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Crude oil and gold reach new nominal highs





Crude oil hit a new post-recession high today. As the second chart shows, in real terms oil is now back to the levels we saw in the early 1980s. Oil prices were shockingly high back then, having surged over the previous 10 years. Yet expensive oil didn't stop the economy from enjoying a boom, and the surge in exploration activity that followed the surge in oil prices soon brought forth a gusher of oil which in turn drove the price back down. Rising oil prices already have resulted in a 116% increase in the North American Rig Count since the middle of last year, according to Baker Hughes, so there are some interesting parallels between now and the early 1980s that are promising. The third chart compares real crude prices with the worldwide rig count, which hasn't risen quite as much as the N. American count; still, note how drilling activity responds to changes in real crude prices. It would be surprising if drilling and exploration activity didn't continue to rise given the current level of prices.

As a reminder, even though oil today is quite expensive in real terms from an historical perspective, there is reason to believe that it won't pose a serious obstacle to growth. Thanks to conservation and technological advances, the U.S. economy uses about half as much oil per unit of output as it did in 1980. As a result, consumers today spend about half as much of their income on energy as they did in 1980.

As the fourth chart shows, gold hit a new all-time high of just over $1400/oz. in nominal terms, but is still below its previous high (which was about $2250 on an intra-month basis).


I've shown this last chart several times before, but it's worth updating. What it shows is that gold has been a good leading indicator of non-energy industrial commodity prices, and it appears that the rally in both isn't over yet. Sooner or later the higher prices of gold, oil and commodity prices will find their way into the CPI (which is plagued by tons of inertia in the form of long-term labor contracts and leases) and we will see inflation rising. But by then it will be old news. You don't wait for the CPI to go up before you realize that inflation is rising; the CPI is the last place that the dollar's ongoing loss of value will show up.

ISM Service Sector looking decent


The November ISM service sector report was about as expected, and confirms the message we are getting from numerous areas: the economy is growing at a modest/moderate pace, and there is continued upward price pressure. The most encouraging thing in the report from my perspective was the employment index, shown above. Almost 53% of those surveyed report their companies are in a hiring mode, the most since before the last recession started.

With so many idle workers still out there, a return of business confidence can quickly result in a significant pickup in jobs and total output. U.S. companies are still accumulating a mountain of over $1 trillion in profits just waiting to be put to work when the conditions are more favorable. It certainly pays to remain optimistic even though the economy seems sluggish.

Jobs growth disappoints but the outlook is improving


November growth in private payrolls was disappointingly low, since I and many others had been hoping to see a modest pickup in the pace of job creation. Instead, the private sector added between 59K jobs, according to the household survey, and 50K jobs, according to the establishment survey. From a longer term perspective, these surveys tell us that, from the low in jobs last December, the private sector has created between 1.47 million jobs (household) and 1.17 million jobs (establishment). Taking an average of the two, that works out to a gain of roughly 1.3 million jobs, for a rate of growth of about 1.3%. That's only enough to keep pace with the natural growth in the labor force, which is why the unemployment rate hasn't changed much over the past year.

Nevertheless, despite the failure of job growth to pick up, there is no sign that it is slowing down. The economy continues to plod ahead at a slow pace. If this keeps up, and worker productivity rises at its long-term average pace of 2% per year, then we can expect to see about 3.5% real GDP growth going forward. My growth expectations remain unchanged since Dec. '08: 3-4% on average. If Q4 growth comes in at 4% then growth for the year will have been 3%. Ho-hum, not much to write home about.

All of this is old news however. What matters most right now is what happens to the Bush tax cuts. If they are allowed to expire that would be bad news for growth next year. But it looks like there is a good chance they will at least be extended for a year or two for all taxpayers, and that would be good news. Uncertainty would decline, and tax rates on capital gains and dividends would remain low, thus encouraging new job-creating investments.

Key market-based indicators point to more growth and higher inflation

Relying on government statistics to track the fundamentals of the economy is a lot like driving by looking in the rear view mirror—and a foggy one at that. The data comes with an unavoidable and sometimes significant delay, it is often manipulated and estimated, and many series are subject to substantial revision long after the fact. That's why it can be more rewarding to watch market-based indicators (i.e., prices), since they reflect real-time information, and they incorporate the collective knowledge and decisions of hundreds of millions of economic actors with access to every conceivable piece of information.

What follows is a quick review of the status and significance of a variety of market-based indicators that I think are important, in no particular order.





Virtually all commodity prices are rising, and have been rising since early last year. Several broad-based indices of non-energy commodity prices are now at or close to all-time highs. This is good evidence that global economies are growing—demand is outstripping supply— and it likely also reflects the fact that most central banks are being very generous with the supply of money: money is cheap just about everywhere. Cheap money makes it easy to engage in commodity speculation, and it also makes investments in tangible goods more attractive, since they provide a hedge against easy money turning into an unexpectedly large rise in inflation.

The first of the charts above is an index of non-energy, industrial spot commodity prices. Only half of its components have related futures contracts, so it is insulated to a degree from commodity price speculation. The second and third charts show industrial metals prices, and their strength makes a good case for global construction and manufacturing activity being strong. The fourth chart shows the relatively obscure prices of textiles, which have been unusually strong of late. With so much evidence of rising prices, it's very hard to escape the conclusion that the global economy is growing and inflation pressures are rising.


Gold is only a few dollars shy of its all-time high, and has been in a rising trend for almost 10 years. It cannot be a coincidence that gold began rising only a few weeks after the Fed surprised the world in early 2001 by cutting the funds rate in response to a weakening economy—and then ended up slashing the funds rate from 6.5% to a mere 1.0% by the end of 2003, where it stayed for an entire year. Easy money got the gold rally going, and easy money has sustained the rally ever since. Gold is telling us that the dollar is likely to suffer a significant loss of purchasing power in the future due to overly-easy monetary policy.


The dollar began declining about a year after gold started rising, and gold has been a good leading indicator of the declining purchasing power of the dollar against other currencies ever since. It is not unreasonable to think that the dollar's huge loss of purchasing power against gold, commodities, and other currencies will eventually be reflected in rising prices of the goods and services that make up the consumer price index. Today the dollar is about 13% above its all-time low in nominal terms, relative to a basket of major currencies. On an inflation-adjusted basis and relative to a large basket of trade-weighted currencies, the dollar is at or very near its all-time low. The dollar is weak no matter how you measure it relative to other currencies, and it's recent upward blip was mostly due to concerns about the euro. This weakness suggests a variety of observations: the Fed is effectively easier than most other central banks; there is an abundance of dollars in the world relative to the world's demand for dollars; confidence in the future of the U.S. economy is low; and many other economies have better prospects than we do.


The implied volatility of an option contract is a good measure of how much the market values the risk-reducing properties of owning options. This in turn makes implied volatility a good measure of the market's risk aversion: high implied volatility implies a lot of risk aversion, while low implied volatility suggests the market is very happy to take on risk. Similarly, implied option volatility can be used as a gauge of systemic risk, since it is reasonable to assume that people are willing to pay a lot for options at a time when systemic risk is high or people perceive it to be high. As the above chart shows, the implied volatility of equity index options and Treasury note and bond options today is relatively low, after soaring to unprecedented heights at the peak of the Lehman crisis in late 2008—a time when many believed that global financial markets were on the verge of a meltdown. The big decline in implied volatility is good indicator that markets have become much less risk-averse, and that systemic risk has declined significantly. We're still not back to normal levels, however, which suggests lingering concerns on the part of investors, and that in turn suggests that the equity valuations are not unreasonable high (euphoric price rises often occur when implied volatility is very low and risk aversion is almost nonexistent).


Spreads on 5-yr credit default swaps are a very liquid and reliable measure of the average risk of corporate defaults. While default risk was perceived to be a bit lower earlier this year—when it appeared that the economy was displaying surprising strength—the level of spreads today is far lower than it was the height of market panic in late 2008 and early 2009. It's still higher, though, than the levels that might be considered "normal." This confirms the message of implied volatility: corporate bond prices and equity prices still have a substantial risk premium built in, and there is still room for more price gains if economic conditions continue to improve.


Swap spreads are also an excellent indicator of risk aversion and systemic risk (or health, as the case may be). After surging to all-time highs during the height of the late-2008 banking crisis, U.S. swap spreads have led the way down (thus accurately forecasting improving conditions) ever since. There was a brief flare-up of concern last May over Euro (Greece) debt contagion, but those concerns have since passed. Swap spreads in the U.S. are now firmly in a range that would be consistent with normal systemic risk. European swap spreads are still somewhat elevated, however, which means that there is still a good deal of uncertainty surrounding the sovereign debt endgame. But to judge from rising commodity prices and rising equity prices around the globe, the world is not very concerned that the EU debt problem is an end-of-the-world-as-we-know-it type of problem. John Cochrane has a good op-ed in today's WSJ that explains why the Euro contagion is not a serious risk.


This chart shows the market capitalization of all global equity markets (in dollars). The message of this indicator is clear: the global economy suffered a devastating blow in 2008, but has since recovered a substantial portion of the ground lost. The best explanation for the huge swings in equity values in recent years is this: the reality of today's economy is an order of magnitude better than it was expected to be just two years ago, when there was almost universal agreement that we were headed for a global financial collapse and a deep depression. It is shocks such as this—when the facts turn out to be far different than expected—that drive huge changes in asset prices. It is not unreasonable to think—especially when one reads the countless analysts who continue to doubt that we will see an ongoing recovery, plus all those who worry that European debt contagion will precipitate another global banking crisis—that the future could prove to be better than many people expect, and that equity prices therefore can continue to rise.


The chart above is based on the 13th Fed funds futures contract, which is a good proxy for the market's expectation of where the funds rate will be in one year's time. Note how the expected funds rate one year forward fell to a low of 0.2% last month; this is consistent with the market fully embracing the Fed's plan to proceed with QE2 and keep the funds rate extremely low for a very long time (at least a year). Since then, the doubts about and the criticism of QE2 have been on the rise, and the news on the economy has been better than expected, and that is confirmed by the 17 bps rise in the one-year-forward expected funds rate. In short, the market is expecting the Fed to scale back the scope of QE2 and to begin reversing it sooner than was recently expected, because the need for and the justification of QE are less obvious now. These expectations are also apparent in the 60 bps rise in 10-yr Treasury yields since mid-October.

UPDATE: Below is a chart which combines implied volatility and equity prices, and shows how the decline in risk and risk aversion has coincided (and even tended to precede) the rise in equity prices. As confidence in the future improves, risk-taking is likely to rise too, and that should result in more investment, more growth, and higher equity prices.

The rebound in auto sales is impressive


November auto sales came in a bit above expectations. Since hitting bottom in Feb. '09, sales are up at a 17% annualized pace, which is in itself rather impressive. Of course, the level of sales is still dismally low from an historical perspective—who would have thought, in the year 1976, that sales 34 years hence would be lower than they were then, despite a 62% increase in the labor force?

There is absolutely huge upside potential here once the economy gets back on solid footing.

More progress on the employment front


Weekly claims (seasonally adjusted) have dropped rather dramatically in recent weeks. That's because on a non-seasonally-adjusted basis, claims have not risen as is usually the case around this time of the year (they've actually been flat since March). It's good news that more people are not being laid off as usual, but it doesn't necessarily mean that employers are hiring. Still, the ADP job estimate yesterday, coupled with the strong ISM employment report, suggest that we are likely to see a modestly rising trend in jobs for the foreseeable future. Thus, we may see a positive surprise in tomorrow's jobs data, with expectations of private payrolls currently at 158K. Whatever the case, I think it's clear that the employment scene has been gradually improving for most of this year and is likely to continue to do so.

Construction activity remains weak


Construction spending was a bit strong than expected in October, but from the looks of this chart, construction activity is barely holding its own. Residential construction is now at a record low 2.2% of GDP, while nonresidential construction has fallen 10% in the past year.

Manufacturing sector continues to improve


The November Purchasing Managers' Index of manufacturing came in about as expected, and continues to suggest that we will see a pickup in GDP growth in the current quarter. The current level of the index is consistent with Q4 GDP growth of 4% or so, judging from past correlations.


Encouragingly, the employment index remains at relatively high levels, as does the export orders index. Meanwhile, 69.5% of those surveyed reported paying higher prices, marking the 18th month in a row that a majority has reported doing so, and further bolstering the view that deflation risk is almost nonexistent.

The "forces of recovery" have been slowly building for the past 18 months, and in my opinion will not be easily derailed. Left to its own devices, the U.S. economy has a strong propensity to grow, and it has been growing despite the fierce headwinds of fiscal and monetary policy. Fiscal policy, while termed "stimulative" by politicians, has actually been restrictive, since it has borrowed massive amounts of funds from the private sector in order to feed an inefficient public sector, bolster unions, and fund a modest increase in public works. In the process, it has raised the specter of a massive future increase in tax and regulatory burdens, discouraging private sector initiative. Monetary policy has also been termed "stimulative," but so far it has only resulted in a weak dollar and fears of rising inflation, both of which dampen private sector investment by increasing uncertainty.

Going forward, I think there is reason to expect that fiscal and monetary policy will become less "stimulative," and thus allow the economy's natural recovery instincts to gain more traction.

Job growth is picking up


The November ADP estimate of private sector job growth rose more than expected (93K vs. 70K), and is now at its highest post-recession level. The picture here is one of gradual improvement, and it jibes with the slowing in the pace of layoffs and the upward trend in private sector jobs that we have seen in both the establishment and household job surveys so far this year. No sign of a boom, but also no sign of a double-dip.

Corporate layoff activity remains subdued


Announced corporate layoffs ticked up in November, but remain very low from an historical perspective.

Mortgage applications rising


As this chart of new applications for mortgages (seasonally adjusted) shows, demand for mortgages keeps rising. They are now up 27% from their July low. As the Mortgage Bankers' Assoc. puts it, this index is "a reliable indicator of impending home sales." In retrospect, there was an obvious slump in the housing market in the May-July period, but it now appears to be reversing, albeit slowly.

Real home prices: 18 months of stability


This first chart shows the inflation-adjusted value of the increasingly-popular S&P/Case Shiller Home Price Index. Prices have been essentially flat for the past 18 months. It's tempting to see a bit of weakness in the most recent months, however. Many observers are calling for a renewed decline in prices due to a flood of foreclosed homes hitting the market once the "robo-signing" problem gets straightened out. My view for some time has been that prices have fallen by enough already to clear the market and establish a new equilibrium level. In real terms, the average house price has fallen 35% from the early 2006 peak, and is only 15% above the early 2000 levels.

Taking into consideration that 30-yr fixed rate mortgage rates have declined from 6% in early 2006 to 4.5% currently, that equates to an effective decline in the monthly cost of purchasing a home of about 50%, not to mention the fact that real personal incomes are up over 6% since 2005. Do prices really need to fall further?


The second chart shows the Case-Shiller index of housing prices in 10 major markets (the first chart includes 20), and it includes data back to 1987. Prices today are 44% above the level of 1987, which equates to an annualized rate of gain of 1.5%. But again, this is less than the rise in real personal incomes (which averages about 3% per year), and less still considering that mortgage rates were in the low double-digits in 1987. Houses are far more affordable today than they were in 1987.


This last chart is an updated version of the one in Robert Shiller's book, "Irrational Exuberance." This inflation-adjusted index extends all the way back to 1890. Here we see that current real housing prices are 32% above their 1890 levels, which equates to an annualized rate of gain of only 0.2%, far lower than the rise in real incomes. It's no wonder that the average person can buy bigger and better houses today than their ancestors did.

None of these charts rules out a further decline in prices, but they do lend support to the view that prices have declined meaningfully to date, and are no longer out of line with historical price trends. Considering the ongoing rise in real personal incomes and the historically low level of mortgage rates today, the average home price has never been more affordable. I can't rule out further home price declines, but I think they are very unlikely.

Life goes on in Europe despite all the bad news


With all the hand-wringing in recent days over the ramifications of the Irish bailout and the continued struggle of the other PIGS to avoid default, I thought this chart might have a calming effect. To the extent that the DAX index of German stocks is representative of conditions in general in Europe, what it shows is that Europe is in fact in better shape than the U.S. German stocks, priced in dollars, have modestly outperformed U.S. stocks since the end of the recession, and over the past 15 years. You wouldn't guess it from the hand-wringing headlines, but today the DAX is only 2.7% below its recent, post-recession high. European stocks underperformed noticeably in the late 90s and early 00s, but that was mainly due to a sharp and pronounced depreciation of the euro, which hit a low of 0.827 against the dollar (37% below its value today) in late 2000 and was very weak through 2002.


As the chart above shows, 2-yr Euro swap spreads are elevated, but that merely confirms that European markets are nervous about what is going on. Swap spreads aren't nearly high enough, however, to suggest that there is a serious level of systemic risk or fundamental lack of liquidity in Europe. Defaults and bailouts are not pleasant, but they aren't life-threatening, at least at the present time. As long as markets remain liquid, factories keep operating, and folks continue to show up for work, the European economies should continue to plod ahead, albeit rather slowly, as is the case here in the U.S.