Thursday, June 23, 2016

Brexit is not the end of the world as we know it

As I write this at 8:30 pm California time, some 70% of the UK Brexit votes have been counted, and "Leave" is winning 51.5% to 48.4%. The betting odds on "Leave" are now approaching 100%, up from just 11% only 24 hours ago. It appears the UK will be leaving the EU, something that as recently as yesterday was "unthinkable" according to the establishment types and many market participants. The hype mustered by those favoring "Remain" has undoubtedly fueled the panic that has sent the pound down 10% in a matter of hours. 10-yr Treasury yields are down almost 25 bps, and gold is up over $50.

I may be swimming upstream, but I don't think this is the end of the world as we know it. Matt Ridley, a very wise fellow, penned these comments in the WSJ two days ago, and they make a lot of sense to me:

In voting Thursday on whether to leave the European Union, the British people face perhaps the most momentous decision since Henry VIII broke from the Roman Catholic Church in the 16th century so he could marry as he pleased. Though lust is not the motivation this time, there are other similarities. The Catholic Church five centuries ago was run by an unelected supranational elite, answerable to its own courts, living in luxury at the expense of ordinary people, and with powers to impose its one-size-fits-all rules despite the wishes of national governments. We were right to leave. 
A centrally planned, regional customs union ... might have made some sense in the 1950s. That was before container shipping, budget airlines, the internet and the collapse of tariffs under the World Trade Organization made it as easy to do business with Australia and China as with France and Germany. 
Even worse than in Westminster or Washington, the corridors of Brussels are crawling with lobbyists for big companies, big banks and big environmental pressure groups seeking rules that work as barriers to entry for smaller firms and newer ideas. The Volkswagen emissions scandal came from a big company bullying the EU into rules that suited it and poisoned us. ... The de facto ban on genetically modified organisms is at the behest of big green groups, many of which receive huge grants from Brussels. 
... the EU’s obsession with harmonization (of currency and rules) frustrates innovation. Using as an excuse the precautionary principle or the need to get 28 countries to agree, the EU gets in the way of the new. “Technological progress is often hindered or almost impossible in Europe,” says Markus Beyrer, director general of BusinessEurope, a confederation of industry groups. Consequently, we’ve been left behind in digital technology: There are no digital giants in Europe to rival Amazon, Google, Apple and Facebook. 
The EU is also against free trade. It says it isn’t, but its actions speak louder. The EU has an external tariff that deters African farmers from exporting their produce to us, helping to perpetuate poverty there, while raising prices in Europe. The EU confiscated Britain’s right to sign trade agreements—though we were the nation that pioneered the idea of unilateral free trade in the 1840s. All the trade agreements that the EU has signed are smaller, as measured by the trading partners’ GDP, than the agreements made by Chile, Singapore or Switzerland. Those the EU has signed usually exclude services, Britain’s strongest sector, and are more about regulations to suit big companies than the dismantling of barriers.

The UK is right to reject the regulatory burdens heaped upon it by an extra-national bureaucracy. The U.S. would be wise to follow suit and shrink the size of our bloated government by a few notches at least. Brexit could be the beginning of a brave new world, in which trade becomes freer and business becomes less burdened by taxes and regulations. The only politician here who is talking about such "radical" ideas is Trump, but he is gaining traction, as did the "leavers" in the UK. There is room for hope.


To close, the chart above puts into perspective today's collapse of the pound vis a vis the dollar. As I see it, the current exchange rate between the pound and the dollar is reasonable (finally), and it has moved, over the past 40 years, pretty much in line with the differential between US and UK inflation (the green line is representative of how the exchange rate would have moved if it exactly reflected inflation differentials over time). 

Tuesday, June 21, 2016

Chemical activity points to a stronger economy

The Chemical Activity Barometer, published monthly by the American Chemistry Council since 1919, has jumped 3% in the past 3 months, and is up 2.5% in the past year. This strongly suggests that industrial production—which has been quite weak for the past year or so (due in part to the big slowdown in oil drilling and exploration)—will pick up in coming months. This should go hand in hand with stronger GDP numbers over the course of the year as well. Definitely good news.


The chart above shows the Chemical Barometer Activity index for the past 8 years. The recent uptick is significant.


The chart above shows the index going back to 1960. It tracks overall economic activity pretty closely.


The index also appears to do a good job of leading the growth in industrial production, and by inference, the overall economy. For more detailed information, see Calculated Risk.


Truck tonnage, shown in the chart above, has also picked up this year. The February spike had looked a bit anomalous, but the May reading confirms that activity has picked up over the course of the year. Chemical activity and truck tonnage both track actual physical activity in the economy, and both are pointing to improvement.


The chart above compares truck tonnage with the inflation-adjusted S&P 500 index. Both look on track for further gains. 

Monday, June 20, 2016

Walls of worry update

For the past several years the economy has been disappointingly weak (the weakest recovery ever), and the stock market has periodically worried that things would get worse. The one reassuring constant in recent years has been 2-yr swap spreads, which have been low and relatively stable, thus casting doubt on the validity of the market's concerns. Nothing much has changed of late. 


The chart above shows how peaks in the market's level of fear, uncertainty and doubt (as proxied by the ratio of the Vix index to the 10-yr Treasury yield) have coincided with lows in stock prices. As fears rise, stock prices decline, and vice versa, as the market "climbs walls of worry." I've now labeled the fits of fear/walls of worry, to help with the analysis. The latest bout of fear has centered on the fears surrounding a possible UK exit from the European Union (aka Brexit). As polls and betting markets show the probability of a Brexit declining, markets have breathed a sigh of relief and stock prices have bounced.


If a Brexit spells bad news for the U.K. and the rest of Europe—I'm not convinced it does, but the market thinks it does—it stands to reason that a Brexit would hurt the Eurozone economy more than the U.S. economy, since U.S. exports to the Eurozone are a small fraction (~10%) of our total exports. And as the chart above shows, Eurozone equities have suffered significantly in the past year, whereas U.S. equities are relatively unchanged. In fact, it's not just a Brexit that is weighing on the fortunes of the Eurozone, it's long-term economic stagnation. I note that Eurozone equities have been underperforming their U.S. counterparts for quite a few years: since mid-2010 the S&P 500 is up almost 50% relative to the Euro Stoxx index. This alone suggests that the UK might be better off if unconstrained by EU shackles.


The chart above compares the price of gold to the price of 5-yr TIPS (using the inverse of their real yield as a proxy for their price). Both are go-to investments for those worried about rising inflation, geopolitical risks, and the end-of-the-world-as-we-know-it. Gold is impervious to the elements, and TIPS are not only impervious to inflation, they are the only security that offers a U.S. government-guaranteed real rate of return. Both prices have jumped in the past 5-6 months, no doubt encouraged by Brexit worries, general economic slowdown worries, terrorist attacks, and rising geopolitical concerns. But in the great scheme of things, prices of gold and TIPS are still lower than they were in 2011-2012, during the height of the PIIGS crisis. Things are bad, but not that bad.


The real yield on 5-yr TIPS is not only a measure of the market's inflation general instability concerns. As the chart above shows, real yields tend to follow the trend growth rate of the U.S. economy. When the economy was chugging along at 4-5% rates of growth in the late 1990s, TIPS carried a monster real yield of about 4%. With the economy growing at 4-5% per year, TIPS had to compete by offering a real rate that was somewhat less (because it is guaranteed). Now that the economy has been growing just over 2% per year for the past several years, TIPS real yields are trading at about 0%. You can lock in a zero real rate of return with TIPS, or you can take your chances with an economy that only promises to deliver 2% (which presumably sets a reasonable expectation for real returns on stocks). Not much has changed in this picture of late.


Bouts of fear are also reflected in credit spreads, which hit all-time highs in 2008, and lower highs during the PIIGS crisis and the recent collapse in oil prices. They are still somewhat elevated, which suggests the market is still concerned about a weak economy getting somewhat weaker. But they are far from panic levels. Oil prices are up, oil patch credit risk is way down, and the U.S. economy still appears to be growing, albeit still slowly.


The chart above is one I've showed many times over the past 7-8 years. It compares 2-yr swap spreads to high-yield credit spreads. I think it shows that swap spreads are good leading indicators of credit spreads and the health of the economy. They rose prior to the past two recessions, and declined prior to the start of the past two recoveries. They tend to rise before other credit spreads rise, and they tend to fall in advance of a decline in other spreads. 

Throughout the recent oil-price-collapse crisis, swap spreads have remained quite low. I argued several times in the past six months that the message of swap spreads was very encouraging. Low swap spreads are indicative of healthy financial conditions—lots of liquidity and very low systemic risk. Healthy financial markets serve as a shock absorber for the real economy. Functioning and liquid markets facilitate the myriad adjustments that market participants make while coping with changing economic realities. The swap spread market was telling us all along that the crisis in the oil patch was going to be resolved without great calamity, and indeed that looks to have been the case.


Finally, the chart above, which compares U.S. and Eurozone swap spreads. U.S. markets are in somewhat better shape than their Eurozone counterparts, but neither market is pointing to a significant negative event on the horizon. That further suggests that the Brexit fears will eventually pass, and the market will successfully climb one more wall of worry.