Wednesday, November 11, 2020

Recovery on track, politics is no longer a threat

The economic news continues to be favorable, and thus supportive of an ongoing V-shaped recovery. Now that the election dust has settled, the political news is also supportive.

Although I'm disappointed that Biden won, I am pleased to note that the much-expected "blue wave" did not materialize. Instead, we have the makings of a classic "divided government,", and that is very good news. The Republicans have substantially narrowed the Democrats' margin in the House (which in turn greatly weakens Speaker Pelosi's hand), and the Republicans are very likely to retain control of the Senate. Biden does not walk into the White House with a mandate to radically transform the American economy or to significantly raise income taxes. With luck he will prove to be a stabilizing and calming influence on the nation's nerves, rather than an existential threat to capitalism. In my view, the economy is quite able to take care of itself and prosper if it is just left alone, without any disturbing "stimulus" measures from either Washington or the Fed.

Trump's legacy can be summed up in lower taxes, greatly reduced regulatory burdens, a less-activist judicial system, and a Mid-East peace accord. Biden's legacy will be measured by how much or how little he squanders Trump's legacy.
Chart #1

I've been featuring Chart #1 in recent posts, because I think it's an excellent leading indicator of the global economy's health and outlook. The ratio of copper to gold prices is almost always driven by the perceived strength of the economy, since a stronger economy boosts demand for copper but depresses the demand for gold, which is a refuge from uncertainty. As the blue line shows, this ratio has turned up in recent months in convincing fashion. The 10-yr Treasury yield (red) is also quite sensitive to the market's outlook for the economy, since the expectation of a stronger economy implies that the Fed is likely to begin raising short-term rates early, rather than keeping them low in order to "support" a weak economy. Higher short-term rates in the future, coming from extremely low levels, is a good predictor of higher long-term rates. All in all, if these recent trends continue both the US and the global economic outlook will be brightening considerably.

Of course, a significant "tightening" of monetary policy and a commensurate rise in long-term rates could pose problems for the economy and thus might not be comforting news. I'm sure that higher rates at some point will be problematic, but I would argue that they are still so incredibly low (which normally would be symptomatic of a very weak economy) that they will have to rise considerably before they pose an obstacle to growth. 

Indeed, given the increasing signs of higher prices, the Fed risks allowing inflation to become endemic, and that would be very bad since ultimately it would assure us of a period of aggressive Fed tightening, which has been the proximate cause of almost every recession in the past half century.

Chart #2

Chart #2 compares the level of the dollar (blue, inverted) to the level of non-energy commodity prices. They tend to track each other pretty well over the years: a weaker dollar corresponds to higher commodity prices and vice versa. The strength of commodity prices this past year is almost certainly related to the weakness of the dollar, which in turn is a function of the Fed's "easy" monetary policy. The Fed has taken rather extreme measures to ensure that there is no shortage of dollar supply given the intense demand for dollars during the Covid recession. Dollars are abundant, and that supports higher commodity prices.

Chart #3

Chart #4

However, as Chart #3 suggests, the price of oil has responded only minimally to a weaker dollar. Oil alone stands out for its very weak response to easy money and a weaker dollar. It's therefore not hard to argue that oil is especially cheap these days. That conclusion is also supported by Chart #4, which shows that, relative to gold prices (a universal standard against which to measure all currencies), oil is quite cheap at current levels. This further suggests that betting against the prevailing wisdom that says that global warming demands a huge reduction in the world's consumption of petroleum-based energy—and the fact that oil-related stocks are very weak—might prove profitable.

Chart #5

Chart #6 updates the level of Credit Default Swap spreads, which are once again at very low levels. This is good evidence that a) liquidity is abundant, b) the outlook for corporate profits is very healthy, and c) the outlook for the economy is also quite healthy.

Chart #6

Chart #6 shows the level of 5-yr real and nominal Treasury yields, and the difference between the two (green) which is the market's expectation for what the CPI will average over the next 5 years. Inflation expectations today are around 1.6-1.7%, which is rather low compared to some past periods, but rather high considering (as the conventional wisdom would ordinarily suggest) that the economy is still plagued by a huge amount of excess capacity. I think that this confirms my hypothesis that the Fed risks remaining super-easy for too long. At the very least it suggests that the Fed is almost certainly not too tight, and that interest rates need not remain at current, extremely low levels. 

To be fair, I must note that the current level of real yields on 5-yr TIPS (-1.2%) would by itself suggest that the economic outlook is extremely weak. That's a fair characterization, but it's also true that extremely low real yields could reflect a very high degree of risk aversion: the market is obviously willing to pay a very high price for the safety of TIPS and Treasuries. 

Chart #7

Chart #7 backs up my assertion above, namely that the market is still full of risk aversion. The price of gold and the price of TIPS are trading at very elevated levels. Note, however, the early signs of a "top" in both prices. If the economy continues to improve over the course of the next year, which I think will happen, then watch for gold prices and TIPS prices to tumble.

Chart #8

Chart #9

Charts #8 and #9 compare the level and ratio US stock prices to Eurozone stock prices. US equities have very strongly outperformed their Eurozone counterparts. As the lower portion of Chart #9 shows, US equities have risen by almost 120% in the past 10 years. I'm pretty sure this is unprecedented. I hesitate to call a top to this ratio, since I have done so before and been proven wrong. But it certainly bears watching.

Chart #10

Finally, Chart #10 shows how the market is becoming less worried about the future, and that is driving equity prices higher. The Vix is still significantly above what might be considered "normal" (~12) and that is good evidence that risk aversion is still alive and well in the world.


Benjamin Cole said...

Yet another terrific review of the US economy by Scott Grannis.

It may be we see a retreat in gold prices, as happened after 1980 and then again after 2011.

The more I think about globalized capital markets and a globalized economy in which "cash" can cross borders with the click of a mouse... the more I think we must consider all the major central banks as acting upon a whole.

That is, the Bank of Japan, The People's Bank of China, European Central Bank, and the Fed are all active players.

If the Fed should turn conservative, but the other three major central banks are all participating in quantitative easing programs, there will still be additional capital sloshing about global capital markets looking for a home, including inside the US.

If we have a globalized economy and three major central banks are printing money like crazy, but the Fed does not, perhaps we still see inflation even inside the US.

Although as it stands now, Europe, China and Japan are at near deflation, and the US at modest inflation.

Milton Friedman once said sustained low interest rates and inflation are a sign that monetary policy has been tight.

But low interest rates and inflation have defined the global economy now for decades.

As my late great Uncle Jerry used to say, "If you are not confused, then probably you don't understand the facts."

Needelman said...

Thank you very much Scott.

I continue to wonder about delinquency rates. Although they've ticked up a little this year, they are hovering near record lows. In fact, going back 35 years, they've hardly been lower than they are today.

I understand the magnitude of Fed and Treasury efforts that eased financial stress and backstopped debt. However, continued unemployment insurance claims (7.285 mil) exceed the 2009 peak by 12%.

In addition, the office/retail/leisure mortgage defaults have not really materialized. Is it just a matter of time before they cascade through the economy or is that just waiting for Godot?

Perhaps past (and future) PPP and blend/extend refinancing allow companies and individuals to remain current? OR -- now that the election and Covid are over, we will begin to sift through the economic debris....

The market is certainly signaling all clear.

pgrommit said...

Good post, thanks.
And especially, thanks for the level-headed, common sense idea of moving on from the election, looking at what we'll be dealing with going forward.

Fred said...

It's going to be very close in Georgia and the democrats could come up with a win unless the republicans get their act together. Our metro counties have gone very deep blue and we'll need a very high turnout in the rural counties to keep the senate. Runoffs have always favored republicans in past elections but this year could very well be different with all the out of state money pouring into the state for Ossoff and Warnock. I would never have thought Georgia would decide the fate of the country given how reliably red we've been, but the tide is turning and nothing should be taken for granted.

GMM said...

"With luck he will prove to be a stabilizing and calming influence on the nation's nerves, rather than an existential threat to capitalism.".

I've followed Scott Grannis every word since 2008. But I have to ask *how* will Biden accomplish this feat? People voted for Jimmy Carter precisely for the purpose of calming the nation. Biden, amazingly begins his presidency as weak as Jimmy Carter was when he left. I don't see the nerves of Trumpers or the Far Left being calmed by this figurehead leader. And no president has started with so many believing he will likely not serve out the whole term.

Ataraxia said...

I believe what Scott means is that because the general public believes that Biden is less a firecracker than Trump, they are automatically calmer with Biden in office no matter his policies.

In other words, Biden does not have to accomplish anything in the future. He is already considered a more stable leader by default.

GMM said...

So would you describe Neville Chamberlain as a firecracker?

Ataraxia said...

I don't know who he is and would not say Trump was a firecracker but have to admit in the beginning I might have felt like that.

I'm just saying that some of the general public thought of Trump as a de-stabilizing and unpredictable president who might make a big mistake. And Biden has politicked into the publics minds as the guy you can trust to do the right thing. Scott pointed out a few times don't listen to Trump, just watch what he does which was not de-stabilizing at all.

steve said...

"I don't know who he is and would not say Trump was a firecracker but have to admit in the beginning I might have felt like that."

You have automatically disqualified yourself from further discussion. Good grief. GMM makes a fair point re NC but Trump has been unnecessarily bombastic and polarizing. Now that he refuses to concede he will be known as the POTUS that divided a nation and obviously could not care less about the welfare of our country but rather only about himself. It boggles my mind how people are blind to this.

kb said...

I agree with Steve about Trump. Some of the things I value in a person are integrity, character, good will, truth telling, and heart. Clearly, I am not a fan of Trump.

wkevinw said...

I love it when people attack one politician about "truth telling". All of them lie.

31 lies from Biden below. Biden? Good Character? LOL (note- the author below is not a right wing nut).

steve said...

You make a good point wk and I didn't agree with much about Obama but he was not a constant Divider and he appears to be a good man, father and husband. Character 'trumps' policy-and Trump's policy was inconsistent and frequently at odds with what many would consider 'conservative'. Anyways, as of Jan 20, it's over. Only Trump and some of his minions don't accept that. The longer leadership of the GOP back this insanity the more they lose credibility which may very well cost them the two senate seats in GA.

randy said...

wkevenw - side comment about SubStack. I hope more and more people find that as an alternative to main stream media (Fox or NYT or Wapo, etc). Wonderful to have thought provoking writers from both left and right that have abandoned or been pushed out of traditional outlets, and can now write freely without getting cancelled. Andrew Sullivan, Glen Greenwald, Matthew Yglesias, Bari Weiss, Matt Taibbi, etc. This kind of outlet, and podcasts will continue to grow I hope.

Soaring Eagle said...

This election is not over! Trump will serve another 4 years for sure. Will post later - soon why this the 4th Coup by the lying Democrats' will FAIL!

Soaring Eagle said...

Back on the 4th Coup - First, this election fraud is a MAMOUTH opportunity for J Trump to CREATE HONESTY in voting NOBODY else succeed.

Dominion Systems found in 28 States - Hammer Scorecard - used in Venezuela to ice Madura's stolen election, etc.

Clapper & John Brennan used in CIA to change votes in some foreign countries slipped to democratic party!

Want to go to KEY BOTTOM LINE - Sidney Powell, key TRUMP Atty = mentions - CRUNK (bad sp) = meaning Trump, very early SECURED A FEDERAL RIGHT/CASE TO FIGHT FULL BOTTOM LINE UNTIL ITS TOTAL END WAY UP FRONT

THE battle has just started and J Trump can't loose. As some have said "its Trump playing Super Chess and Biben playing poor checkers.

pgrommit said...

Soaring Eagle
So THAT'S why the Dems lost seats in the House and didn't gain a majority in the Senate, because they are so good at stealing elections. LOL!