.

S&P 500

One great roller coaster has been S&P inflation-adjusted earnings.

From 2003 to 2004 we saw the great spike in earnings, driven particularly by financial earnings and energy earnings. Annual nominal earnings got as high as $81.96 in 2006 and fell to as low as $14.88 in 2008 (the fourth quarter of 2008 was negative due to all of the bank write-downs). Earnings rallied to $49.26 in 2009 and are projected to reach $66.99 by 2011. (Projections by S&P, top-down as-reported.)

The other was the change in the market’s long term inflation assumptions, which were at 2.5% in August 2008 when I first set up my equity market valuation model, fell to 1% by November 2008 during the financial crisis, and are now back up to 2.7%. Obviously, the S&P swung around a lot, too. It fell from 1,267 in August 2008 to 680 in March 2009 (a 46% drop), and is now back up to 1,137 (a 67% rally).

The chart below shows how the changes in equity prices (and thus yields) and inflation assumptions have affected the projected return of my valuation model. (Calculated at the various dates on which I have written about the model on the blog…for a list of these posts see here.) I use a 50% payout ratio assumption to calculate the implied yield on trend earnings, which is in line with the historical ratio.

From these numbers it’s somewhat clear that the equity market has been targeting a 7% return during this period. A 7% nominal return on the equity market equates to a 5% premium to the 10-year treasury bond on an after-tax, inflation-adjusted basis, which is in line with the historical equity risk premium.

If you think that the 2.7% 30-year inflation assumption embedded in today’s treasury yield curve is correct, then today’s equity market is fairly valued. As I’ve repeated many times, I believe that in the medium term (5-15 years) the US may struggle with deflation, in which case we could see the market retest the lows when we have the next recession and the inflation assumption falls back under 2%. In the short term, however, the equity party rolls on as the economic expansion gains steam.

Fixed Income

Using the yields of various Vanguard Funds and the treasury yield curve from PIMCO’s website, I get the following yields vs. their respective equilibrium yields:

According to this methodology, TIPS are moderately overvalued, long treasuries are fairly valued, and long-term inflation is overstated. Intermediate and long term muni bonds are roughly fairly valued and corporate bonds are mostly overvalued. Yields on the short end of the curve for all types of bonds are way below their equilibrium levels.

For fixed income, the risk lies in corporate bonds. Unless you are in the “hyperinflation” camp, treasuries and munis are an ok value, but uninspiring and at risk to a crisis in which interest rates go haywire, which is highly possible (see below).

The Dollar

The dollar against major currencies is in its long term downtrend range of 70-80:

The real dollar index against all currencies is also in its long term range of 85-95:

The dollar may drift somewhat higher this year, but there is no reason to expect it to trade out of its trend range. Generally, when the dollar is fairly valued against other currencies, it is good for exports and emerging markets.

The dollar has continued to fall against the neutral currency of gold:

In the mid-1980s to mid-1990s, the dollar had settled into a nice range around $375-400 per ounce of gold. The gold price fell during the strong dollar era of the late 1990s. It broke above $400 / ounce in 2005 and hasn’t looked back since. The reason that gold has risen so much faster than the dollar has fallen against other currencies, is that all currencies are falling against gold. It is hard to know when and where this trend will stop. I suspect it has something to do with the currency reserve-building practices of China, the Middle East, et al, which have been artificially holding down interest rates relative to the rate at which the money supply (and financial debt) has been expanding. When this practice finally unwinds…which it will someday, probably by the middle of this decade…watch out for the “final crisis of bubble capitalism”.


The oil / gold ratio is right about at its historical average, meaning oil is fairly valued given the debased value of the dollar relative to gold.

The CRB futures index, which tracks commodities generally, is actually well below its equilibrium value relative to gold:

This implies commodities could continue to rally strongly as long as the economy is spurting forward.


Outside of a trade in commodities, the market has no obvious pockets of value overall. The macroeconomic risk looming over the horizon (2012?) is foreboding, even if it can’t be felt now. The great bubble of money seems to be flowing to emerging markets, which is in turn flowing into the bubble in developed market deficit spending. If I had to guess now…I think the next great crisis will be in the Chinese banking system, which could result in them selling off their currency reserves, which would spike interest rates and cause a deflationary crisis in the US…but would also finally rebalance the world economy and lay the groundwork for renewed, sustainable growth.

Good luck and be safe.

Tyler Newton is not a financial adviser. He is only writing these posts for personal interest. Please be sure to consult with your financial advisor.

2010 Economic Outlook – A strong first half

In my 4-part 2009 economic outlook, I stated my belief that I thought that the US economy was at a key long-term inflection point. The first two installments dealt with the long-term problems facing the US, namely that US economic policy is geared toward promoting consumption and residential housing investment, leading to chronic trade deficits and the resultant high US indebtedness, and that this trend has probably run its course. The second two installments posited that the bursting of the real estate bubble would result in $1.8 trillion of bank losses and that the banking system would be hobbled without offsetting injections of capital, which could delay the recession’s end into early 2010.

The obvious problem is that dealing with the short term issues surrounding the collapse of the housing bubble and the associated damage to the financial system almost by definition postpones dealing with our long-term structural issues. The corollary is that policies designed to fix America’s long-term problems would inflict major short-term damage on a global economy that is geared toward American consumption and housing investment. The world will need wise leaders that can thread the needle by providing short-term economic support while moving together toward long-term sustainability. The problem is that such a shift would probably require the US (and the UK, Ireland, Spain, etc.) to endure a soft depression similar to what has been endured by Japan and Germany for the past 15 years. The US electorate is less docile than the Japanese, however, and is more likely to take a more active role in shaping economic policy in a way that put the interests of the United States above that of the global economy as a whole. So while 2010 is likely to be a pretty good year for the US economy, I expect the “Tens” to be a volatile, crisis-laden decade.

Real estate vs. everything else. We should make no mistake that the financial panic of 2007-2009 was centered around the housing bubble. The housing bubble was aided and abetted by just about the entire globe. The US government encouraged it, foreign governments encouraged it, conservatives encouraged it and liberals encouraged it. The US government encouraged it with tax deductions (encouraged by conservatives and liberals) and with direct subsidies (encouraged mostly by liberals). The US financial system encouraged it by getting the math wrong on derivatives and securitizations (abetted by conservatives that relaxed banking regulations). The bubble was abetted by foreign central banks that created trade surpluses by recycling dollars from abroad into US agency securities. The bubble was also abetted by the US Fed, which printed money in response to the fallout from the tech investment bubble of the late 1990s. Since banks have become “universal” in services, particularly the money center banks in New York, the collapse of housing finance and the associated large losses restricted the availability of capital for everything else: auto and credit card receivables, business loans, commercial paper, municipal finance, buyout loans, venture capital. Without action to stop the banking panic, the entire financial system would have collapsed in a “vicious cycle” of debt deflation.

The financial crisis recedes. The government executed on a good strategy to stem the collapse of the banking system. The combination of the $245 billion invested in banks under TARP, the $1 trillion expansion of the Fed’s balance sheet, the $200+ billion of private capital that has been raised, the $350 billion of Federal debt guarantees, an unlimited backstop for Fannie Mae and Freddie Mac, high bank profits from the steep yield curve and the suspension of mark-to-market accounting rules stopped the debt deflation cycle. As a result of all of these actions, the equity and credit markets began to rise again around the end of March. The old-fashioned financial panic that had pulled the economy down so hard in the fourth quarter of 2008 and the first quarter of 2009 was over. The “second derivative” of economic growth bottomed in the second quarter and GDP returned to positive growth in the third quarter.

The collapse in the demand for credit. I last year’s economic outlook I erred in thinking that stopping the banking system collapse was primarily what was needed to “normalize” the economy. I was focused on the fact that there was a shortage of the supply of credit. What I missed was that there was (and still is) an epochal decline in the demand for credit as well. US consumers, realizing that the “free lunch” of rising real estate collateral has come to an end, have logically pulled in their horns. US household indebtedness has fallen by $255 billion from its peak in the second quarter of 2008 to the third quarter of 2009. While that sounds like a lot, it is only a 2% decline from the more than $13.8 trillion peak. Household debt as a percent of GDP has declined from 97% at the depth of the recession to 95% in the third quarter. Household debt was only $7.3 trillion and 73% of GDP at the trough of the 2001 recession, so there is more room to the downside. In addition, financial sector debt has declined by over $1 trillion since the fourth quarter of 2008, from a peak of about 120% of GDP to 113% of GDP.

The effect of the stimulus. As I discussed in my November 4th post Government Deficits are Necessary (for now), the huge surge in private sector saving to 10% of GDP in 2009 from -4% in 2006 has resulted in a nearly $2 trillion drain of demand from the world economy. There were similar swings in Spain, Ireland and the UK. All of the US, UK, Spain, Ireland and Japan are making up for the loss of private demand by running government deficits in excess of 10% of GDP. The wide trade deficits of the US, UK and Ireland have shrunk significantly. These government deficits are not “crowding out” private investment. If they were, treasury rates would be above their equilibrium rates, whereby the treasury would be competing with private demand, which they are not currently. The fact that we are running a trade deficit of 2.8% of GDP means that we are still pulling more than our share of the weight of global demand, but this is an improvement from the trade deficits of around 6% of GDP at the height of the housing bubble in 2005-2006.

Transition to “normalization”. In 2010 we will see if the economy can transition to normalization in a way that allows for a sustainable expansion. The demand for private credit will continue to be weak. The housing market is not likely to work off its excess until 2011, which hobbles consumer finance in general. In addition, (much needed) banking regulations will likely be passed in 2010, which will require greater capital cushions and suppress the expansion of financial sector debt. Businesses have ample cash flow to self-finance investment and hiring, however, which should in turn help consumer spending by increasing incomes. Government transfers are also helping consumer spending and direct government stimulus spending will add to demand for the first two quarters of 2010. Without the downward pull of the financial panic, the economy should at the very least get a nice cyclical bounce back to “normal” levels of output in sectors not related to housing. GDP growth could get a boost to over 4% in the fourth quarter of 2009, just by virtue of a halt to the decline in business inventories. Auto and chemical production has been increasing and the new economy sectors of IT and health care will resume growth. Aircraft production (the US’s biggest export) should start ramping up, as well.

Durable manufacturing. In 2009 US manufacturing capacity utilization averaged 66%, while output plunged 14% from 2007 to 2009. Much of the decline was in the volatile durable goods area. At the 2007 peak, US durable goods manufacturing was 16% higher than the late 1990s peak, but has since declined by 19%. Industry groups that saw increases in output in the 2000s vs. the late 1990s were “new economy” sectors like computer and electronic products (which nearly doubled production from 1999 to 2007), medical devices and aerospace, as well as housing-related sectors like wood products, non-metallic mineral products, furniture and fabricated metal products. The new economy sectors have an average capacity utilization of 69% today, down from around 80% at the peak, with production down an average of 9%. We should expect to see these sectors ramp back relatively quickly over the next year or two. The housing-related sectors, on the other hand, have seen their capacity utilization fall to an average of 58%, down from around 82% at the peak (in 2006), with production down 31% on average. The truly sickening declines came in motor vehicle and primary metal production, which fell by around 50% from 2005 peak to 2009 trough. Both have since snapped back by 30-40% after the “cash-for-clunkers” program cleared auto inventories and the auto financing markets were stabilized. Motor vehicle capacity utilization stands at only 53% (up from 37%!) and primary metal utilization is at 59% (up from 45%). While an infrastructure-focused stimulus program could quickly bring primary metal production up to pre-crisis levels, auto manufacturing capacity will likely shrink a great deal. A large chunk of the US manufacturing base related to housing and autos has been permanently impaired by the long-term declines in auto production and housing investment.

The excess capacity problem. The problem of excess capacity is not limited to the United States. China, Japan and Germany run chronic trade surpluses, meaning their production exceeds domestic demand as a matter of course. While the cyclical decline in capacity utilization will reverse with the help of global stimulus, the structural excess capacity in Chinese, Japanese and German “old economy” manufacturing and in housing-related sectors in the US and the EU periphery will not go away anytime soon. The way out is known (an increase in domestic Chinese demand), but if the Chinese don’t muster the political will to reverse their mercantilist trade policies, other remedies may end up being put in place (US tariffs) that will do more to upset the global economic order. Instead, the current Chinese stimulus program is geared toward infrastructure investment, increasing production capacity, while they continue to build currency reserves, suppressing demand for imports and contributing to global excess savings.

Is deflation still a threat? When the world suffers from excess capacity, the threat of deflation is real. The developed world is awash in deflation, but deflation has been offset by the rampant printing of paper currencies. Reserve-building countries in Asia are fighting developed country currency depreciation and artificially holding down sovereign interest rates. The safety valve has been the rising price of gold. The US dollar has fallen roughly 66% against the value of gold since the late 1990s boom, while the Euro has fallen 48%. The US dollar has fallen only 22% against the basket of consumer goods represented by the CPI. This means the market is anticipating significant currency debasement as an antidote to the deflationary undertow.

So what does this all mean for 2010? It is key to remember that it is natural for the economy to grow. Recessions are caused by the sudden restriction of credit, whether it’s induced by the Fed or by a banking panic. With the banking panic over, the resilient parts of the economy will resume growth. That means technology, health care, aerospace, mining, agriculture, oil & gas, chemicals, leisure and hospitality services will resume their upward trends. Non-housing-related durable goods manufacturing will have a nice cyclical recovery. Productivity growth will be monstrously high, and we are likely to see several quarters of 3.5%-4.5% growth. Housing, retail and finance are likely to remain problem areas as the market works off excess capacity. The good news for GDP growth is that housing investment has probably bottomed at the lowest level relative to GDP since World War II (down to 2.6% of GDP from a high of 6.1% of GDP).

The trillion-dollar question will be whether business investment will be in a position to take the baton after the effects of government stimulus and inventory restocking begins to fade in the second half of 2010. Signs to look for will be manufacturing capacity utilization jumping to the mid-to-high 70s, a move to a positive change in business inventories, and a continued decline in the trade deficit.

Policy debates will continue to be interesting, with financial reform and climate change legislation on deck for early 2010. In addition, if economic growth is as rapid as I expect, we will likely see rising interest rates in the middle of the interest rate curve and a debate around a deficit-reduction package that will consist largely of tax hikes. The 2010 elections will likely be fought largely on the ground of tax and spending policy. With the Bush tax cuts expiring in 2011 and huge projected budget deficits, it should be quite a show. I project that as usual the US electorate will make the right choice…it just isn’t clear yet what’s the right choice.

It should be a fascinating ride. Happy New Year!

Assessing the Quality of Q3 GDP Growth

In my last post I outlined how I'd assess the quality of future GDP growth.  I expected to see near term growth coming from a combination of of export growth and government spending near term with business investment eventually taking the baton from government near term.  I also said how I would not want to see growth that comes from consumption of consumer goods (with a high propensity to import) and housing investment.  (I use nominal GDP vs. real GDP, becuase I care about actual cash changing hands, and inflation is relatively low.)

The change in nominal GDP from Q2 to Q3 was $150.3 billion.  Personal consumption expenditures was up $162.6 billion, although $39.4 billion came from increased sales of autos and $48.1 billion came from gasoline and other fuels.  Imports of autos increased $43.2 billion, meaning that the increase in auto sales, partly fuelled by the "cash for clunkers" program, was a net drag on GDP growth.  We also imported $42.1 billion of petroleum products.  In other words, the net effect on GDP from domestinc demand in the auto and petroleum sectors (excluding changes in inventories) was a net gain of $2.2 billion.  Exports of autos and parts increased $20.2 billion thanks to increased demand abroad.

Residential construction increased $15 billion, or about 10% of the net increase in GDP.  Given the excess supply already existing in the housing market, I consider this to be low-quality growth, spurred temporarily by the first-time buyer tax credit.

Business investment added $2.9 billion to GDP growth, more than all of which came from a smaller decline in changes in inventories.  Business investment in structures fell $24.5 billion and investment in software and equipment fell $1.7 billion.  I expect investment in structures (largely commercial real estate) to continue to fall and for investment in inventories, software and equipment to start to rise.

Government spending added $28.6 billion to growth.

Exports increased $69.5 billion and imports excluding autos and oil was up $32.6 billion, a net increase of $36.9.  Imports of autos and oil was $85.3 billion, accounting for 72% of the increase in imports.  Thus the net drag from total net exports was $48.4 billion.

If we strip out the effect of housing investment, domestic auto sales and domestic oil consumption, "quality" GDP growth was $128.5 billion, or 3.7% nominal GDP growth.  Government spending accounted for $28.6 billion of that growth, meaning $99.9 billion of nominal GDP growth came from "quality" private sources.  That would have yielded 2.9% nominal GDP growth.

All-in-all, not bad. 

Politics, Parties and Electoral Cycles

Because the US Government is a very large actor in the US economy, and because many of the same principles that apply to analyzing economic cycles applies to politics as well.

Maybe Ron Paul was on to something (9/30/08)

Is the North rising again? (10/16/08)

Was 2008 a realigning election? I’m thinking it probably was. (11/5/08)

Crony Capitalism still Reigns Supreme (4/20/09)

The New Deal’s great mistake (5/3/09)

Post-Lehman: The Banking Oligopoly Reigns Supreme (9/15/09)

David Brooks backs up the Dynamist (9/18/09)

The GOP Will Not Repeal Obamacare (3/23/10)

US Politics: The Middle Class is Still Up for Grabs (10/31/10)