Japan, Deflation and Some Very Bad Charts And Numbers

This chart is by far the most important piece of information about Japan: inflation - or, more specifically, the lack thereof.  While no one wants hyper-inflation, some inflation is actually a good thing, as it indicates that demand is increasing a bit faster than supply, or that supply is somewhat constrained and therefore needs to increase prices because it can't adequately supply the market.

The above chart shows the YOY percentage change in Japanese CPI for the last 20 years.  Note the following:

1.) In the early 1990s, we see a continual decline until 1995.
2.) From 1995 until 200, we see a spike to over 2%
3.) We see some YOY increases from 2005-2009.
4.) The most recent spike is as much due to statistical issues (low previous year comparisons) as economic activity.

For the rest of the time, Japan was in a period of deflation.  Let's explain why this is bad, with hep from the economic dictionary at the Economist:

Deflation is a persistent fall in the general price level of goods and SERVICES. It is not to be confused with a decline in prices in one economic sector or with a fall in the INFLATION rate (which is known as DISINFLATION).

Sometimes deflation can be harmless, perhaps even a good thing, if lower prices lift real INCOME and hence spending power. In the last 30 years of the 19th century, for example, consumer prices fell by almost half in the United States, as the expansion of railways and advances in industrial technology brought cheaper ways to make everything. Yet annual real GDP GROWTH over the period averaged more than 4%.

Deflation is dangerous, however, more so even than inflation, when it reflects a sharp slump in DEMAND, excess CAPACITY and a shrinking MONEY SUPPLY, as in the Great DEPRESSION of the early 1930s. In the four years to 1933, American consumer prices fell by 25% and real GDP by 30%. Runaway deflation of this sort can be much more damaging than runaway inflation, because it creates a vicious spiral that is hard to escape. The expectation that prices will be lower tomorrow may encourage consumers to delay purchases, depressing demand and forcing FIRMS to cut prices by even more. Falling prices also inflate the real burden of DEBT (that is, increase real INTEREST rates) causing BANKRUPTCY and BANK failure. This makes deflation particularly dangerous for economies that have large amounts of corporate debt. Most serious of all, deflation can make MONETARY POLICY ineffective: nominal interest rates cannot be negative, so real rates can get stuck too high.

The above definition gives us same very good information.  The top concept -- that some deflation can be good -- is something we don't talk too much about, but it's an incredibly important and valid point.  When technology advances in a manner that lowers prices, yet at the same time incomes are advancing in some degree, we get a very beneficial economic environment.  For example, in the1990s, the world economy experienced a huge explosion in technology and the like.  This had the overall effect of increasing productivity, thereby lowering costs.  At the some time, we also had the last big income advance of the baby boomers (as people get older, their income typically increases), increasing incomes.  The combination was great.  (As an aside, this also explains part of the US' CPI calculation which tries to adjust for advances in technology.)

Conversely, deflation can also mean slack demand or excess capacity.  If that is the case, it tells us that the economy is in trouble.  People aren't spending as much, so the demand curve moves to the lest, lowering prices.  As people spend less, businesses start to lower their capacity, which in turn lowers employment, which lowers demand, etc... At this point, you get the idea: it's a very bad development.

Overall, here is the end result:

 
20 years of very sub-par economic growth.  And that, is a terrible thing.

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Housing prices: a rebuttal to Barry Ritholtz, part 2

  - by New Deal democrat

As I said yesterday, Barry Ritholtz's argument that house prices will decline further rests generally on three arguments:
     (1) housing is not actually affordable by traditional measures.  Down payments remain unrealistically high, and buyers cannot qualify for mortgages;
     (2) there is a large overhang of "shadow inventory" most especially including but not limited to foreclosures, which are primed to put renewed downward pressure on prices; and
     (3) potential buyers, especially younger buyers, are fearful of the potential immobility that comes with owning a house vs. renting

Today we'll take a look at affordability.  Barry makes 3 important assertions to justify his opinion that house prices must go lower, because they still aren't affordable enough:
  1. the home price to median household income ratio is still higher than the norm.
  2. Home buyers don't have sufficient savings to come up with a $40,000 down payment to afford the median priced house
  3. The NAR's "housing affordability index" fails to take into account household income and savings

 I addressed all of these issues several months ago in How affordable is housing?   I encourage you to read the whole piece, but I'll restate it in condensed form here.

Over the long term the median house has cost about 2.7 to 2.8 times median family income (sorry, I don't have a more updated graph to show you, but I'll set forth the more recent data immediately below):



Median family income differs from median household income in that the latter includes one-person households, the former does not. According to the NAR's existing home sales report, the median home purchased cost about $165,000. Meanwhile the median family income is about $60,000. That means it costs about 2.75 times median income to purchase the median priced house -- in other words, right at the long term average.

 Barry highlights median household income vs median NEW home prices:



Admittedly that has not declined to its long term average, but new homes are only a small share of the overall market. I don't know why housing prices should be decided based on that slice alone. When you consider the broader range of houses available, per my discussion above, we have already declined to the long term average.

 Further, Barry's chosen metric fails to take into account mortgage rates. In 1980 mortgage rates were running at about 20%, In 1990 they were about 10%. Now they're about 4%. That means the monthly carrying cost of a mortgage on an identically priced house is only 1/5 what it was in 1980.

Put another way, the same nominal disposable income today can support 5 times the mortgage amount as it could in 1980. That means, at any given home price, there should be a much higher level of demand. By simple operation of supply and demand, we ought to expect that home prices must be significantly higher to bring supply into equilibrium with that heightened demand. That explains a great deal of the generally positively sloping ratio between house prices an median income shown in the graph Barry relies upon.

CR also makes the point in response that there has been a slight upward slope in the price of housing over the long term, as the US population has increased by 50% in the last 30 years, but God isn't making any more land.

 Barry's second point is that households can't come up with a $40,000 down payment for the median house. Presumably he is thinking of 20% of $200,000. But again, the median existing home sells for about $165,000. 20% of that number is $33,000.

 Beyond that, he makes in my opinion an important mathematical error. First time home buyers aren't the ones buying the median priced house; rather, "move up" buyers do.  First time buyers buy starter homes, and so don't have to come up with the down payment for the median priced house.  Throughout the last 6 years, houses at the 25th percentile have featured list prices of about 2/3 of the median home. Using that as our estimate, a first time home buyer only has to come up with about $22,000, or 20% of $110,000. If they have trouble with $22,000, there is every reason to think they will do what I did when I bought a starter home long long ago in a galaxy far far away. I put up 10% and obtained loans from family members for the other 10%. Once we start thinking in terms of coming up with $11,000 to put towards a starter home, it is much more doable, even in today's depressed climate.

For the same reason, move-up households only have to come up with about $11,000 ($33,000 - $22,000) after selling their starter home.  I will grant that families who bought houses anywhere near the peak of the market will have a hard time moving up, since their equity has declined, in some cases probably to zero. But any family which has owned its home for 10 years and resisted the siren call of home equity withdrawal should have no problem.

Indeed, contrary to Barry's argument that households do not have the savings to come up with a down payment, while the personal savings rate at less than 4% may not be stellar, the amount of savings that households have stashed away since the onset of the last recession is considerable, and indeed is generally better than at any point in the last 20 years:



Barry's final argument as to affordability is that the NAR's affordability index doesn't take into account household income. That's easy enough to do, however.  We start out with the interest rate on a 30 year mortgage and divide that by the Case Shiller 20 city average house price.  That gives us a general affordability rate.  When we divide that number by average hourly earnings, we can easily see how affordable it is for a family earning the average hourly wage to afford the typical mortgage payment for a typically priced house.  That is exactly what this next graph shows us:



The above graph tells us that, despite lackluster wage growth, the renewed decrease in mortgage rates, together with the steep decline in housing prices, have made mortgage payments far more affordable than at any point in the last 25 years.

Finally, Barry says that house prices, like other asset bubbles, typically overshoot the median on the way down. That's very true, but that doesn't mean that it must be accomplished by nominal prices. Rather, if nominal prices rise, but at less than the rate of inflation - and generally remain flat for a very long time after they bottom - then the overshoot can be accomplished in real terms without nominal prices declining further at all.

In summary, Barry's argument about affordability does not necessarily imply any further decline in nominal, as opposed to real, house prices.

 Next: Shadow inventory and foreclosures

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Morning Market Analysis

Today, let's take a look at the currency charts to get an idea for that's happening.

The euro and dollar are trading in a range, with the euro trading between 130-133.5 and the dollar between 21.75 and 22.3.  Notice the large number of similarities: both are trading at or around the 200 day EMA; both are showing low volatility from the narrow Bollinger Band width; both are showing a fairly constrained EMA picture.  However, the dollar is showing weaker volume numbers, while the euro is showing stronger numbers.

The pound has broken out of its range, but not because the UK economy is doing well; instead, the pound is benefiting from not being the euro, and being close enough to the EU to be readily accessible to traders located in the continent.

Both the rupee and the real are moving lower, largely because of the faltering of their respective domestic economies.  India is slowing as a result of near gridlock in the political system, while Brazil is slowing because it is a net exporter of raw materials, and is therefore suffering from lower global demand.

The Australian dollar has decreased, largely because of a slowing economy.  However, prices are now right above the 200 day EMA, moving sideways.  Also note that prices are near multi-year highs right now.

The yen sold off starting in February, after the BOJ announced that they were thinking about engaging in another round of easing.  However, since the, the yen has rallied as traders have questioned the BOJ's resolve.


What do these charts tell us?

1.) Traders are moving assets away from emerging markets because of weak growth.
2.) The US and the EU are in a "jury's out" position.
3.) Traders are having a hard time believing the BOJ's statements.
4.) The Australian dollar is actually in the best position of them all -- at least from a trading perspective.

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EC Fiddles Whilst Europe Burns

Eurozone unemployment has hit a record high of 10.9% (17.3M people are now looking for work), with Greece clocking in at 21.7% and Spain at 24.1%.

The EC claims that it is taking the problem seriously, and will (by the end of May) publish "country specific recommendations".

Given that the rate of unemployment rose by 169K in the last month, this means that even if the recommendations were of any use (which of course they won't be) another 169K people will be out of work by then.

The EC's only real objective is to ensure that it obtains a budget increase of 6.8%, it is fiddling whilst Europe burns!

The EC is not fit for purpose, as the people of Europe are finding out to their cost.

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Bonddad Linkfest

1. It's all the Republicans fault
2. Maybe not
3. Canadian GDP decreases .2% in February
4. Real DPIs up .2; Real PCE up .1 (BEA)
5. Chicago PMI at lowest level since September 2009 (ISM Chicago)
6. RBA lowers the rate 50 BP (RBA)
7. Chinese manufacturing number increases (Marketwatch)
8. UK Manufacturing slows (FT)
9. China makes big corn purchase, bolstering the market (Agrimoney)
10. Soybean prices may make another record this year (Agrimoney)

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Current Accounts, Trade Deficits and Petrodollars

So -- who are the bigger importers and exporters of the larger economies?  Let's take a look.

First, in talking about the current account as a percentage of GDP, it's important to understand what we're talking about.  From the Economists' Economics Dictionary:

The total of all the money coming into a country from abroad less all of the money going out of the country during the same period. This is usually broken down into the current account and the capital account. The current account includes:

*visible trade (known as merchandise trade in the United States), which is the value of exports and imports of physical goods;

*invisible trade, which is receipts and payments for services, such as banking or advertising, and other intangible goods, such as copyrights, as well as cross-border dividend and interest payments;
*private transfers, such as money sent home by expatriate workers;

*official transfers, such as international aid.

The capital account includes:

*long-term capital flows, such as money invested in foreign firms, and profits made by selling those investments and bringing the money home;

*short-term capital flows, such as money invested in foreign currencies by international speculators, and funds moved around the world for business purposes by multinational companies. These short-term flows can lead to sharp movements in exchange rates, which bear little relation to what currencies should be worth judging by fundamental measures of value such as purchasing power parity.

What's important to remember is that all of these totals eventually have to balance out -- that is, if one country is a net importer than other countries have to be net exporters, with the grand total eventually hitting 0.

Let's start with the big net importers:

The US is obviously the world's largest importer.  However, notice that this number has weakened over the last two years in the aftermath of the recession.

The UK is also a large importer.  While their imports have not risen to the GDP level of the US, they are still high.

The EU and Brazil have bounced between net importer and exporter over the last 10 years. 

The exporting juggernauts of the top 10 world economies are Japan and China, both of whom who have modeled their economies to become net exporters.  Overall, their respective philosophies can be partially characterized as mercantilist, which is defined thusly:

Mercantilism is the economic doctrine in which government control of foreign trade is of paramount importance for ensuring the prosperity and military security of the state. In particular, it demands a positive balance of trade. Mercantilism dominated Western European economic policy and discourse from the 16th to late-18th centuries.^[1] Mercantilism was a cause of frequent European wars in that time and motivated colonial expansion. Mercantilist theory varied in sophistication from one writer to another and evolved over time. Favors for powerful interests were often defended with mercantilist reasoning.

.....

Neomercantilism is a 20th century economic policy that uses the ideas and methods of neoclassical economics. The new mercantilism has different goals and focuses on more rapid economic growth based on advanced technology. It promotes such policies as substitution state taxing, subsidizing, spending, and general regulatory powers for tariffs and quotas, and protection through the formation of supranational trading blocs

What started me on this thought process was the following chart from the Free Exchange Blog:

When we think about the entire global balance system, it's easy to start thinking in the US/China/EU paradigm, while forgetting about the importance and overall impact of the oil exporting countries.  It's the oil exporters who, by far, have the strongest current account position; money literally flows into these countries on a daily basis, leaving them with the big question: what do we do with all of this money?

FIRST, the good news: China, the country at the centre of the debate about global imbalances, has a current-account surplus that has fallen sharply over the past few years. Now the bad: China was never really the prime culprit when it comes to imbalances at the global level. The biggest counterpart to America’s current-account deficit is the combined surplus of oil-exporting economies, which have enjoyed a huge windfall from high oil prices (see left-hand chart). This year the IMF expects them to run a record surplus of $740 billion, three-fifths of which will come from the Middle East. That will dwarf China’s expected surplus of $180 billion. Since 2000 the cumulative surpluses of oil exporters have come to over $4 trillion, twice as much as that of China.

One reason why this enormous stash has received much less attention than China’s is that only a fraction of it has gone into official reserves. Most of it is in opaque government investment funds. Middle Eastern purchases of Treasury bonds are often channelled through intermediaries in London, hiding their true ownership. A lot of money has been invested in equities, hedge funds, private equity and property, where ownership is harder to track. Oil exporters’ surpluses are also proving much more durable than those accumulated after previous oil-price shocks. This is partly because the tightness of oil supplies has kept prices high, and partly because oil exporters have spent less of their windfalls on imports than in previous booms.

Perhaps a better way to think of global trade flows is that the world is divided between oil importers and oil exporters.

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Housing prices: a rebuttal to Barry Ritholtz, part 1

   - by New Deal democrat

The big housing debate is whether prices are on the cusp of bottoming (or possibly, already have) vs. whether there is a considerable ways still to go before housing prices bottom.

Two of the most popular bloggers, Bill McBride a/k/a Calculated Risk, and Barry Ritholtz, are on opposite sides.

Back on February 6, CR said:

There are several reasons I think that house prices are close to a bottom. First prices are close to normal looking at the price-to-rent ratio and real prices (especially if prices fall another 4% to 5% NSA between the November Case-Shiller report and the March report). Second the large decline in listed inventory means less downward pressure on house prices, and third, I think that several policy initiatives will lessen the pressure from distressed sales (the probable mortgage settlement, the HARP refinance program, and more).

....[T]his doesn't mean prices will increase significantly any time soon. Usually towards the end of a housing bust, nominal prices mostly move sideways for a few years, and real prices (adjusted for inflation) could even decline for another 2 or 3 years.

Barry Ritholtz responded with a 5 part series, in which he concluded:

homes will continue stumbling along the bottom of the price range, with a negative bias to prices. Another 5-10% is a very easy downside target — assuming nothing else goes wrong.

CR's style is inductive: he looks at past patterns, such as months of housing supply on the market, notices that the same patterns are in evidence now, and concludes we are near a bottom.   By contrast, Ritholtz's piece is more deductive.  Certain factors, since as a large number of foreclosures, are hanging over the market.  It is logical that these will cause prices to fall further, therefore they will. 

It will hardly surprise anybody who has been reading my housing posts for the last year that I believe housing is close to making a "nominal" bottom (i.e., without adjusting for inflation).  My arguments and conclusions are close to CR's.

Nevertheless, Barry Ritholtz has written a comprehensive and intelligent defense of his position.  Since I respectfully disagree, it is fair that I point out why his arguments ultimately fail to convince me.

Ritholtz's arguments can be distilled into three:  (1) housing is not actually affordable by traditional measures.  Down payments remain unrealistically high, and buyers cannot qualify for mortgages; (2) there is a large overhang of "shadow inventory" most especially including but not limited to foreclosures, which are primed to put renewed downward pressure on prices; and (3) potential buyers, especially younger buyers, are fearful of the potential immobility that comes with owning a house vs. renting.

My rebuttal, in order, is in summary that:  as to point (1) Barry's argument regarding traditional housing affordability fails to account for the role of mortgage rates. Once we take those into account, housing is already fairly priced. Beyond that, his argument about what potential homeowners can afford contains a vital mathematical error.  As to point (2) the rate at which foreclosures and other shadow inventory come on the market makes a world of difference as to whether they affect the first derivative of prices (i.e., the direction), or only the second derivative (e.g, rather the rate of increase is faster or slower).  At times Barry's own stated argument is as to the second derivative rather than the first.  Finally, as to point (3) demographics are destiny.  Not only is there "pent-up demand" of young buyers who so far have been unable to buy a home, but there is an ongoing increase in the number of young adults at the age when the purchase of a first home takes place.  This is an increase in demand that will overwhelm the contrary factors.

One final point:  much like the argument as to the overall economy, much of the vehemence is semantic.  CR says that the housing recovery has begun.  Ritholtz says his intent is debunking the housing recovery story.  Despite this, CR and Ritholtz are really not far apart.  Like me, CR believes prices are making a "nominal" bottom and in real terms they will continue to decline.  Ritholtz sees at minimum another 5% to 10% decline, with prices "stumbling along the bottom of the price range."   Those two conclusions aren't necessarily inconsistent, depending on whether part of Ritholtz's decline includes nominal prices.

Next: Housing affordability

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John Hussman's recession index just blew up

  - by New Deal democrat

In early February I wrote that John Hussman's recession warning criteria had been invalidated. Oversimplifying somewhat, Hussman's 4 criteria were: (1) credit spreads wider than 6 months before; (2) the S&P 500 lower than 6 months before; (3) the ISM manufacturing index under 54 simultaneously with less than 1.3% YoY employment growth; and (4) a yield curve of less than 2.5%. In closing, I said that Hussman should at least explain why he believed his recession call was still valid. Put another way, what is the "off" switch for the above criteria, if it is different from the "on" switch?

The next week Hussman spent part of his weekly market comment defending that call. His defense rested, as I understand it, on two grounds: (1) one or more criteria was violated in 2008 and the recession warning, obviously, was still valid; and (2) there is no "off" switch for the criteria, but rather, once "on," a cornucopia of bearish evidence may be invoked, and entirely different criteria, e.g., a positive ECRI growth WLI, signals the end of recession.

Well, Hussman's recession criteria just blew up. This morning the ISM manufacturing index came in at 54.8. YoY employment growth is about +1.5%. The stock market is higher than it was 6 months ago. Credit spreads between corporate bonds and 3 month treasuries are lower than they were 6 months ago. Every single one of Hussman's recession warning criteria is now invalidated, with the sole exception of the yield curve being less than 2.5% (which it was for several decades near the mid 20th century, and probably will be again now). In the past this has only happened once the economy moved out of recession into recovery.

The icing on the cake is that the "all clear" signal that Hussman said he would recognize -- the ECRI WLI growth index turning positive -- has also come into existence for the last 3 weeks. I really don't see any wiggle room left. Under the terms he himself set, Hussman's recession index says we are in expansion.

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Eurocrisis Takes A Day Off

Today being Mayday, means that the financial markets on the continent of Europe are closed. The result being a "lull", for a day anyway, in the crisis engulfing the Eurozone.

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Morning Market Analysis

Yesterday, I noted that I believe the markets are moving into a period of consolidation, largely because equities have fallen from highs will treasuries have rallied.  Today, I want to add to that thesis.

Oil has been trading around the 102 level for the last month.  While it has rallied a bit lately, it's still below highs.  Also note that EMAs are very tightly bundled, giving us no real direction.  However, some of the underlying technicals (MACD, A/D and CMF) are starting to show bullish signs.  But, until we see this follow-through in prices, the chart isn't that exciting.  Here, prices have to move close to the 110 level to indicate we're away from the bearish sentiment.

Industrial metals have rallied this last week.  But prices are still below the 200 day EMA, and are still below the 61.8% Fib level.  Prices need to move through the 21.75 level to indicate there's been a meaningful change of sentiment.

The Chinese market -- which broke the downtrend started at the end of February -- is in an upward sloping channel.  But prices are still at important Fib levels, while the EMAs are tightly bunched.  There are some good underlying technical developments, but they have not followed through in prices yet.

The Brazilian market continues to move lower.  Prices are now right below important Fibonacci levels, while the EMAs are very bearishly aligned -- all are moving lower and the shorter are below the longer.  The volume indicators are also bearish -- money is flowing out of the market.

The Russian market is similar to the Brazilian market, although the EMA picture is not as dire.  In addition, the MACD has given a buy signal -- although the indicator itself is still in negative territory.

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