DIGGING OUT

Published: 01-25-2016

The eastern United States was buried in snowstorm Jonas this weekend, from 42 inches (more than a meter for our non-US friends) in West Virginia to (a mere) 15 inches on Cape Cod. Snowfall records going back more than a century were toppled from Baltimore to New York. Sustained winds in excess of 70 mph added to the mess.

Below is the view from my window this afternoon (70 and sunny here in Santa Monica). Now, if these two photos cause some jealousy, I’m fine with that. But my main point is that looking up into a snow bank does not mean the rest of the world is also buried in snow, just as I can’t look out my window and assume everyone else sees sunshine.

The same used to be able to be said for investing: losses in one market did not mean that there were losses in all markets. Alas, recently, that has not held true: investors have been buried this year in pretty much every market they turned to. Despite the strong performance of markets last week, equities (and commodities) are still down 8% in January (with a week to go).

The swift and substantial decline in equities and commodities to start the year lead investors to ask, reasonably, are there more storms to come? And, will we ever dig out from the current blizzard? The answers are, “probably,” and, “certainly. ”

“Probably” because there are many reasons for worry that will likely persist: China’s transition to a domestic, consumer economy has not been smooth, and the omniscient mandarins in control have made a number of high-profile gaffes. Commodities, oil especially, seem to have no bottom, and while excess supply is the main culprit, weaker demand is contributing: The IMF (again) cut its forecast for global growth last week.

Even the US economy is struggling. We’ll get the first estimate of 4Q GDP on Friday, but it looks like it will come in below 1%. Manufacturing is contracting, in both the US and in China (the PMI diffusion indices are below 50). And the Iowa caucus is one week from today, where the winners are likely to be named Trump, Cruz and Sanders, which no doubt boost the spirits of their supporters, but send an avalanche of fear through investors. So there is plenty to fear.

But “certainly” we will dig out of this mess (both the physical and the financial). Notwithstanding the 4Q slowdown, the US economy is expanding: job growth is strong (the best two straight years since the late 1990s), housing permits, auto sales and even personal incomes are all rising. The widening of credit spreads and the sharp declines in equities have historically been precursors of market crashes and economic recessions, but, as Paul Samuelson observed, have predicted nine of the past five recessions.

While markets are certainly volatile this year, take a look at the TED (T-bills/eurodollars) spread (below). It doesn’t get a lot of attention, but it’s a great indicator of how the market prices financial risk: Over the past decade it reached a high of 455 basis points (October 2008) and a low of 10 (March 2010), averaging 49 bps over this period.  The current reading is 33, below the long-term average. This is not what you see when financial markets are about to implode. That’s because they aren’t.

Despite the rapid drop in equities and commodities this year, I don’t see the excesses in leverage or in valuations that herald a market crash. And despite some weaker economic data, neither do I see an economic contraction as likely this year. We should certainly be prepared for storms to come, but I’m confident we’ll dig out of them in due course.

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