Starting 11 weeks ago, the market suffered a collapse that erased 11% of the value of the S&P 500 in a mere 6 days. Today, it fully recovered from that collapse, and is up 2.2% for the year to date. The apparent cause of the collapse? Fears that the Chinese economy was in free-fall and sharply lower oil prices would produce a wave of defaults starting in the energy sector and spreading to others. Investors extrapolated these fears and began worrying about another global contagion that could rival the near-collapse of the financial markets in 2008. Yet all that has happened between then and now is that a slower-growing China and lower oil prices were not, in fact, contagious. China is not in free-fall, and oil prices have stabilized around $45. Economic life goes on, unperturbed by the problems in China and the oil patch.
Equities have rallied because the future did not turn out to be as bad as investors had feared. This has been the meme of the entire recovery which began in 2009. Equities haven't rallied because things have improved; this is still the weakest recovery ever, and there are no convincing signs to suggest the recovery is going to get meaningfully stronger. No, equities have rallied because there has not been a meaningful deterioration in the economic fundamentals—a deterioration significant enough to justify sitting in zero-yielding cash while foregoing the much higher yields on riskier investments.
As the chart above shows, there has been a very strong inverse correlation between equity prices and the level of fear, uncertainty, and doubt prevalent in the market (using the ratio of the VIX index to the 10-yr Treasury yield as a proxy for FUD). As fears have declined over the past 11 weeks, equity prices have risen, in virtual lockstep.
The ISM October manufacturing survey wasn't particularly impressive. In fact, it suggests that economic growth in the current quarter will remain disappointingly slow.
Fortunately, manufacturing conditions in the Eurozone have firmed marginally over the course of the year. Still, there's nothing here to get excited about, except to the degree to which these surveys rule out another recession.
Meanwhile, September construction spending showed continued strong gains. Total construction spending is up 14% over the past year. led by a 17% advance in residential construction.
It's a hot-and-cold economy, with some sectors (e.g., construction) doing very well while others (e.g., energy production) are doing poorly. This mixed bag of indicators has been highly conducive to FUD.
What was the secret to understanding that the world was not on the verge of another recession? Swap spreads, which have been and continue to be very low. As I've stressed for months, very low swap spreads are an excellent indicator which suggests that systemic risk is low and financial markets are very liquid, and therefore the economic outlook is more likely to improve than not. Liquid markets and low systemic risk allowed market forces to sort out the difficulties presented by a slower-growing China and a lower oil prices. Financial markets have in effect been a very efficient stabilizer which has insulated the global economy from the tremors in the Chinese market and in the oil patch. This stabilizer functions by allowing large institutional investors to efficiently and effectively transfer risk via swap agreements.
Swap spreads continue to point to improving conditions ahead.