Friday, December 5, 2014

Big improvements in the past 2 years

This post is a  review of key economic and financial market fundamentals that have improved significantly in the past two years. It is designed to bolster the arguments made in my earlier post, which argued that equity markets have risen not because the Fed has printed money, but because the economy has proven to be stronger than expected. 

As the chart above suggests, swap spreads have been excellent leading indicators of economic health. Spreads widened significantly in advance of the the past three recessions, and they tightened significantly in advance of the past three recoveries. For the past two years, spreads have traded right around where they should be during periods of "normal" economic activity. This alone is good news, since low and stable swap spreads imply low systemic risk, and low systemic risk provides fertile ground for new investment and future growth.

The chart above takes a closer look at swap spreads here and in the Eurozone. What it shows is that the Fed was right to engage in an extensive program of Quantitative Easing; swap spreads were elevated, a sign of higher-than-normal systemic risk and a general lack of liquidity. The first and second rounds of QE ended prematurely, however, since swap spreads were at the time rising as tensions in the Eurozone were increasing. The end of QE3, in contrast, has seen no deterioration in the economic or financial market fundamentals. The implies that the world no longer needs a huge increase in the supply of safe, risk-free assets like bank reserves, which are now effective substitutes for T-bills since they pay a similar rate of interest and are floating rate and essentially risk free. Things began to improve about two years ago, when the threat of a Eurozone default crisis all but evaporated. Spreads in Europe and the U.S. have been relatively low and declining ever since. It now looks like both the ECB and the Fed have effectively solved their respective systemic risk and liquidity crises. That's great news.

Spreads on corporate bonds and swap spreads (which are a generic measure of the spread between AA-rated bank debt and government debt of similar maturity) have been tracking each other in a relatively normal fashion for many years. Both are currently at levels that in the past have been consistent with "normal" economic and financial conditions. If there is good news here, it is that spreads have not widened at all in recent years, despite the cessation of QE. No need for more QE—the economy can handle things on its own going forward. Low and stable corporate spreads mean that the outlook for corporate America is still quite positive.

Since the end of 2012, when the Eurozone crisis began to fade, the S&P 500 index is up about 48%, and the Euro Stoxx index is up 21%. That makes sense, because the U.S. economy has been growing steadily, at about a 2.3% annualized rate, whereas the Eurozone economy suffered a minor recession and is still growing relatively slowly, and both have been doing better than expected. The major impetus to higher prices was the failure of things to deteriorate as so many feared (e.g., markets were worried about a Eurozone financial collapse and a global double-dip recession) back in the summer of 2012.

Things have changed dramatically in Japan in just the past two years, as the chart above shows. The yen has fallen by about 30% against the dollar. According to my PPP calculations, the yen at the end of 2012 was overvalued by about 38% vis a vis the dollar, but now it is fairly valued. This evidently has been a net plus for the outlook for the Japanese economy, because Japanese stocks are up 24% in the past two years as measured in dollars. Japanese stocks appreciated by much more than the depreciation of the yen, suggesting that the outlook for corporate profits has improved dramatically as a result of the yen's decline. (A stronger dollar also boosts the value of Japan's significant investments in dollar and dollar-bloc currencies.) If Japan's monetary policy had been too tight, now it looks just about right.

In the past two years, U.S. crude oil production has surged by 30%. This huge increase in oil supply has tipped the balance of world supply and demand in favor of lower prices. (Crude prices have fallen by over one-third in the past six months!) Lower energy prices, in turn, should prove very supportive of the majority of the world's economies, because economies need energy to grow. Cheaper energy facilitates more growth, and it makes economies more productive because they can produce more with the same inputs. This is the fundamental formula for prosperity. It's unalloyed good news.

As the chart above shows, in the past two years federal spending has fallen from 22.1% to 20.3% of GDP. That's a reduction of almost 10% in the size of government relative to the economy in just two years. From the recession-era high, federal spending has declined by 17% relative to GDP. We've never seen anything like this in such a short period. This has had the effect of sharply reducing the expected future burden of taxes, and it significantly reduces the amount of the economy's scarce resources that the government is able to misallocate and waste. It's the equivalent of reducing the headwinds the economy has been fighting, and it should lead to a stronger economy in the years to come, if it is not already helping. (See this post which argues that growth has likely improved of late.) Arguably, no one saw this development coming, and many people—notably the Keynesians—thought that such a huge reduction in spending over such a short period would plunge the economy into another recession. That the economy has instead strengthened on the margin has been a major upside surprise shock to the financial markets.

Markets move when the unexpected happens. The economy has done better than expected, so equity markets have risen because the expected discounted future cash flows of businesses has risen.

In just over 3 years, the U.S. dollar has appreciated about 20% vis a vis other major currencies on an inflation-adjusted basis, as the chart above shows. This marks a major reversal in the dollar's fortunes since the dollar hit an all-time low in mid-2011. A currency's strength has a lot to do with the market's confidence in a country's monetary and fiscal policy, and the ability of its economy to grow. Pessimism was rampant just three years ago, and now sentiment is back to something that might be considered "neutral." That's a big change for the better, since more confidence is likely to lead to more investment and a stronger economy going forward.

The chart above suggests that real GDP growth and real yields on 5-yr TIPS have something in common. When economic growth was very strong in the late 1990s, real yields on TIPS were very high; real yields on TIPS needed to be high to compete with the strong real returns to equities that was implied in strong GDP growth. Since then the economy has lost a lot of its oomph, and real yields on TIPS have declined. By late 2012 real yields on TIPS were decidedly negative, which meant that investors were so concerned about the risk of another global recession that they were willing to accept a guaranteed negative real return of almost -2% on 5-yr TIPS in exchange for their relative safety. But in the past two years real yields on 5-yr TIPS have jumped almost 200 bps as the market has begun to price in better expectations for growth going forward. This is a significant change on the margin that is continuing.

As the chart above shows, gold prices started to decline just before real yields started to rise. I think that this is a solid indication that the market's degree of risk aversion has declined and confidence is beginning to return. Rising real yields on TIPS are the flip side of falling TIPS prices. Investors have been selling gold and TIPS because they are much less concerned about the future. Prices of gold and TIPS are still relatively high, however, suggesting that there is plenty of room for confidence to improve.

The world is still relatively risk averse, only much less so in the past two years. The outlook for the next two years has brightened, and that supports higher equity prices.


Benjamin Cole said...

Nice wrap up.

Japan's QE working?

Would that US cut federal outlays to 10% of GDP. Cut Social Security, cut Medicare, cut "national security", eliminate USDA, Commerce.

Benjamin Cole said...

Equity prices:

Possible upside, but US equities are fully priced.

The globe has a lot of capital, some say gluts of it.

Thus, lower returns, and very low interest rates may be the new norm.

Your capital is not scarce, and is priced accordingly.

This might lead to booms and busts in equities....