Asset Allocation Weekly (February 16, 2018)

by Asset Allocation Committee

Do fiscal deficits matter?  This is one of the more polarizing topics in economics.  The recent tax bill and budget agreement will increase the deficit, which has led to all sorts of worries and claims.  Here are a few observations:

  1. Politically, deficits matter to the party out of power. Protesting against deficits are one of the few ways a party out of power can restrain the party in power.  Thus, the party in power tends to ignore deficits because it doesn’t want to be restrained.  In addition, there is always a fear that borrowing capacity could become constrained, so by the time the party out of power regains a majority, it will be stuck with implementing austerity.  Each party believes there are some types of public expenditures that are good for their own sake and should be paid for even if the deficit increases.  Although a generalization, Republicans tend to support defense spending and tax cuts; Democrats tend to support health care and social spending.  Thus, what angers each side about the other side’s priorities is that they view their own priorities as sacred and the others’ as buying votes.
  2. The economic impact is complicated and dependent upon market and economic conditions. One of the most common mistakes people make in terms of the deficit is the error of composition.  This is a classic logic error where one postulates that what is true on a small scale is also true on a large scale.  Thus, it’s common for politicians[1] to note that a household can’t borrow money to unsustainable levels and neither can the government.  However, there is a big difference between a government and a household.  First, the former can use force to collect revenue to service debt (if you don’t pay your taxes, the government can use coercion), and second, the government prints the currency used to pay the debt.  If households could use force to service their debt and print money, they would be like the government and thus could borrow much more.
  3. The major issue with deficits is spending priorities. The government of a developing nation should run deficits to build out infrastructure because the return on the investment will likely exceed the cost.  In wartime, borrowing money to fund the war effort makes sense because the state will cease to exist if the nation loses the war.  Education is arguably a good public investment, as is domestic security.  One would expect strong debates about how much of these public[2] or quasi-public goods should be provided.  The reality is that it’s difficult to estimate the value of public investment and spending, and arguments over these issues will be perpetual.

Do deficits matter?  Yes, but not in the simple form that pundits suggest.  When the government spends more money than it takes in from taxes, that saving has to be acquired from the other major sectors of the economy, the private sector (households and businesses) or the foreign sector (through the trade account).

Private saving balance = (business revenue less business investment) + (household saving less consumption)

Public saving balance = (taxes less government spending and transfers)

Foreign saving balance = inverse of the current account

The above chart shows the three sectors of the saving balance; it’s a macroeconomic identity, meaning that it will always equal zero.  Thus, when the government deficit expands, it must be funded by saving created by either the foreign sector or the private sector.  When the government runs a surplus, it depletes private sector saving or reduces foreign inflows.

The impact on the economy depends on the return from government spending relative to the return from the private sector or the foreign sector.  If public spending has a higher rate of return than investment in the private sector, then fiscal deficits are reasonable.  However, this calculation is extraordinarily difficult.  Think of the rate of return on the Strategic Petroleum Reserve; if the world experiences a major war in the Middle East and oil rises to $150 per barrel, the investment when oil was cheaper would almost certainly be positive.  The same would be true for peacetime defense spending when war breaks out.  However, outside of dire situations and under shorter time frames, private sector investment probably has a higher rate of return.

Our concern is the market impact.  The classic fear is that deficits trigger inflation and higher interest rates.  The theory is that if the government runs a deficit, the private sector will offset it, which will require a drop in consumption and crowd out private investment.  The drop in consumption is usually facilitated by higher prices and the contraction of investment would usually constrain output and lift inflation as well.  The data actually shows that higher deficits did seem to boost interest rates from the late 1950s into the early 1980s; however, the relationship became uncorrelated thereafter.

Since 1983, long-duration Treasury rates have steadily declined despite the trend in the deficit.  In comparison to the first graph, what changed in 1983 was the expanding current account deficit, which brought in another source of saving to fund the fiscal deficit.

One area that will likely be affected is the dollar.  The dollar was mostly uncorrelated with the fiscal balance until the peak of the “Volcker dollar” in 1985.  However, since then, with a two-year lag, the fiscal account correlates directly with the dollar at a level of 70%.  A fiscal surplus tends to be dollar bullish, while a widening deficit is dollar bearish.

We believe this occurs because of the dollar’s reserve status.  There is a constant demand for dollars on world markets to facilitate trade.  A wider fiscal deficit makes more dollars available for world markets; rising supply tends to weaken the dollar’s price, the exchange rate.  On the other hand, a fiscal surplus (or narrower deficit) means the supply of dollars is less, boosting the exchange rate.

Although it is possible that a weaker dollar could lift prices, the evidence is scant; foreign countries use exports for growth and to lower unemployment in their nations. As a result, they tend to accept margin compression rather than give up market share through higher prices.  Accordingly, we think the preponderance of the evidence suggests the expanding fiscal deficit will be dollar bearish and supportive for foreign assets. 

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[1] Usually the party out of power, but not always.  There are a few political figures that are consistently opposed to deficits and government debt regardless of whether or not their party is in control of Congress.

[2] In public finance, a public good is a good that cannot be easily excluded and is non-rivalrous, meaning that it is either provided to all or none.  Fire protection cannot be easily segregated, for example.   In theory, one could argue that the fire department should only put out fires from households that pay their “fire bill.”  In reality, it is probably impossible to allow one house to burn down and not adversely affect neighboring homes who did pay their fees.  Police services, libraries, etc. are examples of pure public goods.  If the government or a non-profit entity doesn’t provide the good, no private sector firm will provide it because it cannot ensure it will get paid (getting back to the government’s ability to use coercion to collect taxes).  Quasi-public goods are goods that can be provided by the private sector but is sometimes provided in less quantities than considered optimal.  If households don’t earn enough to provide for the wellbeing of a family, a quasi-public good would be public assistance.  The private sector does provide food and shelter but it may not produce enough to be a feasible option for a low income household.

Daily Comment (February 16, 2018)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST]

Looking for something to read?  In our travels we are often asked about books we recommend.  As a result, we have created The Reading List.  The list is a group of books, separated by category, that we believe are interesting and insightful.  Each book on the list has an associated review to help you decide if you want to read it.  We will be adding to the list over time.  Books marked with a “*” are ones we consider classics and come highly recommended.

It looks like we are having a pause day after a strong week for equities and foreign exchange and steadily rising interest rates.  Equity futures have turned to unchanged, while the dollar and Treasuries are higher.  However, market moves are fairly benign.  The Chinese New Year is today; as we mentioned yesterday, Chinese markets will be closed into next week and several other Asian markets were closed as well.  Here is what we are watching today:

Tariff hikes in India: PM Modi has been promoting a “Make in India” policy that has been something of a disappointment.  In response, earlier this week, his government announced duty increases on a wide range of products.  India’s development has deviated from the rest of Asia.  From Japan in the 1960s to China in the 1980s, the path to development was based on building a manufacturing base through mercantilism.  Policies were designed to stifle domestic consumption through non-existent safety nets, consumption taxes and an undervalued exchange rate.  As long as the U.S. was willing to play the role of importer of last resort, a function tied closely to providing the reserve currency, the development model worked quite well.

India did not follow that model.  Instead, Indian policy following its independence was essentially autarky.  The country didn’t trade much and built quasi-public national champions that dominated domestic markets.  The model followed the British Labour Party policies after WWII (and advocated today by Jeremy Corbyn). This policy led to high inflation and slow growth.  As India began to develop, it had more success in services and developed a sophisticated trade in financial, medical and technology services.  However, manufacturing lagged in part due to the aforementioned autarkic policies.  To build mass employment, India needs manufacturing to expand.  Modi has tried to build India’s manufacturing with apparently little success.  We are not at all surprised to see India move in the direction of increasing duties; this is part of the mercantilist policy mix that has worked well for others.  However, conditions that made that policy mix successful have and are changing.  The U.S. is becoming increasingly unwilling to play the importer of last resort role and could retaliate against India’s actions.  It is possible that India’s manufacturing base never rivals China, Japan, et al. because it is missing a key element—a willing buyer.

Growth estimates come down: The Atlanta FRB has released its GDPNow estimate for Q1 GDP.  As the chart below shows, it was initially quite elevated but has declined rather sharply.

GDP is expected to rise 3.2% in Q1, which is still quite robust but well below the nearly 5.5% rate estimated earlier this month.  The culprits for slower growth are weakening consumption and investment.

The recent retail sales and CPI data have shaved 60 bps from GDP and weaker residential investment was responsible for the rest of the decline.  Net exports have become an increasing drag on growth; we expect the net export sector’s drag on growth to rise as the data flows the rest of the quarter.

Rising stress: We closely monitor a number of stress indices.  The two we rely on most come from the FRBs of Chicago and St. Louis.  The former has a longer history while the latter tends to be more sensitive and thus give earlier (but more noisy) signals.  The St. Louis FRB Stress Index jumped last week.

This is a decade graph of the two series.  Note that the St. Louis number rose sharply last week.  Both numbers remain below zero, which indicates that stress really isn’t a concern at this point.  However, if it continues to rise, it will signal broader problems in the financial markets.

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Daily Comment (February 15, 2018)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST]

Looking for something to read?  In our travels we are often asked about books we recommend.  As a result, we have created The Reading List.  The list is a group of books, separated by category, that we believe are interesting and insightful.  Each book on the list has an associated review to help you decide if you want to read it.  We will be adding to the list over time.  Books marked with a “*” are ones we consider classics and come highly recommended.

It’s Chinese New Year’s Eve, the year of the dog!  The Chinese New Year is tomorrow so Chinese financial markets are closed today and will remain so until the 21st.  This will slow Asian trading for the next week.  Here is what we are watching this morning:

Cyprus trouble: Last week, on Feb. 9th, Turkish naval vessels blocked an Italian ship contracted by Italy’s oil firm Eni ($33.85) that was planning to explore for natural gas around the island nation.  In response, Italy has dispatched a naval frigate to the area, although the Italians have indicated their vessel is under orders not to engage with the Turkish military ships.

Cyprus’s population is roughly 25% Turkish and 75% Greek.  Both groups have vied for control of the island, which is geopolitically important in that the holder of that island could project naval power into the Levant and block shipping from the Black Sea.  The British held Cyprus as a colony until 1960.  During the colonial period, as was often the case, the British gave the minority Turks extensive rights.  This was a common ploy by European colonists—they would offer strong support to minority groups in a colony, making them dependent on the colonial power.  This practice made managing the colony easier since the minority group was dependent and usually didn’t have enough power to manage independence.  At independence, the British wrote a constitution that gave the Turkish Cypriots extensive minority rights.  It was a recipe for discord and, by 1963, the island was embroiled in a low-level civil war.  The Johnson administration was able to prevent the war from escalating but only by supporting a U.N. peacekeeping mission that essentially partitioned the island.  In 1974, a coup ousted the Greek Cypriot president and the junta planned to forcibly merge the island.  Turkey invaded the northern Turkish zone to prevent unification and declared (an almost universally unrecognized) Turkish Republic of Cyprus in the northern zone.  It has remained divided ever since.

What triggered the current dust-up was that the Greek Cyprus government, which is generally recognized as the legitimate government of the island, licensed blocs offshore for energy exploration as it appears there could be significant natural gas deposits around Cyprus.  However, most of these blocs sit in an area that Turkey has claimed as under its control, even though this area is on the southern end of the island.  However, no other nation in the world, save Turkey, recognizes the Turkish Republic of Cyprus and thus the exclusive zones claimed by this republic are also unrecognized.

At present, we don’t expect this situation to escalate.  Europe appears unable to conduct war without the U.S. and we don’t see the Trump administration getting involved.  In addition, Turkey has significant leverage over the EU; if sufficiently angered, Turkey would release a flood of refugees into Europe.  The last wave has had significant political ramifications and another would likely exacerbate those problems.  At the same time, Turkey has its hands full managing its southern border with what was once Syria and northern Iraq.  It can’t really deal with a full-scale naval battle in the Mediterranean.  We see this spat as jockeying for position in negotiations, with the prize being the control of natural gas reserves.  At the same time, the chances that this situation escalates, while remote, are higher than normal because the U.S. has created a global power vacuum by its steady withdrawal from the world.  Russia, for example, could tip the scales in either direction; supporting Italy might give Moscow an ally to attain EU sanctions relief, while cozying up to Turkey could help it project power in the Middle East.  We believe this event is an example of what we will see more of for the foreseeable future.

The JPY: Japan’s Finance Minister Aso indicated overnight that the recent strength of the JPY is not a major concern, opening the Japanese currency to further appreciation.  Reuters[1] is reporting that Governor Kuroda, who we recently noted is likely to get a rare second term as head of the BOJ, may face a less cooperative group of deputy governors at the central bank.  Overall, we expect the BOJ to allow for steady appreciation of the JPY as long as it doesn’t accelerate.  Openly calling for a weaker currency runs the risk of antagonizing the Trump administration, and Japan would prefer good relations with Washington while it is dealing with significant tensions on the Korean Peninsula and with China.

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Daily Comment (February 14, 2018)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST]

Looking for something to read?  In our travels we are often asked about books we recommend.  As a result, we have created The Reading List.  The list is a group of books, separated by category, that we believe are interesting and insightful.  Each book on the list has an associated review to help you decide if you want to read it.  We will be adding to the list over time.  Books marked with a “*” are ones we consider classics and come highly recommended.

We are seeing a sharp flip in financial markets following a higher than expected print in CPI (see below).  Here is what we are watching:

Is Netanyahu in trouble?  The Israeli police have recommended that Israel’s PM, Benjamin Netanyahu, be indicted for the crimes of bribery and fraud.  Although the PM says he will fight the charges, they do appear serious and may derail his political career.  From here, the attorney general must decide if the evidence supporting the recommendation is solid enough to proceed with the indictment.  We expect this process to take several months but, during that time, it will act as a cloud over Israeli politics.

Zuma faces a no-confidence vote: South African President Zuma is facing a showdown in the legislature in the form of a no-confidence vote.  Zuma has so far refused to leave office despite being ordered to do so by his party, the African National Congress.  Zuma has tried to negotiate an exit that would last several months but his party wants him out.  He faces serious corruption charges and could face years of costly litigation if he leaves the presidency.  Thus, we suspect he is trying to make a deal to leave office in return for some sort of amnesty.  The no-confidence vote could force him from office perhaps as soon as tomorrow.  Zuma’s departure is bullish for the ZAR and precious metals.

Mester for vice chair?  Cleveland FRB President Loretta Mester is apparently under consideration for the vice chair position on the Board of Governors.  We rate Mester as a hawk (we put her at a “2” on our 1 to 5 scale, with 1 being most hawkish).  Although the president promised to shake up the Fed, his selections thus far have been rather conventional and this one would also fit into that characterization.  The White House has indicated the president is not close to filling this position and it is clear more candidates are being considered.

Fed policy: With the release of the CPI data we can update the Mankiw models.  The Mankiw rule models attempt to determine the neutral rate for fed funds, which is a rate that is neither accommodative nor stimulative.  Mankiw’s model is a variation of the Taylor Rule.  The latter measures the neutral rate using core CPI and the difference between GDP and potential GDP, which is an estimate of slack in the economy.  Potential GDP cannot be directly observed, only estimated.  To overcome this problem with potential GDP, Mankiw used the unemployment rate as a proxy for economic slack.  We have created four versions of the rule, one that follows the original construction by using the unemployment rate as a measure of slack, a second that uses the employment/population ratio, a third using involuntary part-time workers as a percentage of the total labor force and a fourth using yearly wage growth for non-supervisory workers.

Using the unemployment rate, the neutral rate is now 3.24%.  Using the employment/population ratio, the neutral rate is 0.97%.  Using involuntary part-time employment, the neutral rate is 2.64%.  Using wage growth for non-supervisory workers, the neutral rate is 1.25%.  The rise in core CPI has lifted the various neutral estimates higher but, as we have seen for several months, two of these measures of slack suggest the FOMC has achieved rate neutrality, while two suggest the FOMC is well behind the curve.  We still expect the FOMC to mostly split the difference and end up between 2.25% to 2.50% for the target at the end of this year.  However, the rise in inflation does increase the odds that the hawks on the FOMC will push for continued rate hikes into 2019; in other words, we may see a repeat of the 2004-06 tightening cycle with steady increases in the fed funds target, perhaps with hikes occurring at meetings lacking a press conference.

The CPI data is clearly bearish for equities, as shown by the quick and sharp reversal from higher to lower in this morning’s futures trade.  The usual impact of higher inflation is to lower the P/E multiple, which occurs as interest rates rise.  We are also seeing the dollar lift, although we doubt that can be sustained given the headwinds the fiscal deficit will cause…unless the FOMC finds its “inner Volcker.”  We wouldn’t count on that.  In fact, if monetary tightening worries begin to weigh on equities, expect the president to go “full Nixon” and tweet against Fed tightening.  Instead of Volcker, think Arthur Burns.

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Daily Comment (February 13, 2018)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST]

Looking for something to read?  In our travels we are often asked about books we recommend.  As a result, we have created The Reading List.  The list is a group of books, separated by category, that we believe are interesting and insightful.  Each book on the list has an associated review to help you decide if you want to read it.  We will be adding to the list over time.  Books marked with a “*” are ones we consider classics and come highly recommended.

Happy Valentine’s Day eve (a gentle reminder to our readers to not forget)!  Equity markets appear to be taking a breather this morning after two strong recovery days.  We expect another few days of “backing and filling” to build a base before a new uptrend develops.  Here is what we are watching this morning:

Was the VIX gamed?  Bloomberg[1] is reporting that the VIX futures were manipulated by a form of order “spoofing,” where an entity places S&P futures option orders that they do not intend to honor.  This activity could push the VIX higher.  It does appear that the VIX move was unusually high relative to the decline in equities; at the same time, we have our doubts that the entire turmoil was caused by manipulation.  It is rather obvious that there was a buildup in short volatility positions based on momentum alone and the short volatility positions were vulnerable to a squeeze when we saw a correction in equities.  However, it is possible that the spoofing, if true, exacerbated the squeeze and led to the panic reversal.

Inflation tomorrow: We get the CPI data tomorrow.  Given recent inflation worries, the market will pay unusually close attention to this report.

Reciprocal trade tariffs?  In an apparent surprise to the White House staff, President Trump indicated he plans to announce a “reciprocal tax” on trade.  The tax seems to be that if they have higher tariffs than the U.S. does, an equalizing tax could be implemented.   This looks to us like throwing a “bone to the base” but, at this point, we don’t see the president or the White House using (or perhaps even having) political capital for passage.  First, current tariff practices are based on years of WTO and multilateral negotiations.  A reciprocal tariff would violate those measures.  Although the U.S. could leave the WTO, the global trade ramifications would be enormous.  It’s not clear if Congress would approve such a tax.  What it does show us is that even if the right-wing establishment that surrounds the president steers policy toward typical establishment GOP policy priorities (lower taxes, deregulation), the president still has a populist theme.  If the U.S. moves toward protectionism, we expect a series of inflation problems to develop and a more profound bond bear market to evolve.  We are not there yet…but we monitor the trade/protection issue very closely.  On a related note, Axios[2] reports that a survey of the majority of CEOs around the world show support for protectionism to restrict technology and intellectual capital.

U.S. attack kills Russian allies in Syria: Bloomberg[3] reports that a force of 200 mercenaries, mostly Russians fighting (volunteering?) for Syrian President Assad, attacked a base and refinery held by the U.S. and allied forces.  According to reports, some of the Russians were veterans of the Ukraine campaign, another area where Russia claimed that volunteers supported operations in a foreign nation.  It is possible that the attack was a rogue operation but it does highlight the level of confusion and uncertainty surrounding the conflict in Syria and western Iraq.

Zuma out?  The African National Congress (ANC) has ordered President Zuma to resign, which would end the scandal-ridden regime and allow for Cyril Ramaphosa, the party leader, to become the new president of South Africa.  Zuma has been trying to stall, asking for a three- to six-month period to exit, but the ANC has apparently had enough.  It is not clear if Zuma will step down.  He likely fears that he will face corruption charges once he is out of office and could end up in prison or face a clawback in illicit funds.  One way or another, we expect Zuma to go which would likely be bullish for the ZAR.  A stronger currency is usually associated with stronger precious metals prices, especially platinum as South Africa is one of two major world producers (the other being Russia).  South African mines pay their workers in ZAR but earn USD when they sell their metals on world markets.  A stronger currency means higher production prices which tends to reduce mining activity.

The chart below shows the relationship of platinum prices to the ZAR exchange rate.  We have inverted the scale; ZAR is quoted in currency per dollar so a smaller number means a stronger currency.  The correlation since 2000 isn’t all that strong, but the correlation since 2010 approaches 95%.  Thus, one of the outcomes from Zuma’s ouster could be stronger platinum prices.

Kuroda set for another term: Current BOJ Governor Kuroda appears on track to be reappointed for a second term.  This is a rare outcome; his term expires in April but if he is reappointed and serves his term he would be the longest serving BOJ governor in history.  Kuroda has been an avid supporter of Abenomics and so Kuroda will likely remain head of Japan’s central bank as long as PM Abe remains in office.

German tensions: Martin Schulz, the leader of the SDP, has made a series of mistakes that have reduced the odds that the SPD rank and file will approve the grand coalition government recently negotiated with Merkel’s CDU/CSU.  Prior to last September’s elections, Schulz indicated he would not join a coalition with the Merkel conservatives.  However, the SDP took a drubbing in the national polls, winning only 20% of the electorate.  When Merkel was unable to cobble together a coalition of Free Democrats and Greens into a government, she would have either had to (a) assemble another grand coalition with the SDP, (b) operate as a minority government, or (c) call for new elections.  The SDP feared that option (c) would lead to even greater losses and thus Schulz had to break his grand coalition promise.  That move angered the SPD membership.  Schulz did negotiate a good deal for his minority party, getting both the finance and foreign ministries, a much stronger outcome than the vote count would have indicated.  Then, he made another unforced error by personally accepting the foreign ministry portfolio, ousting the current SDP holder of that office, Sigmar Gabriel.  The uproar from party members was so intense that Schulz was forced to give up the foreign ministry and allow Gabriel to maintain the office.  Schulz remains party leader but he is deeply wounded politically and it isn’t a certainty that the rank and file vote, which will be completed by March 2, will confirm the grand coalition.  If the vote fails, elections will likely be held later this year and the EUR may face some weakness.

Watching oil: The IEA reported today that OPEC has done a remarkable job in reducing the inventory overhang plaguing the oil market.  However, it warns that rising shale production in the U.S. could scuttle these efforts.  The EIA, the DOE’s data arm, is forecasting that shale output will rise to 6.8 mbpd by the end of March.  Another concern is that part of the recent budget agreement directs the DOE to sell 100 mb of oil out of the SPR, adding to the 189 mb that has been scheduled for sale since 2015.  The government is starting to use the SPR as an “oil piggybank.”  Although the need for SPR has been reduced due to shale production, there is a growing risk that oil prices could spike if a major Mideast oil disruption were to occur.  Finally, the Louisiana Offshore Oil Port (LOOP) is preparing to allow for exports.  The LOOP is the only offshore oil port that can handle supertanker oil directly.  Shifting the LOOP for exports is a major change.  Overall, we remain bullish on oil but these developments are bearish and warrant attention.

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Weekly Geopolitical Report – The Italian Elections: Part I (February 12, 2018)

by Bill O’Grady

(Due to President’s Day, the next report will be published on February 26.)

Italy will hold elections on March 4, 2018.  Given that recent elections in the Eurozone have run an emotional gamut, it is difficult to predict the outcome.  There was great fear before last year’s elections in France that a National Front victory could undermine the Eurozone.  The National Front is a nationalist, right-wing Eurosceptic populist party.  In light of surprise populist victories around the world,[1] there were worries that France would be the next major win for populism.  Emmanuel Macron’s surprising landslide put those fears to rest.  On the other hand, there was little concern surrounding last autumn’s elections in Germany as Angela Merkel was expected to win easily.  However, mainstream parties in Germany saw their popularity decline, offset by surprising strength for the AfD party, an anti-immigrant and Eurosceptic party.  Since winning the election, Chancellor Merkel has struggled to build a ruling coalition.  She recently made a deal with the Social Democrats (SDP) to form another “Grand Coalition” government, but in the process she was forced to give the SDP key ministries that will likely provide Germany more flexibility in managing the fiscal rules of the EU but will make the conservatives less likely to support this government for an extended period.

Thus, expectations for the French elections proved to be too pessimistic, while expectations for the German elections were overly sanguine.  It appears the anticipated outcome for the upcoming Italian elections is similar to that of Germany; although there is clear evidence that populist parties are growing in popularity in Italy, predictions call for a hung parliament and the eventual creation of a center-right coalition that will not threaten the stability of the Eurozone.  This sentiment is evident in the financial markets.

(Source: Bloomberg)

This chart shows the spread between Italian and German 10-year sovereign yields.  Although German yields declined relative to Italian yields into early 2017, the spread has steadily narrowed since April 2017 to the present.  If there were serious concerns about the Italian elections leading to Italy’s exit from the Eurozone, Italian yields would be rising relative to German yields.

Although we think the consensus case is the most likely outcome, there is potential for a negative surprise.  Given that Euroscepticism is high in Italy, even a consensus outcome may not be all that favorable.

In Part I of this report, we will begin with the basic geopolitics of Italy with a focus on the natural divisions in the country that make it difficult to govern.  From there, we will examine the political economy of Italy, especially how Italian political leaders managed the economy to deal with the sharp divisions between the north and south.  In Part II, using this background, we will analyze the polling for this election and the potential outcomes.  We will also touch on the issue of German influence in the EU.  As always, we will conclude with potential market ramifications.

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[1] The presidency of Donald Trump and Brexit are two examples.

Daily Comment (February 12, 2018)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST]

Looking for something to read?  In our travels we are often asked about books we recommend.  As a result, we have created The Reading List.  The list is a group of books, separated by category, that we believe are interesting and insightful.  Each book on the list has an associated review to help you decide if you want to read it.  We will be adding to the list over time.  Books marked with a “*” are ones we consider classics and come highly recommended.

Happy Monday!  Equity markets continue their recovery from Friday’s late surge.  Among candlestick chart aficionados, Friday’s formation was a “hammer.”  That means there was a large drop but the rally on the close led to a smaller body at the top, taking the form of a hammer.  A hammer is all about “hammering out” the bottom, so there is some technical evidence that this decline may be close to exhausting itself.  Meanwhile, there was lots of news over the weekend.  Here is what we are watching:

North Korea’s charm offensive: The Winter Olympics are in full swing, allowing us here in the Midwest to enjoy watching some of the less common sports.  Kim Jong-un has taken full advantage of the world’s spotlight to send a delegation led by his younger sister and a large contingent of cheerleaders to improve the Hermit Kingdom’s image.  So far, it has been a PR coup for Kim.  He has offered to open up leader talks with South Korea, a rather transparent bid to divide the U.S./South Korea alliance.  Although the talk out of South Korea is that the Moon government is cautious, center-left governments tend to be open to talks with Pyongyang.  The U.S. did itself no favors by suggesting that a conventional war on the peninsula, which would devastate South Korea, is preferable to the North Koreans having a deliverable nuclear weapon.[1]  We don’t think anything is happening here other than Kim wanting to divide the nations that are allied against him.  He is having some success but we doubt anything really changes.  The current South Korean government opposes any sort of military action against North Korea, and Kim is trying to build on that sentiment.

War in the Levant: Over the weekend, an Iranian drone moved into Israeli airspace.  The Israeli Defense forces (IDF) shot it down and made a retaliatory strike against the Iranian base where it originated.  Syrian anti-aircraft fire downed an IDF F-16 which led the Israelis to strike 12 targets in Syria, eight Syrian and four Iranian locations.  All this activity masks a broader issue—the region is up for grabs and Iran, Russia and Turkey are all jockeying for position as the U.S. steadily withdraws.  Iran wants to dominate Syria and form a clear arc from Tehran to Lebanon (which is essentially under Hezbollah’s control; Hezbollah is an Iranian proxy).  Turkey doesn’t want that to happen.  Russia wants Syria as its proxy state and Israel doesn’t want Iran on its doorstep.  Until recently, the U.S. would prevent all this from happening.  Since WWII, the U.S. managed to maintain stability through limited wars and its steady military presence.  However, the advent of shale oil has reduced American dependence on oil from the region and consequently the U.S. role in the region has changed.  During the Cold War, the U.S. was determined to prevent the Soviets from gaining control of the region’s oil; the U.S. wanted to keep that oil available for its free world allies.  Now, with ample North American supplies, the U.S. is questioning why it should pay for maintaining stability in the region while Europe gets cheap oil.  This isn’t just a recent development.  President Bush’s decision to oust Saddam Hussein without a clear plan on how to replace him removed the prime impediment to Iran’s regional aspirations.  The U.S. hasn’t been able to contain Iran since.  We see this conflict as “just warming up.”

A second referendum?  The Sunday NYT[2] reported there is growing support for a second referendum on Brexit.  The article noted regions that previously supported leaving the EU are having second thoughts and even hardline anti-EU political figures, such as Nigel Farage, the former leader of the U.K. Independence Party, would like a second vote to prove that the majority still want to leave the EU.  Would another vote bring a different outcome?  Latest polling show 46% would vote to remain in the EU, 42% to leave.  That is close enough to probably declare it a toss-up.  However, we note that the percentage of voters who were undecided in May 2016 was 14%, and it appeared most of those votes broke for leave.  The undecided vote is now down to 7%.  It is quite possible that a second vote would generate a reversal.  What would the EU do?  Although the rules suggest the U.K. would still need to depart because it said it would, we suspect Chancellor Merkel would allow the U.K. to stay with open arms.  In fact, the British may be able to use the Brexit scare as a way to negotiate more favorable treatment from the EU.  After all, it should be noted that the EU faces a growing authoritarian threat from central Europe (Hungary, Poland) and a contentious vote in Italy in March.  Having Britain stay would lessen tensions.  If a second referendum is called and the decision reverses, we would expect a significant rally in the GBP.

The fiscal debt and Treasuries: OMB Director Mulvaney was quoted over the weekend warning of a yield spike due to the rapidly widening deficit.  In reality, the impact of fiscal spending and the deficit is rather complicated.  Over the long run, the relationship between the deficit and bond yields is essentially nil.  The chart below shows the 10-year T-note yield and the deficit as a percentage of GDP (with the CBO’s forecast, which hasn’t been updated for recent developments).  Note the long-term correlation is -0.06%, or virtually uncorrelated.  Conversely, from 1956 to 1995, the correlation was rather significant at -0.65%.  In other words, as the deficit rose (became more negative on the chart), so did bond yields.  Then again, the correlation’s sign flips to positive since 1995, with a reading of 0.64%, meaning yields follow the deficit lower.

It should be noted that many of the deficit hawks, such as Martin Feldstein, came of age during the 1970s and 1980s when deficits seemed to matter.  They apparently believe this period was the norm but have failed to address the fact that the correlation has reversed.  The key issue is how the deficit is funded.  Until the mid-1980s, the deficit was mostly funded domestically, which meant that higher government borrowing “crowded out” domestic investment and, unless the fiscal spending was on something that was critical to growth, the deficits tended to boost interest rates.  However, after the mid-1980s, massive overseas dollar balances, a product of the larger trade deficit, created a source of foreign funding.  Since this foreign funding was a product of foreign nations using the U.S. consumer for growth and development, the U.S. didn’t really face serious constraints on the size of the deficit.  Thus, the correlation reversed.  Our expectation is that the fiscal deficits will result in a much larger trade deficit and a weaker dollar, which is why we are so concerned with protectionist trade measures.  If they are successful, it will lead us to conditions similar to the 1970s and early 1980s, meaning higher inflation and much higher bond yields.  So far, the president hasn’t acted as aggressively on trade as his campaign rhetoric suggested.  Our recent WGR discussion[3] suggests the real goal of the president’s policy is to attract foreign investment.  If we are correct, the scare talk from the deficit is just that—scary, but with no lasting impact.

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[3] See WGR, 2/5/18, Trump & Trade: The First Year.

Asset Allocation Weekly (February 9, 2018)

by Asset Allocation Committee

The continued rise in long-term interest rates is clearly grabbing the attention of financial markets.  Stronger than expected wage growth was the proximate cause of the recent lift in yields.  Although overall wages rose 2.9%, wages for production and non-supervisory workers grew only 2.4%.  Still, it is clear that fears of inflation stemming from an accelerating economy and concerns about monetary policy tightening are leading to rising interest rates.

Here is our updated 10-year T-note model.

The model’s core variables are fed funds and the 15-year moving average of inflation, which we use as a proxy for inflation expectations. The other three variables are the yen, oil prices and German long-duration sovereign yields.  The current yield on the 10-year T-note, which is in the 2.80% range, is running above fair value.  The standard error for this model, shown on the lower part of the graph as the parallel lines running along the midpoint of the standard error, is ±70 bps.  Thus, reaching a level that would signal excessively high yields would be 3.20%.

Complicating this case is the fact that the FOMC is expected to raise rates at least three times this year, and perhaps four, German yields are rising and oil prices have increased as well.  To project the potential lift in yields, we made some projections.  Assuming the FOMC moves the upper end of the target rate to 2.25%, with nothing else changing, fair value for the 10-year T-note will reach 2.825%.  The recent lift in 10-year T-note yields appears to be mostly discounting tighter monetary policy.  If oil prices reach $75 per barrel, the fair value yield would hit 2.90%, and if German yields rise to 1.00%, we would see 2.95%.  This suggests to us that a reasonable projection of variables likely takes us to a 3.00% 10-year T-note in the coming months.  In other words, it appears the 10-year T-note yield is mostly about discounting tighter monetary policy.

One other factor worth mentioning is that bond and stock prices have been positively correlated recently.  Under these circumstances, the effectiveness of bonds as a portfolio diversification tool is reduced.

It’s interesting that the returns were positively correlated from 1970 to 1998.  What caused the reversal?  Most likely it’s a function of the steady decline in interest rates from their high peak in the early 1980s to normal levels by the late 1990s.  In other words, falling yields were the norm during that two-decade period and, as rates fell, it supported rising P/E multiples.  After rates normalized by the end of the 1990s, the ordinary inverse relationship between equities and bond prices emerged.  Although the short-term price action between bonds and equities is a concern, we doubt it will be maintained.  Since the shift in the correlation occurred in the late 1990s, we have seen two periods when the one-year rolling correlation became positive, 2007 and 2015.  Neither event lasted very long nor did it undermine the longer term diversification that longer duration bonds offered.  We suspect the current positively correlated event is due to an overbought correction in equities and a bond market discounting tighter monetary policy (as noted above).  Thus, we view this as a temporary event.

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Daily Comment (February 9, 2018)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST]

Looking for something to read?  In our travels we are often asked about books we recommend.  As a result, we have created The Reading List.  The list is a group of books, separated by category, that we believe are interesting and insightful.  Each book on the list has an associated review to help you decide if you want to read it.  We will be adding to the list over time.  Books marked with a “*” are ones we consider classics and come highly recommended.

It’s official!  We are in a correction.  The S&P 500 has now declined just over 10% on an intraday high-to-low basis.

(Source: Bloomberg)

Do we have more downside from here?  Probably not materially, although we expect more grinding around current levels before we head back higher.  Next week’s CPI data will be important.  If inflation does appear to be accelerating, it may trigger another downleg.  Overall, the economy is still doing fine; the drop in equities might affect sentiment but it’s important to remember that nearly 85% of equities are held by households in the top 10% of income brackets.  In other words, the real losses are concentrated at the top end of the income scale so, for most Americans, the gyrations in equities are not a materially negative factor.

What are we paying attention to?  It is clear in the data that the last major equity market decline in the absence of recession occurred in 1987.  This begs the question, “Is this another 1987 event?”  At present, we don’t think so but, if it is going to be that kind of event, the trigger would probably be the use of volatility products.  In 1987, portfolio insurance led to a selling effect that exacerbated the downdraft.  Volatility trading won’t necessarily involve the same methods, but it could lead to similar results.

We have been getting questions on the volatility trade and note there is some confusion on how it works.  It’s important to note that betting on volatility is just that—it’s essentially trying to predict when the “freight train” is coming while others pick up nickels from the tracks.  To get an idea of this, we refer to the prospectus for the VXX (55.24), which says (on pages 13-14):

The long-term expected value of your ETN is zero.  If you hold your ETN as a long-term investment, it is likely you will lose all or a substantial portion of your investment.

The reason is the roll yield.  The long volatility products are long the front contract of the VIX futures when the term structure of the VIX futures are normally in contango, meaning the deferred futures price is above the nearest price.  When the nearest contract expires, the VXX manager buys the next nearest contract at a higher price.  If nothing happens, that contract will decline to where the previous contract expired, meaning the value of the positon will decline.  Over the long term, that means steady losses for the holder of long volatility.  So, the inverse position in volatility is in the opposite position.  Their position gains over time.  The anti-vol trade is really more of a roll yield position and less of a position on volatility.  Now, when policymakers are dampening volatility with accommodative and transparent monetary policy, the periods lengthen between volatility spikes (when the VXX pays off, or, when the “freight train” arrives), making the anti-vol positions quite profitable.

What led to the collapse of the anti-vol ETP was not just the jump in volatility but the fact that the volatility futures term structure flipped from contango to backward.  In other words, the nearest futures contract rose relative to the deferred contracts.  This means that losses were being accumulated on the roll yield and on the outright short position against volatility, which pushed prices down to points where some (but not all) ETN managers, to protect losses, exercised the call provision of the note and closed their products.

The unknown is how widespread was anti-vol positioning, who was in it and how much leverage was being deployed?  A casual look at the holders of XIV (0.00), the primary inverse ETN, shows a number of banks and broker dealers that were probably holding these for customers.  But, a large number of hedge funds are also represented and that is where the concern lies.  The fact that we are seeing selloffs in the last hour of trading may be a signal that these entities are still trying to build liquidity.  We don’t think the current event is going to be another 1987 situation, but we are watching the volatility issue closely because that is the most likely source if this does turn out to be a similar occurrence.

Is there a Powell put?  At present, if there is one, we are far from its strike price.  Various Fed speakers have been out in recent days and none seem overly concerned about the decline in equities, and fed fund futures are still projecting the odds of a March rate hike at around 85%.

A budget: The president signed the Senate budget deal that was passed early this morning by the House and Senate.  We did have a filibuster in the Senate that delayed the passage but we felt confident it would pass.  The good news is that we have now removed the budget drama from the markets for a couple of years.  What we have to deal with is the additional fiscal stimulus coming from the tax bill and this new spending.  We expect much of the expansion to boost imports, meaning the national growth effect will not be all that impressive but it is quite good for the global economy.

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Daily Comment (February 8, 2018)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST]

Looking for something to read?  In our travels we are often asked about books we recommend.  As a result, we have created The Reading List.  The list is a group of books, separated by category, that we believe are interesting and insightful.  Each book on the list has an associated review to help you decide if you want to read it.  We will be adding to the list over time.  Books marked with a “*” are ones we consider classics and come highly recommended.

BOE monetary tightening: Today, the Bank of England voted unanimously to leave interest rates unchanged but warned that earlier and larger interest rates increases are on the horizon in order to dampen the effects of a faster growing global economy on U.K. inflation.  In the BOE’s quarterly inflation report, each of the members of the BOE Monetary Policy Committee agreed that they are unwilling to tolerate inflation exceeding the 2% target for the next three years.  At a press conference, BOE Governor Mark Carney stressed that tighter monetary policy is needed due to expectations of faster demand growth and diminishing supply.  There has been speculation that the next rate increase could come as early as May.  The pound rallied following the news.

The chart above shows the year-over-year change in CPI for the U.K.  Following the Brexit vote in June 2016, the BOE stated that it would tolerate higher inflation to support domestic growth; as a result, the BOE has been slow to respond to rising inflation even though CPI has persistently remained above the 2% target since January of last year.  The Monetary Policy Committee’s decision to reverse course was largely due to concerns of possible overheating as previous concerns of rising instability following the Brexit decision proved to be unsubstantiated.

Is Goodfriend out?  Bloomberg[1] is reporting that Marvin Goodfriend, the White House’s nominee for one of the vacant Fed governor positions, may not get confirmed by the Senate.  The vote is expected today and he is expected to make it through the Banking Committee but the full Senate may be a problem.  Goodfriend has a controversial record.  He warned against an inflation problem after QE; although he was part of a broader chorus, the call was simply wrong.  He has not backed down from that position and was criticized for it.  He has also made disparaging comments about the dual mandate (a reasonable position from a theoretical standpoint, but Congress mostly likes the dual mandate as it acts as something of a brake on overly tight monetary policy), has shown support for negative interest rates and called for a magnetic strip to be added to paper currency, perhaps to give it a “stale date” in order to prevent currency hoarding under periods of negative nominal interest rates.  That sort of thing is vehemently opposed by Libertarians.  The left-wing populist group “Fed Up” is urging Democrats to reject the candidate.  Rejecting a Fed nominee would be a blow to the administration; it isn’t obvious who they would tap as a replacement.

A budget deal: The Senate leadership has agreed to a two-year funding deal, as we touched on yesterday.  The agreement lifts the sequestration caps and will increase discretionary spending by $300 bn over two years.  Defense spending will rise by about $131 bn and be matched with non-defense spending.  The agreement was not met with open arms by deficit hawks but, given that they are a minority in both houses, we expect this deal to pass.  It’s important to remember that Jacksonians, of which the president is one, are not opposed to government spending.  In fact, they like it, but only on their priorities.  In other words, foreigners and the undeserving should not get help from the government.  It is rare to see the deficit widen during expansions but the CBO is projecting just that outcome after this year and it hasn’t taken into account this new budget agreement in the below chart.

What does the deficit cause?  Although the textbook answer to this question is inflation, in fact, the impact is very complicated.  Our expectation is that budget deficits will most likely bring higher trade deficits and a weaker dollar, but probably have a modest impact on inflation.

Energy recap: U.S. crude oil inventories rose 1.9 mb compared to market expectations of a 3.0 mb build.

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 last March.  We would consider the overhang closed if stocks fall under 400 mb.

As the seasonal chart below shows, inventories are usually rising this time of year.  We are seeing increasing inventories but they are running below the usual seasonal levels.

(Source: DOE, CIM)

The rise in stocks is normal but the surprise this week was that the increase occurred with a sharp rise in refining activity.  If this jump indicates that maintenance is over, oil demand will rise.

Based on inventories alone, oil prices are undervalued with the fair value price of $67.44.  Meanwhile, the EUR/WTI model generates a fair value of $76.56.  Together (which is a more sound methodology), fair value is $73.79, meaning that current prices are below fair value.  We did see oil prices sell off yesterday despite the lower than expected rise in inventories.  That’s because weekly lower 48 production jumped 0.3 mbpd to 9.727 mbpd; coupled with Alaskan output, U.S. output hit 10.3 mbpd.  The market fears that rising U.S. output will cap prices.  Perhaps the largest risk is that Russia and Saudi Arabia decide to stop ceding market share to the U.S.; although we do expect that to occur at some point, it probably won’t happen until the Saudi Aramco IPO price sometime later this year or early next year.

As noted above, refining activity rose.

(Source: DOE, CIM)

Although refiners had been cutting output since late last year, we usually see about two months of reduced activity before production returns.  One week doesn’t make a trend, but this reversal is rather shocking and does suggest that refiners see demand for their product (perhaps exports?).  While the rise in U.S. production is a concern, we would need to see a surge in inventories to become worried about prices.

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