Tuesday, October 14, 2014

Positive fundamentals could overcome Black Swan fears

The equity market is beset by fears, (see this post for an explanation of the above chart) but several important economic variables are in favorable territory. Money is easy, systemic risk is low, and energy prices are falling. Disaster can always strike (e.g., in the form of a Black Swan), but in its absence, the positive fundamentals are likely to carry the day.

The chart above compares the real Federal funds rate (blue line) with the slope of the Treasury yield curve (red line). What it shows is that every recession in the past 50+ years has been preceded by very tight monetary policy. Monetary policy becomes very tight as the real Federal funds rate rises to 4% or more, and the slope of the yield curve becomes flat or negative (i.e., when long-term rates are equal to or lower than short-term rates). In effect, tight money starves the economy of liquidity. Today, however, liquidity is plentiful. Banks are lending-constrained only insofar as they are risk averse—they have enough excess reserves on deposit at the Fed to sustain virtually unlimited lending. Meanwhile, bank lending to small and medium-sized businesses has been growing at double-digit rates so far this year.

Swap spreads are excellent indicators of the health of financial markets and good leading indicators of economic health. Although swap spreads have risen a bit of late, they are firmly within the range of what we would expect to see during periods of "normal" economic conditions (e.g., 20-35 bps). Swap spreads are confirming that liquidity is abundant, systemic risk is low, and the economic fundamentals are healthy. Swap spreads in the Eurozone are also down to "normal" levels, even though the Eurozone economy is distinctly weaker than the U.S. economy. All of this suggests that economic activity both here and in Europe is unlikely to deteriorate and more likely to improve over time.

The chart above compares the real price of crude oil with the real Federal funds rate. What it shows is that expensive crude oil prices and tight monetary policy can squeeze the life out of a recovery (note how the gap between the red and blue lines narrows in advance of recessions). Each of the past recessions has occurred at a time when real crude oil prices rose and monetary policy tightened. One reason the current business cycle expansion has been the weakest on record could be due to the fact that energy prices have been very high. The Fed has in effect attempted to offset expensive energy prices with cheap money, but they can only do so much. Now, cheaper energy prices and easy money may have the effect of strengthening the recovery going forward. At the very least, cheaper energy should serve to limit the downside economic risks.

Within the next few weeks, gasoline prices at the pump are likely to post a 20% decline relative to where they were at the end of June, barely four months ago. That's the message of the chart above, which compares gasoline futures prices (orange line) with the nationwide average of regular gasoline (white line).

The miracle of free markets is that prices adjust to match supply and demand. What we are seeing today is energy prices adjusting downwards in response to increasing energy supplies and weaker demand. Higher options prices (as reflected in a rising VIX index) are serving to match some investors' increasing desire for safety (because owning options limits one's downsize risk) with other investors' willingness to take on more risk. When markets are free to adjust, as they are today, this acts as a shock absorber for the real economy, and that in turn helps mitigate disruptions that arise from unexpected developments.

UPDATE: Today (Oct. 15) markets are succumbing to escalating fears, with a taste of panic. Weakness in the Eurozone and concerns about Ebola seem to be the driving factors.

A longer-term chart for perspective:

Equity markets in long-term perspective:


William said...

WSJ: When it comes to producing millionaires, the U.S. still leads the pack

Between July 2013 and July 2014, the ranks of Americans with a net worth exceeding $1 million grew by 1.63 million, or more than one-third of the 3.84 million adults worldwide who saw their net worth exceed $1 million over that span, according to a new report on global wealth from Credit Suisse.

United States - 1629
United Kingdom - 478
France - 310
Germany - 243
Italy - 216
Australia - 106
Canada - 105
Japan - 91
China - 90
Spain - 89
Turkey - negative 8
Argentina - negative 9


Pretty amazing since we only ranked 12th behind CATO's Bastions of Economic Freedom.

Steve Fulton said...

Scott--any thoughts after today's numbers??

Steve Fulton

Scott Grannis said...

I didn't see anything scary in today's numbers. Retail sales took a dip, but they do that quite often; they are still up 3-4% over the past year. The PPI was a bit negative, but year over year inflation is still 1.5-2.0%. So I think we're just seeing an intensification of the fears associated with a Eurozone slowdown and the Ebola threat. Lots of emotions out there.

The plunge in oil prices is not a scary harbinger of deflation, it is a welcome breath of fresh air for most global economies. Energy is becoming more reasonably priced. It's bad for oil producers like Venezuela and Russia, where conditions are already dicey and likely to get much worse.

Steve Fulton said...

That was pretty much my thoughts. I am long a fair amount of duration in both REITs and long munis. I was thinking of moving some of that risk out of duration and into stocks (mostly boring-high dividend stocks).

Unknown said...


Given that I have a large position in the S&P 500 in both retirement and non-retirement and have a long investing horizon ..... would you sell and re-buy when things settle down or hold?

Thanks for the insights.


Scott Grannis said...

Re whether to sell or not: with a long time horizon I don't think it's wise to sell in the midst of a panic like this.

Scott Grannis said...

Re oil and deflation. The Fed is well aware that it cannot and should not attempt to control oil prices. That is why the Fed focuses on the PCE Core deflator, which is registering inflation of about 1.5%.

Also: people tend to forget that falling oil prices free up spending power that could result in higher prices for other things.

Anonymous said...

I think the fear is that consumers won't spend the money saved on lower energy prices and will save it instead.

Oh my gosh. Did you read Lockheed made a breakthrough in fusion? While that doesn't reflect directly on liquid transportation fuels, it is a harbinger of lower energy prices. Now for sure we will go into a deflationary spiral. (sarcasm alert)

Seriously, nothing could be better for the world, especially developing countries, than low cost energy from fusion. This story is the most optimistic thing I had read in a long time. It means the environmental hypocrites will have nothing to annoy us with any longer. No sarcasm.

Scott Grannis said...

Thanks for the Lockheed news. Sooner or later, it seems, we'll have fusion power, and that would indeed change the future in incalculable ways. Never underestimate man's ingenuity.

For that reason alone I remain a rational optimist.

As for consumers saving and that being a bad thing: people seem to ignore the fact that all money saved (at least the part that isn't stuffed under a mattress) must perforce be spent by the person who is the recipient of the savings.

Savings is not necessarily good or bad. What matters is how the money saved is spent: is it spent productively or not?