Quantifying the pandemic panic

The Coronavirus (Covid-19) is spreading, and panic is spreading throughout global markets. Unfortunately, it's difficult to know whether this will be a true pandemic or just a panic. We'll know more before too long, but I was encouraged this morning to read in a Reuters article that

Mainland China reported nine new coronavirus cases outside the epicenter of Hubei on Monday, the lowest since the national health authority started publishing nationwide daily figures on Jan. 20.

Several provinces have lowered their coronavirus emergency response measures, allowing more flexibility on transportation and helping firms resume production.

About 180 million workers have left their hometowns to return to work since Feb 10, when China ended the prolonged Lunar New Year holiday due to the virus outbreak, according to Reuters calculations based on transportation ministry data.

At the current daily travel flow rate of more than 14 million people, about 192 million people are likely to return to cities where they work during the last two weeks in February, beating a government projection of 120 million.

Nevertheless, it appears to be spreading rapidly in other parts of the globe. One expert predicts that the virus "will ultimately not be containable." (HT: reader "Johnny Bee Dawg")

The following charts are my contribution to understanding the degree of panic that is priced into the market as of this morning. By some measures we have reached very high levels of panic, but not by others. Thus, I think the situation will remain in flux for awhile until we can better assess the degree to which the virus has spread outside of China and how lethal and it ends up being. 

There is likely to be more downside risk before this is over. Whether that means you should sell now, consider what might happen if someone were to announce the availability of an anti-coronavirus vaccine and/or a way to reduce its severity. A reversal of today's panic pricing levels would almost certainly result in a huge market rally. Just today we learned that "Drugmaker Moderna Inc. has shipped the first batch of its rapidly developed coronavirus vaccine to U.S. government researchers." It will be months, however, before we learn if the vaccine is indeed effective and safe to use.

Chart #1

 

Chart #1 compares gold prices to TIPS prices (using the inverse of their real yield as a proxy for their price). Both assets are what might be considered to be true "safe havens." Gold is a refuge against all sorts of evils, while TIPS are free of default risk and government-guaranteed to pay a given real rate of interest. Both prices have surged of late, but they are still short of the levels they reached some 8 years ago, when global markets were still reeling from the shock of the Great Recession and its global financial crisis.

Chart #2 

Chart #2 shows how real yields on 5-yr TIPS tend to correspond to prevailing levels of real GDP growth. With the real yield currently trading at about -0.4%, the chart suggests that the market is priced to a substantial slowdown in US economic growth to something a bit below 2%. That's meaningful, but it's not yet disastrous. A virus is not likely to kill the US economy, but it could definitely slow down overall growth.

Chart #3 

Chart #3 shows how panic attacks (spikes in the ratio of the Vix index to the level of 10-yr Treasury yields) almost always result in sharply lower equity prices. Today the ratio is much higher than it has been during other panic attacks which resulted in much bigger equity market sell-offs. The next three charts show the components of the ratio to better understand why it is so high today.

Chart #4

Chart #4 shows the history of 10-yr Treasury yields. Today they hit an all-time low of 1.3%. This is a big reason why the Vix/10-yr ratio is so high today.

Chart #5

Chart #5 zooms in on the data in Chart #4. Here it becomes clear that today's 10-yr yield marks the lowest closing yield in history. The previous record low was set in mid-2016, when markets were panicked over collapsing oil prices and the threatened breakup of the European Union (i.e., Brexit). 

Chart #6

Chart #6 shows the history of the Vix index. Here we see that by this measure, today's level of "panic" is far below that of past panics. Markets today are pessimistic about economic growth, but markets are not expecting recession nor are participants willing to pay exorbitant prices to avoid downside risk. 

Chart #7

Chart #7 shows Credit Default Swap spreads, which in turn are a highly liquid measure of the market's confidence in the outlook for corporate profits. Credit markets today are worried, yes, but hardly in a state of panic.

Chart #8

Chart #8 compares the inverse of the dollar's value against other major currencies to the inflation-adjusted price of gold. In general, the dollar's value tends to strengthen as gold prices weaken, and vice versa. But it's notable that in the past two years, just the opposite has been the case. Gold prices have surged and the dollar has strengthened. I take this to mean that the current rise in the price of gold is driven almost entirely be fear, and not at all by concerns that the Fed is making a policy mistake which will erode the dollar's intrinsic value. Gold is not rising because of inflation fears. Inflation expectations have been relatively steady at modest levels (1.5-2.0%).

Chart #9

Chart #9 compares the inverse of the dollar's value to an inflation-adjusted index of non-energy commodity prices. As with Chart #8, we see that a stronger dollar tends to correlate to weaker commodity prices and vice-versa. Commodity prices today are behaving much as we would expect, given the relative strength of the dollar. Gold is the one significant outlier in the commodity universe, which again suggests that it is being driven much more by fear and the desire for safety than by monetary fundmentals. 

Chart #10

Chart #10 shows the level of 2-yr swap spreads in the US and the Eurozone. Both are trading well within "normal" ranges, which suggests that liquidity is abundant in the major markets that count the most. Monetary policy is not threatening, and systemic risks are low. This further suggests that the panic over Covid-19 is just that—the virus has yet to make a material impact on global financial and economic fundamentals. 

In sum, while there are obvious signs of panic out there, we are not yet in the midst of a "run for the exits" panic. Things could get worse as the virus spreads, but the outlook could quickly change for the better if science finds a vaccine or a mitigating treatment. 

What to do in the meantime is a tough call which depends on your tolerance for pain. 

UPDATE as of market close Feb 25. The Vix/10-yr ratio has moved higher, and the equity sell-off has intensified. It's still a relatively modest sell-off however. The S&P 500 is only down a little more than 7.5% from its all-time high.

Chart #11

Housing starts are truly impressive

For the past several months, the news from the residential construction sector of the economy has been truly impressive, greatly exceeding forecasts. Only one caveat: building activity in the winter months is typically depressed, so seasonal adjustment factors are large and that can turn a modest increase in actual starts into something bigger than it actually is. Winter weather has been milder than usual, so we need to take the recent data with a grain of salt. Regardless, the outlook for residential construction looks impressive, especially when coupled with the fact that mortgage rates are at or near all-time lows and households' finances have never been so healthy.

Chart #1

Chart #1 may be the most economically bullish chart in my collection. It compares actual housing starts to a measure of homebuilder sentiment. Sentiment has been a good leading indicator of starts, and starts in recent months look to have responded to a dramatic increase in sentiment that began about a year ago. Both now point to a robust environment for residential construction activity which in turn could help power the economy to new heights.
 

Chart #2

Chart #2 shows the history of housing starts going back to the late 60s. The residential construction sector is still recovering from the bursting of the housing bubble in the late 00s, and there looks to be plenty of upside potential left.

Chart #3

Chart #3 shows residential building permits, which essentially predict future housing starts by several months. This chart reinforces the message of the first two: we are in the midst of a burst of new activity in the residential construction sector after several years of meager gains.

Chart #4

Chart #4 shows 30-yr fixed mortgage rates for conforming and jumbo loans. Both are at historically low levels. The world's seemingly insatiable desire for 10-yr Treasuries (which I featured in Chart #7 of my previous post) provides an ample source of funds for mortgage lending. There's every reason to believe that financial market conditions will support continued growth in housing activity.

Chart #5

Chart #5 shows that the delinquency rate for home mortgages has never been as low as it is today.

Chart #6

The message of Charts #5, #6, and #7 is powerful: households are in great shape financially. Delinquency rates are at historic lows for all types of loans, and households' financial burdens are also at historic lows.  

Chart #7

So much winning! Trump has a strong housing wind at his back as the November elections approach.

Updated key market-based indicators

I'm a big fan of market-based indicators—the kind that are determined by the daily decisions of hundreds of millions of savers, investors, and money managers all over the world. Traditional economic indicators (e.g., payroll employment, GDP, CPI) come out with a lag, are subject to revisions, and are based on assumptions that do not necessarily reflect the reality on the ground. Opinion polls are helpful, but they are only an approximation of reality using relatively small samples, and they are subject to bias on the part of the questioner and psychology on the part of the responder. Market-based indicators can be viewed in real-time and they dynamically reflect how "the market" interprets all the information currently available. Markets are where people put their money on the line.

So here is a collection of a dozen or so up-to-date charts that show the status of the market-based indicators that I believe merit ongoing scrutiny. My overall interpretation of these indicators is that the economic and financial fundamentals look sound, and although risk asset prices are high from an historical perspective, they are not high in relation to other variables, and they are undergirded by a healthy degree of skepticism and caution. In short, if the threats of the Kung Flu and Bernie Sanders fade, there is still substantial room on the upside for equities.

Chart #1

Chart #1 compares the level of the real (ex-post) Fed funds rate (blue) with the slope of the Treasury yield curve from 1 to 10 years. Note that every recession on this chart has been preceded by a substantial rise in the real funds rate (and a substantial increase therefore in real borrowing costs) and a flat or negatively-sloped yield curve. Today those conditions are nowhere to be found. Real borrowing costs are historically low, and the yield curve is not inverted. (As other charts below will show, substantial portions of the yield curve are still positively sloped.) This means that the Federal Reserve's monetary policy poses no threat to the economy. It would be fair to say that the Fed's current monetary policy stance is broadly neutral.

Chart #2

Chart #2 compares the real yield on 5-yr TIPS (blue) with the nominal yield on 5-yr Treasuries (red). The difference between the two (green) is the market's expectation for what the CPI will average over the next 5 years. At 1.6%, the market expects inflation will be below the Fed's upper target (2% on the PCE deflator, which would correspond to abut 2.4% on the CPI). While this might be disconcerting to those who believe that a 2% inflation rate is optimal, I would argue that 2% is unnecessarily high; I would always prefer inflation to be as close to zero and as stable as possible. Regardless, there is no indication in market-based signals that the market is worried about the Fed being too easy, and that is the one thing I would really worry about, since that would pose the specter of a tighter Fed to come and a likely recession to follow.

Chart #3

Chart #3 compares the real yield on 5-yr TIPS (red) to the real (ex-post) yield on the overnight Fed funds rate (blue). The former is essentially the market's expectation for what the latter will average over the next 5 years. As such, today the market is not expecting the Fed to do anything that might jeopardize the economic outlook. Indeed, the market currently expects the Fed to lower rates at least once in the next year or so, and then to keep rates flat. From several perspectives it is clear that the Fed does not pose a risk to markets or the economy. Thank goodness!

Chart #4

2-yr swap spreads are very significant coincident and leading indicators of financial market and economic health. In normal circumstances they would trade in a range of 5-35 basis points. At current levels, swap spreads tell us that liquidity both here and in the Eurozone is abundant—central bank monetary policy is non-threatening, to say the least. This further suggests that the outlook for the global economy is healthy, and systemic risks are low.

Chart #5

Chart #5 shows 5-yr Credit Default Swap spreads for generic investment grade (blue) and high yield corporate bonds (red). This is a highly liquid market, and an excellent proxy for the market's confidence in the outlook for corporate profits. Current levels are relatively low, and this implies that the market is not concerned that profits will disappoint. That, in turn, would imply a favorable economic climate in the years to come.

Chart #6

Chart #6 shows two measures of actual corporate credit spreads. As with Chart #5, it is clear that the market is relatively confident regarding the future health of corporate profits.

Chart #7

In contrast to the preceding charts, which paint a picture of optimism regarding the future, Chart #7 reflects a lot of concern regarding the future. Since inflation is expected to be at least as high as current 10-yr Treasury yields (which are within inches of all-time lows), the market is pricing inflation-adjusted, risk-free returns to be somewhere in the neighborhood of zero. The only way this makes sense is to first recognize that Treasury bonds are the world's top choice for a hedge against future risk. The market is generally optimistic about the future, but at the same time there is intense demand for an asset that can hedge against the possibility of that optimism proving wrong. Sovereign yields throughout the developing world are all trading at very low levels, consistent with a view that says there is a lot of caution priced into the markets. Risk assets are pricey, but not many are willing to bet the ranch that the future is guaranteed to be rosy. What this says is not necessarily crazy: the market is optimistic, but unwilling to throw caution to the wind. That's healthy.

The time to worry, of course, is when everyone expects the future to be rosy and no one is concerned enough to hedge their risks. That was the case, by the way, in late 1999 and early 2000, when PE ratios were on the moon and real yields were trading in a range of 3-5%. 

Chart #8

Chart #8 looks at the slope of the Treasury curve from 2 to 10 years. Here we see that the curve has only a modest upward slope, but nevertheless one that is consistent with conditions in the mid- to late-90s, when the economy was growing at a healthy pace. As Chart #1 reminds us, a flat yield curve is not something to worry about unless real yields are also relatively high.

Chart #9

Chart #9 looks out further along the yield curve, from 10 to 30 years. Here we see that the curve has a very normal upward slope. Nothing alarming here at all.

Chart #10

Chart #10 shows the 6-month annualized rate of growth of bank savings deposits, which comprise almost two-thirds of the M2 money supply. Since these deposits pay little or nothing in the way of interest, the growth in these deposits is arguably a good proxy for the world's demand for safe-haven "money." What stands out of late is the sharp increase in the rate of growth of savings deposits over the course of last year, a time when the world became quite worried about the possibility that Trump's tariff wars could lead to a big slump in global economic activity. Lots of demand for money suggests that lots of people were worried the future might turn out to be disappointing; lots of the world's money was seeking the safe harbor of bank savings deposits. This is very similar to what happened to the demand for 10-yr Treasuries in the past year: demand proved so strong that yields fell to extremely low levels.

Chart #11

Chart #11 compares the level of the S&P 500 index to the ratio of the Vix index to the 10-yr Treasury yield. This ratio is a good proxy, I would argue, for the market's level of fear, uncertainty and doubt about the future. Increases in this ratio have usually been accompanied by falling stock prices and vice-versa. Today, concerns are ebbing and stocks are once again rising.

Chart #12

Chart #12 shows the adjusted PE ratio for the S&P 500, according to Bloomberg's calculations (which use only earnings from continuing operations). PE ratios are above average today, but they are still well below the extremes they reached in early 2000. Earnings per share today are 175% above the levels of 2000, but equity prices are up only 125%. This is not necessarily a bubble.

Chart #13

The inverse of PE ratios is the earnings yield on stocks, which in turn is what the dividend yield on stocks would be if companies paid out all their earnings in the form of dividends. PE ratios must be taken into consideration relative to the yields on risk-free Treasuries in order to judge valuations. 10-yr Treasury yields were north of 6% when PE ratios hit 30 in late 1999, whereas today they are 1.6%. Chart #13 looks at the spread (premium) between equity yields and 10-yr Treasury yields. Today that spread is almost 3%, whereas in late 1999 it was -3%. Back then the market was extremely optimistic about stocks and the economy, because equity investors were willing to give up tons of yield for the supposed "privilege" of owning risky assets. Today the market is far from those levels of optimism. Indeed, equity investors demand an unusually large yield premium to hold equities instead of rock-solid-safe Treasuries.

This is not the stuff of which bubbles are made. There is still a lot of caution priced into the market. If the outlook brightens, there is plenty of upside for risk asset prices.

One other market-based indicator that fascinates me currently is the market for predictions about the upcoming elections. As you can see here, the market is saying that as of today, Trump has a 55% probability of winning in November, with Sanders having a 25% chance of becoming our next President. If you don't agree with those probabilities, I suggest you open an account and buy the contract you think is mispriced. Putting your money on the line has a powerful way of focusing your thoughts. I happen to own the Trump-to-win contract, for which I paid 50 cents on the dollar.