Author: Amanda Ahne

Daily Comment (February 3, 2023)

Posted on by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Today’s Comment begins with our concerns about the market’s dovish interpretation of the remarks from the central banks. Next, we discuss why poor Q4 earnings may not lead to a weak performance in the stock market. We end the report by discussing how rising tensions with Russia and China may lead to increased defense spending in the West.

Mixed Signals: Perceived dovishness from the central banks has lifted risk assets, but more questions still need to be answered to know if the upswing will last.

  • A growing number of monetary policymakers have moved away from hawkish rhetoric to favor language with greater flexibility. The three major central banks (Federal Reserve, European Central Bank, and Bank of England) have all offered timid support for automatic rate hikes over the next few meetings. The shift in rhetoric began when Fed Chair Jerome Powell proclaimed in a press conference that the disinflationary process had begun. This dovish sentiment was continued by ECB President Christine Lagarde and BOE Governor Andrew Bailey’s comments that their own subsequent hikes will be data-dependent. Despite each central bank’s acknowledgment that rate hikes are not guaranteed, they all insisted that keeping rates elevated is necessary to fight inflation.
  • Relatively low-inflation countries are moving in the opposite direction. The Swiss National Bank and the Bank of Japan are expected to tighten policy this year. The decision to tighten comes as the countries are seeing an uncharacteristic rise in inflation. The Consumer Price Index (CPI) for Switzerland rose 2.7% from the prior year in December, while Japan had a 4.0% increase in the same period. Although their inflation remains below that of their peers, the sharp rise is well above the ten-year inflation experience within these countries. Therefore, some central banks may pause or cut this year, while others will still be hiking rates.
  • Economic data can vary depending on the country and the circumstance. Just because inflation falls in one country does not mean that prices are decelerating everywhere. The latest surprise in the Spanish CPI demonstrates how price pressures can pop out of nowhere. The unpredictable changes in data may prevent central banks from halting their hiking cycle. January’s blockbuster 517k payroll number in the U.S. is a perfect example of how an economic surprise may suddenly shift sentiment. As a result, investors should remember that central bankers can be very fickle during times of uncertainty and should be reluctant to buy into dovish talk if they don’t want to be blindsided by unexpected rate hikes.

Risk On, Risk Off: Earnings reports have blunted some of the optimism for equities as firms pointed to headwinds felt toward the end of 2022; however, there is still a bright side.

  • Poor results from major tech firms weighed on equities moments before the release of the nonfarm payroll numbers. Apple (AAPL, $150.82), Amazon (AMZN, $112.91), and Alphabet (GOOG, $107.74) reported a slump in sales toward the end of the year. A decline in consumer demand impacted sales for PCs, cell phones, and ads which weighed on investor sentiment. Some of the weak performance can be traced to macroeconomic factors such as the war in Ukraine and China’s Zero-COVID policies. However, much of the pullback in spending may be representative of households preparing for a recession. Amazon’s light-forward guidance also supports the view that firms are worried about a downturn.
  • The disappointing figures from tech companies have mirrored economic data that came out toward the end of the year. Retail sales dropped in the final two months of 2022, and industrial production sank to a nine-month low in December. Additionally, the latest Atlanta GDPNow forecast for Q1 projects a 0.7% annualized increase in economic activity, which is a sharp drop from the 2.9% rise in the final three months of 2022. The combination of earnings reports and government data both suggest that the country may be headed toward a recession sooner than many investors realize.

Look At the Sky: The U.S. and China’s relations are back on the rocks, while the war in Ukraine enters a new phase.

  • A surveillance balloon, suspected to be from China, threatens to undue improvement in diplomatic relations between Washington and Beijing. The spy balloon was spotted in Montana, near an area that is home to several sensitive military sites. Although Beijing claimed to be unaware of the balloon, U.S. experts are confident that it came from China. The incident comes days before U.S. Secretary of State Antony Blinken is scheduled to visit Beijing to help normalize relations between the two countries. As of this writing, the U.S. has not officially canceled the trip; however, the incident could prevent a significant breakthrough as distrust between the two sides remains elevated.
    • The discovery of the balloon suggests that any rollback of export controls on semiconductors is likely off the table.
  • Russian forces are regrouping along the border of Ukraine in preparation for a new offensive. Ukrainian officials have assessed that there are over 500,000 troops ready to invade the country. Due to this renewed aggression from Russia, Ukraine has asked the West to provide it with more weapons as it looks to repel Russian troops from its country. Although Western allies have increased their arms deliveries to Ukraine, it isn’t clear just how much advanced weaponry these countries are willing to dole out. Germany was hesitant to send over tanks, while President Biden is resisting calls to send over F-16s. As a result, the new spring offensive could provide the West with another test of its unity in backing Ukrainian war efforts.
  • Renewed threats from Russia and China highlight the U.S. and its allies’ need to bolster defense spending. A higher level of military expenditures will allow the West to rebuild its inventory from the war in Ukraine and maintain its lead over China in its military technology. Therefore, government investment should support defense equities in the long run. Despite these stocks not having robust performance over the last few months, it is essential to remember that “defense moves in years, while equities move in seconds.” We believe that these equities are likely more attractive than the current sentiment would suggest.

View PDF

Daily Comment (February 2, 2023)

Posted on by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Our Comment begins with the latest Federal Open Market Committee meeting, including the decision to raise rates. Next, we cover the rate decisions of the European Central Bank and the Bank of England. Finally, we discuss Germany’s recent moves to position itself for a greener world.

Not Convinced: Fed Chair Jerome Powell insisted that the Fed will hold rates in the restrictive territory, but the market isn’t buying it.

  • The Federal Reserve raised its benchmark interest rate by 25 bps to 4.50%-4.75%, as expected. The increase was a downshift from the previous meeting and has led to speculation that the Fed is close to ending its hiking cycle. After announcing the rate hike, Powell emphasized that the central bank plans to hike more throughout the year. He argued that core services, which exclude shelter prices, and employment remain elevated and may lead to a wage-price spiral if left unchecked. He also opined that the economy is strong enough to withstand additional rate hikes.
  • Equity prices surged, and bonds rallied as investors posited that the next rate hike would probably be the last. The S&P 500 rose to an intraday high of 1.8%. Meanwhile, the NASDAQ, which tracks tech stocks, closed 2% higher than the previous day. However, the bigger news came from bonds. The yield on 10-year Treasuries dropped by 12 bps which suggests that bond traders are confident that the Fed will reverse course if inflation heats back up. The latest FedWatch tools show that 30-day fed funds futures predict another 25 bps hike in March with a 66% chance that there won’t be an increase in rates above 4.75-5.00% at the following meeting.
  • The last few cycles have shown that the Fed typically uses steps when it raises rates but takes the elevator down when cutting them. Thus, Thursday’s market reaction likely reflects investors’ hopes of a Fed pivot sometime this year. If the market is correct, we could see equities flourish. However, if it is wrong and the Fed decides to hike rates, equities may stagnate or drop. The direction of inflation will likely determine where the market will go. If inflation continues to climb, the Fed could pause or possibly cut in time to prevent a significant downturn.

Not Far Behind: The European Central Bank and the Bank of England had bigger hikes than the Fed; however, neither is committed to raising rates in a downturn.

  • The European Central Bank and the Bank of England both pushed up their respective policy by half a percentage point. The markets anticipated the moves as central bank officials had been hinting at the change for several weeks. Although the ECB maintained that it would stay the course of its policy, it signaled along with the BOE that future rate hikes will depend on economic data. The varying responses from these central banks highlight the pressures policymakers are under to consider the economy as they look to tame inflation.
  • The EUR and the GBP were sold off as investors questioned the ECB and BOE’s commitment to fighting inflation. The markets’ reactions suggest that investors believe that the central banks could end their hiking cycle as their respective economies head into recession. The spread between 10-year government bonds for Italy and Germany, a gauge of European financial stress, narrowed as borrowing costs are less likely to rise for distressed European economies. Therefore, lending conditions could improve in the Eurozone.
  • The market likely interpreted the BOE and ECB as being more dovish than they actually were. Policymakers are likely to continue pushing rates higher as long as the economy remains relatively strong. Although a recession is widely expected in both regions, stronger-than-expected GDP growth in Q4 2022 indicates that it is likely further in the future than originally thought. As a result, central bank policy may begin to tighten as these policymakers look to maintain credibility. That said, the recent comments from these banks suggest that they are not fully committed to remaining hawkish, which means that global financial conditions will likely ease throughout the year.

The German Problem: As Berlin positions its country to adapt to a new normal, it is resisting a major change in the status quo of Europe.

  • Chancellor Olaf Scholz racked up two wins in his race to refocus the German economy toward semiconductors. Apple (AAPL, $145.43) announced plans to invest $1.2 billion in Germany to set up a new European silicon design center and improve research and development. The new investment will help build out the country’s 5G capabilities and enhance its wireless technologies. Additionally, American manufacturer Wolfspeed, Inc (WOLF, $83.01) agreed to produce chips for electric vehicles in Saarland. The two investments show that Germany aims to support the country’s technological shift away from traditional manufacturing and toward greener technologies.
  • Despite attempts to improve its own industry, Germany has set up hurdles for other European countries to make the same transition. The European Union is expected to miss its March deadline for reforms to the Stability and Growth Pact. The changes would allow countries to offer subsidies to compete with the U.S. Inflation Reduction Act. Without these changes to the debt limit rules within the pact, countries will have to make painful budgetary adjustments if they want to offer energy incentives for green projects. Germany insists that any changes to the rules should not impact governments’ efforts to reduce debt loads. As a result, Europe’s Green Deal Industrial Plan will likely be put on hold as officials argue out the details.
  • Germany will always support and put its own interests first, even at the expense of its European allies. As we have mentioned in previous reports, Berlin does not want to fully align its interests with the West since it depends on commodity imports from Russia and trade with China. Germany’s reluctance is also related to wanting a head start on its European counterparts. Thus, it will also likely use the additional time to position itself as a premier European hub for energy manufacturing.

View PDF

Weekly Energy Update (February 2, 2023)

Posted on by Amanda Ahne

by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA | PDF

Crude oil prices appear to have based but so far have failed to break above resistance at around $80-$82 per barrel.

(Source: Barchart.com)

Crude oil inventories rose 4.1 mb compared to a 1.0 mb draw forecast.  The SPR was unchanged.

In the details, U.S. crude oil production was unchanged at 12.2 mbpd.  Exports fell 1.2 mbpd, while imports rose 1.4 mbpd.  Refining activity declined 0.4% to 85.7% of capacity.

(Sources: DOE, CIM)

The above chart shows the seasonal pattern for crude oil inventories.  Last week’s increase was contra-seasonal.  Generally, we expect this year to follow last year, meaning that the usual rise in inventories isn’t likely.

Since the SPR is being used, to some extent, as a buffer stock, we have constructed oil inventory charts incorporating both the SPR and commercial inventories.  For the next few months, we expect the SPR level to remain steady, so changes in total stockpiles will be driven solely by commercial adjustments.

Total stockpiles peaked in 2017 and are now at levels last seen in 2001.  Using total stocks since 2015, fair value is $107.01.

Market News:

  • BP (BP, $36.31), has released its annual energy outlook. The research indicates that peak demand for fossil fuels will occur by 2035 at the latest but could occur by 2030 if policy leans against carbon emissions.  There are a number of factors behind the expected peak, but one of the most overlooked areas is improved consumption efficiency.  Research such as this makes it more difficult to argue for aggressive investment into future production.
  • A normal response to supply shortages is hoarding since insecurity over supply leads consumers to build stockpiles to protect against future outages. Paradoxically, this activity can cause its own supply problems as this stockpiling becomes a source of additional demand.  We note that there are periods when U.S. commercial crude oil inventories are positively correlated to price.  If inventory is simply a residual of supply and demand, then a positive correlation would not be expected.  On this note, the German natural gas inventory manager says it intends to maintain a “buffer,” which we suspect means keeping a higher level of inventory than it would otherwise maintain.  Also, the German government is considering a “strategic” natural gas reserve, which would be another source of demand.  We have postulated, for some time, that as American hegemony wanes, one of the consequences would be insecurity of commodity supply, which would boost prices.  These reports from Germany provide evidence of such activity.
  • The White House criticized Chevron (CVX, $187.30) for its decision to repurchase shares. The administration would prefer the company expand production, but once an environment is created that calls for the replacement of fossil fuels, rewarding shareholders rather than boosting output is a rational outcome.
  • Whenever the price of an important commodity rises, politicians usually charge firms in those industries with “price gouging.” Although further investigation rarely confirms that suspicion, it persists.  Recently, Italian PM Meloni criticized gas station owners by accusing them of price gouging.  In response, they held a one-day strike.  Although closures of stations are rare, this event does highlight the potential for unrest due to high oil prices.
  • One of the consequences of the war in Ukraine has been a restructuring of global oil flows. We also note that the EU is placing a ban on Russian product imports on February 5.  It is not obvious if the markets are ready for this action.
  • Local governments in China have exhausted their funds in the battle against COVID and now find they lack the resources to buy natural gas.
  • One of the side effects of fracking is earthquakes. Although none of these earthquakes are of a high magnitude,[1] they are enough to be felt and raise fears among homeowners that the quakes will trigger structural damage.  Tremors have been reported in Oklahoma and also now in Texas.  It is thought that the primary culprit is fracking wastewater.  Sand, water, and other chemicals are injected into the ground when a well is fracked.  The water usually surfaces and needs to be disposed of, and a cheap solution is to reinject it into the depleted well.  The water is thought to act as a catalyst for these earthquakes.  The solution is to force energy companies to dispose of the wastewater in another fashion, and although possible, changing the regulations would lift costs and eventually raise energy prices.
    • It should be noted that oil activity is said to be in a “boom” in Texas and New Mexico. It is having ripple effects outside of the oil and gas industry by lifting salaries and employment in other sectors of the economy.
  • One of the bright spots for oil production is Guyana, which is expected to steadily boost production.
  • The Biden administration’s decision to aggressively sell oil out of the SPR has been controversial. Although it is arguable that there are still ample supplies, as the previous chart showed, combining both the SPR and commercial stockpiles indicates that inventory levels have notably declined.  The House of Representatives has passed a bill that would limit the Department of Energy’s ability to tap the SPR. While it has no chance of passage, it does reflect the current level of concern.
  • Warm weather has not just lowered natural gas prices in Europe, but it has also taken U.S. prices below $3.00 per MMBTU. Although inventory levels are rather close to their five-year average, we are in the period of the year with the strongest drawdowns, but because of mild temperatures, we actually saw a build in U.S. stocks.  Even if temperatures turn cold, it is likely we will begin the refill season in April with adequate stocks.  We do look for prices to recover in the spring and summer as LNG exports increase to ensure Europe has adequate supplies.

 Geopolitical News:

  • Over the weekend, Iran was hit with a series of aerial attacks. Oil refineries and defense infrastructure were reportedly hit by drones.  The U.S. is suggesting that Israel was behind the widespread attacks, and apparently the U.S. was apprised of the operation.  Iranian media reported that the damage was light, but the fact that the attacks occurred is notable for a few reasons.  First, Israel has been reluctant to support Ukraine due to relations with Moscow (Russia and Israel cooperate in Syria); however, Iran is supplying arms to Russia so by attacking its defense infrastructure Israel could both help Ukraine and attack an avowed enemy.  Second, Israel must believe that Iran has limited scope to retaliate, likely assuming that it probably can’t do much in response between the protests and a weak economy.  Third, although there isn’t evidence that the U.S. directly participated, Washington appears to have abandoned a return to the JCPOA and thus is working on other ways to contain Iran.  This cooperation may include the actions Israel took over the weekend.  Still, the attacks on Iran create conditions where the war in Ukraine could expand.
  • Even with the lack of progress in Iran and the U.S.’s return to the JCPOA, diplomats haven’t completely cut off contact, mostly because they don’t perceive any other available options to restrain Iran’s nuclear program.
  • The U.S. has accused Iran of a “murder for hire” plot to assassinate an Iranian-American writer living in New York.
  • Iraq is dealing with increased currency smuggling, which has led to the Iraqi dinar’s depreciation. It is suspected that Iran is using its allies in Iraq to acquire dollars and the drain is weakening the Iraqi currency.
  • Although Russia and China have publicly declared their strong alliance, in reality, the two nations don’t necessarily align in certain areas. One of the more contentious areas is in central Asia.  Since these regions were formerly part of the Soviet Union, Russia tends to think of the “stans” as part of its sphere of influence.  However, China’s goal of building a Eurasian bloc, expressed by its “belt and road” project, means that China would like these nations to align with Beijing.  China has been using its economic heft to build relations, and we note that Russia is also making overtures to the stans by offering to sell natural gas in return for influence.  So far, the stans have been reluctant to fully sign on.  The central Asian nations are open to joint ventures but are reluctant to give Russia control of infrastructure.
  • The EU has agreed on a price cap for natural gas, while the Intercontinental Exchange is creating a parallel contract in London to match the TTF price in Amsterdam ostensibly to skirt the cap.
  • As Venezuela begins to emerge from sanctions, it is attempting to normalize its trading relationships. While under sanctions, it had used middlemen trading firms, likely for selling oil and to evade U.S. sanctions.  As conditions normalize, it is now demanding cash up front for exports in a sign that it is moving on from sanctions trading.

 Alternative Energy/Policy News:

  • Polls show that the German public now supports nuclear power. Former Chancellor Merkel tried to phase out nuclear power after the Fukushima disaster, but high natural gas prices have changed public sentiment.
  • We are beginning to see price discounting of EVs. Tesla (TSLA, $169.34) started the process, and now Ford (F, $12.94) is following suit.  Some of this action is due to rising inventories, especially at Tesla, but another factor is that the cars may simply be too expensive to compete against gasoline-fired vehicles.
  • China is considering banning the exports of its solar technology. Since it dominates this industry, such an action would send up the cost of solar energy outside of China.
  • Researchers at the University of Illinois Urbana-Champaign have taken an abandoned oil well and turned it into a geothermal energy storage system. The researchers injected 120oF water into the well, and it maintained the temperature, suggesting that other abandoned wells could be repurposed for similar uses.
  • In response to U.S. subsidies in the Inflation Reduction Act, the EU is planning to use tax credits to offer European businesses support for green energy.

[1] Californians would not be impressed.

  View PDF

Daily Comment (February 1, 2023)

Posted on by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with more good news on global price inflation.  Data today showed that the Eurozone’s consumer inflation has again cooled modestly, though probably not enough to prompt the European Central Bank to slow its aggressive interest-rate hikes.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a discussion of the Czech Republic’s controversial new president and a preview of today’s interest-rate decision from the Federal Reserve.

Eurozone:  The January Consumer Price Index (CPI) was up 8.5% from one year earlier, marking a small improvement from the 9.2% increase in the year to December.  However, much of the improvement stemmed from the recent pullback in European energy prices because of the mild winter.  Stripping out the volatile food and energy components, the January Core CPI was up 5.2% year-over-year, essentially the same annual increase as in the prior month.  The report is therefore unlikely to dissuade the ECB from implementing another aggressive interest-rate hike tomorrow as it continues to battle high inflation in the Eurozone.

Czech Republic:  Petr Pavel, the unaffiliated former leader of the Czech army and the former chief of the NATO military committee, has been declared the winner in last weekend’s presidential election.  Running on a platform embracing the EU and NATO, Pavel handily beat populist Former Prime Minister Andrej Babiš.

  • Although the Czech presidency is largely symbolic and has no executive powers, Pavel’s win is being seen as an important political victory over populism and pro-Russian sympathies in the country.
  • Pavel has already risked confrontation with China by taking a congratulatory phone call from Taiwanese President Tsai Ing-wen. He therefore became one of the few elected European leaders who has recently risked Beijing’s ire in such a way.  The gesture in support of Taiwan could encourage other European leaders to take a more assertive stance against China’s geopolitical aggression.
  • In an interview with the Financial Times published today, Pavel was even more blunt, saying, “This is what we have to be very clear about: China and its regime is not a friendly country at this moment, it is not compatible with western democracies in their strategic goals and principles… This is simply a fact that we have to recognize.”

Russia-Ukraine War:  Although the front lines running from eastern to southern Ukraine remain largely static, albeit with heavy fighting in some areas, the Ukrainian government has again warned that it has intelligence that the Russians are planning a major new offensive soon, potentially to coincide with the one-year anniversary of their invasion on February 24.  Among the signs of such a new offensive, the Ukrainians note the Russian military’s increased mobilization of resources and intensified troop training.

India:  Ahead of the next parliamentary elections in Spring 2024, the government of Prime Minister Modi has released a proposed budget for the fiscal year beginning April 1 that cuts taxes for the upper and middle classes and massively boosts infrastructure spending.  The budget assumes Indian GDP will grow between 6.0% and 6.8% in the coming fiscal year, allowing the budget deficit to decline to 5.9% of GDP from an estimated 6.4% of GDP in the current year.

United States-Russia:  In a report sent to Congress yesterday, the State Department said Russia has violated the New START treaty, which cut long-range nuclear arms, by refusing to allow on-site inspections and rebuffing the U.S.’s requests to meet to discuss its compliance concerns.  With spot checks no longer possible, the U.S. can no longer verify the weapon counts reported by Russia.  The violations, which Russia denies, raise the risk that New START, the only remaining Cold War-era arms limitation treaty still in force, will not be renewed when it expires in 2026.

  • As important as the New START treaty is in limiting the U.S. and Russian nuclear arsenals, the agreement doesn’t include China at all. China’s strategic nuclear arsenal remains far smaller than the U.S. and Russian arsenals, but it is rapidly building up its inventory of nuclear weapons and could approach the numbers in the U.S. stockpile in several years.
  • Abrogation of New START could therefore free the U.S. to expand its nuclear arsenal as needed to meet the new challenge of deterring a potentially combined Chinese-Russian nuclear attack.

United States-China:  In a possible retaliation for the U.S.’s stringent new controls on exporting its advanced semiconductor technologies, China is reportedly considering a ban on exporting its own advanced solar energy technologies.  If the plan is adopted, Chinese solar manufacturers would be required to obtain a license from their provincial commerce authorities to export such technologies.  If put into place, the Chinese restrictions could crimp efforts to expand solar generating facilities and solar equipment manufacturing in the U.S., Europe, and developed Asian countries in the coming years.

United States-India:  This week, the Biden administration hosted U.S. business leaders and an Indian delegation led by New Delhi’s national security advisor to discuss ways to shift key technology supply chains away from China and toward India.  The meetings are another instance of how seriously the U.S. government, with bipartisan support in Congress, is seeking to decouple from China and its evolving geopolitical bloc in terms of key technologies and commodities.

U.S. Monetary Policy:  Fed officials wrap up their latest two-day monetary policy meeting today, with their decision due to be released at 2:00 PM ET.  The officials are widely expected to slow their rate hikes at the meeting to just 25 basis points, bringing the benchmark fed funds rate to a range of 4.50% to 4.75%.  However, they are also expected to signal that they won’t be finished tightening policy until they make more progress in bringing down inflation.

  • We continue to believe the continued rate hikes will help push the U.S. economy into recession in the very near future. That suggests U.S. stock prices could well turn downward again, despite their rally in recent weeks.
  • The ECB and the Bank of England will hold policy meetings tomorrow, but they are expected to keep hiking their benchmark interest rates by an aggressive 50 basis points. The narrowing differential between the U.S. and European benchmark rates will probably put continued downward pressure on the dollar.

U.S. Fiscal Policy:  President Biden and House Speaker McCarthy will meet today to discuss a range of issues and, more importantly, to begin negotiating a deal to raise the federal debt ceiling.  Any lack of results could rekindle concerns about a potential U.S. debt default and spark additional market volatility.

U.S. Regulatory Policy:  The Consumer Financial Protection Bureau plans to propose a rule today that would limit the late fees credit-card companies can charge, bringing penalties down to $8 from as much as $41 currently.  The rule, which doesn’t require Congressional approval, could go into effect as early as 2024.  The expected new rule illustrates the Biden administration’s relatively more aggressive regulatory initiatives.

View PDF

Daily Comment (January 31, 2023)

Posted on by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with positive reports on the global gold market in 2022 and world economic growth in 2023.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including signs of better-than-expected economic growth in Europe and China, and news that the U.S. will officially end its COVID-19 emergency in May.

Global Gold Market:  The World Gold Council reported that global gold demand increased 18% last year to 4,741 tons, marking the strongest demand for the yellow metal since 2011.  According to the council, the increase was driven by a 55-year high in central bank purchases.  We continue to believe that factors such as loose monetary and fiscal policies, fear of currency debasement, geopolitical tensions, and the U.S.’s willingness to freeze foreign countries’ dollar reserves will all continue to bolster the demand for gold going forward, pushing up gold prices.

Global Economic Growth:  The International Monetary Fund said it now expects the global economy to grow 2.9% in 2023, an upgrade from its October forecast of 2.7%.  Coupled with unexpectedly strong economic data from Europe and China (see below), the report has given a modest boost to global equity markets so far this morning.

Eurozone:  After stripping out price changes and seasonal factors, fourth-quarter gross domestic product increased 0.1% from the previous quarter, beating expectations for a fall of 0.1% even though Germany and Italy both posted contractions in the period.  The expansion means that the overall Eurozone economy managed to grow in each quarter of 2022, bringing its full-year increase to 3.5%.  It also means the bloc has been able to skirt the recession that was widely expected just a few months ago.  Since the news could embolden the European Central Bank to keep hiking interest rates aggressively, even as the Fed slows its rate hikes, it should be positive for the EUR.

France:  On a less positive note out of Europe today, France is facing its second major wave of strikes in two weeks as education, health, railway, and energy workers go out on strike to protest the Macron government’s proposed pension overhaul.

China:  The country’s official Purchasing Managers Index (PMI) for manufacturing rebounded sharply to 50.1 in December from 47.0 in November, while the PMI for the nonmanufacturing sector jumped to 54.4 from 41.6.  Like most major PMIs, China’s are designed so that readings over 50 indicate expanding activity.  Even though the December manufacturing index was slightly below expectations, the figures suggest that the overall Chinese economy has snapped back to growth after the government abandoned its strict pandemic testing and lockdown policies late last year.  The news is at least a short-term positive for global economic growth and stock prices.

Russia-Ukraine War:  Despite increasing pressures from the beleaguered Ukrainians and a coterie of Pentagon officials, yesterday President Biden appeared to rule out sending the F-16 fighter jets being requested.  On the other hand, yesterday French President Macron signaled that he would be open to sending such support.

  • Given that the allies supporting Ukraine have continually expanded the list of weapons they’re willing to provide, it is possible that they will eventually send Kyiv some type of fourth-generation fighters, at least the European-made Tornado or Gripen.
  • However, a key question is whether such weapons will be sent, in sufficient quantities, in time for the Ukrainians to counter an expected new Russian offensive in the spring.

Russia-Iran:  Russia and Iran have reportedly launched a system to provide standardized, secure banking messages between Russian and Iranian financial institutions.  The system is designed to help Russia and Iran get around Western sanctions barring them from the global SWIFT communications system.

  • The effort to establish a rival system illustrates how countries in the evolving China-led geopolitical bloc are working to develop their own, independent financial relationships.
  • Over time, we expect Beijing to focus on developing and controlling a bloc-wide financial system marked by its own bank messaging system, its own idiosyncratic financial rules, and probably some type of digital, commodity-backed CNY as the bloc’s reserve currency.

India:  Energy and infrastructure conglomerate Adani Enterprises (ADANIENT.NS, INR, 2,892.85) continues to face a massive sell-off and a falling stock price on the Indian market after a recent short-seller’s report accused the company of cooking its books.  Although Adani shares are not available to investors in the U.S., it’s important to remember that international investors have been known to sell a country’s wider stock market on the news that one of its bigger companies is facing issues.

Brazil:  Former President Bolsonaro has applied for a six-month tourist visa to remain in the U.S. while the new government in Brasilia investigates him for corruption and any role he might have played in this month’s rioting in the country’s capital.

U.S. COVID Policy:  President Biden reportedly plans to call for an end to the national emergency and public-health emergency declarations for COVID-19 on May 11.  Ending the emergency declarations would allow for the termination of certain pandemic measures, such as the suspension of eligibility renewal requirements for people on Medicaid.  That could mean that millions of beneficiaries lose coverage just as the economy is falling into recession.

U.S. Monetary Policy:  Fed officials begin their latest two-day monetary policy meeting today, with their decision due to be released tomorrow at 2:00 PM ET.  The officials are widely expected to slow their rate hikes at the meeting to just 25 basis points, bringing the benchmark fed funds rate to a range of 4.50% to 4.75%.  However, they are also expected to signal that they won’t be finished tightening policy until they make more progress in bringing down inflation.

  • We continue to believe that the continued rate hikes will help push the U.S. economy into recession in the very near future. That suggests U.S. stock prices could well turn downward again, despite their rally in recent weeks.
  • Meanwhile, the European Central Bank and the Bank of England will also hold policy meetings this week, but they are expected to keep hiking their benchmark interest rates by an aggressive 50 basis points. The narrowing differential between the U.S. and European benchmark rates will probably put continued downward pressure on the dollar.

View PDF

Daily Comment (January 30, 2023)

Posted on by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with confirmation that the U.S. has secured the cooperation of Japan and the Netherlands in clamping down on key semiconductor technology transfers to China.  The move is designed to suppress China’s military technology development, but it will also feed the continued escalation of tensions between the West and China.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including new, lower forecasts of future fossil fuel use and a preview of the Federal Reserve’s upcoming policy meeting this week.

United States-Japan-Netherlands-China:  As we flagged in our Comment earlier this month, the Biden administration reached a deal with Japan and the Netherlands on Friday under which they will restrict the exporting of certain advanced semiconductor manufacturing equipment to China.  The Japanese and Dutch restrictions will complement the aggressive new rules unveiled by the U.S. in October, which prohibit sending China certain advanced U.S. computer chips, chipmaking equipment, chip components and inputs, and even personal services related to those items.

  • The new U.S. restrictions aim to suppress China’s ability to produce advanced military technology, including not only advanced computer chips but also artificial intelligence, supercomputing, and other technologies for modern warfare.
  • With allies like Japan and the Netherlands signing up to enforce the restrictions as well, the new U.S. rules are likely to seriously impede China’s overall information technology development. On top of that, House Foreign Affairs Committee Chairman McFaul revealed last week that the Biden administration is planning to issue an executive order that would dramatically widen its clampdown on U.S. capital flows into China’s technology industry.  That order would prohibit U.S. investments in whole sectors, such as artificial intelligence, quantum computing, and cybersecurity.
    • In theory, China could still catch up to Western technology standards in the future, but the U.S.-led restrictions are likely to seriously slow the process and crimp U.S. investment opportunities in the country.
    • Of course, the U.S. clampdown on technology and capital flows will also anger Beijing and will almost certainly prompt retaliatory measures and increase friction between the two countries.

United States-China:  As U.S.-China tensions continue to escalate, U.S. Air Force General Mike Minihan, chief of the Air Mobility Command, reportedly ordered his officers last Friday to achieve “maximum combat readiness” this year, in preparation for a U.S.-China conflict that he believes will happen by 2025.  Minihan’s timeline for war is even earlier than the 2027 date predicted two years ago by Adm. Phil Davidson, then chief of the U.S. Indo-Pacific Command.

  • A U.S.-China conflict is still not necessarily inevitable. Nevertheless, it appears that U.S. national security officials are becoming increasingly concerned about tensions boiling over in the near term.
  • We continue to believe that increasing tensions with China and Russia’s aggression in Ukraine will spur more military spending and defense investment throughout the U.S.-led geopolitical bloc in the coming years. However, those increases are coming slowly, largely reflecting bureaucratic delays, resistance by both business elites and populists alike, and the lack of a modern-day Winston Churchill raising the alarm about China’s growing power and military aggressiveness.
    • The West’s defense industry should probably be moving closer to a war footing right now, which should include dramatically boosting its capacity and production. Although we have emphasized that global economic fracturing and shortened supply chains will prompt “re-industrialization” in the West, increased defense manufacturing could also be an important part of the story.  However, the West’s defense industry currently remains on a peacetime footing.
    • If U.S.-China tensions suddenly worsen, it could require a rapid expansion in the West’s defense industry. That kind of expansion could be chaotic, but it could also lead to great wealth creation for those in a position to benefit from defense contracts.

Russia-Ukraine War:  Russian forces, bolstered by recent conscripts, have reportedly changed their tactics and are now making progress in their efforts to surround the embattled city of Bakhmut in eastern Ukraine.  The new Russian progress comes as Western officials begin to worry that the Russians will have the advantage the longer the war of attrition lasts, due to their superior numbers of troops and equipment.  That calculus could well spur the West to speed its deliveries of advanced equipment to the Ukrainians, perhaps even to include jet fighters.

Israel-Iran:  Over the weekend, the Israeli military launched a drone strike on a military facility deep in Iran, in the city of Isfahan.  The strike, the first under Prime Minister Netanyahu’s new far-right government, came just days after the U.S. and Israel held their biggest-ever joint military exercise.  It also comes amid an escalating cycle of violence between Palestinians and Israeli security forces in Jerusalem and in the West Bank.

  • Israel has been reluctant to directly help Ukraine defend itself against Russia’s invasion, given the Israel needs Russia’s acquiescence to attack its foes in Syria.
  • However, the attack on an Iranian military supply depot may have been meant as much to degrade Iran’s ability to support Russia in its invasion as to damage Iran’s own defense capabilities.

European Union:  Figures today showed that Germany’s gross domestic product unexpectedly declined 0.2% in the fourth quarter of 2022, largely reflecting reduced household consumption because of high energy prices.  The contraction in the EU’s largest economy means the bloc’s overall GDP could also show a small contraction in the fourth quarter when the report is released tomorrow.  If that’s the case, the EU’s GDP would have fallen for two straight quarters and would, therefore, have met the standard definition of a recession, although the downturn would still have been much less severe than was widely feared last year.

United Kingdom:  Yesterday, Prime Minister Sunak sacked Cabinet Office Secretary and Conservative Party Chairman Nadhim Zahawi over a simmering scandal revolving around his late tax payments.  That means Sunak has now lost two Cabinet ministers in the last three months, even as a third is under investigation and is likely to resign soon.  The scandals have greatly wounded Sunak politically, even as he struggles to deal with Britain’s high inflation, economic slowdown, massive strikes, and worsening public finances.

Global Energy Market:  In its annual energy outlook publication, BP, plc (BP, $36.32) has reduced its forecasts of global fossil fuel demand to reflect how countries around the world are accelerating their transition to renewable energy in response to Russia’s invasion of Ukraine.

  • In its forecast for 2035, for example, BP now expects global oil demand to fall to just 93 million barrels per day, about 5% lower than what was forecast last year.
  • Despite the expected decline in demand, we continue to believe that oil, gas, and many other key commodities will be richly priced in the coming years, largely reflecting factors like the U.S.-China geopolitical tensions, potential supply shortfalls, and a weaker dollar.

U.S. Banking Industry:  Regional banks and lenders with big credit-card businesses say they are tightening credit standards ahead of an expected recession.  Some lenders also say they are boosting their financial reserves to prepare for a continued increase in delinquencies.  Although consumer delinquencies remain historically low, they have begun rising in recent months.

U.S. Fiscal Policy:  President Biden and House Speaker McCarthy are due to meet on Wednesday to discuss a range of issues and, most importantly, begin negotiating on a deal to raise the federal debt ceiling.  Plans for the meeting may ease concerns about a bitter political fight that could lead to a U.S. default, but a lack of results could rekindle concerns and undermine the financial markets later in the week.

U.S. Monetary Policy:  Fed officials will begin their latest two-day monetary policy meeting tomorrow, with the decision due to be announced on Wednesday at 2:00 PM ET.  The officials are widely expected to slow their rate hikes at the meeting to just 25 basis points, bringing the benchmark fed funds rate to a range of 4.50% to 4.75%, but they are also expected to signal that they won’t be finished tightening policy until they make more progress in bringing down inflation.

  • We continue to believe that the persistent rate hikes will help push the U.S. economy into recession in the very near future. That means U.S. stock prices may well turn downward again, despite their rally in recent weeks.
  • Meanwhile, the European Central Bank and the Bank of England will also hold policy meetings this week, but they are expected to keep hiking their benchmark interest rates by an aggressive 50 basis points. The narrowing differential between the U.S. and European benchmark rates will probably put continued downward pressure on the dollar.

View PDF

Asset Allocation Bi-Weekly – Secular Trends In Bond Yields (January 30, 2023)

Posted on by Amanda Ahne

by the Asset Allocation Committee | PDF

[Note: The podcast that accompanies this report will be posted later this week.]

Secular trends in markets are trends that have an extended life.  Their length can be different across various markets, but they are usually measured in years and sometimes decades.  It is not uncommon for shorter-term trends to occur within the secular trend.  But, in a secular bull market, the cyclical trends usually result in “higher highs and higher lows.”  From an investing perspective, knowing what kind of secular trend is in place in a market can be quite helpful.  The idea of “buying the dip” is rewarded in secular bull markets as downcycles offer buying opportunities.  The opposite notion, “selling the rallies,” makes sense in secular downtrends.

What causes secular trends?  Usually, it is a set of macroeconomic conditions that foster the trend.  These macroeconomic conditions can include growth and inflation trends and are often bolstered by policy.  Detecting reversals in secular trends is difficult[1] as history shows that often the underlying factors that supported a secular trend begin to deteriorate well before the market trend changes.  Some of this extension of the trend is simple inertia, while other times, even though the underlying factors are weakening, the factors that support a new and different trend are not yet in place.  Markets are often driven by narratives,[2] which can then become articles of faith to investors.  If these narratives become imbedded, they can make it hard to see when conditions change.  Complicating matters is that if a secular trend lasts long enough, a large number of investors may have no experience with any other type of trend.  If investors lack personal experience or a foundation in history, the change in trend can be difficult to manage.

There is increasing evidence, in our opinion, that the secular downtrend in long-duration Treasury yields has ended.  The chart provided shows the 10-year T-note yield since 1921.  We have regressed time trends through periods when we estimate that a secular trend was in place.  The bands around the trend reflect a standard error above and below the estimated trend.  Over the past 102 years, we have identified three secular trends.  Clearly, these trends are persistent, and when changes do occur, they definitely matter.

Clearly, it is difficult to know in real time when a secular trend has changed.  Note that in 1931, there was a pop in yields that would have looked big enough to raise concerns that a secular reversal was underway.  However, yields subsequently declined and the downtrend remained in place.  Also, when the uptrend developed in the late 1940s, it probably wasn’t obvious that a trend change was in place for at least five years after the low in the former downtrend had occurred.  The difficulty that dealers had in selling those T-notes yielding more than 15% in 1981 is legendary.  Given the outsized move in yields from 1980-85, we didn’t attempt to calculate a trendline.  However, after a spectacular decline in yields from the peak in the autumn of 1981 to the bottom in July 2020, it appears to us that the secular downtrend is probably over.

What changed?  In our opinion, the U.S.-led hegemonic system, which began in the early 1980s but was bolstered by the end of the Cold War, has ended.  There are multiple causes for the end of this system.  Politically, the U.S. voting public has concluded that providing the reserve currency, which requires running persistent current account deficits, is too much of a burden.  When President Obama couldn’t pass the Trans-Pacific Partnership (TPP) and the Transatlantic Trade and Investment Partnership (TTIP), it was clear that free trade and open investment, which were critical to keeping inflation under control, were in trouble.  These two free trade agreements would have put the U.S. in a dominant position to control global trade.  Another factor was growing political instability in the U.S., and although there are multiple facets to that instability, much of it is driven by inequality.  Ending globalization and addressing inequality will almost certainly bring with it higher inflation, which will then likely lead to a rise in interest rates.

The great unknown is the pace of that expected rise.  Given the long-term nature of secular cycles, there isn’t a large number of “turns” to observe.  Even looking at U.K. Consol yields doesn’t offer much insight because interest rate changes were abrupt until 1825 but have tended to be much more gradual since then.  We have been expecting the secular downtrend in yields to gradually shift to a steady uptrend, similar to what we saw from the late 1940s into the early 1970s.  However, that assumption doesn’t have a strong theoretical underpinning.  The notion of gradual shifts in trend is mostly based on Milton Friedman’s theory that investor inflation expectations are built over a lifetime, and thus, when inflation changes accelerate, investor response tends to be slow.  In other words, it takes a rather long time for investors to adjust to the new inflation regime.

What worries us about the current environment for long-duration yields is that there is still a rather large cohort of baby boomers who have memories of the 1970s inflation crisis and the consequent bond bear market.  It is possible that instead of a slow, steady rise in long-duration interest rates over the next decade or two, we could see a sharp increase.  So far, market action seems to favor that outcome.  If that is the case, the FOMC and Treasury could come into conflict.  A rapid rise in long-duration yields may lead to excessive interest expenses.  Although the Treasury could offset that by shortening their borrowing profile, another response could be to force the Federal Reserve to fix interest rates along the Treasury yield curve.  This policy was executed during WWII and continued into the early 1950s before the Treasury/Federal Reserve Accord was established in 1951.  This accord gave the Fed its independence.  This process, called “yield curve control,” would prevent the secular rise in long-duration yields in Treasuries (but not necessarily in other investment-grade products) but could be catastrophic for the dollar.

Due to these risks, we have shortened duration in our fixed income allocations.  So far, the long end has behaved rather well, but we think there is an elevated risk of an unexpected outcome.  Usually, long-duration fixed income is a good place to be in a recession.  That may be the case this time as well, but if we are in the midst of a secular change in yields, the usual rally in long duration may not occur.

[1] For our reflections on inflection points, see Reflections on Inflections, part 1 and part 2.

[2] For a good discussion on narratives and economics, see: Shiller, Robert. (2019). Narrative Economics: How Stories go Viral and Drive Economic Events. Princeton, NJ: Princeton University Press.

 

View PDF

Daily Comment (January 27, 2023)

Posted on by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Today’s Comment begins with our thoughts on the latest Gross Domestic Product data and what it may say about the economy. Next, we explain why the global bond rally has not eased concerns over government debt management. The report ends with our views on the latest earnings figures from various companies.

A Second Look: The market responded positively to the preliminary GDP data; however, a deeper dive shows signs of potential trouble.

  • The economy expanded at a faster-than-expected pace in the fourth quarter. According to the Bureau of Economic Analysis, GDP rose at an annual pace of 2.9% in the final three months of 2022. The reading was well above expectations of 2.6%. The strong report boosted investor confidence that the country may avoid a downturn. As a result, investors showed an increased appetite for risk, leading to a 1.1% high in the S&P 500 and a 2.0% peak in the NASDAQ. That said, the excitement may be temporary as the overall GDP number overshadowed problems within the underlying data.
  • Much of the GDP growth in the fourth quarter came from volatile elements of the report. Inventories accounted for nearly half of the rise in economic output, while a sharp decline in imports also boosted economic activity. Excluding trade, government spending, and inventory data, the economy only grew at a paltry 0.25% in the final quarter of 2022. The figure, referred to as final sales to private domestic consumers, shows that the country may be experiencing a slowdown. Thus, the market may have interpreted the headline figure as evidence that the Fed may achieve a soft landing, but a deep dive into the report shows that the economy is holding on by a mere thread.
  • This may be a make-or-break moment for the Fed. It had signaled for several weeks that it was committed to raising its benchmark interest rate to 5.0% and above to help bring down inflation. However, this talk was under the belief that a tight labor market reflected a strong U.S. economy. Although policymakers have consistently pointed to the tight labor market as evidence that it has room to tighten, the GDP figures show that the economy may be on the verge of recession. Therefore, Powell may be forced to explain whether the Fed will raise rates into a downturn like officials have suggested or listen to markets and implement a pause.
    • Further proof of the wonkiness in the data is that construction activity, as by housing starts, shows that homebuilders continue to hire workers at a steady pace despite taking on fewer projects.

Debt Problems: Governments have struggled to manage their debts even as the demand for global bonds have surged.

  • The debt-ceiling fight could push the Fed to end its quantitative tightening earlier than expected. The U.S. Treasury is expected to limit the number of treasury bill issuances in the second quarter since the government reached its statutory debt limit earlier this month. The lack of bond offerings will likely cause problems within the financial system as financial institutions, such as money market funds and pension plans, must hold ultra-safe assets on their balance sheets. A lack of available debt could lead to bidding up for collateral within the repo market. The lack of quality capital may force these funds to withhold assets in the short-term lending facility; thus, causing the Fed to prematurely end the shrinking of its bond portfolio in order to prevent a potential crisis .
  • Although European debt sales surged in January, the European Union is having trouble finding takers for its bonds as it considers expanding the bloc’s lending capacity. Interest rates on joint EU bonds are higher than those of many of its members, such as France and Germany. The lack of demand has less to do with the creditworthiness of the region and more to do with its lack of liquidity. Investors view resistance to the bond’s creation as a sign that these bonds can’t be relied upon as safe-haven assets in the future. Therefore, the EU may be limited in its ability to raise the funds needed to compete with the subsidies offered in the U.S. Inflation Reduction Act.

Earnings Slowdown: The GDP shows that consumption helped save the economy from contracting in December, but more firms are expressing doubts about whether this will last.

  • Major firms are forecasting a steep slowdown in sales for the coming year. Microsoft (MSFT, $248.00 ) and Intel (INTC, $30.09) both reported weak PC sales in their latest earnings reports. Meanwhile, Tesla (TSLA, $160.70) slashed the prices of its vehicles to maintain its market share. The deteriorating earnings outlook suggests that the firms may start to feel margin pressure as the economy begins to slow, and thus, it is possible that the market may not have reached its bottom yet.
  • As input prices continue to rise, firms will likely have little room to maneuver to ensure profitability. Higher costs mean that firms depend on consumers to spend more to remain in the black. This feat may be harder to achieve, given the possibility of a looming recession. The negative earnings news on Thursday reversed some of the equity gains from the GDP report and is contributing to weakness in premarket trading. The S&P 500 rose above 1% yesterday but closed only 0.5% up from the previous trading day.
  • The Chinese reopening and strong labor market data have boosted investor confidence that sales will be strong, even during a U.S. recession. However, that sentiment may be more sector dependent. For example, firms that offer more expensive and discretionary products could see a mild tapering of sales as consumption begins to cool. Though, this trend may not be consistent for all industries. Walmart’s (WMT, $142.21) decision to increase pay to all employees and Chipotle’s (CMG, $1,606.29) move to hire an additional 15,000 workers is evidence that not all firms are feeling a profit crunch.

View PDF