Daily Comment (April 22, 2019)

Posted on April 22, 2019 by Rebekah Stovall

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy Easter Monday! Most of Europe is closed today, along with a few Asian markets (Australia, New Zealand). It’s also Earth Day. There was a horrific terror event Easter Sunday against Christians in Sri Lanka.[1] Here is what we are watching:

Oil: The Trump administration is signaling that there will be no more import waivers granted on Iranian oil.[2] This decision was something of a surprise. Although SoS Pompeo and National Security Director Bolton supported this hardline stance, the president was reluctant to take this step for fear of higher oil prices.[3] In response, oil prices have jumped on the news. In other Iranian news, the Supreme Leader Khamenei announced the replacement of the commander of the Iranian Republican Guard Corps (IRCG). Gen. Hossein Salami was elevated to the post, while Gen. Mohammad Ali Jafari was removed.[4] Salami is considered a hardliner (in a rather hardline group), so this move does suggest Iran is preparing for a more hostile environment.

Iran is the proximate cause for today’s lift but we have noted that overall geopolitical risk is adding around $10 to $12 per barrel to the price of oil; the current price is well above what the dollar and oil inventories would suggest. In Libya, the Trump administration shifted course with regard to political leadership, offering a full endorsement of Khalifa Hifter.[5] Hifter, a former Libyan general under Khaddaffi who broke with the late Libyan leader, offers a secular leadership option for the country. It isn’t clear if the endorsement will lead to overt support, such as equipment and funding. So far, Hifter has been less than impressive on the battlefield.[6] If the conflict escalates, the potential for further supply disruption is high.

Venezuela remains problematic. Electricity outages, trade restrictions and sanctions continue to weigh on production. There are reports that the Russians are helping Caracas evade sanctions.[7] Although this action might support an increase in Venezuelan supplies, we doubt the U.S. will allow this evasion to continue indefinitely.

Although we remain bullish on oil prices, we are at the point where the primary bullish factor is geopolitical. We are probably approaching a crux where it will be difficult for prices to sustain these levels without either (a) a continued flow of news that signals further supply disruptions, or (b) improving fundamentals (falling inventories or dollar weakness).

A funny guy wins in Ukraine: The voters in Ukraine have spoken with a landslide victory[8] for Volodymyr Zelensky, defeating incumbent president Petro Poroshenko. Zelensky has no political experience—in fact, he played a political leader on a Ukrainian TV show.[9] Zelensky is a comedian by trade and his victory is another indication of the anti-incumbent mood of electorates and the desire for something “different” across the West. It is unclear how well Zelensky will govern a difficult nation in an unsettled geopolitical environment, but voters in Ukraine were apparently willing to take the chance.

China: Reports that Chinese leaders are more focused on reform and less on boosting growth led to a slump in Chinese equities today.[10] According to reports, in a review of the Q1 economy, the 25-member Politburo congratulated themselves for navigating the trade conflict with the U.S. and signaled that Chinese policy will continue to focus on reform and show less concern toward excessive growth.[11] The need for economic restructuring is nothing new; China is in the midst of the difficult shift from investment-led growth to consumer-led growth. When the U.S. went through this process, we suffered the Great Depression. Japan is still struggling to make this adjustment which began in 1990 and has led to nearly three decades of stagnation. In practice, Chinese leaders have tended to start the process of reform, which will lead to slower growth and falling debt, but upon seeing weaker growth the leadership has panicked and boosted spending and debt. Chinese financial markets have enjoyed a rally on expectations that Chinese leaders have “blinked” again in the face of slowing growth. Today’s news suggests that reform remains on the agenda; our position is that the CPC is not confident enough to allow growth to decline and thus the continued pattern of “reform, panic, stimulus, reform” will continue. But, we do acknowledge that there will be a point when China’s debt capacity will be reached and it will be impossible for them to continue this process. We don’t think we are close yet, but the signal that the endgame is approaching will be when China taps foreign capital markets for loans. That has started but isn’t at a huge level…yet.

The dollar: In a survey of conference calls on Q1 earnings, the largest area of company concern is dollar strength, with the second being increasing labor costs.[12] So far, the Treasury has maintained a strong dollar policy, not supporting steps to weaken the dollar. At some point, we do expect a reversal of this policy and industry opposition to dollar strength could be a factor that brings about this policy shift.

View the complete PDF

[1] https://www.nytimes.com/2019/04/21/world/asia/sri-lanka-bombings.html?emc=edit_MBE_p_20190422&nl=morning-briefing&nlid=5677267tion%3DtopNews&section=topNews&te=1

[2] https://www.wsj.com/articles/u-s-to-end-iran-oil-waivers-to-drive-tehrans-exports-to-zero-11555898664?mod=hp_lead_pos2

[3] https://www.reuters.com/article/us-global-oil/oil-prices-jump-more-than-2-percent-as-u-s-set-to-end-iran-import-sanction-waivers-idUSKCN1RY00J?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosmarkets&stream=business

[4] https://www.nytimes.com/2019/04/21/world/middleeast/iran-revolutionary-guards-leader.html?emc=edit_MBE_p_20190422&nl=morning-briefing&nlid=5677267ion%3DwhatElse&section=whatElse&te=1

[5] https://www.nytimes.com/2019/04/19/world/middleeast/trump-libya-khalifa-hifter.html?searchResultPosition=12

[6] https://www.nytimes.com/reuters/2019/04/21/world/africa/21reuters-libya-security.html?searchResultPosition=2

[7] https://www.reuters.com/article/us-venezuela-politics-rosneft-exclusive/exclusive-venezuela-skirts-u-s-sanctions-by-funneling-oil-sales-via-russia-idUSKCN1RU2A4?feedType=RSS&feedName=businessNews

[8] https://www.nytimes.com/2019/04/21/world/europe/ukraine-elections-zelenskiy.html?emc=edit_MBE_p_20190422&nl=morning-briefing&nlid=5677267tion%3DtopNews&section=topNews&te=1

[9] https://www.washingtonpost.com/world/as-ukraine-votes-in-presidential-runoff-a-comedian-looks-to-unseat-the-incumbent/2019/04/21/b7d69a38-603f-11e9-bf24-db4b9fb62aa2_story.html?utm_term=.c9eb055e69cf&wpisrc=nl_todayworld&wpmm=1

[10] https://www.reuters.com/article/china-stocks-close/china-stocks-fall-most-in-nearly-4-weeks-on-worries-beijing-may-slow-policy-easing-idUSZZN2RKA00

[11] https://www.scmp.com/economy/china-economy/article/3006951/china-leaders-vow-reform-not-stimulate-economy-trade-deal-us?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosmarkets&stream=business

[12] https://insight.factset.com/fx-and-wages-cited-as-top-negative-impacts-by-sp-500-companies-on-q1-earnings-calls?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosmarkets&stream=business

Asset Allocation Weekly (April 18, 2019)

Posted on April 18, 2019April 18, 2019 by Rebekah Stovall

by Asset Allocation Committee

Why is inflation so low? The persistence of low inflation, despite the long expansion and the decline in unemployment, continues to befuddle policymakers. Standard economic theory suggests there is an inverse relationship between inflation and unemployment. When the unemployment rate is low, firms should be experiencing reduced excess capacity. As capacity is constrained, supply bottlenecks would be expected to develop which would eventually result in inflation.

Although the unemployment/inflation theory makes sense, it doesn’t work all that well in real life.

This chart shows the level of unemployment, with an 18-month lag, compared to the yearly change in CPI. In the 1960s, it did appear there was a tradeoff; when unemployment fell, inflation rose 18 months later. However, even during this period, the data relationship was merely directional as sub-4% unemployment led to 6% CPI. In the mid-1970s, 4.5% unemployment led to CPI in excess of 12%. Since the early 1980s, CPI has rarely moved above 4%, and in the current environment sub-4% unemployment has not yet triggered a notable inflation problem.

It turns out inflation is rather complicated. Expectations play a major role; if households and businesses expect rising inflation, they take steps to protect themselves that exacerbate the inflation impulse. Both sectors will build inventory levels, effectively changing their balance sheet allocation from financial instruments to real goods. This action can lift the demand for goods and can trigger inflation.

There also appears to be at least two long-term factors that affect inflation. Inequality seems to have an impact.

History shows that lower degrees of inequality are correlated with higher levels of inflation. We think there are two factors that cause this outcome. First, policies designed to expand supply, deregulation and globalization, tend to improve the efficiency of the economy at the expense of higher inequality. Outsourcing and automation make production more efficient but also reduce the demand for domestic labor. Simply put, one person’s efficiency is another person’s pink slip. Second, CPI is designed to measure prices based on an average household’s consumption patterns. With rising inequality, lower decile households may have less income to spend on basic items, making it difficult for firms to pass along price increases on such goods. On the other hand, under conditions of inequality, prices on luxury items are likely to be priced higher simply because there is more spending power available.[1]

However, it is likely that the most potent reason inflation has stayed low is because of excess capacity in the economy. Measuring excess capacity is profoundly difficult because it is something of a moving target. A simple way is to regress long-term GDP against trend; the assumption is that the trend is a reasonable proxy for capacity.

The chart on the left is real GDP, log-transformed with a time trend regressed through it. The lower line is the deviation from trend. We are currently in a period where GDP is well below trend. The only other period that exhibited such a negative deviation from trend was the Great Depression. The chart on the right shows the GDP deviation line compared to CPI. Note that inflation tends to be low during periods of below-trend GDP. For the overall time frame (1921-2018), CPI averages 2.8%. When GDP is above trend, inflation averages 3.8%; when GDP is below trend, CPI averages 0.4%.

This trend analysis could mean that it may take several years before inflation pressures become notable if policymakers become aggressive with stimulation (i.e., keeping monetary policy accommodative while lifting fiscal policy). It also means the Federal Reserve can probably avoid raising rates for a considerable period.

View the PDF

[1] https://www.pewtrusts.org/en/research-and-analysis/issue-briefs/2016/03/household-expenditures-and-income

Daily Comment (April 18, 2019)

Posted on April 18, 2019 by Rebekah Stovall

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] U.S. equities are mostly flat, while we are seeing weakness abroad. The Mueller report[1] gets released this morning, so the media will be focusing on that all day. European PMI data was lackluster.[2] In a fascinating development, a Democratic Party stalwart announced he isn’t running for president.[3] Note that with the markets closed for Good Friday, we will not be publishing a Daily Comment tomorrow but will resume on Monday. Here is what we are watching:

Turkey: A couple items of note. It appears the opposition has taken control of the city of Istanbul[4] even though President Erdogan continues to contest the vote.[5] There are reports that the Turkish central bank has been tapping swap lines to give the impression it has ample reserves.[6] Although the borrowing is a concern, we would note that the TRY has already depreciated substantially[7] and the current account has shown marked improvement.

We also note that Turkish officials made an unexpected visit to Washington,[8] apparently trying to avoid sanctions tied to its decision to buy Russia’s S-400 missile system. The U.S. had approved the sale of F-35 warplanes to Turkey but is suspicious of selling them to Ankara if it also has Russians in the country “helping” deploy the missile system. Such an arrangement would give the Russians the ability to probe for weakness in the F-35’s defenses and make the stealth plane vulnerable to the S-400 anti-aircraft missiles.[9] Finally, Turkey is working on new trade procedures to continue commerce with Iran but avoid U.S. sanctions.[10]

China trade talk: Although not confirmed, there are reports that the U.S. and China are planning for an early May trade deal announcement.[11] To some extent, financial markets have already discounted a modest agreement, but a deal that would lift tariffs immediately would likely give stocks a boost.

North Korea: North Korea announced it tested a tactical system.[12] It isn’t clear whether the test was artillery or a short-range missile, but it was clearly not a ballistic missile, which would have triggered a strong reaction from Washington. It appears Pyongyang is attempting to get the attention of the U.S. without crossing lines that would escalate tensions. This is not unusual behavior for North Korea; it does not want to be ignored.[13] At the same time, this test is likely nothing more than an attempt to gain attention. Meanwhile, North Korea has indicated it would prefer not to have SoS Pompeo involved in future discussions on its nuclear program.[14] This request is an obvious attempt to split the U.S. foreign policy establishment; we doubt President Trump will grant that request but, if he does, a deal favorable to Pyongyang is more likely.

Conservatives rise in Canada: Albertans voted in a landslide to bring back a conservative provincial government.[15] Center-right parties now control five of the 10 provinces and increase the chances that PM Trudeau may be in trouble in October’s national elections.[16] Trudeau has been pushing for carbon taxes to combat climate change; Alberta is the home of Canadian tar sands and is thus vulnerable to such measures. In addition, Alberta’s energy sector has been under pressure mostly due to the lack of pipeline capacity from the province. Some pipeline projects have been blocked by liberal-leaning provinces. Thus, the conservatives in Alberta were able to blame Trudeau for the economic travails and the tactic was apparently successful. Although Trudeau was never going to poll well in Alberta anyway, the economic message could resonate outside of Alberta and hurt his chances in October.

Indonesia election: Incumbent President Joko Widodo (Jokowi) is the apparent winner in this week’s elections in Indonesia.[17] Financial markets have reacted positively to the news.

Fed talk: Apparently, Herman Cain is undeterred, indicating he won’t withdraw his name from contention for a Fed governor spot even though Senate opposition is growing.[18] Meanwhile, Stephen Moore is finding that professional politicians rarely forget criticism.[19]

Inflation talk: This week’s Asset Allocation Weekly looks at the inflation conundrum—why is inflation staying low despite tight labor markets? The Dallas FRB weighed in on this issue, suggesting the growth of “gig” workers, who work on demand and don’t require a commitment from employers, is reducing wage costs, allowing firms to maintain margins and are thus less compelled to push price increases onto consumers. In addition, the expansion of online retailing means that consumers now have a national market to tap, which helps avoid local bottlenecks and monopolies and thus keeps prices low. Although not mentioned in the article, it also reduces price discovery costs.[20] All these are valid points. Another interesting item—after last year’s tax cuts, we noticed a flurry of bonuses offered to workers to “share” the benefits of the corporate tax rate reduction. However, it appears this generosity was “one-off”; bonuses in 2018 have fallen relative to the prior year.[21]

Energy update: Crude oil inventories fell 1.4 mb last week compared to the forecast rise of 2.0 mb.

In the details, refining activity rose a mere 0.2%, below expectations. Estimated U.S. production fell slightly by 0.1 mbpd to 12.1 mbpd. Crude oil imports fell 0.6 mbpd, while exports were unchanged.

This is the seasonal pattern chart for commercial crude oil inventories. We are nearing the end of the spring inventory build season and will probably not achieve average, although the gap has narrowed significantly in recent weeks.

Refinery activity is still lagging average.

Usually by this week we are seeing utilization above 90%. With summer approaching, we would look for rising utilization in the coming weeks.

Based on oil inventories alone, fair value for crude oil is $55.77. Based on the EUR, fair value is $52.40. Using both independent variables, a more complete way of looking at the data, fair value is $52.71. Current prices are running well above fair value. Geopolitical risks are bolstering prices. The unrest in Libya could end up reducing output to zero if the fighting continues.[22] In Venezuela, the Spanish oil firm Repsol (MCE, EUR, 15.07) has suspended oil swaps with Caracas due to pressure from Washington. Repsol was swapping refined product for crude oil, avoiding dollar payments that would have run afoul of U.S. sanctions. By suspending the arrangement, Venezuela now only has similar deals with Russia and India. The former probably won’t be lost but the latter is vulnerable. More product losses will likely lead to further reductions in Venezuelan oil output. Thus, the geopolitical risk is real but the wide spread to fair value does suggest that a good bit of the risk has been discounted.

View the complete PDF

[1] https://www.washingtonpost.com/world/national-security/attorney-general-plans-news-conference-to-discuss-mueller-report/2019/04/17/f5ca1cc6-6138-11e9-9ff2-abc984dc9eec_story.html?utm_term=.2e29dadcd463

[2] https://www.markiteconomics.com/Public/Home/PressRelease/5e809b959ac94d7d90cbdb6569dae3e2

[3] https://www.nytimes.com/2019/04/17/us/politics/terry-mcauliffe-president.html

[4] https://worldview.stratfor.com/situation-report/turkey-opposition-candidate-becomes-new-mayor-istanbul?id=87179e919a&e=4d1f592612&uuid=81dc1447-4fc0-4a76-8cce-9e674e520e8e&utm_source=Daily+Brief&utm_campaign=8aa8a570f5-EMAIL_CAMPAIGN_2019_04_18_11_33&utm_medium=email&utm_term=0_87179e919a-8aa8a570f5-53536341&mc_cid=8aa8a570f5&mc_eid=%5bUNIQID%5d (paywall)

[5] https://worldview.stratfor.com/article/turkeys-opposition-wins-one-battle-long-war?id=87179e919a&e=4d1f592612&uuid=b40591cb-2311-498f-9714-7dc8cafc8d12&utm_source=Daily+Brief&utm_campaign=8aa8a570f5-EMAIL_CAMPAIGN_2019_04_18_11_33&utm_medium=email&utm_term=0_87179e919a-8aa8a570f5-53536341&mc_cid=8aa8a570f5&mc_eid=%5bUNIQID%5d

[6] https://www.ft.com/content/9718e75e-611d-11e9-b285-3acd5d43599e

[7] https://www.ft.com/content/0dd381e8-619f-11e9-a27a-fdd51850994c

[8] https://www.pulse.ng/news/world/turkish-defense-minister-makes-unannounced-visit-to-pentagon/dyjvpp3?utm_source=GPF+-+Paid+Newsletter&utm_campaign=a5572d5e4d-EMAIL_CAMPAIGN_2019_04_17_03_33&utm_medium=email&utm_term=0_72b76c0285-a5572d5e4d-240037177

[9] https://www.al-monitor.com/pulse/originals/2019/04/turkey-looks-trump-congress-ultimatum-s400-f35.html?utm_source=GPF+-+Paid+Newsletter&utm_campaign=a5572d5e4d-EMAIL_CAMPAIGN_2019_04_17_03_33&utm_medium=email&utm_term=0_72b76c0285-a5572d5e4d-240037177

[10] https://www.jpost.com/Middle-East/Turkey-looking-at-new-trade-mechanisms-with-Iran-to-avoid-US-sanctions-587149?utm_source=gpf+-+paid+newsletter&utm_term=0_72b76c0285-a5572d5e4d-240037177

[11] https://finance.yahoo.com/news/u-china-said-plan-more-184126954.html and https://www.wsj.com/articles/u-s-china-set-tentative-timeline-for-next-round-of-trade-talks-11555521885?mod=newsviewer_click

[12] https://www.washingtonpost.com/world/national-security/north-korea-announces-test-oftactical-guided-weapon/2019/04/17/1f27d682-615f-11e9-9412-daf3d2e67c6d_story.html?utm_term=.2c93fb773aa9&wpisrc=nl_todayworld&wpmm=1

[13] https://www.youtube.com/watch?v=7bLnNqY6Yyk

[14] https://www.reuters.com/article/us-northkorea-usa/north-korea-rejects-pompeo-from-nuclear-dialogue-kcna-idUSKCN1RU0NU

[15] https://www.foxnews.com/world/justin-trudeau-liberal-alberta-elections

[16] https://www.washingtonpost.com/world/2019/04/17/conservative-wave-threatens-canadas-trudeau/?utm_term=.b44899a4b509&wpisrc=nl_todayworld&wpmm=1

[17] https://www.bloomberg.com/news/articles/2019-04-17/growing-intolerance-and-clamor-for-jobs-dominate-indonesia-vote

[18] https://www.wsj.com/articles/herman-cain-says-he-wont-withdraw-from-consideration-for-fed-board-11555529563?mod=hp_lead_pos2

[19] https://www.politico.com/story/2019/04/17/moore-cain-fed-1280545

[20]https://www.dallasfed.org/research/economics/2019/0416?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosmarkets&stream=business

[21] https://www.axios.com/newsletters/axios-markets-ce8f9025-0bf5-4a2a-aa8d-6937a0d6fa44.html?chunk=2&utm_term=emshare#story2 see #3

[22] https://www.wsj.com/articles/libya-fighting-hits-plan-to-revive-oil-gas-industry-11555520941?mod=newsviewer_click

Asset Allocation Quarterly (Second Quarter 2019)

Posted on April 17, 2019 by Rebekah Stovall

The Federal Reserve shifted fully from its hawkish stance at the beginning of the year. We anticipate that the committee will maintain its newly dovish stance with the potential for further monetary accommodation.
Though the employment/population ratio has improved, we find it still indicates slack in the labor force, blunting the full impact of wage growth on inflation.
Should trade agreements be reached with China and the European Union, and Congress approves the replacement for NAFTA, U.S. equity markets will respond positively.
Despite weakness abroad, we expect the U.S. economy to continue to grow through the balance of this year and into next.
The Fed’s accommodation and our expectations for continued U.S. growth over the next two years encourages our continued historically high weighting to U.S. equities in the strategies.

View the complete PDF

ECONOMIC VIEWPOINTS

The Federal Reserve’s pivot at the beginning of the year from a hawkish tone to a dovish posture has greatly influenced sentiment and markets. Though we foresee slowing economic growth over our three-year forecast period, we believe that the Fed’s accommodation will continue to propel the economy and risk-based assets through the end of this year and into next year’s election cycle. We maintain our expectation of 2.7% GDP growth for 2019.

The litmus test for our forecast will be the Fed’s upcoming meeting in Chicago on June 4-5, where the committee will be examining and evaluating its strategies, tools and communications surrounding its formulation of monetary policy. They have been on record regarding their views that labor market conditions are close to maximum employment, yet several members have mentioned the amount of slack that exists in the economy as measured by the employment/population ratio.

We expect the Fed will take a more nuanced approach to inflation targeting, allowing CPI-U to advance above its 2% hurdle until the shortfalls recorded over the past decade are back-filled. If our thesis is confirmed, the potential for a decrease in the fed funds rate later this year becomes a likelihood as indicated by the line on the chart showing the Mankiw Rule model using the employment/population ratio. This will hold short-term advantages for the economy and risk assets, but with long-term ramifications for inflation and, thereby, future bond and stock prices.

The current administration continues to engage in trade negotiations with China and the European Union (EU), and the new NAFTA, now USMCA, is under consideration by Congress. A favorable resolution of any or all of these would be positive for U.S. equities, where the market is still discounting long-term effects of trade barriers. Note that our expectations are not for a return to globalization. Rather, we fully anticipate general de-globalization efforts by the current administration as it seeks bilateral trade agreements favorable to the U.S. in contrast to the multilateral trade deals that were the basis of the globalization trend since the 1980s.

Beyond the U.S., our expectations are for continued softness in global growth and the potential for recession in several jurisdictions, the most notable being Italy and potentially Germany. The European Central Bank (ECB) has indicated that any tightening moves it harbored for this year have been pushed back until next year, at the earliest. Germany will be electing a new chancellor this fall and the ECB will have a new president on November 1, both of whom will exert influence on fiscal and monetary policies. Further influences emanate from China, with its economic stimulus measures and its stated willingness to accept trade measures from the EU. Although our thesis calls for a weakening U.S. dollar over our three-year forecast period, and we can envision an environment where European markets become attractive, there are too many near-term unknowns in Europe that encourage our posture of keeping risk assets in the U.S. for the foreseeable future.

STOCK MARKET OUTLOOK

Despite U.S. corporate profitability growth having slowed from last year’s torrid pace, it has been growth nonetheless. Margins remain high and, in an era of continued deregulation, have the potential to expand further. The decrease in earnings estimates for the first and second quarters have created the possibility for positive earnings surprises. Moreover, our expectations that the Fed will become even more dovish, and potentially politicized in advance of next year’s election season, adds more conviction for our historically high U.S. equity allocations in the strategies. A further element that would stoke the equity furnace is the fear of missing out by retail investors.

According to Morningstar, over the last twelve months investors have pulled nearly $425 billion out of U.S. equity separate accounts and mutual funds. Should retail investors replace their fear of the market with the fear of missing out, the U.S. equity market would become turbocharged. Although our consensus over our full three-year forecast period is certainly less rosy, we are encouraged to retain our historically high weighting to equities in the strategies for the time being.

Within investing styles, we maintain our neutral posture between value and growth. Among sectors, Materials continue to be overweight. We removed the overweight to the Energy and Health Care sectors in favor of overweights to Industrials, where earnings and growth metrics are attractive, and Technology, which was reconfigured late last year as part of the Communication Services realignment and offers a favorable position for the latter stages of an economic cycle.

The latter stages of an economic cycle are typically favorable for mid-cap stocks, which are decidedly overweight in each of the strategies. Attractive valuations using traditional measures of P/E and P/B for the S&P 400 Mid-Cap Index relative to the S&P 500 further our decision to overweight this sub-asset class. The Growth and Aggressive Growth strategies are both overweight to small cap stocks owing to the likelihood of continued elevated M&A activity over the course of the year.

Outside the U.S., we are cautious over the near term. Relative valuations are attractive overseas and our view is for a decline in the value of the U.S. dollar versus major currencies, which would provide a tailwind for returns. However, the cauldron of factors influencing Europe over the course of this year encourages us to remain on the sidelines in the near term. Therefore, we hold all risk assets in the U.S. with no allocation to foreign equities in any of the strategies.

BOND MARKET OUTLOOK

The dovish and potentially politicized Fed going into the election season guides our view that the yield curve will return to its traditional slope over the course of the year, principally through a reduction in short-term rates. Through our full three-year forecast period, we are positive on longer term rates as long Treasuries have significantly attractive yields relative to those from other developed countries. While we harbor concerns regarding the nearly $5 trillion in corporate debt maturing between 2019 and 2023, compounded by the change in interest expense deductibility in 2022 from 30% of EBITDA to 30% EBIT, these concerns are offset by overall corporate health and the recognition that bonds can be refinanced at a competitive price. We extend the duration of bond holdings in the strategies with income objectives, and retain the laddered structure as a nucleus beyond the short-term segment. We eliminated our former position in speculative grade bonds due to concerns about embedded risks in certain sectors as well as our expectations for spread widening over the full forecast period from their current low levels.

OTHER MARKETS

While REITs experienced tremendous total returns in the first quarter, our consensus forecast is for them to only deliver returns commensurate with dividends over the next three years. Accordingly, we reduced the allocation by half in the only strategy where REITs are deployed. We retain the remaining small allocation for the diversified income stream they provide.

We maintain a modest allocation in gold given its ability to offer a hedge against geopolitical risk and the safe haven it can afford during an uncertain climate for the U.S. dollar.

View the complete PDF

Daily Comment (April 17, 2019)

Posted on April 17, 2019April 17, 2019 by Rebekah Stovall

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Equities are trending higher in a quiet trade. China’s economic data was solid. Here is what we are watching:

Chinese data: GDP came in a bit better than expected, at 6.4%, but since GDP is mostly a manufactured number we expect it to always be around forecast. Industrial production made a strong recovery; on a yearly basis, it was up 8.4%.

In fact, the “hockey stick” recovery raises questions as to the veracity of the report. We will be watching future data for a cooling. Fixed investment rose 6.3% in Q1, with infrastructure spending leading the growth.

Overall, the data suggest that stimulus is working to lift the economy which is good news. There are always worries about sustainability given China’s debt levels but, for now, China’s bounce should support global growth.

Fed talk: Larry Kudlow admitted that the White House is looking at other candidates for Fed governor, acknowledging that Senate opposition may be too high to secure the nomination of either Stephen Moore or Herman Cain.[1] We are a bit surprised the White House isn’t pressing harder for its two potential nominees. At the same time, there are lots of doves out there that would be less controversial and almost anyone now would look less so compared to Cain and Moore. An interesting thought comes from Steve Englander of Standard Charter:

“A conservative version of Modern Monetary Theory (MMT) could arguably work just as well as the standard progressive version and would probably support asset prices initially. This conservative version sounds like the Fed-accommodated tax cut regime that the Trump administration seems to be supporting.”

Although MMT is usually considered a tool of the left, in reality, the importance of MMT[2] is that it will give permission to policymakers to ignore the deficit. And, as Englander postulates, it could be a tool of the right which could expand the deficit through tax cuts and defense spending and “encourage” the Fed to accommodate the spending by keeping interest rates low. The U.S. managed WWII spending in this fashion and it was generally successful in funding the war effort. The risk is inflation.

The key is whether the stimulus increased aggregate demand beyond the capacity of aggregate supply; when this occurs, inflation is the result. And so, the issue is capacity. This chart shows real GDP from 1901 on an annual basis. We have log-transformed the data and regressed a time trend through the data. The lower line is an approximation of how far GDP is below trend. We have seen two periods in the last 118 years when GDP was well below trend—the Great Depression and now. Although the trend line may not represent capacity, it is likely a reasonable guess. If so, there is currently ample available capacity for stimulus. And, at some point, we expect one of the political parties to accept MMT for its political goals and one shouldn’t necessarily assume it will be the Democrats that adopt it first. In any case, the adoption of MMT will, eventually, be inflationary. But, that “eventually” may be a lot longer than expected.

Autocrat news: In Egypt, President Abdel Fattah al-Sisi has solidified power by extending his term of office into 2030 and increasing the power of the military.[3] In Brazil, it appears President Bolsonaro may have intervened to prevent Petrobras (PBR, 15.37) from raising prices on diesel fuel. The company has denied the rumors, but such behavior is consistent with “strongmen.”[4]

View the complete PDF

[1] https://www.ft.com/content/a511defe-6075-11e9-a27a-fdd51850994c?emailId=5cb6ab69e6257a00043b2c71&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[2] ICYMI, our WGR series on MMT: Part I (3/11/19); Part II (3/18/19); Part III (3/25/19); and Part IV (4/1/19).

[3] https://worldview.stratfor.com/article/egypt-constitutional-changes-enshrine-militarys-hold-power-sisi-term-limits?id=87179e919a&e=4d1f592612&uuid=0f0caba0-903c-450c-bfc2-b76e4983a4c3&utm_source=Daily+Brief&utm_campaign=63ca6bffd0-EMAIL_CAMPAIGN_2019_04_17_11_34&utm_medium=email&utm_term=0_87179e919a-63ca6bffd0-53536341&mc_cid=63ca6bffd0&mc_eid=%5bUNIQID%5d (paywall)

[4] https://www.investing.com/news/stock-market-news/petrobras-ceo-denies-government-interference-after-diesel-price-hike-canceled-1836881?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosmarkets&stream=business

Daily Comment (April 16, 2019)

Posted on April 16, 2019April 16, 2019 by Rebekah Stovall

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Equities are trending higher in a quiet trade. Media is focused on the tragic Notre Dame fire. Here is what we are watching:

Fed talk: Chicago FRB President Evans and Boston FRB President Rosengren (both voters this year) made essentially dovish statements on monetary policy. Both suggested that inflation should be allowed to move above the 2% target since it has been below target for an extended period.[1] For most of their tenures, both were considered to lean dovish on policy. However, in recent years, both had become more hawkish, citing worries about easy policy causing distortions in the financial markets. Governor Brainard has made similar indications. Although there is theoretical support for such a policy stance (Hyman Minsky would be supportive), in practice, it’s pretty difficult to pull off. Imagine a Fed chair going to Congress and admitting the Fed raised rates to trigger a correction in stocks because the central bank ascertained that the P/E was too high. At the same time, we have showed that the Fed might consider equity volatility in setting policy.[2]

Since the early 1990s the Fed has tended to tighten when the Vix is below 20 (on a 12-week moving average basis). The only time the Fed raised rates with an elevated Vix was in the late 1990s. We note that Greenspan waited for the Vix to fall below 20 before raising rates and Yellen started raising rates after the Vix had been below 20 for a long period of time, only to stop when the Vix spiked. The recent pause is consistent with the rising Vix, although we would note that the Vix has been declining and if it continues we would expect pressure from Rosengren, Evans and Brainard for a rate hike. That’s why dovish comments from the Boston and Chicago FRB leaders are important and likely lifting the market today.

Trade talk: The EU and Japan are engaging in trade talks with the U.S. The EU’s discussions look like a stall tactic; the Europeans want to conclude talks by year’s end. By then, the U.S. presidential election process will be in full swing and EU officials know the White House will want to have talks wrapped up so the president can concentrate on reelection. We also note that the EU refuses to open up negotiations on agriculture and wants to avoid specific measures on autos. We doubt that U.S. negotiators will tolerate these limits.[3] We also note that the EU is considering separate tariffs on U.S. exports, up to €20 bn, if the U.S. penalizes the EU over aircraft subsidies.[4] Two takeaways—first, the EU plans to “slow walk” broader negotiations with hopes that either elections or a new government will relieve trade pressure, and second, the potential for a trade conflict may be falling with China but it may be rising with the EU. The market impact would be the same—bad for risk assets. Meanwhile, trade negotiations with Japan began yesterday.[5] Japan wants to separate talks on goods and services from forex; we suspect Japan is quite pleased with the current level of the JPY and does not want it to strengthen toward parity, which is estimated to be around ¥60.

Shadow lending tightening: In the financial system, there are traditional banks and “shadow” banks. Both do lending but the latter do not take in deposits.[6] Essentially, lenders make money on the spread; either on a time spread, by borrowing short and lending long, or on credit, by borrowing low-risk liabilities and lending to riskier assets. Traditional banks are regulated, whereas shadow banks are generally not. At the same time, shadow banks don’t have access to the Fed’s discount window, where banks can tap funds in times of stress. Thus, shadow lenders have two significant risks. The first is that the flow of funding, essentially the short-term money markets (repo, for example), freezes up; this risk is heightened due to the lack of access to the Fed window. The second is that loans stop performing. With regard to the latter, some notable shadow lenders announced they are taking steps to reduce loan exposure on fears of economic weakness.[7] Paradoxically, these actions can accelerate the trend toward a downturn because even if borrowing costs fall to the shadow banks reluctance to lend can end up weakening economic growth.

A political microcosm: One of the reasons we track U.K. politics is because it often offers insight into American politics. The commonality of language and support for free markets (both nations are considered “Anglo-Saxon” by continental Europe) are likely the reasons for the similarities. Brexit has been interesting to watch because it isn’t directly represented by a person. Instead, it is an idea. When a person represents an idea, the concept itself can get muddled; a voter may oppose the policy of a political figure but like his image and thus continue to support him (it can work the other way, too). This notion relates to what American pundits refer to as the “beer test”—would a voter like to have a beer with this person.

Brexit relieves us of the personality factor. Large political parties strive to be a “big tent”; they want to avoid clear ideological boundaries and instead project rather amorphous values. Within political parties, there are ideologs that try to force the parties to pure positions. The leadership of large parties try to avoid this development and keep the focus on personalities because they see that as the best way to gather a larger swath of votes.

With Brexit, the personality factor is reduced and in its place are two difference visions of state and the future. Leavers want a singular U.K. that is provincial and nationalist; Remainers have a more cosmopolitan view of the world, one that has close ties to the EU. Recent polling shows that the electorate is breaking down, about evenly, between leave and remain. Regardless of who wins, the loser will be a significant minority, one that feels its vision for the country has been lost. For example, among Labour supporters in the poorer parts of Britain, there has been a shift to the Conservatives, who are seen as leavers. Meanwhile, Tories in London who support remaining are shifting allegiance to Labour.[8]

Brexit likely represents a reconfiguration of the two parties; Labour could become the party of the educated and moneyed class (of course, for this to happen Corbyn has to go) and the Tories could become the party of the lower working classes, sprinkled with old-line traditional nationalists from old money. A similar mixing is likely occurring in the U.S., with the GOP rapidly becoming the party of the working class and the Democrats becoming the party of educated technocrats and Greens.

For this reason, we continue to monitor the path of Brexit not so much because of what the British exit or non-exit means but for the potential harbinger of political changes in the U.S. We do expect that if the U.K. leaves, the short-run impact will be difficult, but in the long run it probably makes sense to go because we doubt the EU will last for another decade. Thus, leaving early will probably be a benefit. But, as noted, Brexit reflects political division that are becoming clearer in the U.S. What is uncertain is how the political landscape will look in the future as these divisions are resolved.

View the complete PDF

[1] https://www.reuters.com/article/us-usa-fed-evans/fed-should-communicate-comfort-with-slightly-higher-inflation-evans-idUSKCN1RR1U9 and https://www.wsj.com/articles/fed-official-is-open-to-adopting-an-inflation-target-range-11555372800?mod=hp_major_pos10

[2] See Asset Allocation Weekly (1/11/2019)

[3] https://www.reuters.com/article/us-usa-trade-eu/eu-says-it-is-ready-to-launch-u-s-trade-talks-but-without-agriculture-idUSKCN1RR0OZ

[4] https://www.ft.com/content/79691cea-5d37-11e9-9dde-7aedca0a081a?fbclid=IwAR0hkTgjsq6fnOxtJip7O-hLNnNl8Ubqf6NgkGOY-r46gTz43AUbgcrPQ58

[5] https://www.reuters.com/article/us-usa-trade-japan/japan-and-us-hold-frank-and-good-trade-talks-economy-minister-idUSKCN1RR2GC

[6] Most believe that traditional banks lend out deposits but, in reality, they are not much different than shadow banks in that they don’t really need deposits to make loans. https://www.zerohedge.com/contributed/2014-03-20/bank-england-admits-loans-come-first-%E2%80%A6-and-deposits-follow

[7] https://www.reuters.com/article/us-usa-economy-online-lenders-focus/worried-a-recession-is-coming-u-s-online-lenders-reduce-risk-idUSKCN1RR0BB?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosmarkets&stream=business

[8] https://www.politico.eu/article/brexit-culture-war-in-numbers-exclusive-poll/?utm_source=POLITICO.EU&utm_campaign=809df01d25-EMAIL_CAMPAIGN_2019_04_16_04_58&utm_medium=email&utm_term=0_10959edeb5-809df01d25-190334489

Weekly Geopolitical Report – Reflections on Domestic Policy and American Hegemony: Part I (April 15, 2019)

Posted on April 15, 2019 by Rebekah Stovall

by Bill O’Grady

(Due to the Easter holiday, our next report will be published April 29.)

The dollar is the world’s reserve currency. As such, there is a constant demand for dollars from foreign countries to provide liquidity for global transactions. Because of the reserve currency status, U.S. monetary and fiscal policy affects the world economy in ways that other nations’ policies do not. The Federal Reserve is the U.S. central bank; in its mandate, it only concerns itself with the U.S. economy unless overseas events directly affect America. In general, the Federal Reserve would not be allowed to cut U.S. interest rates to boost the Canadian economy. Fiscal policymakers almost never worry about the impact of spending or taxes on foreign economies. However, U.S. monetary and fiscal policy can affect foreign economies through access to the reserve currency and trade.

Previous reports have discussed the reserve currency role. Recent policy decisions and potential Federal Reserve governor appointments could have a dramatic impact on monetary and fiscal policy. At the same time, because of America’s superpower status and its role in providing the reserve currency, these policy actions will also impact foreign economies. The key issue is the degree to which the U.S. can use hegemony to force domestic economic adjustments on foreigners.

In Part I of this report we will review the basis of the reserve currency role and the impact of the savings identity. In Part II, we will examine the power of hegemony by historical comparison, using the Nixon and Reagan administrations as analogs. In Part III, we will examine how the Trump administration is using American power to force foreign economies to absorb at least part of the economic adjustment. Our normal analysis of potential market ramifications will conclude the third installment.

View the full report

Daily Comment (April 15, 2019)

Posted on April 15, 2019 by Rebekah Stovall

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy Tax Day! It’s a quiet start to a short week. Here is what we are watching:

A Chinese anniversary: This is the 30^th anniversary of the death of Hu Yaobang, a reformist leader in the late 1980s. Deng had supported the rise of Hu, who was implementing market reforms, to the chagrin of the traditional communist party elders. Deng appointed him general secretary in 1982. In 1987, student unrest led to him being fired from his post in January 1987 and he died two years later. His death triggered the Tiananmen Square protests in 1989 that threatened the CPC and eventually led to a harsh repression. Expect the Xi government to attempt to either quash any remembrances of Hu or only allow carefully stage-managed celebrations of this anniversary.

U.S./China trade: Treasury Secretary Mnuchin indicated that the U.S. and China are nearing the final round of concluding issues.[1] Although Mnuchin avoided discussing details of the negotiations, a few items did emerge. First, negotiators are apparently considering the possibility that the U.S. could face “repercussions” from not living up to the U.S. side of the bargain. In other words, if the U.S. fails to meet the terms of the agreement, it is possible that China could implement retaliatory actions, e.g., quotas, tariffs, etc.[2] We are somewhat surprised the U.S. would accept such a deal, even though it seems fair on the surface. We note that both Lighthizer and Navarro have argued that China has no right to retaliate with tariffs because the U.S. is simply reacting to earlier Chinse trade impediments. Thus, this concession, if true, does suggest the U.S. wants an agreement. Second, there are reports that the U.S. has also given in to China’s industrial subsidies.[3] China’s subsidies allow it to produce goods at prices below those of foreign competitors, giving it the ability to gain market share.[4] Third, one of Mnuchin’s aims, reducing the ability of foreign nations to manipulate their currencies to offset the impact of tariffs, is apparently in the agreement.[5] In theory, this position makes sense; in practice, it’s hard to execute. We continue to closely watch Lighthizer; he is a trade hawk with clear ideas on how he wants to change the U.S./China trade relationship. He will not make a deal with China for political expediency. If the White House pressures him to make an agreement he dislikes, we would not be at all surprised to see him resign.[6]

Finnish elections: The Finns went to the polls this weekend[7] and, consistent with what we have seen in the rest of Europe, the outcome showed deep divisions within Finnish society. The center-left, center-right and populist right ended the vote with a near tie. The center-left Social Democrats won 17.7% of the vote (+1.2% from 2015) and claimed 40 seats out of 200. That was a six-seat improvement. The populist right Finns Party won 17.5% of the vote (-0.2% from 2015) and 39 seats, gaining one seat. The National Coalition Party, a center-right group, took 17.0% of the vote (-1.2% from 2015) and 38 seats, a one-seat improvement. The Center party, a centrist farm party, took 13.8% of the vote (-7.3% from 2015) at 31 seats. That was a loss of 18 seats from 2011. The Greens won 11.5% of the vote (+3.0% from 2015) and 20 seats, a five-seat improvement. Finally, the Left alliance won 8.2% (+1.1% from 2015) and 16 seats, a four-seat gain. Various minor parties captured 16 seats.

There is no obvious path to 101 seats because the mainstream parties are uncomfortable with forming a government with the Finns Party. Keeping the Finns Party out of government forces a “grand coalition” structure, similar to what we’ve seen in Germany. Such governments tend to be unwieldy. We expect the process of forming a government to take weeks. But, the bigger issue remains the rise of populism and the inability of the establishment parties to successfully co-opt the movements around Europe.

More on Asian Swine Fever (ASF): As ASF continues to adversely affect the Chinese pork market, analysts are beginning to calculate the impact. China is the third largest consumer, per capita, of pork. However, due to its large population, the impact of China is massive. ASF is a deadly disease to pigs; once infected, whole herds are quickly lost. Simply put, there aren’t enough pigs in the rest of the world to offset the losses in Asia.[8] And, the effects are ongoing. The current loss of herds is curtailing future supply as farmers in China are reluctant to restart herd building. The jump in prices will tend to boost production elsewhere, but there is a natural cycle that must be accommodated.

The ripple effects are starting to show up in the grain markets. Until herds expand elsewhere, demand for grain will decline, especially soybeans. Complicating matters is that planting for corn will likely be delayed due to this weekend’s blizzard; the longer corn planting is delayed, the greater the likelihood that acres will shift to soybeans.[9]

Venezuela: The key to the U.S. policy of ousting Maduro is getting the military to turn on the incumbent. So far, the military has stayed loyal. Why? Most likely, Cuban intelligence operatives.[10]

The Fed:There were a number of comments on the Fed over the weekend. As we noted last week, Herman Cain’s nomination is under pressure. There is clear establishment opposition to the politicization of the Fed.[11] The president hammered on the central bank over the weekend.[12] Starting later today, we will publish the first edition in a new WGR three-part series on the interaction of the Fed on American hegemony. Essentially, it’s all about the ability of the U.S. to impose at least part of the costs of domestic economic adjustment the world. Stay tuned…

View the complete PDF

[1] https://www.wsj.com/articles/mnuchin-says-trade-talks-near-final-round-11555188048?mod=hp_lead_pos7

[2] https://www.ft.com/content/9d363b28-5e5c-11e9-b285-3acd5d43599e

[3] https://www.reuters.com/article/us-usa-trade-china-exclusive/exclusive-u-s-waters-down-demand-china-ax-subsidies-in-push-for-trade-deal-sources-idUSKCN1RR02X

[4] https://www.reuters.com/article/us-usa-solar/chinas-solar-subsidy-cuts-erode-the-impact-of-trump-tariffs-idUSKCN1LF18K

[5] https://www.wsj.com/articles/u-s-china-trade-pact-takes-aim-at-currency-manipulation-11555074003

[6] https://www.ft.com/content/532fd236-5cd7-11e9-9dde-7aedca0a081a

[7] https://www.ft.com/content/69b66888-5ef5-11e9-b285-3acd5d43599e?emailId=5cb404a5316b1d0004e6714f&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[8] https://www.bloomberg.com/news/articles/2019-04-11/hog-apocalypse-in-china-leaves-farmers-fortifying-pigsties

[9] https://finance.yahoo.com/news/deadly-pig-disease-reshaping-global-230000341.html

[10] https://www.washingtonpost.com/world/national-security/venezuelas-military-despite-us-expectations-has-not-turned-on-maduro/2019/04/13/bd0928de-5d2b-11e9-9625-01d48d50ef75_story.html?utm_term=.9fd5c8f4cda3&wpisrc=nl_todayworld&wpmm=1

[11] https://www.nytimes.com/2019/04/11/business/mankiw-moore-cain-federal-reserve.html

[12] https://finance.yahoo.com/news/trump-slams-fed-again-says-151047489.html

Asset Allocation Weekly (April 12, 2019)

Posted on April 12, 2019 by Rebekah Stovall

by Asset Allocation Committee

The employment data is closely watched by financial markets; although the data isn’t necessarily a leading indicator for the economy, it is probably the most important from a political and social perspective. Weak employment data is a worry for political incumbents and concerning to policymakers. However, beyond the headline data, there are usually interesting trends worth noting. In this week’s report, we will examine two trends that have longer term implications.

Career paths were part of corporate culture three decades ago. Large companies often had junior executive programs, where promising young talent was brought to the firm and would follow a rotation of positions in numerous departments before finding a permanent home. In other situations, college graduates would join a company and follow a path of positions of increasing responsibility. However, over the years, outsourcing jobs overseas and increasing industry concentration[1] have probably reduced the number of entry level professional positions in the U.S. This chart shows the percentage of production and non-supervisory workers compared to total non-farm employment.

In the 1970s, this percentage declined to a low of 66%. However, since the early 1980s, the percentage has steadily increased in each business cycle. This data suggests that an increasing number of jobs are non-management positions. We suspect that college graduates are being forced to accept non-management positions as fewer of them are available for an increasing number of graduates. Such disappointment has the potential to cause social unrest. At the same time, reversing industry concentration would tend to boost the number of management jobs in the economy (every firm needs HR, finance, etc.). Thus, support for anti-trust actions could become more popular.

Second, initial claims, on a weekly basis, fell to 40-year lows recently. However, the weekly data is “noisy” and can be affected by floating holidays and weather. Another way of looking at claims is to scale to the civilian non-institutional population. This data is at historic lows.

This low level of claims is likely due, in part, to firms holding on to workers because of tight labor conditions. A rising number of retirees will lift the non-working civilian non-institutional population but fewer workers will tend to depress claims. In any case, this level of claims compared to the population is remarkably low and would argue that wages should rise.

Overall, these two charts offer insights into longer term issues in the labor market. They won’t have an immediate effect on financial markets, but both signal potential for further disruption.

View the PDF

[1] https://finance.eller.arizona.edu/sites/finance/files/grullon_11.4.16.pdf