The Market Looks At Ukraine And Shrugs

by: Calafia Beach Pundit

If the situation in Crimea/Ukraine has the world on edge, markets don't seem all that worried. Key indicators of the market's perception of systemic risk and the economy's health have hardly budged, and point to continued, albeit relatively sluggish, growth.

The euro is up a bit so far this year, but as the chart above shows, it has been strengthening since mid-2012, when it first became clear that the eurozone sovereign debt crisis was receding and the eurozone economy was emerging from its recession. A stronger euro is a good sign that the outlook for the eurozone continues to improve.

Eurozone equities, shown in the red line of the above chart, have been tracking U.S. equities higher since mid-2012, albeit with a significant lag. To judge from the behavior of eurozone equities and the euro, the outlook for the eurozone continues to improve despite the uncertainty that has arisen in Ukraine.

Eurozone 2-year swap spreads, shown in the chart above, have been falling for the past several months, and are close to their lowest level in many years. This suggests that systemic risk in the eurozone is almost down to normal levels (e.g., spreads of 20-25 bps). It's clear that whatever problems the eurozone faces today are, in the eyes of the market, an order of magnitude less than the problems caused by the sovereign debt crisis a few years ago. It appears that, for now, eurozone growth prospects are trumping the risks of Russian incursions into neighboring countries.

U.S. 2-year swap spreads, shown above, are still trading at extraordinarily low levels, which means that markets are extremely liquid and generally quite healthy. It's hard to see here whether rising geopolitical risks have made any difference at all to the U.S. economy and investors' confidence.

The chart above shows the spread between investment grade and high-yield corporate bonds—a good measure of the likelihood of a significant deterioration in the economy. By this measure, the economic outlook is still improving, with credit spreads at or near post-recession lows.

The VIX index, shown above, has ticked up a bit in recent weeks, but remains relatively low compared to where it has been in recent years, when the eurozone sovereign debt crisis threatened the global recovery. Markets are a little worried, but no one is paying outrageous sums to seek downside protection; if they were the VIX index would be much higher, since it is an indication of how expensive it is to buy put and call options in order to limit one's downside risk.

Gold prices are up about $100/oz. so far this year, but as the chart above shows, that is in the nature of a minor blip on the geopolitical risk radar screen. On the margin over the past few weeks, gold prices and TIPS prices are down, which suggests the market has actually become less worried about an end-of-the-world scenario developing. I hasten to add, however, the gold prices are still quite high from a long-term historical perspective, and the real yields on TIPS are still quite low. Both tell me that markets are still willing to pay a substantial premium for the ultimate safety of gold and the default-free inflation protection of TIPS. There is still a good deal of risk aversion out there, but on the margin it is declining.

I'm merely reading the market tea leaves here, not trying to forecast the outcome of what's going on in Ukraine and the Middle East. It strikes me as somewhat unusual that the market would be so relatively complacent in the face of problems that could become quite serious if left unchecked. For those folks who are very worried, it's not too late—or too costly—to seek protection from events that could threaten the health of the economy and push equity prices lower. Options are not terribly expensive, and equity prices are still very close to their post-recession highs.