Thursday, January 8, 2015
The stock market has faced three "walls of worry" in as many months. The first worry was centered around the Ebola crisis, and the second and third were "fueled" by collapsing oil prices. All three involved fears that something big and uncontrollable was going on that threatened global growth. To this day, there is still a lively debate over whether or not the collapse in oil prices will be good for growth or bad for growth. It's good, I and others have argued, because it lowers the cost of engaging in many kinds of economic activity, and that is equivalent to a dose of productivity enhancement that will benefit nearly everyone. It's bad, others argue, because sharply lower oil prices will bankrupt many producers and will cause activity in the mining sector (the strongest economic sector in recent years) to implode (Texas has produced the lion's share of new jobs during this recovery), and all of this will overwhelm any positive effects from lower oil prices.
Reasonable people can disagree on this issue, but in the meantime, let's check out what Mr. Market is saying about the fundamentals of the U.S. economy. Are things deteriorating or not?
We know the energy sector has been hit hard: energy stocks are down over 25% relative to the S&P 500 since oil prices started falling last June. But so far, that hasn't translated into any meaningful increase in announced corporate layoffs, shown in the chart above. To the judge from this chart alone, the economy is still on sound footing.
Even the more timely indicators of layoffs (shown in the charts above) continue to show that underlying conditions in the jobs market are healthy. Weekly claims for unemployment are very close to the lowest level we have ever seen relative to the size of the labor force. Only 2.52 million people today are receiving unemployment insurance, down 44% from a year ago. On a seasonally adjusted basis, this number hasn't been so low since 2006.
Swap spreads continue to be one of my most favorite and cherished indicators. Swap spreads are liquid, market-driven indicators of economic and financial market health. (Lower spreads are better.) As the chart above shows, swap spreads both in the U.S. and the Eurozone are down to levels that are fully consistent with "normal" economic conditions. Furthermore, swap spreads have shown no sign at all of increasing in recent months, despite the end of QE3, despite the sufferings of the energy industry, despite the lack of another QE effort on the part of the ECB, despite the weakness of the Eurozone, Japanese and Chinese economies, and despite the political turmoil that is once again roiling Greece. Swap spreads today are saying that there is no unusual degree of systemic risk in either the U.S. or the Eurozone economies. The difficulties experienced by issuers of energy-related debt are having zero impact on the larger economy.
But what about the synchronized decline in 10-yr sovereign yields? Isn't this a sign that the world's major economies are sinking into Japanese-style deflationary quicksand?
Not necessarily. As the chart above shows, the decline in nominal yields is all about declining inflation expectations, which, in turn, are directly related to collapsing oil prices. Real yields on 5-yr TIPS have increased significantly in the past six months, driving a significant decline in inflation expectations.
Real yields on 5-yr TIPS do indeed tend to track with underlying growth fundamentals. I would note, however, that real yields are still quite low, which I think reflects some enduring pessimism regarding the economy's growth prospects. But on the margin, real yields have increased meaningfully, reflecting an improving growth outlook. The world should be paying more attention to real yields these days than to nominal yields.
The chart above compares the prices of TIPS (using the inverse of their yield as a proxy for their price) and the price of gold. Both have been highly correlated for the past seven years. Since both are unique types of risk-free assets, I think their declining prices reflects the market's declining risk aversion. Underlying conditions are improving, and that is reflected in less investor demand for gold and TIPS. Lower oil prices are contributing to improving confidence in the future, and that shows up in lower gold and TIPS prices.
About all we can say from looking at equity prices in the U.S. and the Eurozone is that the outlook for the U.S. is much healthier than the outlook for the Eurozone. This has been the case for the past several years, as U.S. equities have been consistently outperforming their Eurozone counterparts, likely due to the prospects of improving fiscal policy in the U.S. The collapse in oil prices has not changed this dynamic.
All of the above indicators are market-based, and they are all signaling at the very least that the economic fundamentals have not deteriorated, and most likely have been improving of late. Consequently, I wouldn't be surprised to see the equity market overcome the latest wall of worry and continue higher.
A final note: when thinking about the future, there arguably is nothing more optimistic than the fact that the U.S. economy has experienced its weakest recovery ever. The gap between the current size of the economy and its potential size (assuming that past trends are reasonable guides to the future) is huge—perhaps 10% or more. If the U.S. can get its act together in coming years (e.g., by lowering tax rates, simplifying the tax code, and reducing regulatory burdens), the upside potential is difficult to overestimate. This alone argues strongly in favor of optimism.
Posted by Scott Grannis at 1:03 PM