Tuesday, February 1, 2011

Economic Outlook (Part 5) -- Market Fundamentals

Part 1 (overview) of this 7-part series, which is taken from a recent presentation I made at UCLA, can be found here. Part 2 (monetary policy) can be found here. Part 3 (fiscal policy) can be found here. Part 4 (economic fundamentals) can be found here.

Swap spreads are an excellent proxy for systemic risk (the lower the spread the lower the risk), and they have also tended to be good leading indicators of the direction of other markets. In this chart they suggest that the yield on high-yield bonds is likely to remain relatively stable or perhaps decline a bit further. 

Treasury yields are primarily determined by inflation, but the economy's growth potential can also be an important factor (as was the case in late 2008 when 10-yr yields plunged due to widespread fears of an economic collapse). In this chart, the bond market appears to be saying that we have seen the low in inflation, and that both inflation and real growth are picking up. 

Credit spreads still reflect a degree of caution, suggesting that the market is not overly optimistic. Spreads in general are still significantly higher than what we might expect to see if the economy were healthy and financial conditions were normal. 

The Vix index is a good proxy for the market's fear, uncertainty and doubt. Fears have played a major role in the financial crisis, and this chart suggests we haven't yet returned to normal. That, in turn, suggests that there is still substantial upside potential left in the equity market. 

Key measures of market fundamentals show that while there has been substantial improvement over the past two years, we are still short of returning to what might be termed "normal" conditions. This suggests that the prices of risky assets are not overvalued and that the market is not overly optimistic. 

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