Friday, January 15, 2016

Key charts to watch

Financial markets are once again swooning as oil prices collapse, stoking fears of another global financial crisis. Without trying to minimize the angst we all feel, I offer here some charts which are useful for retaining one's sanity, along with some commentary.


For all the turmoil out there, it's remarkable that the prices of gold and 5-yr TIPS remain in a downward trend. (Note: I use the inverse of TIPS's real yields as a proxy for their price.) If conditions were really unravelling, the market would be paying ever-higher prices for these two safe haven assets. They were much higher in price in late 2011 and 2012 when the PIIGS crisis was at its apogee. That crisis threatened the economies of the eurozone and the euro itself. The current crisis is much more narrowly defined.




Sharply lower oil prices have dramatically increased the risk of default for energy-related corporate debt, as shown in the blue line in the first chart above. But the threat of defaults is concentrated in the energy sector. Non-energy high-yield debt credit spreads are only 660 bps, much less than half the 1600 bps spreads on energy-related bonds, and less than the spreads on all HY debt at the peak of the PIIGS crisis. As the second chart above shows, swap spreads are very low, in sharp contrast to how they behaved in previous recessions. Very low swap spreads tell us that financial markets are highly liquid and that systemic risk is very low. This is mostly a problem affecting the oil patch, not everybody.

Markets today are far more liquid than they were in 2008 and 2011-12. That is of critical importance, and a source of comfort.


Like all the other big selloffs in recent years, fear has been the main driver. (As a proxy for fear I use the ratio of the Vix index to the 10-yr Treasury yield.) The Vix/10-yr ratio hit a high of almost 25 when the PIIGS crisis was at its most intense. So far, the China/oil crisis looks substantially less scary than the PIIGS crisis. 


The PE ratio of the S&&P 500 has dropped to its long-term average of 16.5. So stocks are at "average" valuations today. But: corporate profits are still very high relative to GDP (9-10% of GDP, versus a long-term average of 6-7%). The PE ratio on 10-yr Treasuries is about 50 today (the inverse of their 2% yield). What this means is that the market is deeply distrustful of the staying power of corporate profits. Deeply. Investors are willing to accept extremely low yields on safe assets in order to avoid the perceived risk of stocks. There is a LOT of fear priced into the market, even though PE ratios are not historically depressed.



As the two charts above show, the bond market is priced to the expectation that consumer price inflation will average 1.2% per year for the next 5 years. That's relatively low, but not unprecedented. Deflation/depression fears were rampant at the end of 2008, when inflation expectations fell to negative levels. Today, low inflation expectations are being driven mainly by very low oil prices, as the second chart suggests. Core inflation, I would note, is still running at just under 2%. The problems today center around oil, not the fact that the Fed has raised interest rates a mere 25 bps.


Commodity prices have plunged in recent years, but raw industrial commodity prices (above) are actually up over the past two months. Non-energy commodity markets may be finding support at current levels.


For all the decline in commodity prices, they are still significantly higher today than they were at the end of 2001, when very tight monetary policy (as seen in 4% real yields, a flat- to inverted yield curve, and a very strong dollar) created a genuine risk of deflation. As the chart above shows, most of the extreme moves in commodity prices have been due to extreme moves in the dollar. When commodities are measured in euro terms (blue line above), they are much more stable, and still 70% higher than in 2003. I note that the two y-axes in the chart both have the same range (the top value is 3.5 times the lower value). I note also that the dollar has been relatively flat for most of the past year.

32 comments:

William McKibbin said...

I would not be surprised to see the dollar double in value while commodities collapse to pre-WWII levels -- I think everything is unfolding according to someone's plan -- probably some deal cut between China, Russia, and Israel, but who knows...

Unknown said...

Thank you, Scott.

William McKibbin said...

PS: I can't get the divergences to reconcile -- said another way, I'm scared of the markets right now...

Kgaard said...

Scott ... Good charts here ... I will say that the 2008 was preceded by FALLING gold, not rising gold. And of course we have seen gold fall into the current problems. This supports the interpretation that it is deflation risk (i.e. too low nominal GDP growth) that is the root of all this global market chaos ...

Scott Grannis said...

Kgaard: Actually, gold rose to just over $1000/oz in March 2008. It fell from just under $1000 in July '08 to $730 in October '08. That fall was triggered by the Lehman collapse, and I think it was symptomatic of a severe shortage of money. It took the Fed awhile to realize this, but when they announced QE1 later in the year, gold took off again. Commodities collapsed over that same time frame, confirming, I think, that the Fed had inadvertently created a monetary tightening, by not supplying all the money that the market so desperately wanted. And of course the dollar soared in the second half of '08, further confirming the huge demand for money and the Fed's reluctance to supply it.

So I think 2008 was fundamentally different from today's environment. I think the stronger dollar over the past year or so is more a function of the market's perception that the Fed was getting ready to tighten while other central banks were reaffirming their desire to continue easing, than it is of any actual tightening.

William said...

McKibbin - what motivates you to post such non-sense on this fine and useful blog??

Oh well, you aren't the only person who feels the need to emote here. This weekend will certainly bring dozens of posts.

Christopher Durr said...

McKibbin needs a drinking buddy. Thanks Scott for this analysis.

William McKibbin said...

And yes, I am having a drink right now -- today was another horrible day in the markets -- my estate is holding, and my investment policy is working -- but that doesn't mean I'm not feeling it in valuations -- thank God for rents and dividends...

William McKibbin said...

P.S. I hate to lose money...

William McKibbin said...

P.P S. ""Hope for the best, but plan for the worst "

Benjamin Cole said...

For more than 30 years we have seen falling rates of inflation and interest globally. The world's central banks have ossified into inflation-fighting stances, possibly excluding the People's Bank of China and to some degree the Bank of Japan. The BoJ went through this problem of weak demand and dead inflation already. In literature expelled from US Federal Reserve orifices, we see thousands of references to the word "inflation" for every reference to the word "growth."

There is good news out there for the economy and citizenry, if only our central banks act in accordance with prsent circumstances. They can conduct quantitative easing which would not only cut national debt but would place spendable cash back into the hands of bondholders. No need for deficit spending or larger government programs.

I would like to see tax cuts married to QE, such as decreases in the corporate income tax or reductions in FICA taxes.

The United States is not Japan, but we might have a heavy dose of Japanitis is going on.

Let me put it in this most esoteric and effete way: the Fed should print more money until we see Full Tilt Boogie Boom Times in Fat City and then keep printing more for a few more years.

If QE is in fact inert, as is sometimes alleged, then fine, we can pay off the entire national debt.

William said...

Too funny, why is it the guys with the most Goofy photos post the most goofy comments. Jonhny, are you reading this?? lol

Must be a correlation there somewhere!! OH, TROLLS - needing attention. Posting the same non-sense over and over again. Benjamin, are you reading this??

It is just too funny, how markets' falling bring out these guys.

Benjamin Cole said...

William: wise words are "Live and let live." I enjoy the positive or honest commentary here. Everyone has a point of view, and hey that's fine by me.

Hans said...

"McKibbin - what motivates you to post such non-sense on this fine and useful blog??"

Dr McKibbin, has fallen under the influence of Kirby the Crank.

Sorry, but most if not all indexes using Au as some type of
indicator of future actions will be highly disappointed.

2016 is not going to be a good year for the markets nor the
economy in general.

William McKibbin said...

Hi Hans, rents and dividends are my key indicators -- but with bonds earning nothing, I'm not sure what to do with cash -- maybe just stack it away -- but cheap commodities may yet emerge -- I guess I'm just fishing away for what others are thinking and doing -- of course, a Dow 6,000 or gold $500 would settle my buying decisions -- but I tend to think we won't get both...

William McKibbin said...

P.S. I'm searching for value...

Johnny Bee Dawg said...

Thanks for the updates to these charts, Scott.

I noticed that Bullard made dovish comments and stocks rose 300 intraday. Dudley made hawkish statements the next morning, and stocks fell 500. So it seems to me that the Fed hike still matters...however accommodative they remain.

Rig count has fallen 2/3 in less than a year and a half, but productivity still has us pumping over 9 million bpd. It doesn't look like supply is going to dry up anytime soon. Gonna have to wait for an energy bankruptcy or someone with deep pockets to make an acquistion to set a floor on oil.

Seems to me that the only way these new Chinese leaders can stem the tide of their capital flight is to remove bad policies that are making their millionaires want to send their life savings away. Make capital less threatened, and the Chinese crisis could end. Not likely with this group. They still have 2-3 years of reserves left to prop the RMB at this pace. Trouble is....bad government policies are getting worse all over the world (including here), and capital is being badly threatened.

Bad developments in government policy make for risk aversion, no matter how the economic indicators look. Your fear indexes are not indicating unwarranted or irrational behavior, IMO. Worst start to a year, ever, means something. While there's no recession indicated, a sustained market decline could end up creating one. My indicators are getting washed out, but they have room to fall more.

Thanks again for the updates.

Johnny Bee Dawg said...

Ahhh..."William" who makes personal attacks says I am the Troll. Guess I will look up that definition again. Don't worry, Bill. I can take it! Mama likes my picture, and that's good enough for me!

Andrew Ross said...

Scott;

This chart from the St. Louise FRED data shows 2 year swap spreads to be 1.11%, the highest over the last 5 years. It differs from the chart in your blog.

Why the difference?

Thanks,

https://research.stlouisfed.org/fred2/series/WSWP2

Scott Grannis said...

Andrew: you are looking at the 2-yr swap rate, not the spread. To get the spread you have to subtract the 2-yr treasury yield which currently is just under 1%.

Roy said...
This comment has been removed by the author.
Roy said...

I've started reading Scott's posts from 2008; they are absolutely amazing, Scott managed to keep his conviction and wisdom with all that mess going around. Here's one from November 2008:

"Whatever ails this economy, it is most definitely not a shortage of money or a credit squeeze. This chart shows just how dramatically the Fed has responded to the subprime crisis. In the past eight weeks, the amount of bank reserves—which the Fed creates by buying securities—has increased from $98 billion to $467 billion. That's an increase of 376%, almost a quintupling of the raw material for the world's supply of dollars. The Fed has created four times more high-powered money in the past two months than they created in their entire history.

The Fed is not necessarily creating the preconditions for a hyperinflation. They are responding to an enormous surge in the demand for money by supplying what the market desperately wants. Presumably they will take this money back out of circulation once conditions normalize. As long as the supply of and demand for money are in balance, there is no big inflation problem.

At the risk of potentially creating too much money, the Fed is making sure that that no one will be able to blame them, as many blame the Fed back in the Great Depression, for allowing a monetary deflation to take hold, since that could seriously aggravate the current crisis.

Every measure of the money supply, (e.g., currency, base, M1, M2) is at or very near a record high. Total bank lending is at or very near a record high. Commercial Paper continues its rising trend that began four years ago. Commercial & Industrial loans made by banks to small and medium sized companies are at all time highs.

As I've said many times here, there is no shortage of money, nor any shortage of credit on an economy-wide basis, despite the continuing popular perception that banks are not lending and the economy is being strangled for want of credit. The problem continues to be a shortage of buyers, and that has a lot to do with a lack of confidence. Faced with tremendous uncertainty and a barrage of bad news, everyone is pulling back. But they could just as easily regain their confidence and start spending again. This is not a scenario that leads us to the end of the world as we know it, but that is what the markets are braced for."

Benjamin Cole said...

BTW, the PPI fell 1% in 2016. Deflation. Yes, I know "oil."

Still, if the PPI rises 5% in one year, will people say "oil"? Or insist a wave of hyperinflation is pending?

William McKibbin said...

The good news is that value follows when confronted with...

https://twitter.com/McKibbinUSA/status/688746696864473088

What is everyone buying these days?

Scott Grannis said...

It occurred to me the other day, while discussing the current market turmoil, that what is going on can be illustrated by a simple analogy: OPEC is playing a giant game of chicken with the U.S. fracking industry. OPEC is determined to not cede market share, and OPEC figures it has a lower cost of production and more staying power than the U.S. upstarts.

At some point, someone is going to have to cut back their production. Meanwhile, there are all the oil consumers of the world in the background, who likely are dialing up increased consumption. It's tough to predict how all this will play out. Will it require even lower oil prices, or just the passage of time?

Benjamin Cole said...

Scott Grannis: I think your observations (as always) are very shrewd. The Saudis would love the run the frackers off the face of the earth.

I think the Saudis face the problem that frackers will continue to produce oil at the marginal cost of production. Sure, no more new drilling, and maybe lenders do not get paid back, and equity evaporates. But if it costs $29 to produce a barrel of oil from a frack-well, then it will get produced (or thereabouts). This could take years to work out.

Add on, Iran is increasing production, and has gobs of the stuff. If ever Iraq could settle down, they could produce more oil than Saudi Arabia. I won't even mention Venezuela, Mexico, Libya, Nigeria or any number of other nations, mostly with horrible governments.

How this shakes out over the next 20 years...well, you tell me. My hunch is there is plenty of oil most of time, and less need for it, continuously, thanks to free markets where they exist.

I think we are one generation away from a battery-car people will actually like. Biofuels are getting cheaper too.

Fun to watch this one unfold in the years ahead.



marcusbalbus said...

you and your charts. just post your emini wins/losses daily. would speak more.

Hans said...


"Hi Hans, rents and dividends are my key indicators"

Dr McKibbin, we are all in the same boat. In TVIX at $9.oo, out at $9.70.

Closed our XLE put (Mar55) position with a double. Holding NRZ, ($11.75) with a
15% divy yield and picked up GAIN at $7.oo with a 10.5% yield.

No doubt, finding reasonable yields and values has become most difficult.

Investors, should start to prep themselves for entry points into the
shale sector. This, IMHO, is the next mega play for the next twenty-four
months.

William McKibbin said...

Hi Hans, I like your choice of words -- the coming earnings reports are front of mind for me.

Benjamin Cole said...

BTW for the brave. The Hong Kong exchange is trading at an average PE of 8.7. There are REITs on the HK exchange offering nearly 9% dividends. One hotel REIT is trading at 40% of net asset value.

Someday people may look back at this the way we look back at the 1970s. You mean you could buy stocks in single-digit PE'S?

Right now, the world's major central banks are asphyxiating the global economy. It may take a year or two more for a sea change to occur.

Johnny Bee Dawg said...

So far, the market likes Bullard better than Dudley.
We can say it shouldn't...but it just does.

Johnny Bee Dawg said...

I put cash to work today and bought stocks, if anybody gives a rip.
Too many indicators are washed out. Way washed out.
Former leaders (drugs/biotechs) started screaming higher while stocks were down 500.
Next leg is higher, imo.