Monday, April 24, 2017

Chemical activity and trade still strong

The American Chemistry Council's Chemistry Activity Barometer continued to rise in its latest April release. This index has been a good coincident at at times leading indicator of both industrial production and overall economic growth, and it continues to point to rising industrial production and continued growth of the US economy. At the same time, there is a growing body of evidence that points to increased global trade, at a time when industrial commodity prices have been rising significantly.

The Chemical Activity Barometer rose 5.2% in the past 12 months, one of its strongest showings in seven years (the strongest being the year ended March, when it rose 5.6%).

This indicator almost always goes flat or declines in advance of recessions. Currently it points strongly to continued expansion.

This indicator has been a good leading indicator of growth in industrial production and economic activity in general. Currently it points to a substantial increase in industrial production in coming months.

As the chart above shows, US goods exports have been rising for the past year, and that is corroborated by a sharp increase in outbound container shipments from the ports of Los Angeles. It's notable that US exports to China rose over 20% in the year ending February, after contracting over most of the 2014-16 period. Japan reports double-digit growth in both imports and exports in the year ending March, after declining over most of the 2015-16 period. According to the Netherlands Bureau for Economic Policy Analysis, the volume of global trade rose at an 8% annualized pace in the six months ended January 2017. Expanding global trade is an excellent indicator of improving economic conditions worldwide. Very encouraging.

Rising prices for industrial commodities over the past year or so—at a time when the dollar has been rising—tell us that global industrial activity has generally exceeded the expectations of commodity producers. Also very encouraging.

Yet despite the good global news, the US economy seems still to mired in mediocrity (i.e., 2% growth). That's not necessarily inconsistent with global strengthening, since trade is much less important to the US economy than it is to most other economies. But improving global fundamentals nevertheless provide strong underlying support for activity here.

It's premature to worry about a US downturn, and it's not unreasonable to remain optimistic that things will improve. It pained me today to learn that Trump wants to impose a 20% tariff on imports of Canadian softwood, since all that does is make life more expensive for US residents (UPDATE: Read Mark Perry's excellent critique of Trump's tariff here). But I'm encouraged that he seems pointed in a positive direction in the area of tax reform, and that there is important progress being made on healthcare reform.

French election relieves systemic risk

This is a brief update on the status of global systemic risk in the wake of yesterday's French elections. By rejecting extremists, the French have reduced the risk of a Eurozone/euro collapse. 2-yr Eurozone swap spreads and default credit spreads on French debt, both key measures of systemic risk, have declined significantly from their recent highs. Europe is not out of the woods completely, but investors nevertheless are breathing a sigh of relief. Equity markets, understandably, have moved higher as a result.

The chart above shows the price of credit default swaps on French debt (a form of insurance against default by the French government). They reached a high of over 70 bps at the end of February, and are now down to just under 35 bps. This puts them only modestly higher than their multi-year low of 27 bps, which was registered last September. For context, CDS spreads on German debt—perceived to be ultra-safe—are a bit less than 20 bps.

The chart above compares US and eurozone 2-yr swap spreads. At 34 bps, US spreads are at the high end of their "normal" range of 20-35 bps, whereas Eurozone spreads are still somewhat elevated. The worst of the panic seems to have subsided, thanks to yesterday's elections, but concerns linger.

Eurozone stocks are now up 25% from their lows of last summer. US stocks have far outpaced their Eurozone counterparts since 2009, but Eurozone stocks are starting to close the gap, having outpaced US stocks by 7% since last summer. 

As the chart above suggests, the French election outcome was a relatively minor "wall of worry" that, now partially resolved, has allowed stocks to float a bit higher.

Thursday, April 13, 2017

Market-based chart updates

There are lots of things going on in the world, with the most significant, in my view, being the threat of nuclear war in/with North Korea, followed by deteriorating US-Russia and Mideast relations. On the domestic front, Trump has yet to make meaningful progress on an alternative to Obamacare or on tax reform, but he has made important progress with most of his nominees. However, if we don't get substantial progress on healthcare and taxes before year end, the economy could weaken as uncertainty mounts and people delay income and investment decisions. In the meantime, the nascent rebound in the manufacturing sector and the likelihood of improving corporate profits should sustain the economy for the next several months; but for now, the economy continues to plod along and markets are less than enthusiastic about the future.

What follows are updates of some of the more important charts—all based on market-driven prices—that I am following. These tell us what the market is thinking, as expressed in the prices of the dollar, gold, real and nominal interest rates, equity prices, volatility, swap and credit spreads, and commodity prices. As I read the charts, the market seems relatively unperturbed by all the turmoil, and hopeful that better times lie ahead. This in turn makes the market vulnerable to any shortfall vis a vis expectations, so now is one of those times to be cautiously optimistic rather than gung-ho.

If the US economy were a company, then the value of the dollar would be a good proxy for its relative attractiveness and its future prospects. The chart above shows two of the best measures of the dollar's value, on an inflation-adjusted, trade-weighted basis. By either measure, the dollar is moderately above its long-term average We can infer from this that the Fed has not printed more dollars than the world wants, though it might be guilty of supplying too few. On the other hand, it would appear that the dollar is one of the currencies in most demand, and that is encouraging since it means the US is attracting investment, and investment is the seed corn of future growth.

The chart above illustrates the tendency of commodity prices to move inversely to the value of the dollar (note that the dollar axis is inverted). In the past few years, however, both the dollar and commodity prices have moved higher. This is worthy of attention. I think it tells us that the rise in commodity prices has little or nothing to do with a monetary reflation (because a plentiful supply of dollars tends to boost the prices of most things (aka inflation), but rather more to do with a general strengthening of the global economy at a time when the US economy is expected to be one of the engines of stronger growth. Again, this is encouraging. 

The chart above shows the very strong correlation between industrial commodity prices and emerging market equities. That makes sense, because emerging market economies tend to specialize in the production of raw materials. I believe the rise in commodity prices reflects a general strengthening of global economies, so what's good for commodities is good for just about everyone, especially emerging markets. And as I pointed out in December 2015, emerging markets and commodities had been severely beaten up and prospects for their recovery were bright.


For years I've been amazed at the correlation between gold and TIPS prices, as shown in the chart above (note I use the inverse of the real yield on TIPS as a proxy for their price). The common denominator of both markets is the way they serve to protect people from risk. TIPS are a good hedge for inflation, they are default-free, and they are the only asset that guarantees investors a real rate of return if held to maturity. Gold, on the other hand, is a classic port in a storm for just about anything that makes people nervous about fiat currencies or government excesses. Gold and TIPS have been in a rough holding pattern for the past several years. Declines in gold and TIPS would likely coincide with improvements in the global economic outlook. That they have not yet fallen meaningfully is therefore a good sign that markets are still somewhat risk averse and less than optimistic.

It's almost always the case that stocks tend to weaken as fears tend to rise, as shown in the chart above. But the current level of fear and uncertainty (as reflected in the ratio of the Vix index to the 10-yr Treasury yield) is still quite modest compared to what we've seen in recent years. The Trump era seems to have brought with it a calming effect on global markets. 

Swap spreads are some of the best coincident and leading indicators of financial market and economic health. Spreads have been rising for the past year or so both in the US and in the eurozone, so that could be a sign of deteriorating economic and financial fundamentals. I've tended to dismiss the current rise in US swap spreads, however, because they are still within what we consider to be a "normal" range (20-35 bps); if anything, they were exceedingly low at the end of 2015 and only now have recovered to more normal levels. Eurozone swap spreads have moved substantially higher, however, and that is cause for concern. My guess is that eurozone swap spreads are elevated because of concerns that France could pull a "Frexit," and this could undermine the stability of the euro and the eurozone economy. This risk is not trivial, and is not one to dismiss lightly—unless you believe (as I do) that the demise of the eurozone would not be necessarily a bad thing. For the moment, I note that credit default spreads on French debt are declining (i.e., the market is worrying less about a Frexit since the political left seems to be ascendant for the moment), but this still bears watching.

 Speaking of credit default spreads, the chart above shows that they are relatively low here in the U.S., and that further suggests that systemic risks are low and markets are relatively confident about the future.

One persistent and salient feature of the past 6-7 years has been Treasury yields in the US that are very low relative to inflation, as the chart above shows. Some observers dismiss this with the argument that the Fed is keeping interest rates artificially low, but I'm not a buyer of that line of thinking. I think Treasury yields are very low because markets still have a palpable degree of risk aversion, and are thus willing to pay a lot for the protection of Treasuries. We see this same phenomenon all over the developed world: sovereign yields are unusually low. Most investors have a choice between holding Treasuries and holding riskier assets; that the price of Treasuries is unusually high relative to other assets (e.g., the earnings yield on the S&P 500 is substantially higher than the yield on 10-yr Treasuries) must therefore mean that investors are very distrustful of the outlook for the economy and for corporate profits. In other words, very low Treasury yields are a strong and reliable indicator of a market that is less than optimistic, to say the least. Show me an optimistic/enthusiastic market, and I'll show you nominal Treasury yields that are much higher than they are today.

 The difference between nominal and real yields is a measure of the market's inflation expectations. In the chart above we see that inflation expectations over the next 5 years (the green line) are 2%, and not surprisingly, that is what the CPI has averaged over the past few decades. Markets are not concerned about rising or falling inflation right now; it's steady as she goes. Kudos to the Fed for having managed monetary policy surprisingly well over the years.

The chart above is my attempt to show that the level of real yields on TIPS can and does tell us a lot about the market's expectations for real economic growth. Real growth has averaged about 2% during the current expansion, and 5-yr TIPS yields have averaged about zero. You can invest in the economy and expect to get an average real return of 2%, or you can invest in TIPS and earn a guaranteed zero real rate of return. Guaranteed real rates of return should always be less than expected real rates of return, should they not?. If and when TIPS yields rise significantly, this will be a good indicator that the market is expecting economic growth to accelerate. For now, it may be the case that the market is buoyed by Trump expectations, but to judge from TIPS yields, there is little or no evidence of much optimism.

The chart above shows the 6- and 12-month growth rates of private sector jobs in the US. If anything, jobs growth has slowed over the past few years, from just over 2% to currently about 1.7%. The manufacturing sector looks to be picking up, but the overall economy remains on a sluggish growth trend that of late has been declining modestly on the margin. No sign here of a Trump bump, and it's premature to expect one: we need to see meaningful tax and regulatory reform (or solid reasons to expect such) before getting excited.