By
Calafia
Beach Pundit
:
As the world waits to see how politicians figure out how to
avoid the looming "fiscal cliff," nerves are on edge. Even though
the risks of failure perhaps might not be high, the consequences of
failure could be very serious. Moreover, politicians might avoid
the fiscal cliff but still implement policies (e.g., sharply higher
tax rates on small businesses, the engine of jobs growth) that
could hamstring the economy.
Now is a good time to look once again at key market indicators that
can help us understand how much bad news is already priced into the
market. As I see it, the market is already braced for an unpleasant
outcome to the fiscal cliff negotiations. That's not to say that we
should expect an unpleasant outcome, but rather to say that should
the outcome be unpleasant, that would not necessarily be bad news.
(click to enlarge)
The above chart compares the real yield on 5-yr TIPS to the
running 2-yr annualized growth rate of real GDP. The underlying
premise of the chart is that government-guaranteed real yields that
are available for purchase in the TIPS market can tell us a lot
about the market's expectations for real economic growth. If I buy
a 5-yr TIPS bond today, I have locked in a risk-free real rate of
return of -1.4% per year for the next 5 years. Don't be quick to
dismiss the importance of this; TIPS prices are not distorted.
The spread between 5-yr TIPS real yields and 5-yr Treasury
nominal yields is just over 2%, which means that the market is
expecting the CPI to average about 2% per year for the next 5
years, and that is not unreasonable at all, considering that the
core CPI has risen at an annualized rate of 1.7% over the past 5
years, and the CPI has increased at a 2.1% annualized rate over the
same period.
Apparently the market is quite content to lock in a guaranteed loss
of purchasing power with TIPS. I think that only makes sense if you
accept that the market is willing to do this because there is a lot
of fear out there that buying and holding any riskier asset is
likely to mean real returns in coming years that are
disappointingly low. By inference, if the market expects real
returns on risk assets to be very low (perhaps even negative) over
the next 5 years, then the market also expects the real growth of
the economy to be very disappointing.
That's precisely what the above chart shows: the current level
of TIPS yields is consistent with real GDP growth that is close to
zero over the next 5 years. That could be variously interpreted of
course: it might mean 2 years of recession followed by 3 years of a
moderate recovery, or it could be just total stagnation.
Note how in the chart real TIPS yields do a pretty good job of
tracking the growth rate of the economy over the past 15 years.
When economic growth was robust in the late 1990s, TIPS yields were
very high; and with growth rates slipping to the current 2%, TIPS
yields have declined.
(click to enlarge)
And it's not just the bond market that is pessimistic. As the
chart above shows, the stock market's confidence in the stability
of earnings has also tracked the real yield on TIPS. As the real
yield on TIPS has fallen over the years (shown here inverted), the
earnings yield on the S&P 500 has risen (and the market's P/E
ratio has fallen). Why would the market today be priced to an
earnings yield of 7.3%, when real yields on TIPS are -1.4%?
The only way that makes sense is to accept that the market is
demanding a very high equity earnings yield today because it
expects earnings to be much lower tomorrow. If the market had any
confidence at all in the stability of earnings going forward, then
P/E ratios would be higher (at least above their long term average
of 17) and earnings yields would be lower-at least below the
current 4.5% yield on BAA corporate bonds.
(click to enlarge)
CDS spreads tell the same story. Credit default swaps are a very
liquid market and a very good indication of the market's confidence
in the future health of the economy. CDS spreads today are at the
same level they were just prior to the onset of the Great
Recession. The market is obviously concerned that default risk is
relatively high, and that only makes sense if the market also
worries that the economy might experience another recession. 5-yr
high-yield bonds are trading with yields that are 6 percentage
points higher than 5-yr Treasuries because the market thinks that
there is a significant risk that corporate defaults will be
troublesome in the years ahead, and that is only likely to happen
if the economy is very weak.
(click to enlarge)
When 10-yr Treasury yields are trading at extremely low levels
(these bonds have almost never been so expensive), it's a safe bet
that the world is very risk-averse.
(click to enlarge)
And it's not just the U.S. that is in trouble, according to
market expectations. As the above chart shows, sovereign yields in
the U.S. and Germany are converging on the yields of that paragon
of miserably slow growth, Japan. The market is behaving as if the
world's major developed countries are going to be experiencing the
same stagnate growth as Japan, which has suffered zero net growth
since the end of 2006 (as compared to 4.4% growth in the US over
the same period) and annualized growth of only 0.7% over the past
10 years (as compared to 1.6% in the US over the same period).
Note also, for comparison purposes, that 5-yr real yields on
Japanese inflation-indexed bonds are -0.6%. Negative real yields
and extremely low nominal yields all point to one thing: a market
that expects agonizingly slow growth to prevail-much slower than we
have seen in recent years.
(click to enlarge)
If extremely low 10-yr Treasury yields are symptomatic of
miserably low real growth expectations, and if the Vix index is a
good proxy for the market's level of fear, then the ratio of the
Vix index to 10-yr Treasury yields (shown in the chart above) is a
good indicator of how worried the market is about the future level
of growth.
The Vix/10-yr ratio has spiked during every major crisis in the
past few decades, and although it is significantly lower today than
it was at the height of the 2008 meltdown-when the market fully
expected a global financial market collapse and years of depression
and deflation-it is still extremely high by historical standards.
In short, this indicator suggests that the market is quite fearful
of another recession.
(click to enlarge)
(click to enlarge)
Finally, the above charts show how investors are voting with
their feet. Equity mutual funds continue to experience heavy
outflows, while bond funds continue to experience strong inflows.
This is a picture of a market that is very worried about the future
and very concerned about seeking shelter.
(click to enlarge)
If there is one thing out of place in this picture of a market
obsessed with concerns about growth, it is swap spreads. Swap
spreads have been excellent coincident and leading indicators of
the fundamental health of the financial market and of the economy.
As the chart above shows, swap spreads rose well in advance of each
of the last three recessions, and declined well in advance of the
onset of recoveries.
Today, swap spreads are unusually low, which is telling us that
the fundamentals of the economy are not in the least shaky.
Systemic risk-actual risk as perceived by market participants-is
very low. The wheels are not about to come off this economy. The
best explanation for why so many indicators point to troubles ahead
but swap spreads say everything is fine, is that the market is very
worried about something that has not yet even begun to happen. And
it might not happen, either, if swap spreads are still good leading
indicators.
In short, as I see it, the market is priced to lots of bad economic
news that has yet to hit the tape. The market may end up being
right, of course, but there are reasons to think that the market
may be too pessimistic. At the very least we know that the market
has had plenty of time to work itself into a frenzy of concern,
since there is no shortage of things to worry about: political
gridlock in Washington, a president who is anti-business and
anti-wealth, trillion-dollar deficits for as far as the eye can
see, a Middle East in turmoil, a huge increase in regulatory
burdens, the onset of ObamaCare-which promises wrenching
adjustments for one-sixth of the nation's economy, millions of
underwater mortgages, and monetary policy that is far advanced into
uncharted territory, to name just a few. It should not be
surprising or controversial to discover that, in a time bad news is
in plentiful supply, that the market is priced to pessimistic
assumptions.
If you're worried about the future, you have plenty of company. If
you're seeking refuge and protection, it's extremely expensive. The
world is braced for lots of things to wrong. As I mentioned last
August, it might make sense instead to
worry about something going right
.
See also
Splunk Management Discusses Q3 2013 Results -
Earnings Call Transcript
on seekingalpha.com