Thursday, May 25, 2017

Fed tightening has been a positive for markets

For years people have worried that a Fed "tightening" would derail the economy and the markets, but the facts say otherwise. The Fed first hinted at a tightening a few years ago, with the first hike coming in late 2015. Since then, short-term interest rates have risen by 75 bps and another tightening is virtually assured for next month's FOMC meeting. Today the dollar is stronger, but not too strong; the yield curve is flatter, but not too flat; credit spreads are tighter, but not too tight; equity prices are up, but the equity risk premium is still positive; commercial real estate is up, but not to record highs; equity and bond market volatility is down; and inflation is relatively low but not too low.

What's not to like? To be sure, the economy hasn't yet picked up from the 2% pace that has prevailed for the duration of this rather long recovery, but business and consumer optimism is up significantly in recent months, and that combined with Trump's tax and regulatory reform proposals, if passed, would almost certainly result in a stronger economy. Things could be better, but they aren't half bad—except for the growing threat of a nuclear NoKo and radical Islamic terrorism. For my money, NoKo is the darkest cloud on the horizon. Unfortunately, there's not much an investor can do in the face of that kind of uncertainty.

Here are some charts which put some meat on the story:


The chart above compares the inflation-adjusted current Fed funds target rate (blue) to what the market expects that rate to average over the next 5 years (red). This is effectively a picture of how the real yield curve has evolved over time and is expected to evolve. Recessions are almost always preceded by a flat to inverted real yield curve, because that is the market's way of saying that monetary policy is too tight and it is hurting the economy. Today the market is saying that the Fed will probably raise the real funds rate another couple of times over the next year or two, but not by much more. That tells me the market is not pricing in a robust economy, nor is it predicting a weaker economy, since that would call for a reduction in the real funds rate. It's more a prediction of "steady and slow as she goes."

Note also the all-time low in real 5-yr yields in March 2013, when they fell to almost -1.8%. That was a sign that the market was extremely pessimistic. We've come a long way since then, but real yields are still very low from an historical perspective.


As the chart above shows, 5-yr real yields are still right around zero, where they've been for several years now. It's not a coincidence, I would argue, that real GDP growth has been stuck at 2% for about the same length of time. Translation: the market doesn't see much if any improvement for the foreseeable future. This is not an optimistic market.


Credit Default Swap spreads are a little tighter than they were in March 2013, despite higher real yields and a flatter yield curve. They've been tighter before (e.g., in the late 2000s).


The chart above compares the yield on a variety of assets as of March 31, 2013 (when real yields hit their all-time lows and Fed policy was effectively extremely easy) and as of today (red). Note that short-term yields have risen much more than longer-term yields, resulting in a flatter yield curve. Note also that yields on REITS, BAA bonds and equities have declined even as the Fed has tightened and market yields have risen. All of this is pretty straightforward, right out of the textbooks. Tighter money flattens the yield curve, and when it's not too tight it's good for most asset classes because a positively-sloped yield curve is symptomatic of a reasonably healthy economy. The Fed is not threatening anybody these days.


The dollar began rising once the market started pricing in Fed tightening. That's a good thing. But the dollar today is far from being too strong, as it was in 1985 and 2001. Today it's only marginally higher than its long-term historical average.


With the dollar just above the middle of its long-term range, it's not surprising to see real oil prices trading close to their long-term range. Oil is neither expensive nor cheap, and that can't be bad for the outlook for the economy.


As the chart above shows, 5-yr inflation expectations (as embodied in the market for TIPS and Treasuries) say that consumer price inflation will likely average about 1.7% for the foreseeable future. That's not bad at all: not too high, not too low. In my ideal world, inflation would be close to zero and stable, but nobody is going to worry much if it's 1.7%. Indeed, the Fed would prefer to see inflation above zero. The Fed is not a threat in these conditions.


As the chart above shows, the equity market has suffered from numerous panic attacks in recent years (i.e., spikes in the Vix/10-yr ratio, accompanied by declines in equity prices). Today, however, implied equity volatility is quite low and nobody expects anything outrageous from the Fed, so it's not surprising that equity prices are floating higher.


PE ratios (using earnings from continuing operations) today are a bit over 21, according to Bloomberg, but that's not at all unusual given the very low level of 10-yr nominal and 5-yr real yields. As the chart above shows, the earnings yield on the S&P 500 tends to follow the inverse of the real yield on 5-yr TIPS. If anything, the current earnings yield on stocks suggests that real yields are too low (meaning the Fed could be tighter and real yields higher). Stocks, in other words, appear priced to higher yields than the bond market is assuming.


As the chart above shows, the equity risk premium (the difference between earnings yields on stocks and the yield on 10-yr Treasuries) is still relatively high. That means investors are quite willing to forego the yields and capital gains potential of stocks in exchange for the safety of Treasuries. Again, this is not an overly-optimistic market. If the market were exuberant, the equity risk premium would be negative, not positive. 

What's driving equity prices higher is not anything sinister nor dangerous. Given that the market doesn't expect things to change much, investors are reluctantly conceding that the much higher yields on equities and other asset classes—relative to cash and Treasury note and bond yields—are attractive.

Wednesday, May 17, 2017

The Trump Wall of Worry

We hear breathless reporting describing "tumult" in Washington and cries for Trump's impeachment. The market is starting to worry, and with worry comes a correction—surprise, surprise. I offer the following chart so that readers may judge the magnitude of the market's Trump concerns vis a vis other concerns that have popped up over the past few years. So far it's just a blip on the radar:


I worry more about the blatant attempts by the MSM to destroy Trump's presidency at all costs than his persistent problem with verbal diarrhea.

Tuesday, May 16, 2017

It still makes sense to be optimistic

Stocks in the US and Europe are at or close to record highs, and the Vix index is quite low, as are key measures of credit spreads. That poses a conundrum: if nervousness and credit spreads are unusually low, and stocks are quite high, is the market too complacent? Are equities overvalued, and primed for a fall? To be sure, stocks are far from cheap. But there are reasons to think they still offer decent value, and there are few if any signs of irrational exuberance. Here are 10 charts that tell the story:


US and Eurozone stocks are at or very near all-time highs. Asian stocks, in contrast, are still substantially below their prior highs: Japanese stocks today are only half what they were at the end of 1989, and Chinese stocks are 40% below their mid-2015 high, As the chart above shows, US stocks have outpaced their Eurozone counterparts by more than 40% since early 2009, even after underperforming by some 7% since last summer. If the outlook for US stocks is still positive, Europe might well be even more attractive. 


Periodic bouts of nerves (as measured by the ratio of the Vix to the 10-yr Treasury yield) have invariably coincided with equity market corrections, as the chart above shows. Right now the market looks unusually complacent, so it's no surprise that prices are floating upwards. 

 

A number of recent economic indicators have come in on the weak side of late, but industrial production has proved surprisingly strong, rising 1% in April, and 2.2% over the past 12 months. In the year ended March, Eurozone industrial production rose 1.9%. Even in relatively stodgy Japan, industrial production rose 3.3% in the year ended March. There's a coordinated recovery in industrial activity underway, and its global in nature. 


For quite a few months I've been highlighting the strength of the Chemical Activity Barometer, and how it was likely foreshadowing a pickup in industrial production. With the latest news, the CAB has once again proven to be a good leading indicator of industrial production, as the chart above shows. Moreover, we're likely to see more good news in the months to come.


Housing starts in April were a bit weaker than expected, but sentiment among homebuilders remains quite healthy. This indicator is notoriously volatile on a month-to-month basis, but it's reasonable to think that starts will trend higher over the balance of the year given the strength in sentiment.


Swap spreads are excellent indicators of systemic risk and they have also been good leading indicators of the health of the economy. Currently, they are telling us that systemic risk in the US is quite low, and the outlook for the US economy is therefore positive. (The low level of swap spreads is also a sign that liquidity in the banking system is abundant, and that in turn contributes to a healthy economic outlook.) Eurozone swap spreads are still somewhat elevated, but have dropped significantly in the past month or two, driven in large part by a non-threatening resolution to the French elections and no indications that the ECB is going to take steps to restrict liquidity.


Yields on 5-yr Treasuries and TIPS are exquisitely sensitive to expectations for economic growth, inflation, and Fed policy. Both have been relatively stable now for the past several years. This is consistent with a market that expects the economy to grow at roughly 2% per year for the foreseeable future. If the market were optimistic, both yields would be much higher than they are today. Inflation expectations—the difference between the two yields—are at a non-threatening 1.75% on average for the next 5 years.


Industrial commodity prices remain relatively strong, despite the runup in the dollar's value over the past two years (usually the two move in opposite directions). This strongly suggests that global economic activity remains firm; commodity prices are up because demand has exceeded producer's expectations, not because there is a surplus of foreign exchange.


5-yr credit default swap spreads (see chart above) are a highly liquid and reliable measure of corporate credit risk. Spreads have been falling for the past year and currently are relatively low. This suggests that the outlook for corporate profits is healthy, and investors are reasonably confident that credit risk is unlikely to deteriorate. Confidence and increasing profits are the seed corn of future investment and stronger economic growth.


The earnings yield on stocks (earnings per share divided by share prices) is still substantially higher than the yield on 10-yr Treasuries, as the chart above suggests. This implies that investors are still worried about the potential for an equity market correction, since they are willing to forego a substantial pickup in yield in exchange for the greater safety offered by Treasuries. If the market were irrationally exuberant, the equity risk premium would be negative, not positive.

(Note to readers: The dearth of posts in the past week or so owes much to the fact that there hasn't been a lot of earth-shaking news to comment on, and so the near-term outlook—continued modest growth and low inflation—hasn't changed much if at all. Changes to this hinge crucially on whether Trump and the Republicans are able to pass meaning tax and regulatory reform. I remain cautiously optimistic that they will.)

Friday, May 5, 2017

April jobs: a nothing burger

The April jobs report was a nothing burger. Nothing has changed: jobs are still growing at a modest pace, and that pace has weakened a bit over the past year or so. The economy is most likely still growing at slightly more than a 2% trend rate. Things won't get better until the burdens of taxes and regulations get lifted. The Trump administration is making progress towards this end, but there hasn't been enough so far to make a significant difference. Efforts to reform the tax code are more important than healthcare reform, in my view. If the economy can be boosted a higher trend growth rate path, then lots of reform becomes possible. 



These two charts are all you need to understand the jobs climate. Monthly reports can be very volatile, so you have to consider 6- and 12-month growth trends. Private sector jobs—the only ones that really count—have grown by 1.7% over the past 6 and 12 months. Ho-hum. That, plus the 0.5-0.6% rate of productivity over the past several years gives you overall GDP growth of a bit over 2%.

Wednesday, May 3, 2017

Inconvenient energy fact

Mark Perry has a fabulous post today highlighting the extreme inefficiency which afflicts the solar power industry. It can be summed up in the following chart, but be sure to read the whole thing for all the gory details:


Modest Fed expectations fit with modest growth


Today's FOMC statement was pretty much as expected, to judge from the relative lack of reaction in the bond market. The market currently assigns a relatively high probability of a modest 25 bps hike in the overnight funds rate target at the June FOMC meeting, and a very low probability of another for the remainder of the year. This fits with the current economic growth climate, which remains modest. Second quarter GDP is likely to be much faster than first quarter (0.7%), according to the Atlanta Fed, but the underlying rate of real growth is unlikely to be much faster than 2%. 




The chart above says just about all you need to know about current expectations. The blue line is the current real Fed funds rate (about -0.6%), and the red line is the market' expectation for the average real Fed funds rate over the next 5 years. The difference between the two is quite modest—just over 50 bps—which suggests the market just doesn't think the Fed is going to do much more tightening after next month's meeting for the foreseeable future. I note that the blue line has moved up of late, and that reflects the fact that the Fed's target rate has moved up from 0.25% to 1.0% while core PCE inflation has remained relatively stable at 1.5 - 1.8%.

In many previous posts I've noted that the time to worry about the Fed being too tight is when the blue line equals or exceeds the red line. At that point the market is figuring that the Fed is done tightening because the economy is softening and at risk of recession. Currently that's not the case. But neither is it the case that the market expects much more oomph from the economy.

If the market were optimistic about growth, the gap between the blue and red lines would most likely be much bigger, and the red line would be much higher (real interest rates tend to follow real growth rates). That's not likely to happen unless and until Trump manages to achieve some meaningful tax and regulatory reform. For the time being, the world is on hold.

Tuesday, May 2, 2017

Trump's deal of a lifetime

The value of global equities, according to Bloomberg's index, will probably set a new record high this week of just over $73 trillion. (To avoid double-counting, Bloomberg excludes ETFs and ADRs from its calculation.) The U.S. market is within inches of its record high $26.8 trillion set two months ago. But it's not just the U.S. stock market that is booming: U.S. equities today represent almost 37% of the total, whereas they were almost 45% in early 2004. We are a smaller (but growing) piece of an even-faster growing global pie, and most of the growth is happening in the lesser-developed countries. China's equity market today is worth almost $7 trillion, which is 15 times greater than its value in early 2004 ($440 billion). India's stock market has risen by a factor of 7 since then, and now totals almost $2 trillion.


This surge in global wealth has almost certainly been driven by an expansion of global trade. 18 years ago China's exports to the U.S. were a mere $2.4 billion per month; they now average $32.5 billion per month. Over the same period, India's exports have exploded from a mere $300 million per month to now almost $3 billion per month. Trade is a win-win situation for everyone, with the world's poorest benefiting the most even as developed countries continue to prosper.


As the chart above shows, the volume of world trade has almost doubled over the past 17 years, and it rose 4% in the year ended last February. Most importantly, world trade volumes surged at an annualized rate of almost 12% in four months ending last February, an excellent sign that global economic fundamentals are solid and improving. It's not a coincidence, I suspect, that the value of global equities has risen almost 10% in the most recent four months.

As I and many others have noted, the most troublesome thing about Trump was his failure to understand how international trade works, and in particular his aversion to trade deficits, which any economist worth his salt knows are effectively meaningless. His apparent willingness to impose tariffs on Chinese imports posed a grave threat to international trade and prosperity. Two weeks ago Trump may have made the deal of his lifetime when he offered to forget about our trade deficit with China if the Chinese would in turn help us solve the problem of North Korea. He gave up something that was worthless in exchange for—we hope—a solution to the NoKo problem, which would be priceless.

Friday, April 28, 2017

Weak Q1 growth, but stronger growth to come

First quarter GDP statistics were disappointing, with real growth of only 0.7% annualized (real GDP increased by a mere $29 billion in the quarter, almost a rounding error). However, real growth for the 12 months ended March was 1.9%, only modestly less than the 2.1% annualized growth rate for the current business cycle expansion. More interesting, perhaps, was the rate of inflation as measured by the GDP deflator (the broadest measure of inflation available): 2.3% annualized for the first quarter and 2.0% for the past 12 months. By this measure, the Fed has achieved its target inflation goal, and is fully justified in raising short-term interest rates. The brightest spot in the quarter was a 12% annualized jump in gross private fixed investment, since weak business investment has been the root cause of the current recovery's dismal, 2.1% annualized pace of growth. This may mark the beginnings of a pickup in growth in the years ahead, especially if Trump is able to slash the corporate tax rate as he proposes.


As the chart above shows, real GDP growth has essentially been on a 2% growth path since the middle of 2009. That's about one percentage point below its long-term growth path, and the "gap" between the two is now a bit over $3 trillion. That's a disappointing result, to be sure, but it also implies that the economy has tremendous upside potential, and that is extremely encouraging. As long-time readers will  know, I consider that the current recovery has been weak primarily due to rising tax and regulatory burdens and a dearth of business investment (and the two are most likely closely entwined). Rebuilding confidence, reducing the barriers to business investment and risk taking, and increasing the after-tax rewards to investment will thus be critical to closing the GDP gap. The potential rewards to successful growth-oriented policies are hard to overestimate.


Real gross private domestic investment (shown in the graph above) grew at a 3.7% annualized rate from 1966 through 2007, over which time real GDP growth grew at a 3.1% annualized rate. From the peak of the last business cycle in 2007 until March of this year, private investment has managed to post only 1% annualized growth. It's no wonder then that growth in the current expansion has been only 2.1%. Without more investment, there will be a scarcity of jobs, and a scarcity of the tools (machines, computers, software) necessary to boost the productivity of those who are employed. Investment is the key to prosperity, and so far, in the current business cycle expansion, it has been in scarce supply.


A subset of real gross private investment is gross private fixed investment, shown in the chart above. Largely driven by strong residential investment, it jumped at a 12% annualized rate in the first quarter.


As the chart above shows, inflation as measured by the GDP deflator (the broadest possible measure of inflation) was 2% in the 12 months ended March 2017. Forget deflation. The issue now is whether inflation is likely to accelerate from its current 2% pace. It's also significant that despite the sluggish growth of the past 6 ¾ years, inflation has on balance remained well above zero, a result that runs counter to the Phillips Curve theory of inflation, which holds that weak growth and lots of unused capacity tend to depress inflation. Inflation is a monetary phenomenon, not a function of growth.

The key to the future prosperity of the US economy is business investment. Only the private sector can create prosperity; the proper role of the public sector is to uphold the rule of law, ensure personal freedom, protect private property, and maintain the peace—not to create jobs. Prosperity is the result of people working smarter and harder—and taking on risk in the process. In order to get more prosperity we need more investment, and Trump's tax proposals—while far from ideal—go a long way to incentivizing private sector investment.

Lowering the tax rate on big and small businesses to 15% would significantly increase the after-tax rewards to business investment. One simplistic example: currently a business gets to keep 65 cents on every dollar of profit; under Trump's proposal a business would get to keep 85 cents on every dollar of profit. That works out to a 30% increase in the after-tax rewards to running, starting, and expanding a business. (It also suggests that reducing the corporate tax rate to 15% could boost the stock market—which is the present value of future after-tax profits—by 30%.) When rewards increase to such a significant degree it is only reasonable to expect to see a big increase in business investment, which in turn would result in more jobs, more income, and an expanding tax base. Cutting tax rates needn't result in reduced tax revenues, and cutting the corporate tax rate is the most logical place to start if you want to stimulate the economy. And by the way, we need to continue to cut regulatory burdens and simplify the tax code; shrink the government, and give the private sector the room and freedom to grow.

UPDATE: John Steele Gordon yesterday wrote forcefully (and in much greater depth than I do here) about why Trump's tax proposals would be very good for the economy. Trigger warning: he criticizes those who oppose the proposals.

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.