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The Eurozone turns the corner


Swap spreads have been among the best leading indicators of the health of the economy that I know of. The swaps market is typically very liquid and populated mostly by large institutional investors, the sort that move $billions with a phone call. They are usually smart and well-informed, at least better-informed than the guy on the street. So when swap spreads change in a big way, it's because big money is sensing a big change in the underlying fundamentals.

The big decline in swap spreads in late 2008 and early 2009 correctly foreshadowed the end of the recession some months later. The big decline in Eurozone swap spreads that we've seen this year is a sign that liquidity has returned, confidence in the banking system has returned, and that the risk of a systemic failure in the Eurozone has all but disappeared. (See my swap spread primer for more background) From that it follows that there is reason to think—even though the PIIGS have not yet implemented necessary fiscal reforms—that we've seen the worst for the Eurozone economy. Things could start improving well before year end at this rate.


The equity market is beginning to figure this out. Since the big PIIGS scare of September 2011, the S&P 500 is up over 30%, and Eurozone equities are up over 25%.

Governments don't fix economies, the private sector does—if given breathing room and time. The way I see it, the Fed and the ECB have supplied sufficient liquidity to restore financial markets to health. Liquidity allows big transactions to occur at lower cost, and it allows the market to resume its search for information (i.e., price discovery). Governments are no longer trying to "stimulate" their economies with debt-financed spending. Keynesian stimulus has been thoroughly debunked, and now it's only a matter of time before more sensible stimulus policies are put in place that could really get economies going. In the meantime, we are seeing the U.S. economy undergoing a very modest "organic" recovery that is being held back by powerful headwinds (e.g., the uncertainties surround the election and the looming fiscal cliff).

Jobs growth is disappointing, but it's better than none at all

Today's employment report was not encouraging at all—only 103K private sector jobs created, vs. the ADP estimate of 201K—but neither was it cause for increased concern over the health of the economy.  The economy is still growing slowly, and it is still way below its growth potential. However, it remains the case that it is improving on the margin, and that is the most important thing at this point, because the market is priced to a deteriorating economy. You can see that in the S&P 500's forward PE ratio of 13.3, which is well below the long-term average PE: the market expects earnings, which are currently close to all-time record highs, to decline significantly. You can also see that in today's 1.6% 10-yr Treasury yield, which only makes sense if one has dismal expectations for future economic growth (think Japan). The market has been expecting another recession, and instead we're getting slow growth, and that's good news in a relative sense.


A few things to note in the above chart of private sector employment: The big gap that opened up between the household and the establishment survey early this year has narrowed significantly. I thought there was a chance that the establishment survey could be telling us that the economy was doing much better than most realized, but now that hope has faded. Judging from these surveys, jobs have been growing at about a 1.2% annualized pace over the past six months, or about 110K per month on average. If the productivity of labor equals its long-run average of 2% per year, then the current pace of jobs growth will give us real growth in the economy of about 3% per year. That's about average, but it will never close the current output gap, which I estimate to be at least 12%. The economy is not going to improve enough before the November election to make a difference.


The only reason the unemployment rate has come down is that there are more than 5 million people who have dropped out of the labor force since 2009.


The public sector continues to shrink, but mostly at the state and local level. Mark Perry has some interesting numbers: "From January 2009 to August 2012, there has been a loss of 533,000 local government jobs, a loss of 149,000 state government jobs and a gain of 27,000 federal jobs."

More signs of gradual improvement

Today's economic data provided yet more evidence that the economy continues to gradually improve. More importantly, given that Treasury yields remain extremely low, there is no evidence at all that the economy is deteriorating. The market continues to expect terrible news, but the news keeps coming in better than expected. Thus, the equity market continues to rally even though the economy struggles with a decidedly sub-par recovery.


Announced corporate layoffs are close to record lows. Corporate America is not panicking.


The ADP jobs number was stronger than expected (201K vs. 140K) and once again it points to a stronger than expected payroll jobs number tomorrow (currently expected to be only 140K).


Unemployment claims remain low. This chart shows the raw, nonseasonally adjusted data. Nothing bad at all about this that I can see.


The ISM service sector report was also somewhat better than expectations. It's definitely not showing growth to be excited about, but neither is it deteriorating. When the market expects deterioration and the economy instead grows by only a modest amount, that is bullish.

More signs of improvement on the margin


Auto sales continue to rise, and are up at a 14.5% annualized rate since the bottom in February, 2009. This is what a V-shaped recovery looks like, even though sales have still not yet reached their prior highs. With sales consistently beating expectations, the ripple effects throughout the economy are very positive on the margin.


Home builders' stocks are making new post-recession highs. Still far below their prior highs, but moving in the right direction. Lumber prices have doubled since their low in March 2009, further confirming that there is some genuine improvement in the construction sector.

The meme continues: the economy still stinks, but it is getting better on the margin, and things are not nearly as bad today as the market had feared not too long ago. This is what is driving equity prices slowly higher.

The PIIGS are looking better


2-yr sovereign yields are a good indicator of the market's perceived risk of near-term default. By this measure, the near-term outlook for the Eurozone has improved rather dramatically this year. Yields for most of the PIIGS are still well above German yields, which means they aren't out of the woods yet. But the risk of default is much less today than it was near the end of last year. 



Much of the improvement can be traced to the ECB's provision of abundant liquidity to the Eurozone financial market. The reduction in the cost of obtaining dollar liquidity is also significant, as shown in the second chart above. Swap spreads in the Eurozone are still somewhat elevated, but at current levels they signal that market participants are pretty confident that Eurozone banks do not face an imminent crisis. Swap spreads reflect the market's confidence in the health of the financial system, and they also reflect a significant decline in Eurozone systemic risk. The reduction in swap spreads is the market's way of saying that liquidity is decent, that it is possible to trade, that investors and institutions can reduce or increase their risk exposure without much difficulty. 

When markets are liquid they can handle almost any problem, because those who are uncomfortable bearing too much risk can shift the risk to someone who is more able and willing to take on the risk. Is there anyone left in the world who is holding onto Spanish sovereign debt that doesn't want to? I doubt it. 


5-yr Credit Default Swaps are a good indicator of the long-term perceived risk of default, and here too we see a lot of improvement. Most of the PIIGS now trade better than junk bonds, which means their risk of default is manageable and not very scary.


Europe is still struggling, of course, but it's not going down a black hole, which is what markets were very worried about at the end of last year. Even though the reality in Europe is still grim—most countries are probably in a recession, and Spain is having some real problems—things are better than what markets feared, and that is what has put a floor under the Eurozone equity market. The outlook is still bad, but it's not as bad as what had been priced into markets. So on the margin, there has been some noticeable and welcome improvement.

This is the same theme that is playing out in the U.S. The economy still stinks, but we are in far better shape than markets were expecting. Around the end of 2008, markets were priced to something like the end of the world as we know it. Credit spreads were so high than the bond market was effectively expecting that about one-third of the companies in the U.S. would be out of business by now. The market is still very worried about the future, only less so today than before. PE ratios are below average even though corporate profits are at record levels; that tells you that the market fully expects profits to deteriorate. Credit spreads are still somewhat elevated, which also suggests the market expects the outlook to deteriorate. Treasury yields are still extremely low, which tells you that investors are so worried about the risk of investing in anything else that they are willing to forego almost all of the extra yield available elsewhere.

Quick updates

The ISM manufacturing index came in a bit weaker than expected (49.6 vs. 50.0), but was essentially unchanged from July. The index is fully consistent with a continuation of the relatively slow growth (about 2%) that we have been seeing for the past few years. 


The prices paid index jumped in August, reflecting the rise in commodity prices. If there is any significance to these indices at this point, it is that deflation risk remains very low and the economy is not sliding into a recession.


Construction spending fell in July, but there is no reason to suspect this is anything other than noise. Total construction spending is up a fairly robust 9.3% in the past year; residential is up 17.6%, and nonresidential is up 5.7%. The construction sector is adding to GDP for the first time in six years, and is likely to continue to expand.