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Eurozone update

It's time to look once again at the key indicators of risk in the Eurozone, especially since Eurozone fears are at the epicenter of the fears roiling world markets these days.


First, however, let's check in on the status of fears in the U.S. As the above chart shows, bond yields have fallen back to the levels they hit in late September, when the Eurozone crisis was heating up and there was lots of talk about an imminent U.S. recession. (10-yr Treasury yields hit a new all-time low of 1.7% yesterday.) I interpret this to be the result of a scramble by investors around the world to get into the safest asset that still has a measurable yield, and that sort of demand can only be driven by deep-seated fears of an extended global recession likely triggered by a Eurozone financial implosion. But: although the S&P 500 has taken a hit, it is still almost 20% above its Oct. 3rd low. Why haven't stocks tracked bonds? That's easy: earnings have continued to surprise on the upside, and the U.S. economy has shown no sign of the expected double-dip recession. Equity investors here are rattled, but they aren't nearly as fearful as global bond investors; equities have gotten a lot cheaper relative to Treasuries. Treasuries have never been more expensive. Never. I should also note that the Euro Stoxx index is now very close to its recession-era lows. Add this all up and it says that the biggest economic risks are still relatively isolated, and they can be found mainly in the Eurozone.


According to swap spreads, systemic risk in the U.S. is up a bit, but not nearly as much as in the Eurozone. There is fear of Eurozone contagion, but it's not intense by any means. Interestingly, Eurozone swap spreads are lower today than they were at the peak of the last Eurozone crisis late last year. So swap spreads are saying things are not critical at all in the U.S., and not yet catastrophic in the Eurozone. Yet 10-yr bond yields reflect an extreme degree of concern. The world's demand for Treasuries is exceptionally strong, and seems out of line with other indicators of risk.



The charts above compare 2-yr yields in various Eurozone countries. Both charts make it clear that near-term default risk in the Eurozone has declined dramatically from what it was at the end of last year. Note how the outlook for France has barely budged; the recent elections were not a surprise and the market feels moderately comfortable with near-term prospects there.


On a longer-term horizon, this chart of 5-yr CDS spreads shows that default risk in most Eurozone countries is elevated, but nevertheless equal to or lower than the default risk of the average high-yield corporate bond issuer in the U.S. (high-yield CDS spreads currently average about 700 bps). That's bad considering we're talking about the sovereign debt of developed countries, but from a global perspective it's not exactly the end of the world. Markets can live very comfortably with high-yield debt risk.


This chart helps sum things up. Europe is really struggling, but the U.S. equity market has suffered what appears to be just a correction. So far there are no signs that the U.S. economy has been dealt anything more than a glancing blow by all the turmoil in Europe. And despite all the hand-wringing and the flight to Treasuries and the Eurozone bank runs, key indicators of risk are saying that the fundamentals are not catastrophically bad by any means. I think there's a good chance the world will survive the Eurozone crisis.

What TIPS say about the future



As the world agonizes over a Greek default/banking implosion spreading to the rest of the Eurozone, I thought it would be good to revisit what is going on in the TIPS market. The first chart above compares 10-yr TIPS to 10-yr Treasuries, while the second looks at the 5-yr version of each. Nominal and real yields are on the top of each chart, and the bottom line is the difference between the two, which is the market's expectation for annual inflation over the life of the bonds.

Not surprisingly, both charts show the same patterns. The dominant pattern is that real and nominal yields are moving down at pretty much the same pace, with the result that inflation expectations are not much different today than they have been on average over the past 15 years. The important trend here, then, is the decline in real yields, which is being tracked by the decline in nominal yields; since inflation expectations haven't changed, nominal yields must follow the decline in real yields. Real yields are falling because the market's implicit expectation for real growth is falling. Back in the year 2000 you could buy 10-yr TIPS with a 4% real yield because the market thought the economy was going to be going gangbusters forever; real yields on TIPS had to compete with the market's very bullish expectations for real economic growth.

Today, of course, things are just the opposite. Real yields are now negative, and that means the market has almost no hope for any meaningful economic growth for as far as the eye can see. Why buy 10-yr TIPS with a negative real yield (thus ensuring you will lose purchasing power with your investment, since the total return on TIPS will be less than the rate of inflation) when you could buy an equity index fund and gain exposure to the rise in corporate profits which should be at least equal to the increase in nominal GDP over time? You would be indifferent to these two choices only if you held out no hope for there being any real growth over the next 10 years. Put another way, it's as if the market is saying that since the risk of big losses on everything is huge (e.g. there may be a global depression around the corner), then risk-free TIPS which will deliver a guaranteed real loss are better than investing in anything else because at least you know that with TIPS your real loss will be limited.

If that's not a pessimistic market, I don't know what is. But maybe it's just the case that Europeans are panicking en masse, and they will pay any price for a security backed by the U.S. government. Even so, TIPS and Treasuries are priced to something like a depression. This is a replay of sorts of what we saw at the end of 2008, only this time the market is not expecting any deflation; worrying about deflation now doesn't make sense when Greece might default and the euro might disappear, and maybe confidence in currencies collapses and that all leads of course to inflation.

So: anyone who buys TIPS and Treasuries today is effectively endorsing the view that a deep recession or depression—with average inflation—is the most likely outcome.

If you think that view is too pessimistic, then that effectively makes you an optimist.

Weekly jobs data just keeps getting better



It may be boring, because it's gone on so long, but the news from the labor market just keeps getting better. The trends towards fewer layoffs and fewer people collecting unemployment insurance are still in place after more than 3 years. There were 18% fewer people collecting unemployment insurance last week than there were a year ago, and 11% fewer people were fired last week than were a year ago.

Fewer layoffs and fewer people on the dole don't equate to growth, of course, but they do say a lot about the health of the economy and the incentives that those still unemployed are facing. Businesses are laying off fewer people because business is getting better and it's harder and harder to find ways to cut costs. Fewer people collecting unemployment insurance mean more people are getting hired, and those who aren't have a greater incentive to find and accept a job going forward. With these trends still in place it's hard to see the economy entering another slump, and there's no evidence whatsoever in these numbers of any incipient economic weakness. That's important, because the market today is priced to the expectation that there will be weakness.


In short, markets are worried about what might happen tomorrow because of all the turmoil in Europe, not about what is happening. To date, the economic fundamentals of the U.S. economy continue to slowly improve, and as the above chart suggests, if this improvement continues, the market is going to have to shrug off its Eurozone concerns and get back into rally mode.


Argentina debriefing

On our flight back to the states last week, I picked up a copy of La Nación, one of Argentina's most-respected newspapers. One article jumped out at me: "Buenos Aires, the most expensive and the cheapest city in the world." This is a perfect description, since Argentina is a fascinating study in contrasts, and you can indeed find things there that are incredibly cheap and incredibly expensive, just as you can find the very modern and the very rustic and primitive.

Right next to the the article I was reading was an ad for the Alfa Romeo Giulietta, a 2-door subcompact that is not for sale in the U.S., but that has received good reviews in Europe. Because of tight controls and high tariffs on imported goods, Argentines need a down payment of $20,400 (dollars) plus 36 fixed monthly payments of 3,360 pesos (equivalent to $660 at today's rate). That's the kind of financing you get in Argentina, where in effect you are making a down payment equivalent to half the car's price.

A 15-minute taxi ride in Buenos Aires can cost less than $8. Giving a taxi driver a $1 tip in Tucumán will earn you a big thank-you, and a $4 tip will prompt looks of incredulity, since most taxi rides around the city don't cost much more than that. A giant steak—a bife de chorizo—can be had for $10, and a bottle of good wine averages $10 at most restaurants. Good hotels in Buenos Aires can be found for $100-200 per night; we spent a little over $200/night at the charming Miravida Soho boutique hotel in Palermo. At Don Abel, the hotel we stayed at in Tucumán, we had a comfortable suite for only $100 or so a night, including breakfast. The toll road from Ezeiza airport to downtown Buenos Aires costs only $1.25. The toll road from Tucumán to Salta costs a ridiculous $0.60, which, given the relatively light traffic, might possibly be enough to pay the wages of the toll collectors. In short, anything with pure local content is very cheap.

Don't plan to buy much at the Duty Free in Ezeiza airport. Most prices are off-the-charts expensive. I got the impression that a good portion of the sales they do make are the result of tourists like me spending their leftover pesos in the knowledge that they are worthless once you leave the country. (Reminds me of an old Argentine joke: "Why is the peso like a pair of pajamas? Because you can only use them indoors.") And though you will be tempted by the displays in the boutiques of trendy Palermo Soho, the prices will cool your ardor real fast. Electronics and appliances, most of which are imported, cost upwards of twice what they cost in the U.S. I was told that a person holding a non-Argentine passport could make a living shuttling back and forth between Miami and Buenos Aires, buying iPhones and MacBook Airs and selling them for a 50% profit in Buenos Aires. It's a lot tougher for Argentines to pull this off, because they are thoroughly searched for such items when they return to the country and must pay a steep tax. It's a safe bet that most returning Argentines have purchased new suitcases in the U.S. to hold mountains of new clothes and multiple small electronic items, all purchased for a fraction of what they cost in Argentina. Most sought-after item in Argentina: a new, unblocked iPhone 4S.

Since the government is restricting people's ability to change pesos for dollars, there is a black market in dollars. Despite signs outside showing the official exchange rate, tourists can walk into just about any Casa de Cambio and sell their dollars (clean $100 bills are preferred) for about $5 pesos each, or 10-15% more than you can get at the "official" rate of 4.45, which is what you'll get at a bank. That's a lot better, by the way, than using your ATM card to get peso cash, or using your credit card for routine purchases, since the bank will translate the pesos at the official exchange rate and often add a extra charge for the  trouble. So if you're going to Argentina, you'll want to carry lots of $100 bills with you, and I hasten to add that they are accepted as payment at many restaurants and hotels, but not always at the "black market" rate. Argentines wanting to get large amounts of money out of the country without having to carry wads of $100 bills in their briefcase can do so only via a financial transaction called something like the "blue-chip rate," but they must pay upwards of 5.85 pesos per dollar to do so, which represents a 30% premium. (Bloomberg subscribers can find this by typing .IMPARS G Index) I keep close track of this rate, since the higher it goes the higher the risk of an eventual economic collapse and/or large devaluation of the peso. If you have a friend in Argentina you're going to be visiting, you can facilitate his desire to get money out of the country by offering to bring him, say, a new iPhone (or 2 or 3) in exchange for him giving you pesos to spend when you arrive.


In prior posts I've mentioned the disturbing parallels between the policies of President Kirchner and President Obama. Once again I'll add that every time I described the key features of Obama's policies to an Argentine friend, the immediate response was wide-eyed amazement: "that's exactly what Kirchner is doing!" Radical left-wing political tactics; strong support of unions; industrial policy which favors some industries at the expense of others; nationalization of key industries (e.g., GM and YPF); contempt for capitalists/banks; pitting rich against poor, or, more generally, acquiring political power via divide and conquer strategies; political cronyism to reward friends, collaborators, and contributors; higher taxes on the rich; massive income redistribution; and socialized medicine, to name a few. In the U.S. it's called Chicago-style politics, and in Argentina it's called peronism.

Kirchner's economic policies are doomed to fail, it's just a question of when. The government is fudging the inflation statistics and restricting access to dollars, and that just feeds the fires of capital flight and an eventual currency devaluation. Import restrictions are going to choke off economic growth. Price caps and controls on energy are going to result in energy shortages. The nationalization of YPF and probably other industries is going to result in sharply lower foreign direct investment, which in turn will aggravate the shortage of dollars. Corruption at all levels of government is undermining popular support for the regime. It will end in tears and a big devaluation.

When I went there I expected to see more signs of stress, but I was wrong. Things aren't too bad, but they are slowly getting worse. There might be another year or so to go before things start to really collapse. In the meantime, there's plenty to enjoy in Argentina, since living standards are rising and the economy is growing (but nowhere near as fast as the government claims). The mood of the people is generally good, things are peaceful, the planes fly on time, and we didn't see a single protest/strike/shutdown such as we have seen on previous trips.

What gold, commodities and the dollar tell us about monetary policy


This chart illustrates the strong tendency of Federal Reserve monetary policy to follow the ups and downs in the economy. Capacity Utilization (blue line) is a proxy for the strength of the economy, and the real Fed funds rate (red line) is a good measure of how tight or loose monetary policy is. The stronger the economy, the more the Fed is prone to tighten monetary policy by increasing the real Fed funds rate, and the weaker the economy, the lower the real funds rate.

Capacity utilization has literally soared in the current recovery, as the manufacturing sector has enjoyed a V-shaped recovery with no end yet in sight, but the Fed continues to keep monetary policy very accommodative. Ordinarily this would be highly disturbing, since it would point to accelerating inflation pressures. But this time around things are very different, given the troubles in Europe which have greatly increased the world's demand for dollar liquidity. The Fed understandably wants to be sure there is no shortage of safe-haven dollars in the banking system to satisfy the world's apparently insatiable demand for them. If the Fed were only concerned about the US economy, they would not be keeping interest rates so low for so long, because the great majority of economic indicators—industrial production and residential construction numbers released today being the two most recent examples—point to continued US economic growth.



The behavior of gold, commodities and the dollar in the past year or so also supports the Fed's decision to keep policy very accommodative. The CRB Spot Commodity index is off 17% from last year's high, and gold has dropped 19% from last September's high, and the dollar is up some 13% from last year's low against other major currencies. All three of these key indicators of monetary conditions are consistent with strong demand for dollar liquidity—and some would even say these moves are symptomatic of a relative shortage of dollars. I'm not prepared to accept that dollars are in short supply, however, since these same charts show that gold and commodity prices are still very high from an historical perspective, and the dollar is still very weak. Instead, I would argue that on the margin there has been an increase in dollar demand relative to supply, but that dollars are still relatively abundant from a broader perspective.


In other words, I don't see any emerging deflationary pressures resulting from the recent weakness in gold and commodities and the strength of the dollar, but rather an easing of inflationary pressures. That is confirmed by the relatively tame readings we saw in yesterday's CPI release, as illustrated in the above chart. So far, so good.

The big thing to watch for is an easing of the tensions in Europe, since this has the potential to dramatically change the world's demand for dollars, and that in turn could result in monetary policy becoming once again inflationary—unless the Fed takes decisive steps to mop up any excess dollar liquidity by either draining reserves or increasing the interest rate it pays on reserves.

UPDATE: I should add the obvious, which is that the first chart suggests that the real Fed funds rate should be approximately 2% by now, if everything else were normal. To get there, given that the core PCE deflator is currently 2% and assuming that the Eurozone situation were to normalize by the end of this year, the Fed would need to raise the funds rate to somewhere in the neighborhood of 4%, and that could be done over the course of a year or two. That would undoubtedly be tough on the T-note and T-bond markets, but not insurmountable, particularly since the steepness of the yield curve implies that some degree of tightening is quite likely. The pain of raising rates is probably exaggerated: For one, a healthier Europe would almost surely be a boost to the US economy, and a stronger economy would boost tax revenues. If spending growth can be held in check, a stronger economy would all by itself bring the deficit down to manageable levels (3-4% of GDP) within a few years. In fact, we're already halfway there: the deficit as a % of GDP is down from a high of 10.4% to the current 7.4%. In other words, as the market loses its desire for Treasuries, the government's need to sell Treasuries would be declining at the same time. The solution to all this is not impossible by any means.

Residential construction is definitely improving


For several months we've seen emerging evidence of the long-awaited upturn in residential construction, and now with today's April figures and upward revisions to prior months, it looks pretty official: the housing market has bottomed and is now posting impressive gains—up 30% in the past year, and up 50% from the 2009 low—that should be the norm for the next several years. If a recovery in the residential construction market was the one key piece missing from the US recovery, it is now in place. I find it hard to believe that today's troubles in tiny Greece are going to derail the giant US economy.

Industrial production remains healthy


April U.S. industrial production was stronger than expected, rising 5.2% above year-ago levels. We haven't seen year over year growth this fast since March of last year. As a follow-on to my post yesterday covering Eurozone industrial production, this chart compares U.S. with German industrial production. The pickup in U.S. output is welcome indeed, but it pales in comparison to the strength of German production over the past seven years. Germany has stalled for most of the past year, of course, but March gains were strong, resulting in a 12.6% annualized gain in the first quarter—thus raising hopes that Germany at least has broken free of the stagnation afflicting much of the rest of the Eurozone.


Abstracting from utility output, US manufacturing production continues to improve, having risen at a 6.9% annualized rate over the past six months.

Year over year gains in these charts are hardly what one might term "very strong," but they are healthy gains, and, perhaps more importantly, they do not show any sign of the US economic slump/double-dip recession or Eurozone contagion that has been widely expected and feared over the past 6-8 months.

Some additional perspective on Europe



These charts provide some interesting perspective on the Eurozone economies. The top chart compares industrial production in the U.S. to industrial production in the Eurozone economies in aggregate. Note how there has been a significant gap that has opened up since last August, and note also how closely production in the two major economic areas had tracked up until that time. But as the second chart makes clear, the sluggish performance of Eurozone industrial production since August is mainly driven by the same countries that are facing rising default risk. Germany is doing quite well, and its industrial production recovery has been stronger than that of the U.S.

The second chart breaks out the behavior of industrial production across six major economies within the Eurozone. It seems the Eurozone is split these days between those who produce and those who don't. German industrial production has been the mainstay of Eurozone growth, since German production levels today are only 2.8% below their pre-recession peak. Not surprisingly, Greece is bringing up the rear, with industrial production having collapsed by almost one third since its pre-recession high. France, UK, Italy, and Spain have all experienced almost no recovery in industrial production for the past three years.

The charts also suggest that the problems that have led to the Eurozone's sovereign debt crisis go way beyond Greek contagion, and their roots in fact go back many years. In short, Germany has been doing something right that most of the others have not. For one, Germany made significant cuts in corporate tax rates in 2001 and then again in 2007. Just as importantly, Germany instituted labor market reforms in the mid-2000s that reduced wage costs to levels that were once again competitive. The laggards have allowed their public sectors to bloat and their costs to rise, and have made no attempt to cut tax and regulatory burdens.

As further evidence for the power of tax cuts, I note that Ireland's industrial production is only down 7% over the past four years, after rising by an astounding 300% from the early 1990s, thanks to the country's decision to slash corporate tax rates and keep them low in spite of continual protests from other Eurozone countries who pronounced them to be "unfair" competition.

Germany's fiscal policy has been much more growth-favorable than the policies of the countries that now struggle with default risk. This is a very important point, since it strongly suggests that the austerity measures being proposed in the countries that are still struggling—which consist mostly of attempts to increase taxes—are the problem, not the cure for what ails these countries. Sooner or later the laggards are going to figure this out: the right kind of austerity consists of public sector spending cuts that are accompanied by lower tax and regulatory burdens.

There's a lesson for California here as well. Imagine that the government of California is like the management of a business that is losing customers and money—after all, taxpayers and companies of all stripes are fleeing the state because of its heavy tax and regulatory burdens. California is like a company whose products have become too expensive to remain competitive, but instead of cutting its costs and becoming more competive (e.g., by lowering taxes and reducing regulatory burdens), California's management is trying to increase its prices (i.e., increase tax rates) to stay afloat. It's simply not going to work.

Retail sales continue to be strong


For the third time in the past two years, the world is obsessed with the idea that a breakup of the Euro is going to bring down the global economy. The chart above uses the ratio of the Vix index (which rises as fear increases) to the 10-yr Treasury yield (which falls as the world despairs over the prospects of economic growth) to gauge the amount of destruction that the market is worried about. It was worse in the prior two episodes, but it's pretty bad right now, as market chatter essentially assumes the imminent exit of Greece from the Eurozone, followed by a significant devaluation of the Greek currency, and the subsequent impoverishment of all Greek citizens. 


But to judge from this chart of U.S. retail sales, the revolving Eurozone crises have had no discernible impact on the U.S. economy. By just about any measure (ex-autos, ex-building materials, and/or ex-gas stations) U.S. retail sales are rising at a healthy 6% annual pace, with no signs of any slowdown. Moreover, sales have significantly exceeded their pre-recession highs, even though there are 5 million fewer people working today than at the end of 2007. Indeed, the Eurozone crisis probably has helped boost the U.S. economy, since capital has fled Europe for the relative safety of the U.S. banking system. Things could be a lot better here, but they are improving, albeit slowly.


In other news today, the May home builders' market index rose to a new post-recession high, providing yet more evidence that we have seen the bottom in the housing market. Furthermore, as Mark Perry notes, "there are now at least 25 metro markets that have reported double-digit gains in either the number of homes sold, or median home prices, or in some cases, both."

So what's not to like? Well, of course there are still many problems lurking in the wings, and the list is long, beginning with the "fiscal cliff" of sharply higher tax rates that is approaching come January 1st, followed by the risk that a re-elected Obama might be able to boost tax rates even more, and the possibility that Europe might return to the financial dark ages as governments refuse to tighten their belts and the Eurozone banking system implodes. But meanwhile, life goes on for the vast majority of the globe's population, markets are slowly but surely enforcing some badly-needed discipline on politicians of every stripe, and the internet—via outlets such as this blog—is providing more information and perspective on what's going on than has ever been available before.

Markets work best when they have plenty of information; big problems happen only when something unexpected comes out of the blue. We've known about the Eurozone debt and banking problem for over two years, and we've known about the U.S. fiscal problem for over three years. The U.S. housing market has been under tremendous pressure for over 5 years; there can't be a single sentient, potential homebuyer in the U.S. that isn't aware of the problem of an overhang of foreclosed properties. It's my belief that most or all of the problems have been priced in by now: 10-yr Treasury yields are as low as they've ever been, reflecting a market that holds little or no hope for the future; despite record-setting corporate profits, the PE ratio of the S&P 500 is only marginally higher today than it was at the end of 2008, when the global financial system threatened to collapse; and although swap spreads are off their highs, they are still quite elevated in Europe.


The sum of the fears that still plague the market can also be found in the intense demand for safe-haven liquidity. Fortunately, both the Fed and the ECB have taken extraordinary measures to accommodate this demand for liquidity by expanding their balance sheets to a truly unprecedented degree. I'm not saying that the fears are overblown. I'm simply pointing out that markets have had plenty of time and help in evaluating and accommodating these fears, and that therefore the consequences are not likely to be as bad as the market seems to be expecting.

This has been my thesis ever since the end of 2008, and it continues to be: markets are priced to horrible expectations, but the reality is likely to be less awful than expected.