Main menu

This market seems way too fearful








Judging by the behavior of gold (now at another high of $1890 and looking parabolic), the equity and corporate debt markets (equity prices down 17% from recent highs, credit spreads surging), the Vix (registering significant levels of fear at 41), and the 10-yr Treasury yield (now priced to levels suggesting a deep recession or even depression), the world seems awfully afraid that the simmering European debt crisis is about to reach full boil—bringing with it the end of the world as we know it, or at the least another deep and painful recession. On balance, these indicators of market fears, sentiment and expectations haven't been this awful since late 2008, when the global economy was in virtual free-fall.


Those fears seem way overblown, however, since U.S. swap spreads, while up a bit from their recent lows, are still within the range of what could be considered "normal." European swap spreads are signaling pain ahead for Europe—at the very least a Greek default, some bank failures, and perhaps a recession—but US swap spreads are still consistent with a view that the US banking system and economy will be largely insulated from whatever problems Europe does suffer. Swap spreads have played the role of "canary in the coal mine" quite a few times in the past decade or so. Note, for example, in the second chart above how swap spreads led high-yield CDS spreads in advance of the 2008 recession and in advance of the 2009 recovery. What swaps are saying now is that default risk and recession risk are way overblown; that what we are likely seeing today is one more case of investors that have been burned so badly in the past that they can't bear even the thought of another recession.


Those fears also seem way overblown given what we know about the economy. The problems of 2008 were exacerbated by $150 oil, but today oil is trading well below $100. Real interest rates  were quite high in advance of the 2008 recession, but today they have been negative for almost three years. The yield curve was flat to inverted prior to the 2008 recession, but has now been steeply sloped for almost three years. Inflation plunged in the second half of 2008 as the world's demand for liquidity surged and the Fed was late to respond, but today all measures of inflation are moving higher, there are no signs of any liquidity shortage (e.g. the dollar is very weak, gold and commodity prices are quite strong), and the Fed has pumped $1.6 trillion of reserves into the banking system. Employment collapsed in 2008 and 2009, but jobs have been growing for almost 18 months now. Weekly claims for unemployment surged in 2008, but have been declining for the past two years. Confidence and valuation multiples tumbled as the 2008 recession unfolded, but today confidence has been weak for years and PE ratios are well below average.


I've seen people say that since the economy has barely grown the past two quarters, the economy is like a plane that is nearing "stall speed" and is thus in danger of crashing. But that analogy seems absurd to me. What law says that if an economy doesn't grow it therefore has to collapse? That may be true for individual companies (i.e., if you don't grow you will eventually die or be overtaken by the competition), but it's not true for economies, which can and do languish for long periods. In any event, recessions are the exceptions, not the rule—it takes extraordinary circumstances and policy mistakes to generate a recession.

Europe has plenty of problems, with public sector obesity and over-indebtedness topping the list. But that doesn't mean the end of the world as we know it is inevitable. The money that the PIIGS have borrowed has been spent and much of that spending was wasteful; those losses happened long ago and they are now water under the bridge. What remains to be seen is whether the consequences of those losses (which might be manifested in a series of bank failures) will bring down the European and global economies. In the meantime, governments everywhere are facing intense pressure to trim spending (a very good thing), U.S. swap spreads are saying things are still OK, and commodity prices are saying the global economy is still humming along.

Filled Under:

0 comments:

Posting Komentar