Asset Allocation Bi-Weekly – #90 “The Master of Surprise” (Posted 1/20/23)

Posted on January 20, 2023June 12, 2023 by Amanda Ahne

Weekly Energy Update (January 20, 2023)

Posted on January 20, 2023January 19, 2023 by Amanda Ahne

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

Crude oil prices are trying to base but so far have failed to break above resistance at around $80 per barrel.

(Source: Barchart.com)

Crude oil inventories rose 8.4 mb compared to a 2.0 mb draw forecast. The SPR was unchanged, the first time since the reporting week of May 20, 2022. The unusually large build was caused by slower than expected recovery in refinery operations.

In the details, U.S. crude oil production was unchanged at 12.2 mbpd. Exports rose 1.7 mbpd, while imports rose 0.5 mbpd. Refining activity rose 1.2% to 85.3% of capacity. The Christmas cold snap closed in a significant level of refining activity, and the industry is slowly recovering.

(Sources: DOE, CIM)

The above chart shows the seasonal pattern for crude oil inventories. Last week’s jump in inventory means we are starting the year off with well above average inventory injections. The chart does show that the usual seasonal pattern was not followed last year. This is because the average still reflects the restrictions on U.S. oil exports whereas there isn’t much of a discernable pattern to this data now that exports are allowed.

Th chart below shows the sharp drop and partial recovery in refining operations. Usually, we do see some refinery maintenance this time of year, which will end in early February. Thus, we may not see a full recovery in refinery operations until later in the quarter.

(Sources: DOE, CIM)

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 $107.07.

Market News:

As the government’s SPR sales begin to wind down, the potential for higher prices has increased. We do expect a resumption of sales if oil prices threaten $100 per barrel, but it is unlikely that we will see another large sale just because prices are high. We believe that the SPR sale was an underappreciated bearish factor last year, and if we are correct, an end to selling will likely be more bullish than expected.
- It is our position that the SPR will never be refilled to its +600 mb level last seen before the recent sales. The structure that the Biden administration has put in place to buy oil makes it very unlikely that purchases will occur.
The IEA is warning that the reopening of China will lift global oil demand to a new record.
The Kingdom of Saudi Arabia (KSA) is kicking off investment into the mining sector, likely to diversify its economy away from oil and gas just in case demand for these products fall as green energy expands. The $15 billion starter fund should boost mining investment and will likely support the sector.
- Saudi Arabia, due to cost structure and low emissions from production, believes it will be the last oil producer standing, even as the world moves away from fossil fuels.
- In another effort to diversify its energy sources, one that will be most controversial, the KSA has indicated that it will use its domestic uranium to complete the nuclear fuel cycle. In theory, doing so could give the country the wherewithal to develop nuclear weapons. Given the advanced status of Iran’s program coupled with uncertainty surrounding the U.S. security guarantee, this claim could further raise risks in the region.
The history of oil is littered with “we are running out” narratives. Daniel Yergin’s The Prize is perhaps the best history of the industry, and at several junctures, the accepted wisdom was that the age of oil was ending because all the fields had been tapped. What history shows is that supply shortages lift prices, increasing not just exploration activity but also new technologies. Since oil was discovered in 1859, this cycle has been in place. Thus, when the Financial Times runs a story about the end of shale, we take it with a bit of skepticism. In some respects, the story might be right if current conditions remain in place, but, those conditions probably won’t last. The FT story and the EIA’s short-term forecast for production are predicated on prices staying about where they are. However, as we have noted, if we assume around a 200 mb decline in commercial stockpiles, which would have occurred had it not been for the SPR draw, we would be looking at $135 per barrel for crude oil. Prices at that level will probably change behaviors. Supply issues, such as the lack of workers, capital constraints, regulatory constraints, etc., remain, but all these can be overcome with higher prices.
There is an old adage in markets that “nothing cures high prices like high prices.” In market theory, price is a signal, and high prices tell consumers to conserve, but more importantly, they reward suppliers who bring product to market. As prices rise, especially in Europe, we are seeing a notable increase in exploration and development activity in the eastern Mediterranean. Large natural gas fields are being discovered in a difficult geopolitical environment. Offshore fields south of Cyprus have brought the involvement of Turkey, Greece, Israel, Lebanon, and even indirectly, Hamas. Although there has been some degree of cooperation, deep divisions remain; for example, Turkish and Greek vessels routinely threaten each other. Government instability can also upend agreements, but high prices will make it more likely that these obstacles will be overcome and will improve the supply situation in Europe and the Middle East.

Geopolitical News:

The oil price cap is having a modest impact on Russian oil revenue. It is estimated that Russia has lost $172 million of revenue per day, cut from the typical $688 million per day. So, the loss is notable, but as designed, is not enough to completely cut off oil supplies.
- India remains an aggressive buyer of Russian crude oil. Chinese shippers are moving Russian oil to Asia.
- At Davos, participants are worried that it may be next to impossible to run the global economy without access to Russian oil, gas, and basic minerals. Without Russia, prices for these commodities will be much higher.
Italy announced an effort to develop energy ties to Africa. In some respects, this is nothing new as Eni (E, $31.44), Italy’s energy champion, has had ties to Africa, especially to Libya. However, the company is now planning to expand ties to numerous other African nations in a bid to move away from Russia as an energy source.
China and Australia have been at odds over the latter’s call for an international investigation over the origins of COVID-19. The dispute led to a decline in Chinese imports of Australian commodities. However, there does appear to be a softening of Beijing’s stance as China has lifted its ban on coal imports.
Conoco-Phillips (COP, $120.16) is in talks to sell Venezuelan oil in the U.S. to recoup losses tied to Caracas’s decision to expropriate the company’s assets in 2007. We do note that Venezuela has halted oil exports (likely a temporary situation) as it tries to gain control over its exports. To avoid sanctions, Caracas has used numerous intermediaries to sell oil. One of the problems with using such resources is that they can be either unreliable or costly. As Venezuela “comes out of the cold,” it is trying to end its use of intermediaries, which should mean more revenue for the Maduro regime.
For a number of reasons, Iranian oil exports are rising. We suspect that the U.S. has been quietly easing up on sanctions, but the biggest reason for the rise in exports is the simple fact that the world needs the oil.
- Iran has been a key supporter of the Assad regime. The Syrian government is dominated by Alawites, which could be considered an offshoot of Shiite Islam, making Assad a sympathetic figure. In addition, to the degree Iran can influence Iraq, the so-called “Shiite arc” ranging from Iran to Lebanon needs to include Syria in order for the arc to be completed. And so, Iran has not just supplied Syria with military support, it has also provided economic support as well. However, there are always limits to friendship. As Iran is able to sell more oil on the world market at higher prices, it has ended its practice of selling deeply discounted oil to Syria, leading to further problems for the Syrian economy.
- In a move that will not sit well in Tehran, the Iraqi PM Mohammed al-Sudani, wants an “indefinite” U.S. troop presence, ostensibly, to counter ISIS.
- Iran executed a British citizen accused of spying. Tehran’s decision has angered Westminster.
- The Iranian government is issuing new rules on the hijab. The regime wants to leave the rule in place but soften the penalties.

Alternative Energy/Policy News:

The IEA has issued its annual report on the state of energy technology, which skews toward green energy production. There are a number of takeaways but the one that caught our attention is China’s dominance in the production of components for these products. If the West is going to develop these energy sources, a massive level of investment will be required.
Sweden announced it has discovered a large deposit of rare earths. Rare earths are not really all that rare, although finding concentrated deposits can be a challenge. The mining of such products, however, is environmentally difficult and the processing even more so. Thus, the challenge of overcoming China in this area is, to some degree, tied to either making the process cleaner (and likely more expensive) or accepting the environmental degradation.
China’s dominance in lithium is seen in the chart below.

(Source: IEA)

As this chart shows, China’s dominance in processing rare earths and lithium is a much bigger issue than the mining of ores.
The U.S. government is supporting lithium mining in the U.S.
The China-based solar panel firm JA Solar (002459, CNY, 64.10) announced it will build a factory in Phoenix. The factory will produce two gigawatts of panels a year, adding to the 4.5 GW capacity already in place in the U.S. The fact that a Chinese firm is making an investment in the U.S. does indicate that Beijing is trying to keep market access to the U.S. open. Japan did something similar in the late 1980s
One of the well-known problems of wind and solar power is its intermittency. As evidence, Chinese officials are ordering rooftop solar panels to be shut off during the Chinese New Year celebrations. The holiday will reduce demand and there are fears that solar panels will produce more power than needed.
As part of the Inflation Reduction Act, the U.S. is supporting subsidies to EV firms. European car makers have been upset about this development, and the EU is complaining that U.S. officials are trying to woo European firms to expand their operations in the U.S. in order to acquire the subsidies. Now, Germany announced that it would support EU-wide subsidies to counter the U.S. action, something the German automakers have been calling for. In a sense, EV development is being imbedded into the industrial policies of the U.S. and EU.
Although EVs get lots of attention in terms of reducing oil consumption in transport, efficiency gains far outpace electrics in terms of cutting demand.
Changes in farming practices could reduce carbon in the atmosphere. Essentially, farmland could become a “carbon sink” where CO₂ would be captured by plants and held in the ground. Although agriculture firms are trying to help farmers acquire carbon credits, farmers argue that the benefits from the credits are not enough yet to merit changing farm practices.

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Keller Quarterly (January 2023)

Posted on January 19, 2023January 19, 2023 by Amanda Ahne

Letter to Investors | PDF

A new year is underway, and we wish you and yours all the best in 2023! The stock market certainly seems to be optimistic about the new year: the S&P 500 is up 4.1% through its first full two weeks of 2023 and it’s up 14.5% from the 52-week low on October 13. Without repeating too much of my October letter, you know that we believe a recession is likely in the current year. In fact, that seems to be the consensus among Wall Street economists. So, why the positive market behavior?

Financial markets are not independent entities, but rather represent the collective behaviors of thousands of participants, each of whom is making their best guess about the future. When most of those participants expect the same thing to occur, guess what? It’s “in the market,” as we say; that is, the event is almost certainly reflected in market prices. In my opinion, the stock market spent the middle six months of last year discounting the probability of a 2023 recession.

It remains to be seen whether this recession will be shallow, normal, or deep. Our expectation is that it will be shallow-to-normal, which seems to concur with the consensus view, judging by the market’s behavior. Why is that? The U.S. consumer appears to be in better shape than usual at this point in the cycle. Relatively low unemployment rates mean that most people who want a job have one, consumer debt relative to household cash and income is relatively low, and the banking system appears to be in very good shape relative to past cycles. One reason for this good condition is that the last recession was just three years ago (2020), meaning there hasn’t been a lot of time for businesses and consumers to over-extend themselves. In addition, the extraordinary fiscal and monetary stimulus the economy received in the wake of the pandemic-induced recession allowed many to reduce their debts and “get their houses in order.”

On the other hand, could the recession be deeper? Yes, it is possible that the Fed will raise the fed funds rate beyond what the market presently expects (that is, more than 5.0% to 5.5%), which might cause a worse recession. Geopolitical factors, especially those involving Russia or China, could intervene and deepen a recession. But, at this point, we believe those are lower probability events. The stock market tends to look six to 12 months into the future and, in our opinion, the market is presently looking past the recession to what late 2023 and even 2024 might look like. Our crystal ball gets cloudy that far out, but, as we noted last quarter, we see other trends in place today that will likely continue for many years.

Notably, we expect the average rate of inflation over the next 10 years to be meaningfully higher than the last 10 years. Inflation is “too much money chasing too few goods.” Politicians and economists talk incessantly about the “too much money” part of that definition. Thus, they obsess over money supply and monetary stimulus. What they forget is that the “too few goods” side of the definition is usually the key determinant of inflation. When ever-increasing globalization was dramatically increasing the supply of goods and lowering their cost (from approximately 1980 to 2015), inflation trended lower and stayed there. Once globalization peaked, however, the trend began to change. Throw in the disruptions due to a pandemic and a war and you have a real supply problem, otherwise known as inflation. While the pandemic is winding down and the war will eventually end, deglobalization is here to stay.

As a result, we expect inflation to average 4% or more for the long-term, about double the prior long-term rate. That’s what we’re factoring into our thinking. It is a headwind for investment returns, to be sure, but, as we’ve communicated in prior letters, this is not an environment unknown to us. Our investment strategies and security selection processes were all developed with higher inflation in mind because we are old enough to have experienced it before.

We appreciate your confidence in us.

Gratefully,

Mark A. Keller, CFA
CEO and Chief Investment Officer

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Daily Comment (January 19, 2023)

Posted on January 19, 2023 by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Today’s Comment begins with the market’s reaction to Wednesday’s economic data. Next, we discuss why central banks are now pushing for smaller rate hikes. We end the report with our thoughts about the recent developments in tech and crypto.

A Softish Landing: Poor economic data and hawkish Fed comments led to a sell-off in equities.

Retail sales figures showed that consumer spending declined for the third consecutive month in December. Meanwhile, industrial production data showed that manufacturing activity also waned over that period. The weak figures show that the Fed may not be able to lower rates before the economy enters recession, which would have been known as a “soft landing.” On Wednesday, Cleveland Fed President Loretta Mester and St. Louis Fed President James Bullard stated that the Federal Reserve was not finished raising rates and would need to keep rates tight for some time to bring down inflation. Therefore, the likelihood that the Fed will keep rates higher, even during a downturn, is elevated.
The weak economic data spooked investors who previously believed that the economy may have averted a recession. As a result, the market responded negatively to the dimmer outlook for the economy. The S&P 500 closed down 1.6% from the prior day. Meanwhile, bond prices jumped, and the 10-year Treasury yield plunged to a 4-month low of 3.368%. The market reaction was likely a combination of investors looking to lock in early 2023 gains and secure bonds while interest rates remain relatively high.
In our view, equity investors and bondholders have two opposing views on the Fed. Stock traders believe that Fed Chair Jerome Powell will cave once the economy starts to sputter. Meanwhile, bond traders are convinced that Powell will keep rates elevated even as the country falls into recession. Although it isn’t clear who’s right, the difference will likely dictate how the market performs throughout the year. If equity traders are right, stocks should have strong performance as the market has likely priced in the worst of a recession. However, if bondholders are correct, the slump in equity prices could worsen. At this time, we believe that investors should take a wait-and-see approach before making major adjustments to their portfolios.

The Central Bank Shuffle: Although the Fed insists that it will continue to raise rates, there are growing expectations that it will decrease the size of its hike at its next meeting.

Dallas Federal President Lorie Logan, a voting member, added to the chorus of calls for a downshift in rate hikes beginning at the Federal Open Market Committee meeting next month. On Wednesday, she argued that a slower pace of hikes could reduce interest rate uncertainty, which should alleviate financial conditions. Although she later added that the Fed should ultimately settle rates at a higher level than originally anticipated, her comments did seem to fall in line with market expectations of a 25 bps hike at the Fed’s February meeting. The CME FedWatch tool shows that there is a 95% chance that the central bank will raise its target range from 4.25%-4.50% to 4.50%-4.75%.
Talk of a possible moderation in Fed tightening has helped support foreign currencies and has provided other central banks with more flexibility to set rates. After hitting parity in 2022, the GBP and the EUR have rallied strongly against the USD. Meanwhile, the JPY has skyrocketed following the Bank of Japan’s decision to lift its yield cap on 10-year Japanese government bonds. The three currencies are hovering near seven-month highs, which reduced pressure on these countries’ respective central banks to tighten aggressively in order to defend against a strengthening dollar.
- Despite being one of the strongest-performing assets last year, the USD, as tracked by the DXY index, is down 1.3% to begin the year, which is worse than the poorest-performing asset class in the S&P 500.
Other central banks are now following the Fed’s lead in moderating their tightening. Despite guidance from European Central Bank President Christine Lagarde that borrowing costs will be lifted in 50 bps increments over its next two meetings, there is talk that the ECB could slow hikes as soon as March. Meanwhile, the Bank of Japan’s decision to defy market expectations and not alter its policy on Wednesday has also added to speculation as to whether it plans to tighten policy anytime soon. The dovish shift from central banks should be beneficial to equities as it will prevent a further slowing of the global economy. However, we would like to caution that the mood may change if inflation returns due to China’s reopening.

Tech and Crypto Risk: As investors increase their appetite for risk, tech companies and crypto platforms struggle to find a path forward.

The tech sector is headed for a reset as companies adapt to a higher interest rate environment. Microsoft (MSFT, $235.81) and Amazon (AMZN, $95.46) announced a combined 28,000 job cuts on Wednesday. The huge cutback in their workforce is related to the industry looking to reposition itself after years of robust growth. After suffering its worst yearly performance since the Great Financial Crisis, NASDAQ is now up 5.5% on the year, nearly twice that of the S&P 500. The rebalance in tech could position the sector for stronger growth when economic growth starts to pick back up.
Meanwhile, the fallout from crypto continues to spread. On Wednesday, digital currency platform Coinbase (COIN, $50.21) announced that it was halting operations in Japan. Additionally, reports claim that crypto lender Genesis is preparing to file for bankruptcy. The negative developments in crypto reflect the growing uncertainty surrounding digital assets and suggest that the currency still has many risks. Bitcoin dropped below $21,000 following the development but still remains up 25% on the year.
The end of zero-interest rates monetary policy has forced tech companies and crypto to restructure their businesses. This should make firms leaner and more profitable as well as create a more viable digital currency market in the long run. However, the recent turmoil suggests that there is still some market skittishness toward riskier financial assets. Investors should remember that despite speculation of a soft landing, there is still time for things to turn awry. As a result, investors should remain cautious and complete their due diligence before investing in riskier elements of the market.

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Daily Comment (January 18, 2023)

Posted on January 18, 2023 by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with an upward revision in the International Energy Agency’s forecast for global oil demand this year, which is giving a boost to oil prices so far this morning. We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including an unexpected decision by the Bank of Japan that has given a boost to Japanese stocks but has driven down the JPY.

Global Oil Market: In its monthly forecast, the IEA stated that the end of China’s strict pandemic shutdowns should lead to a further rise in oil demand this year, even though the COVID-19 infections sweeping through China right now are causing widespread economic disruptions at the moment. With U.S. and European oil usage also looking firmer this year, the agency therefore predicted total global oil demand in 2023 will rise to a record-high average of 101.7 million barrels per day, up 1.9 mbpd from 2022.

The news is helping to give global oil prices a further boost so far this morning.
Brent crude oil futures are currently up approximately 1.6% to $87.30 per barrel.

China: In another sign that China is easing up on its economic restrictions and trying to ease tensions with the West, the country’s censors have reportedly cleared two Marvel superhero movies from The Walt Disney Company (DIS, $99.91). That marks the first Chinese clearances for Marvel movies since 2019, and the films will be allowed to be shown in China next month.

Japan: The BOJ today kept its monetary policy unchanged, with a yield target of -0.1% for short-term obligations and a cap of 0.5% for 10-year notes. The decision to hold steady came after a surprise tightening last month. That disappointed many investors who had bet on a further hike in the 10-year yield and a potential end to the BOJ’s long experiment with yield- curve control. In response, Japanese bond yields have declined sharply so far today, pushing down the JPY and boosting Japanese equity markets.

European Union: In her address at Davos yesterday, European Commission President von der Leyen said that the EU will respond to the recent U.S. subsidies for green technologies by easing its restrictions on state aid to industry and pumping cash into strategic climate-friendly businesses. However, her proposed program would still need a unanimous buy-in across all EU countries, and some national leaders believe a better way to keep investment in the EU is to boost the bloc’s productivity, increase research spending, and bring down energy prices.

EU leaders believe the $369 billion in green subsidies under the Inflation Reduction Act will likely draw massive amounts of investment out of Europe and toward the U.S., and they worry that EU countries don’t have the fiscal space to compete with the U.S.
However, the Biden administration continues to argue that the EU should adopt similar “complementary” subsidies that would strengthen the EU as a member of the evolving U.S. geopolitical bloc and reduce the EU’s dependence on China and the countries in its bloc.

United Kingdom: The December Consumer Price Index (CPI) was up 10.5% year-over-year, marking a modest cooling in inflation after the index rose 10.7% for the year to November. However, excluding the volatile food and energy components, the December Core CPI was still up 6.3%, unchanged from the inflation rate in November.

Overall British inflation has now slowed for two straight months, but only modestly, and the wave of strikes now sweeping across the country threaten to buoy wage costs and inflation for months to come.
The Bank of England is, therefore, still expected to keep hiking interest rates at its next policy meeting in February.

Russia: Defense Minister Shoigu outlined a long-term expansion of the country’s military in which total personnel would rise to 1.50 million in 2026 from the current 1.15 million. The plan would also include the creation of new military districts centered on Moscow and St. Petersburg and the establishment of an army corps in the exclave of Karelia.

The expansion of the country’s military will coincide with a likely pullback in economic activity because of factors such as Western sanctions and mass emigration.
As a result, Russia is likely edging closer to the day when its defense spending exceeds 10% of gross domestic product – a “defense burden” that has historically created headwinds for economic growth.

Turkey: President Erdoğan announced that the country’s next presidential and parliamentary elections would be pulled forward by one month to May 14. Erdoğan’s support in public opinion polls is currently at rock bottom because of soaring inflation, high unemployment, and a currency crisis. However, he appears to be gambling that a recent spate of public spending programs and his aggressive foreign policy will help him eke out a win and stay in power.

U.S. Labor Market: As early as today, Microsoft (MSFT, $240.35) is expected to announce another round of layoffs, making it one more in a string of high-profile information technology firms that are shedding workers. Besides technology, it also appears that rising interest rates and the implosion of the housing market have prompted significant layoffs in the real estate and financial services industries.

Nevertheless, with the economy facing an overall shortage of workers, many of those being laid off appear to be finding other jobs quickly. That’s evident in the weekly data on initial jobless claims, which haven’t increased appreciably despite the technology and real estate layoffs.
Indeed, one benefit to the layoffs is that the released workers become available to other industries that are growing but have had trouble finding workers, such as defense.

U.S. Bank Regulation: Acting Comptroller of the Currency Michael Hsu warned that a bank is probably too big to manage effectively and should be broken up if it repeatedly fails to resolve longstanding deficiencies despite reprimands from its regulators and onerous restrictions such as caps on its growth. The statement highlights the increased regulatory and antitrust risk facing many industries under the Biden administration.

U.S. Investment Strategy: An interesting article in the Wall Street Journal describes how financial firms are currently in intense disagreement over the future of the “60/40” portfolio, in which 60% of assets are allocated to stocks and 40% to bonds. Although the 60/40 portfolio largely failed to protect its investors from big negative returns in 2022, its adherents maintain that it was a rare, one-off occurrence. Others believe a fundamental change may be in order, a viewpoint which we share, given the likelihood of a secular bear market in bonds and unusually good prospects for gold and other commodities. For example, a decent standard asset allocation going forward may allocate almost half the previous bond allocation of 40% to gold and commodities.

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Asset Allocation Bi-Weekly – The Master of Surprise (January 17, 2023)

Posted on January 17, 2023January 17, 2023 by Amanda Ahne

by the Asset Allocation Committee | PDF

[Note: The podcast that accompanies this report will be delayed until Friday, January 20.]

They don’t call Haruhiko Kuroda the “Master of Surprise” for nothing. The Bank of Japan (BOJ) Governor lifted the yield cap on 10-year Japanese government bonds (JGB) by 25 bps last month. The bank will now allow the 10-year yield to fluctuate between -0.50% and +0.50% before intervening in the market. The move jolted markets as it paved the way for possible future monetary tightening. Because Japan is the world’s largest creditor, an increase in Japanese yields could attract capital from abroad back to the mainland. As a result, the policy change could lead to an overall increase in borrowing costs for other countries, including the U.S., and could also affect exchange rates.

The JPY surged as much as 5% against the dollar on the day following the BOJ’s surprising decision. This was the JPY’s largest gain since the New York Fed and BOJ joined forces to prop up the currency in 1998. The rise in the currency reflects investor sentiment that the BOJ is getting ready to tighten its monetary policy. The central bank has intervened in bond markets to keep its bond-yield rates around 0%. Attempts by speculators to push the BOJ to adjust its policy prematurely have typically ended in tears as the bank defended its caps aggressively and burnished the short JGB trade as “the widow-maker” in the process.

Although the BOJ maintains that the move was not designed to alter future monetary policy, it is difficult to discern another motive. The latest meeting summary showed that BOJ officials raised their cap to address issues within their bond market. Days before the decision, a BOJ survey revealed that investors’ perceptions of bond market functionality fell to a record low. Additionally, the 10-year JGB failed to trade for four straight days at one point between the October and December meetings, signaling a decline in liquidity. However, the lack of telegraphing, especially given the bank’s sizable bond holding, suggests that the decision may have been more nuanced.

BOJ Governor Kuroda’s term ends on April 8. The two front-runners to succeed him are former BOJ Deputy Governor Hiroshi Nakaso and current Deputy Governor Masayoshi Amamiya. The latter is seen as more of a dove, but both are expected to tighten policy. By raising the yield cap, Kuroda gave his successor more wiggle room to navigate a way forward without rattling markets. The policy adjustment allows the future head of the BOJ to chart their own path forward without the cloud of their predecessor.

The biggest obstacle preventing further tightening is the country’s substantial debt burden. Japan has the largest government debt-to-GDP ratio among advanced economies at 206%. It has been able to manage this burden through its yield-curve control. Japan’s effective interest was 0.6% in 2021, much lower than many of its peers. In contrast, the effective interest rate on Italian debt was 2.3% in 2021, while the U.S. paid 1.6% during that period. Given the size of the debt, a small increase in interest rates could still lead to a sizable jump in debt payments. Although manageable in the long term, a 100-bps rise in interest rates would add 3% to the government debt-to-GDP ratio by 2025, according to Fitch Ratings Agency.

Higher interest rates in Japan could also lift borrowing costs for other countries. An increase in the yield on Japanese sovereigns incentivizes Japanese investors to bring capital home, leading to higher interest rates for the rest of the world. The U.S. is particularly vulnerable. Higher yields on JGB will attract interest from Japanese investors, who are the largest holders of U.S. Treasuries outside of America itself. As a result, the increase in Japanese interest rates could also lead to an increase in U.S. rates.

Although the markets anticipate that the BOJ will tighten policy more in 2023, they are not completely certain. We suspect that Japan’s decision to raise its yield cap by 25 bps had more to do with giving Kuroda’s successor more flexibility to conduct policy. That said, it appears that either candidate expected to take over, Hiroshi Nakaso or Masayoshi Amamiya, is likely to tighten. If correct, this should help boost financial sector equities internationally as it makes it easier for banks to profit from lending.

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Daily Comment (January 17, 2023)

Posted on January 17, 2023 by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with a slew of reports related to China and its recent shift toward supporting domestic economic growth and easing tensions with the West. We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including similarly important shifts in the economic policies of Japan and Europe.

Chinese Real Estate Industry: In the latest sign that Beijing has reversed its previous clamp down on the residential real estate industry, the government has reportedly drafted a 21-point action plan to aid embattled developers with 450 billion CPY ($67 billion) in financing. The plan would also include “reasonable debt extensions” for “high-quality developers.” The government hasn’t indicated which firms are eligible, but it appears the support will focus on large, nationally active, systemically important firms.

The new support programs for real estate developers suggest that China’s traditional growth-oriented, pro-Western policymakers have firmly taken control of the government apparatus. Other recent signs pointing in that direction include the dramatic relaxation of COVID-19 restrictions and conciliatory moves toward the West.
The reversal from the formerly hardline, ideological policies will likely lead to a temporary easing of U.S.-China tensions, a surge in optimism regarding China, and possibly a rebound in Chinese equity markets. The policy easing could also help rekindle Chinese economic growth, which came in at a very weak 3.0% in 2022, according to official statistics released today. We still believe U.S.-China relations will worsen over time, but the current reversal in Beijing’s policies could produce a short-term, investible pop in the value of Chinese risk assets.

Chinese Information Technology Industry: Despite the step-back from tough restrictions on the real estate industry and acerbic diplomacy against the West, other reporting indicates that the government has expanded its longstanding practice of taking 1% equity positions in key private firms as a way to exercise ongoing influence over them. These “special management shares” or “golden shares” typically come with a seat on the private firm’s board of directors and the right to control certain company decisions. This allows the government to wield power over it outside the regulatory regime.

A unit of the Cyberspace Administration of China has reportedly taken golden shares in a digital media unit of Alibaba (BABA, $117.01), along with a seat on its board, and it is reportedly preparing to take similar golden shares in Tencent (TCEHY, $47.79). Other Chinese tech firms that already have such golden shares include Weibo (WB, $20.69) and TikTok owner Bytedance (unlisted).
China’s shift from heavy-handed regulations and fines against its technology industry may look positive at first glance, but the increasing use of golden shares suggests that the step back from regulation is only a tactical adjustment. What we are probably seeing is that Beijing wants to take a kinder, gentler approach to its key real estate and technology industries, but without really losing control over them. Except for those who feel comfortable investing alongside the Chinese Communist Party, investors are likely to see that as a negative for these companies in the long run.

Chinese Population Growth: Today, the National Statistics Bureau said that the country’s population fell by 850,000 in 2022, marking its first decline in decades. That left China’s official population last year at 1.412 billion people.

Like many countries around the world, China’s extremely low birth rate is expected to lead to further headcount declines and worsening population aging in the future. Among the key implications, that means China’s workforce and available military manpower will also continue to decline.
Some countries are in relatively better shape, including India. In fact, India is expected to overtake China as the world’s most populous country later this year.

U.S.-China Geopolitical Competition: Swedish state-owned mining company LKAB announced that it has discovered a deposit of more than 1 million tons of rare earth oxides in the country’s far north. If confirmed, it would be the largest such deposit in Europe.

Rare earth minerals are essential to advanced technology products, and China and its evolving geopolitical bloc currently account for the big majority of the world’s proved reserves, production, and refining capacity.
When the Swedish deposit is eventually mined in a decade or so, it could help reduce the evolving U.S. bloc’s current dependence on China.

Global Automobile Market: Data providers LMC Automotive and EV-Volumes.com reported that global sales of fully electric vehicles surged to 7.8 million units last year, giving them at least a 10% market share for the first time. Fully electric vehicles made up 19% of all car sales in China, 11% in Europe, and less than 6% in the U.S. The rapid growth in the market underlies the rising demand for lithium, cobalt, and other exotic minerals that are especially important in the batteries of electric vehicles.

Japan: The Bank of Japan has begun its latest policy meeting, prompting concern that it could decide on a further loosening of its yield-curve control policy, as it did in December when it decided to let the yield on 10-year Japanese government bonds rise to 0.50%. So far this morning, 10-year JGB yields have moved slightly above that limit, pushing the JPY higher.

European Union: In another sign that the EU is taking up the mantle of industrial policy and the subsidization of its key industries, Competition Chief Vestager has sent a letter to EU finance ministers asking them to consider a new “temporary crisis and transition framework,” which would simplify state aid rules for green projects and renewable energy technologies. The new framework would be designed to compete with the $369 billion in new U.S. subsidies for green energy technology included in the Biden administration’s recent Inflation Reduction Act. European Council President Charles Michel has echoed the call for new EU industry support.

United Kingdom: The British train conductors’ union has voted to hold two more days of strikes early next month, prolonging the long wave of work stoppages among transportation and public services workers. Besides being disruptive to the economy, the wave of strikes continues to weaken the political position of Prime Minister Sunak and his Conservative Party.

World Economic Forum in Davos: The WEF is kicking off its winter conference today in Davos, Switzerland. After two years in which the in-person forum was canceled because of COVID-19, the event will be attended by hundreds of top political and business leaders from around the world. The forum typically produces a lot of interesting political, economic, and business news and commentary.

Russia-Ukraine War: Late last week, the Russian government stated that President Putin has named Gen. Valery Gerasimov as commander of the Russian forces in Ukraine, demoting the previous commander, Gen. Sergei Surovikin to the position of deputy commander. Since Gerasimov was probably heavily involved in overseeing the invasion, the decision is likely to have little appreciable effect on the war. In large part, naming Gerasimov as commander is likely meant to signal that the Kremlin has the war well in hand, despite financier Yevgeny Prigozhin’s effort to claim credit for the recent capture of Soledar, via his Wagner Group mercenaries. Prigozhin continues to disparage the Ministry of Defense and, by implication, Putin himself, likely in an effort to build political support for a potential future challenge to Putin.

Separately, the British government late last week confirmed that it will provide Challenger 2 battle tanks to Ukraine, marking one of the first commitments to send heavy armor to the Ukrainians.
The announcement is important because it is likely to encourage other NATO allies to provide main battle tanks to the Ukrainians, potentially providing a significant boost to the country’s ability to push out the invading Russians.

Peru: Protests against President Dina Boluarte and the ouster of former President Castillo continue to spread around the country. Indeed, the protests are intensifying and becoming more violent, prompting the government to declare a state of emergency in the capital Lima and several other regions.

U.S. Fiscal Policy: On Sunday, newly elected Speaker of the House McCarthy said he would negotiate with President Biden over raising the federal debt ceiling of roughly $31 trillion, which the government is expected to hit this week, but he insisted that the talks include spending cuts. With Democrats insisting that federal programs continue to be funded at least at current levels, the statement illustrates the risk of an impasse, potentially leading to a partial government shutdown or even a debt default, as the government runs out of work-around measures later this year.

U.S. Winter Storms: California was hit by yet another big round of rain and snow storms on Monday, and a smaller set of storms in the middle of this week is now expected to mark the end of a period of intense precipitation. Although the storms have caused widespread death and destruction, they have also helped alleviate the state’s recent intense drought. That could potentially be a boon for California’s important agriculture sector, help bring down produce prices, and modestly reduce inflation pressures.

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Daily Comment (January 13, 2023)

Posted on January 13, 2023January 13, 2023 by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Today’s Comment begins with a discussion on whether the Fed is close to ending its rate-hiking cycle. Next, we explain why changes to Japan’s controversial yield-curve-control policy pose a risk to the international financial system. The report ends with our thoughts on the state of the global economy.

Is the Fed Finished? Investors and policymakers are growing confident that inflation is on the right path; however, the two groups disagree about when tightening will end.

The latest CPI data showed that inflation is continuing to decelerate. Consumer prices rose 6.5% from the prior year, the slowest increase since October 2021. The easing of price pressures has added to the speculation that the Fed will reduce the size of its rate hike to 25 bps at its next meeting in February, with some investors pricing in a pause for March. That said, Fed officials insist that the central bank is not finished. St. Louis Fed President James Bullard insists that the Fed quickly raise rates above 5%, while Richmond Fed President Thomas Barkin urged the central bank to be deliberate in its next rate increases.
The market responses to the data were relatively mixed. U.S. Equities whipsawed but ultimately closed higher. Meanwhile, the U.S. dollar index dipped, and the ten- and 2-year bond-yield spread narrowed. The overall mood of investors appeared to be bullish for stocks as traders now believe that the Fed is nearing the end of its tightening cycle. After the report, swaps signaled less than 50 bps of tightening over the next two FOMC meetings, a sign that investors believe the next hike could be the last one.
It is unlikely that the Federal Reserve will pause rate hikes before lifting its policy rate above 5%. If 2022 serves as a guide, the Fed will lift rates whether markets like it or not. Recent comments from Fed Chair Jerome Powell reinforce this belief. On Tuesday, he warned that the central bank is prepared to raise rates despite political pressures to stop. We suspect that the Fed views the tight labor market as evidence that it can raise rates even during a recession. Thus, market bets of an imminent pause may be short-sighted while inflation remains well above the Fed’s 2% target.

JGB Headaches: The Bank of Japan continues to deal with the fallout after it widened the target range for yields on 10-year bonds.

The announcement that the BOJ will review the side effects of its ultra-loose monetary policy has led to speculation that it could end yield-curve control (YCC). On Friday, the central bank vowed to intervene in markets after traders pushed the yield on the 10-year JGB above the 0.50% target. The jolt in yields was related to a Citigroup report which predicted that the bank could abandon YCC as soon as next week. The added pressure for the BOJ to pivot away from its ultra-loose accommodative policy has boosted the JPY. The currency has now surged more than 3% against the dollar since January 11.
Although the BOJ has consistently maintained that its decision to widen the target range on 10-year bonds was to improve market functionality, traders have interpreted the move as a sign that it was preparing to tighten policy to address rising inflation. As a result, the bank may be forced to delay ending YCC until markets are calmer.
The market rout in Japan poses a risk to the global financial system. The country’s low-interest rates and cheap currency have made it attractive for investors to generate arbitrage profits, known as the yen carry trade. In this situation, investors borrow in one currency and invest the money into high-yielding assets in another currency. As a result of the JPY’s relative weakness against the dollar, it was used as the go-to funding source for cross-border lending, and, therefore, a sharp appreciation in the currency will make it more expensive for borrowers to make debt payments.

The fight against inflation has made the market very sensitive to changes in monetary policy. Hence, central banks and governments must be mindful of major policy changes as they could create a financial crisis. The international financial system narrowly avoided a blowup last year following the release of former U.K. Prime Minister Liz Truss’s disastrous mini-budget.
- As previous reports mentioned, we suspect a U.S. recession is imminent but will likely be of the garden variety. However, a financial crisis, housing market crash, or major geopolitical event could cause a severe downturn.

Recession Receding: There is growing optimism that the global economy is positioned to bounce back from its slowdown.

The IMF believes that the global economy may have averted a recession but has warned that the situation is still fragile. Warmer-than-expected weather helped cushion Europe from the worst of the effects from the war in Ukraine. The better temperatures have meant that EU countries have not needed to use much of their energy inventory through the winter thus far. As a result, Europe has been able to avoid a possible energy crisis. The U.K. also appears to be on better footing. The latest GDP figure showed that the economy grew in November, suggesting that the U.K. avoided a recession toward the end of 2022.
China still poses a risk to the global economy. The latest trade figures from the country showed that exports fell 9.9% in dollar terms from the previous year, while imports fell 7.5% in the same period. The sharp drop in foreign and domestic sales reflects the devastating impact that Zero-COVID has had on demand and production within the country. Although there is much optimism that the country’s reopening will help lift world GDP growth, the chaotic transition away from these restrictions threatens to undermine the confidence of the Chinese consumer, which could crimp future spending.
- Chinese Lunar New Year should provide insight into the psychological impact that the transition has had on consumers. A jump in spending will be a positive sign for the global economy.
Despite the upbeat outlook on the global economy, it is important to remember that many countries will likely face economic contractions this year. The length and severity of the downturns depend on the cause of the contraction. A major unknown is whether central banks will tighten during this period. Policymakers from the European Central Bank, Federal Reserve, and the Bank of England have held steadfast to the idea that increasing rates in a downturn is not out of the question. However, markets have doubts as to whether these officials are serious. As a result, investors should still be vigilant of sudden market changes.

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Daily Comment (January 12, 2023)

Posted on January 12, 2023January 12, 2023 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 Consumer Price Index report and its implications for Fed policy. Next, we discuss the impact that China’s reopening is having on markets. The report concludes with our thoughts on Germany’s response to the U.S. climate-change subsidy initiative.

Inflation Nation: The CPI report will bolster expectations that the Fed will moderate monetary policy this year.

The December inflation report has bolstered expectations that the Fed will reduce the size of its rate hike at its next meeting. Last month, headline CPI rose 6.5% from the prior year. The increase was in line with expectations and below the previous month’s report of 7.1%. The cooling of inflation will give the Fed some flexibility if it decides to slow the pace of interest rate hikes. On Wednesday, Boston Fed President Susan Collins, a voting member, mentioned that she favored a 25 bps hike in February. Meanwhile, Fed Chair Jerome Powell’s lack of clarity on rate policy reinforced investor sentiment that he may favor a downshift in rate rises.
Although the Fed is considering moderation in its policy, other central banks are hesitant to follow suit. European central bank official Olli Rehn insisted that the ECB needs to raise rates significantly in its next meeting to contain inflation. His French counterpart Francois Villeroy also mentioned the importance of raising rates into restrictive territory. In Japan, a review of the central bank’s ultra-easy monetary policy has led to speculation that the Bank of Japan could make another adjustment to its yield-curve-control ban. The reluctance to moderate policy in Europe is related to inflation being well above U.S. levels; meanwhile, rising inflation in Japan may force the bank to tighten.
- The combination of BOJ tightening speculation and Fed moderation has led to a strong uptick in the JPY.
A moderation in the Fed’s monetary tightening will allow other central banks in the developed world to close the interest gap with the U.S. The rise in rates in Europe and possibly Japan will put downward pressure on the greenback. If true, international equities could provide attractive opportunities. Additionally, a consistent deceleration in inflation suggests that the Fed may be able to pull off the elusive soft landing.

China’s Back: There is much anticipation regarding the reopening of the Chinese economy, but the lack of COVID data may be a problem for markets.

Commodity prices are surging due to expectations that the end of China’s Zero-COVID restrictions will boost global demand for materials. On Wednesday, copper prices soared to $9000 a ton, its highest level since June 2022. The rampant rise in the metal is due to hopes that the increase in economic activity in China will boost global growth. Oil prices had a similar bounce as the price of crude jumped 3% on Wednesday, despite a strong build-up in U.S. inventories. It is now expected that Brent could hit $110 a barrel by the third quarter when China and other Asian economies fully reopen.
- The optimism has boosted Chinese equities. Year-over-year performance of the MSCI China Price Index has now surpassed the S&P 500.

Despite the improvement in market sentiment, the lack of infection data from China is troubling. Beijing has not updated its daily COVID reports for three days. Although the reduction of tests rendered the data mostly meaningless, the lack of transparency is feeding concerns that the spread of the virus may be worse than the government originally anticipated. One hospital in China reported that half of its 2000 workers were infected with the virus. Meanwhile, local officials in Henan, the country’s third most populous province, revealed that over 90% of the region had been infected. The mystery behind the scale of the spread has led neighboring countries to push for more testing for tourists leaving China.
A severe outbreak is potentially detrimental to the global economy. A major unknown is how the recent rise in infections could impact consumer psychology. Although it is tempting to believe that things will return to normal after the recent wave, there is also the possibility that people will be much more cautious, particularly when it comes to services. Hence, the recovery may not be as robust as the current market pricing suggests. Spending during the Lunar New Year will likely provide insight as it is one of the year’s biggest shopping periods for China. A sharp increase in sales should boost optimism about China’s recovery.

Berlin Shrugs: Germany may be more open to allowing the U.S. to implement its climate-change subsidies than its comments suggest.

The European Union is moving to compete against the U.S. in the green energy race. German Chancellor Olaf Scholz is pushing for the EU to create financial instruments to make it easier for countries to provide incentives for green investment. Although Scholz did not explicitly call for EU bonds, he did advocate for joint financing instruments to help budget-strapped countries. The call was in response to the U.S. act that gives tax credits to consumers who buy electric cars made in North America. If the EU were to follow through on the initiative, it could pave the way for stimulus throughout the bloc.
The possibility of a joint EU venture reinforced investor optimism that a recession within the region will not be as severe as originally thought. The gap between Italian and German 10-year bonds, a gauge of European financial stress, has shrunk by 53 bps to start the year. Meanwhile, the EUR has surged to parity with the CHF and has been able to hold its value against the USD. The improved outlook has encouraged investors to pour in half a trillion dollars to purchase European bonds, suggesting strong demand for more European assets. However, despite Scholz’s tough talk, we are not confident that he is serious about a push for EU-wide investment.
Although Scholz’s proposal suggests that he supports a pro-European stimulus package, it isn’t clear if it is a genuine plan. In theory, Germany could implement a similar policy unilaterally without EU consent as it did with its controversial energy subsidy. Its unwillingness to do so suggests that it is ambivalent toward the U.S. incentive program. If true, this may disappoint the Biden administration as we suspect it wants the EU to implement a stimulus program supporting European firms. In our view, Washington believes that with increased state action, the EU could become less dependent on China.
- That said, if Scholz follows through on the proposal, the EU will likely create a plan that favors lending and subsidizing firms. This scenario would benefit European equities; however, such a plan could take months or maybe years to implement.

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