Thursday, January 8, 2015

One more wall of worry that we'll likely overcome

The stock market has faced three "walls of worry" in as many months. The first worry was centered around the Ebola crisis, and the second and third were "fueled" by collapsing oil prices. All three involved fears that something big and uncontrollable was going on that threatened global growth. To this day, there is still a lively debate over whether or not the collapse in oil prices will be good for growth or bad for growth. It's good, I and others have argued, because it lowers the cost of engaging in many kinds of economic activity, and that is equivalent to a dose of productivity enhancement that will benefit nearly everyone. It's bad, others argue, because sharply lower oil prices will bankrupt many producers and will cause activity in the mining sector (the strongest economic sector in recent years) to implode (Texas has produced the lion's share of new jobs during this recovery), and all of this will overwhelm any positive effects from lower oil prices.

Reasonable people can disagree on this issue, but in the meantime, let's check out what Mr. Market is saying about the fundamentals of the U.S. economy. Are things deteriorating or not?

We know the energy sector has been hit hard: energy stocks are down over 25% relative to the S&P 500 since oil prices started falling last June. But so far, that hasn't translated into any meaningful increase in announced corporate layoffs, shown in the chart above. To the judge from this chart alone, the economy is still on sound footing.

Even the more timely indicators of layoffs (shown in the charts above) continue to show that underlying conditions in the jobs market are healthy. Weekly claims for unemployment are very close to the lowest level we have ever seen relative to the size of the labor force. Only 2.52 million people today are receiving unemployment insurance, down 44% from a year ago. On a seasonally adjusted basis, this number hasn't been so low since 2006.

Swap spreads continue to be one of my most favorite and cherished indicators. Swap spreads are liquid, market-driven indicators of economic and financial market health. (Lower spreads are better.)  As the chart above shows, swap spreads both in the U.S. and the Eurozone are down to levels that are fully consistent with "normal" economic conditions. Furthermore, swap spreads have shown no sign at all of increasing in recent months, despite the end of QE3, despite the sufferings of the energy industry, despite the lack of another QE effort on the part of the ECB, despite the weakness of the Eurozone, Japanese and Chinese economies, and despite the political turmoil that is once again roiling Greece. Swap spreads today are saying that there is no unusual degree of systemic risk in either the U.S. or the Eurozone economies. The difficulties experienced by issuers of energy-related debt are having zero impact on the larger economy.

But what about the synchronized decline in 10-yr sovereign yields? Isn't this a sign that the world's major economies are sinking into Japanese-style deflationary quicksand?

Not necessarily. As the chart above shows, the decline in nominal yields is all about declining inflation expectations, which, in turn, are directly related to collapsing oil prices. Real yields on 5-yr TIPS have increased significantly in the past six months, driving a significant decline in inflation expectations.

Real yields on 5-yr TIPS do indeed tend to track with underlying growth fundamentals. I would note, however, that real yields are still quite low, which I think reflects some enduring pessimism regarding the economy's growth prospects. But on the margin, real yields have increased meaningfully, reflecting an improving growth outlook. The world should be paying more attention to real yields these days than to nominal yields.

The chart above compares the prices of TIPS (using the inverse of their yield as a proxy for their price) and the price of gold. Both have been highly correlated for the past seven years. Since both are unique types of risk-free assets, I think their declining prices reflects the market's declining risk aversion. Underlying conditions are improving, and that is reflected in less investor demand for gold and TIPS. Lower oil prices are contributing to improving confidence in the future, and that shows up in lower gold and TIPS prices.

About all we can say from looking at equity prices in the U.S. and the Eurozone is that the outlook for the U.S. is much healthier than the outlook for the Eurozone. This has been the case for the past several years, as U.S. equities have been consistently outperforming their Eurozone counterparts, likely due to the prospects of improving fiscal policy in the U.S. The collapse in oil prices has not changed this dynamic.

All of the above indicators are market-based, and they are all signaling at the very least that the economic fundamentals have not deteriorated, and most likely have been improving of late. Consequently, I wouldn't be surprised to see the equity market overcome the latest wall of worry and continue higher.

A final note: when thinking about the future, there arguably is nothing more optimistic than the fact that the U.S. economy has experienced its weakest recovery ever. The gap between the current size of the economy and its potential size (assuming that past trends are reasonable guides to the future) is huge—perhaps 10% or more. If the U.S. can get its act together in coming years (e.g., by lowering tax rates, simplifying the tax code, and reducing regulatory burdens), the upside potential is difficult to overestimate. This alone argues strongly in favor of optimism.


Unknown said...
This comment has been removed by the author. said...

Scott, great capsule summary of why it is good news week.

Couple of quick questions, 1) why is it you look at the vix divided by the 10 year? What is that supposed to tell us? As opposed to just the vix by itself or the ten year by itself?

2) Will you ring a bell at some time in the future when (in your opinion) it is time to be out of stocks, and buy the long treasury? Or, at least dial back on equities and look at the long bond. (Taking WEB's statement some years ago that money will be made in stocks and not in government debt. But there is a time to be out of stocks and into bonds.)

Thank you.

Benjamin Cole said...

Excellent wrap up. The outlook may be brighter for Europe if the ECB embraces QE, which they are pondering. Japan is pursuing QE, so we can hope they will break their 20-year deflationary-recessionary doldrums.
US equities are fully priced and corporate profits at all-time record highs by any metric, and tower above 1950-2000 levels. If regs and taxes are holding back America, you can't tell it by corporate profits. I still wonder why profits have exploded, and if they are the new normal or not.
Budget-cutters: there are now about two times as many people receiving VA service-connected "disability" payments as collecting unemployment checks. The number of people on unemployment has been radically reduced in the last five years, but VA disability rolls have been rising steadily.
SSDI has similar problem, though that is funded by FICA taxes. The VA is funded by income taxes.

Anonymous said...

Excellent read and charts Scott. Thanks as always.

William said...

@ Benjamin

Look at Scott's chart of 10 Year Sovereign Debt! See how Germany yield have dramatically fallen? The effects of QE have already been accomplished.

How much would a European QE do to improve the Euroland economy? The yield on the German 5 year treasury is only 0.01%. With three massive efforts at QE in the USA our 5 years were never that low. What are you expecting: negative yield in Europe?

Benjamin Cole said...

William:Google Milton Friedman and Hoover Institution and Japan and you will find a excellent piece written by Friedman in the 1990s prescribing QE for Japan.
QE does not work by lowering interest rates, it works by forcing bondholders to do something with their money, such as investing or consuming.
the roll call of the economists who have endorsed QE in Japan includes John Taylor, Alan Meltzer, Frederic Mishkin and Ben Bernanke, in addition to Friedman.
There is nothing about QE that prevents lower tax rates or less regulations, by the way I like those, too.
The total elimination of the USDA, the Commerce Department, and the Labor Department, might be a good start.

steve said...

scott, while I do not always agree with your analysis, you are overwhelmingly the most perspicacious blogger of economics out there. always thought provoking and provocative.
clearly, stocks and bonds disagree and it will be interesting to see which is correct.

William said...

@ Benjamin

Was Japan's 5 year treasury yield at 0.01% when Milton Friedman, John Taylor, Alan Meltzer, Frederic Mishkin and Ben Bernanke endorced QE?

With German 5 year treasuries at such a minuscule rate, what more do bond investors need to incentivize them to consume or invest?? It would seem that rates were sufficiently low in recent months to have already accomplished that.

The only possible value of a European QE would be to manipulate the European stock markets by purchasing equities - which Japan has recently done.

No, the history of extremely low interest rates in Japan and recently in Europe is proof positive that high interest rates are NOT their problems. The problems in both economic zones are demographic and structural which central banks can't cure.

Japan is in recession AGAIN in spite of massive QE. And contrary to popular opinion - despite a significant fall in their currency - Japanese exports are DOWN!! The two edged sword of a low currency has come back to bite manufacturers because of a sharp rise in the costs of imported raw material.

QE has a lot of consequences.

Scott Grannis said... Using the Vix alone would produce the same visual effect, since the changes in the Vix usually dominate changes in the 10-yr yield. I include the 10-yr yield only because I think that adds some degree of growth expectations to the mix. (A lower 10-yr yield tends to reflect decreased growth expectations, and vice versa.)

If there comes a time when it appears like exiting stocks in favor of cash or bonds makes sense, I hope I am wise enough to make the call. But there are no guarantees.

Meanwhile the very low level of cash and bond yields mean—to me—that shunning equities almost demands that one believes strongly in a coming recession.

Benjamin Cole said...


Here is the link:

Yes, interest rates were dead then (1998) too. That's why Friedman gave direct and clear support for QE.

Friedman writes with such beautiful clarity and sense. I have never found a situation where Friedman was wrong.

Friedman wrote this piece under the Hoover institution imprimatur at Stanford University. If you get more conservative that that you have to wear jodhpurs and funny little mustache.

It is a sign of the depraved PC-ism of our times that today is considered necessary for "conservatives" to howl about inflation and the need for tight money.

Interestingly, this is a recent fixation or political badge of honor; the Nixonians and Reaganauts wanted looser money.

We see the effects of tight money in Europe. We saw the effects in Japan.

For me, it is just a practical matter. Tight moony does not work; rates of inflation below 2% are not prudent.

I like prosperity and robust growth, maybe you have the a little inflation to get there. So what?

William said...


Thanks for the link; I read it. Friedman makes it sound automatic and simple. Unfortunately, for many reasons the present is not like the economic conditions of the mid 1980s and QE doesn't work well any longer. The US is a prime example: the predicted increase in money supply, growth and inflation didn't happen in spite of the FED's trillions of dollars of purchases. This past year Japan hasn't responded well to massive QE either.

I predict that the Eurozone won't either.

Benjamin Cole said...

William- the Fed QE program was too small, feeble and dithering. $4 trillion sounds like a lot, but not compared the the size of the economy or the total bond market. Some Friedmanite economists also say that the Fed must commit to making the QE balance sheet permanent, for better effect.
But thanks for reading the Hoover piece. It is one of my favorite economic offerings.