Asset Allocation Quarterly (Fourth Quarter 2016)

Posted on October 17, 2016 by Rebekah Stovall

Although presidential elections gather a lot of attention from investors, we believe the specific person or party getting elected in this cycle may be less important than the forces driving the elections.
The Fed is likely to raise rates gradually and we don’t expect the tighter policy to create a recession.
Our equity allocations remain primarily domestic, although we believe emerging markets present an attractive return/risk opportunity for risk-tolerant investors.
We include a range of maturities in our fixed income allocations.
Our commodities allocation remains focused on gold to help address certain geopolitical and currency risks.
Our style guidance remains modestly in favor of growth over value at 60/40.

ECONOMIC VIEWPOINTS

For over 16 years, including many prior to forming Confluence, we’ve worked together providing quarterly reports about our asset allocation models. And every four years we face a presidential election that often attracts an outsized amount of attention from investors. We frame it as outsized because the outcome of most presidential elections alone is generally not of great consequence to the markets. Elections certainly do have broad consequences, but the financial markets usually adjust pretty quickly.

This isn’t to say presidential elections are insignificant. But right now, the specifics of who occupies the White House is perhaps less important than understanding the changing force voters are exerting on the U.S. political system. So, regardless of which party takes the helm, both are going to have to deal with this force, which we expect to continue and grow well beyond this election cycle. What does this force look like? It’s complex and multifaceted, but we think it’s essentially a transition. We believe our economic philosophy is shifting away from an emphasis on efficiency, and more toward one of equality. We expect this shift to take years, and last for perhaps decades. If we are near the beginning of the transition, as we believe we are, there a few things for an investor to monitor.

To begin, let’s consider what we mean by “efficiency” in the economy. With efficiency, tax rates and regulation are lower, fostering greater competition and innovation. Patent applications rise, along with technological developments that drive new products and processes. Business efficiency and profitability rise, while those building better mousetraps earn and keep significant wealth. Global trade rises as businesses seek to shift production to areas of lower cost, while simultaneously growing into new markets. Technology and globalization create obsolescence in the labor force, along with the creative destruction of existing plants, equipment and processes. Innovation and competition lower inflation, which benefits the broad population, but high returns on capital accrue disproportionately to those who have capital. In a nutshell, you get the Internet, iPhone and low prices, while workers are displaced and the wealthy become wealthier. We’ve been in the efficiency cycle for almost 40 years.

In contrast, with an “equality”-focused economy, tax rates and regulations rise, lowering incentives to innovate. Competition declines as a more rigid regulatory framework gains prominence. New product development declines, employment becomes more predictable and there’s less obsolescence. Global trade slows, creating more inflation. The income gap narrows between the wealthy and the poor. Here we see much longer cycles between the new iPhones, and they’re even more expensive with fewer meaningful upgrades. The retail industry is less threatened by Amazonian forces and participation in the labor market can stabilize and even grow. We may be heading into this environment. The chart on the next page illustrates the efficiency/equality transition.

A transition from efficiency to equality will take time and transcend several election cycles. The speed and depth of the transition are difficult to predict, but we feel the political parties are likely to feel ongoing pressure to change the established system of efficiency. Too many voters feel as though the current environment is unacceptable. Politicians and parties will adjust or lose their positions of governance.

Although we may be at the beginning of a transition, we don’t believe it’s likely to create a recession over our projected forecast period of three years. On that front, we believe Fed policy is more immediately relevant. Although the Fed has telegraphed a moderate pace of raising rates, forward interest rates indicate a broad expectation that the Fed will go even slower. In this instance, our expectations are more aligned with the market, and we believe the economy is likely to continue along its path of slow growth for quite a while.

STOCK MARKET OUTLOOK

Although the aforementioned transition to equality may lower growth in corporate profits and increase inflation, we expect a gradual pace of change, allowing equities to perform reasonably well. Looking forward, we believe the return/risk profile of stocks is generally constructive and we continue to diversify across capitalization sizes. This quarter we trim the small cap exposure in some portfolios, recognizing its recent strong performance. We are also beginning to utilize emerging market equities across more portfolios as we see potential upside from favorable currency trends and low valuations. Still, emerging market equities are highly volatile, so we utilize only a limited allocation, except where risk tolerance is high.

With regard to our large cap sector weights, we remain overweight energy but pare back the exposure after the sector’s very strong performance. We are also overweight the technology, industrial and consumer discretionary sectors, while being underweight financials, utilities and telecom. (We continue to allocate to real estate as a separate asset class; see comments in the Other Markets section below.) These sector views are formed from our work on valuations and industry fundamentals. Our growth/value posture remains at 60/40.

BOND MARKET OUTLOOK

As the economy shifts from efficiency to equality, we will be keeping close tabs on inflation, which tends to create significant risks for bond investors. However, we do not anticipate inflation to emerge quickly or without a measure of warning. Excess global supply capacity remains high for many industries and inflation is unlikely to build unless global trade is dialed down. Such a trend is possible but not yet in place. Accordingly, we continue to believe bond investors can utilize a combination of short, intermediate and long maturities in their portfolios. Bonds continue to provide excellent diversification and can help to address market volatility when combined with other asset classes.

At this point we do not anticipate a recession and do not expect large increases in bond defaults. Therefore, we continue to believe corporate bonds are relatively attractive. Still, our focus remains on investment grade corporate bonds, which we prefer over speculative grade bonds.

OTHER MARKETS

We expect real estate fundamentals to remain generally strong and believe this asset class can benefit from ongoing low interest rates. Still, this asset class has performed very well and we trim the exposure in some portfolios this quarter. Looking forward, the return/risk remains attractive, particularly where income is an objective.

Commodities continue to provide diversification and we focus our commodities allocation on gold. Gold helps to address some of the risks emerging from global central bank policies aimed at depreciating currencies. This precious metal can also help address certain geopolitical risks and can perform well in the event the U.S. dollar weakens relative to other major currencies.

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Daily Comment (October 17, 2016)

Posted on October 17, 2016 by Rebekah Stovall

by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] The weekend was full of political news and some policy news as well. On the political front, the Trump campaign is pressing its point that the elections could be “rigged” but has widened the definition beyond mere poll manipulation, suggesting the mainstream media is aligned against him.[1] Polls are leaning toward Sen. Clinton but we are somewhat skeptical of the data. Overall, we think there is likely a higher degree of preference falsification in this election cycle and it probably means the polls are underestimating the degree of support for Trump. There was even some violence as a GOP office was firebombed in North Carolina. Both sides have blamed the other; Mr. Trump has already accused the Democrats of the attack, while some Democratic Party supporters have suggested it was a “false flag” operation. We don’t know who did it but it does suggest the potential for civil disorder is rising in the post-election environment.

The NYT had some long reads about Sen. Clinton over the weekend. There were reports on further Wikileaks of Clinton’s speeches to financial firms, which make it clear why she refused to release the transcripts during the primaries. Her comments were supportive of financial services, not favorable to Dodd-Frank and suggested she was on the bankers’ side. This is a concern of the Left-Wing Populists (Senators Sanders and Warren). We expect that if Clinton is elected president she will face a constant barrage of advice from the Left-Wing Populists about who should serve in regulatory positions in the administration. Although much commentary has been made about the breakup of the GOP, the Democratic Party is facing its own disunion similar to what the Republicans are facing. Our take is that we are in the early stages of a resetting of political coalitions. The last one we saw was in the 1960s, when the Roosevelt Coalition of the Center-Left Establishment and the Right-Wing Populists began to crumble. We don’t know how this one will evolve but it is something we are watching closely.

On the policy front, Chair Yellen indicated that she will be willing to allow the economy to “run hot” and overshoot the 2% inflation target. This isn’t really a shocking insight but it does suggest that the FOMC will lean dovish. What this means in terms of actual policy is that we will likely see a hike in December to placate the hawks but we would not expect another hike until H2 2017, and would only expect one move next year. Meanwhile, at this week’s ECB meeting, expectations call for the central bank to signal that it will extend QE at its meeting in December. These twin expectations should be dollar supportive in the short run but will likely lead to a weaker dollar next year as the market begins to anticipate ECB tapering and also discount very little tightening from the FOMC.

On the geopolitical front, Iraqi forces and allies are beginning the liberation of Mosul from IS. We expect this operation to take weeks. NBC is reporting that the CIA is preparing a package of cyber attacks on Russia in retaliation for hacks affecting the political process in the U.S. Simply preparing attacks isn’t the same thing as executing them. We would be surprised to see anything too aggressive result from these threats.

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[1] This was the point of Matt Taibbi of Rolling Stone in a piece from August. See: http://www.rollingstone.com/politics/matt-taibbi-on-the-summer-of-the-media-shill-w434484.

Asset Allocation Weekly (October 14, 2016)

Posted on October 14, 2016 by Rebekah Stovall

by Asset Allocation Committee

Given continued sluggish economic growth and fears that monetary policy has reached the point where it can no longer stimulate growth, a renewed attention has been brought to discretionary fiscal policy. In the 1970s, discretionary fiscal policy fell out of favor due to a number of shortcomings:

Public investment, if needed, should not be timed to offset recessions. In other words, if the Navy needs an aircraft carrier, one should be built without waiting for a recession. Thus, public investment should be based on need, not designed as a countercyclical policy.
Discretionary policy must pass through the legislative process. This tends to slow the outcome to the point that the recession may have passed by the time Congress allocates spending.
Fiscal spending, especially fixed asset spending, can “crowd out” private spending. In functioning investment markets, investment spending should be generated by cutting interest rates rather than by directing public investment by government fiat. In addition, private investment is forced to pass through the test of profitability, reducing the likelihood of malinvestment.

From the late 1970s, economists generally concluded that discretionary fiscal spending was unnecessary and that countercyclical monetary policy was sufficient to guide the economy through recessions. Although there were occasional extraordinary fiscal measures taken during some downturns, such as tax rebates and extended unemployment insurance payments, for the most part, monetary policy was the measure of choice in terms of countercyclical policy.

However, the developed world now finds itself in a situation where monetary policy may have reached its point of diminishing returns. The Bank of Japan (BOJ), the Swiss National Bank and the European Central Bank (ECB) have tried to implement negative interest rates. In these cases, it appears that the damage to the banking system is offsetting any gains from lower rates. Balance sheet expansions (QE) have been deployed by the aforementioned central banks and the Federal Reserve. In general, balance sheet expansion has become less effective; a common complaint is that asset values have been extended in many markets without generating much economic growth. Central banks are also struggling to find assets to purchase. The BOJ has been buying equity ETFs and the ECB has added corporate bonds to its balance sheet, causing further financial market distortions.

This isn’t to say that the central banks have exhausted all their options, but the ones that remain cannot be implemented without help. For example, central banks could implement quantitative easing by purchasing foreign bonds; this would likely lead to currency depreciation that would boost exports. However, such “beggar thy neighbor” policies would likely bring retaliation and further reduce global trade. The other option is “helicopter money,” which is the direct central bank financing of government spending. Although this policy would be effective, it does require the participation of fiscal authorities. In addition, central bank independence would almost certainly be compromised.

So, if fiscal policy is expanded, would we face the problems outlined above? Generally speaking, the biggest risk would be point #2 above. Getting spending plans through a divided Congress would be difficult. In addition, avoiding malinvestment, regardless of whether it’s public or private, is always hard. But in the current partisan environment, coming up with public investment that would foster future growth will be problematic. However, there is evidence to suggest that public spending has been neglected for some time and that private investment is currently weak, reducing the problem of “crowding out”; in other words, concerns about points #1 and #3 are reduced.

This chart shows the net stock of fixed assets for both the public and private sectors. We have log transformed the data and de-trended both series. In general, a reading over zero indicates the net stock of fixed assets is above its long-term trend and vice versa. Note that public sector assets were above trend from 1940 into the mid-1990s. This was mostly due to elevated Cold War defense spending. During this period, private sector fixed asset levels tended to remain under trend, although a surge that began in the mid-1960s did eventually lead to a rise above trend. Note that the surge of both public and private spending on fixed assets in the 1970s probably led to crowding out and higher inflation.

Current conditions suggest that both private and public sector investment are well below trend. In general, private sector investment tends to have a greater impact on future growth and would thus be preferred. However, given an environment of weak asset formation from both sectors, the economy would likely benefit from increased investment in either sector. Thus, promises of increased spending on infrastructure and defense would likely have a positive effect on the economy and be positive for equity markets.

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Daily Comment (October 14, 2016)

Posted on October 14, 2016October 14, 2016 by Rebekah Stovall

by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Global equity markets are trending higher this morning; the rise is being attributed to inflation running a bit higher than expected in China (see below), reducing the issue of deflation. China’s practice of exporting deflation has been a concern for some time, but mildly positive inflation is positive for the world economy.

Each year, we publish our geopolitical outlook for the coming year in December and an update at mid-year in June.[1] In both recent reports, we have highlighted that the U.S. elections could create conditions that would increase geopolitical risk. In particular, one issue we noted was that a significant shift in policy is likely after the inauguration. A Trump victory would set the U.S. on a course to adopt a Jacksonian[2] foreign policy, which is essentially isolationist unless the U.S. is directly threatened. A Clinton win would introduce a Wilsonian foreign policy, which is why she has been finding neoconservative support. Currently, we are leaning toward a Clinton win (60% odds), although we believe most political pundits are underestimating the potential for a Trump victory. Both Brexit and the Colombia referendum have shown the problem pollsters face from “preference falsification,” the situation where poll respondents lie to pollsters so as not to reveal their true preference.

This shift in foreign policy means that nations who generally oppose U.S. policy could either be facing a situation in which they can more easily project power (a Trump win) or facing a more determined American foreign policy designed to contain their aspirations (a Clinton win). As polls shift to suggest a Clinton win, we have seen two trends. First, there is evidence to suggest Russia is trying to sway the outcome of the election via Wikileaks and hacking. It is understandable that Putin would prefer Trump; the GOP candidate has raised the issue of backing away from supporting NATO and appears friendly with Putin. Clinton would be more traditional in foreign policy. Second, President Obama has been reluctant to confront Russia and China over their power projection. Bloomberg is reporting today that Russia is trying to solidify Assad’s position in Syria before the new U.S. president takes office, which suggests he fears that the next president won’t permit Putin and Assad from acting with the current degree of impunity.[3] We note that Russia has sent Russian carriers to the Syrian coast, including the RFS Admiral Kuznetsov, its first ever deployment, and the RFS Yantar, a ship designed to disrupt communications. In Syria, there is a history of communication disruptions before major offensives. If Assad and Putin are planning a major attack on Aleppo, they may want the additional air support and will desire to cut off cell and internet before the attack. We note the RIA Novosti news service is reporting that Saudi Arabia and the U.S. are allowing IS militants to leave Mosul to fight elsewhere and Hezbollah is alleging that the U.S. is supporting IS in eastern Syria. We doubt the Obama administration is doing any such thing but it is consistent with Assad’s argument that anyone who opposes him is a terrorist.[4]

The bottom line is that the global geopolitical situation is becoming more fluid and this condition will not only continue but could accelerate as the elections unfold. A Clinton win could lead to even more aggressive action as Russia, Iran and China try to take advantage of a closing window of opportunity.

U.S. crude oil inventories fell 4.9 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, seasonally, we should see inventories rise as refineries undergo maintenance. However, inventories have steadily declined even with the drop in refinery operations. The lift this week is more consistent with seasonal patterns; we would expect at least three more weeks of accumulation.

Based on inventories alone, oil prices are overvalued with the fair value price of $43.91. Meanwhile, the EUR/WTI model generates a fair value of $47.44. Together (which is a more sound methodology), fair value is $44.52, meaning that current prices are a bit above fair value. Most likely, the divergence from fair value is due to hopes of an OPEC deal that would boost prices. We are surprised to see oil hold its gains in the face of a rising dollar. The best explanation is that OPEC has engineered this price strength. However, this means that the oil market is quite vulnerable to any disappointment from the cartel.

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[1] See WGRs: 12/14/15, The 2016 Geopolitical Outlook; and 6/27/16, The 2016 Mid-Year Geopolitical Outlook.

[2] See WGR: 4/4/16, The Archetypes of American Foreign Policy: A Reprise.

[3] http://www.bloomberg.com/news/articles/2016-10-13/putin-seeks-to-lock-in-gains-in-syria-before-next-u-s-president

[4] http://www.iraqinews.com/iraq-war/us-saudi-agreement-provide-safe-havens-isis-exit-mosul/

Daily Comment (October 13, 2016)

Posted on October 13, 2016October 13, 2016 by Rebekah Stovall

by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] The FOMC minutes did have some interesting information but no real surprises. It confirmed what the dissents and the dots chart indicated—the FOMC is divided on policy. The hawks are concerned that waiting too long to raise rates could lead to an overheating economy and force the central bank to ratchet up rates quickly, leading to a recession. This group would recommend a modest hike now to prevent that overheating and extend the current business cycle. The doves argue that slack remains in the labor market and, with rates this low, the FOMC has ample room to raise rates if the economy overheats but limited room to cut if the economy weakens.

It doesn’t appear to us that much has changed. We expect the Fed to raise rates in December but make only one more move next year. Fed funds futures put the odds of a December hike at 61%, unchanged from before the minutes. Our position is that the FOMC will raise rates in December to placate the hawks. To calm the doves, forward guidance will suggest that there will likely only be one hike in 2017, barring a surge in economic activity.

The king of Thailand, Bhumibol Adulyadej, died this morning at the age of 88. He had been suffering from a myriad of age-related ailments for years. The king had ruled for over 70 years. He is expected to be succeeded by his son, Crown Prince Vajiralongkorn. The king’s passing could raise political tensions in Thailand. He was the key unifying figure in a country that has seen 19 coups (12 of which were successful) since the absolute monarchy was abolished in 1932. This political instability has been managed mostly by the king intervening when tensions were close to boiling over. His death raises the possibility that the rural-urban divide, the most potent in the country, will become unmanageable. Currently, the country is governed by a military junta that replaced the previous democratically elected government that favored the rural faction. Elections were expected by the end of next year; the king’s passing will likely delay the vote.

Thai financial markets have been under pressure from the king’s illness and his passing.

The chart above shows the Thai baht per dollar, so a rising reading is a weakening baht. Note the rapid spike over the past two days, indicating currency depreciation in light of the political uncertainty. Thai equities have suffered as well.

Finally, as we note below, China’s trade data came in weaker than expected. Exports plunged 10%, much weaker than forecast, and imports were also soft, falling 1.9%. This weakness might explain why the PBOC has been allowing the CNY to depreciate.

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Daily Comment (October 12, 2016)

Posted on October 12, 2016 by Rebekah Stovall

by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] The big news overnight was that PM May will allow Parliament to debate on her plan to exit the EU. The GBP rallied strongly on the reports. However, there is nothing to suggest that she is planning to let the legislature vote on Brexit. There is a constitutional dispute in the U.K. over this issue. A number of legal scholars in Britain are arguing that the referendum on Brexit isn’t really binding and only an act of Parliament can authorize an Article 50 declaration. An Article 50 declaration begins the process for the U.K. to exit the EU. Thus, in order to declare Article 50, Parliament would need to vote on the measure and it is quite possible that an act to authorize Article 50 would fail given the current makeup of the U.K. legislature.

May seems to disagree with this legal position and is indicating that she has the authority to declare Article 50 without an act of Parliament. The basis of this argument is the “Royal Prerogative,” which gives the state executive power to act without permission of the legislature. There is some dispute over who actually now has this power; although historically reserved for the sovereign, in the modern era some have suggested it resides with the actual head of state, the prime minister.

It does not appear that May plans to request an act of Parliament to declare Article 50. However, the legal situation isn’t all that clear and it is possible the courts will need to decide if PM May can actually move to declare Article 50 without an act of Parliament. If this is the case, we could easily see a long process for Brexit, at a minimum. It also isn’t out of the question that it still may not occur. May’s action today doesn’t appear to be an impediment to her plans to declare Article 50 without an act of Parliament, but we do expect a legal challenge if she tries to start the Brexit process without one.

At 2:00 EDT, the Federal Reserve will release the minutes from the September meeting. Although the heavily edited discussion is always closely scrutinized, this one will come under particular focus due to the growing divergence of views within the FOMC. As noted before, we had three dissents to not raising rates at the September meeting, but the dots plot showed that three participants wanted to leave rates steady for the remainder of the year. Fed fund futures are signaling a 68% chance of a rate hike at the December meeting. The strength we are seeing in the dollar (which is, in our opinion, behind recent equity market weakness) is due, in part, to expected tightening. However, the deferred Eurodollar futures are putting the terminal rate at 100 bps two years from now. That suggests a hike this December and one next year. Barring more aggressive easing by the other G-7 central banks, this strength in the dollar will be difficult to maintain. In general, we look for dollar strength into year’s end but a retreat thereafter. We will have more to say on this in the coming weeks in the Asset Allocation Weekly.

This chart shows the implied three-month LIBOR rate two-years from now, based off the Eurodollar futures. Note that after Chair Bernanke introduced the idea of tapering in May 2013, the implied rate began to rise rapidly in anticipation of a withdrawal of monetary stimulus. After the December 2015 rate hike, expectations began to fall rapidly and are currently suggesting the Fed will reach 1.00% for the fed funds target and hold that level. Since the dollar’s rally was mostly precipitated by rates 80 bps higher, we would look for a moderation in the greenback next year.

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Daily Comment (October 11, 2016)

Posted on October 11, 2016 by Rebekah Stovall

by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Global equity markets are mixed this morning. The EuroStoxx 50 is trading higher by 0.4% from the last close. In Asia, the MSCI Asia Apex 50 closed lower by 1.7% from the prior close. Chinese markets were higher, with the Shanghai Composite moving up by 0.6% and the Shenzhen index moving up by 0.5%. U.S. equity futures are signaling a lower opening.

Financial markets were mostly quiet overnight. We are seeing some modest weakness in oil prices. Oil rose yesterday, bolstered by comments from Russian President Putin who indicated that Russia would consider production cuts if OPEC reduced output. This morning, the Russian Energy Minister, Alexander Novak, indicated that Russia was only considering a freeze on production, not a cutback. The head of the state controlled Rosneft (MCX: ROSN, RUB 362.40), Igor Sechin, a key oligarch, indicated his company would not reduce output. Rosneft controls 40% of Russia’s output, which hit a new national record recently at 11.1 mbpd. In fact, analysts project Russia will increase output next year by 1.6%. Russia has a history of promising to cooperate with OPEC but failing to follow through.

The WSJ reports that Libya, Iran and Nigeria could add as much as 0.7 mbpd of production in the coming months. The IEA indicated that OPEC output recently reached 33.6 mbpd, a new record. Thus, even the advertised cut would only reduce output to 33.1 mbpd, and if the aforementioned nations hit their targets, OPEC output would actually rise to 33.8 mbpd. We believe the talk about cutting output is driven by a form of Saudi “window dressing” as it prepares for a global bond issue and the Saudi Aramco IPO in 2018. Given the run up in oil prices, any disappointment could lead to a sharp selloff in the near term.

On the topic of oil, there are two other side notes of interest. The DOE, for some unknown reason, has decided to exclude a category of oil called “lease stocks” which is oil in the process of moving to pipelines, railcars or trucks on their way to refineries or tank farms. In reality, it’s still oil and will eventually become part of the inventory number, but the change is material—lease stocks represent about 31 million barrels (mb) which will be cut from the inventory number this week. Thus, on Wednesday, expect to see a massive draw in crude oil. In reality, any number less than 31 mb will actually be a build in oil inventories. Why did the government do this? Strictly speaking, lease stocks are not available for current use and thus are not actually accessible. On the other hand, the oil is available in short order and so excluding it now doesn’t necessarily make much sense. The weekly data won’t contain it, although once we get past this week, the weekly changes should be consistent with the data that have the lease stocks included. It appears that lease stocks generally run between 31 to 33 mb. They probably should be considered like base gas in the natural gas inventory numbers; base gas pressurizes storage wells and remains mostly stable, although we have seen circumstances where storage operators tap base gas when supplies are unusually tight. The bottom line…don’t be shocked to see a massive drop in stockpiles this week.

Second, we are seeing a steady rise in the dollar. A strengthening dollar is generally bearish for commodities, including oil. The longer this rally in the dollar extends, the greater the odds of an oil correction. Based on a $1.1100 €/$ exchange rate, fair value for oil is $46.49. Each penny drop in the exchange rate cuts the fair value for oil prices by $2.33.

We did see a rather sharp selloff in the South African rand after news broke that the well-respected Finance Minister Pravin Gordhan was summoned to appear in court over fraud allegations. According to reports, the fraud stems from his role as head of South Africa’s tax authority a decade ago. Gordhan and President Zuma have been at odds for some time over control of the country’s state finances. Zuma tried to fire him in the past but was forced to relent due to financial market volatility. We suspect these charges are a power grab by the president.

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Weekly Geopolitical Report – American Foreign Policy: A Review, Part II (October 10, 2016)

Posted on October 10, 2016October 6, 2016 by Rebekah Stovall

by Bill O’Grady

Last week, in Part I of this study, we examined the four imperatives of American policy with an elaboration of each one. This week, we will discuss why each is important. We will examine why there has been a “drift” in American foreign policy since the end of the Cold War. This drift has now reached a critical point as the U.S. appears to be backing away from its postwar trade policies and the geopolitical imperatives that avoided WWIII. As always, we will conclude with the impact on financial and commodity markets.

The Importance of the Imperatives

To review, the U.S. had four geopolitical imperatives after WWII. They were:

Deal with the Soviet Union, in particular, and the threat of global communism, in general
Maintain peace in Europe
Maintain stability in the Middle East
Maintain peace in the Far East

All four of these imperatives were critical to maintaining global peace. Preventing the expansion of communism was “job one,” but removing the “German problem” from Europe was also very important as was keeping tensions manageable between China and Japan. Although it was difficult to justify supporting authoritarian regimes in the Middle East on moral or ethical grounds, it was necessary to maintain stability. Essentially, American foreign policy was designed to contain communism and freeze three potential conflict zones in Europe, Asia and the Middle East.

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Daily Comment (October 10, 2016)

Posted on October 10, 2016 by Rebekah Stovall

by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Global equity markets are mixed this morning. The EuroStoxx 50 is trading higher by 0.7% from the last close. In Asia, the MSCI Asia Apex 50 closed lower by 0.05% from the prior close. Chinese markets were higher, with the Shanghai Composite moving up by 1.5% and the Shenzhen index moving up by 1.9%. U.S. equity futures are signaling a higher opening.

Trading is a bit thin this morning. In Asia, markets in Japan, Hong Kong and Taiwan were closed last week and U.S. fixed income markets are not open for the Columbus Day holiday. Most of the weekend news was political although there was some other news as well.

The political backdrop: Four weeks from tomorrow most Americans will go to the polls to elect electors for president and to vote on Congressional candidates. There were three big items over the weekend. First, a 2005 “hot mic” on Donald Trump revealed a series of comments that put the candidate in a very bad light. As the weekend passed, a large number of GOP candidates pulled their endorsements and the GOP leadership appears to be withdrawing its support for Trump and instead is trying to salvage the down ballot candidates. There was talk that Trump would be forced out as the party’s candidate, and rumors continue to circulate that Sen. Pence may leave the campaign as well.

We view this from the prism of establishment v. populist. Trump has been the candidate of the latter; the center-right was never comfortable with his candidacy. We find it a bit odd that the tapes were taken as a surprise—how many times has Trump said something that would have ended the candidacy of an establishment candidate, but seemingly had little impact on the Trump campaign. We doubt these revelations will change the minds of committed Trump voters who are attracted to him for his positions on trade and immigration. However, that group isn’t large enough to win the election and without the support of the center-right, the hurdle to win is quite high.

Second, a series of Wikileaks were released, detailing comments following Sen. Clinton’s speeches to financial services firms (for which she was well compensated). They suggested that her positions on financial services regulation, trade and the like were solidly establishment. It came up in the debate where she was asked about her comments about having public and private positions. She responded with a rather unconvincing story about how the comments were part of a critique of a movie about President Lincoln. Had this come out during the primaries (in other words, if the transcripts of her talks to financial services firms had been released), she might not have been able to defeat Sen. Sanders.

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