Financial Pacific - U.S. financial health (third party)

Wealth Management Research 15 August 2011

Financial crisis thermometersMonthly update

• In this monthly report, we measure financial, economic andcredit health with the help of "thermometers."

• The financial health thermometers deteriorated across allfour measured regions since March.

• The US economic health thermometer deteriorated visiblysince March through July and now sits at the midpoint of thehealthy zone.

• The US credit health thermometer improved since March,and it now it stands at a slightly better level than normal.

US financial health (updated monthly, last update 10 August2011): Please see the Appendix for a detailed explanation of thisthermometer. The US financial health thermometer deterioratedvisibly recently and at 101.3° now stands at its highest levelsince June 2010. The only visible improvement was a drop inthe corporate bond credit spread. The deterioration is somewhatreminiscent of the 2008 blow-out, as implied equity volatility andthe credit default swap (CDS) spread are leading the deterioration.However, US money market and corporate spreads have remainedfairly healthy. The Eurozone fiscal woes are probably weighingheavily on the former two indicators in the US. To reflect a fullnormalization, the thermometer would have to improve further toa level of 100°.

US economic health (updated monthly, last update 10 August2011): Please see the Appendix for a detailed explanation of thisthermometer. The US economic health thermometer has fallenover the past few months to 99.3° in July. At that level, it is inthe midpoint of the healthy range, which is consistent with realGDP growth between 0% and 3%. Given our outlook for only amoderate recovery, we continue to think the index will likely staywithin the healthy range, with a tendency to be closer to 100° than98.5°.

Thomas Berner, CFA, economist, UBS [email protected], +1 212 713 4108

US financial health thermometerDETERIORATEDNormal index (sample: 1 Jan 06 – 20 Jul 07) =100

Source: Thomson Datastream, UBS WMR, as of 10August 2011

US economic health thermometerDETERIORATEDNormal index (sample: Feb 1969 – present) = 100

Source: Thomson Datastream, UBS WMR, as of 10August 2011Past performance is no indication of futureperformance. The market prices provided are closingprices on the respective principal stock exchange. Thisapplies to all performance charts and tables in thispublication.

This report has been prepared by UBS Financial Services Inc. (UBS FS). Please see important disclaimers anddisclosures that begin on page 9.

US credit health (updated monthly, last update 10 August2010): Please see the Appendix for a detailed explanation of thisthermometer. The US credit health thermometer has improved inthe recent past. At 99.6° in June it actually has slipped into thehealthy zone. The contraction in commercial bank lending has cometo a halt, but the Aaa and Baa investment grade corporate cred-it spreads widening a bit. Lending standards continued to be loos-er and the money market spread rose somewhat. On a trend ba-sis, credit health has improved from a historical high of 104.5° inNovember 2008 and now stands at a level slightly worse than nor-mal. In our view, it will probably stay close to a normal reading ofaround 100°.

US credit health thermometerIMPROVEDNormal index (sample: Jan 1973 – present) = 100

Source: Thomson Datastream, UBS WMR, as of 10 Au-gust 2011

Eurozone financial health (updated monthly, last update 10August 2011): Please see the Appendix for a detailed explanationof this thermometer. The Eurozone financial health thermometerhas been deteriorating steadily since the end of March and recentlyjumped on the back of the renewed eruption of fiscal woes in theEurozone. At 102.6° the thermometer is at its highest level sinceMarch 2009. Just like in the US, the CDS spread and the impliedequity volatility led the deterioration. It is somewhat surprising thatthe money market spread has not deteriorated that much given thefunding concerns about the Eurozone banking sector.

Eurozone financial health thermometerDETERIORATEDNormal index (sample: 1 Jan 06 – 20 Jul 07) =100

99

100

101

102

103

104

Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul-11 Aug-11

Thermometer Thermometer (excl. CDS)

Unhealthy

Healthy


UK financial health (updated monthly, last update 10 August2011): Please see the Appendix for a detailed explanation of thisthermometer. The UK financial health thermometer has risen to101.7°, its highest level since July 2009. As seen in the US andthe Eurozone, implied volatility and the CDS spread rose the most,whereas money market and corporate spreads remained fairly wellanchored.

UK financial health thermometerDETERIORATEDNormal index (sample: 1 Jan 06 – 20 Jul 07) =100

99

100

101

102

103

104



Unhealthy

Healthy


Financial crisis thermometers

Wealth Management Research 15 August 2011 2

Japan financial health (updated monthly, last update 10 Au-gust 2011): Please see the Appendix for a detailed explanationof this thermometer. The Japan financial health thermometer rosesharply after the earthquake and the related tsunami hit the coun-try. Since then the thermometer has held on to its gains, reflectingrather unhealthy levels. At 101.1° the thermometer is at its highestsince March 2011. And again, as it is the case for the other threeregions, implied equity volatility and the CDS spread led the deteri-oration, while the money market and corporate spreads held steady.

Japan financial health thermometerDETERIORATEDNormal index (sample: 1 Jan 06 – 20 Jul 07) =100

99

100

101

102

103



Unhealthy

Healthy




AppendixFinancial health thermometersThe financial health thermometer is a weekly gauge of financialstress. Conceptually, we constructed it in the same way for all fourregions: the US, the Eurozone, the UK and Japan. Due to data lim-itations in Japan, however, the construction of the Japanese ther-mometer is a little bit different. The financial health thermometeris the weighted average of four "standardized" indicators, wherestandardized means that the original series were transformed tohave a mean of zero and a standard deviation (volatility) of one. Theweights are assigned according to the explanatory power of eachindicator of the variance in the whole data set (Principal ComponentAnalysis). The four indicators are:

• Bank liquidity: measured by the difference between moneymarket rates and central bank rates. Specifically, it is the spreadof the 3-month London Interbank Offered Rate (LIBOR) interestrate over the respective central bank target rate. The higher thespread goes, the harder it is for banks to get liquidity.

• Corporate default: measured by the difference between cor-porate bond rates and government bond rates. Specifically, itis the spread of the investment grade 10-year corporate bondyield over the 10-year government bond yield. The higher thespread goes, the higher the risk of corporate default.

• Financial intermediaries default: measured by the five-yearcredit default swap (CDS) spread of the financial intermediariessector. The CDS spread measures the cost of insuring an un-derlying credit security against default over a certain period (inour case, five years). The higher the spread goes, the higher theaggregate risk of default of financial intermediaries. In Japan,a CDS spread for the financial intermediaries sector was notavailable. We used the average CDS spread of the three biggestbanks in Japan (Mitsubishi UFJ, Sumitomo Mitsui and Mizuho)instead.

• Equity volatility: measured by the implied volatility of themajor stock market indexes. The implied volatility indexes arebased on the implied volatility as priced into option prices onthe underlying stock indexes. The higher the implied equityvolatility goes, the more investors are willing to pay to hedgeagainst equity volatility and, thus, the higher the perceived eq-uity risk is in the market.

The interpretation of the financial health thermometer is construct-ed as follows: We used the period between 1 January 2006 and20 July 2007 as the benchmark for “normal” (the benchmark peri-od). In late July 2007, the first financial market dislocations occurredfollowing the US subprime mortgage crisis. While any choice for abenchmark is arbitrary, we are interested in knowing when we willreach the financial health that existed before the July 2007 liquiditycrisis. Each regional financial health thermometer in this report av-erages 100 over the normal benchmark period, so an index level of100 is considered normal.

US financial health thermometerNormal index (sample: 1 Jan 06 – 20 Jul 07) =100

99

100

101

102

103

104

105

Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11


Unhealthy

Healthy


Eurozone financial health thermometerNormal index (sample: 1 Jan 06 – 20 Jul 07) =100

99

100

101

102

103

104



Unhealthy

Healthy


UK financial health thermometerNormal index (sample: 1 Jan 06 – 20 Jul 07) =100

99

100

101

102

103

104



Unhealthy

Healthy




• To make the measurements easier to interpret, we introduceda Fahrenheit degree scale, where 100° indicates normal bodytemperature. Each Fahrenheit degree deviation from 100°equals 10 standard deviations from the mean that existed dur-ing the normal benchmark period. For example, a financialhealth thermometer that stands at 103° is 30 standard devia-tions above its mean during the normal benchmark period. Thismight seem like a lot, but we are comparing the current finan-cial health to the normal benchmark period, when volatility wasvery low.

• Each Fahrenheit degree also has its own color zone, with a high-er degree associated with a higher temperature and thus poor-er health. The color scheme goes from green (healthy) to in-creasingly darker shades of yellow and up to dark orange orred (unhealthy).

Since we used the same normal benchmark period and methodol-ogy for all four regions, the levels of each regional financial healththermometer are comparable. Keep in mind, however, that theJapanese thermometer was constructed slightly differently.

Japan financial health thermometerNormal index (sample: 1 Jan 06 – 20 Jul 07) =100

99

100

101

102

103



Unhealthy

Healthy


All financial health thermometersNormal index (sample: 1 Jan 06 – 20 Jul 07) =100

99

100

101

102

103

104

105


US Eurozone UK Japan

Unhealthy

Healthy




US economic health thermometerThe economic health thermometer gauges the stance of the USeconomy in a single and timely measure on a monthly basis. Thisgauge will help investors assess whether the US economy is movingout of recession before it shows up in the GDP figures.

The economic health thermometer is the weighted average of three“standardized” indicators, where standardized means that the orig-inal series were transformed to have a mean of zero and a standarddeviation (volatility) of one. The weights are assigned according tothe explanatory power of each indicator of the variance in the wholedata set (Principal Component Analysis). The three indicators are:

• Business climate: measured by the level of the Institute forSupply Management (ISM) Manufacturing Purchasing Man-agers’ Index (PMI). The ISM surveys purchasing managers atmanufacturing firms every month on changes in new or-ders, unfilled orders, production, employment, supplier deliv-ery times, inventory, export orders, imports and prices paid.The ISM Manufacturing PMI is the average of the sub-index-es for new orders, production, employment, supplier deliverytimes and inventories. A level above/below 50 signals an expan-sion/contraction in the national manufacturing sector. The ISMindex correlates strongly with real GDP year-over-year growthand is thus seen as a good proxy for overall economic activi-ty. However, manufacturing cycles can sometimes diverge fromthe overall business cycle. Thus, care is required when interpret-ing the level of the ISM index.

• Consumer sentiment: measured by the level of the Confer-ence Board (CB) consumer confidence index. The CB indexgauges how consumers assess their present and future situa-tion. The index is constructed as the average of the indexedanswers to five questions about consumers’ assessment of thecurrent and future employment situation, current and futurebusiness conditions and future total family income. The an-swers can be positive, negative or neutral. For each question,the sub-index is derived by calculating the ratio of the propor-tion of the positive answers to the sum of the positive and neg-ative answers. This number is then indexed, with 1985 equal-ing 100. Thus, the level of the CB consumer confidence indexis not readily interpretable as positive or negative, but has tobe compared to its history to assess whether or not the valueis conducive to real consumption growth. The index dates backto February 1969 and averaged 95.4 through February 2009.A level of around 90 is consistent with trend growth of about3.5% in real consumption.

• Labor market health: measured by the monthly growth ratein non-farm payrolls, which count the number of jobs in theentire economy, excluding the farm sector. Although non-farmpayrolls tend to get revised rather sharply, they swing more inline with real economic activity than the unemployment rate,which typically lags the overall business cycle. Non-farm payrollgrowth of 0.16% per month, or about 2% annually, is consid-ered normal employment growth or commensurate with trendgrowth in real GDP.

US economic health thermometerNormal index (February 1969 – present) = 100

96

97

98

99

100

101

102

103

Feb-69 Feb-79 Feb-89 Feb-99 Feb-09

US economic health thermometer

Unhealthy

Unhealthy

Healthy




The interpretation of the economic health thermometer is as fol-lows:

• The average of the entire sample from February 1969 to thecurrent month equals 100.

• To make the measurement easier to interpret, we introduced aFahrenheit degree scale, where 100° implies normal body tem-perature. Each Fahrenheit degree deviation from 100° equalsone standard deviation from the mean over the entire sample.For example, an economic health thermometer that stands at102° is two standard deviations above its sample mean.

• There are three color zones.1. The green zone (from 98.5° to 100°) is commensurate with real

GDP growth between zero and 3%, with the latter being trendgrowth over the sample period.

2. The dark orange zone (100° or higher) is commensurate withreal GDP growth above 3%, or an overheating economy.

3. The blue zone (98.5° or lower) is consistent with contractingreal GDP, or a recessionary economy.

We classify both an overheating and a recessionary economyas unhealthy, and see normal growth between zero and 3%as healthy. Note that the boundaries between healthy and un-healthy are blurred. Ideally, the US economy should be grow-ing at potential growth of around 3%. However, we want-ed to mark the line between contraction and expansion (zerogrowth or 98.5°). That does not mean that we think that itwould be healthy for the US economy to expand at +0.5%per year for several years.



US credit health thermometerThe credit health thermometer gauges credit conditions in the US ona monthly basis. It summarizes information on the price, availabili-ty and flow of credit. The credit health thermometer is the weight-ed average of five “standardized” indicators, where standardizedmeans that the original series were transformed to have a mean ofzero and a standard deviation (volatility) of one. The weights areassigned according to the explanatory power of each indicator ofthe variance in the whole data set (Principal Component Analysis).The five indicators are:

• Bank liquidity: measured by the spread of the 3-month Eu-rodollar deposit rate over the fed funds rate. We used the 3-month Eurodollar deposit rate instead of the 3-month LIBORrate since it has a longer history. They correlate very closely,however. The higher the spread goes, the harder it is for banksto get liquidity.

• Corporate default: measured by both the spread of theMoody’s Aaa 20-year corporate bond yield over the 20-yeargovernment bond yield and the spread of the Moody’s Baa 20-year corporate bond yield over the 20-year government bondyield. The higher that any of these spreads goes, the higherthe risk of corporate default in the respective segment of theinvestment grade corporate bond market.

• Availability of credit: measured by commercial bank lendingstandards for consumer installment loans. The higher the stan-dards are, the tougher it is for consumers with low credit rat-ings to get credit.

• Loan volume: measured by the real (inflation-adjusted)monthly growth rate of commercial bank loans (real estate,business and consumer loans). The higher the growth rate goes,the more rapidly loan volumes on banks' balance sheets arerising.

The interpretation of the credit health thermometer is as follows:

• The average of the entire sample from January 1973 to thecurrent month equals 100.

• To make the measurement easier to interpret, we introduced aFahrenheit degree scale, where 100° implies normal body tem-perature. Each Fahrenheit degree deviation from 100° equalsone standard deviation from the mean over the entire sample.For example, a credit health thermometer that stands at 102°is two standard deviations above its sample mean.

• Each Fahrenheit degree has its own color zone, with a higherdegree associated with a higher temperature and thus poorerhealth. The color scheme goes from green (healthy) to increas-ingly darker shades of yellow and up to red (unhealthy). Weconsider credit conditions between 98° and 100° as generallyhealthy, with the healthiest credit conditions closest to 100°.Credit conditions are looser as the thermometer approaches98°. Credit conditions that are too loose (such as extendingcredit to insolvent borrowers) can also create problems.

US credit health thermometerNormal index (sample: Jan 1973 – present) = 100

97

98

99

100

101

102

103

104

105

106

Jan-73 Jan-83 Jan-93 Jan-03

US credit health thermometer

Unhealthy

Healthy




Appendix

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