Tuesday, March 19, 2019

No more panic, but still lots of caution

The panic attack that ravaged markets in the fourth quarter of last year, causing a 20% loss in the S&P 500 index, has almost completely reversed. Overseas equity markets have recovered as well; credit spreads are back to normal levels, the dollar is relatively stable, and commodity prices are up. What's changed to produce such a welcome result? For one, it's become increasingly likely that Trump will secure some sort of deal with China, thus reducing the threat of a global trade war. Second, while fears that the Fed would over-tighten turbo-charged the December panic, a more dovish Fed stance announced in early January helped sow the seeds of recovery. The bond market is now priced to no more tightening for the foreseeable future, based on an emerging consensus—apparently held by both the market and the Fed—that the US economy is going to be growing at a modest pace and inflation is going to average roughly 2%. 

One important condition prevailed throughout this extraordinary panic attack: the economic and financial market fundamentals remained healthy. Fear and uncertainty are what's been holding the economy back. As a result, the economy has upside potential waiting in the wings. It still pays to be optimistic, since risk-free yields remain fairly low and the market is not priced to overly-optimistic assumptions. 

Chart #1

Chart #1 shows 2-yr swap spreads, arguably an important barometer of systemic risk and liquidity conditions, and at times a leading indicator of economic health. Today, US swap spreads are about as low as they get (which is very good), and in the Eurozone they recently have declined to levels (~36 bps) that are approaching the zone of normalcy. In the latter case that is grounds for optimism, given that spreads have been elevated for the better part of the past two years and the Eurozone economy has been struggling. Eurozone swap spreads are telling us that conditions may be about to take a turn for the better across the pond, notwithstanding the UK's inability to Brexit.

Chart #2 

Chart #2 shows 5-yr Credit Default Swap spreads for generic investment grade and high-yield corporate debt. This is a liquid and timely proxy for the bond market's confidence in the outlook for corporate profits. Spreads have shed their year-end panic and returned to relatively low and stable levels. Taken together with the low level of swap spreads, the bond market is sending a positive signal about the underlying health of the financial market and the economy.

Chart #3

Chart #3 shows two key measures of corporate profits. The blue line represents the trailing 12-month sum of reported earnings per share (adjusted for continuing operations), while the red line represents the quarterly annualized level of economy-wide corporate profits (adjusted for inventory valuation and capital consumption allowances, all derived from data reported to the IRS). The surge in profits which began a few years ago has been driven largely by the reduction in corporate tax rates.

Chart #4

Chart #4 shows the PE ratio of the S&P 500. It's plunged from 23 early last year to now just under 19. The elevated PE ratios of early last year were the market's way of discounting an expected surge of profits resulting from reduced corporate tax pressures. Earnings per share are no longer surging, and PE ratios have settled back down to levels that are only modestly above average; in short, the boost from lower tax rates is now waning, and future growth in earnings will thus be largely organic. Currently the market expects earnings to grow at a 9-10% rate over the next few years—down from the 26.5% growth of earnings registered in the 12 months ending last November.

Chart #5

Chart #5 shows the difference between the earnings yield (the inverse of the PE ratio, and equivalent to the dividend yield of the S&P 500 if corporations paid out all their earnings in the form of dividends) of the S&P 500 and the yield on 10-yr Treasuries. This is a proxy for the premium that investors demand to hold equities instead of Treasuries. Over long periods this premium is close to zero, but today it is reminiscent of what we saw in the late 1970s, when the economy was burdened by slow growth, rising inflation, and a collapsing dollar.

Yet today the fundamentals are much healthier. This can only mean  that the market has little confidence in the ability of corporate profits to grow at an outsized pace—and by inference not much confidence in the economy's future health. Put another way, a lot of capital appears to be willing to give up a significant amount of (equity) yield in order to get the safety of T-bond yields, and that implies that risk aversion (and caution) is still alive and well. That further suggests that equities are not overpriced and could in fact be attractively priced, assuming one is optimistic about future economic growth being stronger than the market currently expects.

Chart #6

Chart #6 is an update to a chart I've featured frequently. Here we see that the market's fears are dissipating and equity prices are regaining their prior levels. One more "wall of worry" is being overcome. 

Chart #7

Chart #8

As Chart #7 shows, the big news on the interest rate front is the decline in real yields. 5-yr real yields on TIPS have fallen from a high of 116 bps in November (just before the market crashed in December), to now 52 bps. As Chart #8 suggests, this tells us that the market's expectations for economic growth have fallen, since over time the level of real yields tends to track the economy's growth trend. Based on this chart, I estimate the bond market is priced to the expectation that GDP growth will be about 2.5% per year for the foreseeable future. If the market expected 3-4% growth, I would expect to see real yields on 5-yr TIPS trade substantially higher, to 2% or so.

Chart #9

Chart #9 compares the market's forecast of what the real Fed funds rate will average over the next 5 years (red line) with the current level of real Fed funds (blue line). Currently these two lines are equal—meaning the front end of the real yield curve is flat. This implies that both the market and the Fed expect inflation to remain anchored at just below 2% (as shown in the green line in Chart #7), and economic growth to remain unremarkable, probably 2.5% or so, for the foreseeable future (as shown in Chart #8). It's a forecast of steady-as-she-goes humdrum, with no need for the Fed to do anything. No surprises, just stable and unremarkable conditions on the horizon.

Now, whenever the market decides that the status quo is likely to persist indefinitely, one needs to worry, because lots of things could happen to upset the market's applecart. My money says that the most likely surprise is stronger-than-expected growth. If I'm right, then real rates will need to rise in a manner commensurate with stronger growth. The Fed would need to guide real rates higher, but not by enough to threaten future growth. The thing to worry about is inflation, but for now it appears to be well anchored. No need to fear the Fed for now.

Chart #10

The front end of the yield is flat because the market does not expect the Fed to raise or lower short-term rates. But as Chart #10 shows, the long end of the yield curve has a definite and quite normal upward slope.

Chart #11

Chart #11 compares an index of truck tonnage to the S&P 500 index. Not surprisingly, the stock market tends to follow the physical expansion and contraction of the economy, as proxied by truck tonnage. Current GDP growth expectations for the first quarter are pretty meager: 0.5 - 1.5%. This chart suggests that the stock market may be overly cautious, because truck tonnage has been rising at a 5-6% rate for the past year, and it's up some 18% since the 2016 elections.

Chart #12

Swap spreads (see Chart #1) are often good leading indicators of economic and financial market health. It's worth repeating that Eurozone swap spreads have been tightening of late, which suggests that the Eurozone economy may be ready to pull out of its long slump. That would be a welcome sign for Eurozone equities, which have fallen far behind their US counterparts, as Chart #12 shows.

Chart #13

Chart #13 compares an index of industrial metals prices (orange line) with the price of Arab Light crude oil (white line). Both have moved higher since their lows several months ago. Metals prices are up about 8%, and crude oil prices are up almost 30%. That strongly suggests that the global economy is already rebounding from its fourth quarter weakness. 

Chart #14

Chart #14 shows two measures of the dollar's inflation-adjusted, trade-weighted value. Here we see that the dollar is only about 10% above its long-term average vis a vis other currencies, and it's been around that level for the past several years. This is very different from the dollar's strength in the mid-1980s and the last 1990s; back then the Fed was actively tightening monetary policy and commodities were very weak. Those were terrible times for most emerging market economies, since they are quite dependent on commodity exports. 

Chart #15

It's not so bad these days, even though the dollar is relatively strong. As Chart #15 shows, industrial commodity prices are holding up pretty well, as are gold prices.