Thursday, August 10, 2017

The Nork Wall of Worry

Kim Jong-un is making today's headlines with his threats to attack Guam in short order and somewhere in the US at a later date—and to attack with nuclear weapons no less. He's also sparked a mini panic attack in global markets. But so far, markets have been quite blasé about the threat that North Korea poses. The chart below puts things in perspective, as of 7 am beach time:

Believe it or not, the threat of imminent nuclear hostilities is (so far) just a blip on the market's radar screen. About as big as the threat of a Frexit, but far less than Brexit, collapsing oil prices, or a Chinese economic implosion. If you want protection from a nuclear holocaust, options are still relatively cheap, with the Vix this morning trading around 14-15, up from a very low 10 a few days ago.

So either the market is ridiculously unconcerned, or the market rates the chances of a nuclear explosion as remote. Considering that the So. Korea stock market is down less than 4% in the past few weeks, it's probably the latter. (You would think Seoul has the most to lose if Kim Jong-un gets crazy enough to start pushing launch buttons.) I note as well that gold is up only 2% or so in the past week.

I'm not offering investment advice here, I'm merely laying some facts on the table.

It's also worth noting that industrial metals prices yesterday reached an 18-month high, having risen more that 60% from their January 2016 low, as the chart above shows. That's pretty impressive, and it suggests that global economic activity has definitely perked up.

I'm reminded of the fact that the recession of 2001 ended just a few months after the 9/11 attack. The US economy is amazingly resilient, and the global economy perhaps just as resilient.

Monday, August 7, 2017

Credit spreads tell a bullish story

Credit spreads—the extra amount of yield that investors demand to hold debt that is riskier than Treasuries—are uniformly low these days. That tells us that liquidity in the bond market is abundant, systemic risk is low, and the outlook for corporate profits and the economy is healthy. '

Swap spreads (see a short primer on swap spreads here) are arguably the bedrock and most important of all credit spreads. "Normal" spreads on 2-yr contracts are roughly 20-40 bps. At today's 25 bps, 2-yr swap spreads are perfectly normal. This tells us that bond market liquidity is relatively abundant. Fed tightening has not created a shortage of money, as it usually does in advance of recessions. It also tells us that systemic risk is perceived to be low. As the chart above suggests, swap spreads tend to be good predictors of conditions in the broader economy; spreads tend to rise in advance of recessions and decline in advance of recoveries.

As the chart above shows, swap spreads in the Eurozone are elevated. Conditions are not as healthy there as they are here. Eurozone spreads are not dangerously high, but they do reflect some systemic risk, which is likely related to the perception that the Eurozone still faces existential risks from countries thinking about "exiting" the Eurozone. Given the higher spreads in the Eurozone, it is not surprising that Eurozone GDP growth has been lagging that of the US for a number of years. Riskier markets tend to receive less investment—and consequently less growth—than less risky markets.

The chart above shows credit spreads as derived from the universe of bonds issued by US corporations: $6.3 trillion of investment grade bonds, and $1.3 trillion of high-yield (junk) bonds. Both spreads are relatively low, as you would expect them to be in a healthy, growing economy. They are not at record lows, but they are low enough to be impressive.

The chart above compares 2-yr swap spreads to high-yield corporate spreads. Here we see further evidence of how swap spreads tend to be good predictors of the health of the economy (HY spreads are particularly sensitive to the underlying health of the economy).

The chart above shows 5-yr Credit Default Swap spreads. CDS spreads are derived from generic contracts representing hundreds of large, liquid corporate bonds, so they are reliably good proxies for overall credit risk. Their message is the same as other credit spreads: conditions are normal, and thus the outlook for the economy and corporate profits is healthy.

Commercial real estate still strong

A quick update on the health of the commercial real estate market, which remains quite good. According to the folks at CoStar, their composite (equal weighted) price index rose a staggering 17.5% in the 12 months ended June, 2017. Price gains were strongest in the lower-priced, secondary and tertiary markets. Gains in higher-priced and larger markets were a solid 5% over the same period.


Tuesday, August 1, 2017

No boom, no bust

My reading of the economic and financial tea leaves is that the economy continues to grow at a sub-par pace (about 2%), just as it has for the past 8 years. I don't see evidence of a coming boom, nor of an imminent bust. I think the market expects roughly the same thing; it's not priced to either a boom or a bust, just more of the same. Dull.

Here are a baker's dozen charts, with the latest updates, to flesh out the story:

The chart above is one of my enduring favorites. It shows that the ISM manufacturing index does a pretty good job of tracking the growth rate of the economy. What's especially nice is that the index comes out with a relatively short lag of just a week or two, whereas we usually have to wait months to get a read on the economy. What it's saying now is that GDP growth in the current (third) quarter is likely to be in the range of 2-4% annualized. That won't necessarily mean that the underlying pace of growth is picking up though; it's more likely that some faster reported growth in the current quarter which will make up for the relatively weak growth of recent quarters. Such is the volatile nature of GDP stats.

The two charts above are encouraging, since they show that global economic activity is likely picking up. US manufacturers are seeing relatively strong overseas demand, and Eurozone manufacturers have experienced a significant improvement over the past year or so, after years of weak activity.

The chart above shows that US manufacturers are at least somewhat optimistic about the future of their businesses, since many reportedly plan to increase hiring activity in the months to come.

The chart above shows that the ISM manufacturing index does a pretty good job of predicting corporate revenues. For months now, the ISM index has been telling us that revenues per share for the S&P 500 were likely to increase, and they have indeed in increased by over 5% in the 12 months ended July. 

Not surprisingly, faster growth of revenues has gone hand in hand with increased profits. Trailing 12-month earnings per share (earnings on continuing operations) were up over 9% in the year ending July. No wonder the stock market continues to edge higher. Profits and prices are both at all-time highs and rising.

The current trailing PE ratio of the S&P 500 is just over 21, according to Bloomberg's calculation of earnings from continuing operations. That's a good deal above its long-term average of just under 17, but it's not impossibly high. The inverse of the PE ratio—the earnings yield on stocks—is still a healthy 4.7%.

The chart above subtracts the yield on 10-yr Treasuries from the earnings yield on stocks. Equity investing still gives you a yield that is substantially higher than the risk-free yield on Treasuries. It's not always thus. In fact, during periods of robust growth and strong stock markets—such as the 1980s and 1990s—the earnings yield on stocks was usually less than the yield on Treasuries. When investors are confident and the economy is strong, investors are willing to accept a lower yield on stocks because they expect to more than make up for that with capital gains (i.e., rising share prices). The situation today is quite the opposite: a positive equity risk premium suggests that investors are skeptical of the ability of earnings to grow, and are thus willing to accept a lower yield on Treasuries in exchange for their increased safety.

Not all is rosy, however. As the chart above shows, the dollar has taken quite a hit since the "Trump bump" of last November. It's down about 10% in the past 8 months, in what is surely a sign that the world has become a lot less excited about the growth prospects of the US economy.

The chart above provides more evidence that the market doesn't expect the US economy to be very strong going forward. The current real Fed funds rate—the best indicator of whether monetary policy is tight or not—is about -0.25%. The current 5-yr real yield on TIPS (a good indicator of what the market expects the real funds rate to average over the next 5 years) is only 0.11%. This means the market doesn't expect the Fed to do much more in the way of tightening for the foreseeable future. And that, in turn, means the market holds out very little hope for any meaningful improvement in the US economy.

The chart above suggests there is very little reason to expect a recession for the foreseeable future. Every recession for the past half century has been preceded by a monetary tightening sufficient to raise real short-term rates to at least 3-4%, and to flatten or invert the Treasury yield curve. We're a long way away from either of those conditions today. The Fed is relatively easy, and is not expected to tighten much, if at all, because the economy is not expected to improve much, if at all. 

The chart above compares the 2-yr annualized growth of real GDP to the 5-yr real yield on TIPS. I use a 2-yr measure for GDP to "edit out" the quarterly fluctuations which are more due to statistical vagaries than to any real change in the economy's strength. The chart suggests that the current level of real yields is a sign that the market thinks the economy is still likely on a 2% growth trend. (The latest revision to GDP boosted growth during the 2014 -2015 period, but reduced it in the past two years. That is consistent with my repeated observations that the trend growth rate of jobs has slipped in the past year or so from 2.0% to 1.6-1.7%.)

Another not-so-rosy-sign is construction spending, which has softened and dipped year to date. This could just be a pause that refreshes, but in a worst case scenario—if this weakness continues—it could be an early warning sign of another recession. I doubt that is the case, since mortgage originations and home sales are still relatively healthy, but if you want something to worry about, here it is.

I highlighted this chart a few weeks ago, noting that the stability of China's foreign reserves this year is a healthy sign that the yuan has moved to a level that is balancing capital flows (forex reserves under a floating-pegged currency regime such as China's are a direct measure of net capital flows). The yuan has appreciated a bit more of late, a sign that the situation in China is improving on the margin (more money wants to get in than out). Good news from overseas is always good news for the US, especially for a major player like China.

To sum up: I see no sign of excessive optimism or pessimism in market prices. The market's expectations are for a dull economy to remain dull and for inflation to remain relatively low. 5-year expected inflation, according to TIPS and Treasury prices are 1.7%. There is no compelling reason to worry about a recession, or to get excited about a boom. The market is thus "vulnerable" to signs of emerging weakness or increased strength. If we get a decent tax reform package, look for optimism to emerge. If we don't get tax reform, the downside risk is likely not significant, since reform expectations have not been priced in. Fortunately, we have had some meaningful reform in the area of regulatory burdens so far this year, and this should give the economy enough of a lift to keep things on an even, 2% growth trajectory or maybe slightly better.