Author: Amanda Ahne

Daily Comment (October 21, 2022)

Posted on by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment discusses how Brexit may have paved the way for Liz Truss’s brief stint at Downing Street. Next, we explain how the Fed’s monetary policy has forced central banks to accumulate greenbacks. Lastly, we conclude with an overview of countries adapting to the security threats posed by Russia and China.

 Now What? Liz Truss’s quick rise and fall in the U.K. may serve as a cautionary tale for other countries looking to exit from the European Union.

  • The race to succeed Liz Truss as prime minister of the United Kingdom has commenced. The front-runners include previously ousted Prime Minister Boris Johnson, ex-Chancellor of the Exchequer Rishi Sunak, and Leader of the House of Commons Penny Mordaunt. Given the previous prime minister’s reckless fiscal policy, the markets will be hesitant to trust any new leader. So far, British bond yields have surged from Thursday’s low, while the British pound has dipped to $1.11. The new leader is expected to be picked by next week.
  • The new prime minister will be the country’s fifth since the 2016 Brexit vote. After leaving the EU, the U.K. has not been able to establish its post-EU identity. The Theresa May government sought to blend pro-remain and pro-Brexit ideals, while Boris Johnson ran promoting a nationalistic agenda, and the short-lived Liz Truss wanted to bring back Thatcherism. The frequent shifts in identity show that the country is still unsure of how it will fit into the world separate from Europe. As a result, investing in the U.K. may be difficult as it isn’t clear what direction the country will go in the next five years.
  • The swift market backlash that the U.K. faced following its decision to abandon economic fundamentals could lend to more support against an EU breakup. Consistently, Eurosceptics have argued that leaving the EU will prevent the need for draconian policies in favor of pro-growth policies. The recent selloffs in the British pound and bonds contradict these claims. Although this may not be enough to prevent Eurosceptics from complaining about the EU, it should be easier for the EU to push through free-market reforms in countries like Italy.

Central Bank: U.S. monetary policy has pressured central banks to hoard USD.

  • The Federal Reserve’s hawkishness continues to grow as the central bank is determined to prove its inflation-fighting credentials. New Fed Governor Lisa Cook and Philadelphia Fed President Patrick Harker warned markets that the central bank is prepared to lift rates above restrictive territory and keep it there for some time. Investors responded to the remarks by placing bets that the Fed will raise its benchmark rate to 5% next year, which is 50 bps higher than median fed funds in the latest dot plots. That said, we think the talk is cheap. The Fed has not demonstrated that it can withstand the public scrutiny of raising rates during a recession. Thus, the Fed may pause sooner than the market realizes.
  • The Bank of Japan is determined to squash speculators betting against its currency. The central bank signaled that it would intervene in FX markets for the first time since 1990 to prevent the yen from weakening further against the dollar. Currency chief Masato Kanda warned that the bank has limitless resources to protect the yen. As the largest holder of U.S. Treasuries, we suspect the bank could liquidate its holding to prop up the currency. Although this would be a temporary fix, the move would be another example of how reluctant the BOJ is to remove monetary accommodation to combat inflation.
    • The sale of U.S. Treasuries can lead to complications in the international banking system. For example, central banks’ usage of the Overnight Reverse Repo Facility retreated to $330 billion in the period ending October 19, down from an all-time high of $333 billion. The drop suggests that foreign central banks are withdrawing some of their cash holdings at the New York Fed. The lack of cash could make it harder for repo transactions to take place for financial firms facing a liquidity crunch.
  • To accommodate the need for greenbacks, the Federal Reserve set up a series of USD swaps with its prominent central bank counterparts. The Fed will give the swap lines to the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, and the Swiss National Bank. The measure should help alleviate liquidity problems abroad as banks cope with tighter financial conditions. Although this is a positive step forward, we still believe that the international banking system may be susceptible to runs in the event of a financial crisis.

The Geo-Poly Shuffle: Threats from Russia and China have forced Western countries to rethink their alliances.

  • The U.S. is one step closer to removing sanctions on Venezuelan oil. The political opposition in Venezuela has discussed plans to wind down its support of Juan Guaidó’s claim of being the country’s legitimate leader. The move could pave the way for Maduro’s government to sell its crude overseas again. Venezuela has an oil production capacity of 1 mbpd. The U.S.’s decision to work with an authoritarian government suggests it feels pressure to fill the supply gap left by Russia.
  • Japan and Australia will discuss improving defensive ties as they look to counter China’s influence throughout the Indo-Pacific. Beijing’s increased assertiveness over the South China Sea and Taiwan has made the partnership vital. The countries plan on sharing military intelligence and working on joint projects to build wartime technology. Tensions in the Pacific have been overshadowed by the war in Ukraine, but we believe that a conflict could break out within this region in the next five to ten years. Fighting in the area can potentially disrupt over $5.3 trillion of annual global trade. Hence, investors should be sensitive to any hostilities within the region.
  • The Ukraine war continues to cause divisions within the European Union. Although the countries could agree to gas-price caps, it will not come easy. Germany, probably the most dependent on Russian energy, has decided to drop their opposition to the cap, albeit while kicking and screaming. However, the lack of unity around this issue shows that the members may not be fully cohesive in their efforts to cut themselves off entirely from Russia.

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Daily Comment (October 20, 2022)

Posted on by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment begins with our explanation as to why unorthodox policies can lead to currency weakness. Next, we discuss how the possibility of a withdrawal of Western support could help end the war in Ukraine. We end the report with our thoughts on rising inflation’s impact on earnings and its implications for economic growth.

 It’s the Economy: Japan and the U.K. are facing backlash as the countries’ unorthodox policies continue to stir controversy.

  • U.K. Prime Minister Liz Truss was forced to resign from her position on Thursday. Truss’s failed attempt to push through a controversial set of tax cuts designed to stimulate the economy has led her party members to question her leadership. Her removal from office led to a rally in the pound, but we suspect that uncertainty over her possible replacement could lead to a reversal. Additionally, another reshuffling of the party’s leader may erode Tory support among the general populace. The resulting chaos has led rival parties to call for new elections. The latest polls show that the Labour party would be heavily favored if there were another election.
  • The 10-year yield on Japanese Government Bonds exceeded the Bank of Japan’s target on Thursday, forcing the bank to intervene. The BOJ offered to buy an unlimited amount of 10-year notes at 0.25%. The surprise action helped push the yen to 150 per dollar, a multi-decade low. It is unclear whether the Bank of Japan will end its ultra-low policy accommodation; however, it is becoming clear that the market believes it has no other choice.
  • Market pushback against Japan and the U.K. may explain why central banks may be hesitant to end policy tightening prematurely. As the impossible trinity shows, a central bank has three policy options: fixed exchange rate, sovereign monetary policy, and free capital flow, but it can only choose two. Because Japan and the U.K. have decided to maintain the latter two, they are forced to grapple with sudden changes in their exchange rates when they go against the market. This problem is particularly an issue as the Fed raises rates because it gives investors a higher-yielding and safer alternative. As a result, we suspect global tightening will likely continue as long as the Fed feels it is appropriate to continue raising rates.

 Higher Prices, Higher Profits: Rising inflation has helped boost earnings; however, this trend is unlikely to last forever.

  • High inflation figures in the U.K., Canada, and the Eurozone suggest more global monetary tightening is on the way. The September Consumer Price Index rose 10.1% from the prior year in the U.K. and 6.5% for the same period in Canada. Meanwhile, the revised CPI report for the Eurozone showed prices rising 9.9% since September 2021, down 0.1% from the previous report. The persistent inflationary pressures will force central banks to raise rates to restore price stability. These three countries control half of the world’s six most traded currencies. As a result, foreign countries that repay debt using these currencies could see their interest payments increase due to the fluctuation in exchange rates.
  • U.S. firms still have significant pricing power. On Wednesday, consumer goods companies Procter & Gamble (PG, $130.14) and Nestle (NSRGY, $105.70) posted better-than-expected earnings thanks to price increases. These companies’ ability to push costs onto consumers suggests that inflation may be stickier than initially thought. This relationship is exemplified when comparing the prices paid by retail producers for food and alcohol and the prices paid by consumers for the same goods. We expect that the economic slowdown and margin contraction will not sustain the current price trend. Thus, we do believe that inflation could be heading down faster than most investors realize.

  • As inflation becomes more of a problem, central banks will respond by raising rates. The Federal Reserve has already increased its benchmark rate by 300 bps this year and could hike it by at least another 100 bps by December. Although the Bank of England and the European Central Bank have not tightened as aggressively as the Fed, both banks are expected to have similar hikes. Moreover, tightening financial conditions will worsen the economic slowdown and hurt company profits. We believe that as global growth slows and inflation remains high, it will be favorable for commodities.

Under Pressure: Despite Ukraine’s recent successes on the battlefield, it is now facing political headwinds from the West.

  • As the U.S. prepares for midterm elections, Kyiv frets over whether it can rely on American aid to sustain its war efforts. On Wednesday, House Minority Leader Kevin McCarthy warned that if Republicans take over the House, Congress will not write Ukraine a blank check to help fight its war. This message caught many Ukrainian officials off-guard as it had received previous assurances from the lawmaker that nothing would change if Republicans won. The lack of U.S. support will make it difficult for Ukraine to maintain its current momentum. As a result, Ukraine forces may look to consolidate their territorial gains now.
  • Meanwhile, energy supply constraints could weaken the European Union’s support for Ukraine. In Italy, the likely new Prime Minister Giorgia Meloni is expected to navigate the EU’s third-largest economy away from the economic abyss. Although she favors aiding Ukraine in its war efforts, her likely coalition partners, Silvio Berlusconi and Matteo Salvini, do not, especially if it means no Russian gas for Italy. The lack of unity around this issue suggests that Italy may not be much help to Ukraine.
    • The German Chancellor Olaf Scholz expressed concern over implementing an EU-wide cap on gas prices. He warned that the plan could backfire. Although not a surprise, given Deutschland’s dependence on Russian energy, his comments reflect a growing hesitancy among EU members to support Ukraine.

In short, an indefinite war for Ukraine may be out of the question. If it wants to continue fighting, it needs to tighten its fiscal belt now because it cannot rely on the West’s support in the future, especially as these countries head toward recession. That said, there is a silver lining. Ukraine could be forced to the negotiating table next year, in which it may have to accept some territorial losses in order to maintain its sovereignty. If we are right, the situation could pave the way for Russian commodities to enter the market, thus providing much relief for struggling countries. At the same time, EU energy consumers can never look at Russian supplies the same way again. Even if Russian oil and gas returns to Europe, there will still be an incentive for redundant supply sources. It would not be inconceivable to see quotas on Russian oil and gas flows. Thus, even if the hostilities end, the reverberations will continue.

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Weekly Energy Update (October 20, 2022)

Posted on by Amanda Ahne

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

Crude oil prices remain in a downtrend as concerns about global growth, especially with China, are weighing on prices.

(Source: Barchart.com)

Crude oil inventories fell 1.7 mb compared to a 2.0 mb build forecast.  The SPR declined 3.6 mb, meaning the net draw was 5.3 mb.

In the details, U.S. crude oil production rose 0.1 mbpd to 12.0 mbpd.  Exports rose 1.3 mbpd, while imports fell 0.2 mbpd.  Refining activity fell 0.4% to 89.5% of capacity.  We are approaching the end of refinery maintenance season, which means oil demand should begin to rise soon.

(Sources: DOE, CIM)

The above chart shows the seasonal pattern for crude oil inventories.  As the chart shows, we are past the seasonal trough in inventories.  The build seen from October into November is usually strong due to refinery maintenance.  With the SPR withdrawals continuing, the seasonal build has been exaggerated this year.

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.

Total stockpiles peaked in 2017 and are now at levels last seen in 2003.  Using total stocks since 2015, fair value is $105.59.

 Market News:

  • In a widely anticipated move, Germany has extended its use of nuclear power plants into next April.
  • Although the actual cuts in production from OPEC+, as we noted last week, won’t be as dire as the headlines suggest, it will still remove some barrels from the world’s oil supply. Unfortunately, the U.S. won’t be able to fill the gap, despite rising production in the Permian.
  • As world trade flows for energy adjust, Europe is moving away from Russia as an energy supplier and working to establish new flows with other nations. The U.S. has become an important supplier and so has Qatar.
    • Currently, Russia is supplying the EU with about 0.6 mbpd of crude oil. Those flows will be cut off on December 5. Not only will the EU stop importing Russian oil, but European insurance firms will no longer be able to underwrite cargo insurance for oil tankers.  Without this insurance, the costs of Russia shipments will soar because some of the key chokepoints won’t allow vessels to pass without this insurance.  It is not obvious, as we note in the above bullet point, where this crude will come from.  This is where the price cap idea comes into play.  If a buyer were willing to pay less than the cap, insurance would be provided.  Of course, the opposition of OPEC+ to the price cap was likely part of the reason to cut production targets.
      • Interestingly enough, Indian refiners, who have been large buyers of Russian crude oil, have suspended purchases until clarity is provided on how the EU sanctions will work.
    • One potential place for the EU to purchase oil would be from the U.S. SPR. However, some members of Congress are pushing for a bill that would ban the export of SPR crude oil.  However, this action would contradict the original SPR measures created by the IEA.  Under IEA rules, in a global emergency, national SPRs could be under the IEA’s jurisdiction.  The goal of the SPR is to discourage hoarding.  If we were to see national governments prevent the export of SPR oil, it is quite likely that global oil prices would soar.  If this bill gains traction, it could cause further disruption to global oil markets.  However, we could also see a situation where SPR oil would simply displace the domestic oil that would have been exported instead.
    • On the topic of the SPR, the Biden administration has announced additional sales, although the announcement did cause some confusion. There is about 15 mb of sales left in the original announcement and 26 mb scheduled for release next year (as part of a budgetary agreement), but the administration is worried about high gasoline prices and has suggested even more could be sold from the reserve.
      • As we noted in earlier reports, the administration seems to be moving the SPR from a strategic reserve to a buffer stock. Buffer stocks have been used in commodity markets before, with the goal being to stabilize prices.  The trick to managing the stock is getting the price right (which begs the question:  why bother?). Set it too low, and the stock becomes exhausted.  Set it too high, and it becomes too large.  When first floated, the administration suggested $80 as a baseline to begin buying oil.  That has now fallen to a range of $67 to $72.  We don’t expect that ANY oil will be bought by this administration as there does not seem to be a price that is politically low enough.
    • The EU has been able to build natural gas inventories, in part, because weak Chinese demand for LNG has allowed for shipments to be diverted. China is signaling this diversion will end, although Chinese demand is expected to remain sluggish.  China is also indicating that it will increase its energy reserves as winter approaches.
    • As the EU attempts to shift its natural gas supply away from Russia and to LNG, it is finding that bottlenecks at terminals are becoming a problem.
    • The EU has generally been unable to craft a functioning price cap for natural gas, so the group is trying to create other measures to bolster available supply.
    • To a great extent, the world’s energy situation is dependent upon the weather.
  • The DOE has issued estimates for this winter’s heating costs, and although natural gas remains the cheapest source of heating, it is poised to have the fastest price increases.
  • Although crude oil inventories appear adequate, the situation in diesel fuels is a growing concern.

(Sources:  DOE, CIM)

  • Diesel fuel is often used for emergency electricity generation, and so, if there are disruptions in electricity this winter, demand could rise into a tight market which will then lift crude oil prices as well.
  • One of the factors that has reduced U.S. crude oil production has been the demand from investors that companies focus on profits and returns to shareholders. This desire is partly driven by the ESG movement and the fears that peak oil demand is near.  If oil and gas are going to be industries in decline, then shareholders will tend to focus on near-term returns.  In terms of net-zero promises, there is evidence to suggest that publicly traded firms are more sensitive to such goals than are private firms.  It appears that such pressures are leading Harold Hamm to take Continental Resources (CLR, $73.68) private.
  • Prime Minister Truss of the U.K. has essentially lost control of her government after proposing a radical economic program that the financial markets fundamentally rejected. The new Chancellor, Jeremy Hunt, has reversed nearly her entire fiscal package.  Part of the original package was massive support measures to protect businesses and consumers from higher energy prices.  The original bill was expected to cost £60 billion and its generosity was part of the reason that the financial markets panicked.  However, in walking back the package, Hunt didn’t offer a replacement to protect less affluent households that may be at risk due to higher prices.

Geopolitical News:

  • Mohammed al-Sudani has been appointed to be the new prime minister of Iraq. It is unclear how long he will be in office because he is not popular with the al-Sadr faction.
  • Last week, Saudi Arabia argued that its decision to support a cut in oil production targets was based on market concerns and was not done to support Russia. The U.S. has dismissed the explanation as “spin.”
  • Russia is proposing to make Turkey a hub for natural gas transfers. Although clearly attractive for Turkey, we doubt the EU would see this as a viable alternative.  It might not help Russia either, because if Iran ever normalizes relations, Turkey could be a conduit for Iranian gas as well.
  • Exxon (XOM, $101.23) announced that it has fully withdrawn from Russia after accusing Moscow of “expropriation.” The charge could signal that the company is planning to sue Russia over its exit.
  • Unrest and atrocities continue in Iran. Recently, there was a fire at the infamous Evin prison which houses dissidents and political prisoners.  It appears that the fire was related to recent national protests.  There is a general question about the stability of the regime, and one of the keys to watch for is if the security services turn on the government.  There is little evidence that that most potent Iranian forces have joined the protesters.
  • Iran’s support for Russia’s war effort has triggered a response from the U.S. Washington is planning various penalties against Iran that could target third parties.
  • In France, protests against high fuel prices have evolved into complaints about inflation in general.

 Alternative Energy/Policy News:

  • One of the more controversial issues in environmentalism is geoengineering. As defined, these are various technologies designed to offset some environmental ill. Trees, for example, can be used to reduce CO2.  However, some measures that would reflect sunlight out into space in order to keep the planet cool could raise fears concerning unexpected side effects such as changing rainfall patterns that could then create distributional or geopolitical concerns.  And so, these worries have tended to dampen investment in such technologies.  However, the White House has announced a five-year research study on geoengineering to investigate its various technologies.
  • CO2 emissions growth looks set to unexpectedly slow this year after declining global growth.
  • Financial analysts argue that there is ample liquidity available for the private sector to fund alternative energy. However, the bulk of this investing power is in the energy and mining sector, which may not be keen on investments that will harm its basic industry.
  • At the CPC conference, General Secretary Xi said China would not “rush” its clean energy transformation, likely meaning that fossil-fuels consumption will remain elevated.
  • Although there is a wide debate over climate change and its effects, one area where the impact is quantified is in insurance. The insurance industry and the Treasury are analyzing climate risk, which may result in some areas paying much more for coverage.  Insurers are pushing back against the government’s investigation.
  • The SEC is pressing publicly traded firms for information on climate issues. Lobbying efforts to shape regulation are increasing.
  • Russian drones have attacked an important sunflower oil terminal in Ukraine. Although this attack will obviously affect the world supply of edible oils, it may also have an impact on biofuels.
  • Although starting from a low base, carbon capture project activity is increasing rapidly.
  • We are also starting to see increased investment in green hydrogen projects.

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Daily Comment (October 19, 2022)

Posted on by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with an update on the Russia-Ukraine war, including reports that Iranian military personnel have been deployed to Russian-occupied Crimea to help Russian forces operate their Iranian-supplied drones.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including news that the Biden administration is planning further sales of crude oil from the country’s Strategic Petroleum Reserve in a bid to hold down energy prices.

Russia-Ukraine:  As Russian forces remain under pressure in both the northeastern Ukrainian region of the Donbas and the southern region around Kherson, they continue to strike back with waves of missile, air, and kamikaze drone attacks on Ukraine’s civilian infrastructure.  New reports indicate that members of Iran’s Islamic Republican Guards Corps have deployed to Russian-occupied Crimea to either advise the Russians on how to make better use of their Iran-supplied drones or to operate those drones themselves.  The presence of the Iranians illustrates how the war could potentially widen over time.  Indeed, some European officials have already called for tougher sanctions on Iran because of its support for Russia (the situation is also rapidly pushing European officials toward giving up on re-instituting the 2015 deal limiting Iran’s nuclear program).  A Ukrainian strike on Crimea that killed IRGC members could be especially dangerous since it could encourage even greater Iranian involvement in the conflict.

Global Energy Market:  Spot rates for liquified natural gas tankers have risen to yet another record this week of approximately $450,000 per day, compared with a range of just $30,000 to $300,000 in 2021.  The jump in rates illustrates how the energy-supply disruptions from the war in Ukraine have increased demand for LNG.  Spot rates for LNG tankers are expected to keep rising during the winter.

United Kingdom:  As shown in the data tables below, the U.K.’s September consumer price index was up 10.1% year-over-year, accelerating from the 9.9% increase in the year-to-August and matching the highest rate in four decades.  After stripping out the volatile food and energy components, the September Core CPI was up 6.5%, accelerating from a 6.3% rise in the year-to-August.  The re-acceleration in inflation ensures that the Bank of England will implement another big interest-rate hike at its next policy meeting in November.

China-United Kingdom-Australia:  The British and Australian militaries are both investigating reports that some of their former air force pilots were offered lucrative financial deals to teach Chinese pilots how to fly western attack aircraft.  The approaches were made through a flight school based in South Africa.  According to a British official, some serving pilots were also solicited.  The incident suggests China is looking for ways to better understand and learn Western war-fighting skills as it ramps up its own military forces.

China-Taiwan-Japan:  The world’s most important manufacturer of advanced computer chips, Taiwan Semiconductor Manufacturing (TSM, $63.71) is reportedly considering expanding its fabrication capacity in Japan to reduce its geopolitical risk.  As we have long highlighted, the company is at risk as China puts increasing political, economic, and military pressure on Taiwan to reunify with the mainland.

  • The company has already begun building new capacity out of harm’s way, including in the U.S.
  • The latest reporting suggests that the company will continue to diversify its production capacity in the future.

Turkey:  To bolster his chances for re-election in an upcoming poll, President Erdoğan has launched a $50-billion, state-subsidized housing construction program for lower income citizens.  More than seven million have already signed up for the new housing units.  Of course, the increased spending will likely exacerbate Turkey’s sky-high inflation and put further downward pressure on the lira.

U.S. Energy Market:  Today, President Biden plans to announce that the Energy Department will sell the last 15 million barrels of crude oil out of the 180 million barrels he authorized for sale from the Strategic Petroleum Reserve in March.  He will also direct the Energy Department to prepare for more sales from the approximately 400 million barrels left in the reserve if Russia or other petroleum-producing nations continue to disrupt world markets.  The sales to date have helped push down prices for gasoline, diesel, jet fuel, and other petroleum products that had been driven up by supply shortages related to the war in Ukraine.

U.S. Labor Market:  Workers for Amazon (AMZN, $116.36) in upstate New York voted against unionizing, despite a successful unionization vote at an Amazon facility on Staten Island earlier this year.  Even though the tight U.S. labor market has generated successful unionization drives at a range of service companies recently, the Amazon vote shows that the trend isn’t universal or set in stone.

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Keller Quarterly (October 2022)

Posted on by Amanda Ahne

Letter to Investors | PDF

Summer has concluded and we’re starting to feel the chill of winter.  For reasons that I’ve never fully understood, the stock market “feels a chill” this time of year also.  More often than not, September produces a negative return for U.S. stocks, and this September was no exception.  For some reason, investors come back from their vacations and decide to sell stocks.  October is only a little better.  The market’s seasonality is not as regular as a farmer’s planting and harvest cycles, but it usually returns annually.  Savvy investors have known for generations that this time of year presents bargain prices that other seasons often do not.

Of course, this season’s downtrend wasn’t just due to turning the page on the calendar, but to expectations that the Fed will induce a recession.  We talked at length about this in our July letter. The Fed has few tools to fight inflation and most of them risk a recession.  To make matters worse, the current Fed previously guessed that inflation wouldn’t be too bad or long-lasting (“transitory,” they called it), so they left rates unusually low (near zero) for a very long time.  By the time they discovered they were wrong, inflation was raging and they felt it necessary to raise rates dramatically and quickly, further adding to the risk of a recession.

Last quarter we indicated that we thought it unlikely the Fed could rein in inflation without causing a recession.  Three months later, it now seems that a recession is likely.  Recessions have been rare over the last three decades, the result of very low inflation that allowed our central bankers to keep rates low.  But we believe the rise of persistent inflation will make recessions more frequent.  A recession two or three times a decade is actually much more common in financial history than the once-a-decade recession occurrence we’ve recently seen.  Investors who are not accustomed to this frequency regard recessions as cataclysmic as earthquakes or alien landings, but this is not the case.  We tend to look at recessions the same way farmers look at spring thunderstorms: nasty, but not unexpected.  They’re entirely manageable if you prepare for them.

Fear grips many investors as a recession nears, but, as we pointed out in July, strong companies often get stronger during a recession.  Yes, their profits may decline for a few quarters, but their competitors are often hurt more during a recession, leaving the stronger company in a better competitive position.  Additionally, the lower stock prices that cyclical bear markets produce mean that such periods are often the best times for long-term investors to be buyers of high-quality stocks.

Longer term, we do not believe inflation is temporary.  We believe the strong disinflationary trends of globalization and deregulation have peaked during the last decade.  We expect that globalization will continue to recede and that regulation of businesses will increase.  Inflation creates special problems for investors.  It is a silent financial thief, reducing the value of the cash an investor expects to receive in future years.  Our portfolios are structured for long-term inflation because we believe that, even if we have a recession that reduces inflation, it will return quickly in the recovery thereafter.  Inflation is a headwind, yes, but many companies are in a better position to deal with it than others, and these are the centerpieces of our equity portfolios.

I’ve received more questions about bonds this year than I have in decades.  Specifically, investors are surprised that bond prices have dropped at the same time as stocks.  In most recessions over the last 30 years, quality bonds rallied when a recession approached.  It’s different this time and for a single reason: rising inflation.  With their fixed coupons, long-term bonds are especially vulnerable to the effects of inflation.  Prior to the peak in long-term rates back in 1981, this sort of bond market behavior was common.

It’s important for bond investors to keep their maturities shorter than they would have in recent years in order to protect principal.  That’s not only what we recommend, it’s what we are doing in our fixed income portfolios.  For several years, we have been using target date fixed income ETFs in short- to intermediate-term “ladders” for our asset allocation, balanced, and fixed income portfolios.  Bond investors can structure their portfolios to take advantage of future inflation by rolling those laddered maturities into what we believe will be higher coupons in the future.

Whether you are invested in one of our equity strategies, asset allocation strategies, or fixed income/balanced strategies, you can be sure that we are not lackadaisical about inflation.  We regard it as a major threat to real returns and overcoming it as our overriding concern.

We appreciate your confidence in us.

 

Gratefully,

Mark A. Keller, CFA
CEO and Chief Investment Officer

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Daily Comment (October 18, 2022)

Posted on by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with an update on the Russia-Ukraine war, including details on the shooting of newly mobilized troops at a training camp in Russia and signs that Russian oligarch Yevgeny Prigozhin may be positioning himself to eventually push President Putin aside.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including several items related to China and a discussion of the evolving energy crisis in Europe.

Russia-Ukraine:  Russian forces, which are now on the defensive in Ukraine’s northeastern Donbas region and in the southern region around Kherson, continue to launch missile, artillery and drone strikes on residential areas and critical infrastructure across Ukraine.  The strikes appear to have very little direct military value, as they are apparently geared more toward terrorizing the population and undermining Ukrainian morale.  As one example, the strikes have been focused heavily on destroying Ukrainian energy infrastructure ahead of winter.

  • New details are emerging about an incident over the weekend in which three recently mobilized Muslim men opened fire in a Russian training camp, killing many. The shooting apparently was sparked by Muslim inductees complaining that they should not be fighting Russia’s war, to which the camp’s commander said it was a “holy war” and called Allah a coward.  The Muslims opened fire to avenge the insult to Allah.  The incident highlights the tensions arising as the Kremlin continues trying to force ethnic minorities to shoulder the bulk of the burden of the war.
  • Separately, Yevgeny Prigozhin, the leader of Russia’s mercenary company known as the Wagner Group, continues to openly disparage the established Russian military for its ineffectiveness in the war.  According to Prigozhin, the well-funded Wagner fighters are in a class far above the regular Russian troops, suggesting that he may be positioning himself as an alternative for president if Putin continues to be embarrassed by the war effort.

Global Commodity Markets:  Anglo-Australian mining giant Rio Tinto (RIO, $55.18) warned that prices for iron ore and other key commodities are likely to keep falling in the near term as the U.S. and European economies fall into recession and Chinese housing construction continues to fall back.  We still think today’s geopolitical frictions will buoy commodity prices in the coming years, but the warning from Rio Tinto is a reminder that the asset class could still pull back sharply in recessionary periods.

European Energy Crisis:  German Chancellor Scholz said his government will now allow the country’s three remaining nuclear generating plants to keep producing electricity until mid-2023 to help get Germany through Europe’s winter energy crisis.  Longstanding plans had called for the plants to be shut down permanently at the end of 2022.  The decision essentially reflects a major backdown by the German Greens, one of the three parties in Scholz’s coalition.  The decision is also further evidence that nuclear energy is getting a second look now that many countries are facing energy shortages because of the war in Ukraine and other geopolitical frictions.

  • Separately, amid spreading unrest over high inflation, some 21 countries in the EU have now raised their minimum wages in order to help their lowest-earning citizens deal with higher prices for energy and other goods and services.
  • However, in most of those countries, the minimum wage hike has not been enough to offset overall consumer price inflation, leaving real minimum wages lower than before, as shown in the following chart. The decline in minimum wage earners’ purchasing power will contribute to the impending recession in the EU.

United Kingdom:  Although British financial markets have calmed considerably since Prime Minister Truss’s government backed away from its massive, debt-funded tax cuts, new reports suggest that the Bank of England will further delay its planned sale of billions of pounds of government debt beyond its current start date of October 31.  According to the reports, the central bank officials worry that the market for Gilts is still too unstable to launch the quantitative tightening program.

China-United Kingdom:  Yesterday, British Prime Minister Truss  expressed concern after a video emerged that appeared to show a Hong Kong activist being dragged inside the Chinese consulate in Manchester and beaten during a protest.  The aggressive behavior by the Chinese diplomats will likely further strain China-U.K. relations.

China:  As we receive more detail on the Communist Party’s 20th National Congress, one thing that strikes us is that President Xi in his opening speech Sunday called on the country’s military to develop faster so that it can win “regional wars.”  That marked a departure from recent years, when Xi typically called on the military to fight and win “wars,” with no reference to their scale.  Reverting to China’s customary emphasis on regional wars may simply aim to focus the military on the potential conflict around Taiwan, but it could also be a tacit admission that China cannot yet hope to vanquish the U.S. and its allies in a broader conflict.

United States-China:  Apple (AAPL, $142.41) has reportedly suspended plans to use memory chips made by China’s largest memory chip maker, Yangtze Memory Technologies Company, even though Yangtze had already completed the months-long verification process for Apple to use the chips in its newest iPhones.  The decision illustrates the impact of the new U.S restrictions on the involvement of U.S. persons in developing chip facilities in China, and on equipment and materials shipped to Chinese wafer fabricators that produce NAND flash-memory chips with 128 layers or more.

  • The decision by Apple is a body blow to China’s dreams of building a more competitive memory-chip industry.
  • As such, the new U.S. technology restrictions are likely to ratchet up tensions between the U.S. and China. As we have recently written, China’s likely response over time will probably include efforts to restrict key mineral commodity exports to the U.S. and its allies.

U.S. Hurricane Damage:  Reinsurer Swiss Re (SSREY, $18.35) said it expects approximately $1.3 billion in claims from Hurricane Ian after it struck Florida last month.  The company also estimated that the storm caused total insured losses of between $50 billion and $65 billion, making it the second-most expensive storm in U.S. history after Hurricane Katrina in 2005.

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Daily Comment (October 17, 2022)

Posted on by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with an update on the Russia-Ukraine war, including news of further progress with Ukraine’s counteroffensive to retake the Russian-held city of Kherson in the country’s south.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including an ominous delay in China’s release of its third-quarter economic data.

Russia-Ukraine:  The Ukrainian counteroffensive in the country’s northeastern Donbas region has now slowed considerably, but the latest reports indicate that the Ukrainians are launching significant new attacks in the southern region around the Russian-occupied city of Kherson.  Meanwhile, Russian forces continue to launch missile, artillery, and drone strikes at military and civilian targets across Ukraine.  Reports also suggest that the first of Russia’s newly-mobilized troops have been killed in combat in Ukraine. Often, these troops have received only a few days of training.  That news is reportedly sparking increased popular anger in Russia, although it still appears that the government has control over the situation.

  • Meanwhile, thousands of Russian troops were deployed to Belarus over the weekend to join Belarussian forces arrayed on the border with Ukraine, ostensibly to help Belarus deter a purported Ukrainian attack. Even though some reports suggest the new Russian troops arrived without artillery or vehicles, the deployment is being seen largely as a Russian effort to further threaten Ukraine and force it to shift troops to the Belarussian border and away from its successful counteroffensives in the northeast and south.
  • Also, more than a dozen missile and artillery strikes hit the Russian province of Belgorod, on the border with Ukraine, on Sunday alone. The strikes almost surely were launched by the Ukrainian military and were meant to bring the reality of the war to Russian citizens.
  • Responding to reports that Russia’s latest attacks have relied heavily on Iranian-supplied Shahed 136 kamikaze drones, European Union foreign ministers have warned that they could impose new economic sanctions on Tehran if it continues to offer Russia such support.

China:  The Chinese Communist Party opened its week-long 20th National Congress yesterday, during which President Xi is expected to win a precedent-breaking third term in power with a revamped Politburo to support him.

  • In his opening speech, Xi defended his foreign policy as a series of successes in fending off Western “bullying” and protectionism, but his praise was coupled with a somber warning that the nation must stand united behind the party to cope with a world he depicted as increasingly turbulent and hostile.
  • In domestic policy, Xi declined to back down from his tough, restrictive “Zero-COVID” policies. With recent data pointing to new waves of infection, a new round of tough social-distancing restrictions is likely to be imposed soon, causing yet another pullback in Chinese economic activity.
  • In an ominous sign for China’s latest economic data, the government delayed publication of its report on third-quarter gross domestic product at the last minute. This suggests to us that the growth rate is uncomfortably low, to the point where it would distract from the positive tenor that Xi is trying to strike in the Congress.  Continued economic weakness in China is likely to be a headwind for global economic growth and world financial markets.

European Union:  Yesterday, EU commissioners agreed on a preliminary proposal to set a maximum “dynamic price” at which natural gas transactions can take place in the bloc over the next three months.  The aim is to empower the EU to intervene in cases of extreme natural gas prices while not hurting the security of supply or encouraging consumption.  The proposal will be debated by EU national leaders on Thursday and Friday before being finalized.

United Kingdom:  Newly-appointed Chancellor Hunt today said that the government will reverse nearly all of Prime Minister Truss’s proposed tax cuts and slash her planned energy subsidies to restore fiscal credibility.  Hunt also warned that there will be “more difficult decisions” on taxes and spending in the future.  Meanwhile, the Bank of England confirmed that, as planned, it had ended the emergency bond buying it put in place two weeks ago to calm the markets following the initial release of Truss’s tax-cutting plans.

  • U.K. markets improved on the news that the government is apparently getting its fiscal house in order. Benchmark 30-year Gilt prices rose, pushing their yield down to 4.36%.  The pound also rallied, and it is currently changing hands at about $1.1303.
  • Despite the U-turn, Truss is now just barely hanging onto power. Over the weekend, more Conservative Party members of parliament said that the prime minister’s position is increasingly untenable.  Most of those officials appear to expect Truss can survive only a few days to a few weeks.

Japan:  With the yen weakening further this morning to ¥148.60, close to the psychologically important level of ¥150.00, Finance Minister Suzuki warned that the government would take bold action against any “speculative” foreign exchange moves.  The statement has left currency traders on the lookout for any intervention to support the yen, similar to what the government implemented last month.

Iran:  Anti-government protests continued over the weekend, spreading to a notorious prison for political dissidents and foreigners.  Although the Islamic regime doesn’t appear to be threatened by the protests just yet, the widening unrest does pose a longer-term threat to the government.

Brazil:  In their first one-on-one debate ahead of their presidential run-off election, conservative President Bolsonaro apparently scored several body blows against leftist Former President Luiz Inácio Lula da Silva over corruption and his ties to left-wing autocrats in the region.  The latest polling suggests Lula’s lead over Bolsonaro has narrowed to just 5%.  If Bolsonaro continues to make progress against Lula, we suspect the prospect of a continuing conservative government in Brasilia would be positive for Brazilian stocks.

U.S. Economy:  In the Wall Street Journal’s latest quarterly survey of economists, 63% fully expect that the U.S. economy to fall into recession within the next 12 months, up from 49% in July.  The surveyed economists now expect the economy to contract in both the first and second quarters of next year.  Based on our own analyses, we agree that the economy is more likely than not to be in a recession sometime in the coming year.

U.S. Energy Market:  Utilities in New England are warning that they could face challenges in delivering electricity this winter if a surge in natural-gas demand abroad threatens to reduce the supplies they need to generate power. New England relies on natural-gas imports to bridge winter supply gaps, so it is now competing with European countries for shipments of liquefied natural gas.

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Asset Allocation Bi-Weekly – An Update on Bonds (October 17, 2022)

Posted on by Amanda Ahne

by the Asset Allocation Committee | PDF

Our starting point for examining bond yields begins with our yield model.  The key components are fed funds, the 15-year average of CPI (which is a proxy for inflation expectations), the five-year rolling standard deviation of CPI (a measure of inflation volatility), German Bund yields, oil prices, the yen/dollar exchange rate, and the fiscal balance scaled to GDP.  Based on this model, the current yield on the 10-year T-note is well below fair value.

Although yields have increased, as the deviation line shows, they are still well below the model estimate.  Interestingly enough, it is not unusual for the deviation to be below the model estimate as the economy approaches recession.  This condition reflects the flattening and inversion of the yield curve.  As monetary policy is tightened, the markets begin to expect slower economic growth which in turn depresses long-duration yields.  However, the current deviation is wider than normal, which suggests that a backup in yields is still likely.  A yield of 4.10% would be in line with the lower standard error range.

Long-duration Treasury yields may be on track for consistently higher yields in the future.  Since peaking in the early 1980s, the 10-year T-note has been steadily declining.  Persistently low inflation has supported that downtrend.  However, market action suggests that we may be at the turn in yields which, if true, could create a secular bear market in bonds.

Since the late 1980s, the downtrend has been steady and mostly captured by a trendline flanked by a plus/minus of one standard error from a regression model.  That downtrend was definitively broken in March.

Why is the trend changing?  Most likely because investors fear that the inflation regime which fostered the downtrend is coming to an end.  Increasing political tensions, a breakdown in the globalization regime, and uncertainty about policymakers’ willingness to maintain low inflation are all conspiring to affect inflation expectations.  We would expect the yield to decline in a recession.  If the trend has truly changed, the low will likely be set above the upper line.  If that occurs, a long period of steadily rising yields becomes more likely.

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Daily Comment (October 14, 2022)

Posted on by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning. Today’s Comment begins with our thoughts on yesterday’s CPI report. Next, we discuss significant policy shifts in some of the most influential countries. Finally, we discuss how Russia’s nuclear threat has encouraged other countries to become more pugnacious.

The Market Reacts: A possible short-covering rally lifted equity prices on Thursday as investors digested the latest Consumer Price Index (CPI) report.

  • The horrible September inflation report raised the likelihood of another jumbo hike from the Fed in its next meeting in November. Although headline CPI decelerated from 8.3% to 8.2% last month, core CPI jumped from 6.1% to 6.3%. Much of the disappointment in the CPI report came from accelerating rent, transportation, and airline prices. The stronger-than-expected inflation report means that the Fed will raise its benchmark interest rate by at least 75 bps and possibly 100 bps next month.
  • Initially, the market viewed the report negatively, but sentiment began to change once investors dismissed the chance of a soft landing. All 11 of the S&P 500 sectors rose while bond prices fell due to concerns that the Fed will have to lift rates higher. Several theories exist for the equity rally, including short-covering, inflation peak expectations, and a possible Fed pivot. Whatever the reason for optimism, we do not expect it to last much longer as the economy continues to show signs of slowing. Although it’s easy to assume that the Fed could rein in its tightening if the country falls into recession, there are Fed officials who are for additional hikes even during a downturn. In short, we are not convinced that the stock market has hit its bottom quite yet.
  • It isn’t all bad when you look at the monthly data. Core goods prices were unchanged from the previous month thanks to a sharp drop in used autos and apparel prices. Meanwhile, food and energy prices are showing consistent signs of deceleration. Hence, much of the rise in the year-over-year change in inflation was due to base changes as opposed to renewed inflationary pressures. In fact, we suspect that the October CPI report could surprise to the downside. If we are correct, it will likely encourage Fed officials to signal a pause in 2023.

Big Changes: Major countries are beginning to make sudden shifts in their economic and foreign policy agenda to cope with the challenging environment.

  • In a shock, U.K. Prime Minister Liz Truss sacked Chancellor Kwasi Kwarteng on Friday. The move comes after Truss was forced to make an embarrassing U-turn on major parts of her flagship tax plan. The new budget will eliminate the £18 billion corporate tax cut. Following the news of the budgetary changes on Thursday, U.K. government bonds and the British pound rallied. Although Truss’s policy reversal will relieve the financial stress caused by her tax plan, there is no guarantee that the market turmoil will end after the BOE ends the bond purchasing program today. Additionally, there is still concern that Truss’s leadership may be in jeopardy.
  • China will host its 20th National Party Congress on Sunday. The convention will formally instate Xi Jinping as President for the third consecutive time and will outline the country’s plan for the next five years. Although the remarks have not been released, we expect Xi will emphasize that the country should shift its focus away from constant growth and toward self-dependency. The Chinese economy is facing one of the rockiest economic periods in recent history. It has struggled to contain a faltering real estate market, persistent COVID outbreaks, and isolation from the U.S. An inward-focus economy will benefit domestic industries, particularly in tech, and the country looks to aid their development through stimulus.
  • The European Central Bank officials intend to unwind the bank’s balance sheet in 2023. As opposed to selling the bonds, members of the Governing Council prefer to let the bonds mature. If the bank follows through on this plan, it could lead to more financial stress in European Bond markets, especially as the central bank raises its policy rate.

Missiles, Missiles, Missiles: Speculations of a Russian nuclear strike in Ukraine have forced other countries to flex their might.

  • The chance of a nuclear Armageddon is rising. EU foreign policy chief Josep Borrell warned Moscow that NATO countries would “annihilate” Russian forces if Putin decides to use nuclear weapons in Ukraine. Both Russian and NATO forces have planned nuclear drills. The escalation in rhetoric has led to concerns that there is a possibility of miscalculation. In order to mitigate that risk, French President Macron clarified that his country would not respond in kind in the event of a nuclear attack on Ukraine. Financial markets are the least of your concerns in the event of nuclear war; however, in the build-up, commodities will benefit from the rising uncertainty.
  • Not wanting to be left out, North Korea reminded the world that it also has weapons. Earlier today,  it launched two ballistic missiles and sent fighter jets close to the border of its southern neighbor. South Korea responded to the provocative acts by scrambling its jets and slapping unilateral sanctions on Pyongyang. The escalation of tension on the Korean peninsula has flown under the radar due to the war in Ukraine. A fight between North and South Korea could lead to an intercontinental war in Asia as Japan, the U.S., and China all have vested interests in the outcome of the conflict. As a result, we think investors should be cautious when looking at international equities as geopolitical risks are still quite elevated.
  • The U.S. now believes it is battling nuclear threats in both Europe and Asia. The Biden administration’s new National Security Strategy stated that Russia was an imminent concern, and that China was a long-term threat. The focus on these two countries comes amidst heightened tensions over Ukraine and Taiwan. The document states that the U.S. will not allow these countries to achieve their foreign policy objective by use of force. This posturing by the U.S. signals that it is prepared to invest more in its defense to take on its foreign challengers. The resulting increase in military spending should favor more aerospace and defense industries.

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