Last week, we discussed secular cycles in the Treasury market. This week we will discuss equities. The rule for secular cycles in equities is rather simple: the price/earnings (P/E) is the critical factor. In general, profits tend to rise over time. Driving the secular trend in equity markets is what investors are willing to pay for those earnings.
This chart shows the S&P 500 on the lower line (log-scaled) with the 10-year P/E on the upper line.[1] Secular bull markets are shown in gray. What generates the secular trend is the multiple. When the P/E is rising (and the 10-year P/E generally shows the underlying trend in the multiple), equity values tend to rise as well. Secular bear markets are characterized by flat to falling P/Es.
So, the key question is, “What drives the multiple?” Most variables that are important are also complicated and the P/E is, too. In general, the multiple is a sentiment indicator—it measures how optimistic equity investors are about future prospects. Our analysis suggests that inflation plays a role as does general sentiment.
The chart on the left shows the aforementioned P/E with the 10-year rolling standard deviation of inflation. Secular trends are shaded in gray. Although not a perfect indicator, in general, rising inflation volatility tends to coincide with a lower P/E. With all financial assets, inflation is an important variable. Investors have balance sheets; in a way, inflation is the return on real assets so fears of rising inflation, expressed with rising volatility, should discourage investment in financial assets. The chart on the right shows consumer sentiment. Although the data is rather limited compared to inflation, it does show that periods of falling sentiment tend to coincide with P/E contraction.
There is an old saying that “bond investors don’t build hospital wings.” In other words, equities are the best way to build wealth. At the same time, investing in equities requires optimism about the future. War, civil unrest, social disruption and geopolitical uncertainty should make citizens reluctant to invest. For example, the end of the Cold War was likely a contributing factor to the steep rise in the P/E during 1995-2000. Perhaps the relief that the Great Financial Crisis didn’t trigger another Great Depression boosted the P/E after 2008.
Our view on secular trends in equities is based on two factors—what is inflation doing and how do people feel? Rising inflation and increasing volatility of price levels will tend to reduce investor optimism. The perception of how society is doing will affect sentiment. Inflation can be easily measured, while sentiment is more of an observational “call.” At present, the secular bull market appears intact but under threat from two directions. First, if populism gains traction then inflation will likely follow. Second, the high level of political partisanship could eventually affect consumer sentiment. If these trends gain strength, we may be entering into a new secular bear market in equities. That would mean a period of steady to declining multiples. Investors can still make positive gains in equities in such an environment, but passive investing tends to struggle during secular bear markets.
[1] The 10-year P/E is calculated by the 10-year average of nominal earnings divided by the current value of the S&P 500. The multiple is similar to the Shiller P/E except that the latter deflates both by CPI.
Happy employment day! We cover the data in detail below but the quick snapshot is that the numbers are showing clear and increasing evidence of a tightening labor market. The unemployment rate dipped to 3.8% (out to three digits, it was 3.755%), payrolls exceeded expectations and earnings ticked up to 2.7%. The data all support further policy tightening by the FOMC and thus the initial market reaction is a bit bearish for equities, dollar bullish and bearish for bonds.
A side note: The WP[1] is reporting that President Trump appeared to break protocol in a tweet that read, “Looking forward to seeing the employment numbers at 8:30 this morning,” about 69 minutes before the release. Given that the numbers were very strong, it would appear the president tipped off the financial markets to the data. The White House gets the numbers about a day before they are officially released (news media gets it a bit in advance as well—that’s why they can write stories on the data so quickly), but previous presidents hadn’t commented on the reports before the official release. Here is why this matters: financial markets are like poker players, all looking for a “tell.” Finding something that gives one advance information is highly prized. For the markets, if next month he doesn’t signal anything, will the financial markets then assume the data is weak? Or, if the president knows it’s weak and tries to preempt the information by discrediting it in advance, will that lead to early sell-offs? This act has added another layer of uncertainty surrounding this report; we will be watching next month for clues to the numbers.
Italy gets a government: President Mattarella approved a coalition government of populist parties, the two main groups being the Five-Star Movement and the League. The new PM is Giuseppe Conte, with Giovanni Tria, a professor of political economy, as finance minister. It was the finance mandate that led the president to scuttle an earlier configuration. Paolo Savona, the Euroskeptic, will be the minister for EU affairs (that should be interesting). The coalition’s fiscal plans are estimated[2] to cost about 6% to 7% of GDP. If those plans are acted upon, it will lead to a confrontation with the EU (read: Germany). The financial markets are taking this outcome as better than new elections but it isn’t a good outcome for financial markets. At the same time, the two major coalition parties barely won 50% of the vote and this may end up being a short-lived government anyway.
Rajoy out: This morning, Mariano Rajoy lost the no-confidence vote and was replaced by socialist party (PSOE) leader Pedro Sanchez. Upon accepting the position, Sanchez promised to keep the budget plan of the previous administration as well as open up dialogue with secessionists in Catalonia. Even though PSOE does not support secession, the group has historically been open to making concessions to appease Catalonia. That being said, Sanchez’s legitimacy has been questioned by political rivals Cuidadanos and PP because he doesn’t have the backing of the people; he lost the previous two elections. Sanchez’s party currently holds 84 seats in parliament, making it unclear how long his administration will last. In the event of an election, the party we will pay close attention to is Ciudadanos, which will likely pose a challenge to the establishment parties PSOE and PP.
The problem with trade policy: The private sector in capitalist economies are remarkably flexible. It is part of the reason capitalism triumphed over communism. Capitalist economies react better to change; production methods, supply chains, customers, etc. can all be adjusted to maximize profits, sales or whatever the business is trying to accomplish. Businesses constantly complain about regulation, for example. For the most part, however, history shows that industries do manage to adjust.
But, this system functions only if conditions are reasonably stable. Rapidly changing price levels, regulations that vary on a whim or the perception of a wide range of potential outcomes can freeze managers into a position where it becomes difficult to make long-term plans. How does one invest when conditions are rapidly changing? Only with great difficulty.
Herein lies the problem with the administration’s trade policy. It is becoming difficult to tell what future trade arrangements will emerge. If the aluminum tariffs are going to remain in place, a consumer should probably build stockpiles to protect against future price increases…unless the policy changes for some other reason. And, what should a company do if it finds itself as the target of trade retaliation? Invest in lobbying to try to reverse the policy? Woo foreign governments to change their minds?
The U.S. has engaged in a reserve currency system that brings costs and benefits. The beneficiaries are most consumers (we get lots of imports that keep prices down) and the financial system (foreigners need U.S. dollar assets to hold their reserves until needed). The reserve currency is also a source of influence; Iranian sanctions were successful, in part, because other nations feared the loss of access to the U.S. banking system. The costs were borne by those working in import-competing industries. The dollar/reserve policy has been partly responsible for rising inequality. The U.S. has every right to change the rules of the game to help those adversely affected by the policy.
However, the dollar/reserve system is deeply imbedded in how the global economy functions and changing it requires careful adjustments to avoid causing an unexpected crisis. Moving fast and breaking things raises the risks of an unforeseen consequence that will tend to make investors cautious; this will likely play out in the equity markets in the form of multiple contraction.
Energy recap: U.S. crude oil inventories fell 3.6 mb compared to market expectations of a 0.9 mb draw.
This chart shows current crude oil inventories, both over the long term and the last decade. We have added the estimated level of lease stocks to maintain the consistency of the data. As the chart shows, inventories remain historically high but have declined significantly since last March. We would consider the overhang closed if stocks fall under 400 mb.
As the seasonal chart below shows, inventories are usually starting their seasonal decline this time of year. This week’s decline is consistent with that pattern. We expect steady stock withdrawals from now until mid-September. If we follow the normal seasonal draw in stockpiles, crude oil inventories will decline to approximately 426 mb by September.
(Source: DOE, CIM)
Based on inventories alone, oil prices are overvalued with the fair value price of $62.88. Meanwhile, the EUR/WTI model generates a fair value of $63.52. Together (which is a more sound methodology), fair value is $62.92, meaning that current prices are above fair value even with the recent pullback. The stronger dollar is putting downside pressure on oil prices, which is only partially being offset by falling stockpiles. Although we don’t expect a bear market to emerge (there is probably too much geopolitical risk for a decline below $50 per barrel), prices did get a bit ahead of themselves and some consolidation would be normal.
Assad threatens U.S. forces in Syria: Recent comments from Syrian President Assad are an example of the level of geopolitical risk we are seeing. Yesterday, he warned that his government would “wage war” to expel U.S. troops from northeastern Syria if negotiations for withdrawal fail.[3] U.S. troops have supported the Kurds who have established control in parts of Syria. Assad’s comments are really ill-advised. President Trump has already indicated he wants to leave Syria. At the same time, Trump is a Jacksonian; besmirch his honor and he will react harshly. Even threatening to attack U.S. troops could lead the president to react harshly. Assad appears to be overconfident; if he simply keeps quiet, it is likely the U.S. will exit without fanfare. It should be noted that without Russian and Iranian support, Assad would likely be out of power. We doubt either of his supporters would countenance a direct attack on U.S. troops. But, if conditions suddenly escalate, it increases the chances of a geopolitical event in the Middle East and could support oil prices if it spreads.
[Posted: 9:30 AM EDT] It’s the last day of May! Markets are mostly steady, the dollar is a bit weaker and Treasuries are seeing a modest bump in yields. Here is what we are watching this morning:
Italian populists try to form a government: Italy’s president has given the populists more time to form a government,[1] but the League’s leader, Matteo Salvini, has been reluctant to finish the deal, likely hoping that his party’s standing would improve with new elections. Hopes that new elections could be avoided sparked a strong rally in Italian bonds and a pullback in flight to safety instruments, such as the yen and U.S. Treasuries. It seems a bit odd that the formation of a populist government is preferred to new elections, but the fear of new elections is that they will turn into a referendum on the Eurozone and Italians will decide to leave.
In reality, the populist coalition in Italy is rather unusual and may not survive. We have dubbed it a “Nader coalition” of left- and right-wing populists. Why is this rare? It’s a bit like the Tea Party and Occupy forming a government in the U.S. Nader’s argument is that both populist wings share similar goals on economic policy and thus should subsume their social differences to improve their economic conditions. History shows that a more durable coalition is when a center party aligns with a populist party, with the former giving enough economic “goodies” to the populists to keep them together. Franklin Roosevelt’s center-left coalition with the white working class lasted from the 1930s into the mid-1960s.
If the populists do form a government, we doubt it will last long. The League’s base is in northern Italy, which is industrial and economically successful. The Five-Star Movement is based in economically depressed southern Italy. That’s why you see a policy mix that includes tax cuts, anti-immigration and basic national income. The only way such a policy mix works is if the EU simply stops enforcing fiscal rules. However, the financial markets will pressure Italy if such policies are adopted. If we get new elections, look for fear to pressure financial markets but, in reality, new elections are probably necessary and we don’t see Italy leaving the Eurozone in the short run. In fact, about the only way Italy exits the Eurozone is if Five-Star dominates the government.
Trade war looming? The deadline for steel and aluminum tariff exemptions is tomorrow and there is every indication that the Trump administration is moving to implement some form of tariffs, although a short-term waiver is possible. If trade actions are taken, we expect the U.S. to implement quotas on imports, with tariffs applied once the imports exceed the quota level. The real worry is retaliation. We would expect all nations adversely affected to apply their own trade retaliation. Expect the retaliation to be targeted to politically sensitive areas of the economy, including agriculture, bourbon and motorcycles. The tariff threat could also kill this weekend’s scheduled talks between Commerce Secretary Ross and Chinese officials.
Rajoy in trouble: The formal debate to hold a confidence vote on the current Spanish government begins today. Rajoy might survive even though his support is weak because of party rivalry; voting Rajoy out puts the Socialists in power, which the center-left parties don’t want. We expect the eventual outcome to be new elections. Although political turmoil is a bearish factor for confidence assets, this problem is more normal. What is going on in Spain is all about domestic issues, while Italy affects the foundation of the Eurozone. Thus, we would not expect Spain to turn into a Eurozone crisis.
A hawk flies away: The BOE’s Monetary Policy Committee bid adieu to Ian McCafferty and announced that Jonathan Haskel will be joining the group. McCafferty has been a recent dissenter to steady policy, voting to raise rates. It is unclear how Haskel will vote. He is an economics professor and specialist in productivity and growth measurement. Most likely, the committee has become a bit more dovish.
The OECD boosts growth forecasts:The OECD is forecasting global GDP to rise 3.8% this year, up from its last forecast of 3.5%, mostly due to stronger U.S. growth. Although the strong dollar’s impact on emerging markets was noted as a risk factor, the group remains optimistic about the near term.
[Posted: 9:30 AM EDT] Financial markets are a bit calmer this morning. Equities are rebounding and Treasury yields are rising. The EUR is also higher. Here is what we are watching:
Italy: The populist coalition is trying to revive talks to form a government, perhaps coming up with a less controversial slate of ministers. However, disputes between the Five-Star Movement and the League have developed as they both try to jockey for power. Meanwhile, Carlo Conttarelli has been assigned the task of putting together a government by Italy’s president and has made little progress on that front. It looks like the most likely outcome is a new vote, which will occur in late July at the earliest but more likely by mid-September.
The EU has also weighed in on the turmoil. Germany’s EU commissioner, Günther Oettinger, indicated that the financial markets would show Italian voters they should reject populist parties.[1] He faced harsh criticism from the president of the EU council, Donald Tusk, but the general feeling is that his comments were not incorrect, but rude. And, this statement coming from a German, the nation being blamed for the woes of southern Europe, didn’t help matters.
This is what we are seeing in the political trends. The populist coalition could have been saved but the League seems to want new elections. Polls suggest its support is growing and the leadership of the party seems to believe new elections would designate it as the senior partner in a coalition with Five-Star. The establishment in Italy wants to make the next election a full-blown referendum on the Eurozone, betting that Italian voters, though unhappy with the fiscal restrictions of the Eurozone, will not support exiting the single currency for fear of the high costs involved with moving from the euro to a new currency. It looks like the most probable outcome is (a) new elections, but (b) no party will be able to build a working coalition, and thus (c) more muddling through.
When one forecasts anything, there is the short run (now to three years roughly) and the long run (the eventual outcome). In reality, the long run is really nothing more than an envelope of short runs that eventually travel toward the most likely equilibrium. The Eurozone has a structural problem. Successful currency blocs (such as the U.S.) have:
Common political and, more importantly, fiscal transfer systems which allow for some degree of equality across regions;
High labor and product mobility;
Jointly held debt.
Or, in simple terms, states and regions in a currency bloc have limited sovereignty. In the U.S., for example, states have some sovereignty but not complete power; they don’t print their own money. For the Eurozone to really work, European nations have to give up sovereignty to the EU. Absent of some unifying war, there is little chance that these nations will willingly give up enough sovereignty for the Eurozone to work. Here is a milestone that would show the Eurozone will work—when Germans are willing to underwrite a Eurobond that allows Greece to issue debt that is guaranteed by the whole Eurozone (read: Germany). It could happen…but it’s not likely. In other words, Europeans can have the Eurozone and the single currency at the cost of reduced sovereignty or keep the current level of sovereignty but give up the single currency. They can’t have both. Every Eurozone crisis could be the “one”; however, conditions are probably not quite dire enough to push Italy to vote to exit the Eurozone, which would be expressed by voting in a massive coalition of populists.
Trade:The Trump administration has moved to put tariffs on $50 bn in Chinese imports, just a few days after it appeared a truce was in place. We will be watching to see if North Korea suddenly turns hostile again. The U.S. has also decided to impose greater limits on Chinese visas, perhaps in a bid to reduce China’s ability to send students to the U.S. to study and boost China’s tech prowess.[2] Commerce Secretary Ross is scheduled to meet with Chinese officials this weekend. The new tariff announcement could scuttle these talks. On June 1, the temporary postponement of steel and aluminum tariffs on numerous American allies expires; it isn’t clear if they will be postponed further or not. If they are not, look for retaliation. The trade drama continues but the direction is steadily moving toward a change in the trade relationship with the world.
[Posted: 9:30 AM EDT] It’s clearly another “risk off” morning—equities are lower around the world, the dollar, yen and Treasury prices are up, and most other currencies are lower. Europe is the culprit. Here is the story:
The Italian job: Over the Memorial Day weekend, Italy’s president, Sergio Mattarella, refused to allow a populist coalition of the Five-Star Movement and the League to form a government.[1] The sticking point was the group’s decision to name Paolo Savona as finance minister. Savona is deeply skeptical of the Eurozone and would likely press for Italy to exit the single currency. So, Mattarella scuttled the negotiations and instead appointed Carlo Cottarelli as a caretaker PM. Cottarelli is an anathema to the populists; he is a former IMF official and represents everything the populist coalition detests.
Italian bond yields continue to rise on the news.
(Source: Bloomberg)
Perhaps what is most impressive isn’t the spike in Italian yields but the drop in German Bund yields, which are now down to 31 bps from mid-60 bps before the crisis. The drop in German yields is a clear indication of capital flight, most likely from Italy.
The disgruntled coalition has called for Mattarella’s impeachment and there are reports that demonstrations and strikes are possible.[2] Assuming Cottarelli cannot form a government (and it is highly probable he won’t be able to), elections are likely to be scheduled for September. This election could be pivotal for the future of the Eurozone and the euro. Up until this point, the Italian parties have not really campaigned on leaving the single currency. The populist parties, instead, planned on flouting fiscal restrictions, daring the EU to stop them. However, the September poll is shaping up to be about Italy’s status in the Eurozone. Most polls show a slim majority support for continued membership in the Eurozone; only about 55% support the single currency, the second lowest of any Eurozone nation. Only Cyprus is marginally lower. Still, that means the majority of Italians still support remaining in the Eurozone. Thus, if the election does become a referendum on the single currency, the populists may not win. At the same time, the centrist parties are in deep disarray and may not be able to form a government anyway. Thus, the risks are unusually elevated that the September vote leads to a radical outcome.
What we find most interesting about the Italian situation is that Italy has created the “Nader coalition” of populist right and left wings.[3] Nader’s vision is that the economic goals of the right- and left-wing populists are close enough to build a dominant political coalition. Nader wrote his book for U.S. voters; however, to date, a Trump/Sanders coalition looks like a low probability event. Italy may be closer to Nader’s idea; interestingly enough, the policy mix of lower taxes, immigration restrictions and a basic national income doesn’t fit with any degree of fiscal restraint. Perhaps the secret to the Nader coalition is to jettison fiscal control.
Although purchasing power parity clearly favors the euro over the dollar, the potential for a bust-up of the Eurozone will hang as a major threat to the single currency and consequently weigh on the exchange rate. Of course, the worst case scenario rests on a significant populist win in September, which may not happen. Although Italy’s debt/GDP ratio is a whopping 132%, most of that debt is held domestically…in euros. If the Italian government leaves the Eurozone and tries to change the debt currency to the “new lira” instead of euros, the backlash would be significant. Our read is that most Italians like the external governor that Eurozone membership provides but oppose the fiscal constraints. Leaving the Eurozone would almost certainly be painful for Italian savers; thus, if the September vote becomes a referendum on remaining in the Eurozone, we suspect the populists will fail to form a government. But, the vote will be close and any casual observation of Italy’s economic performance since joining the Eurozone makes it clear that Italy will be better off outside the Eurozone once the painful adjustment process is complete. Getting to that “promised land,” however, requires a great deal of disruption that no one wants in the short run.
Spain, too: PM Rajoy faces a confidence vote on Friday. Rajoy’s center-right government has faced a series of scandals that have undermined sentiment. If the vote goes against Rajoy, the odds of new elections increase. Additional European political turmoil adds to concerns about the euro.
North Korea dialogue: After postponing talks, North and South Korea have moved aggressively to support negotiations. The leaders of the two Koreas have met[4] and envoys from both the U.S. and North Korea are meeting; in fact, a high-ranking North Korean official, Kim Yong Chol,[5] has arrived in New York for discussions. Although the Trump/Kim summit isn’t officially on, in reality, there are indications that talks are likely.
China trade: Breaking at the time of this writing, the Trump administration indicated it would proceed with tariff plans against China.[6] Given that negotiations continue, we see this as mostly posturing rather than signaling action.
Last week we discussed the general idea of secular versus cyclical trends. This week we will look at these concepts with regard to longer duration fixed income.
The goal of theory is always to simplify. Theorizing is all about taking complex phenomena and reducing it to basic elements that can guide us in estimating the future. However, as Albert Einstein noted, “Everything should be made as simple as possible, but not simpler.” The yield on sovereign debt instruments should be a function of the policy rate and inflation expectations. The longer the duration of the instrument, the more important inflation expectations are to the yield. However, specific historical conditions do count. For example, a nation’s credit risk can change over time; government borrowing behavior can play a role. Even geopolitical risks can matter; Tsarist bonds traded at 95 rubles to par of 100 in late 1914, only to have the debt later repudiated by the Bolsheviks.[1] Thus, secular trends can abruptly change if underlying conditions adjust significantly.
The above chart looks at inflation trends and the yield on 10-year T-notes. For inflation, we use CPI from 1915 to the present; the data prior is the General Price Index. Although not perfectly equivalent, the two indices do give general insight into inflation. We have added a 10-year average of yields and a 15-year average of inflation to highlight the trends in the data.
Inflation behavior until the 1930s was rather erratic. This was because the U.S. was on the gold standard and the money supply was partly driven by mining activity and partly driven by industrial activity. In other words, deflation is highly likely if the money supply is fixed while output is rising rapidly (as was the case during the industrial revolution).
These charts show the behavior of our inflation series; the chart on the left shows the dispersion during the years 1810 until June 1933, when President Roosevelt ended the ability of citizens to hold gold. The average inflation rate over this time frame was a mere 0.5%; however, range was wide. Note that the highest rate recorded was 34.4% during the Civil War and the lowest was 16.2% during a downturn after there was a lull in public investment. During this period, deflation occurred almost 53% of the time. After June 1933, the average inflation rate rose to 3.6% but the range narrowed significantly, from 19.7% after WWII to a low of -4.1% during the 1936-37 recession. Deflation only occurred 6.5% of the time after Roosevelt ended the gold standard. Economists discovered that people have an asymmetric response to inflation and deflation—rising prices tend to spur buying which supports growth, while deflation can lead consumers to stop buying in anticipation of even lower future prices.
It would be reasonable to assume that longer duration yields would be rather low during the period when deflation was common. In fact, they averaged 4.6% in the years from 1810 to 1933. Yields remained low during the Great Depression, and, during WWII, the Treasury forced the Federal Reserve to keep rates low to reduce borrowing costs. Thus, the “modern era” really begins in March 1951 with the Federal Reserve-Treasury accord. That pact allowed the Federal Reserve to set interest rates based on economic conditions. In theory, central bank independence is generally thought to lead to better inflation control. In the absence of an external restraint on money creation, i.e., gold, central bank independence should create conditions of better inflation control. However, from the 1950s into the early 1980s, the Federal Reserve raised short term interest rates to try to quell steadily rising inflation. Since the policy rate acts as an anchor for longer duration instruments, T-note yields rose during this period. The average yield on T-notes from March 1951 to the present is 5.1%. However, as the above charts show, long-duration rates steadily rose until the early 1970s and then rose rapidly with each business cycle until peaking in late 1981. By the late 1970s, policymakers were moving aggressively to contain inflation through strict monetary policy, deregulation and globalization. Those policies triggered a secular bull market in bonds that continues to this day.
We believe this bull market in bonds is likely nearing an end. Populism is becoming an increasingly potent force throughout the West. In general, populism usually leads to re-regulation and deglobalization. These factors should, over time, lead to steadily rising inflation and bond yields.
Our base case is that we will likely see a gradual increase in yields over the next 10 to 20 years. We do not expect that increase to be sudden, but do look for higher high yield and higher low yield in each business cycle. The asset allocation committee believes this situation can be managed with a modest shortening of duration and the use of “ladders” using target-date exchange-traded products.
However, as part of our scenario planning, there is the possibility that we may see discrete jumps instead of a gradual increase in interest rates. This is due to the generational experience of inflation.
This chart shows the adult experience of inflation, starting with age 16. The current 64-year-olds have experienced the highest average adult inflation, at 4.1%. Note that the experience of inflation declines rapidly for the current age cohort in their 50s. Over time, the area of the graph will shift to the right, meaning that society’s memory of the high inflation years will gradually diminish. However, that isn’t the case now; a significant cohort remembers inflation and, if populist policies expand quicker than we expect, the baby boom generation could react strongly and trigger inflation fears.
If inflation fears are triggered, we could see a bear market in bonds develop characterized by rapid spikes in long-term interest rates that choke off growth and lead to less stable financial markets and shorter business cycles. This is not our base case. However, the particular demographic pattern could lead to this outcome, which we will monitor closely.
[Posted: 9:30 AM EDT] Happy Friday! Here is what we are watching this morning:
Capping oil prices: On the eve of the first summer holiday, gasoline prices are becoming an issue. The recent rise in crude oil prices has taken gasoline higher. Although higher gasoline prices are a natural consequence of higher crude prices, perhaps no other price has greater visibility and political impact. The president has tweeted against high oil prices in the recent past and now the issue is starting to have some political implications.[1]
There have been three reasons behind the recent rise in oil prices. First, OPEC + Russian output discipline has been solid. We believe Saudi Arabia has held production steady to support its IPO of Saudi Aramco, which we expect sometime next year. Second, supply was curtailed further by falling output from Venezuela. The potential for additional sanctions on Iran has boosted bullish sentiment. Third, the dollar was weak for most of last year; most of the time, there is an inverse correlation between the dollar and oil. The weaker dollar acted as a bullish factor for oil prices.
These factors have been reversing. OPEC has enjoyed the rise in prices but has been disappointed with the loss of market share caused by the surge in U.S. shale production. It does not want to cede market share indefinitely. Consequently, the cartel is looking to boost production.[2] Second, the dollar has been rising, mostly due to expectations of tighter monetary policy. We note that the dollar is still expensive on a parity basis and history suggests rising deficits will pressure the dollar going forward. Thus, we don’t expect the dollar to rise over the long run but, until the FOMC is set to “pause,” the dollar will tend to be underpinned by policy divergence.
The political fallout should not be underestimated. President Trump has two policy levers at his disposal to bring down gasoline prices. First, he can release oil from the Strategic Petroleum Reserve. Although this oil is held for emergencies, in fact, previous presidents have tapped it to curb price increases. Second, he can use his “tweet” bully pulpit to pressure OPEC into raising production. Given that the Saudis have been actively trying to cultivate good relations with the president, it looks like this is the direction the kingdom wants to go in anyway.
We have been bullish on oil prices for several months. Given the above factors, a more neutral position is probably warranted. That doesn’t mean oil prices are heading to the basement. Geopolitical risk remains elevated and we expect U.S. refiners to ramp up output for the summer driving season. But, a pullback into the low $60s would not be a huge shock.
No summit: We were surprised by the president’s decision to walk away from the summit with North Korea but we do agree that Beijing was likely behind the breakup. China has been afraid the U.S. would make an ally out of North Korea and, given the Koreas’ almost natural opposition to China, Chairman Xi had reasonable concerns that Kim could be turned. Thus, he moved to ease sanctions on North Korea and we saw a near about-face in North Korea’s rhetoric. The White House made some unforced errors, too. John Bolton’s talk of the “Libya model” was a mistake, although it is also probable that Bolton wasn’t thrilled with the summit anyway.
The key issue is, “now what?” We see two consequences from the summit’s cancellation. First, trade negotiations with China will likely become hostile again. It appeared the White House was pulling its punches in trade talks with China, likely hoping Beijing would assist the U.S. in negotiations with North Korea. Now that the summit is canceled, we would expect the Navarro/Lighthizer hardline wing to return to the forefront. Second, the risk of military action against North Korea will likely increase in the coming weeks. If it occurs, it will tend to lift flight to safety assets.
Backdoor bonds: The EU is working on a proposal to create “sovereign bond-backed securities” (SBBS), which would create a securitized bond composed of the government debt of the various EU nations. The stated reason for the creation of these instruments is to create a bond that European banks could buy in lieu of their national government bonds and reduce the odds of the “doom loop” that occurs during crises. However, this probably isn’t the real issue. One of the reasons the EUR can’t compete with the USD for reserves is that there is no single sovereign bond that is backed by the full faith and credit of the Eurozone. Thus, if a nation wants to hold EUR as reserves, it has to pick a single country bond to invest in. That reduces the attractiveness of the EUR. Creating a securitized debt instrument with “all” the bonds in the Eurozone could be a substitute for the lack of a Eurobond (defined as a single full faith and credit instrument).
The Germans saw through the ruse. Germany’s finance minister, Olaf Scholz, slammed the plan, correctly pointing out that if such a securitized instrument was viable the private sector would have already created it. Germany has vehemently opposed any attempt to mutualize Eurozone debt, worried that higher spending nations (read: Italy) would borrow heavily against the credit of Germany and force the Germans to fund Italy’s spending in the case of a crisis. This little dust up tells us that the mandarins within the EU still pine for a unified Eurobond.
[Posted: 9:30 AM EDT] The two big news items are the deterioration of conditions with North Korea and Trump’s call for a 25% tariff on autos. Here is what we are watching:
BREAKING NEWS: PRESIDENT TRUMP CANCELS SUMMIT MEETING WITH NORTH KOREA.
What’s going on with North Korea? For most of last year into early this year, it looked like war was increasingly likely. Then, everything turned with President Trump agreeing to a summit. Now, the summit is off. North Korea has returned to the nuclear rhetoric.[1] What happened here? There were a couple of missteps by the Trump administration. Suggesting that North Korea could use the “Libya model” was clearly a blunder (the South Africa model would have been a better example). Selecting John Bolton for national security director sent a hostile signal. But we don’t think these issues were key.
Instead, what we think is going on is that China is using North Korea to manage U.S./China trade relations.[2] China was generally comfortable with the status quo in North Korea. However, it was afraid that the U.S. and South Korea were trying to pull North Korea out of China’s orbit and thus has taken steps to reel Pyongyang back in. There are reports that China has eased up on sanctions.[3] Now, Beijing may be sensing an opening in which it may be able to pull both Koreas into its orbit and isolate the U.S. After all, Trump renegotiated the Korean Free Trade Agreement to be less favorable to South Korea. If Xi can get North and South Korea to become friendlier he might be able to reduce U.S. influence in the region. A failed summit might move that goal along. Of course, the risk is that a failed summit leads to an open conflict. But, if South Korea won’t cooperate militarily, the U.S. probably won’t act. Trump’s decision to hold a summit with Kim was a bold move but the inability to complete the deal may lead to a new arrangement that is less favorable to the U.S.
Auto tariff threats: President Trump, citing national security concerns, is threatening a 25% tariff[4] on automobile imports. Although the national security angle seems to be a stretch, the Commerce Department has opened a study to determine the threat. This study will likely take months, so this issue will hang over the market for some time. Although the administration’s trade actions have tended to be less onerous than the rhetoric, trade impediments are inflationary and will tend to pressure financial markets.
Fed minutes: The minutes were taken as dovish, although our read leans more toward neutral. There was some support for allowing inflation to exceed target for a while, but that expectation wasn’t a complete surprise. Although current policy rates were described as “accommodative” (which we would agree with), there were “some” members who suggested this could be revised soon. This indication may mean that some members are thinking we are approaching a neutral policy rate. If true, a “stall” in tightening could occur, but we don’t think this is the base case. Although two of the Mankiw Rule variations have the current rate essentially at neutral (wage growth and the employment/population ratio), the unemployment rate and the involuntary part-time employment rate shows many more hikes in the pipeline. Thus far, the FOMC has not had to face a situation where some of the variations show tight while others show loose, but that day is approaching. We would expect dissention to increase for a couple members over rate increases.
Iran responds: The supreme leader of Iran, the Ayatollah Khamenei, laid out conditions for the European powers to remain in the nuclear agreement. Specifically, there will be no new negotiations on Iran’s missile program or its security policy in the Middle East. The Europeans must continue to buy Iranian oil and safeguard trade with Iran. Europe must condemn the U.S. for breaking the nuclear deal and “stand up” to U.S. sanctions.[5] These are effectively non-starters for the U.S. Iran is clearly trying to separate the U.S. and Europe in terms of Middle East policy. We believe that Europe’s best interests lie with the U.S. but following the Trump administration will tend to raise oil costs for European consumers.
Turkish lira rebounds: The Turkish central bank raised rates 300 bps to 16.5% yesterday afternoon, triggering a sharp short-covering rally in the TRY. However, this morning the exchange rate has started to weaken again, although it has not made new lows…yet. Usually, markets will test the resolve of a central bank, forcing it to raise rates enough to convince traders that it will “do what it takes” to stabilize the exchange rate.
1997 redux? The turmoil in both Argentina and Turkey has raised fears that we may be on the cusp of another emerging market crisis. The high levels of debt in the emerging space, much of it in dollars, has also brought concerns.
This chart, courtesy of the St. Louis FRB,[6] shows a surge in emerging market debt, although most of the growth is emanating from China. And, since the financial crisis, the dollar has become the borrowing currency of choice. This borrowing has made emerging markets more sensitive to dollar strength.
However, it should also be noted that there are significant differences between now and 1997. First, many of the emerging economies pegged their exchange rates to the dollar. When the pegs failed, debt service costs for dollar borrowers took a discrete jump and exacerbated the crisis. Once one pegged currency failed, it led to a contagion that became impossible to control. This time around, currencies are floating, meaning that they will not rise with discrete jumps, which should make debt management easier. And, it should reduce the risk of contagion. That being said, the emerging space needs dollar weakness to flourish and the debt data is a major reason why.
Energy recap: U.S. crude oil inventories rose 5.8 mb compared to market expectations of a 2.0 mb draw.
This chart shows current crude oil inventories, both over the long term and the last decade. We have added the estimated level of lease stocks to maintain the consistency of the data. As the chart shows, inventories remain historically high but have declined significantly since last March. We would consider the overhang closed if stocks fall under 400 mb.
As the seasonal chart below shows, inventories are usually rising this time of year. This week’s rise is inconsistent with the onset of seasonal patterns. We expect steady stock withdrawals from now until mid-September. If we follow the normal seasonal draw in stockpiles, crude oil inventories will decline to approximately 429 mb by September.
(Source: DOE, CIM)
Based on inventories alone, oil prices are overvalued with the fair value price of $61.73. Meanwhile, the EUR/WTI model generates a fair value of $64.76. Together (which is a more sound methodology), fair value is $63.39, meaning that current prices are above fair value. The combination of a stronger dollar and the unexpected rise in inventories means current oil prices are overvalued. Using the oil inventory scatterplot, a 429 reading on oil inventories would generate oil prices in the high $70s. The current high price is mostly a function of growing geopolitical risk which we don’t see abating anytime soon. However, oil prices cannot continue to defy fundamentals; at some point, a correction may be in the offing.
[Posted: 9:30 AM EDT] It’s looking a bit ugly out there this morning for risk assets. Equities and most commodities are lower, while gold, Treasuries and the JPY are higher. This is a classic pattern of flight to safety buying. Here is what we are watching:
Twin crises: Turkey and Italy are the primary problem areas this morning. Turkey is facing a full-blown currency crisis.
(Source: Bloomberg)
The above is a three-decade chart of the TRY/USD exchange rate in terms of lira per dollar. We are not only making new lows but making them in rapid fashion. The drop in the TRY is a classic example of why leaders shouldn’t undermine the independence of the central bank. The textbook response to this sort of decline is a massive increase in short-term interest rates. This action increases the cost of shorting (the short has to borrow in the shorted currency) and usually arrests the decline. However, President Erdogan is strongly opposed to interest rate increases so we have a showdown between the financial markets and the president. Compounding the problem is that the Turkish private sector has borrowed in foreign currencies, meaning the drop in the TRY is rapidly escalating the cost of debt service. S&P[1] is threatening a downgrade. Turkey is holding national elections on June 24. Erdogan is hoping to solidify his political position to change the nature of the presidency, boosting the executive’s power. A currency crisis that triggers a debt crisis won’t help Erdogan’s popularity.
Meanwhile, the travails of Italy continue. The Five-Star Movement and the League are close to forming a government but have hit two snags. First, their candidate for PM, Giuseppe Conte, a politically unknown law professor, appears to have either lied about or inflated his accomplishments on his resume.[2] Second, the coalition is recommending Paolo Savona for finance minister, an avowed Euroskeptic.[3] President Mattarella, who must approve any government, is not comfortable with either choice for PM or FM. Italian credit markets are showing signs of stress. First, sovereign interest rates are rising.
(Source: Bloomberg)
This chart shows the Italian vs. German 10-year sovereigns. The spread is widening out rapidly; what is worrisome is that while Italian yields are rising, German yields are declining (albeit modestly). This suggests we may be seeing capital flight out of Italy into German paper. Second, Italian bank bonds, especially those with elevated levels of non-performing loans, are coming under pressure.[4]
OPEC: Oil prices slipped yesterday afternoon on reports that OPEC may boost output to offset declines in Venezuelan production.[5] The cartel probably does not want to see the U.S. gain market share due to Venezuela’s woes. If it actually occurs, we don’t see this change in OPEC as necessarily bearish but it will tend to cap some of the recent enthusiasm. Oil prices have mostly ignored the recent rise in the dollar, but eventually the stronger greenback will tend to adversely affect oil prices.
Facebook (FB, 183.80): Mark Zuckerberg was given kudos for coming to testify in Europe; that’s where the praise ended. The apology was more in the vein of, “I’m sorry you were upset,” and it was apparent that the company has no interest in changing its advertising-driven business model. At this point, social media’s greatest threat comes from Europe.
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