Friday, May 18, 2012

Eurozone update

It's time to look once again at the key indicators of risk in the Eurozone, especially since Eurozone fears are at the epicenter of the fears roiling world markets these days.

First, however, let's check in on the status of fears in the U.S. As the above chart shows, bond yields have fallen back to the levels they hit in late September, when the Eurozone crisis was heating up and there was lots of talk about an imminent U.S. recession. (10-yr Treasury yields hit a new all-time low of 1.7% yesterday.) I interpret this to be the result of a scramble by investors around the world to get into the safest asset that still has a measurable yield, and that sort of demand can only be driven by deep-seated fears of an extended global recession likely triggered by a Eurozone financial implosion. But: although the S&P 500 has taken a hit, it is still almost 20% above its Oct. 3rd low. Why haven't stocks tracked bonds? That's easy: earnings have continued to surprise on the upside, and the U.S. economy has shown no sign of the expected double-dip recession. Equity investors here are rattled, but they aren't nearly as fearful as global bond investors; equities have gotten a lot cheaper relative to Treasuries. Treasuries have never been more expensive. Never. I should also note that the Euro Stoxx index is now very close to its recession-era lows. Add this all up and it says that the biggest economic risks are still relatively isolated, and they can be found mainly in the Eurozone.

According to swap spreads, systemic risk in the U.S. is up a bit, but not nearly as much as in the Eurozone. There is fear of Eurozone contagion, but it's not intense by any means. Interestingly, Eurozone swap spreads are lower today than they were at the peak of the last Eurozone crisis late last year. So swap spreads are saying things are not critical at all in the U.S., and not yet catastrophic in the Eurozone. Yet 10-yr bond yields reflect an extreme degree of concern. The world's demand for Treasuries is exceptionally strong, and seems out of line with other indicators of risk.

The charts above compare 2-yr yields in various Eurozone countries. Both charts make it clear that near-term default risk in the Eurozone has declined dramatically from what it was at the end of last year. Note how the outlook for France has barely budged; the recent elections were not a surprise and the market feels moderately comfortable with near-term prospects there.

On a longer-term horizon, this chart of 5-yr CDS spreads shows that default risk in most Eurozone countries is elevated, but nevertheless equal to or lower than the default risk of the average high-yield corporate bond issuer in the U.S. (high-yield CDS spreads currently average about 700 bps). That's bad considering we're talking about the sovereign debt of developed countries, but from a global perspective it's not exactly the end of the world. Markets can live very comfortably with high-yield debt risk.

This chart helps sum things up. Europe is really struggling, but the U.S. equity market has suffered what appears to be just a correction. So far there are no signs that the U.S. economy has been dealt anything more than a glancing blow by all the turmoil in Europe. And despite all the hand-wringing and the flight to Treasuries and the Eurozone bank runs, key indicators of risk are saying that the fundamentals are not catastrophically bad by any means. I think there's a good chance the world will survive the Eurozone crisis.


Squire said...

For the last half hour of trading it was an epic battle for Facebook at $38.00. Sellers pushed the shares to $38.01. Everytime the price when to $38.00 the bid shares went to well over a hundred thousand. At $38.10 there were very few shares bid. The underwriters were simply not going to allow the price to go below $38.00.

I live near Facebook’s campus. They had media & police helicopters hovering over the campus this morning. Media vans with dishes on top were all over and hundreds of reporters and cameramen and others wandered around. It was beautiful weather so why not. One Facebook employee I know has been working with almost no sleep since Wednesday in anticipation of today. You should see the nice car she is going to buy. There is so much money going to be pumped into the local economy soon. Into stocks? I doubt it.

It is going to be a party all weekend long mid-peninsula.

randy said...

I like to think my 15 yr old son is pretty savvy. He thinks Facebook is only for girls sharing pictures. That view is supported by the fact that Facebook just bought Instagram to take out a possible disruptor. He thinks Twitter and Stumble Upon are much more in vogue. My daughter likes Pinterest. My conclusion is that Facebook's primary user base is fickle as hell and they risk becoming irrelevant. As for ad revenue - the only stories I know (in press and personal knowledge) are of businesses that want it to pay off but haven't yet - see GM. Their huge user base presents lots of opportunities, but jeez... it'd be nice if they actually produced something.

McKibbinUSA said...

I must reserve any optimism until after California settles -- hopefully, Gov Brown will take action to balance the California budget rather than go to the voters to ask for a tax increase -- however, I doubt that he will collapse -- said another way, Gov Brown appears prepared, if not eager, to lead California into insolvency and perhaps court mandated tax increases -- either way, California is about to experience either drastic cuts in spending, or drastic increases in taxes -- I need to understand what will happen in California before I take any chances on optimism -- the only good news is a sudden collapse of California will only make equities cheaper than ever -- I intend to buy cheap equities through the crisis -- bargains are everywhere right now (and by bargains, I am not talking about Facebook)...

Squire said...

Faceflop or fadebook. I am not young. My first job out of college was as a broker. I quit in shame and disgust. Nothing has changed. The hype was so the owners could cash in at a higher price. California loves this because there will be a large capital gains tax in the billions. I arrived in California several years before the then governor Jerry Brown got the public employees to unionize. The current governor Jerry Brown is the same guy and he was going to take on the unions. Just like Arnold was going to. Californians believe, like Europeans, in a privileged government class. Most new revenue goes to union pension plans to make up for under funding. If Californians are delusional, the truth will prevail someday. We will see.

By the way, my daughter who is exhibiting some good traits as a trader picked up some FB shares at just over the IPO price of $38 by being patient and waiting for the first wave of selling. This was her goal and she pulled it off while others paid up to $45 after the shares opened at $42. She may soon have a different kind lesson coming her way.

Hal Tearse said...

And what in the heck does facebook, at 127 times earnings, have to do with what Scott is talking about?
California and Greece have much in common. The end of the socialist nations and states is coming soon.

William said...

If you have had enough with Pessimism and would a more positive take on the US and Europe, you might want to read .

It is an offering my Ken Fisher's Fisher Investments which manages $37 Billion.

burmanhands said...

A few questions.
Is the bond purchasing not a form of internal QE - not as you would imply money coming from Europe.
Who do you believe should provide jobs when the private sector can no longer do it - who other than government is the source of job creation when confidence has failed. Wealth is only ever generated by increased efficiencies in technology and always squandered by inept government and financial institutions - both in USA and Europe.
I live in Ireland - its bankrupt.
Have you ever known unemployment yourself - not because you didn't work hard but because your industry stopped functioning. I don't know the economic jargon and I am not fooled by well manicured statistics - I see a broken system. Hurting broken people is not working.
Massive government projects as in the great depression will work - maybe not ideal but better than structural social unrest and misery.

Family Man said...


Big houses consider the worst case scenario i.e. bank run in Europe which could lead to sudden stop in EM economies (take a look on Kospi index, authorities there consider intervention to stabilize the market)), so naturally the whole investment community loads ust/bunds. The problem is while it occurs valuation metrics does not work, what works is CB action.

BTW, what is your take on ficsal cliff story.

Hans said...

Did Ken Fisher marry Abby Cohen?

Scott Grannis said...

Re "the fiscal cliff." I'm not too worried about this. If spending gets cut that is a good thing, not a bad thing. If taxes increase that is bad, but I just don't see a majority of Congress in favor of allowing that to happen given the economy's relative weakness.