Saturday, June 6, 2020

Recommended reading

Steve Moore, a long-time supply-side friend from my Art Laffer and Jude Wanniski days, as well as the founder of the Club for Growth (of which I was a charter member), is now at the helm of the Committee to Unleash Prosperity. They put out a daily newsletter which I've been reading and enjoying. It focuses on current topics of interest and initiatives that can enhance the economy's ability to grow and (of course) prosper. Caveat: it does have a conservative bias.

You can subscribe here, and it's free.

Covid-19 is yesterday's news

The Chinese virus (aka Covid-19) is no longer a big source of concern for the market. The growth rate of new cases and deaths is decelerating just about everywhere in the world. The infection fatality rate is increasingly estimated to be as low as 0.2% or even in the range of 0.06% to 0.16%—which is similar to that of the seasonal flu. Long-time readers of this blog will remember that I first floated this suspicion in late March.

One reason it has not proven to be as fatal as originally feared could be that a significant portion of the world's population was not susceptible to the virus to begin with, due to having "resistance at the T-cell level from other similar coronaviruses like the common cold."

In any event, what was once thought to be a catastrophic pandemic is now understood to be dangerous mainly to the aged and the infirm, leaving the vast majority to pursue their lives as before; not without risk, but not condemned to huddle at home in fear. For many, the virus may even be losing its potency.

The shutdown of the US economy, which I have been calling "the most expensive self-inflicted injury in the history of mankind," is no longer a source of concern either, from the market’s perspective. (But governments may well find themselves in the crosshairs of those angry at the shutdowns; see the recent report condemning the German government's handling of the Covid-19 crisis here.) Many states are reopening, of course, but more importantly, as I've been pointing out since March 19th, key financial market and economic fundamentals have been improving on the margin, at the same time our fear of Covid-19 has been tempered. The May jobs report made it clear that the economy is doing much better than feared. It's changes on the margin, like this, that move the market.

So, as investors we need to forget about Covid-19, the shutdown, and the economy, since these are all on the mend; it's no longer a question of when things start to improve, the question now is how fast they will improve.

Looking ahead, the critical areas of concern, in my mind, are 1) can Trump recover from his currently depressed levels of approval and go on to beat Biden in November, thus avoiding the economically-disastrous policies (e.g., higher taxes, increased regulation, and multiple "green" initiatives) that Biden is proposing? and 2) can the Fed react to the dramatic improvement in the economy—and the rebound in confidence which is sure to follow—by raising interest rates in a timely fashion and thereby averting an unexpected surge in inflation?

I have already begun to address this second question here, here, and here, and at the bottom of this post, but more observation is clearly needed. I will begin to address the first question in the months to come. In the meantime it is still important to track key measures of financial and economic fundamentals, some of which I update in the following charts:

Chart #1

In Chart #1, the Vix index is a good proxy for the market's level of fear. What we have seen in recent months is a perfect inverse correlation between fear and equity prices. Fear rises, prices fall; fear declines, prices rise.

Chart #2

Chart #2 shows two market-based indicators which tend to track the market's outlook for economic activity. 10-yr Treasury yields have fallen to record lows, driven by collapsing estimates of economic activity. Similarly, the ratio of copper to gold prices (which tends to increase when the market's economic growth expectations increase) recently fell to record lows but has since rebounded. Together, these two indicators seem to be signaling a major turn for the better in the market's expectation for economic growth.

Chart #3

TSA screenings continue to rise, and are up 240%, on a 7-day moving average basis, from their April all-time lows. There is still lots of room for improvement, since at this time last year screenings were averaging about 2.38 million per day. But it's clear that activity is increasing significantly on the margin.

Chart #4

Chart #4 shows Bloomberg's index of US airline stock prices, which has turned up significantly the past few days. American Airlines stock is up 65% in the past three days. Wow. Confidence in the future is improving dramatically.

Chart #5

Chart #5 shows the spread between High Yield and Investment Grade Credit Default Swap Spreads, commonly referred to as the "junk spread," or the additional yield that investors demand to move from the relative safety of investment grade to the more risky high sector sector of the corporate bond market. These spreads have decline significantly in a relatively short period of time. The Covid-19 credit crisis has reversed dramatically. This is another way of saying that investors' confidence is returning.

Chart #6

Chart #7

Chart #6 shows the 3-month annualized rate of change in money demand, for which, as a proxy, I use the sum of bank demand and savings deposits. These deposits pay almost nothing, and thus are attractive to economic actors only as a store of value, since they are relatively default-free and liquid. These deposits have increased by $1.8 trillion (+16%) since March 9th. Not coincidentally, this is almost exactly equal to the recent $1.7 trillion increase in excess bank reserves (which reflects, in turn, the Fed's recent purchases of securities), as shown in Chart #7. What this means is the Fed's purchases have gone almost completely to support the public's sudden, increased demand for safe money.

Note also that the first three episodes of Quantitative Easing did not correspond with any sudden increase in money demand on the part of the public (the growth of money demand as shown in Chart was somewhat elevated from 2008 through 2013, but not sudden, as we have seen recently). Thus, the initial rounds of QE were mainly designed to accommodate the banking industry's demand for safe assets (e.g., bank reserves), because banks needed to shore up their balance sheets in the wake of the near-collapse of the global banking industry. This time around, QE efforts have largely accommodated the public's demand for safe assets.

Going forward, all eyes will be watching the aftermath of the recent gigantic increase in demand and savings deposits. How long will the public want to maintain these outsized deposits? When optimism returns and the demand for money declines, where will the $1.8 trillion go? The only way that money can "disappear" is if the Fed reverses its asset purchases—by selling securities and absorbing/extinguishing bank reserves in the process. If the Fed doesn't reabsorb the money it has created as the demand for that money declines, then the unwanted money will find its way into asset prices and the general price level (i.e., rising inflation). Recent increases in stock prices could be an early sign of declining money demand, but it is too early to come to that conclusion, especially since, as I noted in my previous post, the market in general does not appear to be overly optimistic.

Wednesday, June 3, 2020

Lots of green shoots

Economic fundamentals are definitely on the mend. It's no wonder stocks are rising nearly everywhere: the virus is burning out and lockdowns are ending. People are anxious to get out and go back to work, and it shows. Numerous high-frequency indicators show sharp turnarounds, and the stock market appears to be pricing in a substantial recovery. There's a whiff of a market "meltup" in the air, in the sense that those who cashed out when the cannons were blasting are now worried about whether and when to get back in. But it's not at all clear that prices are overbought or that investors are over-confident.

Chart #1

As Chart #1 shows, equity prices have recovered a substantial portion of what they lost in March. The Vix Index (fear) is still elevated however, so it's tough to say that investors are throwing caution to the wind, especially given the still-low level of 10yr Treasury yields (0.75% as of today).

Chart #2

Chart #1
Both the 10yr Treasury yield and the ratio of copper to gold prices have turned up a bit of late (see Chart #2), and this is a good sign that global economic conditions are beginning to improve. Still, there is lots and lots of room for further improvement.

Chart #3

As Chart #3 suggests, consumption of motor gasoline has rebounded significantly. This is a good measure of the extent to which consumers are still sheltering at home and working at home.

Chart #4

Thanks to aggressive Fed action to supply much-needed liquidity to the banking system, over financial conditions have improved dramatically, as Chart #4 shows. We've never seen such a rapid rate of financial healing after a recession.

Chart #5

Chart #5 shows that credit spreads have narrowed significantly and rather rapidly. When liquidity is abundant and the economy is expanding, the risks to corporate profits decline. Spreads are still somewhat elevated, but they have retreated meaningfully from the edge of the abyss.
Chart #6

As Chart #6 shows, Eurozone equities have also rallied significantly. However, US stocks continue to be the strongest. The S&P 500 index has outpaced its Eurozone counterpart by roughly 100% over the past decade.

Chart #7

Earnings are very likely to be weak for the remainder of the year, but even discounting that, the equity risk premium is at least 3%. Investors are still willing to give up a substantial amount of yield in exchange for the safety of Treasuries. Again, no sign here that caution has been thrown to the wind.

Chart #8

The business activity subset of the ISM service sector surveys (Chart #8) shows a significant rebound in the month of May. This should move higher still with this month's survey.

Chart #9

Chart #9 shows an index of new mortgage purchases (mortgages taken out for an initial home purchase, as contrasted to mortgage refinancings). Home sales must be doing quite well these days, despite the shutdowns.

Chart #10

Chart #10 shows the national average of 30-yr fixed rate mortgage rates. Mortgage rates for conventional mortgages have never been lower in the history of the US. However, they do have room to decline further, since the spread between this index and the 10-yr Treasury is still unusually wide.

Chart #11

On a 7-day moving average basis, TSA screeners as of yesterday had processed three times the number they processed just two months ago. Still a long way to go to get back to normal, but there is a noticeable increase in the demand for air travel.

I still worry about a potential surplus of money. Monetary expansion has been off the charts in the past two months, and that is fine as long as the market wants precautionary and safe haven money balances. But as confidence returns the demand for money will inevitably decline, and it will be critical for the Fed to respond to this by raising short-term interest rates. Whether this will play out soon or later this year is an open question.

I can point to some evidence of declining money demand which is showing up as rising prices for stocks, commodities, and risk assets in general. But as yet it's not clear that prices for any of these things is irrational, as might prove the case when and if the Fed is slow to offset declining money demand with higher interest rates. But I am keeping a sharp eye out for this.

In the meantime, the chance of an unexpected rise in inflation has probably never been so likely, given that hardly anyone is concerned about this at a time when the fundamentals could definitely support higher inflation. That increases the attractiveness of debt in general, and of real estate and other hard assets.