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Systemic risk remains low, so equities continue to rise




I must have showed this chart at least a dozen times since late 2008, but it's still worth showing again. The story here is that a big cause of the recession was fear: fear of an international banking collapse, widespread bankruptcies, a global depression, and just plain fear that the world was coming to an end. So it made sense to think that if and when fear subsided, then the world and the global economy would sooner or later get back on the path of growth, asset prices would recover, and that's what has been happening ever since.

In the chart above, we see that the Vix index, a good measure of the fear and uncertainty priced into the equity market, has been fairly low for over a year now, and equity prices have been slowly but surely recovering. The Vix is still somewhat elevated, to be sure, since it was as low as 10 back in late 2006 and early 2007, so the market is not entirely fearless. Ditto for credit spreads (below), which have come down a lot from their recession highs, but remain meaningfully higher than their pre-recession lows. Both indicators of fear, doubt, and uncertainty show that the market is still infused with a degree of caution, which further suggests that asset prices are not over-priced.



The upward blip in unemployment claims a few weeks ago gave the market pause, but as the chart above suggests, investors appear to understand that the rise was due to statistical noise rather than any actual weakening of the economy. In the next few weeks the 4-week moving average of claims should move back down to 400K or less, putting it back on track with a slowly rising stock market.


Swap spreads (above) tell a similar story. As a leading indicator of financial and economic risk, swap spreads in the U.S. are telling us that there is no reason to expect any calamity: economic and financial fundamentals are healthy, liquidity is abundant, and default risk is low. Europe is where systemic risk still lingers, in the form of looming sovereign debt defaults/restructurings. Still, the level of swap spreads in Europe is low enough to suggest that whatever problems Europe faces are unlikely to be calamitous—painful, to be sure, but unlikely to cause any significant disruption to the Eurozone economies. The market has seen the likelihood of a Greek default, it has been priced in (see chart below, which shows 2-yr Greek government yields at almost 25%, a level which indicates a very high likelihood of default), and it is unlikely to be earth shattering when it happens (German 2-yr yields are a mere 2%).


Meanwhile, life goes on, and some sectors of the stock market are at new, all-time highs, such as the relatively pedestrian consumer staples sector, shown below.


The Fed's role in all this (so far) has been to help the market deal with and overcome its lingering fears. Short-term interest rates have been set close to zero for more than two years, in part to accommodate the market's huge appetite for risk-free cash and cash equivalents. The world has been content to accumulate cash and cash equivalents paying little or no interest, as shown in the chart below. If a zero short-term interest rate were way below the market clearing rate, then the demand for M2 (i.e., the demand for cash and cash equivalents) would have collapsed, and nominal GDP would have exploded, but it has not (at least so far).


But there are increasing signs that we are transitioning out of the fear phase of this business cycle. As I've pointed out before, bank loans to small and medium-sized businesses have been growing this year, a sure sign of rising confidence. As banks lend more, they increase their deposits, and that increases the amount of required bank reserves, as we see in the next chart. Required reserves have increased at strong double-digit rates so far this year.


All of these developments are significant, and they all act to reinforce each other; rising confidence displaces fear, rising confidence boosts asset prices, and rising confidence and stronger markets fuel more investment, which in turn feeds back into more jobs, more production, and rising profits. This process is unlikely to be easily derailed, and it has a lot more room to run.

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