Thursday, August 7, 2014

Calm before the storm?

As we bask in the lovely Maui calm before tomorrow's Iselle storm, it's tempting to draw a similar analogy to the markets. Weekly claims for unemployment are about as low as they get, and such levels have traditionally been followed by the onset of a recession; swap spreads—the most reliable forward-looking indicator of economic and financial market health—have risen 10 bps in the past month from extremely low levels; high-yield spreads—a good coincident and sometimes leading indicator of economic stress—have jumped 80 bps since their post-recession lows of late June; stocks are down almost 5% from their all-time high; and the Vix has surged from a low10.3 to almost 17. Is there a recession lurking in the wings, much as hurricane Iselle, still hundreds of miles from where we are, is bearing down on Maui? Hurricane hysteria has probably peaked, but maybe the world hasn't fully appreciated the signs of deterioration in the past two months.

Let's look at all these facts from a big-picture perspective. I think you'll see that while nothing rules out an economic deterioration of sorts, there is no sign yet of the deterioration that we would need to see in advance of another recession. If there's to be a trigger for another recession, it could be that John Bolton is right when he says that "the world has descended into chaos." What's affecting the market today is not any meaningful deterioration of the U.S. economic fundamentals, but a deterioration in the geopolitical fundamentals affecting the world. So far, the underlying fundamentals of the U.S. economy remain healthy.

Unemployment claims don't get much lower than they are today. But each time they've descended to this level, another recession has been just around the corner. However, it's important to keep in mind that claims don't trigger recessions; bad fiscal and/or monetary policy does. Claims are what result from the improvement or deterioration of the economy. So far, the U.S. economy continues to improve.

One way of thinking of swap spreads is that they are a proxy for the price that you have to pay to offload some of your risk onto someone else. They rise when big investors start getting anxious and everyone begins to feel uncomfortable with the level of risk they are carrying and uncomfortable with taking on counterparty risk. What we see in the above chart is that 2-yr swap spreads are still pretty low. In fact, for the past year or so they have been exceptionally low, and they are now back to levels (20-25 bps) that in the past have coincided with healthy, normal economic conditions.

Above you see the long-term graph of swap spreads. From an historical perspective they don't indicate anything unusual going on.

The recent rise in corporate credit spreads, shown in the graph above, hardly registers on a long-term time scale. 

The Eurozone is nearer the epicenter of the current geopolitical crisis, so equities there have suffered more than in the U.S. The Euro Stoxx index fallen about 7-8% relative to the S&P 500 in the past two months. Europe has problems that we don't have; our economy is far less vulnerable to a deterioration of trade with Russia. If Europe deteriorates further, that will add to the considerable headwinds the U.S. economy is already facing, but it won't necessarily be a killer for the U.S.

Implied volatility, a proxy for the market's level of fear, uncertainty and doubt, is still very low from an historical perspective, as you see in the graph above. So far, the current "crisis" looks like a 2.5 tremor on the Richter Scale.

None of these charts looks very scary. Which is another way of saying that if you are scared of what might happen, then it's not going to cost you a lot to bail out of risk positions. Bear in mind, however, that bailing out means sitting in cash that pays you almost nothing, while risk assets continue to deliver much higher yields.

Update: The Obama Administration's ongoing efforts to stop corporate "inversions" arguably represent a more serious threat to the economy than the Russia/Ukraine crisis. Obamacare was arguably the most stupid thing the Obama administration has done to date. Trying to stop corporate inversions might be the second most stupid thing. Not only are they showing themselves to be very anti-business, they are displaying supreme ignorance of how business and taxation interact. Instead of trying to stop inversions they should simply fix the tax code. But no, they want to force things to work their way, giving top priority to government's claim on profits. This will keep the economy weaker than it otherwise could have been for the next few years, because capital doesn't like to stay where it is not welcome.

5 comments: said...

Like WEB said, political events in far-off places have little real effect on the value of a farm in Nebraska.

Similarly, if the stock selloff IS do to political events, then the lower prices represent opportunity for investors.

Be greedy when others are fearful.

Benjamin Cole said...

Very interesting post. Bolton is an extremist-alarmist; huge chunks of the world, such as China and India, are moving to market-ish economies. Good.
It might be a poor juncture to raise taxes and regs (Obamacare) or cut QE (the Fed). Or get into fantastically expensive wars (Bolton).
If the federal government put economic growth first for 10 years...egads, imagine the prosperity.

Anonymous said...

Bolton is not talking about economics. He is talking about the vast pain and suffering, death and destruction that is happening.

ronrasch said...

Markets have been in a long rally.
A correction would be healthy. Thank you for the heads up.

William said...

Jim Paulsen of WellsCap

"... investors may be better served by focusing more on the Fed’s boss — the economy — for clues as to when
short-term yields will begin rising...Currently, all four major Fed economic bosses are indicating a Fed tightening may be much closer at hand than most now

1) The yield curve is within 25 to 50 basis points of
being steep enough to intensify pressure for Fed tightening.

2) The U.S. resource markets (unemployment and capacity utilization) have just reached a level which has prompted
imminent tightening six out of six times in the last 50 years!

3) Nonsupervisory wage inflation has been accelerating for the
last 20 months and based on history the Fed is already far
behind the wage curve.

4) loan growth has spurted to its quickest growth rate of the recovery and the pace of loan growth now suggests a rate hike is nearing.

Our best guess for the first hike in the funds rate is in the first
quarter of next year. And we would
not be surprised if the financial markets are shocked by a much
quicker time table than almost anyone currently anticipates.