Wednesday, September 14, 2016

Perspective on the recent market turmoil

It's interesting that in the past week both stocks and bonds have sold off, since previous selloffs have typically seen stock prices drop while bond prices rose. In today's market, bonds don't serve their traditional role as a hedge against weakness in stocks and/or the economy.

What's happening is certainly interesting, if not disturbing (it's always bad when all prices fall). But to be honest I can't find any unifying theme or explanation for what's happening. If I had to give a quick answer, I'd say simply that not much has happened in the past week when viewed from an historical perspective. This may all be much ado about not very much.

In any event, the following charts let you see for yourself whether there are any significant or obvious patterns out there:

It does look like stocks have run into another "wall of worry," but it's a pretty minor one according to the chart above. The Vix index jumped from a low of 12 to a high of just over 20 in the past week (indicating increased fear and uncertainty), but this was offset by a rise in 10-yr yields from 1.5% to 1.7% (which might possibly mean the market is less pessimistic about the economy's ability to grow, which is not necessarily a bad thing at all). In any event, stock prices so far have only dipped modestly, and that tends to happen quite often in fact.

Real yields are up almost 40 bps in the past few months (a sign that the market is more optimistic about the economy's ability to grow), but they haven't changed much at all in the past week. Gold prices are down a bit in the past week and they have been relatively flat for the past few months. Together they signal that the market is slightly less pessimistic or slightly less concerned about disturbing things happening in the future. But it's hard to build a big case around these modest changes.

10-yr Treasury yields, shown in the chart above, have indeed jumped in the past week and in the past few months. But they are still quite low relative to where they've been in the past year or so. If anything, I'd say this shows the market has become slightly less worried about weak economic growth—less worried than it was in the immediate aftermath of Brexit, which occurred in late June.

The chart above compares 5-yr Treasury yields to 5-yr TIPS yields; the difference between the two is the market's expectation for what the CPI is going to average over the next 5 years. Inflation expectations are relatively low, and they haven't changed much at all of late. We're not in the presence of anything like an inflation scare. The economy remains in slow-growth mode and the market is priced to a 20% chance the Fed will raise rates next week. This is not a Fed-related panic. Why should the Fed push rates up if the economy is weak and inflation expectations are low and stable?

The chart above compares 10-yr Treasury and 10-yr TIPS yields, and the market's expectation for what the CPI will average over the next 10 years: a very modest 1.5%. Nothing much going on here.

The chart above shows the CRB Metals Index. It fell a bit in the past week, but it is still up almost 30% since the end of last year. If anything, this says that global economic fundamentals have firmed a bit year to date, and that's encouraging.

Given the revelations about Hillary Clinton's health in recent days, it's not surprising that her poll numbers have weakened. Trump has managed to become a bit more presidential of late, and a bit less off-the-wall, so it's not surprising that his poll numbers have improved. But I don't think we're yet at the point where the market is going to start pricing in a Trump victory. Hillary is still the odds-on favorite, though not by as much as she was a few weeks ago.

Regardless, the outlook for changes in fiscal and regulatory policy remains highly uncertain at this point, as I noted early last week. In the presence of uncertainty, economic actors are more likely than not to postpone major investment decisions, and that is going to keep the economy weak for the time being (although it wouldn't be surprising to see third quarter GDP come in a bit stronger than first and second quarter). And even if Trump's prospects improve dramatically, I don't think the market is going to be quick to conclude that a Trump presidency promises a vigorous economy. If anything, the likelihood of a Trump presidency could unnerve many people all over the globe. Until, that is, it becomes clear that he is bound and determined to lift the burdens of taxation and regulation that have been acting like a ball and chain around the economy's legs for the past seven years.

And even if it becomes clear that Trump will win and will pursue healthy tax and regulatory reform, the prospect of a stronger economy brings with it the likelihood of a significant rise in interest rates. It's going to take the market a while before it embraces the notion that stronger growth, rising profits, and higher interest rates are all of a piece. I've argued for years that higher rates won't threaten growth, because they will be the by-product of stronger growth. I have also argued for years that stock prices have not been inflated by "easy money" or artificially low interest rates, because the Fed hasn't been pushing rates down; the Fed has been lowering interest rates in response to a weak economy, lots of risk aversion, and strong demand for money. Thus it's logical to conclude that a stronger economy, declining risk aversion, and falling demand for money would all go hand in hand with higher interest rates. A stronger economy would also mean a lower deficit, and that would mitigate the impact of rising rates on the federal government's debt burden. In short, I'm not worried about the implications of a Trump win, but it might take the market awhile to digest it.


Benjamin Cole said...

Great post.

I am not sure that Fed can lower long-term rates except by being chronically tight.

We have seen long-term rates trending down for 30 years.

Johnny Bee Dawg said...

Nobody is pricing in a Trump victory just yet, but was interesting to see that the market rallied 240 points when Hillary collapsed at 9/11, and is now rallying nearly another 150 while Trump presents his excellent economic plan. (Thank you Art Laffer, Larry Kudlow and David Malpas, et al.)

No biggie. Markets do their own thing, but they do happen to rise when there's good news for Trump. He is looking better than ever in swing state polls. We will just have to see.

Another 8 years of Clinton's high taxes, massive regulations, increasing government power over the individual, and increasing debt to GDP ratio will be thoroughly depressing. Wasted potential is shameful. We just had the weakest GDP growth and productivity gains in US history. America needs to start winning again. Its been too long.

Scott Grannis said...

Trump's economic plan ( has lots of good stuff—e.g., lower income tax rates, a 15% business income tax rate, reduced regulatory burdens—but it suffers from too much protectionist rhetoric (e.g., branding China a currency manipulator) and pandering to the middle class. I'd like to think the worst things (e.g., punitive tariffs which would be paid mostly by the middle class in the form of higher prices) would never see the light of day. One of his advisors, Steve Moore, whom I've known for a long time, is a really solid supply-sider and I'm sure he would do his best to avoid the mistakes Trump keeps promising to make.

But for all its flaws, Trump's economic plan is still far better than Hillary's, without doubt.

steve said...

I could not disagree more than the idea that the markets will embrace DT. Markets HATE change and DT represents more change than Hillary since we can assume a GOP congress. If DT continues to do well expect the markets to reflect "uncertainty".

ronrasch said...

Scott, I really appreciate your analysis and perspective it creates.

Scott Grannis said...

Ronrasch: Thank you!

Johnny Bee Dawg said... the rumor and sell the news!

Jessy James said...

Markets hate politicians that can't be controlled. This recovery sits squarely on the back of cheap credit and cheaper gas prices--those will change when firms can't continue because they can't borrow. The 2009 recession was easily turned around on the credit--lets just see how that will work in 2017...