For all the turmoil out there, it's remarkable that the prices of gold and 5-yr TIPS remain in a downward trend. (Note: I use the inverse of TIPS's real yields as a proxy for their price.) If conditions were really unravelling, the market would be paying ever-higher prices for these two safe haven assets. They were much higher in price in late 2011 and 2012 when the PIIGS crisis was at its apogee. That crisis threatened the economies of the eurozone and the euro itself. The current crisis is much more narrowly defined.
Sharply lower oil prices have dramatically increased the risk of default for energy-related corporate debt, as shown in the blue line in the first chart above. But the threat of defaults is concentrated in the energy sector. Non-energy high-yield debt credit spreads are only 660 bps, much less than half the 1600 bps spreads on energy-related bonds, and less than the spreads on all HY debt at the peak of the PIIGS crisis. As the second chart above shows, swap spreads are very low, in sharp contrast to how they behaved in previous recessions. Very low swap spreads tell us that financial markets are highly liquid and that systemic risk is very low. This is mostly a problem affecting the oil patch, not everybody.
Markets today are far more liquid than they were in 2008 and 2011-12. That is of critical importance, and a source of comfort.
Like all the other big selloffs in recent years, fear has been the main driver. (As a proxy for fear I use the ratio of the Vix index to the 10-yr Treasury yield.) The Vix/10-yr ratio hit a high of almost 25 when the PIIGS crisis was at its most intense. So far, the China/oil crisis looks substantially less scary than the PIIGS crisis.
The PE ratio of the S&&P 500 has dropped to its long-term average of 16.5. So stocks are at "average" valuations today. But: corporate profits are still very high relative to GDP (9-10% of GDP, versus a long-term average of 6-7%). The PE ratio on 10-yr Treasuries is about 50 today (the inverse of their 2% yield). What this means is that the market is deeply distrustful of the staying power of corporate profits. Deeply. Investors are willing to accept extremely low yields on safe assets in order to avoid the perceived risk of stocks. There is a LOT of fear priced into the market, even though PE ratios are not historically depressed.
As the two charts above show, the bond market is priced to the expectation that consumer price inflation will average 1.2% per year for the next 5 years. That's relatively low, but not unprecedented. Deflation/depression fears were rampant at the end of 2008, when inflation expectations fell to negative levels. Today, low inflation expectations are being driven mainly by very low oil prices, as the second chart suggests. Core inflation, I would note, is still running at just under 2%. The problems today center around oil, not the fact that the Fed has raised interest rates a mere 25 bps.
Commodity prices have plunged in recent years, but raw industrial commodity prices (above) are actually up over the past two months. Non-energy commodity markets may be finding support at current levels.
For all the decline in commodity prices, they are still significantly higher today than they were at the end of 2001, when very tight monetary policy (as seen in 4% real yields, a flat- to inverted yield curve, and a very strong dollar) created a genuine risk of deflation. As the chart above shows, most of the extreme moves in commodity prices have been due to extreme moves in the dollar. When commodities are measured in euro terms (blue line above), they are much more stable, and still 70% higher than in 2003. I note that the two y-axes in the chart both have the same range (the top value is 3.5 times the lower value). I note also that the dollar has been relatively flat for most of the past year.
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