Tuesday, April 13, 2010
Here are two different looks at credit spreads. The top chart shows credit default spreads over the past few years, and the bottom chart shows corporate spreads (investment grade and high yield) going back over 20 years. The message of both charts is the same: credit spreads have narrowed significantly since the end of 2008, a clear reflection of dramatic improvement in the economic outlook; but spreads are still a lot higher than they tend to be during periods of relative economic tranquility.
This fits nicely with the thesis I have been fleshing out since late 2008. Markets were literally terrified in late 2008 and early 2009, consumed by fears of a global financial meltdown and a deep and lasting depression and deflation. This fear was sparked by the realization that the subprime crisis had morphed into a massively destructive force that culminated in the Lehman bankruptcy and the mad dash by governments all over the world to shore up their financial systems and economies with previously-unheard-of stimulus measures.
Fears were multiplied by the Obama/Pelosi/Reid $787 billion faux-stimulus budget which ushered in new visions of expansionary government and massive hikes in future tax burdens. Even as the market reached the pinnacle of its fears in early March of last year, I continued to believe that the economy was well on the way to healing itself, despite the headwinds of out-of-control fiscal policy and massively accommodative (and potentially hyperinflationary) monetary policy, and that the recession would end by mid-year. I pointed to declining swap spreads in October and November of '08 as the leading indicator of this improvement, which were then joined by rising commodity prices and a steeper yield curve.
By now it's pretty clear to most (though the NBER is still debating whether or not the recession has officially passed) that the economy is growing. In the space of just one year the debate has shifted from how deep and long the depression was likely to be to how weak or strong or durable the recovery is likely to be. The market was priced to Armageddon, and instead we got a recovery; that alone is enough to justify the 77% rise in the S&P 500 in the past 13 months. But the market is still not prepared to abandon its fears (e.g., of a double-dip recession, or a "new normal" recovery with meager, 2-3% growth and very high European-style unemployment for as far as the eye can see). The market is still demanding a substantial risk premium, in the form or credit spreads that are still historically high, implied volatility that is still historically high, PE ratios (using NIPA after-tax corporate profits) that are still historically low, and Treasury yields that are still historically very low.
The market is still very worried, and with good reason: the economy may be doing better than expected, but we are not out of the woods yet.
The Federal Reserve has more than doubled the monetary base since the financial panic set in, with enough excess reserves now in the banking system to potentially cause hyperinflation and the collapse of the dollar. With no move yet to drain reserves, the best the Fed can do to reassure the world is to lay out a plan to fully drain excess reserves within the next 5 years. The amount of monetary uncertainty this poses is nevertheless so great and so unprecedented that it is difficult for mere mortals to comprehend.
U.S. fiscal policy is out of control, with Congress effectively having abandoned all pretense at living within a budget. Unfunded liabilities of the healthcare, social security, and public sector pension systems are so large as to be clearly unsustainable, yet no one in government has proposed even the beginnings of a solution.
What is holding everything together so far is the U.S. economy's inherent dynamism, its oft-demonstrated ability to forge ahead despite great adversity, and the accumulating V-signs of recovery in many sectors (but not all, to be sure) of the economy. Just as important, but often overlooked, is the political dimension of our fiscal and monetary problems. There have been some seismic shifts in the political landscape in the past year (e.g., the rise of the Tea Party, the election of Scott Brown in MA, and polls that show a majority of Americans favor repealing the healthcare bill) that augur well for a dramatic shift in the balance of power in Congress come November.
If we do indeed see a major political shift take hold, and if it leads to measures that effectively restrain the growth of government and minimize the risk of higher tax burdens, then I think the there is a lot of room for improvement in a number of areas: tighter credit spreads, higher PE ratios, and lower implied volatility. I also think that progress on these fronts would most likely come hand in hand with higher Treasury yields and higher mortgage rates. I'm encouraged, and I remain optimistic for the future.
Posted by Scott Grannis at 11:33 AM