Asset Allocation Weekly (June 22, 2018)

by Asset Allocation Committee

Cycle studies are common in analyzing markets.  Such studies can be quite useful in some markets that are affected by seasonal factors, such as commodities.  We all know it gets cold in the winter and rains in the spring, and measuring the timing of when market participants discount these events can offer insights into market behavior.  In general, the more regular and reliable the factors are that cause the cyclicality, the more trustworthy the analysis.  Seasonal cycles tend to be consistent and thus are heavily used in commodity analysis.  Of course, once a pattern has been discovered, traders attempt to position in front of the expected price cycle.  Commodity analysts will note that price patterns still work but they often start sooner.

Human cycles tend to be much less reliable.  Usually, these cycles occur because of the structure of regulation; one example is tax selling, which sometimes weakens equity prices in late Q3.  It doesn’t always work because (a) tax laws change, or (b) sometimes investors don’t have a lot of losses to “harvest.”  Market research is full of examples that “used to work.”  Often, once analysts notice a cycle, there is a temptation to publish it, in part for reputational enhancement.  However, publishing makes the cycle better known and will often render it useless.

Elections in democracies create cycles with some degree of regularity.  In the U.S., elections are not called, as is common in a parliamentary system, but occur on schedule.  Policymakers are aware of elections and want to manipulate the economy in ways that improve their chances of re-election.  For example, presidents have an incentive to implement painful policies during the first two years of their term with the hopes of an economic rebound in the last two years.  That pattern usually means the mid-terms hurt the party of the president.  At the same time, a president is at the peak of his political capital at inauguration.  That capital erodes with time and thus if one is going to do something “big” the best chance is in the first 18 months of the presidency.  By around May of the second year, the initial political capital is mostly exhausted, meaning little new accomplishments are enacted.  In the third year, the president tries to implement policies that support growth to increase the chances of re-election and Congress often participates for the same reason.

To measure these effects, we created a database using the Friday close of the S&P 500, beginning in 1928.  We indexed each four-year cycle at the beginning of the election year.  Thus, we ended up with 22 cycles, excluding the current one, which began in 2016.  Here is what the patterns indicate:

The blue line on the chart shows the long-term average of all cycles.  The green line shows the pattern for a newly elected Republican president and the red line shows the current administration.  The pattern suggests that equities tend to favor the GOP, at least for the first 18 months of the cycle.  The two average lines converge by Q4 of the first full year.  The second full year tends to be the most disappointing for equities, on average, although a strong rally from the mid-terms into the year prior to the next election usually develops.

President Trump’s first term was closely tracking an average new Republican president until it became clear that the tax law changes were going to pass.  This led equities to rise sharply.  However, in the aftermath of the tax changes, equities have moved sideways, which is consistent with the second full-year pattern but, in this particular case, from a much higher level.  The usual pattern could be indicating one of two outcomes.  First, equities will likely struggle into Q4 and then stage their usual third-year rally.  Or, second, we have already had the “Trump bull market” and the rest of his first term will be “churn,” leaving us about where we would be without the tax-driven lift in markets.

Although either scenario is possible, we tend to expect the first is more likely.  There is little evidence that the economy is near recession, which is the primary cause of cyclical bear markets.  While earnings growth will likely slow next year, the tax law changes should keep the level of earnings elevated.  In fact, the recent weak performance in equities is due to multiple contraction, most likely due to fears surrounding trade conflicts.  If the administration can resolve these issues without serious incident, it would bolster the case for a rally next year.  On the other hand, if trade issues escalate, the second scenario is more likely, which would be no major pullback in equities but a long-term sideways market.

Clearly, other factors will play a role and these cyclical studies are not definitive.  Nevertheless, they do offer some insight into the normal policy cycle, which the current presidency was tracking until November.  For now, we consider a trade war the most near-term serious threat to equities.

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Daily Comment (June 22, 2018)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] We made it to Friday!  Markets are rather quiet this morning as immigration has overshadowed trade concerns.  We are seeing a bit of “risk-on” today after a rather rough week.  Here is what we are watching this morning:

OPEC: We have a deal. The cartel agreed to a 1.0 mbpd increase in quotas but not in production.  Since many of the members lack excess capacity, the real increase is about 0.6 to 0.8 mbpd.  That is a bullish outcome.  We are still waiting to see the Russian reaction but our expectation is that Russia will increase production to take market share from the formal cartel.  But, overall, this is a bullish result relative to fears of a much larger rise in output.  At the same time, we think Saudi Arabia is trying to guide prices modestly lower (low $60s to high $50s) in response to President Trump’s persistent criticism of high oil prices.  The president wants lower oil (and gasoline) prices going into the mid-terms.  Thus, don’t be surprised to see bearish comments from the Saudis in a bid to cool today’s early price spike.

Turkish elections: Most recent polls show Erdogan’s party coming in at 51.6%; if accurate, he would win Sunday’s election outright.  On the other hand, if he fails to achieve 50%, he would face a run-off election.  It should be noted that the most recent polls are illegal; Turkish electoral law indicates that no polls should occur 10 days before the election.  Thus, the veracity of the most recent polls is questionable.  The last legal polls showed Erdogan with 45.8% support.  The second place party is the Kermalist CHP; the policy platform of this party isn’t remarkably different than Erdogan’s except that the CHP leadership is campaigning on the goal of improving global relations.  We expect a close election and wouldn’t be surprised by a run-off.  But, in the end, we expect Erdogan to eke out a narrow victory.

Greek deal: After eight years, the Greek bailout is finally complete.[1]  Greece did not get a debt write-off but it did receive a 10-year extension of the loan terms and a decade deferral on interest and amortization.  Although this buffer will likely give Greece enough financial space to be able to tap the financial markets for loans, its government debt/GDP ratio remains at 180% and terms of the deal require austerity to remain in place.  In our opinion, this is another “can kicking” solution but, given that Greece has essentially more than a decade to build cash reserves, we shouldn’t see Greece affecting financial markets for a while.  Greece will be making mere token payments on its debt unit 2030.

German/French EU reform hits opposition: France and Germany reached an agreement on EU reforms.  The agreement was not all that ambitious but it is facing rather strong opposition from a number of EU nations, including the Netherlands, Finland and Austria, which are questioning the need for any Eurozone fiscal capacity.[2]  The economic theory of currency unions usually requires some sort of fiscal unity to address growth divergences within the union.  The Eurozone lacks this feature; instead, the Germans tried to use strict fiscal spending limits to address this problem.  What has developed instead is wide growth divergences.  The natural split in the Eurozone is between the north and south.  The opposition to France’s plan is mostly coming from the north.  Thus, we have doubts that anything of substance will come from Germany and France’s plan.

European immigration problems: The U.S. isn’t the only part of the world with immigration turmoil.  Chancellor Merkel is facing a breakup of one of the most durable coalitions in European political history, the CSU/CDU union.  Differences on immigration policy are threatening this long-standing arrangement.  The CSU, based solely in Bavaria, wants to block refugees from entering Germany.  Since Bavaria sits on Germany’s southern border, this action is essentially a national policy.  Merkel opposes this policy.  She is trying to work out a compromise but Italy scuttled her plans by rejecting a proposal that would have allowed refugees in Germany to be returned to their nation of entry which, in most cases, is Italy for migrants coming from Africa.[3]  It is possible that the Merkel government could fall over this issue.  German media is reporting that the other party in Merkel’s grand coalition, the SPD, is planning for snap elections.[4]  New elections would likely boost the AfD and lead Germany in a more populist direction, which would likely be bearish for the EUR.

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Daily Comment (June 21, 2018)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy Summer Solstice!  Here is what we are watching this morning:

Trade and the dollar: India joined other nations by applying tariffs against the U.S.[1]  EU officials are worried that U.S. trade policy will upend its longstanding Common Agricultural Policy (CAP), which is a system of subsidies critical to maintaining EU unity.  Earlier this month, the U.S. applied trade restrictions to Spanish olives but the fear is that the action will broaden.  It is interesting to note that French President Macron criticized CAP,[2] but we don’t see this as a commonly held position among European leaders.  Essentially, nearly all nations offer some degree of support for agriculture.  Food security is simply too important politically and countries want control over the food supply.  This leads to preferential treatment for farmers in all sorts of ways.  CAP, a system of farm subsidies, is how the EU maintains a free trade zone, essentially preventing overt trade restrictions within the EU.  However, these restrictions reduce foreign imports of agricultural products.  This is what the U.S. is attacking.  But, if the CAP system devolves, the EU could very easily fall apart, too.  Nations within the EU would almost certainly put up internal barriers to agricultural trade to protect their domestic farmers and ranchers, and once internal barriers for one product are implemented it would not be a surprise to see other industries ask for protection.  It’s important to remember that the EU began as a free trade zone and has morphed into a much larger entity.

We are starting to see the trade actions causing secondary effects.  Daimler (DAI, EUR 58.20) warned today that tariffs could adversely impact its profits.[3]  This is the first time we have seen trade offered as a reason for lower earnings.  This news led European automaker shares lower.  And, in what has to be a most bizarre situation, the Commerce Department is reportedly “probing steel profiteering after tariffs.”[4]  Often, the left is criticized for implementing regulations and then being surprised that prices rise.  A GOP administration being “shocked” that steel prices rose and companies are making more money after the government takes steps to restrict foreign supply is really surprising.  Meanwhile, U.S. agriculture is being roiled by retaliatory tariffs.[5]

The bottom line is that global trade impediments are a reversal of nearly 90 years of steadily falling tariff barriers.  This trend only occurred because of U.S. leadership; the U.S. essentially traded access to the U.S. consumer in return for cooperation on global security.  For example, Japan and Germany gained access to the U.S. market and we got to place military bases on their territories.  That system worked great during the Cold War but in its aftermath we haven’t created a rationale for continuing it.  Although Trump is catching the blame for disruption, the reality is that domestic political support for free trade has been under pressure for a long time.  Trade impediments act like a restriction on the dollar supply and thus, all else held equal, the wider the “trade war” goes the greater the bullish impact for the dollar.

BOE: The Bank of England left policy unchanged as expected, but the vote was 6-3, indicating rising opposition to current policy.  The dissenters wanted to raise rates.  The idea that rates could rise in the near future boosted the GBP.

OPEC: Oil prices reversed yesterday’s gains on bullish inventory data (see below) due to fears that OPEC would boost output significantly.  There are reports that Iran is softening its opposition to raising production.  Russia has been pressing for an increase of 1.5 mbpd.  We believe Saudi Arabia is supportive of that level of increase (since it will provide most of it), but the kingdom wants to keep peace within the cartel, which means a compromise.  We have been in the compromise camp, expecting a token increase of 0.4 to 0.6 mbpd.  The latest suggests that Saudi Arabia is more in the 1.0 mbpd camp.[6]  This level of increase may not add all that much to world supply as disruptions in Libya and Venezuela will offset some of this proposed increase.  However, it is a bearish surprise for the market.  In addition, U.S. output, which has been rising at a surprising clip, is about to stall because of the lack of pipeline capacity in the Permian Basin.  Reports indicate “DUCs” are rising rapidly, which will reduce current supplies but represents future production.[7]  As we note below, a strengthening dollar is a bearish factor for oil; rising supply probably caps current prices.  On the other hand, there doesn’t appear to be enough oil on global markets to cause a major bear market to develop.

Energy recap: U.S. crude oil inventories fell 5.9 mb compared to market expectations of a 1.0 mb draw.

This chart shows current crude oil inventories, both over the long term and the last decade.  We have added the estimated level of lease stocks to maintain the consistency of the data.  As the chart shows, inventories remain historically high but have declined significantly since March 2017.  We would consider the overhang closed if stocks fall under 400 mb.

As the seasonal chart below shows, inventories are well into the seasonal withdrawal period.  This week’s rather large decline is consistent with that pattern.  If anything, the draw was stronger than normal.  If the usual seasonal pattern plays out, mid-September inventories will be 418 mb.

(Source: DOE, CIM)

Based on inventories alone, oil prices are near the fair value price of $65.51.  Meanwhile, the EUR/WTI model generates a fair value of $60.96.  Together (which is a more sound methodology), fair value is $62.05, meaning that current prices are above fair value.  Currently, the oil market is dealing with divergent fundamental factors.  Falling oil inventories are fundamentally bullish but the stronger dollar is a bearish factor.  And, as we noted above, if OPEC increases output the rising trend in oil prices will probably stall.

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[5] and and



Daily Comment (June 20, 2018)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s Wednesday!  Financial markets are moving steadily higher this morning, mostly on the lack of new trade pronouncements.  Here is what we are watching today:

Trade: The EU unveiled €2.8 bn of tariffs on U.S. goods[1] in retaliation to American tariffs.  About a third of the tariffs (which will be a 25% levy) are applied to agricultural goods (e.g., peanut butter, bourbon), with the rest on a variety of consumer goods.  The size of this action isn’t all that large, but it does show that the EU is willing to meet each U.S. action with a response.  The general consensus in the financial media appears to be that China will eventually “blink.”  The president is said to believe this as well.[2]  On its face, this position makes sense.  As a general rule, the trade deficit nation faces an inflation problem from trade impediments, while the trade surplus nation suffers unemployment.[3]  The general belief is that China cannot tolerate rising unemployment and will cave as a result.  However, this position has two potential flaws.  First, Chairman Xi, unlike his predecessors, has amassed significant power.  Like his predecessors, he is at risk to a weakening economy, but Xi has the power now to keep the middle class satisfied by taxing the wealthy.  Second, one of the narratives around China’s rise is retribution against the West for the humiliation that began with the Opium Wars.  Backing down to Trump may be more costly to Xi than the economic damage that a trade war would cause, at least in the short run.

Wars often begin because of an underestimation of the costs and overestimation of the benefits by the parties involved.  Trade wars are no different.  Foreign nations will target politically sensitive areas in the U.S.  The EU choosing to tax bourbon isn’t an accident; it’s a key product of the home state of the Senate majority leader.  China is considering targeting energy, which would affect states that have been solidly “red.”[4]  It is true the U.S. will probably be less adversely affected than the current account surplus nations, but that doesn’t mean the negative effects on the U.S. are not significant.

Brexit: A key bargaining position for PM May is that she could walk away from an adverse deal from the EU and simply withdraw without a treaty arrangement.  That outcome could harm the EU and thus gives the U.K. some leverage.  However, the House of Lords and the House of Commons are taking steps to take that position away from May, leaving her with the unenviable choice of perhaps being forced to take whatever the EU wants to give her.  Essentially, the bill before Commons would give the legislature a “meaningful vote” on the final position of Brexit.[5]  How this outcome would affect the markets is binary.  On the one hand, passing this law would likely lead to a “soft” Brexit that would almost look like the U.K. is still part of the EU.  That outcome would be bullish for British financial assets.  On the other hand, a loss on this bill could generate a no-confidence vote and an election that could bring Labour’s Corbyn to power, which would be a majorly bearish event for British financial assets, including the exchange rate.  Consequently, increasing volatility is likely.

Merkel and Macron make a deal: The leaders of France and Germany have agreed to an outline[6] for greater European integration.  Merkel agreed to a formula that could create an EU budget, allowing some degree of fiscal integration.  This may include an EU finance minister.  It doesn’t appear the budget would be very large, but Macron probably hopes that the creation of an EU budget will be the “camel’s nose under the tent” for fiscal integration.  Merkel also agreed to plans for an EU rapid reaction military force; her change of heart may be tied to uncertainty surrounding America’s defense support.

Chinese market support: The PBOC unexpectedly injected funds into China’s money markets[7] and is considering lowering reserve ratios[8] in a bid to support the economy through the trade row with the U.S.  These steps show that China does have some resources to deal with an economic slowdown due to the trade situation.

OPEC:The cartel meets Friday amid growing acrimony.  The Iranian oil minister[9] is adamant in opposing any quota increases as new sanctions will probably limit its ability to increase exports and thus the resulting lower prices would merely reduce revenue.  The Saudis find themselves in a delicate position.  They do have excess capacity and could raise output.  The kingdom is getting pressure from the U.S. to boost production and it appears highly probable that Russia will increase output, ending its cooperation with OPEC.  We still expect a token increase in output quotas but Saudi Arabia appears to have little support for anything significant.  If the meeting breaks without a clear settlement of these issues, the markets will likely assume that output will rise.  This would be bearish for oil prices.

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[3] This is partly why the U.S. economy was so hard hit by the Great Depression.  We were the China of that era.



[6]  and




Daily Comment (June 19, 2018)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s looking like a “tough Tuesday.”  Risk-off is clearly evident—Treasuries, the yen and the dollar are higher, while gold is flat and equities, especially emerging markets, are under pressure.  Oil and commodities are lower as well.  Here’s the story:

Trade: President Trump has threatened[1] an additional $200 bn in tariffs on Chinese imports; China has vowed to retaliate in kind.  At the same time, the Senate voted overwhelmingly to reinstate the penalties on the Chinese tech company ZTE (SHE: 000063, CNY 20.54).

What makes analyzing this brewing trade war so difficult is that we really haven’t had anything like this since the 1930s.  Under U.S. leadership, tariffs have been steadily declining since the end of WWII.  Even though there has been the occasional trade spat, such as the “voluntary” auto export restrictions in the late 1980s, a broad-based trade war is something that probably no living analysts remember.  The Smoot-Hawley Tariffs were passed in 1930.  A 30-year-old analyst at that time would be about 118 years old.  Accordingly, there probably isn’t anyone out there with actual adult experience of rapidly rising tariffs.

So, if this continues to escalate, what happens?  In our opinion, the most likely development is higher inflation.  The steady decline in inflation that began in the early 1980s was mostly due to supply-side reforms.  Globalization and deregulation led the way to improving efficiencies and reducing labor costs.  Although the latter remains in place, a trade war will obviously undermine globalization.  That development would lead to less efficiency and higher prices.  However, other than the trend, significant uncertainties still remain.  First, if markets remain deregulated, meaning the new introduction of technology will continue unabated, then rising labor costs will be partially blunted by increasing automation.  Second, the Federal Reserve can keep inflation expectations anchored by proving its independence and raising rates high enough to maintain low inflation expectations, even at the risk of recession.  If these two factors remain in place, inflation probably remains relatively tame.

Market behavior suggests investors believe these two factors will remain in place.  If investors believed otherwise, we would be seeing a rise in long-duration yields.  In fact, the opposite is occurring; bond yields are falling, suggesting the financial markets believe the risk of recession is higher than the risk of reflation.  Interestingly enough, there is nothing in the data to suggest a recession is on the horizon.  For example, the Atlanta FRB’s running estimate of Q2 GDP is now +4.8%.

Here is the evolution of the data by estimated contribution to growth.

Virtually all sectors are additive to growth, including net exports, which is surprising given how U.S. growth is outpacing most of our trading partners.  As one would expect, consumption is robust, accounting for more than half of the growth estimate.  There is nothing in this data to suggest an imminent slowing.

The dollar’s strength is a drag on equities, especially large caps and foreign equities.  The dollar’s rally is based on two trends.  First, the divergence on monetary policy is dollar supportive.  Historically, the record on interest rate differentials is decidedly mixed but, for now, the tightening Fed is bullish for the greenback.  Second, assuming the dollar remains the preferred reserve currency, restrictions on imports, the primary way the world acquires dollars, act as a reduction on the global dollar supply.  As a result, tariffs are dollar bullish until nations decide to use another currency for reserves.  At present, there is no real alternative to the dollar so we should assume the threat of tariffs will be dollar bullish.  A tariff-driven dollar bull market would be unprecedented in post-WWII history.

The other key issue to watch is the Fed’s independence.  If the economy begins to weaken, the White House will likely put pressure on Chair Powell to lower rates quickly.  We note the two-year deferred Eurodollar futures implied yield is holding around 3.00%, suggesting the market does not expect more than four more rate hikes.  If there were serious inflation fears, we would expect that implied rate to move higher.  That hasn’t happened, which is further evidence that the financial markets don’t expect this recent growth spurt to last.  The consensus also expects the FOMC to keep inflation expectations anchored.

The other factor that makes this situation so fluid and difficult is that the White House doesn’t appear to have a clearly detailed plan in place.  In other words, it’s hard to know what would constitute a victory.  There have been a parade of comments in the financial media suggesting these announcements are mere posturing and that a trade war isn’t likely.  Perhaps that is the case.  However, Treasury Secretary Mnuchin seems to have disappeared and the president seems to have taken over trade policy.  If victory requires foreign nations to admit they were wrong and simply accept tariffs, then that probably isn’t going to happen.  Although the EU, Canada or Mexico might eventually offer the president a symbolic win, we can’t see China doing that.

There remain numerous positive factors.  As noted above, economic growth remains strong.  Earnings are great.  Consumer and business sentiment remain elevated.  Household cash is rising, which could fuel equity buying.  Simply put, there are clear positive factors that could fuel an equity rally.  But, the high uncertainty surrounding a trade war is offsetting these bullish factors.  If these bullish factors begin to fade, increasing financial stress is likely.

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Weekly Geopolitical Report – China’s Foreign Reserves: Part III (June 18, 2018)

by Bill O’Grady

This week, we will conclude our study on China’s foreign reserves.  In Part I, we discussed the evolution of foreign reserves from gold to the dollar, with a historical focus.  In Part II, we used the macroeconomic saving identity to analyze the economic relationship between China and the U.S.  This week, using this analysis, we will discuss the likelihood that China will “dump” its Treasuries and the potential repercussions if it were to do so.  From there, we will examine the impact of such a decision by China to reallocate its reserves.  Finally, we will conclude with market ramifications.

What if China decides to dump its reserves?
So, finally, we come to the issue at hand.  Are China’s foreign reserves a real threat to the U.S. economy?  Are the reserves a viable financial weapon?  China occasionally suggests they are.[1]  However, a weapon is only credible if the blowback isn’t significant.  It appears that the costs to China of dumping its U.S. Treasury bond positions would be considerable.

What would happen to the value of China’s reserves?  A common problem with holding concentrated positions is retaining value while exiting the position.  If China began aggressively selling its position, the value of its reserves would decline as well.  If yields rose by 100 bps, to 4%, we estimate the yearly return would drop by approximately 7.9%.[2]  China’s total foreign reserves are around $3.2 trillion; as mentioned in Part II, it’s a state secret as to the allocation but if we assume Treasuries represent 70% then a 7.9% decline would cause a capital loss of $152 bn.  Obviously, a 10-year T-note rate of 4% would likely trigger a U.S. recession but the costs to China would be significant as well.  It is also important to note that this calculation doesn’t take into account the impact on the dollar’s exchange rate.  But, mostly certainly, the dollar would depreciate, causing even greater losses to China’s dollar foreign reserve holdings.

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[2] This is calculated with a regression of total return on the 10-year T-note against the (a) yearly change in 10-year yields, and (b) the level of interest rates on the 10-year T-note.

Daily Comment (June 18, 2018)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy Monday!  It’s a risk-off day so far this morning.  Here is what we are following:

Tariffs and trade: While there wasn’t any major news on this issue over the weekend, financial markets are discounting the potential outcome of a trade war.  Although there are legitimate concerns about the long-run impact of a breakdown of the global trade system, the short-run benefits to the administration are clear—talk of tariffs is boosting the president’s popularity.

The chart on the right overlays the president’s average approval ratings with the Google Trends tracking of the work “tariff.”  The low point in approval occurred as the tax law was being enacted last December.  Soon after, the president’s policy emphasis shifted from taxes to trade and his approval ratings rose.  Although the tax cuts are clearly popular with the right-wing establishment, the right-wing populists were not all that impressed.  However, the prospect of tariffs has clearly boosted sentiment.  The chart on the left shows a scatterplot of the series on the right.  The conclusion to be drawn by the White House is that trade impediments are resonating.

Equity markets, however, are not impressed with trade impediment rhetoric.

This chart shows the data from Google Trends on the word “tariffs” and the S&P 500 weekly close.  Since trade impediment talk has heightened, equities have declined from their highs and moved sideways.  It’s interesting to note that equities recovered when the rhetoric eased a bit recently.  As talk of trade impediments has escalated, equities have started to stall again.

A common remark we hear is that, “The president won’t want a weak equity market going into midterms.”  This data would suggest that the president probably isn’t all that concerned as recent equity market weakness hasn’t dented his approval ratings.

OPEC: Last week there were great fears that OPEC was planning to boost production by 1.0 to 1.5 mbpd.  Current comments suggest a much less increase of only 0.3 to 0.6 mbpd.  Russia is pushing for a bigger increase and we suspect Russia will simply cheat if it doesn’t get it.  The nations within OPEC that lack excess capacity, mostly Venezuela, Iraq and Iran but others within the cartel as well, are reluctant to boost output.  Saudi Arabia is in a tough spot.  President Trump has deployed social media to criticize OPEC for keeping prices too high and the Saudis are sensitive to those comments.  However, the kingdom also has an IPO to price at some point and wants higher oil prices to boost the value of the sale.  Thus, it looks like we are getting a compromise which, given recent price weakness, is bullish.

On the topic of oil, we have seen the Brent/WTI spread widen out, in part due to the lack of American capacity to move oil into the export market.  We are hearing reports that China is considering targeting oil and other energy products (perhaps even coal) for the second round of tariffs.  In theory, which assumes a frictionless world, the loss of exports to China would be offset by exports to other places.  And, over time, that would happen.  But, in the short run, where “friction” exists, the China threat is bearish for WTI.

Merkel wins: Last week, we noted the refugee spat between Chancellor Merkel and CSU leader and interior minister Horst Seehofer.  Seehofer had threatened to block refugees coming into Germany who mostly enter through Bavaria, where the CSU dominates.  This morning, it appears a compromise has been achieved where any new policies would be introduced gradually.  Merkel is trying to build an EU-wide policy on refugees; we think she is probably going to fail on this effort as rising populism will thwart her efforts.  But, for now, Merkel has fended off this threat.

Egypt implements fuel price increases:In a bid to introduce austerity measures as part of an IMF agreement, Egypt has increased fuel costs, boosting transportation costs by at least 20%.[1]  Historically, when governments take steps to introduce austerity and raise subsidized prices, civil unrest often follows.

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Asset Allocation Weekly (June 15, 2018)

by Asset Allocation Committee

The last topic in our series on secular trends is the dollar.  It is arguable as to whether or not exchange rates are actually an asset class.  In our asset allocation, we don’t treat it as one.  On the other hand, the behavior of the dollar affects most of the other asset classes.  There is a clear inverse correlation between the dollar and commodities.  Since most commodities are priced in dollars, a weaker dollar is a price cut for non-dollar buyers.  The increase in demand will usually lead to higher prices for commodities when the dollar dips.  Foreign equities to U.S. investors are directly affected by the dollar’s exchange value.  In general, foreign equities tend to outperform during periods of dollar weakness because, for a dollar-domiciled investor, appreciating foreign currencies act as a tailwind for foreign assets.  Of course, if foreign currencies become too strong, it adversely affects the foreign economy and can become too much of a good thing.  Even domestic equities are affected.  A weaker dollar tends to support large cap stocks relative to small caps because the latter are less globalized.  And, an excessively weak dollar can foster tighter monetary policy as a very strong dollar can prompt the Federal Reserve to ease credit.

The dollar is the nexus of most foreign exchange transactions.  Although there is a market for cross rates in the major currencies, most transactions are into and out of dollars.  That way dealers don’t have to make markets in thousands of currency permutations.  Because of the widespread use of the U.S. dollar, it is the global reserve currency; when nations accumulate foreign reserves, the currency of choice is mostly the greenback.  About 63% of official foreign reserves are in dollars, with the next closest competitor, the euro, at 20%.[1]  The dollar represents 88% of all forex turnover.[2]  Thus, the dollar’s exchange rate against various currencies deviates from classic textbook valuation measures because there is a natural demand for transaction and reserve purposes.

However, even with that caveat, some opinion on the direction of the dollar is critical because, as noted above, it affects numerous markets.  In our observation, the dollar’s path tends to be driven by “flavor of the month” factors.  During various periods, markets focus on the trade deficit, relative productivity, interest rate differentials and monetary policy divergences, to name a few.  In other words, there hasn’t be a consistent variable that has affected the dollar’s exchange rate in all markets.  Here are the variables we use when examining the greenback.

First, history shows a cycle to the dollar.

To measure the general value of the dollar, we use the JP Morgan real effective dollar index, which adjusts the dollar for relative inflation and trade.  We note that the dollar tends to peak about every 15 to 17 years.  There is always a danger in such observations…it’s a bit of the correlation/causality problem.  Just because something has followed a pattern for a long time doesn’t mean it will do so in the future.  This cycle does “rhyme” with relative growth; the dollar tends to strengthen when U.S. economic growth exceeds the rest of the world.  However, the important market takeaway from this chart for long-term investors is that exchange rates probably don’t matter if one holds a position for around 15 years.  And, dollar bear markets tend to last longer than dollar bull markets.

Second, for long-term valuation purposes, we use purchasing power parity.  This theory of currency valuation argues that exchange rates should adjust to equalize prices across countries.  A nation with higher price levels should have a weaker currency, which would equalize the prices of a lower inflation country.

This chart shows the calculation of parity for four currencies, the euro, yen, Canadian dollar and British pound.  Deviations from the model’s fair value forecast are wide but, at extremes, the model does suggest reversals are more likely.  Currently, the dollar is richly valued compared to these four currencies.

What about other models?  Relative growth between Europe and the U.S. yields a similar fair value.  Interest rate differentials clearly favor the greenback but the relationship isn’t all that strong either.

This chart shows the spread between U.S. and German two-year sovereigns and the EUR/USD exchange rate.  Although the rate spread is historically wide, in the last tightening cycle in 2004-06 the dollar faded shortly after the tightening cycle ended.

Perhaps the most important issue facing the dollar is the future of American hegemony.  If the world loses faith in the dollar’s reserve value, we would expect a profound bear market to develop.  At this point, there is no obvious rival to the dollar.  However, one of the reasons no rival exists is that no other nation with a reasonably attractive currency is willing to run persistent trade deficits.  The Trump administration is trying to adjust or reverse America’s importer of last resort role which is part of being the reserve currency provider.  If the U.S. puts up trade barriers, we would expect the dollar to appreciate as long as reserve demand remains.  But, if the world decides the U.S. is no longer a reliable provider of the reserve currency, even if no obvious replacement exists, the dollar will almost certainly decline.  Reserve currency changes don’t occur very often; we have only had two reserve currencies over the past two centuries, the British pound from 1815 to 1920 and the U.S. dollar from 1920 to the present.  With events that occur so rarely, it is difficult to determine the path of the greenback but it does appear we are moving into an era of significant change.  This is a factor we will be closely monitoring in the coming months and years.

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Daily Comment (June 15, 2018)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s Friday, the close of a very busy week.  Today will be active, too.  Here’s what we are following:

Tariffs: As expected, the Trump administration leveled tariffs on $50 bn of Chinese imports this morning.  The action will be broken into two tranches; the first set, applied to 818 product lines and $34 bn in value, will come into force on July 6.  The remainder, on 284 product lines and $16 bn in value, will be applied later after further review.  These tariffs will affect mostly aerospace, robotics, manufacturing and auto parts.  China has already indicated it will retaliate[1] in kind, with the focus being on agricultural products.

In other trade news, Mexico is considering another $4 bn in tariffs[2] that would be applied to corn and soybeans.  We note that soybeans peaked near $10.62 per bushel in late May; this morning, prices are trading at $9.28 per bushel, down just over 12.5%.  Corn is acting in a similar fashion, down 13.7% from the recent high.  Although trade fears are playing a major role in the weakness, we note that growing conditions are nearly perfect.  Soils were moist, but favorable breaks in the rain allowed the crop to be planted on time.  Now we are seeing warm and wet conditions, which will offer the promise of another bumper crop.

In addition to Chinese tariffs and Mexican retaliation, the president wants to put tariffs on foreign cars before the midterms.[3]  The Reagan administration implemented “voluntary” import restraints on steel and cars in the 1980s[4] but conditions were much different then.  Country of origin could be more easily determined at that time.  Now, auto manufacturing is truly global, with parts and production dispersed around the world.  Optically, a foreign auto tariff could be popular before an election but actually executing it could prove harder than it looks.

In watching how markets are taking this news, it is clear that equities are not pleased.  Tariffs should be considered inflationary (it’s a consumption tax on imports, after all) but bond yields are continuing to decline, suggesting that long-duration buyers are confident the Fed will raise rates enough to counter the potential inflationary impact of tariffs.  We are less confident; our position is that Trump is Nixonian in his stance on monetary policy and, once policy tightens enough to “bite,” Chair Powell will find himself the target of tweet eruptions.  But, so far, nothing like that has happened so the bond market is focusing on the economic depressant effect of tariffs.

Merkel under siege[5]: Chancellor Merkel actually leads two parties, the Christian Social Union (CSU) and the Christian Democratic Union (CDU).  The CSU, though conservative, is a regional party.  It operates only in Bavaria and currently holds 46 seats (out of 709) in the Bundestag.  The CDU, on the other hand, has 200 seats and operates in the other 15 German states.  The CSU is generally more conservative on social matters and less market oriented compared to the CDU.  The CSU has been quite uncomfortable with Merkel’s open border policy on refugees.  Recently, Horst Seehofer, the leader of the CSU and current interior minister, offered a plan to tighten Germany’s asylum program.  Part of this plan would give German police the power to prevent asylum seekers from crossing into Germany if they have registered as refugees in another EU state.  This policy runs in direct contradiction to Merkel’s border and refugee policy.  It’s likely that Seehofer is worried that the AfD, a right-wing populist party, could gain a majority in Bavarian elections expected later this year.  The AfD holds an anti-immigrant policy stance that, as in other countries, has become favored among right-wing populists.

There have been rumors that this internal spat could lead to a collapse of the Merkel government.  We doubt that’s the case but it is clearly undermining support for Merkel, and her government is rather fragile anyway.  What it is clearly doing is focusing Germany inward during a period when leadership would be welcomed.  For example, Italy is threatening to scuttle the recently negotiated Canada/EU free trade deal.[6]  A distracted Germany makes such events more likely.

A new Colombian president: Ivan Duque appears likely to become the next president of Colombia in Sunday’s elections.  He is 42 years old and, if elected, would become the youngest president in the nation’s history.  A conservative, he is supported by former President Alvaro Uribe.

Bitcoin is not a security:The SEC ruled yesterday that Bitcoin and Ethereum are not securities.  It isn’t clear who will become the regulator (our bet is that the CFTC will get the role), but Initial Coin Offerings are securities.  Bitcoin jumped on the news.

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[4] Robert Lighthizer, the current USTR, was a deputy USTR when these voluntary restraints were negotiated.



Daily Comment (June 14, 2018)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s ECB decision day!  The World Cup also begins today in Russia.  It’s also Flag Day and President Trump’s birthday.  The financial markets are trying to figure out if the Fed was hawkish or not.  Here is what we are watching today:

ECB: The European Central Bank left rates unchanged, as expected, although did hint that rates may begin to rise by the end of summer 2019.  However, the big news is that the bank intends to taper its QE by €15 bn starting in October (from €30 bn) and end QE at the end of December.  Thus, QE in the Eurozone is coming to an end…with caveats.  The word “intends” was not used for flourish but reflects the ECB’s position that it expects to taper but does want the flexibility to maintain asset purchases.  The markets took the statement as dovish.  The EUR initially rallied but fell sharply on the “intends” signal; in fact, the EUR is facing its biggest single-day drop since October 2017.  European equities moved from red to green on the dovish take.

During the press conference, President Draghi emphasized that the central bank has “optionality” in its decision making, suggesting the path of policy tightening isn’t necessarily inevitable.  At the same time, he did note that the vote on today’s policy announcement was unanimous, which would suggest support for tightening is reasonably solid.  Overall, the market take on the ECB is very dovish.

The Fed: The FOMC, as expected, moved to lift rates 25 bps, with a range of 1.75% to 2.00%.  Effective fed funds usually trade around the mid-point.  The median dot plot is signaling two more hikes this year, although the average is signaling a year-end rate of 2.25%.  The average plot shows rates hitting 3.00% next year and peaking around 3.5% in 2020.  The dispersion did narrow, suggesting a consensus is developing among the members.

The statement itself was a bit odd.  The “accommodation” language remained but Chair Powell indicated in the presser that the FOMC is approaching a neutral rate.  In addition, the phrase “warrant further gradual increases in the fed funds rate” was removed.  Equity markets slumped on the news (although the banks initially rallied), but the dollar failed to hold early gains and precious metals recovered.  In the press conference, Powell downplayed the potential for higher inflation, which probably led to the dollar’s decline.  The other important item was that the chair will hold a press conference after every meeting, beginning next year.  This isn’t a big surprise but, as we noted yesterday, we see it as an unfortunate development.

Financial markets continue to look for a rate two years from now around 3.10% for fed funds.

This chart shows the fed funds target with the implied three-month LIBOR rate, two years deferred from the Eurodollar futures market.  In general, the FOMC has tended to raise rates until the target moves above the implied LIBOR rates; such events are shown on the chart with vertical lines.  The Eurodollar futures are suggesting another 125 bps of tightening over the next eight quarters.

The other factor we note in the aftermath of the meeting is that the yield curve is continuing to flatten.  The chart below shows the 10-year T-note less the two-year T-note spread.

(Source: Bloomberg)

The curve is the flattest it’s been since 2007, just before the recession began.  The fact that the 10-year yield is rising slower than the two-year does suggest long-duration investors remain confident that inflation will remain under control.  The flattening of the curve is a concern as inversion is a very reliable signal of recession.  At present, the vast majority of indicators are signaling little risk of recession but the continued narrowing of the yield curve could lead the FOMC to pause sooner than their comments yesterday would suggest.

Brexit: Pressure on PM May remains high as she tries to weave a path between the “leavers” and “remainers” among the Tories.  However, Labour leader Corbyn faced a rebellion in his party yesterday.  The action was tied to the vote on an amendment that would have forced the government to negotiate staying within the European Economic Area (EEA, or the “Norway option).  Corbyn ordered Labour MPs to abstain from the vote.  Corbyn doesn’t like the EEA because it would have required the U.K. to abide by EU rules and immigration.  One shadow minister[1] and five secretaries resigned after Corbyn’s order.  The amendment failed but Corbyn’s leadership took a serious hit, which is probably good news for the GBP.

China tariffs: The administration is preparing for $50 bn of new tariffs on China,[2] although the president hasn’t decided if he wants to delay the action.  So far, the markets are taking the move in stride.  Since trade policy does tend to vacillate from initial harsh announcements to a middle ground, the financial markets appear to be reacting less, waiting for the final decision.

Energy recap: U.S. crude oil inventories fell 4.1 mb compared to market expectations of a 1.5 mb draw.

This chart shows current crude oil inventories, both over the long term and the last decade.  We have added the estimated level of lease stocks to maintain the consistency of the data.  As the chart shows, inventories remain historically high but have declined significantly since March 2017.  We would consider the overhang closed if stocks fall under 400 mb.

As the seasonal chart below shows, inventories are usually starting their seasonal decline this time of year.  This week’s decline is consistent with that pattern.  If the usual seasonal pattern plays out, mid-September inventories will be 424 mb.


(Source: DOE, CIM)

Based on inventories alone, oil prices are overvalued with the fair value price of $63.60.  Meanwhile, the EUR/WTI model generates a fair value of $62.17.  Together (which is a more sound methodology), fair value is $62.23, meaning that current prices are above fair value even with the recent pullback.  Although prices remain richly valued, the degree of overvaluation improved from last week as the dollar eased modestly and inventories fell.  Falling crude oil imports and strong refining activity offset the continued relentless increase in U.S. output.

Meanwhile, Saudi CP Salman and Russian President Putin are meeting during the Saudi/Russian opening match at the World Cup.  Russia wants to resume full production.  Much of OPEC opposes any Saudi changes[3] because they lack the spare capacity to boost output.  OPEC meets on June 22-23.

Yemen: Saudi Arabia and the GCC coalition are launching an offensive[4] on the port city of Hodeida.[5]  Controlled by Houthi rebels, the port is the main entry point for food and humanitarian aid in Houthi-controlled areas.  If Saudi forces are successful in capturing this city, it will cut off the Houthis from resources.  At the same time, it would also trigger a humanitarian crisis.  Although we don’t expect this offensive to affect oil supplies, it could trigger retaliatory missile attacks on Saudi infrastructure.  If successful, oil prices would likely rise.

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[1] A shadow minister would take this role if the minority party were in power; thus, there is a shadow exchequer, for example.