Thursday, October 19, 2017

A Goldilocks dollar?

I've had a number of posts over the years that have looked at the value of the dollar vis a vis other currencies. One common thread in these posts has been a reference to each currency's Purchasing Power Parity (PPP), which in theory is the exchange rate which would make prices roughly comparable between two countries. Since the mid-1980s I've used the same methodology for estimating this value, and I've been continually impressed with how it's held up over time. Since I started this blog in late 2008, the dollar has been all over the map: plunging to its weakest level ever in 2011, then soaring over the subsequent five years to its late-2016 high. My PPP analysis says that today the dollar is pretty close to what could be called "fair value" against most of the major currencies, with the notable exception being the Australian dollar, which I estimate to be trading about 25% above my estimate of its PPP value vis a vis the dollar.

To calculate a currency's PPP value against the dollar, I first look for a period—a base year—when prices in that country were roughly comparable to prices in the US. I then adjust the value of the currency in the base year for the difference in inflation between that country and inflation in the US over time. If a country has lower inflation than the US, its PPP value will rise over time, and if a country has more inflation than the US, its PPP value will decline. I should add that I've had occasion to visit each country over the years, and have been able to validate my PPP estimate by subjectively comparing how prices for food, clothing, hotels, etc. compare to US prices (there's an element of judgment at work here, but I think most observers would agree that my estimate of PPP is not too far off—comments pro and con are welcome). As you can see in the charts below, a currency rarely trades at or near its PPP. Instead, most currencies tend to cycle up and down relative to their PPP value, becoming alternately strong and then weak. One important caveat: although divergences between a country's PPP rate and its actual exchange rate tend to close and even reverse over time, PPP should not be used to bet on a currency's future strength or weakness, since it can take years for conditions to change. This is not a trading tool, it's a way to judge how strong or weak a currency is at any one time.

I begin with the Fed's calculation of the dollar's inflation-adjusted value vis a vis a trade-weighted basket of currencies. This is arguably the single best measure of the dollar's overall strength or weakness. The blue line measures the dollar against a basket of more than 100 currencies, while the purple line compares it to a basket of about a dozen currencies. Against a broad basket of currencies the dollar is today is roughly equal to its average since 1973. Relative to the largest currencies, the dollar is about 5-10% above its long-term average. Call it a Goldilocks dollar: neither too strong nor too weak.

The chart above shows how the Euro has tracked its PPP over time. The Euro began in 1997, but I extended its value back in time using the DM as a proxy. Note that the Euro's PPP has trended upwards against the dollar over many decades, a reflection of the fact that Europe has had less inflation than the US. Today the Euro is trading at almost exactly my estimate for its PPP. US visitors to Europe should find that prices there are pretty similar to prices here. Similarly, European visitors to the US should not be surprised to find things cost about the same here as in Europe.

As the first chart above shows, Japan has had a lot less inflation than the US since the late 1970s, and the yen has been very strong throughout most of that period. Some would say the Bank of Japan has been too tight, keeping inflation too low and the yen to strong, and that in turn has curtailed economic growth by making Japanese exports expensive, among other things. In any event, the yen is no longer too strong. As the second chart shows, the yen may now be at a level that is allowing the economy to pick up. Note that the stock market has surged in the past year or so, even as the yen has strengthened a bit.

As the chart above shows, the UK has experienced a lot more inflation than the US in the past several decades; as a result the Pound has been in a long-term, declining trend vis a vis the dollar. Currently the Pound is trading very close to my estimate of PPP. Traveling to the UK in the mid-2000s, as I did frequently, was a painful experience since prices were very expensive. Today it's a much nicer experience.

As the first chart above shows, Canada's inflation has been very similar to US inflation for the past 30 years. However, the Canadian dollar has been all over the map—very weak in the early 2000s, and extremely strong in the late 2000s. The strength or weakness of the Canadian dollar has tended to be the mirror opposite of the dollar's strength or weakness, and both have been highly correlated—until recently—with commodity prices, as the second chart above shows. (Canada positively correlated, the US dollar negatively correlated)

Finally, we come to the Australian dollar, which by my calculations is trading about 25% above its PPP value vis a vis the dollar. Australia continues to benefit from strong commodity prices and from strong demand from China. But the loonie is no longer egregiously strong, as it was some 5 years ago.

At current levels, exchange rates paint a picture of a global economy that is rough equilibrium. No country, with the possible exception of Australia and a few others—is judged by the market to be inherently more attractive than others, on a risk-adjusted basis, and thus worthy of a relatively strong currency. Currency risk has ebbed, as a result, and this may contribute to a continuation of global growth (less risk tends to favor investment, which in turn is the engine of growth). Altogether, not a bad state of affairs.

Wednesday, October 11, 2017

Recent & notable charts

Here is a collection of charts, in no particular order, that I have updated in the past week and which I think are worth noting. If they have a common theme, it's that economies both here and abroad continue to improve.

The message of this chart is that the real value of the S&P 500 index has increased in line with the physical expansion of the US economy for the past 45 years. As a proxy for the economy's physical size, I've used the American Trucking Association's index of total truck tonnage hauled by the nation's truckers. I note that there have been a few times when equity markets have diverged significantly from the the trucking index, particularly the late 1980s, the late 1990s, and during the depths of the 2008-2009 recession. I would characterize those as periods of excessive optimism and pessimism—sentiment not warranted by the progress of the overall economy. Currently, the advance in equity valuations seems to be very much in line with the growth of the economy.

Today the Japanese stock market reached a two-decade high, after not making much progress on balance for a very long time. It's interesting that this occurred despite the fact that the yen has been strengthening of late against the dollar. As the chart above shows, since 2005 Japanese equities had shown a strong inverse correlation to the value of the yen (e.g., equities would rise as the value of the yen fell, and vice versa). People have made various attempts to explain this inverse correlation, with perhaps the most convincing being that the Bank of Japan has been pursuing misguided monetary policy at times, such that a stronger yen (one result of very tight monetary policy) put a lot of downward price pressure on Japan's industries (because it made their products more expensive to foreign buyers), while a weaker yen mitigated this pressure and eventually became "stimulative." I'm not quite sure what to make of the action offer the past year or so, but I think it may be that the yen has settled into a reasonable valuation zone. Perhaps not coincidentally, my calculation of the Purchasing Power Parity exchange rate between the yen and the dollar is about 114, which is very close to the current exchange rate of 112. This further suggests that central banks have been doing a pretty good job of managing things, and currencies are trading at reasonable levels in general. (The Fed's Real Broad Trade Weighted Dollar index is currently very close to its 45-year average, by the way.) This suggests that the uncertainties that arise from significant currency fluctuations have been mitigated, and that further suggests that economic fundamentals have become more conducive to investment and growth. Reduced uncertainty is almost always good for investors, and for investments, and for economies.

As the chart above shows, property prices for commercial real estate continue to rise, and have clearly surpassed their prior peak. You hear a lot these days about how shopping malls are dying all over the country (thanks to predators such as Amazon), but this suggests that things are not necessarily bad at all in general.

The charts above are based on Bloomberg's calculation of equity market capitalization. I note that non-US equity markets have been strongly outperforming their US counterparts for most of the past year. However, all markets have registered equivalent gains for the past decade or so, on balance. We're in a global recovery that shows every sign of continuing.

The September ISM survey of service sector businesses in the US was extremely strong, as the chart above shows. This could well be one of those random blips, but at the very least it suggests that the US economy continues to improve. It's also worth noting that a similar index of Eurozone service sector businesses has been trending higher for the past several years. It looks like we're in a synchronized global growth cycle.

I've commented often and for years about the curious and continuing dance between gold and TIPS prices, as illustrated in the above chart (see a recent post here). I've also commented on how the real yield on 5-yr TIPS (shown inversely in the chart in order to serve as a proxy for their price) tends to move in line with the real growth trend of the US economy. With 5-yr TIPS real yields only slightly above zero, the market is apparently unconvinced that any good will come from the Trump administration, at least insofar as something that might push the US economy out of its 2% real growth rut. If there is anything that makes a convincing rebuttal to the widespread claims that the market is insanely optimistic and egregiously overpriced, this chart is it. If the market were convinced that the economy was on the cusp of growing 3% per year or more, I think real yields would be significantly higher and gold prices would be significantly lower.

The most recent survey of small business optimism showed a downtick, but the index is still at rather lofty levels. Small business owners are already seeing a reduction in regulatory burdens, as are banks. It may well be the case that entrepreneurs are already gearing up for better things ahead, but that we won't see the results (e.g., more hiring, more investment) for some months to come. These things take time to unfold.

As the chart above shows, car sales had been in a disturbing slump since last year. Fortunately, the September numbers revealed a substantial bounce. This may be just one of those quirks of seasonal adjustments, so we'll have to wait for a few more months to declare victory, but it is nevertheless encouraging. 

Saturday, October 7, 2017

Healthy households

A few weeks ago, I had some charts (the last two in this post) that showed how our net worth as a country on a real and per capita basis has reached new all-time highs. Our collective prosperity rests on the value of our savings, our investments, and our capital stock. Regardless of who owns all that money (as of June 2017 the net worth of the private sector was over $96 trillion, with total assets worth over $111 trillion), we all enjoy the fruits of those assets in the form of jobs, services, products, and infrastructure. Does a worker really care who owns the building he works in? Who pays his salary? Who owns the toll road he drives to work on? Who owns the tools he uses? He shouldn't. What's important is that the assets that have generated our record-setting wealth are available to all of us, everyday.

The Fed recently updated its calculation of households' debt service burdens, as of Q2/17. Total household liabilities climbed to a record $15.2 trillion, but that represents less than 14% of total household assets. As the charts below show, households' financial burdens (the cost of servicing debt as a percent of disposable income) are about as low as they have been for decades. And households' overall leverage (total debt as a percent of total assets) has fallen by one-third since its record high in early 2009.

On balance, U.S. households are in very healthy financial shape, and that in turn means that the fundamentals of the U.S. economy are also in good shape.