Main menu

Tracking the recovery: pessimism still pervasive

For the past three years this blog has been steadfastly of the belief that while the economy was likely to improve, the recovery would be sub-par because of too much fiscal stimulus and too much uncertainty surrounding monetary policy. At the same time, I have repeatedly observed that the market's implied outlook for the economy was overly pessimistic, thus making equities very attractive. And indeed, the economy has been steadily improving, but the recovery has been definitely sub-par. As for the market, I still see signs that it is priced to overly pessimistic assumptions about the future, and therefore still attractive. What follows is a quick recap of some important indicators and how they are evolving:


The ratio of the Vix index to the 10-year Treasury yield is one way of judging how much fear (Vix) is priced into the market, and how much optimism about the future (10-yr) is priced in. Last October this ratio hit a peak as the market braced for a wave of Eurozone defaults, a financial market meltdown, and a double-dip recession. Fear was intense, and the market's outlook for future growth was dreadful. Things have since improved, but there's still a lot of concern expressed in this ratio. The Vix index is still some 40% higher than it would be if the market were calm and relaxed, and the 10-yr yield, at 2%, is still at a level which implies dismal prospects for economic growth. The 10-yr Treasury yield is equivalent to the market's guess for what the Federal funds rate will average over the next 10 years, and it will only average 2% if the Fed keeps the funds rate at or near zero for at least the next several years. And that, in turn, will only happen if the economy remains very sluggish for years to come. If the market believed that today's jobs report marked the beginning of a significantly stronger economy, then it would be pricing in a much more aggressive Fed posture, and that would imply a much higher 10-yr yield.


This chart shows how the ups and downs of fear have been important drivers of equity market performance. On balance, the story of the last three years is simple: the market started out with the expectation that the future was going to be catastrophically bad: years of depression and years of deflation. When the economy started to grow instead of collapsing, the market began to be less fearful, and equity prices rose. We've seen two waves of fear push the market down in the past few years, both caused by concerns over a Eurozone sovereign debt crisis. Yet each time the fears have proved to be overdone, and as fear subsided, equity prices rose.


This chart shows how the relatively steady improvement in the economic fundamentals (i.e., declining weekly jobless claims) has guided the equity market higher. It's hard to argue with improvement in the current fundamentals, even if you remain concerned about the future.


Corporate profits according to the National Income and Product Accounts have never been stronger, yet PE ratios remain very depressed by historical standards, and hugely depressed considering the very low level of Treasury yields (the 7.3% earnings yield of the S&P 500 compared to the 2% yield on 10-yr Treasuries implies a huge equity risk premium). This points to only one conclusion: the market is convinced that profits are set to collapse, perhaps because of a global recession sparked by a Eurozone disaster, and/or because our enormous and growing federal debt burden will crush the economy via a mega-increase in future tax burdens.


I would argue that the Fed's attempts to flatten the Treasury yield curve (by promising to keep short rates near zero for at least 3 years and by selling short-maturity bonds and buying longer-maturity bonds) have very little impact on 30-yr bond yields, because the Fed owns only a very small portion of outstanding, marketable Treasury debt. 30-yr Treasury yields are determined by the market's outlook for growth and inflation, and they are as low as they are today because the market's outlook for growth is still dismal and inflation expectations are unremarkable. However, as the chart above shows, there is a huge and growing disconnect between the rise in equity prices over the past several months, and the continued low level of bond yields. The equity market is grudgingly accepting the view that the economy is doing better than expected, but the bond market is still in the grips of fear. Domestic and foreign investors are still very worried about Eurozone defaults and a financial meltdown, and so the demand for the safety of Treasury bonds is still intense.


The bond market has experienced a rather significant change of late, however, and it shows up in the spread between 10- and 30-yr Treasury yields (the blue line in the above chart). Fed expectations haven't changed much, and that is reflected in 10-yr yields that are still below 2%. But Fed expectations can't keep 30-yr yields from rising as the economy beats dismal expectations. Since early October, 10-yr yields are up 20 bps, whereas 30-yr yields are up over 40 bps. Over the same period, forward-looking inflation expectations have risen from 2.0% to 2.5%, as the market figures that the risk of very low or negative inflation has declined because the economy has proved stronger/less weak than expected.


The market can't be considered to be optimistic about the future until we see that expectations for Fed policy have been radically revised, and that change, if and when it occurs, will show up in a dramatically higher 10-yr Treasury yield. As long as the 10-yr bounces along around 2% (see chart above), we know that the market's outlook for the future remains pessimistic.

Service sector remains healthy



The January ISM service sector report also exceeded expectations, led by a huge (and perhaps suspect) gain in the employment index. Or perhaps it was just that the numbers reported in the past several months were depressed because everyone was afflicted with concerns that the Eurozone financial crisis was going to tip the U.S. economy into a double-dip recession, and now those concerns are fading. Either way, the picture that emerges is one of ongoing growth; not spectacular, but almost certainly not what you would expect if the economy were at the tipping point of another economic slump.

Jobs report beats expectations

The January jobs report beat expectations by so much that virtually all observers are finding reasons to downplay the news, even me. January is a big seasonal month, since jobs always decline as businesses wind down from the holiday crush of activity. The raw (not seasonally adjusted) numbers show that the economy actually lost 2.7 million jobs in January, but the gain was reported to be +243K on a seasonally adjusted basis. What actually happened in January was that the economy lost a lot fewer jobs than expected. Does that mean it's a whole lot stronger? Perhaps. More likely, it just reflects the fact that the economy has been doing better than expected for the past several months, and the market has been rather consistently under-appreciating the inherent dynamism of the U.S. economy.

So the job gains probably were somewhat exaggerated because of statistical quirks and seasonal adjustment factors. But the fact remains that this was a solid jobs report, and a big (and probably final) nail in the coffin of the double-dip recession that was supposed to have emerged by now. The economy continues to grow and it continues to overcome the obstacles (e.g., the financial jitters and big economic slowdown in the Eurozone) and headwinds (faux fiscal stimulus and extreme monetary stimulus) that have been thrown in its path.



As the top chart shows, the biggest upside surprise came in the household survey, which (seasonally adjusted) reported a gain of 1.1 million private sector jobs. Wow! A lot of this was probably catch-up, since it had been growing more slowly than the establishment measure of jobs of he past several months. Taken from the post-recession low, the two surveys are now showing private sector job gains of 3.7 - 4.1 million jobs. Let's make it simple: over the past two years, the economy has gained about 4 million private sector jobs, for an average of about 170K per month, and the pace appears to have picked up in recent months. That's decent, but not yet what is needed to get the economy back on its long-term growth path. But most importantly, it is a whole lot better than the market's gloomy expectations.

As the second chart shows, we continue to see a decline in public sector jobs. That's been good news all along (with apologies to those who have been laid off) because the public sector had grown way too much and some shrinkage was essential in order to stop suffocating the more-efficient private sector. Let's hope we see a lot more of this over the next year or two.

Financial fundamentals continue to improve


This index of financial conditions is very comprehensive (see the components listed in the above chart), and—no surprise—it is highly correlated to the Vix index of implied equity volatility. Financial conditions—call it the financial fundamentals of the economy—are still not back to normal, but they have improved substantially since October 2nd last year, when the S&P 500 hit its low for the year. The chart below is a closeup comparison of the Bloomberg Financial Conditions Index and the S&P 500 index, and it shows they have been very tightly correlated (about 0.9 over the past year). This is one more reminder that the health of financial markets is an essential component of the economy's ability to grow and prosper. As financial markets heal, they lay the foundation for healthier growth to come.


Labor market conditions continue to improve



The ongoing improvement in labor market conditions is about three years old now, and there are no signs that it is about to end. The U.S. economy is inherently dynamic; people and businesses adapt to adversity and cope with changing fundamentals. Resources have been shuffled from the housing sector to other sectors (e.g., mining and export-oriented industries). Costs have been cut, productivity enhanced, and profits have soared. All of this despite the efforts of politicians to stimulate the economy by transferring trillions of dollars from those who are working to those who aren't. (Over the past three years the increase in federal government transfer payments has been on the order of 4% of GDP—about $600 billion a year.)

As the top chart shows, corporate layoffs have already been cut to the bone; they don't get much lower than this. As the second chart shows, there is still room for improvement when it comes to layoffs in general, but at today's level (367K) we're not too far away from what is probably the minimum level of weekly claims (300K).

None of this is very surprising. What's different this time around is that we have yet to see much of a rebound in the economy (the output gap is a huge 13%). We're still waiting for the next shoe to drop: a surge in new investment and new jobs. For that we need more confidence in the future, and one good way to get that is for the federal government to stop trying to help. (Remember Reagan's famous quote: "... the 10 most dangerous words in the English language are ‘Hi, I’m from the government and I’m here to help.’") We need to simplify our monstrous tax code so that it stops distorting economic decisions; we need to lower corporate tax rates so that our businesses can be more competitive with those of other countries; we need to reduce marginal tax rates (by lowering and flattening our tax structure) in order to increase the incentives to work and invest; we need to reduce regulatory burdens in order to reduce the costs of starting and running a business; and we need to shrink government in order to free up resources for the more-productive private sector.

Still more improvement in the Eurozone



I've been highlighting the importance of swap spreads as good leading indicators for over three years, and three weeks ago I noted how euro basis swap spreads (a measure of the difficulty that Eurozone banks are having in obtaining dollar liquidity) were pointing towards improvement in swap spreads. Well, things are really picking up. Eurozone 2-yr swap spreads haven't been this low since last October, and U.S. 2-yr swap spreads are back to August levels.

It really does look like the world may be exiting the Eurozone sovereign debt crisis, thanks mainly to the improvement in liquidity conditions in the Eurozone financial system. I caution that the fundamental problem in the Eurozone—bloated government spending—remains unsolved, but at least the world can deal with the problem if financial markets are able to function with some semblance of normality. That's the key. In a worst-case scenario, PIIGS defaults might erase some $2 trillion in capital, but that's a only a drop in the $100 trillion global capital market bucket. If financial markets can spread the risk around, we can deal with a loss that size. But if financial markets are frozen, it's like what happens when someone yells "fire" in a theater and the exits are blocked: panic.

Car sales remain strong



January total light vehicle sales exceeded expectations, posting a very strong 12.7% gain over the previous 12 months. Sales are now up over 50% from their early 2009 low, for an annualized gain of almost 15%. This is very strong evidence that the economy's health is improving.

Yes, sales are still very depressed from an historical perspective, but it's always taken years for sales to recover in the wake of important recessions. Light truck sales have not rebounded as fast, but then they didn't decline as much as car sales.

5-yr Treasury yields and inflation



It's always good to put things in perspective, so here's some long-term perspective on Treasury yields and inflation. I'm showcasing the 5-yr Treasury here, since the 5-yr maturity is very representative of the current Treasury market: the bulk of the $10.5 trillion of Treasury bills, notes and bonds held by the public mature within the next 10 years, and the average maturity of outstanding marketable Treasury debt is just over 5 years.

As the top chart shows, 5-yr Treasury yields today are at rock-bottom lows of only 0.7%, and they are very low relative to inflation. Over time, Treasury yields have a very strong tendency to track the level and the direction of inflation.

The bottom chart zooms in on the past 20 years and puts core inflation on a slightly different axis, in order to suggest that when the two lines overlap (i.e., when Treasury yields are 1 percentage point higher than core inflation), then 5-yr Treasuries are at "fair value," since they offer investors a modest real return—which is appropriate for a relatively short-term, risk-free asset. Treasuries offered excellent value in the 80s and 90s, and fair value from 2008 through early last year. Since April of last year, however, they have moved decisively into "undervalued" territory, as yields have sharply diverged from core inflation (in the wrong way) for the first time in modern memory. We are living in unprecedented times, with core inflation moving higher while Treasury yields fall to record lows. And it's not that yields are low because the market fears deflation, since the expected inflation embedded in TIPS and Treasury prices is within the range of 2-2.5%.

The explanation for why Treasury yields were high relative to inflation in the 1980s and 1990s is simple: monetary policy was generally tight from 1979 through 2002. When the Fed is tight, the market expects the Fed to react promptly to changes in the economy's growth and inflation fundamentals, and to have a bias to keeping rates higher than inflation in order to prevent strong growth from becoming inflationary.

The explanation for what's going on now is a bit more complicated. For some time now, the Fed has been working hard to convince the market that it is willing to sacrifice higher inflation in exchange for stronger growth, by keeping interest rates very low relative to inflation, and for a very long time. The prospect of many years of near-zero short-term rates almost forces investors to move out the yield curve in order to pick up incremental yield. Beginning last summer, fears of sovereign debt defaults among the PIIGS countries began to create intense demand for dollar-denominated safe-haven assets (with short- and intermediate-term Treasuries being the prime candidate), and foreign buying of Treasuries has dovetailed nicely with the Fed's desire to make interest rates as low as possible across the yield curve.

But: Can very low Treasury yields that are also low or negative in real terms really be a prescription for more real growth? And how much longer can yields remain so far below inflation?


Treasury yields form the backbone of the global bond market, since almost all bonds are priced off of comparable maturity Treasuries. Thus, very low Treasury yields tend to result in very low yields on other sovereign bonds, on corporate bonds, and on mortgage-backed securities. And indeed, today the yield on the average investment grade corporate bond is 4.3%, which is very near its lowest level ever, and substantially less than the average yield of 5.5% over the past 5 years. Similarly, the yield on current coupon MBS is now at an all-time low of 2.6%, and is significantly less than the average yield of 4.6% over the past 5 years. Junk bond yields currently average 7.9%, which is lower than the 10.4% average of the past 5 years, but about the same as what we saw in 2004 and 2011, when yields also averaged 7.9%. So there's a caveat here: record-low Treasury have not resulted in record-low borrowing costs for everyone—only high-quality borrowers are getting an unusual break these days.

In any event, today's low yields don't necessarily translate into a growth stimulus, because they are the by-product of weak growth and dismal growth expectations. If the world had high expectations for future growth, investors would simply not be paying such a high price for Treasuries. To date, investors have been content to buy Treasuries at absurdly low yields because they perceive that they have few alternatives to Treasuries on a risk-adjusted basis. They are so worried about future growth and the possibility of default on non-Treasuries that they are willing to accept a negative real yield on Treasuries.

Therefore, growth—even the modest growth that we have seen during this tepid recovery—ultimately presents the biggest threat to the Treasury market. The more time that passes without a calamity, the more upward pressure there will be on Treasury yields, since the rationale for their purchase—to avoid a calamity—will be slowly evaporating.

Construction begins to recover



As these charts show, the construction industry has suffered a devastating decline since peaking in late 2005. After six years of contraction, the sector has shrunk by two-thirds relative to the size of the economy. But now it looks like the worst is over, and a slow and gradual recovery is beginning. It will likely be many years before the industry fully recovers, but along the way we could see some pretty spectacular growth rates. I expect it will be slow progress this year, but picking up lots of speed by next year.

ADP report points to decent jobs growth


The ADP estimate of January private sector job gains dipped from its relatively strong December level, but is fully consistent with the 163K jobs number this Friday that the market is expecting. No sign here of any meaningful deterioration. As with the manufacturing report today, this is one more reason to expect 3-4% growth, and one more reason to not worry about a double-dip recession.

Another decent manufacturing report


The January ISM survey of the manufacturing sector was fully consistent with an economy that is growing by at least 3%. We already knew from the Q4/11 GDP report, but today's report suggests the economy may even be picking up to a 4% pace. Of course, even 4% growth pales in the light of the economy's massive output gap, but at least we are seeing signs of improvement and not the dreaded double-dip recession that the folks from ECRI have been predicting since late last summer. As the chart above suggests, January's 54.1 reading on the manufacturing index tends to coincide with GDP growth of 3-4%.


Export activity appears to have picked up, and this is a very welcome sign given all the concerns that the Eurozone financial crisis has tipped Europe into a recession, and given the hand-wringing about a slowdown in the Chinese economy. A strong global economy provides a nice cushion against any lingering weakness here.


The increase in the prices paid index is the second hint we've received of late that the big slowdown in inflation last quarter has ended—the first being the significant pickup in commodity prices over the past month.


The manufacturing sector is still in hiring mode. All in all, a nice report and reason to be optimistic.

Home prices are still weak, but very affordable



As these charts show, both nominal and real housing prices have declined to new post-recession lows, though the decline since the end of the recession in mid-2009 has been modest: between -3% and -7%. These price indices may well slip a bit more, but I don't think that is inconsistent with my view that we have seen the worst of the housing and residential construction bust, and that a slow recovery is now underway. Note that the prices reflected in these charts are an average of prices during the months of September, October and November, so they are rather old news. Plus, I think it's important to add that homebuilders' stock prices have jumped some 50% since the end of September, the National Assoc. of Home Builders' Market Index rose from 14 last September to a 4-year high of 25 in January, and housing starts rose 25% last year. Housing price indices such as these are most likely a lagging indicator of the underlying dynamics in the housing market; real-time data suggests we are seeing improvement on the margin. Furthermore, mortgage rates are now at rock-bottom levels (the nationwide average of 30-yr fixed conforming mortgage rates is only 4.07%), making housing more affordable to the average buyer than ever before.

Commodity prices are turning up


This index of non-energy industrial commodities (mundane things such as burlap, butter, cocoa beans, copper scrap, corn, cotton, hides, hogs, lard, lead scrap, print cloth, rosin, rubber, soybean oil, steel scrap, steers, sugar, tallow, tin, wheat, wool tops, and zinc) began to weaken last summer as the Eurozone sovereign debt crisis was heating up and fears of another financial crisis caused sparked a wave of risk-aversion and de-risking: swap spreads rose, equities declined, Treasury yields plunged, and credit spreads widened as investors feared a double-dip recession. Yet so far this year, we have seen just the reverse: swap spreads, particularly in the U.S., have declined, equities are up, credit spreads have tightened, and now—as the above chart shows—commodity prices are turning up (as of Friday, the CRB Spot index had exceeded both its 50- and 100-day moving average). Moreover, copper prices have jumped 27% since October, and the JOC metals index is up almost 16% since December. All of this suggests that global growth fundamentals are improving.


As this chart of credit default swap spreads shows, there has been a substantial improvement in spreads since late November '11. Spreads are still relatively high, but there's been important improvement on the margin. 


I note again that Treasury yields remain terribly depressed, despite all the stirrings of activity going on. How much longer can the bond market remain terrified of growth?