Weekly Geopolitical Report – Reflections on Globalization: Part III (April 23, 2018)

Posted on April 23, 2018 by Rebekah Stovall

by Bill O’Grady

This week, we will conclude our series on globalization with a discussion of how China and Russia threaten U.S. hegemony, the potential responses and close with market ramifications.

China, Russia, the U.S. and Hegemony
U.S. policymakers, heeding the Washington Consensus, assumed that developing nations would eventually adopt both market economics and representative democracy. American policy toward China was thus based on the idea that integrating China’s economy into the world trading system, which was dominated by the U.S., would eventually lead Beijing to drop communism and adopt democracy. After all, a string of other nations had made similar transformations, including Japan, Germany, South Korea and Taiwan. Japan and Germany had to lose a mass mobilization war to make this shift, but South Korea and Taiwan eventually shelved authoritarian regimes in favor of democratic governments.

Based on this expectation, the U.S. gave China wide latitude in its trade policy. Although obviously mercantilist, it was generally believed that China would eventually integrate into the world economic system on U.S. terms as its economy developed. China has integrated into the world economy but not in a manner preferred by the U.S.

There was a serious flaw in this expectation. Germany and Japan were willing to adjust to U.S. demands[1] because both nations were dependent on America’s security guarantee. China, on the other hand, was not necessarily protected by the U.S. Although Nixon’s opening to China was partly due to China’s worry about Soviet aggression, in reality, China didn’t face any serious outside threats after the collapse of the Soviet Union. Its military was mostly concerned with internal control.

China is making it clear that it is a strategic competitor to the U.S. It does not want to necessarily challenge the U.S. around the world but it does not want to be beholden to the whims of American policy. In his recent work on Thucydides’s Trap,[2] Graham Allison noted that the U.S. threatened British hegemony in the Western Hemisphere in the early 20^th century. Although the British were uncomfortable not projecting power into that region, American power was overwhelming and the British faced another strategic threat from Germany. Thus, the British ceded the Western Hemisphere to the U.S. Part of the reason for taking this step was the cultural similarities between the two countries. Both were market economies and democracies, which made Britain’s actions more reasonable. And, Germany was becoming a more proximate threat (and proved to be a real one by 1914).

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[1] Examples include the 1985 Plaza Accord, the 1994 Halifax Accord and Japan’s “voluntary” export restraint on cars in the 1980s.

[2] Allison, G. (2017). Destined for War: Can America and China Escape Thucydides’s Trap? New York, NY: Houghton Mifflin Harcourt Publishing Company.

Daily Comment (April 23, 2018)

Posted on April 23, 2018 by Rebekah Stovall

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It was a very busy weekend. This morning, 10-year T-note yields briefly touched 3.00% and remain near that level. The dollar is higher on somewhat soft European PMI data. Here is what we are watching this morning:

North Korean thaw: Kim Jong-un said his nation would close its nuclear test site and suspend its long-range missile launches but didn’t go so far as to give up his nuclear arsenal, at least not immediately. In one sense, this is a big deal; the NY Times[1] speculated this may signal an end to the current leader’s signature policy, “byungjin,” which is essentially a “guns and butter” approach to the economy. Instead, North Korea would allow the civilian side of the economy to prosper by allocating it more resources than the military side. If true, this signal alone is important because it suggests Kim has enough confidence in his control of the military that he can reduce its resource base.

However, like all complicated issues, this one comes with caveats. First, the nuclear test site has probably been compromised. Mount Mantap, the site of six nuclear tests, may have suffered enough damage to threaten leakage if another test occurs there.[2] Although North Korea has other test sites, this one is clearly the favorite. We would not be shocked to discover that China has pressured North Korea to stop testing at Mount Mantap. At the same time, we doubt North Korea has completed enough tests to reliably believe it can build a working warhead, so the agreement to suspend tests is important. Second, a suspension of missile tests can end quickly.

George Friedman at Geopolitical Futures[3] argues that North Korea is shifting from a “ferocious, weak and crazy” strategy to a “ferocious” strategy. Kim acknowledged that North Korea is now a nuclear power, thus the weak part of the original strategy is no longer operative. And, nuclear powers cannot be unpredictable; it invites pre-emptive attacks. The concessions will offer both the U.S. and North Korea room to bargain but we would not expect North Korea to immediately give up its nuclear weapons program. But, a runway for integration into the world economy would bolster North Korea’s economy. The key unknown is Kim’s views on markets. His grandfather and father saw markets as a threat but it appears Kim does not. Thus, North Korea may be opting for a Chinese model of development.

Europe visits the White House: President Macron and Chancellor Merkel are visiting the White House this week. We expect each of them to suggest that allies don’t fight over trade (which really isn’t true—Reagan did with Japan and Germany) and that the U.S. should not simply jettison the Iranian nuclear deal. President Trump and President Macron seem to get along well on a personal level which might help discussions. However, we still view the chances that the Iranian deal gets scotched as elevated. SOS nominee Pompeo will likely not be recommended by the Senate Foreign Relations committee this week but will probably still get the position by a narrow margin in the Senate vote. His appointment would add another Iran hawk to the administration.

China rumblings: There were four items of note on China. First, Treasury Secretary Mnuchin tried to lower the temperature on trade tensions with China over the weekend. At the spring IMF meetings, Mnuchin met with PBOC Governor Yi Gang and informed the Chinese official that he is interested in visiting China. It appears China was open to talks. In discussions at the IMF meeting, Mnuchin expressed optimism that a trade conflict would be avoided. Second, President Xi and PM Modi of India have announced they will hold informal talks on Friday and Saturday of this week. India and China have a contentious mountain border and the former has looked at the one-belt, one-road project with trepidation, fearing encroachment by China into South Asia. China has allied itself with Pakistan, India’s arch-enemy. Although India has improved ties with the U.S., concerns about the stability of American policy may be prompting Modi to seek accommodation with China. Third, the Pakistani press[4] is reporting that China is “ready to provide security guarantees for the one-belt, one-road project.” At this point, China doesn’t have the military infrastructure to back such claims. However, we note that the U.S. didn’t either when it unveiled the “Monroe Doctrine.” Simply making the claim is important if no outside power challenges the claim. Fourth, the EU is claiming that China is using criminal groups to avoid VAT in Europe.[5]

Global tensions: Greece is reporting that Turkey has been increasing incursions into Greek airspace and waters recently.[6] Greece was given islands near Turkey at the end of WWI, which was also the end of the Ottoman Empire. It appears that Turkish President Erdogan is trying to rebuild at least part of that fallen empire. He is also encroaching into Iraqi and Syrian territory and the threats to Greece are part of that posture. In the same region, widespread protests were reported in Armenia. The former president, Serzh Sargsyan, had to step down due to term limits. He then took the role of prime minister and transferred all the power of the presidency to his new role. Anger over Sargsyan’s ploy to extend his rule has led to the unrest. Widespread protests also continue in Iran. Much of the unrest is due to deteriorating economic conditions. A drought is leading farmers to demonstrate against Iran’s water allocation policies. The nuclear deal was partly done to improve the economic lot of Iranians. However, lingering sanctions and uncertainty about the future path of the nuclear deal have tempered economic growth. If President Trump does kill the nuclear deal, Iranian leaders will likely welcome that outcome because it would allow them to blame the U.S. for their economic woes. The nuclear deal raised expectations that have not been met; reinstituting sanctions would reduce those expectations.

U.S. aluminum prices fall: There are reports that the administration may ease sanctions on Rusal (HKD 0486, 1.52) after its controversial leader, Oleg Deripaska, offered to step down as president. The news has led to a drop in U.S. aluminum prices.

Saudi scare: Over the weekend, there were reports of massive gunfire in Riyadh. Although there were unconfirmed rumors of a coup attempt, the official report was that a drone had strayed near the Royal Palace, triggering a wave of anti-aircraft fire. There were unconfirmed reports King Salman was moved to a secure bunker in the capitol. At this point, it is unclear if this incident was anything more than the official version of the story. Clearly, the oil markets are unconcerned as prices are slumping this morning. We will be watching in the coming days to see if there are any reports of arrests. However, even if the official version is correct, the reaction observed in Riyadh does suggest that security forces are on elevated alert.

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[1] https://www.nytimes.com/2018/04/21/world/asia/north-korea-kim-jong-un-nuclear-tests.html

[2] https://www.washingtonpost.com/world/after-six-tests-the-mountain-hosting-north-koreas-nuclear-blasts-may-be-exhausted/2017/10/20/ccdfa016-b50d-11e7-9b93-b97043e57a22_story.html?utm_term=.bc0f2e110390

[3] https://geopoliticalfutures.com/north-koreas-strategy-halting-nuclear-program/ (paywall).

[4] http://paktribune.com/news/China-ready-to-provide-security-guarantees-for-the-One-Belt-One-Road-project-280601.html

[5] http://m.scmp.com/news/world/united-states-canada/article/2142760/eu-suspects-tax-fraud-chinas-gateway-europe-state?amp=1&__twitter_impression=true

[6] https://www.nytimes.com/2018/04/21/world/europe/greece-turkey-islands.html

Asset Allocation Weekly (April 20, 2018)

Posted on April 20, 2018 by Rebekah Stovall

by Asset Allocation Committee

The Trump administration has made it a key policy goal to reduce the trade deficit. The reasoning is that reducing the trade deficit will boost jobs in areas that have been adversely affected by foreign competition. Although this might be true (trade is very complicated), the risk is that trade restrictions will likely result in higher inflation.

This chart shows net savings balances. These are macroeconomic identities, which, like a balance sheet, total to zero. However, how they reach zero is interesting. Usually, government dissaving (more commonly called a fiscal deficit) is offset by the combination of private and public sector saving. Foreign saving is the inverse of the current account; when a nation accumulates foreign saving, it is running a trade deficit. Private sector saving comes from the household and business sectors. For the former, it’s the difference between income and consumption. For the latter, it’s the net of revenue after investment. Thus, for the entire private sector, net saving is saving less investment.

Since the early 1980s, foreign saving has become a nearly permanent fixture. Most pundits argue that the U.S. must “attract” foreign saving due to the fiscal deficit. However, the direction of causality can be difficult to trace. For instance, under conditions of free trade, if a foreign nation purposely builds excess saving, that excess saving will become a trade surplus and the rest of the world must absorb that excess production (saving). If trade barriers exist, that excess saving is transformed into domestic investment, either by inventory accumulation or increased investment spending.

Because the U.S. is the provider of the reserve currency, it is the most likely target of foreign saving. Note that in the late 1990s, the U.S. ran fiscal surpluses with rising foreign saving inflows. There was a plunge in private saving, mostly due to business dissaving. Some of that increased investment was due to Y2K spending but some ended up bidding up existing asset prices (the tech bubble was partly a beneficiary). Ben Bernanke referred to a global “savings glut” in the last decade that is seen in the foreign inflows.

President Trump wants to reduce the trade deficit; if he is successful, he will also reduce foreign saving to the U.S. With the fiscal deficit rising, the private sector will be required to make up the difference. That can either come from falling consumption relative to income or falling investment relative to business saving. Falling consumption usually comes from either increases in inflation (which reduces real spending) or unemployment. Although reducing the trade deficit may benefit specific sectors of the economy, in reality, there are downsides to the policy.

This chart shows the yearly change in CPI with foreign saving into the U.S. We have placed a vertical line on the chart, beginning in 1983, when foreign saving increased. During the period of small trade deficits (low for negative foreign saving), inflation averaged 4.4%. The onset of foreign saving has reduced inflation significantly.

The U.S. benefits from foreign saving inflows. It keeps inflation low and allows the U.S. to run fiscal deficits that would not be possible for other nations. For the most part, foreign nations accept this tradeoff to acquire the dollar for reserve purposes. The cost to the U.S. economy is that the trade is clearly unfair; foreign nations purposely build saving through policies designed to boost household saving. These include an undervalued exchange rate, consumption taxes, an inadequate or non-existent social safety net, tariffs and quotas. In one sense, if a foreign nation wants to deprive its citizens of goods and services and force them to save,[1] then the U.S. should accept their “generosity” and repay them with Treasuries. However, there are negative effects for some sectors of the economy that compete with imports.

These charts show the U.S. furniture industry. The upper chart is employment. It has fallen by more than a third from the peak. The lower left-hand chart shows imports and exports (with the former rising rapidly) and the lower right-hand chart shows industrial output for furniture, which fell sharply during the last recession but has failed to recover anywhere near the previous peak. Clearly, this industry has been harmed by imports.

The trade issue is really a matter of who bears the burden of trade adjustment. Tariffs mean consumers bear the costs via higher prices. Subsidies mean taxpayers bear the burden. In the absence of either, the workers and owners in the U.S. bear the burden. However, in a macroeconomic sense, acts that raise the cost of imports will tend to bring higher inflation. If that becomes the favored policy, investors will face rising interest rates and falling P/E multiples. Thus, we continue to closely watch the president’s trade policy to for widespread effects and the impact on price levels.

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[1] Something the U.S. did during wartime with rationing.

Daily Comment (April 20, 2018)

Posted on April 20, 2018 by Rebekah Stovall

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It was a mostly quiet overnight session. Here is what we are watching this morning:

Policy talk boosts greenback: Dovish comments from the ECB and BOE have lifted the dollar this morning. The ECB is considering delaying the path of tapering due to recent economic weakness and BOE Governor Carney made similar statements as well. We have been bearish the dollar based on valuation issues; using inflation parity, the dollar remains overvalued, although the degree of overvaluation has been reduced. Monetary policy, under conditions of overvaluation, is usually not all that important. However, the dollar has been range-bound in recent months and we suspect that condition will remain in place for a few more weeks before the dollar’s decline resumes.

Trump and OPEC: The president tweeted this morning that OPEC is “at it again” artificially boosting prices. Oil prices dropped sharply on his comments. He argued that there are “record amounts of oil all over the place.” This is clearly wrong. As we detailed yesterday, oil inventories are well off their peak and we have not seen the usual seasonal build in stockpiles that typically occurs in the first four months of the year. The president suggested “this will not be accepted.” There are two things the president could do to bring down oil prices. First, he could authorize a release of oil from the Strategic Petroleum Reserve (SPR). Although the government plans to sell oil out of the reserve in the coming years for budgetary reasons, there is still ample oil available in the reserve. This action would be improper—the SPR is designed for emergencies, not for guiding prices. However, other presidents have used the reserve in this way; President Clinton did so in the late 1990s (although officially this release was related to heating oil). The second action he could take would be to recommend legislation to stop oil exports. This would lower U.S. oil prices relative to the world and give OPEC + Russia what it really wants, which is an end to the supply threat from shale oil. We remain bullish oil; the president could affect oil supplies but, in reality, this morning’s tweeting is simply jawboning. However, politically, his comments make sense; high gasoline prices are never popular with the public and calling out OPEC is one way to react to higher gasoline prices.

In related news, Saudi Arabia and Russia will begin talks over the weekend “on sending a signal on what they will do beyond next year.”[1] Saudi Arabia needs Brent around $75 per barrel to meet its fiscal obligations. Russia can balance its budget with $53 oil. The two must decide if they will continue their program to reduce supplies or begin to retake market share. Although we are bullish crude oil, any news that OPEC is boosting supplies will be bearish for prices, at least in the short term. Longer term, if the Iran deal ends or the conflict in Syria spreads, oil prices would likely rise.

North Korea: Media reports indicate that North Korea will not have preconditions for upcoming talks. Although there is concern about strategic ambiguity (the U.S. and the DPRK say the same thing but mean something different), it does appear that Kim wants a deal of some sort. The talks are a high-stakes gamble. If negotiations are successful they could bring peace to a troubled part of the world and give President Trump an historic breakthrough. If they fail, it’s hard to see how war doesn’t follow.

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[1] https://www.wsj.com/articles/an-oil-deal-between-saudi-and-russia-worked-now-what-1524130200

Daily Comment (April 19, 2018)

Posted on April 19, 2018 by Rebekah Stovall

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT]

Castro era coming to an end: Today, Raul Castro, brother of Fidel Castro, is expected to step down as Cuba’s president. Castro will be replaced by his vice president, Miguel Diaz-Canel Bermudez, but will still retain his role as head of the Communist Party until 2021. Miguel Diaz-Canel will be the first non-Castro president since the end of the Cuban Revolution in 1959. His ascension to the presidency will likely be well-received by many Cubans, especially the younger population, as the country is in the midst of economic stagnation. Since Diaz-Canel has maintained a relatively low profile prior to his nomination, it is unclear what changes he is likely to make, if any. Many speculate that his nomination represents a subtle break in Cuban political continuity as he was born after the Cuban Revolution. At this moment, it is unclear what his nomination means for U.S.-Cuba relations, but it was reported that he was skeptical of Raul Castro’s attempt to normalize relations with the U.S.[1] Tensions have been elevated between the two countries following a sonic attack on the U.S. embassy in Cuba that left diplomats injured.

Complete denuclearization in NK? According to South Korean President Moon Jae-in, North Korea has expressed interest in an agreement to completely denuclearize without the condition of U.S. troop withdrawal from the Korean Peninsula.[2] This marks another breakthrough in normalizing relations between the two Koreas; yesterday the countries agreed to hold talks to formally end the Korean War. The caveat to possible complete denuclearization is that the U.S. would have to agree to end hostile policies against North Korea and guarantee its security. The comments appear to be a prelude to the proposed meeting between President Trump and Kim Jong-un. President Trump has expressed a limited amount of optimism regarding the meeting, stating that he is prepared to pull out of the meeting if it is not “fruitful.” We will continue to monitor this situation.

Return to $100 a barrel? Oil prices touched four-year highs due to speculation that OPEC will extend supply curbs into 2019. There have been rumors that senior Saudi officials are pushing to force prices to reach $80 or even $100 a barrel in order to boost the IPO price as well as support some Saudi economic initiatives, such as Vision 2030. Energy stock prices also rose on the news.

Energy recap: U.S. crude oil inventories fell 1.1 mb compared to market expectations of a 0.6 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 decline in stockpiles is counter-seasonal. Every week that fails to show a build on the seasonal pattern is a week where the seasonal factors become less bearish. We are approaching the end of the seasonal build period; assuming a strong summer driving season, this chart is bullish for crude oil.

Based on inventories alone, oil prices are undervalued with the fair value price of $64.99. Meanwhile, the EUR/WTI model generates a fair value of $74.57. Together (which is a more sound methodology), fair value is $71.40, meaning that current prices are below fair value. Oil prices have been rising on geopolitical tensions and bullish fundamentals. We still view oil prices as undervalued but the degree of undervaluation is diminishing. However, as the above chart on seasonal pattern suggests, declining inventories this summer portends higher prices.

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[1] https://www.washingtonpost.com/world/the_americas/in-cubas-national-assembly-raul-castro-marks-last-moments-of-his-familys-rule/2018/04/18/82f82cd4-4293-11e8-b2dc-b0a403e4720a_story.html?utm_term=.a3d5e1585c0c

[2] https://www.reuters.com/article/us-northkorea-missiles-moon/south-koreas-moon-says-north-seeking-complete-denuclearization-idUSKBN1HQ119

Keller Quarterly (April 2018)

Posted on April 18, 2018April 18, 2018 by Rebekah Stovall

Letter to Investors

As you well know, the U.S. stock market has been selling off for about ten weeks now. From some of the calls I’ve been getting, one would expect that another Great Crash is upon us. There is little evidence to suggest, however, that this is anything more than a normal correction in the context of a bull market. Rather, the emotional response we’ve been hearing is, in my opinion, largely a result of the lack of volatility we have experienced over the last two years.

As Ned Davis Research recently reported, over the last 90 years the stock market has averaged 3.4 corrections of 5% or greater per year. Over the same time frame the market also averaged 1.1 corrections of 10% or greater per year. From February 2016 to January 2018 (23 months), the market saw neither of these rather common contrary events. It seems that during this time of stock market nirvana (consistently upward sloping with nary an adverse wiggle), investors began to believe this was normal.

It surely was not normal, but abnormal in the extreme. The great financier J.P. Morgan was regularly asked what stock prices will do. His standard response: “They will fluctuate.” Sometimes the simplest answers are the best. (This quote is included in Benjamin Graham’s classic work, The Intelligent Investor. That book and many others are included in our new Reading List of recommended books that you can find on our website.) Indeed, stock prices will and do fluctuate in wide ranges all the time. Stock prices are among the most volatile asset prices most people will ever encounter.

This shouldn’t be a revelation, but corrections such as the current one always seem to catch people by surprise. We rather welcome such downward volatility for a couple of reasons:

When the market doesn’t sell-off periodically, investors do really crazy things like bid prices up to outrageous levels, resulting in eventual horrendous sell-offs. Examples of this phenomenon are 1998-2002 and 1987.
We like to buy stocks of great companies at a discount. Sell-offs provide that opportunity.

But could this correction be the start of something much worse? While we certainly cannot predict the future, our response is “probably not.” Why? Because stocks are a reflection of economic reality, not a perfect reflection, but a fairly reliable one. And the economy is growing rather steadily, at a sustainable pace. There are only a few evidences of excess, but that’s normal for an expansion over nine years old. A recession a few years from now would not surprise us, but it is not imminent, in our opinion.

We are experiencing a completely normal correction for completely normal reasons, in our view. Stocks sell off after an extended advance when investors worry about growth that might be too rapid, which might induce inflation, thus prompting the Fed to raise rates. Throw in a government that’s unhappy with the behavior of trading partners and you have all the excuses you need for a correction. This is the stuff of a healthy economy and a normal bull market. Thus, we intend to treat it as such and look for opportunities to buy good companies at good prices in our equity portfolios, and add equity exposure, where appropriate, in our asset allocation portfolios.

As always, we appreciate your confidence in us.

Gratefully,

Mark A. Keller, CFA
CEO and Chief Investment Officer

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Daily Comment (April 18, 2018)

Posted on April 18, 2018 by Rebekah Stovall

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Equity markets are quietly ticking higher. Earnings remain strong. Although there wasn’t much market news, there was a great deal of other news. Here is what we are watching:

Pompeo to Pyongyang: Over Easter, CIA Director and SOS nominee Mike Pompeo was dispatched to North Korea and met directly with Kim Jong-un. The meeting was confirmed by the president in an early morning tweet. With the breakdown at the State Department under Tillerson, the White House has been using the intelligence channel to communicate with Pyongyang. Reports indicate the CIA has been the conduit of backchannel talks with officials at the Reconnaissance General Bureau, the North Korean version of the CIA. The president has also given his “blessing” to North and South Korea to begin peace talks.

There has been some discussion about the idea of denuclearization. This has the potential to be an area of “strategic ambiguity,” where two parties say the same thing but mean something entirely different. For the U.S., it is generally assumed that denuclearization means North Korea gives up its nuclear program. For North Korea, the term means the U.S. and North Korea no longer threaten each other directly and U.S. troops leave South Korea. Most analysts have considered the North Korean position a non-starter for the U.S. Those American troops on the Korean Peninsula are part of U.S. power projection in the region. However, that analysis may be misreading the president’s core position on foreign policy. In terms of foreign policy, Trump is Jacksonian.[1] That means he rejects the burdens of hegemony; foreign policy is mostly based on honor. In this light, the Syrian policy is perfectly clear—the use of chemical weapons is a direct affront to the president and American honor but there is no need for the U.S. to shape policy in the region because it’s none of our business. Thus, the White House might be perfectly fine with the withdrawal of U.S. troops from South Korea in exchange for an end to North Korea’s ICBM program. In other words, the Far East would still be threatened by North Korea’s nuclear program but the U.S. would not.[2]

There are two other items that are part of these meetings. First, it is notable that Pompeo met with Kim over Easter, which was just after Kim met with Xi in Beijing. The timing would suggest Washington and Beijing are vying for the attention of the “young general.” Second, Pompeo is struggling with Senate confirmation. The announcement that he is in the midst of sensitive talks with North Korea will probably be enough to encourage the senators to approve him so as not to disrupt negotiations.

China and telecom: The U.S. is limiting the ability of ZTE (ZTE: CNY 31.31) to use American technology for seven years. The White House has been complaining about China’s confiscation of U.S. intellectual property and thus has decided to punish one of the few truly international Chinese telecom companies.[3] ZTE also engaged in business with nations under U.S. trade restrictions. Huawei Technologies (SHE: CNY, 7.20) announced it will refocus on existing markets due to difficulty in doing business in the U.S.[4] Although there has been much focus on tariffs and commodities, the real battle is in technology, where the U.S. is opposing China’s attempts to establish high-tech dominance.

Is Clarida more dovish than we thought? Barron’s[5] offers analysis suggesting the president’s nominee for vice chair may be more dovish and less conventional than at first glance. We will have more on this idea in the coming days but we have been concerned the president would lean dovish in picking Fed officials and may berate the central bank for rate hikes at some point. In other words, relations between the Fed and the White House could eventually become Nixonian, which would mean higher inflation, lower nominal yields and a weaker dollar.

IMF and growth: The IMF is forecasting 3.9% GDP growth for this year, the strongest year since 2011. The group noted that the global economy is in a widespread expansion, but did warn that a trade war could undermine the current good times.

Nickel prices jump: Nickel prices are higher this morning on fears that new sanctions on Russian nickel producers could restrict supplies.

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[1] For background, see WGRs, American Foreign Policy: A Review, Part I (10/3/16) and Part II (10/10/16)

[2] The meetings with PM Abe must have been awkward in light of the Pompeo news.

[3] https://www.nytimes.com/2018/04/16/technology/chinese-tech-company-blocked-from-buying-american-components.html

[4] https://www.wsj.com/articles/huawei-looks-to-existing-markets-as-tech-becomes-target-in-u-s-china-trade-spat-1523966693

[5] https://www.barrons.com/articles/reading-richard-clarida-hawk-or-dove-1523929538

Asset Allocation Quarterly (Second Quarter 2018)

Posted on April 17, 2018April 17, 2018 by Rebekah Stovall

Near-term expectations for earnings growth resulting from the Tax Cuts and Jobs Act of 2017 remain heightened.
Continued Fed policy tightening, through measured increases in the fed funds rate and reductions in the size of the Fed’s balance sheet, is not expected to weigh on the economy over the next two years.
Our outlook for a softer U.S. dollar is underscored by recently released CBO estimates of the projected budget deficit.
Equity exposures remain elevated across all strategies relative to our historic allocations.
Our sector and industry outlook favors a growth style bias among U.S. equities at 60%.
We initiate a position in precious metals to add diversification given the potential for global political instability and appreciation against a soft U.S. dollar

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ECONOMIC VIEWPOINTS

Measures of the U.S. economy continue to point to a continuation of the expansion, which is poised to tie for the second longest expansion on record and a year away from becoming the longest expansion dating back to 1854. Though the U.S. NFIB Business Optimism Index readings have moderated somewhat over recent months, the index remains elevated by historic standards. Similarly, consumer confidence has declined recently, as measured by the Conference Board’s Consumer Confidence Index and the University of Michigan’s Index of Consumer Sentiment, yet remains at high levels. The recent declines notwithstanding, the Federal Reserve’s efforts to reduce its balance sheet and raise the fed funds rate multiple times this year and next appear to continue unabated. While our view is for continued economic growth until nearing the end of our three-year forecast cycle, we remain wary of the potential for a misstep by the Fed that would lead to excessive tightening and increase the odds of a recession. Such wariness is balanced by the prospect for an uptick in GDP from its mild post-recession figures. The combination of the fiscal stimulus in the latest budget accord and the corporate and individual benefits unleashed by the Tax Cuts and Jobs Act of 2017 set the stage for potentially rapid growth over the next two years. With a higher level of GDP growth, we would expect the Fed to be more hawkish in its tightening over the next two years, which would thereby impede the nascent inflationary pressures that caused investor angst in early February.

The domestic economic environment we forecast for our three-year cyclical outlook is supportive of range-bound intermediate and long-term rates and equity valuations. Specifically, inflation expectations of 2.1%-2.2%, inferred by the breakeven rate of TIPS versus maturity-equivalent Treasuries, underscore our thesis of the current fair valuation for equities and bonds.

From a global perspective, the recent saber-rattling on trade and tariffs has the potential to be highly disruptive to global economic growth. While we harbor optimism that cooler heads will prevail on matters of trade, the rise in populism keeps our hopes for unfettered global trade in check. Although trade accords, such as NAFTA and TPP, offer the potential for improvement, we are less than sanguine that they will be resolved amicably, at least absent a high degree of histrionics. Among non-U.S. economies, Europe is three years into its economic expansion. Though facing political headwinds, most recently illustrated by the Italian and Hungarian elections, the European economic climate is improving. In addition, our analysis of purchasing power parity of the U.S. dollar versus other major currencies indicates continued overvaluation despite recent softness, which should prove to be a tailwind for returns of non-U.S. equities for U.S.-based investors. As the accompanying chart illustrates, the environment for emerging market equities is particularly attractive.

STOCK MARKET OUTLOOK

Our views on U.S. equities are favorable. We expect inflation to remain contained, accompanied by low levels of unemployment. We also expect an increase in earnings spawned by last year’s corporate tax reduction, and an increase in share repurchases and M&A activity stemming from the repatriation of overseas assets. Our positive forecast for equities reflects our expectations for P/Es, as depicted on the accompanying chart, which encourages elevated exposures across all strategies relative to our historic allocations.

At this stage of the economic expansion, we retain a 60% tilt toward growth and 40% to value. In U.S. large caps, we overweight energy, financials and materials, while establishing an equal weight in technology and consumer discretionary in anticipation of their reconstitution as part of the new communications services sector in September. Mid-cap and small cap equities have an identical tilt to growth and are both overweight in the more growth-oriented strategies. Outside of the U.S., we retain our historic maximum exposure owing to our expectations of a continued soft U.S. dollar.

BOND MARKET OUTLOOK

As we noted last quarter, the rise in Treasury yields since the passage of the tax legislation has many commentators suggesting a bear market in bonds has developed. The jump in rates in early February added further fuel to their argument. While we understand and appreciate their premise, our view is that such a bear market will be secular and, accordingly, will require years to unfold. As evidence, we review the figures from the secular low in 1945 and the two decades that ensued prior to rates becoming a problem for financial markets. Absent inflationary pressures, we uphold our forecast for a gradual rise in rates that will be borne mostly by the front-end of the curve as the Fed maintains its tightening measures, inclusive of the reduction in its balance sheet. Accordingly, we expect the curve to continue to flatten, with the intermediate and long-term maturities being range-bound over our forecast period and a terminal fed funds rate of 2.50%-2.75%.

Our expectations for a gradual rise in rates reinforce our use of a bond ladder in strategies that have income as an investment element. Bond ladders hold the dual attraction of offering a degree of defense against rising rates through capturing the roll yield while also allowing maturing issues to be deployed at the longer rungs of the ladder, benefitting from the yield advantage farther out on the curve. The laddered nucleus will modestly reduce the overall duration from one quarter to the next until a new rung on the ladder becomes available later in the year. Relative to spread sectors, we maintain exposure to investment grade corporates in the ladder and a concentration in the intermediate segment of the yield curve through the use of an ETF containing mortgage-backed securities. Speculative grade bonds hold less allure as spreads have tightened and have double-digit exposure to telecommunications company debt. As a result, we substantially reduce exposure to speculative grade bonds.

OTHER MARKETS

We retain our allocation to real estate in the more income-oriented strategies given attractive and improving dividend yields, while reducing the REIT allocation in risk-tolerant portfolios. As a function of yield relative to potential risk, we view REITs more favorably than speculative bonds.

We introduce an allocation to gold this quarter within commodities, where we have been void for the past year. Recognizing that gold can serve as a safe haven during periods of heightened geopolitical and currency risks, we are incorporating a modest allocation as a means to temper these potential risks. Moreover, our analysis of the fair value price of gold indicates it is currently attractively priced, as depicted on the accompanying chart.

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Daily Comment (April 17, 2018)

Posted on April 17, 2018April 17, 2018 by Rebekah Stovall

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It was mostly quiet overnight. Continued robust earnings are lifting equities this morning. Here is what we are watching:

Abe to Florida: Japanese PM Abe will meet today with President Trump at Mar-a-Lago. The meetings come at a difficult time for Japan. Abe is facing domestic scandals that have weakened his popularity ratings, and he faces party elections in the fall which may lead to his ouster as PM.[1] Japan was caught off-guard by the White House’s decision to hold talks with North Korea. Abe fears the U.S. will focus on mitigating North Korea’s ICBM threat while leaving a potent short-range missile program in place, which threatens Japan. The anti-trade rhetoric of the Trump administration also has to be a concern as Japan runs a large bi-lateral trade surplus with the U.S. The chart below shows the rolling 12-month goods trade deficit with Japan. Exports represent about 18% of Japan’s GDP.

The “dirty little secret” for Japan is that the JPY is deeply undervalued. The chart below is Japan’s parity calculation using relative CPI. The current fair value is ¥60.56 to the USD compared to the current ¥107.00. A leg of Abenomics was a weaker JPY to buy time for restructuring. In reality, the restructuring didn’t really occur (true restructuring would require increasing income to the household sector and reducing it to the corporate sector) so allowing the JPY to remain weak is counterproductive to U.S. interests. So far, the president hasn’t figured out the exchange rate issue but, at some point, we expect him to use this tool in his trade policy.

We expect these meetings will be frustrating for PM Abe. President Trump should focus on North Korea. Japan lacks other allies and thus will need to accept whatever the U.S. offers. Thus, the goal for Abe should be to at least give the appearance of camaraderie.

China’s GDP: This report is always taken with a degree of skepticism because it is so stable. Growth rose 6.8%, although independent estimates put the real growth number closer to 4.8%. Property investment rose 10.4% after being in single-digits since 2014. Infrastructure spending rose 9.0%, which is unusually slow; usually this number rises between 15% and 20%. Overall, China continues to ensure growth remains solid even if that means “goosing” real estate activity. On a trade note, China indicated it will impose surcharges on U.S. sorghum exports of 178.6% as part of a “dumping” allegation. China did indicate the finding is “preliminary,” which may mean it will be adjusted. The U.S. exports around $1.0 bn per year of sorghum. The majority of sorghum is grown in western Kansas, eastern Colorado and western Texas with a belt of production in south-central South Dakota. However, some of the crop is planted in most states; nearly 40 of the lower 48 states record some sorghum planting.

Fed governor nominees: The White House confirmed it is nominating Richard Clarida and Michelle Bowman for two open positions on the Fed’s Board of Governors. Clarida is a professor at Columbia University and is also on the payroll of PIMCO. Bowman has extensive experience in community banking and will fill that position on the board. We expect both to sail through the nominating process. We have adjusted our “hawk/dove” spreadsheet. Our current read on the two new nominees is that they are both centrists. We have also pulled John Taylor from our potential roster of vacancies. Marvin Goodfriend remains on the list, although his performance during his nomination hearing was weak enough that the administration may consider a different candidate. We have also moved Williams to the NY FRB, although Bill Dudley will be in office until June. We are estimating that a moderate will replace Williams at the San Francisco FRB. Below is our view of the current composition of the board.

The current composition including projected members has an average of 2.64, making it mildly hawkish. Last year’s voters averaged 3.20, a mildly dovish composition. We are continuing to research Chair Powell and may change his position to a more hawkish leaning. But, for now, we believe the new governors make the voting roster a bit less hawkish.

Russia cyberwar: The U.S. and U.K. issued warnings that Russia is targeting Western internet infrastructure with intrusions into home and business routers. By taking control of routers, Russia can control internet traffic. On a related note, President Trump decided to delay expected sanctions on Russia tied to its support of Assad. UN Ambassador Haley indicated these would occur on the weekend news shows, but the president didn’t feel comfortable executing them.

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[1] This is a possible, but unlikely, outcome.