Tuesday, February 21, 2012

Charting the recovery

I've put together a fairly random selection of charts that I think provide some valuable insight into the nature of the economic and financial market recovery that began about 32 months ago. Two major themes stand out: 1) although the economy is still quite weak, there is noticeable improvement on the margin in a number of key areas, and 2) markets are still priced to very pessimistic assumptions about the future. Although there are many things to worry about (e.g., huge federal budget deficits, excessive monetary accommodation, sovereign debt defaults), the market is fully aware of the problems and only reluctantly accepting the fact that things are improving on the margin. 

The economic recovery has been very modest—quite weak in fact. I estimate the economy is operating about 13% below its potential, which is why there are 6 million fewer jobs today than there were at the peak of the previous business cycle. The economy is still struggling to grow, most likely because the Fed and the Congress have been trying so hard to "stimulate" it. Yet despite the economy's dismal state, there are numerous indicators that show substantial improvement on the margin. Things could be a lot better, to be sure, but things are nevertheless getting better.

Bank lending to small and medium-sized businesses continues to expand, and at an accelerating pace: C&I Loans are up at a 13.4% annualized pace over the past 3 months, and up 12.1% over the past year. This reflects increased confidence on the part of businesses and banks, and is an excellent sign that underlying financial and economic fundamentals are improving.

The ongoing improvement in the stock market tracks the ongoing improvement in the health of the labor market, in the form of declining claims for unemployment. This rally is based on improving fundamentals, not excessive optimism.

Rising equity prices are being driven in large part by declining fear. The Vix index is still somewhat elevated from an historical perspective (12-15 would be considered "normal"). 10-yr Treasury yields are still very low, and the ratio of the two is a good measure of the degree to which panic and pessimistic views of the future are driving market sentiment. Bottom line, the market is still fearful of the risk of Eurozone defaults, central bank accommodation, and very pessimistic regarding the ability of the U.S. economy to grow, because 10-yr yields are still trading a depression-era levels.

The market is still trading at PE ratios that are below the long-term average, yet corporate profits are at all-time highs, both nominally and in terms of GDP. This is a good sign that the market is still priced to pessimistic assumptions (e.g., profits are expected to decline significantly).

The banking industry is still in miserable shape, but technology and even consumer staples have staged impressive recoveries. Technology is leading the way, and that is good because that's a significant source of improved productivity for workers all over the world, and that, in turn, augurs very well for future economic growth.

Swap spreads in the U.S. are back down to levels that reflect little if any unusual systemic risk in the financial system. Eurozone swap spreads are still quite elevated, however, but do show some recent improvement. The Greek "bailout" announced today does little to improve confidence in Greece's ability to service its debt (a default is still highly likely), but the Eurozone financial system has pulled back from the brink of the abyss thanks to the ECB's efforts to expand liquidity, since this has bought time for the market to digest the huge losses that are priced into Greek debt (trading today at 20 cents on the dollar) and for risk-takers to take on more of the risk of future Eurozone defaults. Given time and and liquidity, free markets can solve almost any problem.


Benjamin Cole said...

What a superb wrap-up by our fearless leader, Scot Grannis.

Not sure about the p/e chart. With unknown land mines out there (AIG, Long-Term Capital Management, Spain, Iran), a lower p/e might be the new norm, even with low interest rates (which are likely to stay "low" for a long time. Low is the new normal, see Japan).

That said, we are in place for a sustained, secular bull market in property and equities, if the Fed, ECB and Bank of Japan move to growth policies, and they may be.

Even the Bank of Japan, which has brought about deflation in Japan for 20 years (a disaster) now says they will target 1 percent inflation.

We could see boom times ahead.

Inflation will help pay down national debt. As the rich pay income taxes to pay down the debt, deleveraging through inflation will help the wealthy. This will free up more investment capital.

McKibbinUSA said...

Another good sign for equities is that US unit labor costs have declined by more than 90% since 1970, and has been trending sharply downwards since 2001 -- more at:


The cost of labor as a percentage of production is at its lowest point since at least 1947.

Public Library said...

Read a good article a few weeks ago about 'economic potential'. The short of it is; in order to get back to 'potential' we would need double, maybe triple-up on the kind of policies (fiscal/monetary) that produced these results in the first place.

The takeaway is this is highly unlikely or desireable so the concept of 'potential' is probably misguided.

Scott Grannis said...

Public: I would argue just the opposite: we need one-half or less of the "stimulus" that we have had to date in order to see a robust recovery. I think the economy has improved in spite of fiscal and monetary stimulus, not because of it.

sgt.red.blue.red said...

It would be interesting to see a chart showing corporate profits as a percent of normalized GDP.

Two things going on here: 1) profits are increasingly being generated by U.S. companies outside the U.S. and 2) subpar domestic G.D.P. growth since late 2006.

Bill said...

Gallup is estimating that unemployment will rise to 9% for February. I really do wonder if it's true that many are dropping out of the labor force by claiming disability for "mental issues" so that the "improvement" in employment is really a mirage. I just don't see much evidence of recovery based on the small number of new corporate transactions in our legal practice.

Public Library said...

Scott I agree but this pertains more to the last 30 years, not just the past 3 years.

Your chart starts about when Nixon cut the gold standard and the global market started going debt happy.

The entire global infrastructure is built on the assumption that debts do not matter. We are finally running into the wall head-on.

marcusbalbus said...

one good thing about any recovery is it will leave scott with nothing to say

Hans said...

I am glad that our fearless leader has denoted a weak recovery...

Jim said...

Corporate profits as percentage of GDP seems like a trailing indicator. Is this what others have been using as to the health of corporations?