Author: Rebekah Stovall

Daily Comment (January 13, 2017)

Posted on by Rebekah Stovall

by Bill O’Grady, Kaisa Stucke, and Thomas Wash

[Posted: 9:30 AM EST]   Happy Friday the 13th!

Outside of the Chinese trade data (see below), there wasn’t a lot of news. The number from China came in a bit soft as exports fell 6.1% from last year in USD terms. For China, the weaker trade data does create a dilemma. On the one hand, the drag on growth from a narrower trade surplus could, at least in theory, be offset by fiscal spending, rising consumption or investment. The first and third options would not be preferred, whereas the middle option, rising consumption, could weigh on net exports even more because it usually follows from rising consumption as imports increase. The other option is to depreciate the CNY to improve competitiveness. The Chinese are actually trying to stabilize the currency as capital flight has been putting downward pressure on the CNY. We note that bank regulators in China are putting additional restrictions in place, forcing banks to keep their foreign ledgers balanced which will make it more difficult to move money out of the country. It appears that if a bank finds that outflows are larger than inflows, it can’t facilitate the movement out of China. The moves being made by China are looking increasingly desperate and we don’t think they will work over time.

Meanwhile, Fed officials are becoming increasingly hawkish. The general consensus is that the Fed will raise the fed funds target at least twice this year and maybe three times. Chair Yellen held a town hall yesterday. Although nothing of consequence seemed to emerge, she did sound quite optimistic about the economy. Today’s WSJ notes an unusual level of “harmony” among Fed officials about moving rates higher. Over the past two weeks, five of the 12 regional FRB presidents have suggested that we should see two to four hikes this year. The report contrasts information gleaned from the recently released Fed meeting transcripts from 2011 which show a high degree of dissention among the FOMC and the measures that Chair Bernanke was forced to take to contain dissention.

We note that both St. Louis FRB President Bullard and Philadelphia FRB President Harker are calling for shrinking the Fed’s balance sheet. Although Bullard continues to call for only one hike this year, consistent with his narrative that the Fed shouldn’t be in the business of projecting policy, the fact he is also suggesting a reduction in the balance sheet clearly signals a hawkish bias. Harker suggested that once the fed funds target reaches 1%, the Fed should begin reducing the balance sheet by ending the reinvestment process and, over time, actually start selling down the balance sheet. It is unclear how that would affect financial markets. Regular readers are familiar with this chart:

The chart shows a model for the S&P 500 based on the Fed’s balance sheet.  From 2009 into mid-2016 the S&P mostly tracked the asset side of the Fed’s balance sheet.  However, since last summer, equities have started outperforming model, suggesting that equities have shifted from focusing on monetary policy to other factors, mostly likely economic growth and fiscal policy.  In theory, shrinking the balance sheet is a form of policy tightening; if this occurs as the FOMC is raising the fed funds target, it could easily amplify the policy tightening effect.  This is a factor we will be monitoring in the coming months.

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Asset Allocation Weekly (January 13, 2017)

Posted on by Rebekah Stovall

by Asset Allocation Committee

Last week, we reviewed Sebastian Mallaby’s recent biography of Alan Greenspan.[1]  This week, we will focus on the issue of financial crises and financial stability.  As noted in last week’s review, the financial system has evolved from a disjointed and diffuse system where banks could not establish themselves across state lines to one of increasing interconnectedness and concentration.  Although this has made the financial system more efficient, it has also made it less robust. Simply put, we have created a “too big to fail” problem that means that the Federal Reserve must stand ready to intervene and support failed financial firms to prevent a broader systemic meltdown.  This factor, coupled with inflation targeting, means that policy will tend to produce rising financial asset markets that are prone to infrequent large bear markets.  The analogy we have used in the past is similar to a forestry policy that will not tolerate any forest fires.  By preventing small fires, excessive underbrush grows, creating conditions that allow for extreme fire events that are difficult to control.  By constantly rescuing smaller financial firms, policymakers encourage excessive risk which leads to unstable financial markets.

If FOMC officials are convinced that regulators and financial policymakers will not address the “too big to fail” issue effectively (and we tend to believe they won’t[2]), then in reality the Federal Reserve has three mandates—full employment, controlled inflation and financial stability.  Currently, the FOMC uses monetary policy to address the first two mandates and relies on regulation to manage financial stability.  The track record for regulation is poor—even Vice Chair Fischer noted that so called “macro-prudential regulations” don’t work all that well, based off his experience as head of the Bank of Israel.[3]  Regulatory capture, the phenomenon where regulators are co-opted by those they regulate, is well-documented.  The only effective policy available to manage financial stability is monetary policy—raising or lowering interest rates.  However, it is very difficult for a central banker to raise interest rates because the equity P/E is too high or bond yields are too low; in fact, as we noted last week, it’s a good way for a central bank to see its independence stripped.

We have previously discussed the disconnect that has developed between financial stress and monetary policy.

This chart shows the Chicago FRB’s Financial Conditions Index (“CFRBFCI”) and the rate of fed funds.  The CFRBFCI is a measure of financial stress—it has 105 variables that include interest rates, borrowing levels, outstanding debt, credit spreads, credit surveys and money supply among many other factors.  In general, a rising number suggests worsening financial conditions and a reading above zero indicates worse than average financial conditions.  From 1973, when the index was first created, until the end of 1997, the CFRBFCI and the level of fed funds were closely correlated, at +85.1%.  When the Fed raised rates, financial conditions generally worsened and vice versa.  Essentially, this relationship acted as a “force multiplier” for monetary policy.  When the Fed raised rates, worsening financial conditions acted to depress the economy; when the Fed cut rates, improving financial conditions boosted growth.  However, since 1998, the two have become completely uncorrelated.  When the FOMC raised rates from 2004 to 2006, financial stress didn’t rise; when the financial crisis hit in 2008, the sharp drop in rates was slow to lower stress.  In fact, it wasn’t until April 2013 before financial stress fell to pre-crisis levels.

We have puzzled over this change for some time.  Mallaby’s biography of Greenspan offers one possible explanation.  In 1998, during the Long-Term Capital Management meltdown and Asian Economic Crisis, the FOMC, pressed by Greenspan, cut rates 25 bps at three consecutive meetings (Sept. through Nov.).  These cuts occurred in an environment of steadily falling unemployment.  Simply put, the FOMC cut rates as financial stress rose even though the case for lowering rates was difficult to justify given the state of the economy.  It appeared that investors concluded a policy asymmetry was in place—policymakers would cut rates if financial stress rose but would refrain from raising rates if stress was low.  In other words, the “Greenspan put” on financial markets was in place.

This leads to a rather uncomfortable problem.  If monetary policymakers are concerned that the financial system is fragile and cannot cope with much financial stress and they also conclude that regulators will never address this fragility due to regulatory capture, then they will be reluctant to raise rates and will only do so by clearly telegraphing their plans to avoid creating financial stress.  There are four conclusions to draw from this problem.  First, since the Fed will continue to target inflation, which is mostly held in check by globalization and deregulation (characterized mostly as the unfettered introduction of technological change), there will be a tendency for asset prices to reach unsustainable levels.  Second, given the impotence of financial regulation, the FOMC will unofficially target the suppression of financial stress, also fostering higher financial asset prices.  Third, investors will realize that the policy of suppressing financial stress will allow them to take on more risk.[4]  Fourth, monetary policy will be only modestly effective in reducing financial stress when the inevitable drop in asset values eventually occurs.

For investors, this policy situation creates a condition where one should remain invested in riskier assets until extremes in valuation are achieved.[5]  History does suggest financial problems tend to occur during recessions, which is another factor we closely monitor.  Overall, though, the central bank appears to be conducting policy in such a manner that supports asset prices and this is expected to continue for the foreseeable future.

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[1] Mallaby, S. (2016). The Man Who Knew: The Life and Times of Alan Greenspan. New York, NY: Penguin Press.

[2] There is an effective measure to address financial stability.  It requires banks to hold more capital.  That position is profoundly unpopular with banks because capital is something of a “dead weight” to the balance sheet.  For a good introduction to this issue, we recommend the following podcast:  http://www.npr.org/sections/money/2016/12/27/507125309/episode-744-the-last-bank-bailout

[3] https://www.federalreserve.gov/newsevents/speech/fischer20140710a.htm

[4] The problem discussed by Hyman Minsky.  Minsky, H. (2008). Stabilizing an Unstable Economy. New York, NY: McGraw-Hill (First edition published 1986, Yale University Press).

[5] See Asset Allocation Weekly, 12/16/2016, for thoughts on equity levels.

Daily Comment (January 12, 2017)

Posted on by Rebekah Stovall

by Bill O’Grady, Kaisa Stucke, and Thomas Wash

[Posted: 9:30 AM EST] The primary market theme this morning appears to be a broad reversal of the so-called “Trump trades” that have dominated the markets since the election.  We are seeing weaker equities globally and the dollar is weaker, while Treasuries and gold are doing better.  There are two factors that need to be separated from these markets moves.  First, a portion of this action is simply normal market adjustment.  The trend in the Trump trades has been pronounced and relentless.  Some market reversals for profit taking and position squaring make sense.  Second, one must determine where the interpretation of the Trump trades may have been in error.  The idea is that reversals that are merely “a pause to refresh” should be viewed as positioning opportunities.  Reversals based on mistakes may have more “legs.”

For example, it’s hard to see how trade restrictions will be bullish for bonds or stocks.  Deglobalization will tend to be inflationary, leading the Fed to raise rates and generally leaning against profit margins and growth.  Thus, the rise in bond yields make sense; the broad rally in equities less so.  This doesn’t mean that certain parts of the equity markets won’t do well.  Financials will be supported by regulatory relief and rising rates.  Energy should receive regulatory relief and the Ryan tax plan may tax oil imports, giving more support for domestic small cap equities.  Small and mid-cap stocks, due to their lower exposure to overseas markets, should outperform large caps.  However, populist policies favor equality over efficiency, which isn’t good for capital because it favors labor.  Thus, Trump’s policies may prove to be less supportive for the broad equity market, and consequently the fall in bond yields probably wouldn’t last and any weakness that develops in energy or financials may be a buying opportunity.

This chart shows the distribution of national income to capital and labor (the numbers don’t exactly add to 100 because we don’t include government’s share of national income).  From the late 1960s into the early 1990s, labor’s share averaged around 66% and capital about 28%.  Since the early 1990s, capital has been gaining share in each expansion cycle of the business cycle.  The current average share of labor in this expansion is around 61.5% compared to 36% for capital.  The deteriorating position of labor is probably behind the rise of populism.

Trump’s policies against trade are, in part, a bid to improve the labor share at the expense of capital.  These measures may not help all that much because, in a floating exchange rate environment, the dollar will likely rise to offset many of these measures.  This morning, for example, we are seeing a sharp drop in the dollar; although the dollar is technically overbought and due for correction, we expect Trump’s tax and trade policies to lead to dollar strength.  About the only way that the dollar’s rise can be stopped is if the Federal Reserve is badgered into holding rates steady.  We would not expect this outcome; thus, we see the dollar’s weakness as a technical correction, not a longer term change in trend.

Finally, as a side note, the Italian Constitutional Court rejected a request for a referendum on Renzi’s labor market reform.  This union-led request, if allowed, would have probably triggered new elections.  By rejecting the bid, the odds of an Italian election this year are reduced.

U.S. crude oil inventories rose 4.1 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 below shows, inventories remain elevated.

We won’t publish the annual seasonal pattern chart this week because, by design, the first week isn’t meaningful.  It will return next week.  We do note that the build is rather large this week which suggests OPEC cuts have not affected U.S. supply.  Of course, now that the cartel is officially reducing production, we should see a slower than normal build in the coming week.

Based on inventories alone, oil prices are overvalued with the fair value price of $41.79.  Meanwhile, the EUR/WTI model generates a fair value of $35.94.  Together (which is a more sound methodology), fair value is $36.05, meaning that current prices are well above fair value.  OPEC has managed to lift prices but maintaining these levels will be a challenge given the dollar’s strength and the continued elevated levels of inventories.

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Daily Comment (January 11, 2017)

Posted on by Rebekah Stovall

by Bill O’Grady, Kaisa Stucke, and Thomas Wash

[Posted: 9:30 AM EST] There was a lot of political and geopolitical news overnight.  The most widely covered were reports that the Russians have compromising information about Donald Trump.  The 32-page report, published last night by Buzzfeed, makes a series of allegations, suggesting that the president-elect engaged in salacious behavior in Moscow, Trump campaign officials made numerous contacts with Russian officials and the Wikileaks were used to divulge information about Hillary Clinton and members of her campaign for “plausible deniability.”

It should be noted that these allegations circulated among the media well before the election.  They didn’t get a lot of traction because news organizations could not establish their veracity, but that doesn’t mean there isn’t an element of truth in them.  Russia’s two short-term goals are to get sanctions lifted and to rebuild influence in its near abroad.  Although it isn’t completely obvious that Trump would help in this area, Clinton was a known quantity and it was abundantly clear she would have bolstered NATO and pressed to keep sanctions in place.  Thus, trying to support Trump and undermine Clinton was a reasonable policy for Russia.

One of the more interesting sidelights of this affair begs the questions of why is this material coming out now and why did the intelligence agencies allow it to come to light?  It is plausible that the intelligence agencies are not happy with the incoming president and wanted to signal to him that they do have the ability to affect his presidency.  Trump holds a press conference at 11:00 EST this morning.  How he handles this issue will be worth monitoring.

Will this issue be enough to seriously undermine his presidency, leading to impeachment or resignation?  Probably not, but it should be noted that it might compromise his leadership to some degree.  It is important to remember that the establishment wings of both parties oppose many of Trump’s campaign promises.  Using this issue to prevent aggressive immigration reform or trade restrictions is not out of the realm of possibility.

At the same time, it should be remembered that foreign nations try to affect U.S. elections as a matter of course.  The fact that the Russians were so obvious about it suggests either a rather profound degree of incompetence or an indication that Putin’s personal loathing of Hillary Clinton got the best of him.  We note Politico is reporting that Ukraine was engaged in measures to support Clinton because it wanted a friendly person in the White House.  This support included reports that the country was investigating Paul Manafort for corruption in activities in Ukraine.  According to this source, Ukrainian officials are rapidly backtracking on these efforts in an attempt to build favor with the Trump White House.

China was in the news as well.  The military sent a strategic bomber near the Spratly Islands.  In addition, the Chinese Navy sent a flotilla of warships, including its lone carrier, the Liaoning, through the Taiwan Strait.  This show of force led the Taiwan military to scramble jets and send its own navy to surveil the Chinese vessels as they moved through the area.  China’s actions triggered Japan and South Korea to scramble warplanes earlier this week.  China’s increased aggression is coming as the U.S. prepares to transfer power and as Chairman Xi (who is speaking at Davos next week, the first Chinese president to speak to this group) is laying the groundwork for his second term, which will begin in November.

On the topic of China, the under-the-fold story in today’s FT reports that Chinese authorities are scrutinizing the bitcoin price surge.  According to the story, Chinese bitcoin exchanges are monitored for large transactions.  We suspect this is true.  However, smaller deals are not closely watched and thus bitcoin may have become the portal of choice for less affluent households to diversify their holdings.  Reuters is reporting that forex regulators are telling banks to keep their regulations surrounding capital exports secret and to let bank analysts know that any negative thoughts on the CNY should be “kept to themselves.”  SAFE, the Chinese regulator that manages forex, has been issuing oral regulations to conceal regulatory changes.  This forces banks to refuse transfer business that they may have performed previously, but the banks have to do so without indicating why.  These measures suggest that Chinese officials are very concerned about capital flight.

Finally, Bloomberg is reporting that Russia has started reducing oil production; as much as 148 kbpd of output may have been shut in.  Russia is notorious for reneging on production cut agreements, so the fact that it appears to have started the process (the Russians have promised cuts of 300 kbpd over the next few months) is remarkable and bullish for crude oil.

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Daily Comment (January 10, 2017)

Posted on by Rebekah Stovall

by Bill O’Grady, Kaisa Stucke, and Thomas Wash

[Posted: 9:30 AM EST] China reported its producer prices (see below).  China’s PPI has been rising, suggesting growing inflation pressures in the country.

Over the past year, producer prices have been rising rapidly in China after more than two years of producer price deflation.  The combination of monetary stimulus, a weaker currency and a policy to reduce excess capacity does seem to be working to raise price levels.

The rise in China’s producer prices will export inflation to the rest of the world, although the weaker CNY will offset some of that price pressure.  Still, there is evidence to suggest that rising price pressures in China could find their way to the U.S.

This chart shows the relationship between China’s PPI and U.S. import prices on a yearly change basis.  The two series are closely correlated, with r=89.0%.  Since 1998, import prices have averaged +1.3% per year.  Of course, import prices are also quite sensitive to the dollar.  Using the JPM dollar index, when the dollar index is above 110, the average growth is only 0.3%; when the index is less than 110, the average rises to 2.3%.  The current JPM dollar index is 118.6, suggesting that the dollar will tend to inoculate the U.S. from most of the impact of rising Chinese inflation.  However, the rest of the world won’t be able to as easily rely on this protection; thus, rising Chinese PPI will likely lead to rising global prices.  This factor could push emerging economies into a difficult position.  Rising prices should lead to tighter monetary policy in the emerging world but the stronger dollar will tend to raise financial stress in the emerging world, which would call for easier policy.  China’s PPI could become an issue for the rest of the world.

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Weekly Geopolitical Report – War Gaming: Part I (January 9, 2017)

Posted on by Rebekah Stovall

by Bill O’Grady

(Due to Martin Luther King Jr. Day, Part II of this report will be published on January 23.)

One of the key elements of global hegemony is the ability of a nation to project power.  Ideally, this means a potential hegemon needs local security.  In other words, a nation that faces significant proximate threats will struggle to project power globally.  As a general rule, it’s easier to attack via land compared to the sea.

Rome’s power base was the Italian peninsula.   It only needed to defend the northern part of the land mass.  Spain had a similar situation.  The Netherlands was the global hegemon for a while but was always facing a land threat from France.  Britain, being an island, was geographically ideal for superpower status; the last successful invasion of the British Isles was in 1066.  Finally, the U.S. has managed to create an island effect on a larger land mass giving America more access to natural resources compared to Britain, making the U.S. a nearly ideal hegemon.

In Part I of this report, we will examine American hegemony from a foreign nation’s perspective.  In other words, if a nation wanted to attack the U.S. to either replace the U.S. as global superpower or to create conditions that would allow it to act freely to establish regional hegemony, how would this be accomplished?  This analysis will begin by examining America’s geopolitical position.  As part of this week’s report, we will examine the likelihood of a nuclear attack and a terrorist strike against the U.S.  In Part II, we will examine the remaining two methods, cyberwarfare and disinformation, discussing their likelihood along with the costs and benefits of these tactics.  We will also conclude in Part II with potential market effects.

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Daily Comment (January 9, 2017)

Posted on by Rebekah Stovall

by Bill O’Grady, Kaisa Stucke, and Thomas Wash

[Posted: 9:30 AM EST] It was a rather quiet weekend.  We are seeing a drop in oil prices this morning attributed to reports that production in Northern Iraq, which is under Kurdish control, may be rising.  It was never certain whether the Kurds would cooperate and the worry is that if one major producing nation cheats then the rest of the cartel may also defect from the agreement.

On Saturday, China released its foreign reserves data.  Reserves dropped by $41 bn, near forecast.

(Source: Bloomberg)

Since peaking in June 2014, China’s foreign reserves have declined by nearly 25%, or about 10.7% annually.  Although the level of reserves is still high, the drop since the peak is approaching $1.0 trillion, a massive amount.  There are reports that the PBOC has been meeting with bitcoin firms in China; currently, the discussions appear to be about curbing advertising.  If this is the case, it would suggest that Chinese officials, at least for now, will tolerate “insider” use of bitcoin but are interested in discouraging it from becoming a mass product.  We suspect that officials realize that shutting down bitcoin would be difficult because it is most likely being utilized by CPC members for capital flight.  Thus, controlling it and keeping it from the commoners makes sense.

In other news, PM May’s comments about restricting immigration sent the GBP lower this morning.  Although the pound remains at historically cheap levels, worries about a “hard Brexit” continue to weigh on the currency.  Reuters is reporting that leftist parties in Germany, namely, the Social Democrats (SDP), the hard-left Die Linke and the Greens, are considering a coalition.  This party mix actually now controls more seats in the Bundestag and could rule.  However, the SDP, which is center-left, does not agree with the pacifist Die Linke, which wants to pull out of NATO.  We suspect the SDP will remain in a grand coalition with Chancellor Merkel’s CDU-CSU but is using this threat to gain more influence in the autumn elections.  This suggests to us that Merkel will retain power but be a weaker leader.  Finally, Ayatollah Ali Akbar Hashemi Rafsanjani died over the weekend.  Rafsanjani was an influential Iranian political figure who held numerous positions since the revolution, including president.  He was powerful enough to act as a counterweight to the conservative mullahs; his passing creates something of a power vacuum that will likely be filled by the conservatives.

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Asset Allocation Weekly (January 6, 2017)

Posted on by Rebekah Stovall

by Asset Allocation Committee

Over the holiday, I had the pleasure of reading Sebastian Mallaby’s recent biography of Alan Greenspan.[1]  The book was thoroughly researched and well-written, and I recommend it to our readers, albeit with fair warning—it’s long and the endnotes are critical to fully understanding the points of the work.

Here are the key points of the book.

All presidential administrations want easy money:  Truman implored William Martin to accommodate the Korean War spending, intimating that not doing so was supporting communism.  Nixon leaked a rumor (perhaps an early form of “false news”) that his Fed Chair, Arthur Burns, wanted a pay raise.  The report infuriated Congress and put Burns on the defensive.  Nixon let Burns know that he would set the record straight in return for easy money.[2]  Nixon got his wish.  Ford wanted accommodative policy.  Reagan consistently complained about Volcker’s tight policy and believed a return to the gold standard would be a painless way to weaken inflation expectations.[3]  George H.W. Bush felt Greenspan’s tight money cost him the election.[4]  Bill Clinton generally avoided publicly criticizing the Fed but was worried that high bond yields would kill the economy.[5]  The goal of any president is to stay in power; having the unfortunate circumstance of a recession occurring into an election year is a career-ending event.  Thus, wanting the central bank to support the economy into the election is a desire of all presidents.

Financial crises are inevitable—so are government bailouts:  Greenspan was a devotee of Ayn Rand and a member of her “Collective.”  He opposed government support for bad behavior.  However, his youthful position changed as he entered government.  The political and economic fallout of letting large and connected financial firms fail was simply too costly.  Although the heavily regulated and geographically dispersed financial system avoided crises from 1945 to the early 1970s, it was also an era of higher rates and a less efficient financial system.  For example, the ratio of prime lending rates to fed funds in the 1950s to the late 1960s was 1.57x; that fell to 1.18x from the 1970s to the late 1980s.  However, improved financial market efficiency came at the cost of financial system problems.  What the book makes clear is that regulators won’t prevent crises and no regulator has determined a level of capital that will, either.  The only way to reduce the frequency of financial crises and bailouts is through policies that make the financial system less efficient.  During good times, the majority of people want the financial system to accommodate their borrowing desires.  Thus, they support imprudent lending that inevitably leads to financial crises.  Pressing policies that impede lending are unpopular and are only considered in the aftermath of financial events.  Over time, these measures will be diluted and repealed.  Greenspan supported the repeal of Glass-Steagall and opposed the CFTC’s attempt to gain regulatory control over the swaps market.  Although these measures might have reduced the magnitude of the 2008 Financial Crisis, the bipartisan support for Fannie Mae and Freddie Mac (both bodies opposed by Greenspan) made the mortgage crisis unavoidable.  Greenspan believed that it was better to allow the bubble to inflate and clean up the “debris” in its wake.  That isn’t an optimum policy but probably the only one that is politically feasible.[6]

Inflation targeting leads to asset inflation:  As early as 1993, Lawrence Lindsey, a Fed governor, pointed out to the FOMC that focusing solely on inflation control has the potential side effect of creating asset bubbles.[7]  Lindsey observed that inflation was falling due to globalization (and not due to Fed policy).  We would add deregulation as well.  If inflation is low, the central bank could be lured into keeping policy accommodative, potentially leading to asset bubbles in equities, housing and fixed income.  Greenspan mostly ignored Lindsey’s concerns; Mallaby speculates that the Fed Chair realized that keeping goods prices in check was politically acceptable but restricting wealth would not be tolerated.  Essentially, if some future Fed chair wants to tighten policy ostensibly to deflate an asset bubble, he will have to come up with an inflation narrative to do so.  Consequently, monetary policy in an era of globalization and deregulation will tend to support asset prices and increase the odds of asset bubbles.

What do these insights tell us?  In a world that is globalized and deregulated, financial markets will have a bullish bias because monetary policy will be persistently accommodative.  If President-elect Trump signals an end to globalization and perhaps the unencumbered introduction of new technology, inflation targeting will become less friendly to financial markets.  Still, there is no evidence to suggest that the Fed will no longer face pressure from the White House for easy money, not rescue financial markets from volatility or ever target asset prices in setting policy (at least consistently and overtly).

Our conclusions from Mallaby’s work tend to confirm prior comments we have made about S&P 500 P/Es.  This chart shows the trailing P/E for the S&P 500; for the current quarter, we use a mix of three quarters (Q1, Q2, Q3) and consensus forecasts for Q4.  The area in gray, which encompasses the period from 1988 to the present, has seen an upward shift in the P/E.  Essentially, the lows recorded in this period are closer to the average observed over the entire time frame.  Investors appear to have shifted their risk tolerance and are willing to “pay up” for earnings.  Part of the reason why this shift occurred could be contained in the above analysis of monetary policy.  The combination of expectations of central bank “rescues” from market turbulence and policy accommodation stemming from inflation targeting in a globalized economic environment may have given investors more “courage” about accepting a higher earnings multiple than seen in the past.  Thus, the current P/E, though historically elevated, may not be all that risky…as long as the monetary policy environment doesn’t change.

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[1] Mallaby, S. (2016). The Man Who Knew: The Life and Times of Alan Greenspan. New York, NY: Penguin Press.

[2] Ibid.  Greenspan disputed Mallaby’s claim that the former was responsible for letting Burns know how he could get the rumor squelched, pp. 141-144.  Mallaby stands by his position.

[3] Ibid, p. 267.

[4] Ibid, p. 569.  Dick Darman, Bush’s budget director, suggested Greenspan may be similar to Norman Bates, p. 415.

[5] Ibid, p. 430.  James Carville’s famous quote about reincarnating as the bond market.

[6] Ibid, pp. 675-677.

[7] Ibid, p. 435.

Daily Comment (January 6, 2017)

Posted on by Rebekah Stovall

by Bill O’Grady, Kaisa Stucke, and Thomas Wash

[Posted: 9:30 AM EST] Happy employment data day!  We have the details below but, in general, the data was mostly in line with expectations.  We did see a bit of wage growth which has been bearish for bonds but supportive for the dollar.

U.S. crude oil inventories fell 7.1 mb compared to market expectations of a 2.0 mb draw.  The large drop is mostly due to seasonal factors.  At year’s end, firms have an incentive to lower stockpiles for tax reasons.  We do note that product inventories jumped last week.

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 below shows, inventories remain elevated.

The annual seasonal pattern shows that inventories fell more than the seasonal pattern suggested they should.  It is important to note that we are heading into an inventory accumulation period that will last into April.  If OPEC is having success in reducing supply, we should see a slower than normal rise in inventories this year.

Based on inventories alone, oil prices are overvalued with the fair value price of $42.77.  Meanwhile, the EUR/WTI model generates a fair value of $35.32.  Together (which is a more sound methodology), fair value is $35.86, meaning that current prices are well above fair value.  OPEC has managed to lift prices but maintaining these levels will be a challenge given the dollar’s strength and the continued elevated levels of inventories.

On a related note, employment in oil and gas extraction hasn’t started to lift yet.

However, we have seen stable levels of employment in oil and gas extraction since mid-2016.

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