Last week, we examined the three types of statements deemed true. This week we will discuss the appropriate assignment of these statements and the dangers in their inappropriate use. We will conclude with how investors can use this analysis. As an aside, these last two WGRs have examined a broad topic outside the usual scope of this report, some “summertime reading,” if you will. Next week, we will return to our usual analysis.
[Posted: 9:30 AM EDT] There are two items of note this morning. First, talk coming from the FOMC is that of two minds. On the one hand, several members are taking great pains to suggest that all meetings are “live.” Today’s weakness in equities and dollar strength is being attributed to comments from Vice Chair Fischer who said the economy is “…close to our targets” for raising rates further. Fischer appears to be in the camp that believes recent economic sluggishness is not a permanent feature but a series of temporary headwinds. This position is different than what we have heard from the San Francisco and St. Louis FRB presidents, who have suggested that sluggish growth may be more persistent and that the FOMC may need to have a much lower terminal rate target or tolerate higher than 2% inflation.
Chair Yellen will speak later this week at Jackson Hole, WY, at the annual gathering sponsored by the KC FRB. The markets do not expect Fischer and Yellen to contradict each other; if Fischer’s comments are hawkish, the fear is that Yellen will reflect similar sentiments on Friday.
We do note that WSJ Fed whisperer Jon Hilsenrath has an article today in which he admits his earlier opposition to raising the inflation target was probably wrong. Raising the inflation target solidifies the “lower for longer” position but it also assumes that central banks can control inflation, which we think is incorrect. The intersection of aggregate supply and demand sets inflation. Monetary policy tends to affect aggregate demand but only if banks circulate the reserves (which they have not done). In a globalized and deregulated world, aggregate supply is ample, leading to a mostly flat supply curve, meaning that the economy can take lots of stimulus before price levels start to rise. That is why we have been watching the populist uprising in the West; if anything could upend the current regime of globalization and deregulation, it would be nationalism and populism. But, as long as centrists continue to control government, the current regime will probably stay in place.
To some extent, the FOMC probably wants to inject a bit of uncertainty into the financial markets. This is a fool’s errand—financial markets are calling the Fed’s bluff and we doubt the FOMC will raise rates because of an elevated P/E. Thus, even if they do raise rates, we would expect a parade of Fed speakers to make it clear that a hike at one meeting doesn’t necessarily signal a series of hikes. This gets us to the “two minds” problem. On the one hand, the Fed would like to raise rates a bit; on the other hand, it’s becoming clear that more members are buying into the secular stagnation idea, which means the terminal rate will be lower.
In foreign central bank news, the Reserve Bank of India announced its new governor. He is Urjit Patel, a former Yale economist who spent time at the IMF in the early 1990s. He replaces Raghuram Rajan, who had fallen out of favor with the Modi regime. Patel is said to be an inflation hawk, so we don’t expect much change in policy. We also note that BOJ Governor Kuroda said over the weekend that there is “sufficient chance” of further easing at the next policy meeting. It is unclear how much more could be done, absent of direct fiscal financing.
Second, we are seeing lower oil prices this morning. The latest commitment of traders’ data confirms that the rally over the past two weeks has been nothing more than massive short covering. In Nigeria, the rebel group that has cut the nation’s output by about a third has agreed to a ceasefire and is “ready for dialogue.” We suspect that the government will have to pay off these rebels in order to lift output; that was the strategy of the former government. In addition, Iraq has announced a deal with the Kurds to lift Iraqi oil exports by 5% in the next few days. The Northern Iraqi Oil Company owns the oil but uses pipelines that move through Kurdish territory. There was a payment dispute but that has apparently been resolved. Finally, Reuters is reporting that Chinese refiners are boosting exports to record levels. Diesel exports are up 182% from last year and gasoline shipments are up 145%. We expect to see oil prices ease back toward recent lows in the coming weeks as the summer driving season in the U.S. comes to a close.
[Posted: 9:30 AM EDT] We have been monitoring the situation in Russia since early August. There have been a number of reports indicating a troop buildup on the Ukrainian border. There have been unsubstantiated accounts of an attack in Crimea; Russia claims Ukrainian special operations forces attempted an attack, while Ukraine suggests Russian soldiers staged the event. High-ranking leaders within the Kremlin have been sacked. Russia is launching airstrikes from Iran. Russian military activity in support of the Assad regime remains high despite a highly visible withdrawal earlier this year. Russia is making noise about an oil output freeze and cooperating with OPEC.
What is Putin up to? Although we will have more to say on this in the coming weeks, here is a brief sketch of what we think is going on:
Reuters is reporting this morning that Chancellor Merkel “sees no reason” to lift sanctions against Russia because it hasn’t met the requirements of various treaties. Although Greece and Italy have hinted they would like to see sanctions relaxed, we doubt anything will happen without German support. Given the pressures that Putin faces, it is reasonable to expect that he will create more problems. Just how this friction will affect financial and commodities markets isn’t completely obvious but we suspect Russian actions will be bullish for the dollar, gold and Treasuries. The impact on oil is mixed. A stronger dollar is generally bearish for oil, whereas military threats will tend to boost oil prices. Given the ample level of stockpiles, the dollar effect would probably overwhelm the geopolitical impact. However, Russia does have an incentive to lift oil prices and working directly with Iran in the Middle East is a major threat to Saudi Arabia. We will be watching Putin closely in the coming weeks to see how this all unfolds.
U.S. equity markets are showing impressive strength.
This chart shows the S&P 500 Index along with the 200-day moving average. The white horizontal line shows recent highs; note that the S&P 500 has recently moved above these highs. Technically, this is a “breakout” and suggests the market will likely move higher.
Still, this rally has occurred with slowing earnings growth. Although S&P 500 operating earnings are coming in better than expected, they are still down about 2% from last year.[1] Rising equity prices with falling earnings implies a rising P/E (confirmed below). Without an increase in future earnings, equity markets are becoming increasingly pricey.
One of our more reliable indicators during this cyclical bull market has been the relationship between the S&P 500 and the Federal Reserve’s balance sheet.
This chart shows the size of the Fed’s balance sheet along with the S&P 500 Index. Periods of quantitative easing (QE) are shown in gray. Note that since the recovery began in 2009, equity values tended to rise during and in anticipation of a balance sheet expansion and move sideways during periods where the balance sheet remained steady.
This chart shows a regression of the relationship.
This chart shows the fair value for the S&P 500, based on the Fed’s balance sheet, along with standard error bands. Over the past seven years, the upper standard error band has been a signal that markets are overvalued; dips to the lower standard error bank suggest a more favorably valued equity market.
We are currently well above one standard error which raises three possibilities. The first is that equities are overvalued and primed for a pullback (fair value is 2,025 and the lower standard error line is 1,947). The second is that the relationship was always spurious and the recent rise is uncorrelated. The third is that there are other variables that are now more important which can justify the recent rise. We disagree with the second possibility because the relationship between the Fed’s balance sheet and the Shiller P/E is also quite strong, suggesting that unconventional monetary policy boosted investor sentiment and supported a higher P/E.
This chart shows the relationship of P/E ratios and the balance sheet; note that the P/E rises sharply during periods of QE. We believe this relationship offers support for the notion that unconventional monetary policy lifted investor sentiment and P/E ratios remained steady in its absence.
However, the third possibility does remain—there are new factors that are boosting equities. We note the equity markets rallied on Friday’s strong employment data. However, the historical record on the relationship of employment and equities is mixed. Clearly, an improving labor market signals that a recession isn’t imminent. But, when the labor market becomes very strong, it often triggers tighter monetary policy. At present, the financial markets do not expect tighter policy until December at the earliest. Thus, at least in the short run, the equity markets may be in a “sweet spot” where better growth may lift top line revenues without triggering tighter policy. However, these favorable conditions may not last. Therefore, our base case is that equities are fully valued but a correction may not be imminent.
At the same time, equities are not cheap and could be vulnerable to exogenous issues, such as the U.S. presidential elections and terrorism. As a result, we would not be surprised to see a modest correction in the coming months but, as long as a recession is avoided (which we expect), a major pullback isn’t likely.
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[1] Using Thompson-Reuters’ calculation of operating earnings.
[Posted: 9:30 AM EDT] The FOMC minutes offered a short period of market volatility; the initial reaction was hawkish but that faded rather quickly. After reading the full report, it appears that the majority of members believe that:
Overall, despite recent comments that September is “live,” the fact is that the risks of raising rates are thought to be greater than the risks of keeping policy accommodative. Thus, the minutes suggest policy will remain steady for the foreseeable future. Neil Irwin of the NYT suggests in an article today that the FOMC lacks the framework for monetary policy. We also suspect that is the case. Recently, St. Louis FRB President Bullard suggested the Fed should base policy on “regimes,” which seem to be medium-term conditions, and adjust when regimes change. San Francisco FRB President Williams appears to be focusing on the steady drop in the term premium and is calling for a higher inflation target. As we have noted before, by any measure of the Phillips Curve, the Fed should be raising rates aggressively. The fact that it is not moving rates suggests the Fed really doesn’t have an idea what is presently driving policy.
U.S. crude oil inventories fell 2.5 mb compared to market expectations for a 0.3 mb build. This chart shows current crude oil inventories, both over the long term and the last decade. The usual seasonal inventory draws, which are more evident in the chart below, are starting to slow. So, inventories remain elevated. Inventory levels have been running below seasonal norms, although the divergence has been narrowing. It narrowed significantly this week. We are in a period of the year when crude oil stockpiles tend to fall at a slowing pace; in fact, this month, declines slowed markedly. Oil prices rose due to a surprise 3.3 mb draw in gasoline stocks. Although this was clearly bullish for gasoline, the “clock” is running on this product because the summer driving season is rapidly coming to a close. Still, for an oversold market, it was the catalyst for an impressive rally.
In early July, inventories rose contra-seasonally; this week’s decline puts us back on the normal seasonal path. This situation is concerning and does suggest we will end this draw season with crude stocks in excess of 500 mb.
Based on inventories alone, oil prices are profoundly overvalued with the fair value price of $36.52. Meanwhile, the EUR/WTI model generates a fair value of $48.21. Together (which is a more sound methodology), fair value is $42.16, meaning that current prices are a bit rich. Given that we don’t expect significant declines in inventory over the coming weeks, the key to oil prices continues to rest with the dollar.
Although OPEC jawboning is probably to blame for the recent rally, we would be surprised to see any significant action to lift prices much beyond the recent rally. Reuters reports this morning that it is planning to expand production again this month to a new record level. If so, the kingdom’s output would exceed Russia’s, making Saudi Arabia the world’s largest producer. The Saudis appear to be lifting production in front of a proposed output freeze, which would tend to undermine the effectiveness of a freeze to reduce the level of supply overhang in crude oil.
[Posted: 9:30 AM EDT] It was another quiet night for news, typical of summer. The most interesting information came from NY FRB President Dudley and Atlanta FRB President Lockhart, who both suggested that the September Fed meeting (9/20-21) is “live” and the markets are underestimating the odds of a rate hike. So far, the markets are unimpressed. The dollar is a bit higher this morning but has been weak lately; if a rate hike were imminent, we would be seeing the dollar doing much better.
One factor that could be spurring this rate move talk is evidence of improving economic conditions. The Atlanta FRB GDPNow tracker is showing that Q3 could be very strong.
The current “nowcast” from the Atlanta FRB is 3.6% GDP, at the upper end of the Blue Chip consensus.
As we saw in Q2, consumption remains robust; based on the available data, it is adding 242 bps to the 3.6% rise in GDP. Also note that inventory rebuilding, which cut GDP last quarter by 116 bps, is lifting GDP by 75 bps this quarter. Government, which reduced Q2 GDP by 16 bps in Q2, is expected to add 32 bps to Q3 growth. Also, a lift in equipment investment, which reduced GDP by 21 bps in Q2, is expected to lift growth by 43 bps in Q3. Net exports are the largest drag on growth, cutting GDP by 45 bps so far.
If GDP comes in this strong, the argument for raising rates will be on solid ground. On the other hand, raising rates into an election year, though not unprecedented, would be institutionally difficult in this election cycle where populist sentiment is strong. If the Fed is going to move rates higher before the election, September may be the only live meeting; the next opportunity may not present itself until December. This morning, fed funds futures have the odds of a rate hike exceeding 50% at the February 1, 2017 meeting.
Oil prices have rallied strongly over the past few days on comments from Saudi Arabia and others suggesting an output freeze may be coming. We view this as mostly jawboning the market. Saudi Arabian production is elevated and so freezing output at current levels would be acceptable to the kingdom. However, we doubt it would participate in a freeze and allow Iran to capture market share. Nevertheless, the oral intervention does indicate that Saudi Arabia is probably trying to establish a trading range with $40 (basis WTI) at the low. The problem is that the overhang of crude supplies remains high and we are heading into a weak seasonal period for oil as the end of the vacation season comes on Labor Day. The vigorous nature of the bounce has all the characteristics of short covering; if that buying is exhausted and the traders return their focus to inventory levels and the end of summer driving demand, a retest of the $40 level would not be a surprise. We will have more on oil tomorrow when we recap the inventory data.
[Posted: 9:30 AM EDT] Risk markets are mixed today in the midst of relatively thin global trading volumes. The dollar continued to slide lower amidst lower expectations for a Fed hike. The chart below shows the year-to-date move in the dollar, which has given back the gains it made due to uncertainty from the Brexit vote. Minutes from the FOMC’s most recent meeting in July will be released tomorrow and will provide more color on the Fed’s view of the strength of the economy.
At the same time, emerging market currencies have moved higher as milder expectations for a Fed hike support emerging market equities. The chart below shows the MSCI Emerging Market Currency Index since the beginning of the year.
Yesterday, the June TIC portfolio flows data was released. The long-term flows, which mostly mean Treasuries, declined $3.6 bn, much weaker than the $42.0 bn forecast. Including short-term securities such as stock swaps, foreigners sold a net of $202.8 bn compared with net selling of $11.0 bn the previous month. The data signals that global investing uncertainty has diminished somewhat as fewer investors sought the safety of U.S. stocks.
We are in the “dog days” of summer. The world is in turmoil. The U.S. presidential elections offer us a stark choice between a traditional establishment candidate and a populist alternative. Populism is on the rise in Europe, exhibited by the Brexit vote. Lone wolf terrorist attacks seem to occur with frightening regularity. China is threatening the U.S.-dominated maritime order of the past seven decades.
Perhaps most disconcerting is that there seems to be a steady dissonance of viewpoints. I often hear comments like, “how can a person think like that?” The internet, for all its power, has been creating virtual thought islands. Essentially, people can tailor their reading and information sources to fit their biases and rarely confront other viewpoints. And, when confronted with other viewpoints, people seem to be at a loss on how to hold a civil discussion on these differences or have the tools to understand positions that vary from their own.
Last spring, my youngest son took his first philosophy course. He was exposed to the classic thinkers in the Western canon, including Plato, Descartes, Kant, Nietzsche and others. We had long discussions about these thinkers, harkening me back to my Jesuit philosophical training of more than 30 years ago. Our talks forced me to revisit these philosophic issues with three decades of additional experiences. As I thought about these issues, I was absorbed by the relevance of these philosophic questions to our current economic, social, political and geopolitical conditions.
In this week’s report, we will take a detour from our usual analysis of specific global events to a broader analysis of knowledge. Part 1 of this report will offer a short course on the basics of knowledge, focusing on an examination of the three types of knowledge statements. We will then discuss the strengths and weaknesses of all three and how philosophers have tried to resolve the dilemmas that they posed. Next week, in Part II, we will discuss how one uses this information, concentrating on the idea that it is important to match appropriate ways of knowing to the areas we are examining.
These reports will be a bit more personal and academic than most, but given the divergence of opinion in the world now, I believe this analysis can be useful to investors approaching information and positions that differ from their own.
[Posted: 9:30 AM EDT] Equities are moving higher alongside oil as the outlook for a Fed rate hike has become more dovish. The market-implied likelihood of a September hike fell to 18.0% this morning. However, despite very short-term expectations falling, the probability of a hike has risen for next year. The likelihood moved to over 50% by March 2017, up from a 50% likelihood in May before last Friday’s retail sales and PPI data.
The chart below shows the year-to-date prices of the S&P index and WTI crude. In the first four months of the year, the moves in equities and oil were highly correlated. However, the high correlation has broken down since June as attention turns to central bank policies and political uncertainty.
Japanese GDP came in lower than forecast (see below). The details of the report revealed declining net exports and a drop in business investment. However, consumption was stronger than anticipated. The chart below shows the country’s year-over-year GDP growth. Growth has trended lower, but market expectations are still calling for the BOJ to keep monetary stimulus unchanged when they meet next month.
