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.