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Conditions in Europe are improving



The financial fundamentals in Europe are improving on the margin. 2-yr German government yields are up almost 30 bps from their all-time lows of last month, which was a time when the world thought the euro was going to collapse. Euro swap spreads have dropped almost 20 bps from their highs of late May, in a sign that the market is much less concerned now about a Greek default spreading contagious death and destruction throughout the European banking community. The euro is up 6% from its low one month ago, as the likelihood of a European economic collapse and the dissolution of the euro itself begin to fade. German stocks are now up 1.3% on the year, while the S&P 500 is still down 4.8%.

U.S. swap spreads, meanwhile are back to normal.

Emergency unemployment recipients drop 30%




The number of new weekly claims for unemployment insurance has been flat to slightly down so far this year, and that suggests that conditions in the labor market are not deteriorating and are probably improving a bit on the margin. We see the same story in the number of new jobs created this year: modest improvement.

One of the biggest changes affecting the labor market has gone largely unreported, however: emergency claims for extended unemployment insurance have dropped by 30% (about 1.75 million) since March. When we add those who continue to receive claims, we find that the number of people receiving some form of unemployment compensation insurance has dropped by 3 million since January (bottom chart). Undoubtedly many of those are feeling pretty badly right now, but some (almost a million) have new jobs, and some are going to be more inclined to find and accept a job, even if it means the pay doesn't match their expectations. (I've seen numerous reports of businesses that are having trouble finding willing workers, since the pay they offer doesn't beat the combination of leisure and unemployment insurance that unemployed workers are receiving.)

I would add that never before in history has the government been so generous in its provision of unemployment insurance, thanks to the size and extent of the emergency program. Whether that has been a factor retarding the recovery, or whether on balance it has helped, we really don't know. But if you're looking for "what's different" about this recovery, here is a big one.

This has the makings of a bottom



Equities are up over 3% today, and the Vix Index has dropped by almost half since its recent high. Given how depressed the market was until recently, I think this has all the makings of a bottom, at least for now. The financial fundamentals I watch have all improved substantially over the past month or so, even as the equity market worked itself into a lather over the prospects of a big economic slowdown. Swap spreads both here and in Europe are down meaningfully from their recent highs, and implied volatility is down significantly. Commodity prices had a meaningful correction, but they have not collapsed by any stretch. Oil is almost back up to its average over the past year. The dollar is off 5% from its recent high, another sign that the climate of fear that drove investors to dollars has subsided. Ditto for gold, which is down almost 5%.

It looks to me like the equity market just got carried away, letting its attention drift from the fundamentals to worry instead about all the dire warnings being advanced by pundits everywhere.

Leaving for Egypt and Africa this weekend

The last time I went on an extended trip was mid-March last year, about one week after the stock market hit a very ugly bottom. I'm hoping the timing of our next extended trip, which starts this weekend, will be as fortuitous. With the market action today I'm quite hopeful this will be the case.

Last year we travelled to Argentina, this year to a continent I've never been to before. Friday morning we depart for New York, where we'll spend some time with our daughter. Then we depart Sunday for Cairo for one week in Egypt. Then three weeks in southern Africa, which will include the safari that everyone says you need to do at least once in your life. I plan to continue following the markets, but obviously blogging will be light and irregular until we get back. The mix of posts ought to improve, however, as I plan to take some pictures along the way and highlight some of the interesting things we hope to see and do.

TIPS prices likely to fall



TIPS prices most likely peaked a week ago, and if the economy avoids a double-dip recession, as I think it will, then TIPS prices are likely to decline further, but not significantly.

This chart shows the real yield on 10-yr TIPS, and it is changes in this yield that affect the market price of TIPS (inversely). I've added my subjective estimate of valuation bands to the chart. When real yields are below 1.5% I consider TIPS to be expensive, and I would note that yields have yet to drop below 1%. I think we're likely to see real yields drift up by another 50 bps, which would imply a roughly 5-6% decline in the typical TIPS fund (e.g., TIP). I don't expect TIPS to revisit "cheap" territory in the foreseeable future, since that would only occur if the Fed started to tighten monetary policy in earnest, and/or if the economy started booming.

This is not a strong "sell" recommendation on TIPS, since I think they still make sense for those who want some conservative long-term protection against rising inflation.

There are two ways to make money on TIPS: through price appreciation that is driven by lower real yields, or through rising inflation, since the notional value of TIPS is adjusted upwards by the change in the CPI. It's the first of these that is not likely to work going forward, but the latter still holds potential.

Full disclosure: I am long TIPS and TIP as of this writing.

Dr. Copper says the patient is fine


The price of copper is traditionally such a good indicator of the economy's health that copper has earned the nickname "Dr. Copper." In this chart we see copper trading today at about the same level as it was for a few years prior to the crash of 2008. At $3/lb., copper today is worth almost five times as much as it was in November 2001, when most commodity prices hit bottom. That was also the end point of the 2001 recession, and also the beginning of what would be many years of very accommodative monetary policy from the the Federal Reserve.

I keep hearing the drumbeat of deflation concern, but it's hard for me to understand. Back in the early 2000s deflation risk was extremely high: gold fell to $260/oz., most commodity prices hit lows they hadn't seen since the 1970s, and the dollar was soaring against most currencies. Now all these key indicators of the scarcity of money are reversed: commodity prices are near all-time highs, gold is $1200/oz., and the dollar is in the lower end of its historical trading range vis a vis other major currencies.

If nothing else, copper prices today tell us that deflation is not a concern but that inflation is. I think copper also is telling us that the global economy is pretty healthy, as demand for the metal has been unusually strong for a number of years. My friend Mike Churchill points me to an interesting story suggesting that copper supply is also relatively tight. Whatever the case, $3 copper is saying that deflation and recession are simply nowhere to be found in the global economy.

MBS yields are probably bottoming


Barring an actual double-dip recession, which I think is quite unlikely, mortgage rates are most likely at or very near their lows. As this chart shows, the spread between MBS yields (which are typically about 50 bps below what homeowners pay on a 30-yr fixed rate mortgage) is about as low relative to 10-yr Treasury yields as it has ever been. 10-yr Treasuries, in turn, are down to levels that are consistent with very low inflation and economic recession. Treasury yields aren't likely to go lower unless all heck breaks loose, as it did in late 2008.

For those unfamiliar with how MBS work, they have what is called "negative convexity." That means that the duration of MBS falls as yields fall, and rises as yields rise. Most other bonds have positive convexity, which means their duration increases as yields fall, and falls as yields rise. (Duration is a measure of how sensitive a bond's price is to changes in yields. A duration of 5 means that a bond's price will rise by 5% if it's yield falls by 1 percentage point.) Institutional investors (the vast majority of whom hold significant amounts of MBS in their portfolios) seeking to keep their overall portfolio duration at a given level must therefore use Treasuries and Treasury futures to hedge their MBS exposure. That means adding exposure to Treasury bonds as interest rates fall, so that the duration gain experienced by Treasuries offsets the duration loss experienced by MBS. If Treasury yields start to rise, the process must be reversed by selling Treasuries. This negative convexity dynamic can at times increase the market's volatility, exaggerating the up and down swings in interest rates, because buying increases as Treasury bond prices rise, and selling increases as bond prices fall. The long and short of it is that if this indeed proves to be the low in yields—and I think it will because I really doubt the economy is rolling over—then the rebound in yields could be rather dramatic.

Yields and MBS spreads are both extraordinarily low right now, and to remain at this level or to go lower would require a rather dramatic deterioration in the economy's growth prospects. Yields are already quite low in anticipation of a double-dip; so the market would at least need a double-dip to happen to keep yields from rising. I for one just don't see the reason for the economy to collapse.

In response to a reader's question, here is the sort of thing I would need to see to be worried about the future: I think it would have to be some unforeseen and unexpected government action that threw a curve ball at the markets and the economy. A round of Smoot Hawley-like tariff wars, for example, that could shut down global trade. A big change in the laws governing the financial system, in which the law of unintended consequences could step in and turn what politicians thought was a sensible "solution" into a new nightmare. A big hike in corporate income taxes, which are already the highest in the developing world. A decision to impose capital controls, which might result in a sharp reduction in foreign investment.

No shortage of money


I first articulated this theme in September 2008, and have returned to it many times since. My point is that the recession of 2008-2009 was not caused by a Federal Reserve tightening of monetary policy, the way it's been with every post-war recession. The recent recession was caused by a massive increase in the demand for money, which the Federal Reserve then struggled to accommodate. Since the Fed finally caught on and pumped up bank reserves by a cool trillion, the economy has been awash in money. Banks may be still somewhat reluctant to lend, but borrowers have also been reluctant to borrow, on balance, and many people seem to want to actually reduce their borrowing (i.e., by deleveraging).

This chart shows that it takes more and more money to accommodate a growing economy and ongoing (albeit fairly low these days) inflation. The red line shows the annualized growth rate of M2 on a rolling three-month basis, and the blue bars show the annualized growth rate of nominal GDP on a quarterly basis. On average and over time, M2 tends to grow by about the same amount as nominal GDP. Over the most recent 3-mo. period ending June 21st, M2 grew at a 4.1% pace and shows signs of accelerating. I'm guessing we'll see nominal GDP growth of at least 3-4% in the second quarter, and if so that would be a sign that M2 velocity (GDP/M2) is roughly stable. I actually think that velocity is likely to increase a bit—it's been rising at a decent pace since last summer—and if so, then we could see nominal GDP come in at an even higher rate.

The dollar has weakened of late, and the growth of currency in circulation (a good proxy for he world's demand for dollars) has slowed down in the past few months, and those are both good signs that M2 velocity is rising (velocity being the inverse of money demand). So with M2 rising and M2 velocity likely rising as well, there is good reason to believe that we will be seeing healthy rates of GDP growth. Again, no sign here of any slowdown or imminent recession.

Shipping update


I suppose the worst thing you could say about the Harpex Shipping Index is that it is a lagging indicator. After all, it didn't turn up until earlier this year, well after the global economy started turning up last summer. Nevertheless, it is catching up with a vengeance, as it now more than double what it was at the end of last year (up 115% to be precise). At the very least, this tells us that demand for container shipments in the N. Atlantic has improved rather dramatically in recent months. Last I heard, the European economy was still alive and well, and I see today that the Euro is up 6% from its recent lows.

Once again, how one can look at things like this and worry about a double-dip recession is beyond me.

Corporate profits are strong, but pessimism rules




There's so much talk about a coming double-dip recession and the parallels between now and the 1930s that I feel compelled to counter the pervasive pessimism with some reasoned optimism.

The first chart here shows PE ratios as calculated by Bloomberg. As of June 30th, they stood at 14.9, which is below the long-term average of 16.7. As Brian Wesbury notes, if you use forward earnings estimates, PE ratios are now under 12.

Lots of pessimism in those figures, as I think you can see from the second chart, which compares profits according to the NIPA calculations (which in turn are based on IRS data), and standard earnings calculations based on what companies report using GAAP and writeoffs. I note that the NIPA measure of profits is much less volatile than the S&P measure, and to my eye the NIPA series tends to lead the S&P series. NIPA profits are just a shade below their all-time high (as of last March), while S&P profits are still almost 25% below their all-time high. If the NIPA series is indeed a leading indicator of reported profits, then there is plenty of good news on the profits front to come.

How reasonable people can look at these strong profits numbers and conclude that we are on the verge of another recession or even a depression is beyond me.

What we should be concerned about is not the absence of profits but the fact that while corporations are generally very profitable these days, they are noticeably very reluctant to invest those profits. Record levels of profits and tepid job creation is a sign of a lack of confidence in the business community, and it's not hard to understand why: consider the almost unprecedented anti-business attitude that emanates from the White House; the out-of-control federal spending that creates deep-seated fears of an eventual surge in tax burdens; the Congressional urge to dump huge new regulatory burdens on private industry; and the Federal Reserve's unprecedented purchase of $1 trillion of MBS, which creates a mountain of uncertainty in regards to future inflation and the value of the dollar. Here is a video of Steve Wynn making his views on the subject quite clear.

ISM: service sector still growing


The June ISM surveys revealed a modest deterioration in the health of the service sector, with the result that 58.1% of service sector companies, rather than 61.1% in May, reported improving business activity. But as this chart shows, month-to-month fluctuations like this are to be expected—they are almost the rule, not the exception. The important thing is that the level of the index is sharply higher than it was just six months ago, and it is showing that a clear majority of businesses see conditions improving. There is nothing in this index that would point to a double-dip recession.

P.S. The correlation of this index, which I have traditionally followed, to the more frequently cited Service Sector Composite Index is 0.97. Both show almost exactly the same pattern.

4th of July at the beach



It's a beautiful day in So. California, especially at the beach. This is the first real sunny day we've had in almost two weeks. The beaches are packed but the waves are so big that not many people are swimming today. We walked along the coastal footpath to San Clemente and back earlier today, and I didn't hear a single person or see a single sign complaining about Obama or the economy—what a relief! Lots of flags and BBQs though, as people get ready to watch the fireworks tonight.

The first shot is looking down on Calafia Beach from a nearby bluff, and the second shot is looking west (Calafia beach is almost a south-facing beach) towards the San Clemente pier with Dana Point in the background. On a clearer day you can see Catalina Island off to the left.