Walls of worry update

The market continues to lose some of the fear and uncertainty that stems from the concern that plunging oil prices and a Chinese economic slowdown will prove contagious, bringing the global economy once again to its knees. I've argued for some time that these fears were overdone, since swap spreads have remained very low despite the sharp increase in corporate credit spreads. Very low swap spreads are evidence of abundant liquidity and healthy financial markets. They imply that big financial players (e.g., major banks and large institutional money managers) can trade amongst themselves with little or no fear of counterparty risk. This in turn reflects on the fact that systemic risk in the economy and the financial markets is very low. When financial markets are liquid and systemic risk is low, the global economy has a good chance to work through the dislocations caused by falling commodity prices.

Equities are up not because the market expects the economy to strengthen, but rather because the market is losing its fear of another recession. It was almost two years ago that I argued that avoiding recession is all that matters, and it is still valid today:

Cash and cash equivalents pay either nothing or next to nothing, while alternative investments yield much more. Cash yields are zero because the demand for money is extremely strong, and because risk aversion is very high. The Fed's QE program has been specifically designed to satisfy this extraordinary demand for money. The world eschews much higher-yielding investments in favor of accumulating record levels of cash because market participants are very afraid of an economic downturn that will reward the decision to hold cash.

We are still likely stuck in a disappointingly slow expansion for the foreseeable future. But that's a lot better than falling into another recession. This theme—that the future has turned out better than expected, despite the fact that it's been the weakest recovery ever—has appeared in numerous posts on this blog since 2009, and it's still the best explanation for why risky assets have done well. It's been a reluctant recovery and a risk-averse recovery for years, and it continues to be. When the market is priced to recession and instead we get continued growth, however weak, the prices of risk assets has to rise (i.e., the yield on risk assets has to move closer to the zero yield on cash). I don't see signs that this has gone too far. Indeed, yields on corporate bonds (especially of the high-yield variety) have become much more attractive of late.