Recovery on track, politics is no longer a threat

The economic news continues to be favorable, and thus supportive of an ongoing V-shaped recovery. Now that the election dust has settled, the political news is also supportive.

Although I'm disappointed that Biden won, I am pleased to note that the much-expected "blue wave" did not materialize. Instead, we have the makings of a classic "divided government,", and that is very good news. The Republicans have substantially narrowed the Democrats' margin in the House (which in turn greatly weakens Speaker Pelosi's hand), and the Republicans are very likely to retain control of the Senate. Biden does not walk into the White House with a mandate to radically transform the American economy or to significantly raise income taxes. With luck he will prove to be a stabilizing and calming influence on the nation's nerves, rather than an existential threat to capitalism. In my view, the economy is quite able to take care of itself and prosper if it is just left alone, without any disturbing "stimulus" measures from either Washington or the Fed.

Trump's legacy can be summed up in lower taxes, greatly reduced regulatory burdens, a less-activist judicial system, and a Mid-East peace accord. Biden's legacy will be measured by how much or how little he squanders Trump's legacy.

 

Chart #1

I've been featuring Chart #1 in recent posts, because I think it's an excellent leading indicator of the global economy's health and outlook. The ratio of copper to gold prices is almost always driven by the perceived strength of the economy, since a stronger economy boosts demand for copper but depresses the demand for gold, which is a refuge from uncertainty. As the blue line shows, this ratio has turned up in recent months in convincing fashion. The 10-yr Treasury yield (red) is also quite sensitive to the market's outlook for the economy, since the expectation of a stronger economy implies that the Fed is likely to begin raising short-term rates early, rather than keeping them low in order to "support" a weak economy. Higher short-term rates in the future, coming from extremely low levels, is a good predictor of higher long-term rates. All in all, if these recent trends continue both the US and the global economic outlook will be brightening considerably.

Of course, a significant "tightening" of monetary policy and a commensurate rise in long-term rates could pose problems for the economy and thus might not be comforting news. I'm sure that higher rates at some point will be problematic, but I would argue that they are still so incredibly low (which normally would be symptomatic of a very weak economy) that they will have to rise considerably before they pose an obstacle to growth. 

Indeed, given the increasing signs of higher prices, the Fed risks allowing inflation to become endemic, and that would be very bad since ultimately it would assure us of a period of aggressive Fed tightening, which has been the proximate cause of almost every recession in the past half century.

Chart #2

Chart #2 compares the level of the dollar (blue, inverted) to the level of non-energy commodity prices. They tend to track each other pretty well over the years: a weaker dollar corresponds to higher commodity prices and vice versa. The strength of commodity prices this past year is almost certainly related to the weakness of the dollar, which in turn is a function of the Fed's "easy" monetary policy. The Fed has taken rather extreme measures to ensure that there is no shortage of dollar supply given the intense demand for dollars during the Covid recession. Dollars are abundant, and that supports higher commodity prices.

Chart #3

Chart #4

However, as Chart #3 suggests, the price of oil has responded only minimally to a weaker dollar. Oil alone stands out for its very weak response to easy money and a weaker dollar. It's therefore not hard to argue that oil is especially cheap these days. That conclusion is also supported by Chart #4, which shows that, relative to gold prices (a universal standard against which to measure all currencies), oil is quite cheap at current levels. This further suggests that betting against the prevailing wisdom that says that global warming demands a huge reduction in the world's consumption of petroleum-based energy—and the fact that oil-related stocks are very weak—might prove profitable.

Chart #5

Chart #6 updates the level of Credit Default Swap spreads, which are once again at very low levels. This is good evidence that a) liquidity is abundant, b) the outlook for corporate profits is very healthy, and c) the outlook for the economy is also quite healthy.

Chart #6

Chart #6 shows the level of 5-yr real and nominal Treasury yields, and the difference between the two (green) which is the market's expectation for what the CPI will average over the next 5 years. Inflation expectations today are around 1.6-1.7%, which is rather low compared to some past periods, but rather high considering (as the conventional wisdom would ordinarily suggest) that the economy is still plagued by a huge amount of excess capacity. I think that this confirms my hypothesis that the Fed risks remaining super-easy for too long. At the very least it suggests that the Fed is almost certainly not too tight, and that interest rates need not remain at current, extremely low levels. 

To be fair, I must note that the current level of real yields on 5-yr TIPS (-1.2%) would by itself suggest that the economic outlook is extremely weak. That's a fair characterization, but it's also true that extremely low real yields could reflect a very high degree of risk aversion: the market is obviously willing to pay a very high price for the safety of TIPS and Treasuries. 

Chart #7

Chart #7 backs up my assertion above, namely that the market is still full of risk aversion. The price of gold and the price of TIPS are trading at very elevated levels. Note, however, the early signs of a "top" in both prices. If the economy continues to improve over the course of the next year, which I think will happen, then watch for gold prices and TIPS prices to tumble.

Chart #8

Chart #9

Charts #8 and #9 compare the level and ratio US stock prices to Eurozone stock prices. US equities have very strongly outperformed their Eurozone counterparts. As the lower portion of Chart #9 shows, US equities have risen by almost 120% in the past 10 years. I'm pretty sure this is unprecedented. I hesitate to call a top to this ratio, since I have done so before and been proven wrong. But it certainly bears watching.

Chart #10

Finally, Chart #10 shows how the market is becoming less worried about the future, and that is driving equity prices higher. The Vix is still significantly above what might be considered "normal" (~12) and that is good evidence that risk aversion is still alive and well in the world.

The outlook for growth continues to improve

On the eve of our historic election, here's a collection of charts with the latest data and some brief commentary:

Chart #1

Chart #1 compares the US ISM manufacturing survey with that of the Europe. Conditions in both areas have improved dramatically in the past several months, but the US outlook is even brighter—almost as strong as it was a few years ago.

Chart #2

Chart #2 shows strong improvement in export orders for US manufacturers. This is a good sign that the global economic outlook is improving.

Chart #3

Chart #3 tells us there has been a much, much-needed improvement in manufacturers' outlook for new hiring. That also implies a new willingness to invest and expand operations.

Chart #4

Chart #4 shows that a majority of manufacturing firms are seeing price increases in the things they buy. This confirms that monetary policy is accommodative, and at the very least it means that liquidity is abundant. The Fed poses no threat to the outlook for improved growth.

Chart #5

Chart #5 compares the ratio of copper to gold prices (blue) to the level of 10-yr Treasury yields (red). Both appear to have bottomed out; that in turn is strongly suggestive of a nascent rebound in growth expectations both in the US and around the world. 10-yr Treasury yields today reached 0.9%, which is their highest post-Covid level. Yields are still extremely low from an historical perspective, which is consistent with their being still a lot of risk aversion priced into the market (i.e., people are still willing to pay extremely high prices for the safety of Treasuries). Optimism is returning, but only by a little.

Chart #6

As Chart #6 shows, the PE ratio of the S&P 500 Index is quite high (a bit over 26 as I write this). Does this mean the market is over-valued and primed for a crash? Not necessarily. The market understands that corporate profits have plenty of room to grow, being still depressed after the huge Covid-induced economic crash we are still recovering from, so an elevated PE ratio today only means that the market is pricing in an increase in future corporate profits. Today, the market expects profits (EPS) over the next year to grow by about 8% from current levels; that would leave next year's earnings per share about 12% higher than they were last year. 

Chart #7

Stocks don't exist in a vacuum, however. Investors have a choice between the expected returns on stocks or the guaranteed returns on Treasury bonds. The higher the price one pays for a security, the lower the expected return. Today, Treasuries (and their close cousin cash) are trading at very high prices historically, though they have dropped a bit of late. 

Cash is more "expensive" to own than every before: it yields either zero if held in the form of currency or in some savings deposits, and a minuscule 0.09% if held in the form of ultra-safe and extremely liquid T-bills. Meanwhile, inflation is running at least 1.5% per year. So the real return on cash is negative: holding cash implies losing about 1.5% of your purchasing power every year.

Holding cash is a losing strategy, and even holding 10-yr Treasuries (0.9% yield) is a loser in terms of purchasing power. But stocks have an earnings yield (the inverse of their PE ratio, which is the dividend yield an investor would receive if companies paid out all their earnings in the form of dividends) of about 3.8%. That represents a "risk premium" over 10-yr Treasuries of almost 2%. As Chart #7 shows, stocks today are not at all expensive relative to Treasuries (e.g., when the risk premium is negative, they are expensive). The reason stocks are "cheap" relative to Treasuries can be easily explained by the prevailing preference among investors to pay up for safety. Risk aversion is alive and well.

Chart #8

Chart #8 shows Credit Default Swap spreads, which is a measure of the cost of hedging oneself against the risk that corporate bonds default. That cost today is pretty low from an historical perspective, which means the market—despite the prevailing mood of risk aversion which makes stocks relative cheap—is fairly confident in the outlook for corporate profits and, by inference, for the health of the economy. It also indicates that liquidity is plentiful.

Chart #9

Chart #9 sums it all up. The Vix (fear) index is still quite elevated, and the stock market is trading today at about the same level as before the Covid crisis struck. The stock market is priced to some bad news (according to the Vix index), so it is not necessarily vulnerable to a negative news shock.

And with that I'm going to sit back and watch the election returns. Biden has been leading strongly in the polls until recently, and now it's possible Trump could snatch a victory from the impending jaws of defeat. It's going to be a wild ride no matter what. My fingers are crossed for Trump, mainly because I am sure his policies would be much more likely to deliver a prosperous economy than Biden's.

Timely indicators still quite positive

While we wait for the results of next week's election, here are just a few charts of timely economic indicators (all based on very recent daily and weekly data) that show continuing improvement in the economy:

Chart #1

Chart #1 is a very timely compilation of high-frequency weekly economic indicators designed by the NY Fed. It shows continued and rather dramatic improvement (aka a V-shaped recovery).

Chart #2

Chart #2 shows the amount of gasoline supplied, which as of last week was only 7.7% below the level of last year. 

Chart #3

Charer #4

Passenger air traffic (Chart #3) is up only modestly over the past month, but as Chart #4 shows, it continues to improve relative to the levels of last year at this time. This would probably be best described as a U-shaped or gradual recovery. It's going to have to improve significantly before we can conclude that economic activity is getting back to normal.

Chart #5

Chart #5 shows continuing claims for unemployment, which continue to decline rather dramatically. Lots of people are going back to work. My son, who has been furloughed since April, was recently notified that he is being called back to work starting November 9th.