Daily Comment (January 22, 2018)

Posted on January 22, 2018 by Rebekah Stovall

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST] The media is focused on the government shutdown but, if the markets are a guide, there isn’t much to see. This is what we are watching this morning:

BREAKING: The IMF has boosted its estimate for global GDP to 3.9%, up 0.2%, in part due to the U.S. tax cut. This would be the fastest growth in seven years.

The shutdown: The shutdown continues this morning with little signs of reconciliation. For this to end, one side has to concede to the other and the primary impetus would be negative polling. That’s why both sides are desperately spinning blame on the other side. Although reliable and timely polling remains scarce, it appears to us that partisans are convinced the other side is responsible and will suffer the most damage. Until it becomes obvious that one side is clearly being blamed, this shutdown could go on for a while. Currently, the decision markets are putting the odds at 50/50 for an end to the shutdown by Thursday. We would not be surprised to see this go into the weekend.

What are the potential effects? First, if the shutdown does last into the weekend, the president probably won’t go to Davos. Second, more parts of the government will begin to shut down and other services will slow. The economic effect will be modest, perhaps 0.1% to GDP. Third, the most important market effect would occur if economic data starts to be delayed. For example, we may see initial claims delayed if this shutdown lasts a week. The weekly crude oil inventory report could be affected, although the latest news from the EIA is that the data will be released on time. As this shutdown continues, even if the data has been collected there may not be workers in place who can sort and publish it. The longer this goes on, the more markets will be “flying blind.” Overall, this shutdown isn’t likely to be a big deal. The focus from the financial markets has been on tax reform and since that bill was passed expectations for 2018 were rather low anyway. Thus, we view it as a media event but nothing more.

Turkey invades: Turkish troops have crossed the border into Syria to attack a Kurdish rebel group that has gained control of the area. The U.S. has been supporting the Kurdish Syrian Democratic Forces who have been attacking what remains of Islamic State. Ankara’s action is provocative; Syrian leader Assad has opposed the move and Russia is struggling to remain neutral. And, the U.S. opposes Turkey’s invasion. President Erdogan has promised the operation will be swift; no leader wants to find himself bogged down in an insurgency war in a foreign country. At the same time, the borders of Syria and Iraq are borders in name only in various parts, and Turkey may decide that controlling a part of what was once Syria to prevent the Kurds from gaining control is an attractive position.

The Brazil problem: Brazil is holding presidential elections in October. The two leading candidates are Luiz Inácio Lula da Silva and Jair Bolsonaro. The former, known as “Lula,” was president from 2003 to 2011. He is considered a hard leftist, although one could argue he governed as a center-left president. Lula is the leading candidate and will probably win in the fall, except…an appeals court this week could uphold his earlier conviction for corruption and money laundering. If the court upholds the conviction, Lula can’t run (and could go to jail). Bolsonaro is a hard-right candidate who has allegedly made disparaging comments about women, Africans and gays. As we are seeing in many parts of the world, the center isn’t holding support and radical candidates are doing well in polls. If Lula’s conviction is upheld, we may see Brazilian financial markets suffer.

Merkel wins (the first step): The SDP did agree to open formal coalition talks with the CDU/CSU this weekend. The vote was close, as these things go—only 56% of the SDP party leadership was on board with beginning discussions. Usually, these decisions are executed with a voice vote but it was too close for that procedure. The next step is for the parties to decide on mandates—which party controls various ministries. Once that is done, the SDP membership must approve the actual coalition. Although joining another grand coalition is not very popular with SDP members, the alternative of another election is even more troubling. Thus, we think the grand coalition will be formed and Chancellor Merkel will continue to govern Germany.

Iranian banks: We recently discussed Iran’s protests in a WGR.^[1] The weekend NYT^[2] reported that a factor in the protests was a series of bank failures that caused the loss of depositors’ money. In the West, such concerns have been ameliorated through deposit insurance. Prior to the 1930s, bank failures would often cause depositor losses. Iran shows no signs of adopting deposit insurance and the general tone of the article suggests the authorities are blaming depositors for their losses. Iranian political leaders should be careful with such claims. Bank balance sheets are always a bit opaque because it is hard to determine the value of bank assets (mostly loans); a healthy bank can become a troubled one with a few defaults. It appears that in Iran, the politically well-connected were able to secure favorable loans that they defaulted on and the costs are being born by depositors. Losing deposits tends to adversely affect the middle class who have less liquidity to diversify into other asset classes.

OPEC: Russia and OPEC members are hinting they may continue to cooperate even after the current agreement expires. We doubt Russia will be joining OPEC or cooperating all that much in the future. But, as we noted last week, Russia’s Reserve Fund is exhausted and falling oil prices would be deadly for its economy. Thus, this “jawboning” to keep oil prices elevated is a costless way to keep revenues strong.

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[1] See WGR, The Iranian Protests, 1/8/2018.

[2] https://www.nytimes.com/2018/01/20/world/middleeast/iran-protests-corruption-banks.html?emc=edit_mbe_20180122&nl=morning-briefing-europe&nlid=5677267&te=1

Asset Allocation Weekly (January 19, 2018)

Posted on January 19, 2018 by Rebekah Stovall

by Asset Allocation Committee

Since the beginning of the year, long-term interest rates have moved higher. The constant maturity 10-year Treasury yield ended 2017 at 2.40%. That yield climbed to 2.60% in January, which is above our recently released 2018 Outlook forecast. We are not adjusting our forecast quite yet because the driving factor behind our forecast was continued flattening of the yield curve. However, if the curve doesn’t flatten further, we will need to revisit that forecast.

The recent rise in yields has led several commentators to declare a new bear market in bonds had developed. We sort of agree with this statement; we believe a secular bear market in bonds began in 2016 and we will likely see gradually rising rates for the foreseeable future. However, the key word is “gradually.” The last secular bear market in bonds began in 1945 and took over two decades to become a serious problem for financial markets.

The above chart shows the 10-year T-note yield from 1921 to the present. In 1945, yields made their secular low and gradually rose into the early 1980s. Note the gradual ascent of yields for the first couple decades. It wasn’t until yields rose above 5% in the late 1960s that rising rates began to have an adverse impact on financial markets. Of course, when one is talking about secular cycles that last three to four decades, the last experience may not be indicative of what the current secular bear market will look like. Fortunately, the Bank of England has maintained long-term databases of British interest rates and can offer us some insights into long-term cycles. The chart below shows the interest rate of British Consols beginning in 1701. These instruments were bonds without a maturity; essentially, they were very long-duration instruments. Note that bull and bear markets tended to last a very long time and, in fact, the British bond bear market after WWII was impressive in terms of rate increases but rather normal in terms of length.

Why do secular cycles in bonds last so long? For the most part, secular cycles in long-duration interest rates are driven by inflation expectations. Rising inflation undermines the real value of interest return; investors, stung by inflation, will demand ever higher yields for protection. When policy changes to corral inflation, it takes some time before investors “forget” their unpleasant experiences and accept a lower interest rate. After a long period of low inflation, investors are “fooled” by rising inflation, at least at its early stages. This underestimation in inflation leads to falling real returns and prompts demand for rising rates.

What makes the current period interesting is that the baby boomers are unusually sensitive to inflation fears because most of them spent their formative years during the high-inflation period of the 1970s. Thus, any signs of inflation, regardless of how minor, tend to lead to “discomfort” in the fixed income markets. The existence and current prominence of the baby boom generation will likely keep long-duration rates from rising very much in the coming years. The oldest boomer is 72 this year, while the youngest is 54. Clearly, over the next two decades, the memory of 1970s inflation will fade and the subsequent generations will be much more likely to be fooled by inflation and will be slow to demand higher yields. This fact will probably lead to the final stages of the bond bear market, which will be rather painful for investors.

So, what does an investor do in the meantime? We look for gradually rising rates over time. The policies of neoliberalism, which supported globalization and deregulation,[1] successfully ended the high inflation period of the 1970s. We are likely in the early stages of a retreat from neoliberalism. The rise of populism in the West is partly due to citizens becoming acutely aware of the costs of neoliberalism (high level of inequality and job insecurity) without being aware of its benefits (low inflation, long business expansions). Although it will take some time, tolerance of higher inflation will likely increase. Investors have two strategies for such an environment. First, corporate credit tends to do better in the early stages of a secular bear market because gradually rising prices reduce credit risk as firms find it easier to pass along higher prices. Second, bond laddering, the purchase of instruments at various points of the yield curve, offers some defense from rising rates. As time passes, the duration of a laddered portfolio falls, reducing rate risk. As the nearest instrument matures, the investor buys a longer term instrument and the process repeats. We are currently deploying both strategies in our fixed income allocations.

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[1] We define deregulation as the unfettered implementation of new technology and methods on the economy.

Daily Comment (January 19, 2018)

Posted on January 19, 2018January 19, 2018 by Rebekah Stovall

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST] We are seeing continued strength in equities this morning and a modest decline in Treasuries. Here are some things worth noting today:

Shutdown looming: Although a continuing resolution passed the House rather easily, it looks like a long shot for the Senate to pass a similar measure. The Senate needs 60 votes to pass the measure and it’s not clear if it has unanimity among Republicans. Wars usually start because both sides overestimate the odds of success. Both parties believe the other party will take the blame for a shutdown. What we suspect will happen is (a) there will be a brief shutdown, (b) blame will be equally shared, with partisans blaming the other side loudly and often, and (c) financial markets won’t be all that concerned. We are seeing a modest decline in Treasury yields this morning but, given the recent rise, this may be nothing more than short covering. We doubt equities will be harmed significantly.

Davos: The Davos meeting is next week and President Trump is scheduled to make an appearance. The major media is anticipating an “Al Czervik” type of appearance, but we expect a more low-key event. We would look for the president to make his America First policy well publicized, which is in direct opposition to the Davos ethos. This will likely be a media event but not a market-moving event.

Trade wars: Two reports today suggest the administration is becoming increasingly agitated on trade. First, Bloomberg^[1] is reporting that U.S. negotiators are “losing patience” over NAFTA talks and want Mexico and Canada to offer concrete proposals on major issues. Of course, neither nation has an incentive to make changes because the trade deal has been very positive for both. CNBC^[2] is reporting that President Trump is anxious to sanction China on trade as well. Equity markets are clearly marching higher, boosted by the tax bill, which will lift corporate earnings this year and generate strong economic growth. However, a trade war could derail this trend. Our base case is that the president talks like a populist but governs like an establishment figure and we expect that to continue. But, if the president does start trade wars, equities would be adversely affected.

Japan upgrades: The Abe government raised its assessment of the Japanese economy for the first time in seven months due to a lift in consumer spending. If Japan continues to improve, we would expect the JPY to appreciate further. An improving economy and perhaps rising inflation will likely move the BOJ to reduce its very accommodative policy stance.

John Williams for Vice Chair? The WSJ^[3] reports that the White House is considering John Williams, currently the president of the San Francisco FRB, for the position of Vice Chair. We rate Williams a “2” on our “hawk/dove” scale, meaning he is moderately hawkish on policy. The administration has also floated Mohammad El-Erian, Larry Lindsey and Richard Clarida for the job, although the latter is said to no longer be under consideration. The fact that Williams’s name has surfaced suggests the White House remains uncertain about this selection. All the candidates under consideration would be qualified; El-Erian would be the most dovish pick of this group, and we would rate him a “3” on our 1-5 scale, with “5” being most dovish.

Russia’s broke? During the oil boom years, Russia built a Reserve Fund, a sovereign wealth fund for “rainy days.” Apparently, the Putin regime is experiencing Seattle-like conditions because what was left of this Reserve Fund has been moved to the National Wealth Fund, which backs Russia’s pensions. Russia has faced a spate of bank failures over the past year and has apparently drained its sovereign wealth funds to fill the gaps caused by bailouts. This is occurring despite attractive oil prices. On the one hand, Russia will be tempted to cheat on its supply restrictions to raise revenue; on the other, doing so could lead to lower oil prices and exacerbate its precarious financial position. We expect Russia to hold the line on output and hope that U.S. output fails to grow as fast as expected (see below) and that problem states, like Venezuela, see continued declines in output.

Energy recap: U.S. crude oil inventories fell 6.9 mb compared to market expectations of a 2.9 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 they have declined significantly since last March, by 120 mb. This decline doesn’t take into account the withdrawal from the SPR, which added an additional 31 mb to supply. Taking the SPR into account, inventories fell a whopping 152 mb.

As the seasonal chart below shows, inventories fell this week. We are now at the beginning of the Q1 seasonal build season. The fact that oil inventories fell this week is quite bullish. If this pattern continues (and one week doesn’t make a trend), we could see stockpiles drop below 400 mb later this year, which would be at the high end of normal.

Based on inventories alone, oil prices are undervalued with the fair value price of $69.94. Meanwhile, the EUR/WTI model generates a fair value of $69.62. Together (which is a more sound methodology), fair value is $69.65, meaning that current prices, although elevated, are below fair value. The weak dollar and falling oil inventories are bullish for oil prices and suggest there is more upside, especially if inventories fail to rise in their normal seasonal fashion.

In the face of this bullish data, the IEA is projecting a major increase in U.S. oil output this year which has pushed oil prices lower this morning. In fact, the group is expecting production outside of OPEC to increase by 1.7 mbpd this year. Although this is possible, we have some doubts. Neither rig counts nor hiring levels have moved significantly higher. Although productivity has been increasing, a boom of this magnitude would need at least some increase in productive resources. As our analysis above suggests, oil prices are low relative to inventories and the dollar. The fact that there are a plethora of bears isn’t necessarily a bearish sign.

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[1] https://www.bloomberg.com/news/articles/2018-01-18/u-s-said-to-be-losing-patience-as-key-nafta-issues-unresolved

[2] https://www.cnbc.com/2018/01/19/trump-is-determined-to-bite-somebody-and-china-is-the-most-likely-target-trade-expert-says.html

[3] https://www.wsj.com/articles/white-house-considering-san-francisco-fed-president-john-williams-for-feds-no-2-job-1516317905

Daily Comment (January 18, 2018)

Posted on January 18, 2018 by Rebekah Stovall

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST] We are seeing a modest retreat in equities this morning after a major rally yesterday. The dollar is weakening after rising yesterday as well. Here are some things worth noting this morning:

China’s GDP: Although a highly manipulated number, last year’s GDP rose 6.9%, a bit faster than forecast. It appears that China did “goose” growth last year, ostensibly to make the CPC October meeting go smoothly. The great known/unknown with China is this—will Chairman Xi use his exalted position to implement a painful restructuring of the economy, which will reduce China’s debt level and push economic power away from the CPC elite and toward average households, or will he maintain current policies? Taking the hard road is unavoidable; at some point, China will need to address its debt problem. On the other hand, China still has debt capacity. One way it could continue to borrow would be to open up its capital markets to foreign buyers. The yield on Chinese 10-year sovereigns is 3.97%; with a stable exchange rate, we suspect foreign buyers would flock to buy Chinese debt. Now, going this route would be a “9^th inning” signal because the introduction of foreign participation into China’s financial markets will bring market volatility, which is the primary reason China hasn’t made this move yet. We think odds favor Xi taking the hard road but, to date, Chinese leaders have known the debt is a problem and have backed away from reducing debt after numerous false starts. If they take the hard road, global growth will slow and commodity demand will decline as well.

Bond bear market: We will have more on this issue in next week’s Asset Allocation Weekly (which will be published on Friday in this report), but we have seen the 10-year move above 2.60% this morning.

These charts show our basic interest rate model for the two- and 10-year Treasuries. The two-year is “cheap”; current yields are over 60 bps above fair value. Meanwhile, the 10-year yield is a bit higher than fair value. What we are seeing is a dramatic flattening of the yield curve. In general, the two-year is much more sensitive to fed policy whereas the 10-year is more sensitive to inflation expectations and oil prices. The rise in oil prices and the uptick in German yields is lifting the long end but the short end is also seeing a rise in yields. Usually, during periods of policy tightening, the two-year approaches its standard error line (the upper parallel line on the lower part of the graph). Thus, we expect continued weakness in the short end. Our expectation for 2018 was continued flattening of the yield curve because of depressed inflation expectations. We continue to monitor the rise in the long end but expect it to be gradual unless inflation surprises to the upside.

Government shutdown: Policymakers continue to struggle to make a deal to extend the government’s spending authority. We would not be surprised to see a temporary closure of the government, simply because the White House and party leaders are assuming the other side will take most of the blame for any dislocations. But, we expect any potential shutdown to be short and thus not a major market problem.

Cryptocurrencies: South Korea is considering closing exchanges and Bitconnect, an exchange platform, has closed on reports that it was running a Ponzi scheme.^[1] Since mid-November, we have seen a definite inverse pattern between bitcoin and gold.

On the above chart, the black line is gold and the orange line is bitcoin. We view cryptocurrencies as similar to gold and this chart tends to confirm that belief.

Although we doubt this is the primary reason, one factor involved in the decision by South Korea and China to crack down on cryptocurrency exchanges may be to undermine North Korea’s economy. The latter has been accused of ransomware and money laundering activity which cryptocurrencies are famous for; perhaps China and South Korea see weakening the value of bitcoin as a way to weaken the Kim regime.

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[1] https://techcrunch.com/2018/01/16/bitconnect-which-has-been-accused-of-running-a-ponzi-scheme-shuts-down/

Daily Comment (January 17, 2018)

Posted on January 17, 2018 by Rebekah Stovall

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST] Financial markets were mostly quiet overnight. Yesterday turned out to be a rare down day for equities but futures are signaling a higher opening this morning. Treasury yields are modestly higher. Here is what we are watching this morning:

A continuing resolution: Congressional leaders are likely to simply extend the government’s spending power for about a month and not resolve any of the underlying issues. This means we won’t see an imminent government shutdown but will revisit the issue next month. Yesterday, a special election in Wisconsin, in a heavily GOP district, went to a Democrat. This was for the state Senate, so it doesn’t affect the U.S. Congress, but it does suggest the chances for a swing in November are rising. Patty Schachtner, a rather centrist Democrat (her bio notes that she is a former member of the Wisconsin Bear Hunter’s Association), defeated a well-funded and solid assemblyman, Adam Jarchow. Recent Democrat victories are further hardening the stance of the national party with the idea that their party’s chances are improving for November and thus the incentive is waning to negotiate with Congressional Republicans and the president. As a result, we will likely see increased gridlock in Washington for 2018. In the short run, this is probably bullish for equities; gridlock means the status quo remains in place and the status quo is favorable for stocks. Longer term, political turmoil may become a bigger issue.

Fed policy: With the release of the CPI data we can update the Mankiw models. The Mankiw rule models attempt to determine the neutral rate for fed funds, which is a rate that is neither accommodative nor stimulative. Mankiw’s model is a variation of the Taylor Rule. The latter measures the neutral rate using core CPI and the difference between GDP and potential GDP, which is an estimate of slack in the economy. Potential GDP cannot be directly observed, only estimated. To overcome this problem, Mankiw used the unemployment rate as a proxy for economic slack. We have created four versions of the rule, one that follows the original construction by using the unemployment rate as a measure of slack, a second that uses the employment/population ratio, a third using involuntary part-time workers as a percentage of the total labor force and a fourth using yearly wage growth for non-supervisory workers.

Using the unemployment rate, the neutral rate is now 3.18%. Using the employment/population ratio, the neutral rate is 0.94%. Using involuntary part-time employment, the neutral rate is 2.59%. Using wage growth for non-supervisory workers, the neutral rate is 0.94%. The modest uptick in core CPI has lifted the various neutral estimates higher but, as we have seen for several months, two of the measures of slack suggest the FOMC has achieved rate neutrality, while two suggest the FOMC is well behind the curve. We expect the FOMC to mostly split the difference and end up between 2.25% to 2.50% for the target at the end of this year. However, if the two variations that are signaling lower rates turn out to be the accurate measures of slack, this degree of tightening will lead to an increased risk of recession.

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Keller Quarterly (January 2018)

Posted on January 16, 2018 by Rebekah Stovall

Letter to Investors

Welcome to 2018! The stock and bond markets did much better in 2017 than most participants expected, by my reckoning. This has led to an unusually large proportion of the forecasts for this year predicting dire outcomes, also by my reckoning. Predicting the future is impossible, of course, but that doesn’t stop everyone from trying. Simple bromides such as, “This past year was so good that this coming year must be worse,” or “What goes up must come down,” have the patina of wisdom, but really declare nothing useful. Markets don’t submit to simple maxims and they definitely don’t obey the law of gravity.

Markets are made up of hundreds of thousands of individuals (and more than a few computers) making independent decisions every day. The great quantity of individual decisions leads some to think that this data can be analyzed to predict the future, as we can with thousands of observations of natural phenomena. But trying to make an educated guess about the future of the stock market isn’t like predicting the movements of the planets, which follow long-established rules of physics. It’s more like trying to guess what your children are going to do next: you have a pretty good idea (because you know them well), but they never cease to surprise you. Human beings don’t all make the same decisions under the same circumstances. When the world is tranquil they tend to do the same things, but under stress people often make emotional and irrational decisions (like those children you think you know). This is why forecasting financial markets, even with lots of data in hand, is so hazardous. As you may have heard me say before, we are not forecasters, we are odds-makers. Successful investing involves putting yourself in the best position to be prosperous in an uncertain future.

Getting back to the outlook for the current year, dire projections are everywhere, but, as we noted in last quarter’s letter, fears by so many that a recession and bear market are just around the corner is good evidence that they are not. Recessions and bear markets are usually the product of complacency, not fear. The economy is doing rather well, unemployment is low, consumers are spending at a slightly faster rate than in recent years, and business optimism is high. These conditions correlate better with continued stock market appreciation than with a bear market.

While we have our doubts as to how positive of an impact the recently enacted tax bill will have on economic activity, we have no doubts as to its impact on American stockholders: very positive. Lower tax rates should result in higher net income and cash flow going forward, even with U.S. business profit margins already at historically high levels. As the cash piles up and as overseas cash is repatriated, we expect increased dividends, share buybacks, and acquisitions from U.S. corporations. All of these events are favorable to the stock market.

Is there anything to worry about? Indeed! The Federal Reserve is famous for “taking the punch bowl away just as the party gets going.” They have forecasted four increases in the fed funds rate this year, or one full percentage point. If they follow through with that intention, the economy’s rate of growth could slow. There also are plenty of geopolitical and economic risks that could throttle back our markets. But the biggest risk I fear is not yet present: a sense among investors that the market can go nowhere but up. The conditions that could produce such complacency seem to be coming together in 2018. So, while we presently aren’t as pessimistic as most forecasts for the current year, we can imagine a world where we would be much more worried: a world where everyone else is optimistic!

Here’s an old adage that we swear by: Be bold when others are cautious and cautious when others are bold.

Thank you for your confidence in us.

Gratefully,

Mark A. Keller, CFA
CEO and Chief Investment Officer

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Daily Comment (January 16, 2018)

Posted on January 16, 2018 by Rebekah Stovall

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST] Welcome back from the long weekend! In a sense, not much has changed—equity markets continue to move higher. Here are the news items of note:

Germany’s political turmoil continues: The EUR has dipped this morning, a pause in a torrid appreciation, as two items are raising concerns about the recent SDP/CDU-CSU coalition agreement. First, the rank and file of the SDP must approve the agreement and it isn’t clear if the agreement will have enough votes. If the SDP members reject the deal, the coalition is dead and Chancellor Merkel will either have to run a minority government or call snap elections, both unprecedented in the postwar era. It should be noted that Merkel has ruled out a minority government, so we may be looking at new elections if the SDP fails to approve the coalition. The second problem is that the official opposition traditionally gets the budget committee chair in the Bundestag. If the SDP joins the government, the populist AfD will become the official opposition party and thus would gain control of this important committee. This committee is especially important because it approves funding for bailouts; in other words, if another EU crisis develops, this committee is key to establishing German support. The AfD is anti-EU and would likely oppose such measures. Although the EUR has lifted recently for a number of reasons, clarity on German governance has been a contributing factor to the rally. If Merkel does call new elections, it isn’t obvious that a more workable outcome will emerge—in fact, the AfD might do even better and push the SDP into political oblivion. Thus, we expect the SDP to approve the coalition but Germany may have to live with the AfD in a position of power.

Cryptocurrencies tumble: The major cryptocurrencies fell over 20% overnight on growing concerns that governments are moving to crack down on this market.

This chart shows the daily close for bitcoin, the best known of the cryptocurrencies. We are down over 37% from the peak in mid-December. South Korea is considering a full ban on trading cryptocurrencies and two exchanges in the country were raided by authorities. The AP reports that France is considering tougher rules on bitcoin, primarily to prevent its use by criminals.[1] As governments become more aggressive in regulating the use of cryptocurrencies, maintaining valuations will become more difficult.

Government shutdown? It’s beginning to look like lawmakers may not be able to avoid a shutdown as government spending authority expires on Friday. The White House and Congressional Democrats have been trying to work out a deal on immigration for a funding bill. Those negotiations appear to have stalled which may lead to a government closure. We view this issue as political posturing on both sides. We suspect the White House believes a short-term shutdown over immigration will be seen as positive by right-wing populists, and Congressional Democrats probably feel that a shutdown over defending DACA is worth it as well. As long as the shutdown is very short (a weekend, perhaps), it isn’t a big deal. But, if it becomes longer, it will become a “spin war” as to who takes the blame. The rally we are seeing in Treasuries this morning may be due to ideas of a shutdown, which tends to support flight to safety buying.

Middle East news: There were a number of interesting news items out of the Middle East. Although none were market-moving outside local equity bourses, they show the degree of turmoil in the region. First, late last week, 11 Saudi princes were arrested for protesting the king’s decision to suspend state subsidies for utility bills for the royal family. This action was one of several austerity measures as the Kingdom of Saudi Arabia (KSA) tries to get spending under control. The KSA has also implemented a value added tax (VAT) and fuel price increases. The princes reportedly staged a “sit-in” at the palace in Riyadh last week, refusing to leave. We doubt the princes have garnered much public sympathy and, if anything, this move may bolster public support for the crown prince, who is seen as being behind these austerity measures. Second, we also note that the Riyadh Ritz (MAR, 139.78) has reopened to the public after the government requisitioned the facility as a high-class prison for royal family members and others who were accused of corruption in the November purge.[2] This probably means that those caught up in the purge have made deals with the government (expensive deals, most likely) to gain their freedom. In related news, Qatar has denied claims by the UAE that Qatari fighter jets intercepted an Emirates passenger aircraft. Last year, Qatar was blockaded by the rest of the GCC over a number of complaints, including the existence of Al Jazeera and its close relations with Iran.[3] The UAE’s accusations could further raise tensions in the region; in fact, they have become elevated enough for President Trump to tell the nations in the region to “cool it.”[4]

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[1] https://apnews.com/a7126216919e435280356b51ed99e3e1/France-wants-tougher-rules-on-bitcoin-to-avoid-criminal-use

[2] See WGRs: Moving Fast and Breaking Things: Mohammad bin Salman, Part I, 11/20/2017; Part II, 12/4/2017; and Part III, 12/11/2017.

[3] See WGRs: The Qatar Situation: Part I, 8/7/2017; and Part II, 8/14/2017.

[4] https://www.bloomberg.com/news/articles/2018-01-16/trump-to-arab-gulf-countries-cool-your-jets

Asset Allocation Weekly (January 12, 2018)

Posted on January 12, 2018 by Rebekah Stovall

by Asset Allocation Committee

Last week, we issued an addendum to our 2018 Outlook[1] to take into account the recent tax law changes. Our top-down analysis suggests there will be a significant increase in corporate earnings which will translate into higher S&P 500 earnings. Our original forecast was for $129.82[2] for 2018; we have increased our earnings forecast in light of the tax bill to $144.84. We are assuming a 21.1x P/E multiple for 2018, meaning our forecast for the S&P 500 has increased from 2739.20 to 3056.12.

Whenever we make a forecast, as part of the process, we look for factors that could lead us to be wrong. In the original 2018 Outlook, we focused on a number of factors, including an unexpected recession, excessive monetary policy tightening, etc. In our 2018 Geopolitical Outlook,[3] we added other events that could adversely affect this forecast. In this report, we will focus on another factor that could lead to forecast variance.

One of the goals of the tax bill is to boost investment. The focus on investment does make sense; since the early 1980s, investment levels relative to GDP have been falling with each expansion.

This chart shows the average level of corporate investment relative to GDP for each expansion since the 1960s. As noted, the level of corporate investment has been falling with each expansion. It isn’t obvious why this is occurring—a number of factors are probably involved, including more corporate investment offshore due to globalization, improved efficiency of investment due to technology and less investment due to industry concentration (fewer firms making the same things don’t duplicate productive capacity). The problem is that these are structural factors and we doubt mere changes to the tax bill will foster a significant boost in investment.

This chart shows capital investment and the level of business saving. Ample capital investment can occur without business saving; in fact, it is not uncommon for business dissaving to occur during periods of expanding capital expenditures. The recent rise in business saving coincides with falling levels of capital expenditures.

Cutting corporate tax rates could lift investment if there was a lack of available liquidity because cutting tax rates should lift the level of cash available for investment. However, there is little evidence to suggest a liquidity shortage. First, as seen above, flows into business saving have been rising. Second, cash and near-cash holdings of non-financial corporations is relatively high and well above the trough level seen since 1980.

Current liquid assets relative to total assets are 4.9%, which appears ample for self-funding investment.

Third, and perhaps even more telling, is that commercial and industrial (C&I) loan growth is at a level associated with recession.

The current yearly growth of C&I loans is +0.09%; in the past, this level is usually observed either when the economy is in recession or shortly after one has ended. In no period during the postwar experience has C&I loan growth been this weak without being associated with a recession. The reason that slowing C&I loan growth affects the economy is that when commercial banks begin cutting back on loans, it usually lowers investment; at the same time, commercial banks tend to be cautious and don’t begin restricting lending until it is abundantly clear that the economy is weakening, thus making this indicator mostly a lagging one. Lending surveys from the Federal Reserve do not suggest senior loan officers are tightening credit. Thus, we conclude that the drop in lending is probably a function of falling demand for the loans—simply put, businesses don’t need the liquidity and aren’t borrowing for the current level of economic activity.

As a result, the corporate sector, which has ample liquidity and isn’t borrowing, is about to get even more liquidity pushed its way. The key issue is most likely a lack of aggregate demand. In other words, the economy isn’t growing fast enough to trigger an expansion of the capital base. Thus, unless other parts of the tax law encourage economic growth, the economic impact from the tax cuts will likely be rather small.

However, the financial impact could be significant. Expanding corporate liquidity will likely encourage higher dividends, share buybacks and merger activity. Given the expected boost in earnings from the tax cuts, the expansion of corporate liquidity and the anticipated response from corporations to reward shareholders should support the continued elevated multiple and perhaps even lift investor sentiment further.

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[1] See 2018 Outlook and 2018 Outlook: Addendum

[2] Using Standard & Poor’s operating earnings rather than the more commonly quoted Thomson/Reuters operating earnings, which averages approximately 8% higher.

[3] See WGR, 12/18/17, The 2018 Geopolitical Outlook

Daily Comment (January 12, 2018)

Posted on January 12, 2018January 12, 2018 by Rebekah Stovall

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST]

Coalition deal in Germany: This morning, Chancellor Merkel announced that an agreement has been reached to form a conservative coalition with the Social Democrats (SPD). This agreement will likely pave the way for Merkel to finally form a new government after months of negotiations following the results of the September election. Recently, there has been speculation that Merkel may step down from her role as chancellor due to her inability to form a government; this agreement has quelled those fears. The euro appreciated immediately after the news broke. Although an agreement has been reached, it still needs to be finalized by members of the SPD during its party conference on January 21.

Pakistan intelligence: Yesterday, Pakistan announced it would withhold key ground intelligence from the United States in response to the State Department’s decision to withhold security aid. The U.S. has accused Pakistan of harboring Afghan Taliban and has demanded that Pakistan do more to assist in the fight against terrorism if it would like to receive additional aid. The lack of intelligence is likely to hamper U.S. war efforts in Afghanistan; however, the U.S. will still be able to gather intelligence from air surveillance and intercepted communications. Pakistan’s retaliation is likely to escalate tensions and could push it to strengthen its relationship with China. The waning relationship with Pakistan could be further evidence that the U.S. is pivoting its foreign policy toward improving relations with India, which it sees as a counterweight to China’s influence throughout Asia. During a press conference in Norway, President Trump singled out India, in addition to Russia and China, as a country with which he would like to build a working relationship. Furthermore, Pakistan and India have always had a tense relationship since Pakistan split from India in 1947.

DACA deal: Yesterday, a bipartisan deal to protect those who were brought into the U.S. as children illegally, also known as dreamers, was rejected by the president. Clauses that caught the president’s ire involved maintaining the diversity lottery in developing countries, which the president has openly opposed in the past. After hearing about its inclusion in the bill the president gave a somewhat salacious response questioning the logic behind diversity lotteries. Those comments have been widely reported elsewhere, so we will not repeat them here, but instead we will focus on how it may impact his legislative agenda going forward. The president’s remarks could make it harder to reach a deal on immigration in the future, which has held back budget talks. In addition, Democrats will likely use President Trump’s harsh rhetoric as fodder for their base in the run-up to the mid-term elections.

Nuclear deal lives another day: President Trump is expected to extend sanctions relief to Iran on the condition that the U.S. and its allies come up with a better nuclear deal. The president has never been a fan of the agreement, labelling it the “worst deal ever.” There was some speculation that the president would pull out of the deal due to the Iranian government’s response to recent protests in the region. We will continue to monitor this situation.

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