Thursday, October 1, 2015

Reasons to avoid panic

Markets are still very worried that the U.S. economy is going to succumb to all the nasty things going on in the world: a pronounced slowdown in the Chinese economy, the struggles of commodity-dependent economies (e.g., Brazil, Australia, Canada), the sudden reversal of fortune of the world's oil producers, and the recent heightened U.S.-Russian conflict in the Middle East. Is the world spinning out of control? Can the U.S. remain a bastion of strength in a weakened world? These are the questions that investors are struggling with as they decide whether to de-risk and seek out the safety of cash, even if that means giving up significant yield.

As the chart above suggests, fleeing corporate debt, emerging market debt, and equities implies giving up yields of 5-8% at a time when cash is yielding almost nothing.

The decision is not obvious, nor is it easy. Although it is unusual for the global economic tail to wag the huge U.S. economy dog, it's not impossible. What would be the consequences for the world if Russia effectively controls the better part of the Middle East? There's lots of uncharted water out there. Would a tiny hike in U.S. interest rates push too many fragile economies over the edge?

While pondering these uncertainties, it's important to remember that the vital signs of the U.S. economy are still reasonably healthy.

Weekly unemployment claims are within an inch of a multi-decade low. If the U.S. economy were fraying on the margin, claims would be rising, not falling.

Announced corporate layoffs have ticked up a bit in recent months, but the big rise was due to one-time troop reductions. On balance, layoff activity remains relatively muted, confirming the message of weekly claims. It's worth noting as well that only 1.87 million people in the U.S. currently are receiving jobless claims. That's a huge drop from the 2010 high of 11.65 million, and it is the lowest in almost 15 years.

This morning's ISM announcement was about as expected, but as the chart above shows, activity in the manufacturing sector has been slowing down of late. Nevertheless, the index is still well above levels that would signal an emerging recession in the overall economy.

Not surprisingly, weakness in the rest of the world has shown up in a softening of export orders to U.S. manufacturers.

As the charts above show, manufacturing activity in the Eurozone continues to expand, albeit slowly. The low level of Eurozone swap spreads reflects generally healthy financial conditions and thus points to continued growth.

Manufacturing activity may be on the soft side, but construction spending is rising at strong, double-digit growth rates. Residential construction activity is still far below the levels of a decade ago, and thus has lots of upside potential left.

Credit spreads are clearly elevated, but their message—that a weakened economy is increasing default risk—is still not yet at crisis levels. Importantly, swap spreads are quite low, which suggests that the economy still sits on strong financial bedrock. Fears are high, but systemic risks are low. Markets are very liquid, and that is a necessary if not sufficient condition for surviving the current turmoil.


Car sales have doubled in the past six years, and September sales exceeded expectations. On a 3-mo. moving average basis (to filter out the monthly noise), sales are up over 6% in the past year. As the chart above shows, sales have rarely been this strong. But that's not surprising, since sales fell so much for so long that there has to be some catch-up. The U.S. auto fleet has aged meaningfully over the past six years, and it will most likely take several years of above-average growth to get back to what we previously considered "normal." So there's every reason to expect sales to continue to increase for at least the next year or so.


marcusbalbus said...

the charts, the charts, the charts. then BAM! go long my friends.

Thinking Hard said...

Scott - Kind of off topic, but I have been reading into ON RRPs a little more. What implications do you see in short term private financing if there is a full allotment ON RRP facility? Do you see any problems with short term private financing in international markets with a full allotment ON RRP facility?

Interested in views about the Fed lifting the cap on ON RRPs. Also interested in views about potential consequences in international short term financing risk with an increased ON RRP rate during times of stress.

J.S. said...

Scott, I like your HY and 2 year swap spreads chart but I believe the commentary is not accurate. The HY debt market has become pretty illiquid. Bonds are trading down points at a time just to find clearing levels. And I'm not talking about HY Energy. I think this is definitely something to keep an eye on.

Scott Grannis said...

J.S.: I think you have misconstrued my commentary. I'm not saying anything about the liquidity of the HY debt market, only that spreads are up and default fears and risks have risen. My comments on liquidity refer only to swap spreads; I interpret very low swap spreads to be an indicator of several things, one being that the swap market is very liquid. Much more liquid than the HY market.

J.S. said...

Ah got it. Thank you for the clarification. I enjoy your blog - keep up the good work!

Benjamin Cole said...

Seems like there is a lack of aggregate demand, globally. At the same time interest rates and inflation are trending toward zero, as they have for the last 30 years.

I contend central banks have misconstrued present-day low interest rates and inflation to be "easy money."

Yes, central banks of been so accommodative in recent decades that we have reached zero lower bound permanently with zero inflation in Europe and Japan.

Dudes, the "easy money" story just does not hold water. I do not believe you get to zero inflation and zero interest rates by decades of easy money. This "easy money story" is some sort of partisan acid test not grounded in macroeconomic observations. On the left, we see the "rape on college campus" story. These two stories are twins.

The Bank of Japan is currently spending about $50 billion a month to buy bonds in an economy about half the size of the US, and they still do not have much inflation and their unemployment rate is 3%.

I think the Fed should go back to aggressive quantitative easing.

BTW, the artifically high exchange rate for the US dollar is hurting US manufacturing.

Unknown said...

Hi Scott

What is your take on this comment about the falling unemployment rate in the US from ?

"The real reason that recorded unemployment is falling in the USA is not that jobs are rising—though there has been job creation of course—but that the percentage of the population that is recorded as being in the workforce has plunged. The so-called participation rate is now below the average since the end of WWII, and back to levels that applied when female participation in the workforce was far lower than it is today."

steve said...

the trend in "junk" bonds is worrisome. now trading below the lows of last december and clearly indicating a concern of default rate elevation (weak economy). given that the fed is considering raising rates (strong economy), the 10 year is trading on the threshold of 2% (weak economy), something has to give...
given feds track record of being WRONG consistently, I defer to the markets and am holding HY munis and cash awaiting a better opportunity to get back into HY corps.

Hans said...

Today's employment numbers continue the downward trend.

The good news, however, Antarctic is still growing at double digit.

Scott Grannis said...

Unknown, re: unemployment. That comment (i.e., the unemployment rate has fallen in large part due to the decline in the labor force participation rate) is basically correct. There are up to 10 million people who have "dropped out" of the labor force, for a variety of reasons. Several are overlooked too easily: the relatively high marginal tax rates facing many upper income workers, the onerous regulatory burdens that many face when creating a small business, and the ongoing increase in transfer payments, which create perverse incentives to not work. All conspire to reduce people's desire or willingness to work on the margin.

Johnny Bee Dawg said...

Just to correct the record, Jobs numbers were UP from prior month in Sept, not down. (142k vs 136k)
Sept numbers have a history of sucking, as Scott pointed out.

I have to hand it to marcusballbust who gave us the best advice of the week, when he said "Go long, my friends!"
Dow is up this morning nearly 1300 points from its August low. Half of that gain came in just the past week.


This blog has been spot-on the entire way, so far, by pointing out overblown fear indicators, combined with tranquil systemic risk indicators.
Facts and data, rather than agenda.

3rd quarter had a whopping 6.4% decline in the S&P500.
America has survived the shock...SO FAR.

Percent of stocks trading above their 50 day moving average has made a higher low and started rising during Friday's 400 point reversal up. It's screaming higher today. That percent had gotten down to levels where stocks have bottomed in the past (below 8%), in August.

Johnny Bee Dawg said...

VIX has been dipping below 20 for a couple of days.

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