More encouraging developments

Ten days ago I wrote about a few encouraging developments amidst a sea of negativity. I'm happy to report that the list of encouraging developments is expanding. At root, the good news is the growing perception that China is not collapsing and oil prices are not going to zero. In fact, China seems to be on firmer footing these days, albeit with less rapid growth, and oil prices have rebounded over 50% from their recent lows. Meanwhile, the outlook for the U.S. service sector has improved, commodity prices continue to rally, credit spreads continue to narrow, and bank lending continues to surge. First quarter GDP growth may prove to be miserably slow (Bloomberg's consensus is for 0.6% growth), but that's old news by now and is trumped by a range of market-based prices that reflect improving economic fundamentals on the margin.

China's foreign exchange reserves (the red line in the chart above) are best thought of as a measure of net capital flows, given the central bank's exchange-rate policy.  Since the central bank relies on a managed peg regime, whenever more money comes into China than leaves, the central bank must buy any net inflows, which in turn increases forex reserves; by the same logic, net capital outflows show up as declining forex reserves because the central bank must sell reserves to keep the yuan from declining. 

The fact that reserves have been relatively stable for the past two months, while the yuan has actually risen a bit suggests that the central bank has been successfully managing the changing dynamics of the Chinese economy. The market had worried about a deluge of capital outflows and a weaker yuan and a weaker economy, but those fears appear to have been largely put to rest. In other words, the much-feared panic exit from China has not materialized, and markets seem to be finding a new equilibrium.

The stabilization of the yuan (it needn't fall further if there are no net capital outflows) has, unsurprisingly, coincided with the restoration of some confidence to the Chinese equity market, which has firmed up in recent months as shown in the chart above. Investors are still smarting from the equity market collapse in June of last year (which now looks increasingly like a speculative bubble that was doomed to burst), but prices today are still 50% above the levels that prevailed prior to the yuan's devaluation and prior to the loss of forex reserves. On the margin, the outlook for Chinese growth is improving (now 6-7% a good deal less than the 10% annual average over the past two decades, but still impressive), to judge from the stabilization of reserves and the yuan, and the rising stock market.

With the dollar no longer appreciating, commodity prices have found new support. Industrial metals prices, shown in the chart above, are up over 20% in the past 3-4 months. At the very least this dispels any notion of a global economic collapse or slump, and hints instead at improvement on the margin.

Most important is the fact that oil prices are up over 50% in since mid-February, as cutbacks in oil production have restored some balance to the oil market (see chart above). For example, the number of active drilling rigs in the U.S. has plunged by a staggering 78% in the past 18 months. Meanwhile, oil consumption has undoubtedly risen in response to very low prices.

5-yr Credit Default Swap spreads have narrowed meaningfully since mid-February, as investors infer that rising commodity prices reflect an improvement in global economic fundamentals. CDS spreads are now only modestly elevated relative to prior lows. 2-yr swap spreads remain very low, and continue to suggest that liquidity conditions are excellent and systemic risk is low. In short, markets are dealing successfully with, and overcoming, the oil price and China slowdown shocks.

Spreads on high-yield energy bonds soared to almost 2000 bps in mid-February, but have since dropped back to 1200 bps. The stench of panic is rapidly dissipating.

The March ISM service sector business activity index, shown in the chart above, rebounded strongly from its February low. This is the functional equivalent of a big sigh of relief, as a much-feared deterioration failed to materialize. February's very weak reading was likely influenced by the panic that had infected some areas of the market. Confidence, in other words, is returning.

Bank lending to small and medium-sized businesses, shown in the chart above, continues to surge, rising at a 16.6% annualized pace in the past three months and 10.3% in the past year.

Not surprisingly, as the market's fears have been allayed, equity prices have risen:

We're still not out of the proverbial woods yet, to be sure. The Vix index remains somewhat elevated (14), 10-yr Treasury yields are very low (1.76%), real yields on TIPS are very low (flat to negative), and the earnings yield on stocks is still unusually high, especially relative to the yield on Treasuries (5.3% vs. 1.75%). These market-based indicators all reflect the presence of caution and concern. If markets were confident and optimistic, Treasury yields would be higher (3-4%), the earnings yield on stocks would be lower (i.e., PE ratios would be higher), and the Vix index would be 10-12.

To top it all off, we have the great uncertainty surrounding this year's presidential elections and what the result holds for the direction of fiscal policy, since that holds the key to the future health of the U.S. economy. We've been muddling along with 2 - 2 ½% growth for the past seven years, thanks mainly to the economy's inherent dynamism which has managed to overcome rising tax and regulatory burdens. The economy has a lot of untapped potential if fiscal policies were to become more growth-friendly (e.g., tax reform, lower tax rates, reduced regulatory burdens). But a replay of the faux "stimulus" policies of 2009, coupled with higher taxes (as both Democratic candidates are advocating) could deliver more years of disappointingly slow growth—or even no growth.

To judge from the degree of caution and concern still priced into the market, I think the consensus of investors is that the fiscal policy headwinds are more likely to strengthen than weaken (i.e., bad news is priced in). But if the outlook for China and the global economy continues to improve, this could go a long way towards offsetting the negatives that might surface in November. Regardless, it's hard to develop strong convictions about where policy is headed next year given all the variables still in play (e.g., a Hillary indictment, Trump vs. Cruz, who controls the Congress). I'm inclined to believe that things will improve, if only because in the past 8 years we have tried so much of what doesn't work.