Monday, August 22, 2011

This market seems way too fearful

Judging by the behavior of gold (now at another high of $1890 and looking parabolic), the equity and corporate debt markets (equity prices down 17% from recent highs, credit spreads surging), the Vix (registering significant levels of fear at 41), and the 10-yr Treasury yield (now priced to levels suggesting a deep recession or even depression), the world seems awfully afraid that the simmering European debt crisis is about to reach full boil—bringing with it the end of the world as we know it, or at the least another deep and painful recession. On balance, these indicators of market fears, sentiment and expectations haven't been this awful since late 2008, when the global economy was in virtual free-fall.

Those fears seem way overblown, however, since U.S. swap spreads, while up a bit from their recent lows, are still within the range of what could be considered "normal." European swap spreads are signaling pain ahead for Europe—at the very least a Greek default, some bank failures, and perhaps a recession—but US swap spreads are still consistent with a view that the US banking system and economy will be largely insulated from whatever problems Europe does suffer. Swap spreads have played the role of "canary in the coal mine" quite a few times in the past decade or so. Note, for example, in the second chart above how swap spreads led high-yield CDS spreads in advance of the 2008 recession and in advance of the 2009 recovery. What swaps are saying now is that default risk and recession risk are way overblown; that what we are likely seeing today is one more case of investors that have been burned so badly in the past that they can't bear even the thought of another recession.

Those fears also seem way overblown given what we know about the economy. The problems of 2008 were exacerbated by $150 oil, but today oil is trading well below $100. Real interest rates  were quite high in advance of the 2008 recession, but today they have been negative for almost three years. The yield curve was flat to inverted prior to the 2008 recession, but has now been steeply sloped for almost three years. Inflation plunged in the second half of 2008 as the world's demand for liquidity surged and the Fed was late to respond, but today all measures of inflation are moving higher, there are no signs of any liquidity shortage (e.g. the dollar is very weak, gold and commodity prices are quite strong), and the Fed has pumped $1.6 trillion of reserves into the banking system. Employment collapsed in 2008 and 2009, but jobs have been growing for almost 18 months now. Weekly claims for unemployment surged in 2008, but have been declining for the past two years. Confidence and valuation multiples tumbled as the 2008 recession unfolded, but today confidence has been weak for years and PE ratios are well below average.

I've seen people say that since the economy has barely grown the past two quarters, the economy is like a plane that is nearing "stall speed" and is thus in danger of crashing. But that analogy seems absurd to me. What law says that if an economy doesn't grow it therefore has to collapse? That may be true for individual companies (i.e., if you don't grow you will eventually die or be overtaken by the competition), but it's not true for economies, which can and do languish for long periods. In any event, recessions are the exceptions, not the rule—it takes extraordinary circumstances and policy mistakes to generate a recession.

Europe has plenty of problems, with public sector obesity and over-indebtedness topping the list. But that doesn't mean the end of the world as we know it is inevitable. The money that the PIIGS have borrowed has been spent and much of that spending was wasteful; those losses happened long ago and they are now water under the bridge. What remains to be seen is whether the consequences of those losses (which might be manifested in a series of bank failures) will bring down the European and global economies. In the meantime, governments everywhere are facing intense pressure to trim spending (a very good thing), U.S. swap spreads are saying things are still OK, and commodity prices are saying the global economy is still humming along.


Benjamin Cole said...

The market is jittery. A lot of fear-mongering going on, and gold-mongering, sometimes the same thing. Talk radio operates in some sort of alternative universes.

Other much more important commodities, such as natural gas and oil, are much more subdued than gold.

When major presidential candidates suggest they would execute Federal Reserve officials, some people might think it is time to pull money out the USA, or investments in general. That's not confidence-building talk.

We have an ugly election coming up, almost nothing either party will do will boost investor confidence. Both parties will do much to savage investor confidence.

There is some hope:

"Bruce Bartlett, who served as an adviser to Ronald Reagan and as a Treasury official under George H.W. Bush, called Republican presidential hopeful Rick Perry "an idiot" Friday, referencing negative comments the Texas governor made about Federal Reserve Chairman Ben Bernanke this week.

While campaigning in Iowa Monday, Perry said it would be "almost treasonous" for Bernanke to print more money between now and the 2012 election. "I don't know what y'all would do to him in Iowa, but we would treat him pretty ugly down in Texas," he said.

Bartlett reacted to the comments Friday during an appearance on CNN's "American Morning." "Rick Perry is an idiot, and I don't think anybody would disagree with that," Bartlett said.

Perhaps the GOP will go with a more-sensible alternative to Obama, and we can get a pro-business President in the White House instead of a kook or idiot. I hope so.

Many GOP economists are suggesting a more-stimulative Fed is needed, such as Greg Mankiw and Ken Rogoff. If we get a GOP president, maybe they will be listened to.

Keep your fingers crossed.

Frozen in the North said...


My impression is that investors are running scared. They don't trust anything or anyone anymore. Aside from the massive loans to the banks by the Feds, this afternoon BOC's CDS are trading at 370 bps...

Investors are tired of the lies, the insider dealing and the failure of buy and hold. so they are taking their money out, and investing in treasuries, because rule one of investing is: Don't lose money!"

This makes perfect sense, as investors lose faith in the market. First it was Private equity taking the good companies private, the hedge funds and now HFTs that suck what's left on the bone.

If you are 55 and up, American and watching 10 years of no performance on the market you stayed with trough thick and thin, you look at the current environment and say: "I wont be the sucker this time"

Unknown said...

Mr. Grannis,

Any thoughts on David Rosenbergs' recent "double-dip" comments making the rounds of the web today? He seems convinced we are going into a recession.



Scott Grannis said...

Rosie has been very bearish for a very long time. Although the economy has done poorly in the past year and stocks and bonds are priced to a recession, I don't see signs of an imminent recession or a double-dip in the physical economy.

Rick said...

US Treasury yields have priced in a recession. Who says that this recession must occur in the US? If Scott's observations about the recent increase in M2 are accurate, then the lower yields are evidence of a likely recession in Europe.

The increase in the price of gold reflects the likelihood of the monetization of the trillions of private debt that has been transferred to government balance sheets. The price of gold has been rising against most all currencies over the past 10 years. It has now risen even more significantly against the Euro than the US dollar in recent months.

The recent increase in the US debt ceiling actually constitutes a monetization of unpaid TARP balances, the $787 billion Obama stimulus plan, the $400+ billion supplemental appropriation in 2009 and the resulting stealth increases in the federal budget baselines iff and when the federal government ever gets around to passing a budget.

The recent GDP report and revisions prove that after 3 years, the US GDP has not recovered all of its real losses in this recession. In that sense, the recession is not yet over. They also prove the failures of QE1 and QE2 to lift the economy to a full recovery. Instead, index prices have retreated to pre-QE2 levels in recognition of the fact that the last leg of the last bull cycle was a liquidity event only and not a product of a real economic recovery. In this respect, I disagree with Benjamin about the Perry effect on the stock market and bond yields. Both were falling before Perry made his controversial remarks.