Thursday, August 10, 2017

The Nork Wall of Worry

Kim Jong-un is making today's headlines with his threats to attack Guam in short order and somewhere in the US at a later date—and to attack with nuclear weapons no less. He's also sparked a mini panic attack in global markets. But so far, markets have been quite blasé about the threat that North Korea poses. The chart below puts things in perspective, as of 7 am beach time:


Believe it or not, the threat of imminent nuclear hostilities is (so far) just a blip on the market's radar screen. About as big as the threat of a Frexit, but far less than Brexit, collapsing oil prices, or a Chinese economic implosion. If you want protection from a nuclear holocaust, options are still relatively cheap, with the Vix this morning trading around 14-15, up from a very low 10 a few days ago.

So either the market is ridiculously unconcerned, or the market rates the chances of a nuclear explosion as remote. Considering that the So. Korea stock market is down less than 4% in the past few weeks, it's probably the latter. (You would think Seoul has the most to lose if Kim Jong-un gets crazy enough to start pushing launch buttons.) I note as well that gold is up only 2% or so in the past week.

I'm not offering investment advice here, I'm merely laying some facts on the table.


It's also worth noting that industrial metals prices yesterday reached an 18-month high, having risen more that 60% from their January 2016 low, as the chart above shows. That's pretty impressive, and it suggests that global economic activity has definitely perked up.

I'm reminded of the fact that the recession of 2001 ended just a few months after the 9/11 attack. The US economy is amazingly resilient, and the global economy perhaps just as resilient.

Monday, August 7, 2017

Credit spreads tell a bullish story

Credit spreads—the extra amount of yield that investors demand to hold debt that is riskier than Treasuries—are uniformly low these days. That tells us that liquidity in the bond market is abundant, systemic risk is low, and the outlook for corporate profits and the economy is healthy. '


Swap spreads (see a short primer on swap spreads here) are arguably the bedrock and most important of all credit spreads. "Normal" spreads on 2-yr contracts are roughly 20-40 bps. At today's 25 bps, 2-yr swap spreads are perfectly normal. This tells us that bond market liquidity is relatively abundant. Fed tightening has not created a shortage of money, as it usually does in advance of recessions. It also tells us that systemic risk is perceived to be low. As the chart above suggests, swap spreads tend to be good predictors of conditions in the broader economy; spreads tend to rise in advance of recessions and decline in advance of recoveries.


As the chart above shows, swap spreads in the Eurozone are elevated. Conditions are not as healthy there as they are here. Eurozone spreads are not dangerously high, but they do reflect some systemic risk, which is likely related to the perception that the Eurozone still faces existential risks from countries thinking about "exiting" the Eurozone. Given the higher spreads in the Eurozone, it is not surprising that Eurozone GDP growth has been lagging that of the US for a number of years. Riskier markets tend to receive less investment—and consequently less growth—than less risky markets.


The chart above shows credit spreads as derived from the universe of bonds issued by US corporations: $6.3 trillion of investment grade bonds, and $1.3 trillion of high-yield (junk) bonds. Both spreads are relatively low, as you would expect them to be in a healthy, growing economy. They are not at record lows, but they are low enough to be impressive.


The chart above compares 2-yr swap spreads to high-yield corporate spreads. Here we see further evidence of how swap spreads tend to be good predictors of the health of the economy (HY spreads are particularly sensitive to the underlying health of the economy).


The chart above shows 5-yr Credit Default Swap spreads. CDS spreads are derived from generic contracts representing hundreds of large, liquid corporate bonds, so they are reliably good proxies for overall credit risk. Their message is the same as other credit spreads: conditions are normal, and thus the outlook for the economy and corporate profits is healthy.

Commercial real estate still strong

A quick update on the health of the commercial real estate market, which remains quite good. According to the folks at CoStar, their composite (equal weighted) price index rose a staggering 17.5% in the 12 months ended June, 2017. Price gains were strongest in the lower-priced, secondary and tertiary markets. Gains in higher-priced and larger markets were a solid 5% over the same period.


Impressive.