Tuesday, March 19, 2019

No more panic, but still lots of caution

The panic attack that ravaged markets in the fourth quarter of last year, causing a 20% loss in the S&P 500 index, has almost completely reversed. Overseas equity markets have recovered as well; credit spreads are back to normal levels, the dollar is relatively stable, and commodity prices are up. What's changed to produce such a welcome result? For one, it's become increasingly likely that Trump will secure some sort of deal with China, thus reducing the threat of a global trade war. Second, while fears that the Fed would over-tighten turbo-charged the December panic, a more dovish Fed stance announced in early January helped sow the seeds of recovery. The bond market is now priced to no more tightening for the foreseeable future, based on an emerging consensus—apparently held by both the market and the Fed—that the US economy is going to be growing at a modest pace and inflation is going to average roughly 2%. 

One important condition prevailed throughout this extraordinary panic attack: the economic and financial market fundamentals remained healthy. Fear and uncertainty are what's been holding the economy back. As a result, the economy has upside potential waiting in the wings. It still pays to be optimistic, since risk-free yields remain fairly low and the market is not priced to overly-optimistic assumptions. 

Chart #1

Chart #1 shows 2-yr swap spreads, arguably an important barometer of systemic risk and liquidity conditions, and at times a leading indicator of economic health. Today, US swap spreads are about as low as they get (which is very good), and in the Eurozone they recently have declined to levels (~36 bps) that are approaching the zone of normalcy. In the latter case that is grounds for optimism, given that spreads have been elevated for the better part of the past two years and the Eurozone economy has been struggling. Eurozone swap spreads are telling us that conditions may be about to take a turn for the better across the pond, notwithstanding the UK's inability to Brexit.

Chart #2 

Chart #2 shows 5-yr Credit Default Swap spreads for generic investment grade and high-yield corporate debt. This is a liquid and timely proxy for the bond market's confidence in the outlook for corporate profits. Spreads have shed their year-end panic and returned to relatively low and stable levels. Taken together with the low level of swap spreads, the bond market is sending a positive signal about the underlying health of the financial market and the economy.

Chart #3

Chart #3 shows two key measures of corporate profits. The blue line represents the trailing 12-month sum of reported earnings per share (adjusted for continuing operations), while the red line represents the quarterly annualized level of economy-wide corporate profits (adjusted for inventory valuation and capital consumption allowances, all derived from data reported to the IRS). The surge in profits which began a few years ago has been driven largely by the reduction in corporate tax rates.

Chart #4

Chart #4 shows the PE ratio of the S&P 500. It's plunged from 23 early last year to now just under 19. The elevated PE ratios of early last year were the market's way of discounting an expected surge of profits resulting from reduced corporate tax pressures. Earnings per share are no longer surging, and PE ratios have settled back down to levels that are only modestly above average; in short, the boost from lower tax rates is now waning, and future growth in earnings will thus be largely organic. Currently the market expects earnings to grow at a 9-10% rate over the next few years—down from the 26.5% growth of earnings registered in the 12 months ending last November.

Chart #5
 

Chart #5 shows the difference between the earnings yield (the inverse of the PE ratio, and equivalent to the dividend yield of the S&P 500 if corporations paid out all their earnings in the form of dividends) of the S&P 500 and the yield on 10-yr Treasuries. This is a proxy for the premium that investors demand to hold equities instead of Treasuries. Over long periods this premium is close to zero, but today it is reminiscent of what we saw in the late 1970s, when the economy was burdened by slow growth, rising inflation, and a collapsing dollar.

Yet today the fundamentals are much healthier. This can only mean  that the market has little confidence in the ability of corporate profits to grow at an outsized pace—and by inference not much confidence in the economy's future health. Put another way, a lot of capital appears to be willing to give up a significant amount of (equity) yield in order to get the safety of T-bond yields, and that implies that risk aversion (and caution) is still alive and well. That further suggests that equities are not overpriced and could in fact be attractively priced, assuming one is optimistic about future economic growth being stronger than the market currently expects.

Chart #6

Chart #6 is an update to a chart I've featured frequently. Here we see that the market's fears are dissipating and equity prices are regaining their prior levels. One more "wall of worry" is being overcome. 

Chart #7

Chart #8

As Chart #7 shows, the big news on the interest rate front is the decline in real yields. 5-yr real yields on TIPS have fallen from a high of 116 bps in November (just before the market crashed in December), to now 52 bps. As Chart #8 suggests, this tells us that the market's expectations for economic growth have fallen, since over time the level of real yields tends to track the economy's growth trend. Based on this chart, I estimate the bond market is priced to the expectation that GDP growth will be about 2.5% per year for the foreseeable future. If the market expected 3-4% growth, I would expect to see real yields on 5-yr TIPS trade substantially higher, to 2% or so.

Chart #9

Chart #9 compares the market's forecast of what the real Fed funds rate will average over the next 5 years (red line) with the current level of real Fed funds (blue line). Currently these two lines are equal—meaning the front end of the real yield curve is flat. This implies that both the market and the Fed expect inflation to remain anchored at just below 2% (as shown in the green line in Chart #7), and economic growth to remain unremarkable, probably 2.5% or so, for the foreseeable future (as shown in Chart #8). It's a forecast of steady-as-she-goes humdrum, with no need for the Fed to do anything. No surprises, just stable and unremarkable conditions on the horizon.

Now, whenever the market decides that the status quo is likely to persist indefinitely, one needs to worry, because lots of things could happen to upset the market's applecart. My money says that the most likely surprise is stronger-than-expected growth. If I'm right, then real rates will need to rise in a manner commensurate with stronger growth. The Fed would need to guide real rates higher, but not by enough to threaten future growth. The thing to worry about is inflation, but for now it appears to be well anchored. No need to fear the Fed for now.

Chart #10

The front end of the yield is flat because the market does not expect the Fed to raise or lower short-term rates. But as Chart #10 shows, the long end of the yield curve has a definite and quite normal upward slope.

Chart #11

Chart #11 compares an index of truck tonnage to the S&P 500 index. Not surprisingly, the stock market tends to follow the physical expansion and contraction of the economy, as proxied by truck tonnage. Current GDP growth expectations for the first quarter are pretty meager: 0.5 - 1.5%. This chart suggests that the stock market may be overly cautious, because truck tonnage has been rising at a 5-6% rate for the past year, and it's up some 18% since the 2016 elections.

Chart #12

Swap spreads (see Chart #1) are often good leading indicators of economic and financial market health. It's worth repeating that Eurozone swap spreads have been tightening of late, which suggests that the Eurozone economy may be ready to pull out of its long slump. That would be a welcome sign for Eurozone equities, which have fallen far behind their US counterparts, as Chart #12 shows.

Chart #13

Chart #13 compares an index of industrial metals prices (orange line) with the price of Arab Light crude oil (white line). Both have moved higher since their lows several months ago. Metals prices are up about 8%, and crude oil prices are up almost 30%. That strongly suggests that the global economy is already rebounding from its fourth quarter weakness. 

Chart #14

Chart #14 shows two measures of the dollar's inflation-adjusted, trade-weighted value. Here we see that the dollar is only about 10% above its long-term average vis a vis other currencies, and it's been around that level for the past several years. This is very different from the dollar's strength in the mid-1980s and the last 1990s; back then the Fed was actively tightening monetary policy and commodities were very weak. Those were terrible times for most emerging market economies, since they are quite dependent on commodity exports. 

Chart #15

It's not so bad these days, even though the dollar is relatively strong. As Chart #15 shows, industrial commodity prices are holding up pretty well, as are gold prices.

Thursday, February 28, 2019

GDP beats but the market remains skeptical

It's old news by now, but today's Q4/18 GDP report came in a bit stronger than expected (+2.6% vs +2.2%), and growth for the calendar year 2018 (3.1%) was the strongest in more than a decade, and stronger than the 2.3% average annual growth rate of the current economic expansion. However, the market is acting like it thinks this may be the high-water mark for the foreseeable future. This is a show-me market, and so far the economic improvement we've seen under Trump's ministrations is less than spectacular, and certainly less than supply-siders (like me) would have expected to see given Trump's successes at rolling back regulatory burdens and slashing corporate income tax rates. But it is nevertheless progress.

Chart #1

Chart #1 shows the year-over-year growth in quarterly real GDP. Q1/15 actually holds the record for post-recession growth (+4.3%), but Trump apologists prefer to look at calendar-year growth since that puts last year in a more favorable light.

Chart #2

Chart #2 remains one of my most-favorite charts (and arguably a top Reader's Choice as well). You can cheer last year's 3.1% growth all you want, but from a historical perspective, it's only equal to the 40-year average growth rate that preceded the Great Recession. It's nice that the GDP "gap" suggested by the chart is no longer widening, but it's clear that things could be a whole lot better. We'll have to see more and better growth numbers in coming quarters before crowning Trump the King of Growth.
 
Chart #3

Chart #3 shows quarterly figures for real and nominal annualized GDP growth. The last quarter hardly stands out as unusual.

Chart #4

Chart #4 shows the year over year change in the quarterly GDP deflator, which is the broadest measure we have of economy-wide inflation. Last year inflation notched a 2.0% rate of growth, which is a bit higher than the 1.6% average for the past 10 years. But there is no obvious sign of inflation trending higher or lower than the Fed's preferred 2% rate. I'm always willing to be an inflation bull, however, especially during times when lots of political pressure is being put on the Fed to avoid being too tight with monetary policy. So I worry that inflation might trend a bit higher in coming years because the Fed will likely prefer to err on the side of caution and postpone rate hikes. But as with growth, we'll need to see more evidence before drawing firm conclusions.

Chart #5

In order for the economy to break out decisively from its "new-normal" 2+% growth rate since 2009, we'll need to see a pickup in business investment. Chart #5 shows one such measure: real gross private domestic investment registered an impressive 7.05% last year, which is substantially higher than its long-term trend of just over 4%. Still, there still appears to be a "gap" here that is sizable. Good news, but not yet in the nature of "winning."

Chart #6

Chart #6 updates another of my favorite charts. Here we see that the market's level of fear and uncertainty continues to edge downward as equity prices continue to edge higher. The market is climbing one of its biggest "walls of worry" in years, and it still has a bit to go before establishing new record prices. That's understandable, given that Trump's character is still under the microscope, trade agreements are still lacking, problems like N. Korea continue to worry, and we have yet to see convincing evidence that the economy is on its way to sustained, 3-4% rates of growth.

Chart #7

To emphasize my point that the market remains skeptical, I offer Chart #7. This compares the level of real yields on 5-yr TIPS (which arguably reflect the market's perception of the economy's real growth potential) to the 2-yr annualized growth rate of real GDP. Real yields do tend to track real growth, and that makes perfect sense. It's notable, therefore, that real yields have dropped by about 50 bps since late last year. This suggests to me that the market was much more optimistic about future growth a few months ago than it is now. Not surprisingly, the Fed is too. That is why nobody is projecting any meaningful rises in short-term rates for the foreseeable future. This chart suggests that the market expects real growth to average about 2.5%. That's ho-hum enough to keep the Fed—and the bulls—on the sidelines.

Chart #8


I'll close with an optimistic chart, since I remain optimistic that things will work for the better. Chart #8 is Bloomberg's weekly Consumer Comfort chart, and it shows a meaningful rebound in consumer sentiment in recent weeks. It's up an impressive 35% since just before the 2016 elections, and close to the all-time high of 66 which was reached in early 1999 under the Clinton administration.

Friday, February 15, 2019

US vs Eurozone comparisons

Here are four charts that look at key aspects of the US and Eurozone economies: swap spreads, industrial production, equity prices, and exchange rates. By now everyone knows that the Eurozone has its problems, especially with the UK's bumbling attempt to exit the Eurozone trade agreement, France's violent protests, Germany's struggle to assimilate millions of muslim immigrants, and Italy's refusal to address its fiscal deficit. But if you think things are bad in the US, you've been reading too much fake news. 

Chart #1

Chart #1 compares 2-yr swap spreads—my all-time favorite financial indicator—in the US and Eurozone. Here we see that swap spreads have been extremely well-behaved in the US, trading within a normal range of 10-30 bps for most of the past 5 years. This is a clear sign that the financial fundamentals of the US economy are sound: systemic risk is low and liquidity is abundant. The Fed has not made any move that would disturb this. The Eurozone, in contrast, has been struggling with above-average systemic risk and liquidity shortages for the better part of the past 3 years, even as many Eurozone bond yields trade in negative territory; low interest rates are not necessarily stimulative. Eurozone yields are low because growth and opportunity are in very scarce supply.

Note in particular how Eurozone swap spreads began to surge in the first half of 2011, some 3-6 months before a recession hit, and how they began to decline well in advance of the end of the Eurozone recession. This is yet more proof that swap spreads can be excellent leading indicators of economic and financial market health. I have more background on swap spreads here, and numerous charts on swap spreads over the years here.

Chart #2

Chart #2 compares industrial production in the Eurozone and the US. Here we see how Eurozone industrial production declined throughout its 2011-2013 recession, whereas US industrial production kept rising and has now moved well ahead of the Eurozone. The recent decline in Eurozone industrial production hints strongly at a recession, but the Eurozone's relatively stable and only moderately elevated level of swap spreads argues against a Eurozone recession.

Chart #3

Chart #3 compares equity market performance in the US and Eurozone. Note how both markets suffered a setback in the run-up to the Eurozone's 2011-2013 recession, then proceeded to rally throughout the course of the recession. Equity markets can indeed be leading indicators of economic troubles, but not always. In any event, the industrial side of the US economy has zoomed far ahead of its Eurozone counterpart over the past decade. The US is, by this measure, the most dynamic of the advanced economies on the planet.

Chart #4

Chart #4 compares the value of the Euro/dollar exchange rate to my calculation of the Purchasing Power Parity of the Euro. (The PPP value of one currency versus another is driven by changes in relative inflation, and in theory it is the rate which would make prices in both economies roughly equal. In this case, since Eurozone inflation has been lower than US inflation since 1995, the PPP value of the Euro has been slowly rising since 1995.) Over the past decade, as Eurozone industrial production has lagged US industrial production (and by inference the US economy has outperformed), the nominal value of the Euro has been falling, from a high of 1.60 to now 1.13. This supports my view that the current strength of the dollar is largely driven not by tight money or higher interest rates, but by the fact that the US economy is simply a much more attractive place for capital.

Thursday, February 14, 2019

Mixed signals put the market in a holding pattern

The S&P 500 has rallied almost 17% in the past seven weeks, but it is still down about 6% from its all-time high of almost 5 months ago. Corporate profits continue to rise—trailing 12-month earnings are up almost 22% in the past year—yet PE ratios (how much the market is willing to pay for a dollar's worth of earnings) have dropped by over 20% in the past year. Key Treasury yields have dropped precipitously since their early November '18 highs: 10-yr yields have fallen 55 basis points, and 5-yr real TIPS yields are down 40 bps. (Treasury yields tend to be good barometers of the market's optimism about future growth prospects, and their decline reflects a meaningful loss of confidence in the outlook for future growth.) Measures of confidence also have dropped quite a bit in the past month or so. Yet despite all this, stock prices have rallied, and job openings are at record highs.

How can we reconcile all these disparate moves? It's a mixed bag, to be sure, but my reading of the market tea leaves points to investors that are still acting more out of caution than of greed or optimism. The stock market is up, but it's not euphoria that's driving things, it's simply the market becoming less worried about the future. Still worried enough, however, to limit forward progress.

Chart #1

Chart #1 compares the real yield on 5-yr TIPS to the 2-yr annualized rate of growth of real GDP. The two tend to move together, which suggests that real yields on TIPS are a good proxy for the market's expectation of the current trend in economic growth. Economic growth has been picking up for the past two years, and real yields have moved up in sync. But the recent drop in real yields suggests the market is now pricing in the expectation that real growth is unlikely to exceed 2.5% or so over the next year or two. This further suggests that the market believes that the beneficial effect of Trump's tax and regulatory cuts has been mostly exhausted. Conclusion: the bond market is not very optimistic about future growth prospects. Hopes were higher a few months ago, now they're more tame.

Chart #2

Chart #2 compares job openings—which have jumped in the past year to record highs—to the number of people actively looking for a job. This sounds like jobs nirvana: more jobs on offer than there are people looking to work! 

Chart #3

But as Chart #3 shows, the unemployment rate has ticked up in the past two months, from a low of 3.7% to now 4.0%. That sounds bad on the surface, but there is a positive explanation for this: with more jobs and higher salaries being offered, more people have decided to enter the jobs market who were previously sidelined. The workforce (those working or looking for work) is expanding faster than jobs are being created. This is fabulous. In the past, an uptick in the unemployment rate meant the economy was beginning to slow down. Now the uptick means the the economy has more upside potential than it did before. Mixed signals, but the unifying explanation is that the economy is still OK, still healthy, and primed for more growth if and when worries subside further.

Chart #4

Chart #4 shows the recent sharp drop in consumer confidence. It's still relatively high by historical standards, but a drop like this after a long run-up is reminiscent of what happens just before recessions. I hate to say that "this time is different," but the recent drop in confidence seems to have been motivated by "global angst" more than by any actual deterioration in the economy's fundamentals. I expect to see confidence turn up with the February survey, and I think the stock market rebound in the past month or so makes that a reasonably safe bet. The stock market is much quicker to respond to changing conditions than monthly surveys of confidence.

Chart #5

Chart #5 shows the sharp drop in small business optimism that has occurred since last August's peak. The best explanation for this is that higher tariffs on Chinese imports—which Trump thinks put pressure only on the Chinese—are making life difficult for a number of US industries. Higher tariffs on steel make steel more expensive, and that in turn makes a lot of things that use steel more expensive, for example. People are justifiably worried that Trump's tariff war with China could be getting out of hand. At the same time, the December plunge in the stock market added to concerns that conditions were deteriorating. For now the decline in confidence and optimism are most likely lagging indicators rather than leading indicators of worse things to come.

Chart #6

Chart #6 compares the performance of Chinese and US equities. Note that both y-axes are scaled equally (the top value is 15 times the bottom value) and the chart is plotted on a semi-log scale. Chinese equities have not only been much more volatile than US equities, their total gains over the past quarter century have much weaker. Who says China is beating us? In any event, both the US and Chinese equity markets have turned higher in recent months, which suggests the market is sniffing out an end to the tariff wars. That makes sense to me, since reducing or eliminating tariffs is good for all concerned. Why would the Chinese want to resist a deal that would be positive for their economy?

Chart #7

Chart #7 makes a similar comparison between US and Eurozone equity markets. US stocks have outperformed their Eurozone counterparts by a staggering 75% since the lows of March 2009. In fact, US stocks have outperformed Chinese stocks by almost the same amount over the same period. The US economy is on a roll, and global capital wants a piece of the action.

Chart #8

The strength of the dollar, shown in Chart #8, is broad-based, but not excessive—as it was in the mid-1980s and the early 2000s. Those periods were characterized by aggressive Fed tightening, which is not occurring today. Today the dollar's strength arguably owes more to the relative attractiveness of the US economy than to any actions on the part of the Fed.

Chart #9

Chart #9 compares the value of the dollar (inverted) to an index of industrial metals prices. When the Fed was very tight and the dollar was very strong in the early 2000s, commodity prices were extremely weak. Today it's different. The dollar has risen significantly in the past 5 years, but commodity prices are still relatively strong. Conclusion: US monetary policy is not adversely affecting the global economy, and that's good. Emerging market economies (the ones most dependent on commodity prices) are not being strangled by an overly-strong dollar. In fact, the Brazilian stock market in dollar terms is up 180% in the past 3 years! The laggard economies are to be found in Europe and Asia, where government intervention has smothered private sector initiative.

Chart #10

Chart #10 shows the two main measures of corporate profits. NIPA profits are based on corporations' filings with the IRS and are annualized and adjusted for inventory valuation and capital consumption allowances. S&P profits are trailing 12-month earnings per share, reported according to GAAP standards. Both show that profits have risen at an impressive rate in the past year or so. Much of that is due, no doubt, to the reduction in corporate income tax rates, but it is still impressive.

But consider this: since the end of 1999, just before the blowout peak in stock prices, GAAP reported profits have tripled, and NIPA profits are surged by almost 250%. Yet the S&P 500 index is up only 87%. It's hard to use this data to make a case for equities being overpriced.

Chart #11

Chart #11 shows the history of PE ratios for the S&P 500. They peaked in 2000 at around 30, and now stand at just over 18, a mere 8% above their average since 1960. Again, it's hard to use these facts to argue that stocks are over-priced. Profits have surged, yet the price of a dollar's worth of profits has plunged. This market is cautious about the outlook for the future.

Chart #12

Finally, Chart #12, my favorite "wall of worry" chart. The market appears to have gotten over the bulk of its recent worries, but worries still linger in the form of a higher-than-normal Vix and relatively depressed Treasury yields.

I'd characterize the market and the economy as in a holding pattern: fundamentally healthy but still worried about the future. Animal spirits are on a tight leash until it becomes clear than global disturbances are being correctly dealt with. All eyes are on Trump and Xi and their upcoming meeting.

Sunday, February 10, 2019

Recommended reading: Sandy's War

This essay by Kevin Williamson (arguably one of today's greatest philosopher-journalists) is fascinating, weaving together themes of social media, identity, fame, environmentalism and socialism in an insightful fashion. Here are a few brief excerpts from a rather long piece:

“This is going to be the New Deal, the Great Society, the moon shot, the civil-rights movement of our generation,” Representative Alexandria Ocasio-Cortez (D., N.Y.) says about her so-called Green New Deal. ... a “new national, social, industrial, and economic mobilization on a scale not seen since World War II.” 
Under whose command? That of Field Marshal Sandy, of course. 
Passionate hatred can give meaning and purpose to an empty life. Thus people haunted by the purposelessness of their lives try to find a new content not only by dedicating themselves to a holy cause but also by nursing a fanatical grievance. A mass movement offers them unlimited opportunities for both. 
While many causes associated with the moral equivalent of war are well-intentioned and honorable in spirit (fighting poverty, conservation, etc.), the problem with the idea itself is that it is totalitarian ... .
... the call for a World War II–level national deployment in the service of an old, tired, hackneyed, shopworn Democrat-socialist wish-list is not about reversing the trend of climate change ... or even about redistributing wealth or aggrandizing the power of petty politicians. Field Marshal Sandy needs a great cause to which to attach herself, lest she return to being only Sandy, obscure and unhappy and of no consequence — or at least no consequence obvious enough for someone with her crippled understanding of what life is for.

Do read the whole thing.

And do read a much shorter essay by Roger Simon, who explains why "AOC represents the natural outgrowth of our extraordinarily biased higher education system."

It's not global warming that's the problem, as the Green New Deal would have it (though its actual intention appears to have little to do with the environment and everything to do with promoting socialism). The real problem is our colleges (and earlier education, obviously) that are turning out the likes of AOC on an assembly line of the sort that drove Charlie Chaplin mad in Modern Times.

If a majority of today's voters cannot understand that AOC's Green New Deal is the product of the fevered imagination of a young, ignorant socialist struggling to give her life meaning, then the future of our country is bleak indeed.

Friday, February 1, 2019

The labor market continues to improve

The January jobs report handily beat expectations, with a gain of 296K private sector jobs vs. expectations of 175K. Considering all the disruptions (weather, government shutdown) and despite a big drop in consumer confidence, the numbers appear solid enough to say that the labor market continues to improve.

Here is a small collection of charts that I find most interesting:

Chart #1

Chart #2

Chart #1 shows the monthly change in private sector jobs, while Chart #2 shows the percentage gain over 6- and 12-month periods (which is important in order to filter out the notorious month-to-month volatility of this series). The growth rate of jobs bottomed in September 2017 at 1.5-1.6%, and it now stands at 2.1%. That's a meaningful increase, and it likely accrues to both Trump's tax cuts and and his frontal assault on regulatory burdens.

Chart #3

Chart #3 compares private sector jobs to public sector jobs. Here we see that there has been ZERO growth in public sector jobs for the past 10 years! Public sector jobs as a percent of total jobs now stand at the lowest level since 1957. Wow. If you believe, as I do, that public sector workers are less efficient than private sector workers (and less productive), then this means that the underlying productivity of the U.S. workforce has increased meaningfully in the past decade.

Chart #4

As Chart #4 shows, part-time employment has also been flat for the past decade. Relative to total private sector employment, part-time employment has shrunk impressively over the course of the recent expansion.

Chart #5

As Chart #5 shows, the labor force participation rate (the ratio of those working or looking for work relative to the total number of people of working age) has ticked higher for the first time in many years. People who were "on the sidelines" are now beginning to reenter the workforce. If this continues, it means the economy has lots of upside potential.

UPDATE (Feb. 4): In response to a reader's request, here is the latest chart on Consumer Confidence, per the Conference Board. It looks scary, but it is not necessarily a good predictor of an impending recession. Especially considering the rebound in stock prices over the past month or so. A good part of the reason stocks collapsed was a collapse in confidence. Both are now rebounding.


And here is the latest update to my "Walls of Worry" chart. I note that as of 9:20 PST, the S&P 500 is down a bit less than 8% from its all-time high of last September.


Thursday, January 31, 2019

Waves of worry recede

Since last October I've been arguing that the equity selloff had more to do with a "panic attack" than to any serious deterioration in the economy's fundamentals. Waves of worry (e.g., a China economic slowdown, tariff wars, Trump's unpredictability, a weakening Eurozone economy, stumbling emerging market economies, collapsing oil prices, weaker corporate earnings, rising credit spreads, and Fed tightening) converged into a "perfect storm" just before Christmas, causing the S&P 500 to fall almost 20% from its late-September high.

Since then, the "worry headwinds" have abated. Oil prices are up almost 28%. Emerging market economies have bounced (the dollar value of Brazilian stocks is up almost 25% in the past 5 weeks). Commodity prices have firmed. Credit spreads have tumbled. Corporate profits have firmed. Key financial fundamentals in China are improving (the MSCI China index is up 14%). And the S&P 500 has rallied some 15%.

One big reason for the improvement: Yesterday the Fed reiterated in detail the apology it made earlier this month. The Fed no longer expects to raise rates twice this year. Instead, Powell has promised to wait for a reason to tighten (e.g., rising inflation, which to date remains very much under control). Shrinking the Fed's balance sheet has morphed from being on "autopilot" to now flexible, a very reassuring sign for future market liquidity conditions. In short, the Fed is paying attention to its dancing partner (the market), and everyone is happier. The bond market doesn't see the Fed doing anything for the foreseeable future. Inflation expectations are in the sweet spot (1.7% per year over the next 5 years). The yield curve is doing just fine.

Another big, but under-appreciated reason: Liquidity has been abundant in the U.S. financial market, as reflected by low and stable swap spreads—a fact that I've been highlighting consistently. Liquid financial markets are a major antidote to financial panics, since they allow market participants to quickly and easily alter their risk exposure as their appetite for risk changes. Put another way, liquid financial markets act as a shock absorber for the real economy.

Chart #1

Chart #1 shows how big changes in oil prices affect the market's inflation expectations. Currently, the bond market expects CPI inflation to average 1.7% per year for the next 5 years. That's a bit below the Fed's "target," but it is nothing to worry about. In my book, lower inflation is always better. Meanwhile, the recent bounce in oil prices dampens concerns about the solvency of oil producers, and it is also evidence that the Fed is not too tight, nor is it expected to be too tight.

Chart #2

Chart #2 compares the real Fed funds rate (blue line) to the market's expectation for what the real funds rate will average over the next 5 years (red line). In the wake of the Fed's apology, the market now assumes the Fed is going to be in "pause" mode for an extended period. This makes sense if you don't expect economic growth to pick up meaningfully from the 2-2.5% range we've seen over the past decade. However, if the economy performs better than that—something we won't know for sure for at least the next 3-6 months)—then it's very likely that real interest rates will rise and that will require the Fed to adjust nominal rates upward from current levels. In the meantime, I take this to mean that the market is not very optimistic about the economy's ability to strengthen from "new-normal" rates of growth.

Chart #3

Chart #3 compares the value of the dollar (inverted) to the level of industrial metals prices. Over time there has been a strong inverse relationship between the two. In recent years, however, commodity prices have held up very well despite a noticeable strengthening of the dollar. This suggests to me that the global economy is, and remains in, fairly good shape. It also is evidence that the Fed is not so tight as to artificially push up the value of the dollar. The dollar is relatively strong not because money is tight, but because the outlook for the U.S. economy is better than that for most other major economies, and that's a good thing.

Chart #4

Chart #4 shows the dollar value of Brazilian equities. As with the case of most emerging market economies, tight U.S. monetary policy and a strong dollar (which prevailed in the late 1990s and early 2000s) pose substantial risks, since those two factors combine to crush the prices of the commodities on which those economies depend. Today that's not the case. At the same time, Brazil is enjoying a new, more market-friendly government. Emerging market economies appear to have substantial upside potential.

Chart #5

Chart #5 provides evidence that the Chinese central bank has managed to stabilize the value of the yuan (blue line), while at the same time arresting the outflow of capital which threatened China's ability to grow. Forex reserves (red line) are basically a barometer of net capital flows, which have been close to zero for the past few years—after being very negative from mid-2014 through late-2016. The recent rise in the yuan is likely an indicator that the market senses a U.S.-China trade truce in the offing. Since their late-October lows, the yuan has appreciated 4% and the MSCI China index is up some 3%. Baby steps, to be sure, but at least they are moving in a positive direction.

Chart #6

The front end of the Treasury yield curve has been pretty flat in recent months, a reflection of the market's belief that the economy will grow at a moderate pace and the Fed will remain on hold for an extended period. But the long end of the curve, shown in Chart #6, is nicely positively-sloped. This is reminiscent of the mid-1990s, when the Fed was non-threatening and the U.S. economy was picking up speed. It's a healthy sign of long-term growth prospects.

Chart #7

Chart #7 is one of the most important. Swap spreads in the U.S. have been rather low for a long time, and this is a reflection of healthy liquidity conditions, low systemic risk, and a non-threatening Fed. It's nice that Eurozone swap spreads have been moving lower of late, especially given the pronounced weakness we've seen in Europe in the past year. As I've emphasized for many years, swap spreads tend to be excellent coincident and leading indicators of economic and financial market health.

Chart #8

Credit default swap spreads are a highly liquid and generic indicator of the market's outlook for corporate profits and the future health of the U.S. economy. They have fallen significantly since just before Christmas, suggesting in turn that the market has become much less worried about the future.

Chart #9

The trailing 12-month earnings yield on the S&P 500 is now a rather robust 5.5%. That is about 2.9 percentage points higher than the current 2.6% yield on risk-free 10-yr Treasuries. As Chart #9 shows, the extra yield on stocks is relatively high when viewed from a historical perspective. This is a sign that the market is still priced to a skeptical view of the ability of corporate earnings to continue rising. The market has lost a good deal of its former fear, but it's still far from being optimistically-priced.

Chart #10

Chart #10 shows how surging bouts of fear (panic attacks, red line) have coincided with equity selloffs (blue line), and how receding fears lead to rising stock prices. 

It's not yet possible to be confident that the recent selloff was just another panic attack, but it's looking that way for now.