Weekly Geopolitical Report – Reflections on Globalization: Part I (April 9, 2018)

Posted on April 9, 2018 by Rebekah Stovall

by Bill O’Grady

For much of recorded human history, we have seen waves of globalization and deglobalization.[1] Periods of globalization tend to be characterized by the emergence of either large regional hegemons or global hegemons. When these hegemons see their power wane, deglobalization occurs. Recently, globalization has come under fire. In some circles, being called a “globalist” is a slur. This new denigration of globalization should be viewed in a historical context.

Our position has been that we have experienced the apex of globalization and a steady cycle of deglobalization will occur over the next few decades. This is the context in which we should view the current American political situation. Political pundits tend to focus on personalities, which are important in the short term. However, in the long term, it is no surprise to us that we have a president who is jaded on America’s superpower role given where we are in the globalization/deglobalization cycle.

Notwithstanding, we believe there are peculiar circumstances in the current environment that offer interesting insights into how conditions may evolve. This evolution is important to investors as it will affect valuations of financial assets. Inflation is a key depressant to financial asset values. Deglobalization will almost certainly lead to higher price levels over time. But, how that process develops is important. For example, war would likely bring a rapid increase in inflation. On the other hand, a steady contraction of supply chains and reduction in trade would lead to a much slower rise in inflation.

This chart shows British inflation from 1900 to 1950. The war years show an obvious spike in inflation.

In Part I of this report, we will discuss the end of the Cold War and the reactions of U.S. policymakers to that event. In Part II, we will begin with a reflection on markets, continue with an examination of hegemony and conclude with the expansion of globalization and the rise of meritocracy and its discontents. In Part III, we will discuss how China and Russia threaten U.S. hegemony, the potential responses and conclude with market ramifications.

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[1] A good study of this history can be found in Kevin O’Rourke’s and Ronald Findlay’s book. O’Rourke, K. and Findlay, R. (2007). Power and Plenty: Trade, War and the World Economy in the Second Millennium. Princeton, NJ: Princeton University Press.

Daily Comment (April 9, 2018)

Posted on April 9, 2018 by Rebekah Stovall

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] There is a whiff of “risk-on” this morning, with global equities higher while “risk-off” assets, such as gold and Treasuries, are lower. Presidential tweets were relatively calm over the weekend. Here is what we are watching this morning:

Social media to Capitol Hill: Facebook (FB, 157.20) CEO Mark Zuckerberg will testify later this week before Congress. According to media reports, he is furiously preparing for the event. The core issue facing the social media part of the tech industry is the public’s general lack of understanding of how these firms make their revenue. There are no free services; if a service doesn’t include a charge, the firm is making money by collecting your data. To some extent, this is how media has made money for a long time—newspapers sold advertising based on circulation. Although they usually required a subscription, that was not the key source of revenue. Social media has taken that model and expanded it by encouraging users to willingly offer up information about their behavior. Previously, a firm advertising in a paper could know how many readers would receive their advert and maybe target a region for circulation. By gathering information about you, social media can help advertisers target their segment (or, more to the point, “you”) directly. An old line about advertising is, “50% of what I spend on advertising is wasted, but I can’t determine which 50%.” Social media helps reduce the waste in advertising, so the more info the social media firm can gather about our behavior the more efficient advertising can become.[1] Of course, the more social media knows about me the less privacy I have. The debate society is now having is, “How much data-gathering is legitimate?” Don’t expect social media firms to offer a reasonable response; it’s like asking a realtor if it’s a good time to buy a house. This is where regulation will be required. Regulation will tend to undermine the business model of social media but we won’t know to what degree until new rules are put into place. But, in any case, the threat of regulation will tend to weigh on the tech sector.

Syria: Over the weekend, there were widespread reports that the Syrian government used a gas attack on civilians. President Trump tweeted against the action and has, in the past, attacked Syrian military bases for using gas. It appears Israel did launch missiles at a Syrian airbase. Iran accused the West of fabricating the attack as a pretext to attack Assad. President Trump has recently expressed the desire to pull U.S. troops out of the region. It is probably no accident that Assad engaged in these horrendous acts after Trump’s comments. The gas attack puts the U.S. in a difficult dilemma. The Middle East has become uncontrollable. Ever since the U.S. invasion of Iraq disrupted the balance of power in the region, Iran has been trying to expand its influence, Turkey has been countering against Kurdish statehood aspirations, IS rose and fell and Saudi Arabia has been trying to expand its influence as well. Essentially, removing Saddam Hussein created a power vacuum and regional powers have been vying to fill the gap since. The U.S. has been trying to extricate itself from the costs of being the balancing power in the region because (a) it is costly and distracting, and (b) we don’t need the oil anymore. So, if Trump reacts by increasing American military presence in the Middle East, it means less resources to contain Russia in Europe and China in the Far East. If the U.S. does nothing, we look weak, and Assad, Russia and Iran will try to expand their influence further. With John Bolton taking over this week as national security advisor, we would not be surprised to see a rather robust response to Syria’s actions.

Lula turns himself in: Although former Brazilian President Lula resisted beginning his 12-year prison term for corruption, he has turned himself in, ending a potential source of civil unrest. As we noted last week, the Brazilian Supreme Court’s decision to uphold his conviction throws open the presidency; there are no clear front-runners for October’s vote.

Orban wins: Although there was little doubt that PM Orban’s Fidesz party would prevail in this weekend’s elections in Hungary, the result was sweeping, bringing a two-thirds majority to the legislature. Orban has been running on a nationalist and populist platform, opposing the EU and immigration. European nations are turning toward populist and anti-EU parties (the recent Italian elections show a similar trend), and this is yet another election suggesting that populism is on the rise.

China talks CNY devaluation: Another part of the trade war threat came from China over the weekend as the country hinted it is “studying” the potential for devaluing the CNY. We have been somewhat surprised that the administration hasn’t moved to weaken the dollar as a tool against the trade deficit. China may be seeing this lack of currency commentary as an opening. Although the CNY has been appreciating recently, China does control its currency and could decide to weaken it. However, there is a danger for China, too. History shows that fears of currency weakness seem to trigger capital flight out of China. Chairman Xi may be confident that he has enough controls in place to prevent widespread capital flight, but money does tend to “find a way” under pressure.

North Korean denuclearization: Over the weekend, North Korea indicated it is open to discussing denuclearization with the U.S. in upcoming summit talks. Although this assertion raises hope of a major deal, it also carries the risks that (a) Kim may be using this to lure President Trump into talks, and (b) the term “denuclearization” is fraught with strategic ambiguity. Regarding point (a), just getting the meeting is a boost for North Korea. Previous presidents have been reluctant to talk directly, using that as the ultimate “carrot” for Pyongyang. So, even if the talks don’t bring about any major developments, the photo-ops of the two leaders together will improve Kim’s stature. Concerning point (b), denuclearization for Kim probably means that he allows inspectors if all U.S. troops leave South Korea and North Korea is no longer a target for regime change. For the U.S., the term means that North Korea gives up its nukes. Both leaders can agree on denuclearization and come away with completely different positions. A reasonable expectation? North Korea keeps its nukes but gives up long-range missiles, which would reassure the U.S. but terrify Japan, South Korea and China.

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[1] An old, but famous, incident of data-gathering and advertising was documented here: https://www.nytimes.com/2012/02/19/magazine/shopping-habits.html?_r=1&hp=&pagewanted=all

Asset Allocation Weekly (April 6, 2018)

Posted on April 6, 2018 by Rebekah Stovall

by Asset Allocation Committee

Recently, the three-month T-bill/Eurodollar spread (TED spread) has widened, raising concerns about financial stability. In this report, we will offer a primer on the spread and discuss its recent rise.

The TED spread has two components; it’s a direction-of-rate spread and a flight-to-quality spread. Eurodollars (also known as LIBOR) represent dollar borrowing that is not government-guaranteed. It originally began when Europe accumulated dollars during the 1960s as part of Bretton Woods and the dollar’s reserve status. As Europe ran trade surpluses with the U.S., they acquired dollars which they wanted to lend to earn interest. At the time, U.S. interest rates were governed by “Regulation Q,” which set deposit rates for U.S. banks. During periods of tight monetary policy, U.S. borrowers could find European dollar lenders willing to lend those dollars at a premium to domestic interest rates. Thus, if banks found themselves unable to borrow from the Federal Reserve, they could use the Eurodollar market to acquire liquidity. However, unlike the domestic market, Eurodollars offered no lender of last resort protections and thus carried premium interest rates. Under normal circumstances, the yield premium was around 20%. So, if domestic dollar borrowing rates were set at 5%, Eurodollars yielded 6%. Obviously, if domestic rates doubled, to 10%, Eurodollars yielded 12%. This pattern explains the TED spread’s direction-of-rate element; during a rising rate market, speculators would short Eurodollars and go long T-bills, profiting from a widening spread. In a falling rate market, the reverse position would be implemented.

The other component is the flight-to-quality spread. Because Eurodollars are not government-guaranteed and do not have direct support of a central bank, investors flock to T-bills and shun Eurodollars during periods of stress. This widens the TED spread.

This chart shows the long-term TED spread.

As the chart shows, there was a great deal of volatility in the spread. As we will discuss below, this was partly due to flight-to-quality incidents along with volatile monetary policy. Under Chair Volcker, the Federal Reserve targeted the money supply instead of fed funds which led to rate volatility. Spread volatility declined as interest rates fell and the Federal Reserve returned to fed funds targeting. In addition, the end of Regulation Q in 1986 ended the government’s practice of setting maximum deposit rates. This increased the government-guaranteed rate and essentially narrowed the spread.

To separate the direction of interest rate effects from the flight-to-quality factors in the spread, we regressed the Eurodollar (LIBOR) rate by the T-bill rate with a variable to account for Regulation Q. This chart shows the results of that model.

The lower line on the chart shows the deviation in Eurodollar interest rates relative to T-bill rates. A widening spread is represented by a rising lower line. Clearly, financial, political and geopolitical events can widen the spread; we have marked the important ones. The current spread is essentially at fair value, suggesting the widening of the TED spread isn’t due to any sort of financial crisis but is entirely due to rising yields. In other words, the widening of the TED spread is consistent with increasing interest rates and, so far, does not indicate significant financial stress.

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Daily Comment (April 6, 2018)

Posted on April 6, 2018 by Rebekah Stovall

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy employment day! We cover the data in detail below but the quick take is that it was much weaker than expected. Payrolls came in well below forecast and the unemployment rate held steady compared to an expected small decline. The data should be taken with caution because the parade of winter storms that hit the Northeast last month probably affected the report. The other major issue is, again, trade. Here is what we are watching this morning:

Tit for tat: Last night, President Trump suggested another $100 bn of new tariffs on China because of its reaction to the first salvo. The usual market response developed; equity futures slid while gold and Treasuries rallied. However, the reaction was not as pronounced compared to earlier periods. It appears the financial markets are steadily adjusting to the president’s social media messages and beginning to focus more on the endpoint than the tweet. The situation with China remains fluid and there is still the probability of a trade war. But, there is also the potential for the outcome we have seen with NAFTA as it seems the U.S., Canada and Mexico are nearing an agreement. When the discussions began, it looked like the treaty was in deep trouble. Now, it looks like all the rhetoric was a negotiating stance.

It is still important to remember that China has taken advantage of the U.S. and the West during its development. This isn’t anything new. Export promotion has become the development model of choice since the end of WWII. The basic recipe is to implement policies that curtail consumption and boost investment. These policies include an undervalued exchange rate, import restrictions, easy corporate borrowing and intellectual property theft. The program works if the global superpower tolerates it. The U.S. did tolerate this behavior during the Cold War, although there were occasional pushbacks (the Plaza Accord, “voluntary” Japanese vehicle import restrictions, etc.). However, every nation that deploys the model reaches a point of development where it no longer works. First, other nations begin to retaliate against the trade surpluses. Second, debt levels usually become untenable. There are essentially four paths to transition away from export promotion. The first is to boost household consumption by reducing saving. This approach can create a debt crisis; in the U.S., resolving this crisis was called “anyone, anyone, the great, Great, Depression.”[1] In Japan, it has led to 30 years of stagnation. The second path is war. War allows the nation to redirect its excess capacity to the war effort instead of exports. The winner destroys the export capacity of his enemy and can keep export promotion policies in place, perhaps even gaining colonies (see below). The third path is to raise the value chain. The excess capacity is transformed into higher value goods. Germany has used this path since the 1980s and the China 2025 plan looks like a similar plan. The fourth path is colonization, where colonies are forced to absorb the excess production caused by malinvestment. The U.K. used this system with its commonwealths, Germany is using it now with the Eurozone and China hopes to use the same method with the “one belt, one road” program. China knows it is at a critical point where it needs to transition its economy. Chairman Xi has amassed enough power to give him the wherewithal to make these difficult changes.

To some extent, U.S. goals of reducing its trade deficit with China are consistent with China’s goals of restructuring its economy. However, China won’t simply accept U.S. trade impediments as they are seen as a form of attack on its sovereignty. Encouraging a stronger CNY and dictating global trade rules, as TTP would have done, would have been a better path. Thus, we have the risk of a trade war, but such a conflict is still avoidable.

Oil tariffs? There are growing fears that China will put tariffs or quotas on U.S. crude oil exports. Tariffs might occur, but they would likely be ineffective. U.S. oil exports to China are rising but are still only about 300 kpbd as of January. Nevertheless, if China raises the cost of U.S. oil exports, other nations will fill the U.S. market share. But, since oil is mostly fungible, the flows will change but U.S. exports should remain the same. For example, let’s say Saudi Arabia fills the U.S. market share. Unless the Saudis increase output and violate their OPEC quota, they will reduce oil sales to some other customer and the U.S. will likely fill that gap. The same thing could happen with soybeans. China needs commodities, and selectively slapping tariffs on U.S. commodity exports will have an effect on flows but not necessarily on overall exports.

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[1] https://www.youtube.com/watch?v=uhiCFdWeQfA

Daily Comment (April 5, 2018)

Posted on April 5, 2018 by Rebekah Stovall

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Equities rebounded strongly yesterday after an opening sell-off. So far, U.S. stocks are building on yesterday’s gains. Here is what we are watching this morning:

As a point of reference: We have a weekly chart on the S&P 500 P/E ratio at the end of this report. The methodology of our calculation is explained in the footnote but, essentially, we try to create a multiple that avoids the pure backward-looking problems of a trailing P/E and the worst of the “fantasy” of a pure forward-earning estimate. With the onset of Q2, the P/E has dropped 2x. The combination of strong earnings and the recent price correction has reduced some of the valuation concerns. Continued economic growth and the impact of the tax bill on earnings should support continued robust earnings growth.

The key worry remains inflation. Inflation volatility does affect the P/E.

This is a near replica of the chart at the end of this report but we have added two periods with gray bars and created averages and standard deviation lines for these periods. The lower line on the chart shows the five-year rolling standard deviation of CPI. During periods of low inflation volatility, the multiple tends to expand. Based on the assumption that inflation volatility will remain less than 2% (what we see in the gray areas), the current multiple isn’t excessive.

This is partly why the trade turmoil is causing such market volatility. Since the 1980s, the trade deficit has clearly dampened inflation. This is the impact of globalization. Backing away from free trade carries the potential to boost price levels and raise inflation volatility. The real concern is if inflation volatility rises to levels seen outside the gray areas on the above chart; a reset of the P/E would be expected to follow. In periods with higher inflation volatility, the P/E averages 13.1x. In periods of low volatility, it averages 17.7x. The reset creates extended bear market conditions. So far, we remain in the gray band, which is favorable for equities. Nevertheless, trade war worries are legitimate and inflation volatility is the key metric.

Lula looks finished: Former Brazilian President Lula had been a candidate for a return to office. However, the Brazilian Supreme Court has ruled that the former president should face jail time for his corruption conviction. Lula was involved in the widespread “Lava Jato”[1] scandal and convicted of receiving bribes. Lula maintains his innocence; apparently, the Supreme Court disagrees. With this decision, the October presidential election is up for grabs. Polling showed Lula as the most popular candidate but this ruling likely ends any chances he will be eligible to run. Thus, the potential for political and market volatility will increase as the elections approach.

A new Plaza? The 1985 Plaza Accord led to a massive downtrend in an overvalued dollar in a bid to bring down the trade deficit. So far, the Trump administration has mostly avoided currency manipulation as a threat or tool in trade negotiations. However, that strategy may change. In the next few weeks, the Treasury is expected to produce its semi-annual update on exchange rates. The report determines whether an exchange rate is being manipulated in such a way as to build a trade advantage. In practice, this report usually perpetuates the fiction that no nation is engaging in such currency policies, although, like gambling at Rick’s American Café, everyone knows it’s going on. There is growing speculation that the president will discover the power of forex pressure. The recent new trade deal with South Korea included a side agreement to end the country’s rather blatant currency manipulation. We would not be shocked to see the administration begin talking down the dollar. We bolded the word “mostly” above because Treasury Secretary Mnuchin noted at Davos that a weaker dollar would aid in lowering the trade deficit. The president recoiled at the term “weak dollar” but if he can be schooled on the idea that a weaker dollar is good for trade then it would make sense to use exchange policy to achieve this aim. The market outcome would be to further support foreign investing for dollar-based investors. It should also help precious metals.

Energy recap: U.S. crude oil inventories fell 4.6 mb compared to market expectations of a 2.0 mb build.

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 was unusual and is bullish for prices. Every week that fails to show a build on the seasonal pattern is a week in which the seasonal factors become less bearish. While there is still time for stockpiles to rise, it is unlikely they will reach their seasonal norms.

Based on inventories alone, oil prices are undervalued with the fair value price of $65.74. Meanwhile, the EUR/WTI model generates a fair value of $74.94. Together (which is a more sound methodology), fair value is $71.98, meaning that current prices are below fair value. Oil prices remain range-bound but should move higher by early summer when the driving season begins.

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[1] Car Wash

Daily Comment (April 4, 2018)

Posted on April 4, 2018 by Rebekah Stovall

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Risk markets are down this morning on continued trade worries. Here are the key items we are watching this morning:

Trade wars: The U.S. announced tariffs on $50 bn of Chinese imports[1] and China responded in kind. Goods included in China’s tariffs include most of the grains, so soybeans, corn, etc. are sharply lower this morning. Fear in the financial markets is palpable. However, the fear factor is more based on continued escalation, not what was actually announced yesterday and this morning. The proposed tariffs open up 60 days of negotiations. We fully expect that any tariffs actually implemented will probably be less than what have been announced over the past few hours. In other words, these announcements are the opening salvo in broader negotiations. United States Trade Representative (USTR) Lighthizer is a seasoned trade negotiator and seems to have the confidence of POTUS. Thus, we believe it is too soon to panic. China has shifted from attacking exports of blue states (California almonds) to red states (Iowa pork, corn and soybeans). This will raise political opposition in the U.S. to the tariff proposals.

It is important to remember that the White House’s ultimate goal probably isn’t merely a drop in the trade deficit. After all, that would be quite easy to implement. Just trigger a recession, which cuts consumption, reduces imports and, lo and behold, cuts the trade deficit.

This chart shows the current account (trade + remittances) as a percentage of GDP. Note that in every recession, the current account either shifts to a surplus or the deficit narrows. No politician wants this outcome; what is really desired is job growth. The president should want export growth. A better tool for this would be dollar weakness.

This chart shows the yearly change in the JPM dollar index and the yearly change in exports. They are correlated at -62% (with a one-quarter lag). Note the dollar has weakened recently, which should help improve the trade situation. Stronger goods job growth is positively correlated to export growth.

The real issue is boosting market access to China—an obvious way to get there is with a weaker dollar/stronger Chinese yuan. This is the path the Reagan administration took during the 1980s with the yen and D-mark at the Plaza Accord, in which Lighthizer participated.

We do not want to be overly sanguine on this topic. The president is mercurial and could stumble into an open trade war. However, we are not in one now and there is a mostly clear path to avoid one. China has used a mercantilist trade policy to foster development. Most nations do this—the U.S. could have been accused of similar practices 150 years ago. But, a point is reached where such policies become counterproductive. The U.S. ran into this issue in the 1930s, as did Japan in the late 1980s and Germany in the mid-1980s (although Germany was able to maintain such policies via colonization, otherwise known in polite company as the Eurozone). China is at that point now. It under-consumes, is over-indebted and needs to rebalance by reducing debt and investment and boosting household consumption. Chairman Xi has accumulated massive political power; if he wants to restructure China’s economy, he has the power to do so. A stronger CNY would assist in that process.

It should be noted that other nations are beginning to understand that U.S. trade policy is going to affect them as well. South Korea’s revamped trade deal with the U.S. will require a stronger won. Japan is increasingly concerned that the U.S. is going to demand a stronger yen and a reversal of Abenomics.[2] Perhaps the clearest signal we are getting is that the U.S. wants dollar weakness. If so, that is usually bullish for foreign equities (to dollar-based investors, obviously).

Thus, the bottom line is that although risks are elevated, a full-scale trade war remains in the “tails” of the distribution. The most likely outcome is a negotiated trade deal that increases foreign investment in the U.S., opens markets abroad and brings a weaker dollar. We remain concerned about a policy error, but it is too early to declare that one has occurred.

Williams at the NY FRB: Despite calls for diversity, in the end, the NY FRB selected John Williams as its next president. We suspect that the need to add a strong economic mind to the roster of permanent voters on policy outweighed other concerns. We would not be surprised to see a more regulatory oriented replacement for Williams at the San Francisco FRB. We rate Williams as more hawkish than Bill Dudley, who is leaving the NY FRB president positon in mid-June, so the FOMC just got a bit more hawkish.

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[1] This actually clears up one serious concern, which was whether it would be $50 bn in tariffs, which would be huge, or tariffs on $50 bn of goods, which is roughly 9.5% of Chinese exports to the U.S.

[2] https://www.reuters.com/article/us-usa-trade-japan/japan-braces-for-trump-assault-on-trade-yen-policy-as-summit-looms-idUSKCN1HB0K7

Daily Comment (April 3, 2018)

Posted on April 3, 2018 by Rebekah Stovall

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] We are seeing a bit of a recovery this morning after a hard sell-off yesterday. Here are our thoughts:

This is mostly about technology: Tech companies have, until recently, had a reputation for good. Their goal seemed to be to improve our lives at apparently low cost. That reputation has taken a beating in recent months. The social media model is one element of the problem. These firms seemingly offer their products for free but, in reality, they are platforms to watch us, foretell our future behavior based on past actions and sell this information to advertisers. The power of this information is, as it turns out, extensive. Not only can it be used to direct us to items we might want to purchase, but it can shape our opinions on politics and social factors.

Steadily, we are being warned of the potential and real dangers posed by this data gathering.[1] The influential and powerful are trying to harness this data to shape the world in their image. How this situation is resolved is unknown. However, it is apparent that the industrialized world’s citizens are beginning to realize these tech companies and what they provide are not necessarily benign, and that there is a cost to convenience.

The U.S. has faced similar issues before. In the 1890s, it was becoming evident that the industrial trusts were reaching levels of concentration to where they represented the market. In other words, price, the method by which market economies match supply and demand, was becoming so controlled on one side that price no longer worked for creating an ideal distribution of goods and services. This is how anti-trust law was born. The concentration of data is different in many ways. Unlike price, which is obvious, the value of our personal data is not clear. Thus, there is grave danger that we are undervaluing our personal data and tech companies are illicitly capturing value because of our ignorance. Essentially, they are monetizing our behavior without compensating us. In the political sphere, we are at risk of being manipulated—being fed simplified outrage to capture our vote. At least the old party machines used to pay people for their votes!

The uncertainty the market faces is how the political class will regulate the data accumulators. When the trust-busters broke up the large industrial firms in the early part of the last century, it turned out to create value. The smaller firms were better managed, the competition encouraged their growth and they provided ample services to the economy. A similar outcome is possible today. But, until we understand the landscape, the current dominant firms will be under fire and this will likely increase the volatility of their price performance in the coming months and years. We suspect this situation will be part of the environment for a long time. It’s important to remember that the Sherman Anti-Trust Act passed in 1890, but Standard Oil wasn’t broken up until 1911.

Equities and the Fed: A question we are getting from advisors is whether market weakness will delay or stop Fed tightening? This is really a question about the “Fed put,” which captures the central bank’s reactions to market declines by easing monetary policy. Greenspan did cut rates after the 1987 crash and there is an obvious pattern to rate cuts during financial crises, which are usually accompanied by equity market declines. So far, we aren’t seeing evidence from the interest rate markets that the FOMC should change behavior. Expectations from fed funds futures still show an 80% chance of a rate hike at the June meeting, and Eurodollar futures say the FOMC has at least another 100 to 125 bps of tightening.

This chart shows the implied three-month LIBOR rate, two years deferred, from the Eurodollar futures market and the fed funds target. The Fed tends to raise rates until the two rates cross.

So far, financial authorities and the interest rate markets are treating this equity pullback as a normal correction. Given the lack of evidence of a recession, that is a logical conclusion. Thus, until proven otherwise, that would be the prudent expectation.

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[1] Galloway, S. (2017). The Four: The Hidden DNA of Amazon, Apple, Facebook and Google. New York, NY: Random House. See ‘Reading List’ for our recent review of this work. Also, https://www.ft.com/content/6c6c730e-3298-11e8-ac48-10c6fdc22f03.

Daily Comment (April 2, 2018)

Posted on April 2, 2018April 2, 2018 by Rebekah Stovall

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] We are seeing a mixed market this morning—U.S. equity futures are lower as are Treasury prices, while commodities are higher. Much of Europe is closed today for Easter Monday. Here is what we are watching this morning:

China retaliates…sort of: China slapped tariffs on 125 items, mostly foodstuffs. Steel and aluminum were targeted, a direct action against U.S. tariffs on those two metals. Frozen pork was included, as were tree nuts, including almonds. Between 2012 and 2017, about 75% of China’s almond market came from the U.S.[1] However, we do note that soybeans were specifically excluded from the list, suggesting China is taking a measured approach to trade tensions. A potential trend we are watching is that China may be implementing trade actions against products in “blue” states; putting tariffs on soybeans harms the Midwest, which is generally supportive of the GOP. Assigning tariffs that harm California, on the other hand, probably won’t trigger an aggressive response from the White House.

NAFTA threat: There are reports that “caravans” of Central American migrants are moving through Mexico to the U.S. The president tweeted that if Mexico doesn’t stop these flows then he will end NAFTA. Trade and immigration policy are complicated. The agriculture and hospitality industries often need seasonal workers and the local markets are simply unable to provide enough labor.[2] Completely restricting immigration will adversely affect some industries; therefore, reform needs border control but also rules to allow needed workers in some industries. Meanwhile, U.S., Canadian and Mexican trade negotiators are working to reform the NAFTA agreement, but the statements we saw on Easter from the White House complicate those discussions. There is no doubt that the U.S. will be less affected than other nations in a trade war. However, there will be significant costs to the U.S.; for investors, a trade war means higher inflation, which lifts nominal interest rates and contracts P/Es.

A threat to Putin? Although President Putin has faced widespread protests in the past, they have obviously failed to remove him from office or prevent him from executing his preferred policies. However, last week there was a fire at a shopping mall in Kemerovo, a small city in south-central Russia, killing 64 people, 41 of which were children. A zoo and its animals also perished. Protests have broken out; corruption is being blamed for the deaths as emergency services and normal precautions were clearly inadequate. Local leaders have been astoundingly tone deaf—one official noted that children die every day and thus dismissed the protesters as trying to court the media. As anger has increased, Putin has followed his usual script, which is a staged photo op of him showing concern. Protests have begun to spread, with large demonstrations noted in 20 cities. The governor of the Kemerovo Province, Aman Tuleev, resigned over the weekend. History suggests that these protests will eventually die out but the fact that they have not only lasted this long but also spread does suggest that Putin’s power may be under pressure.

The NY FRB spat: John Williams, the current president of the San Francisco FRB, is the leading candidate to fill the president vacancy at the NY FRB. Its current occupant, Bill Dudley, is expected to retire by summer. Williams is an accomplished economist and is qualified for the position. However, two problems have emerged; first, diversity advocates would prefer someone other than a white male for the job, and second, there are concerns about his regulatory history. Here is what we find interesting about this debate. During the late 1960s into the early 1980s, central banks in the West were often compromised by political influence. This was true at the Federal Reserve, which became legally independent of the Treasury under Truman. Nixon pushed out Fed Chair William Martin in the late 1960s and then undermined his successor, Arthur Burns, forcing him into inappropriate policy accommodation in the early 1970s to support Nixon’s re-election campaign. Central banks in much of the West were beholden to finance ministries to “coordinate” monetary policy with fiscal policy. In fact, standard Keynesian economics argues that monetary and fiscal policy should be coordinated. In a non-political world, this idea is uncontroversial. In the real political world, it’s a recipe for inflation because the political class usually opposes austerity. So, in the deregulatory revolution of the 1980s, central bank independence became common. Since the 1980s, the Federal Reserve has mostly operated with minimal congressional oversight (governors require congressional approval while regional bank presidents only require approval from the Board of Governors). Some on the right, notably the Pauls (Ron Paul was a Texas congressman and Rand Paul is the current junior senator from Kentucky), have been calling for “Fed audits” which are really policy audits. Their goal is to force a monetary policy that mimics a gold standard. However, if we see monetary policy politicized, the most likely outcome would be inflation. The current uproar over John Williams likely portends a bigger shift to reinjecting political oversight into monetary policy. We have been expecting policy reflation to steadily develop over the next decade. This potential interference into the policy process is one part of that expected development.

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[1] http://www.chinadaily.com.cn/business/2017-05/24/content_29471108.htm

[2] http://www.ky3.com/content/news/Branson-want-permanent-job-recruiting-relationship-with-Puerto-Rico–464249763.html

Asset Allocation Weekly (March 29, 2018)

Posted on March 29, 2018 by Rebekah Stovall

by Asset Allocation Committee

After peaking at 2872.87 on January 26, the S&P 500 has been in a corrective phase. The index fell just over 10% and has been range bound ever since, well below the aforementioned high. Here are the primary reasons equities have struggled:

Valuations became a bit stretched: The P/E, as we calculate it (trailing except for the current quarter, which includes two previous and two forecast quarters), reached 20.8x. This level is at the high end of the dispersion of the multiple for our P/E models and is no way inexpensive. The rally seen after the tax cuts became rather excessive and a pause to consolidate would be normal.
Trade war fears: The administration, which had put trade policy on the backburner as it tried to overturn the Affordable Care Act and enact the tax bill, has recently turned its attention to trade. Trade impediments and the pullback from globalization would weaken the policy commitment to low inflation that has been in place since the late 1970s.
Political instability: It is common for the personnel in the White House to change over time. Under normal circumstances, when a party has been out of power for an extended period, a plethora of experienced officials are poised to join the new administration when the party regains power. As time passes and the new president becomes more comfortable in his role, less powerful aides are recruited and the powerful, often with their own agendas, leave the White House. President Trump was enough of an outsider to disrupt this process to some degree. Still, the president did surround himself with some seasoned advisors from the military and business sectors. Although the media probably overstated the case that these figures “corralled” the president’s instinctual management style, it does appear that the White House became less chaotic after Gen. Kelly took over as chief of staff. In the past few weeks, however, there has been a wholesale change in personnel, including Secretary of State, Head of the CIA, and National Security Director. The replacements have hawkish reputations and could bring geopolitical instability. These changes have increased uncertainty and weighed on market sentiment, as have the prospects for political disruption stemming from the upcoming midterm elections.
Policy tightening: The Federal Reserve is steadily tightening monetary policy. Although current policy has not reached a point where it would be considered restrictive, the direction for interest rates is clear. Monetary policy has tended to support financial asset prices since the 1987 crash, in that declines in equity prices have led Fed chairs to either reduce rates during pullbacks or promise to act if financial conditions deteriorate. However, the new Fed chair, Jerome Powell, made no mention of current market volatility, raising concerns that the “Fed put” may no longer exist.

All these worries have some basis in fact. However, we believe the bearish case is overstated based on what we know now.

Earnings will be robust: The tax law will shift, in our estimation, about 1.3% of GDP to after-tax profits. If equity prices hold near current levels, valuations will improve in coming months.
Trade policy: Although we are concerned about the turn toward protectionism, in the short run we have seen initially aggressive positions that have been adjusted to become less onerous. A retreat from globalization is probably underway but it hasn’t progressed enough yet to trigger higher inflation.
Policy instability: President Trump will likely be considered one of the most unique presidents in history. His extensive use of social media has overturned the Washington order, for better or worse. Future presidents will likely have to decide if they will continue to use microblogging as a way to message the country, unfiltered by the media. At the same time, financial markets rapidly discern signal from noise. If markets determine that a social media rant is not material to market action, the markets will begin to ignore what is coming out of the White House. It is true that this president values flexibility and does not want to be contained. And, a president with such characteristics can make unexpected decisions. At the same time, it should be noted that President Trump’s period of greatest influence is coming to a close. History shows that the bulk of a president’s political capital is exhausted within about 18 months after the election. That’s because, in most cases, the midterms lead to a decline in congressional support and lawmakers realize that the influence of a president wanes once the midterm election season is underway. Simply put, by early summer, President Trump’s ability to make major changes in domestic policy will decline rapidly.
Monetary policy: The Federal Reserve has engineered three “soft landings” since becoming independent in the early 1950s. Every other tightening cycle generally resulted in a recession. However, the timing from the end of the tightening cycle to the onset of recession can vary widely.

In many cases, especially prior to the 1981-82 recession, the onset of recession coincided with the peak in fed funds. However, in the three recessions since 1982, the peak in rates has preceded the recession by an average of 14 months. If the same pattern holds, we are probably at least 12 to 18 months away from the next recession[1] as policy tightening will likely continue into next year.

In conclusion, although the aforementioned concerns are legitimate, we think they are probably overdone, at least in the short run. In addition, there appears to be ample liquidity to fuel higher equity prices.

This chart shows the level of retail money market fund holdings along with the S&P 500 Index. The shaded areas show periods when money market funds are at levels of $920 bn or less. These periods tend to coincide with sluggish equity performance. Current fund levels exceed $1.0 trillion; unless investors now view returns on cash as adequate enough to consider it an asset class, we suspect the high levels of liquidity are an indication of caution. If a degree of calm returns to the market environment, it appears there is enough liquidity to at least challenge the previous highs in equities.

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[1] Assuming a geopolitical event isn’t responsible for the next downturn.