Monday, June 27, 2016

Brexit Panic progress report

The UK's vote to leave the European Union has sent tremors throughout global financial markets. But keep in mind that the vote was not binding, and nothing has happened so far; it will likely take a year or so for the UK to hammer out new trade agreements, if indeed it does exit the EU. The UK is a huge net importer of goods, so the great majority of its trading partners will be loathe to lose access to its market. It's conceivable that the UK could eventually end up with better trade deals than it has currently. The EU made free trade deals with the US difficult, for example, so an independent UK might benefit from better US ties.

But anyway, who wants trade to grind to a halt? That's one of the great things about the age of globalization: the more trade there is among nations, the more incentive everyone has to coexist peacefully and prosperously. Trade barriers and tariffs exist only to protect favored interests; in an ideal world, all trade would be free, just as capital should be free to go wherever it wants. If the UK comes out of this stronger, other nations will follow (competition is a wonderful thing). In fact, that's one of the very good things that could come of a Brexit: shaking off the Eurosclerosis that has held back growth in the Eurozone for many years.

For example: once unencumbered by EU regulations, the UK could convince Apple to relocate to London under favorable tax terms that wouldn't be subject to EU rejection. Plus, with the pound so much cheaper, investment in the UK suddenly looks more attractive on the margin.

Unfortunately, we don't live in an ideal world. Global trade and prosperity are far from being maximized, thanks to politicians and special interests. The real issue surrounding Brexit is whether the gradual breakdown of the EU (others are sure to follow, especially if the UK comes out a winner) will result in trade that is freer or less free. We won't know the answer to that question for years, of course, but I suspect that competition among nations will drive better and freer trade relations, and that would be very good for growth from a long-term perspective.

In the meantime, life and trade goes on and the latter is quite unlikely to grind to halt or even slow down, for the next several months. Meanwhile, the world's productive assets are trading at a 5-10% discount all of a sudden. Absent some clear indication that global commerce is truly at risk, it will be hard for this discount to deepen much further or persist for long, especially when cash still yields almost zero.

For now, markets are actively exploring the possibilities, and risk-averse investors are getting out while others pick up assets on the cheap. To put things into perspective, I offer 10 charts which chronicle the progress as of today:


To begin with, I note that the volume of world trade, shown in the chart above, has more than tripled in the past 25 years, rising at an annualized rate of 5% from 1991 through last April. But the expansion of global trade has slowed down significantly since 2008, and it is up only 1.4% in the past year. I'd put some of the blame for the slowdown on trade barriers and eurosclerosis. The US has suffered from slow growth over the past decade or so, but the Eurozone has suffered much more; no wonder there's so much popular discontent.


In the past month, since the likelihood of a Brexit began to rise, the pound has lost about 10% of its value relative to the dollar and 9% relative to the Euro. Two years ago, at 1.70 to the dollar, the pound was expensive on a PPP basis. Now it's trading around fair value, according to my calculations. This ought to be enough to awaken interest in UK investments.


2-yr swap spreads are still relatively low, which suggests that liquidity is plentiful and systemic risk is relatively low. Spreads are quite a bit higher in the Eurozone than in the US, however, which is not surprising given all the concern over there. But spreads are much lower today than they were at the height of the PIIGS crisis back in 2011. The Eurozone is not on the verge of collapse, and no one is talking about abandoning the Euro.



Having plunged to 1.44% today, 10-yr Treasury yields are about as low, on a closing basis, as they have ever been (the all-time closing low was 1.39% in late July 2012). It's almost as if the world has lost all hope of ever enjoying decent growth or rising inflation again. Treasury yields are abysmally low not because the Fed is driving rates down artificially; rates are low because the market despairs of ever seeing stronger growth, meanwhile continuing to worry about slow growth devolving into deflation. This is one of the best barometers of pessimism that I know. Meanwhile, 10-yr government yields are -0.12% in Germany and -0.19% in Japan—both at all-time record lows. Abandon all hope, yee who live in the modern world today, the market seems to be saying. Pessimism is the order of the day.



Credit spreads have ticked up of late, but they are still far below levels that we would expect to see in a crisis.


Not surprisingly, the Brexit Panic has boosted the prices of the world's classic hedges against uncertainty: gold and TIPS. But we seen worse, as the chart above shows. Gold is up 25% so far this year, and it's up 10% in just the past month, but it is still down 30% from its 2011 high. Similarly, TIPS prices today (as proxied by the inverse of their real yield in the chart above) are up this year, but still much less than they were at their peak in 2012. Investors are crowding the exits, but we've survived worse.

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The chart above is one I've shown repeatedly for a long time. One curious development of late is that the market's level of fear, uncertainty, and doubt is almost as high as it has been during other crises of recent years, but the decline in equity prices has been much less. In fact, the Vix index fell from 25.8 yesterday to 23.9 today, while stocks fell almost 2%. Typically, stocks and the Vix move in opposite directions. The chart below helps explain why:


The chart above compares the S&P 500 to its Eurozone counterpart. Using these two indices as representative of stocks in the US and in the Eurozone, US stocks have outperformed Eurozone stocks by a whopping 55% over the past six years. What's bad for the Eurozone has not been bad at all for the US. The world's two economic powerhouses are no longer moving in lockstep. All the more reason for the UK to abandon the leaky EU ship.

We may well see more pain and suffering as investors worry about all the unknowns that lie down the road over the next few years. But the end result doesn't have to be bad at all, and it could in fact be very positive. The UK has just opened the door to competition in Europe, and competition almost always results in things getting better. Only politicians and bureaucrats think otherwise.

UPDATE (6/28, 13:30 PT): Stocks had a nice bounce today, while the Vix/10-yr ratio fell sharply, due mainly to a plunge in the Vix Index; 10-yr yields barely budged from their all-time lows. Note the magnitude of the move and the recent reversal of the Vix/10-yr ratio in the chart below, compared to the relatively muted response of stocks. This suggests that Brexit fear is out of proportion to the realities on the ground:


Thursday, June 23, 2016

Brexit is not the end of the world as we know it

As I write this at 8:30 pm California time, some 70% of the UK Brexit votes have been counted, and "Leave" is winning 51.5% to 48.4%. The betting odds on "Leave" are now approaching 100%, up from just 11% only 24 hours ago. It appears the UK will be leaving the EU, something that as recently as yesterday was "unthinkable" according to the establishment types and many market participants. The hype mustered by those favoring "Remain" has undoubtedly fueled the panic that has sent the pound down 10% in a matter of hours. 10-yr Treasury yields are down almost 25 bps, and gold is up over $50.

I may be swimming upstream, but I don't think this is the end of the world as we know it. Matt Ridley, a very wise fellow, penned these comments in the WSJ two days ago, and they make a lot of sense to me:

In voting Thursday on whether to leave the European Union, the British people face perhaps the most momentous decision since Henry VIII broke from the Roman Catholic Church in the 16th century so he could marry as he pleased. Though lust is not the motivation this time, there are other similarities. The Catholic Church five centuries ago was run by an unelected supranational elite, answerable to its own courts, living in luxury at the expense of ordinary people, and with powers to impose its one-size-fits-all rules despite the wishes of national governments. We were right to leave. 
A centrally planned, regional customs union ... might have made some sense in the 1950s. That was before container shipping, budget airlines, the internet and the collapse of tariffs under the World Trade Organization made it as easy to do business with Australia and China as with France and Germany. 
Even worse than in Westminster or Washington, the corridors of Brussels are crawling with lobbyists for big companies, big banks and big environmental pressure groups seeking rules that work as barriers to entry for smaller firms and newer ideas. The Volkswagen emissions scandal came from a big company bullying the EU into rules that suited it and poisoned us. ... The de facto ban on genetically modified organisms is at the behest of big green groups, many of which receive huge grants from Brussels. 
... the EU’s obsession with harmonization (of currency and rules) frustrates innovation. Using as an excuse the precautionary principle or the need to get 28 countries to agree, the EU gets in the way of the new. “Technological progress is often hindered or almost impossible in Europe,” says Markus Beyrer, director general of BusinessEurope, a confederation of industry groups. Consequently, we’ve been left behind in digital technology: There are no digital giants in Europe to rival Amazon, Google, Apple and Facebook. 
The EU is also against free trade. It says it isn’t, but its actions speak louder. The EU has an external tariff that deters African farmers from exporting their produce to us, helping to perpetuate poverty there, while raising prices in Europe. The EU confiscated Britain’s right to sign trade agreements—though we were the nation that pioneered the idea of unilateral free trade in the 1840s. All the trade agreements that the EU has signed are smaller, as measured by the trading partners’ GDP, than the agreements made by Chile, Singapore or Switzerland. Those the EU has signed usually exclude services, Britain’s strongest sector, and are more about regulations to suit big companies than the dismantling of barriers.

The UK is right to reject the regulatory burdens heaped upon it by an extra-national bureaucracy. The U.S. would be wise to follow suit and shrink the size of our bloated government by a few notches at least. Brexit could be the beginning of a brave new world, in which trade becomes freer and business becomes less burdened by taxes and regulations. The only politician here who is talking about such "radical" ideas is Trump, but he is gaining traction, as did the "leavers" in the UK. There is room for hope.


To close, the chart above puts into perspective today's collapse of the pound vis a vis the dollar. As I see it, the current exchange rate between the pound and the dollar is reasonable (finally), and it has moved, over the past 40 years, pretty much in line with the differential between US and UK inflation (the green line is representative of how the exchange rate would have moved if it exactly reflected inflation differentials over time). 

Tuesday, June 21, 2016

Chemical activity points to a stronger economy

The Chemical Activity Barometer, published monthly by the American Chemistry Council since 1919, has jumped 3% in the past 3 months, and is up 2.5% in the past year. This strongly suggests that industrial production—which has been quite weak for the past year or so (due in part to the big slowdown in oil drilling and exploration)—will pick up in coming months. This should go hand in hand with stronger GDP numbers over the course of the year as well. Definitely good news.


The chart above shows the Chemical Barometer Activity index for the past 8 years. The recent uptick is significant.


The chart above shows the index going back to 1960. It tracks overall economic activity pretty closely.


The index also appears to do a good job of leading the growth in industrial production, and by inference, the overall economy. For more detailed information, see Calculated Risk.


Truck tonnage, shown in the chart above, has also picked up this year. The February spike had looked a bit anomalous, but the May reading confirms that activity has picked up over the course of the year. Chemical activity and truck tonnage both track actual physical activity in the economy, and both are pointing to improvement.


The chart above compares truck tonnage with the inflation-adjusted S&P 500 index. Both look on track for further gains.