Updated key market-based indicators

I'm a big fan of market-based indicators—the kind that are determined by the daily decisions of hundreds of millions of savers, investors, and money managers all over the world. Traditional economic indicators (e.g., payroll employment, GDP, CPI) come out with a lag, are subject to revisions, and are based on assumptions that do not necessarily reflect the reality on the ground. Opinion polls are helpful, but they are only an approximation of reality using relatively small samples, and they are subject to bias on the part of the questioner and psychology on the part of the responder. Market-based indicators can be viewed in real-time and they dynamically reflect how "the market" interprets all the information currently available. Markets are where people put their money on the line.

So here is a collection of a dozen or so up-to-date charts that show the status of the market-based indicators that I believe merit ongoing scrutiny. My overall interpretation of these indicators is that the economic and financial fundamentals look sound, and although risk asset prices are high from an historical perspective, they are not high in relation to other variables, and they are undergirded by a healthy degree of skepticism and caution. In short, if the threats of the Kung Flu and Bernie Sanders fade, there is still substantial room on the upside for equities.

Chart #1

Chart #1 compares the level of the real (ex-post) Fed funds rate (blue) with the slope of the Treasury yield curve from 1 to 10 years. Note that every recession on this chart has been preceded by a substantial rise in the real funds rate (and a substantial increase therefore in real borrowing costs) and a flat or negatively-sloped yield curve. Today those conditions are nowhere to be found. Real borrowing costs are historically low, and the yield curve is not inverted. (As other charts below will show, substantial portions of the yield curve are still positively sloped.) This means that the Federal Reserve's monetary policy poses no threat to the economy. It would be fair to say that the Fed's current monetary policy stance is broadly neutral.

Chart #2

Chart #2 compares the real yield on 5-yr TIPS (blue) with the nominal yield on 5-yr Treasuries (red). The difference between the two (green) is the market's expectation for what the CPI will average over the next 5 years. At 1.6%, the market expects inflation will be below the Fed's upper target (2% on the PCE deflator, which would correspond to abut 2.4% on the CPI). While this might be disconcerting to those who believe that a 2% inflation rate is optimal, I would argue that 2% is unnecessarily high; I would always prefer inflation to be as close to zero and as stable as possible. Regardless, there is no indication in market-based signals that the market is worried about the Fed being too easy, and that is the one thing I would really worry about, since that would pose the specter of a tighter Fed to come and a likely recession to follow.

Chart #3

Chart #3 compares the real yield on 5-yr TIPS (red) to the real (ex-post) yield on the overnight Fed funds rate (blue). The former is essentially the market's expectation for what the latter will average over the next 5 years. As such, today the market is not expecting the Fed to do anything that might jeopardize the economic outlook. Indeed, the market currently expects the Fed to lower rates at least once in the next year or so, and then to keep rates flat. From several perspectives it is clear that the Fed does not pose a risk to markets or the economy. Thank goodness!

Chart #4

2-yr swap spreads are very significant coincident and leading indicators of financial market and economic health. In normal circumstances they would trade in a range of 5-35 basis points. At current levels, swap spreads tell us that liquidity both here and in the Eurozone is abundant—central bank monetary policy is non-threatening, to say the least. This further suggests that the outlook for the global economy is healthy, and systemic risks are low.

Chart #5

Chart #5 shows 5-yr Credit Default Swap spreads for generic investment grade (blue) and high yield corporate bonds (red). This is a highly liquid market, and an excellent proxy for the market's confidence in the outlook for corporate profits. Current levels are relatively low, and this implies that the market is not concerned that profits will disappoint. That, in turn, would imply a favorable economic climate in the years to come.

Chart #6

Chart #6 shows two measures of actual corporate credit spreads. As with Chart #5, it is clear that the market is relatively confident regarding the future health of corporate profits.

Chart #7

In contrast to the preceding charts, which paint a picture of optimism regarding the future, Chart #7 reflects a lot of concern regarding the future. Since inflation is expected to be at least as high as current 10-yr Treasury yields (which are within inches of all-time lows), the market is pricing inflation-adjusted, risk-free returns to be somewhere in the neighborhood of zero. The only way this makes sense is to first recognize that Treasury bonds are the world's top choice for a hedge against future risk. The market is generally optimistic about the future, but at the same time there is intense demand for an asset that can hedge against the possibility of that optimism proving wrong. Sovereign yields throughout the developing world are all trading at very low levels, consistent with a view that says there is a lot of caution priced into the markets. Risk assets are pricey, but not many are willing to bet the ranch that the future is guaranteed to be rosy. What this says is not necessarily crazy: the market is optimistic, but unwilling to throw caution to the wind. That's healthy.

The time to worry, of course, is when everyone expects the future to be rosy and no one is concerned enough to hedge their risks. That was the case, by the way, in late 1999 and early 2000, when PE ratios were on the moon and real yields were trading in a range of 3-5%. 

Chart #8

Chart #8 looks at the slope of the Treasury curve from 2 to 10 years. Here we see that the curve has only a modest upward slope, but nevertheless one that is consistent with conditions in the mid- to late-90s, when the economy was growing at a healthy pace. As Chart #1 reminds us, a flat yield curve is not something to worry about unless real yields are also relatively high.

Chart #9

Chart #9 looks out further along the yield curve, from 10 to 30 years. Here we see that the curve has a very normal upward slope. Nothing alarming here at all.

Chart #10

Chart #10 shows the 6-month annualized rate of growth of bank savings deposits, which comprise almost two-thirds of the M2 money supply. Since these deposits pay little or nothing in the way of interest, the growth in these deposits is arguably a good proxy for the world's demand for safe-haven "money." What stands out of late is the sharp increase in the rate of growth of savings deposits over the course of last year, a time when the world became quite worried about the possibility that Trump's tariff wars could lead to a big slump in global economic activity. Lots of demand for money suggests that lots of people were worried the future might turn out to be disappointing; lots of the world's money was seeking the safe harbor of bank savings deposits. This is very similar to what happened to the demand for 10-yr Treasuries in the past year: demand proved so strong that yields fell to extremely low levels.

Chart #11

Chart #11 compares the level of the S&P 500 index to the ratio of the Vix index to the 10-yr Treasury yield. This ratio is a good proxy, I would argue, for the market's level of fear, uncertainty and doubt about the future. Increases in this ratio have usually been accompanied by falling stock prices and vice-versa. Today, concerns are ebbing and stocks are once again rising.

Chart #12

Chart #12 shows the adjusted PE ratio for the S&P 500, according to Bloomberg's calculations (which use only earnings from continuing operations). PE ratios are above average today, but they are still well below the extremes they reached in early 2000. Earnings per share today are 175% above the levels of 2000, but equity prices are up only 125%. This is not necessarily a bubble.

Chart #13

The inverse of PE ratios is the earnings yield on stocks, which in turn is what the dividend yield on stocks would be if companies paid out all their earnings in the form of dividends. PE ratios must be taken into consideration relative to the yields on risk-free Treasuries in order to judge valuations. 10-yr Treasury yields were north of 6% when PE ratios hit 30 in late 1999, whereas today they are 1.6%. Chart #13 looks at the spread (premium) between equity yields and 10-yr Treasury yields. Today that spread is almost 3%, whereas in late 1999 it was -3%. Back then the market was extremely optimistic about stocks and the economy, because equity investors were willing to give up tons of yield for the supposed "privilege" of owning risky assets. Today the market is far from those levels of optimism. Indeed, equity investors demand an unusually large yield premium to hold equities instead of rock-solid-safe Treasuries.

This is not the stuff of which bubbles are made. There is still a lot of caution priced into the market. If the outlook brightens, there is plenty of upside for risk asset prices.

One other market-based indicator that fascinates me currently is the market for predictions about the upcoming elections. As you can see here, the market is saying that as of today, Trump has a 55% probability of winning in November, with Sanders having a 25% chance of becoming our next President. If you don't agree with those probabilities, I suggest you open an account and buy the contract you think is mispriced. Putting your money on the line has a powerful way of focusing your thoughts. I happen to own the Trump-to-win contract, for which I paid 50 cents on the dollar.

Good economic news overshadowed by Kung Flu and Sanders risks

January private sector jobs growth solidly beat expectations (206K vs 155K), but benchmark revisions going back many years reduced the number of people currently working in the private sector by 440K. Jobs growth in earlier periods was revised downwards, but growth in the past six months was increased. A mixed bag, to be sure, but in the end neither worrisome nor cause for celebration. At worst, the economy appears to be on a slightly slower growth track now than it was in the first two years of Trump's administration. At best, the economy appears to have picked up a bit in the past six months, and this reinforces news from the service and manufacturing sectors that the worst of the negative impact of Trump's tariff wars has passed—capped, of course, by the recent signing of Phase 1 of the U.S.-China trade agreement.

In any event, the signs of improvement in recent data is for the time being eclipsed by the global spread of the Coronavirus (which one wag suggested should be called the Kung Flu). The U.S. actually faces two significant risks, neither of which seems likely, but either of which would have devastating consequences: a viral pandemic and a Bernie Sanders presidency (socialism always results in tears). In prediction markets, Sanders leads the Democratic pack by a wide margin, but Trump leads overall with (currently) a 55% chance of being re-elected. Needless to say, both risks bear watching, but it's premature to run for the exits at this time.

Chart #1 

Chart #1 shows the monthly change in private sector payrolls—the private sector being the only sector that truly counts. The green dashed line is meant to highlight the fact that jobs growth in the past few years has been slower than it was in earlier years. However, there does appear to be a pickup in the past six months or so.

Chart #2

One of the most salutary—yet widely overlooked—trends in the current business cycle expansion has been the absence of growth in public sector jobs (see Chart #2). There were 22.7 million public sector jobs at the recession-era peak in April '09 (not counting the temporary boost from the census), and there are just as many public sector jobs today. Never before in recorded history have we seen such a dramatic relative shrinkage in the number of public sectors jobs. The ratio of private to public sector jobs hasn't been this high since 1957! This dramatic relative shrinkage of the public sector is akin to turning an economic headwind into a tailwind, because private sector jobs are inherently more productive, on average, than public sector jobs.

Chart #3

Chart #3 shows the 12- and 6-month rates of growth of private sector jobs. Here again we see the decline in jobs growth in recent years, and the noticeable pickup in the past six months.

Chart #4

A pickup in the labor force participation rate, shown in Chart #4, is another piece of good news to be found in today's January jobs report. This confirms that workers who were sidelined (of working age but unwilling to work or look for a job) are now being enticed to get back in the game. The economy has plenty of room to expand if this recent trend continues, and I see no reason it won't. Unless, of course, a viral pandemic emerges and/or a socialist takes control of the U.S. government.

Chart #5

Chart #5 compares the ISM manufacturing index to the quarterly annualized growth rate of the U.S. economy. The two have become less correlated in the past decade than in previous decades, but it is definitely encouraging to see the recent surge in the ISM index. At the very least this rules out the prospect of a significant near-term weakening in the economy. At best, it confirms that we've seen the worst of Trump's trade war, which has almost certainly been a significant headwind for the past year. The price we've paid to force a change in China's behavior has been steep, but it may yet prove a worthwhile gamble on Trump's part.

Chart #6

Chart #6 focuses on the export orders component of the ISM manufacturing index. Here we see solid evidence that the negative impact of Trump's tariffs and China's retaliations—which began in early 2018—has not only faded but substantially reversed.

Chart #7

Chart #7 shows the ISM service sector business activity index, which also provides evidence that things have improved significantly of late.

Chart #8 

Unfortunately, despite all the signs of improvement in Charts #1-7, the economy's animal spirits, which were perking up in the latter half of 2019, have since reversed. This can be seen in Chart #8, which shows a remarkable correlation between 10-yr Treasury yields (red line) and the ratio of copper to gold prices (blue line). The 10-yr Treasury yield tends to rise as confidence in the economy improves, and it tends to fall as growth expectations fade and risk-aversion rises. Similarly, copper tends to rise relative to gold as growth expectations improve, and copper tends to fall relative to growth as growth expectations fade (less growth means less demand for copper) and risk aversion rises (which increases the demand for the safety of gold).

The current low level of yields and the low level of the copper/gold ratio are two important signs that the market is quite cautious about the future (i.e., few have ignored the threats of a global pandemic and the new enthusiasm for socialist polices). Needless to say, all eyes should be glued to the prices of copper, gold, and Treasuries.

In the meantime, there is still much encouragement to be found in the fact that 1) swap spreads are very low, which means liquidity is still abundant and systemic risk is low, 2) credit spreads are quite low, which means the outlook for corporate profits is healthy, 3) real yields are very low, which means the Fed is not a threat to growth, 4) inflation is relatively low and stable, which means the Fed has no need to tighten policy, 5) the dollar is relatively strong and stable, which means the Fed has not been "printing money," and 6) the market still displays lots of signs of caution (e.g., gold is up, money demand is strong, and interest rates are extremely low).

Bloomberg, watch your charts!

Today Bloomberg announced he is upping his ad spending in the wake of the Iowa Caucus debacle. But catching and beating Trump is going to be a real uphill battle, to judge by one of Bloomberg's own charts:

Chart #1

What Chart #1 shows is that consumer comfort is higher now than at any time in the past 34 years. The Bloomberg Consumer Comfort index started to soar just days after the November '16 elections. It appears quite likely that Trump's policies were the proximate cause of much, if not all, of this dramatic improvement in sentiment.

Chart #2

As Chart #2 shows, Small Business Optimism also began to soar just after the November '16 elections.