Weekly Geopolitical Report – Brexit (February 29, 2016)

by Kaisa Stucke, CFA

The U.K. joined the European Common Market, what is now known as the EU, in 1973.  In 1992, the Maastricht Treaty formally created the EU.  However, as part of the treaty, the U.K. negotiated that it would be exempt from adopting the euro and joining the Eurozone.  Despite the EU’s founding premise that members should seek an ever closer union, both politically and monetarily, the U.K. is questioning the net benefits of its membership altogether.

The British public’s perception of the benefits of the U.K.’s EU membership has always been mixed.  Following a recent increase in public opinion asking to separate from the EU, U.K. Prime Minister David Cameron set a referendum on membership for June 23.  Cameron supports remaining in the EU, especially after he was able to negotiate a deal with the EU regarding some hotly contested issues for the country.  However, several other highly visible members of Cameron’s Conservative Party have stepped out in support of leaving the EU.  Political discussions have recently become quite heated and will likely remain so until the June referendum.  Additionally, political uncertainty will likely weigh on financial markets, increasing volatility as we move closer to the referendum date.

In this week’s report, we will take a look at the main factors leading to the call for Brexit and their impact on the economy and the markets.  As always, we will conclude with market ramifications.

View the full report

Weekly Geopolitical Report – The 2016 Election: An Update (February 22, 2016)

by Bill O’Grady

Almost two years ago we published a series on the 2016 elections.  In these three reports we suggested that rising discontent among the electorate could increase the odds of electing a president that may turn America away from the superpower role.  Although there have been a number of surprises in the current nominating process, some of the trends we discussed in these reports have come to pass.  In addition, the underlying causes of discord we identified appear to be the driving force in the current political turmoil.

In this report, we will review the three issues related to the superpower role that the establishment has failed to properly address which have led to the rise of unconventional candidates.  Next, we will examine the current primary season, focusing on the two major populist candidates, and discuss the reaction of the establishment thus far.  As always, we will conclude with market ramifications and a short discussion about the long-term changes that the rise of populism may entail.

View the full report

Weekly Geopolitical Report – Russia’s Struggles (February 8, 2016)

by Bill O’Grady

Over the past year, Russia has faced a growing number of challenges that have the potential to weaken President Putin’s hold on the reins of power.  In this report, we will discuss recent trends in the country, including the economic problems caused by falling oil prices and the military operations occurring in Ukraine and Syria.  We will examine the Putin government’s responses to these issues.  As always, we will conclude with market ramifications.

View the full report

Weekly Geopolitical Report – Trouble in Taiwan (February 1, 2016)

by Bill O’Grady

Taiwan held elections on January 16th and the Democratic Progressive Party (DPP) won a resounding victory over the Kuomintang (KMT).  This election will likely raise tensions between Taiwan and Mainland China (People’s Republic of China, PRC).

In this report, we will begin with a history of Taiwan.  Next, we will recap the election results, discussing what the election means for Taiwan’s foreign and domestic policies, the PRC’s problems with the DPP’s victory and the election’s potential impact on regional stability.  As always, we will conclude with market ramifications.

View the full report

Weekly Geopolitical Report – Italy’s Banking Crisis (January 25, 2016)

by Kaisa Stucke, CFA

On January 1, 2016, the EU implemented a new bank restructuring directive.  The new and stricter rules are aimed at forcing private stock, bond and deposit holders to accept losses before public funds would be used in a bank restructuring.  Although all EU countries are affected by these new rules, Italy remains of particular concern due to the number of distressed loans in the country.  The Italian banking index is down almost 20% in 2016 due to concerns over nonperforming loans in the country’s banking system and the limited protection that private investors will receive under the new directive.

This week, we will look at the overall health of Italy’s banking system as well as the nonperforming loan problem in the country.  We will explore the various issues affecting Italy and the EU with regard to finding a solution for Italy’s troubled banking system.

View the full report

Asset Allocation Quarterly (First Quarter 2016)

  • Low global growth rates and tighter Fed policy are combining to lower financial market return potential, while increasing overall volatility.
  • We believe U.S. growth will remain low and the Fed will raise rates gradually. At this point we do not foresee a recession.
  • The low growth rate in the U.S. will likely be higher than that of many foreign countries. We expect China’s lower growth rate to have an adverse effect on many other countries.
  • We remain diversified across capitalization sizes. Our allocation remains entirely domestic, except for a limited foreign developed allocation for aggressive investors.
  • We expect inflation and interest rates to remain low. We continue to emphasize intermediate and longer maturity bonds.
  • Our growth/value style bias remains at 60/40, based upon our sector and industry outlook.

ECONOMIC VIEWPOINTS

After an up and down year in both the stock and bond markets, 2015 ended roughly flat. The S&P 500 Index posted a total return of 1.4%, while the ML Domestic Bond Index came in at 0.6%. Throughout the year, we saw bouts of higher volatility as the markets wrestled with ongoing slow growth, tighter Fed policy and rising geopolitical risks. Unfortunately, as we’ve noted in the past, we could be entering a period of lower returns and higher risk. This doesn’t necessarily create an adverse investing climate, but it does underscore the importance for investors to appropriately position themselves according to risk tolerance and to properly calibrate reasonable return expectations.

What is behind this change in the return/risk landscape? Several factors are at play, but valuations are certainly front and center. Recall that during the last recession, valuations for many asset classes became extraordinarily low. As they recovered, the positive contributions to asset class returns were very significant. Then, valuations (and investor returns) were given additional boosts as the Fed engaged in a multi-year stimulative monetary policy known as Quantitative Easing. Easy monetary policy also lowered volatility across most asset classes.

However, as we look forward, similar valuation escalations appear unlikely. In part, it’s because we simply aren’t starting from an unusually low point. It’s also important to note that the Fed is no longer increasing monetary stimulus…it is in fact now doing just the opposite by raising short-term rates. We believe tighter monetary policy is likely to not only limit valuation growth, but also to increase market volatility.

Against this backdrop, much of our viewpoint is shaped by how successful (or unsuccessful) the Fed is in managing tighter monetary policy. We’ll put it front and center that we feel it’s very odd, and perhaps hazardous, to be raising rates right now. Economic growth remains well below long-term averages and inflation is also very low. There just isn’t an obvious need to tap the brakes on the economy.

Fortunately, the U.S. economy remains stable, even if its growth is low. We monitor a wide range of factors including manufacturing activity, sentiment, consumer trends and borrowing, to name a few. For example, the chart on the next page shows the Chicago Fed National Activity Index where readings above zero indicate the economy is growing faster than its long-term trend. The index is a pretty reliable indicator of recessionary periods, which are shaded in grey. We note that recessions tend to emerge when the trend moves below the red line (for more details, please see our 2016 Outlook report). Currently, we are above the recessionary level, but the economy is growing at a pace below trend. Because many other indicators confirm this trend, we don’t foresee a recession at this point.

We believe the primary risks to the economy are a Fed policy error (raising rates too far or too fast) and pockets of weak foreign growth that could ultimately slow the U.S. economy. Both factors appear to have played a role in financial market volatility in early 2016. As the Fed contemplates further rate hikes, we believe it will be important for policymakers to move slowly, perhaps even pausing for a while if economic conditions deteriorate.

 

STOCK MARKET OUTLOOK

Recessions tend to foster some of the greatest risks for equity investors, which is why we monitor economic conditions so closely. At this point, we don’t foresee a recession. Slow but stable growth in the U.S. economy should create a reasonably good operating environment for many corporations.

Still, there will likely be areas where growth is absent or even negative due to industry conditions. We have ongoing concerns over fundamentals in the energy and materials sectors, which we underweight. Cyclical concerns in financials, healthcare and telecom cause us to be underweight these sectors as well. On the other hand, we are overweight technology, consumer discretionary, consumer staples and utilities, which we believe can provide a combination of specific industry growth and counter-cyclical resilience. Our style bias remains at 60/40 growth/value, based upon our viewpoints for sector exposures.

We remain entirely out of foreign stocks, except for a relatively small allocation for aggressive investors. Although foreign valuations are low, we still favor domestic equities. We believe many foreign developed countries face ongoing weak economic growth, if not recessions. Meanwhile, China continues to adjust to a significantly lower growth rate, which is creating financial market turmoil and is adversely affecting other emerging economies. For these reasons, we remain allocated primarily to domestic equities, with diversified allocations across a variety of capitalization sizes.

BOND MARKET OUTLOOK

Although their returns were generally flat in 2015, bonds played a very helpful role in portfolios. Not only did they provide meaningful stability, bonds also contributed significant diversification. Oftentimes, bond prices rose when equities experienced some of their biggest downdrafts. In this way, bonds delivered a very important aspect of risk control.

Our bond allocations remain focused on intermediate and longer maturities. With the Fed raising short-term rates, many investors have questioned this posture, concerned that tighter Fed policy could potentially cause long-term rates to rise. Our view has been that tighter Fed policy would put the most upward pressure on shorter maturities, which has been the case thus far. In a low growth, low inflation environment, we believe longer maturities can provide attractive opportunities, even as the Fed tightens. For example, if the Fed overtightens and the economy stalls, longer maturity bonds should perform well. On the other hand, if the Fed retreats from tighter policy, the market may consider this to be very accommodating to longer maturities. For these reasons, we maintain our focus on intermediate and longer maturity bonds, including both corporate and Treasury sectors. Speculative grade bonds can be useful where income is a priority, but we have been lowering this allocation for a while and exit the asset class entirely this quarter. Defaults may begin to rise, particularly among energy issuers.

OTHER MARKETS

We continue to hold real estate allocations in most portfolios. Real estate fundamentals remain strong, benefiting from low interest rates, high occupancy and strong demand from foreign investors. However, like many other asset classes, real estate valuations have risen in recent years. For this reason, we have been lowering allocations and now utilize a more limited exposure. Still, we believe real estate can benefit portfolios, particularly where income is an objective. We also believe real estate can help to address rising levels of volatility in equity asset classes.

In recent quarters, we have witnessed significant price declines in many commodities, including those related to energy, industrial and precious metals, and grains. Much of the decline reflects lower demand from slower global economic growth, particularly in China. However, prices also reflect excess supply capacity as well. We believe that some prices may be reaching equilibrium levels and may have the potential to recover.  However, at this point we believe the cycle continues to have more downside and we remain out of commodities in all of the portfolios.

View the complete PDF

Weekly Geopolitical Report – The Saudi Executions (January 11, 2016)

by Bill O’Grady

On January 2, Saudi Arabia executed 47 people accused of various crimes against the state.  Of this unfortunate group, 46 were Sunni jihadist radicals and one was a Shiite cleric, Sheik Nimr al-Nimr.  Al-Nimr’s execution set off protests in Iran and the Saudi Embassy in Tehran was sacked.  In response, the Saudis broke off diplomatic relations with Iran for the first time since 1980.  Several other Sunni nations have either followed Saudi lead in breaking off relations or have recalled ambassadors in protest.

These executions are the result of several important trends and factors that are affecting Saudi Arabia, specifically, and the Middle East, in general.  In this report, we will discuss the executions and the signals they send.  We will also analyze the transformation occurring in the Middle East and the Saudi response.  As always, we will conclude with market ramifications.

View the full report

Keller Quarterly (January 2016)

Letter to Investors

The turning of the annual calendar occasions all sorts of prognostications in our profession.  We prefer not to think in terms of forecasts, but rather in terms of probable scenarios. All sorts of things are possible in 2016, but not all scenarios are equally probable.  For example, a great many purveyors of gloom and doom are forecasting that the U.S. dollar will cease to be the world’s primary reserve currency in the near future.  These prognosticators speak of it as an inevitability and trouble the souls of many with the supposed dire results (although I believe they misinterpret the implications of such an event). The issue is not that this event is not possible (it is), but that it is of very low probability.  In fact, we regard the probability of that occurrence as extremely low, not just within the next year, but within the next several decades.

There are a great many negative scenarios one may construct for the coming year, but those we need to be on guard for are those that have some real probability attached to them.  In October I wrote to you that there were three problems that really matter to investment portfolios: 1) high levels of consumer debt, 2) decelerating growth in China and the emerging markets, and 3) Federal Reserve (Fed) intentions to raise short-term interest rates.  Since then, the third concern has shot to the top of the list.

In December the Fed raised the fed funds rate by 0.25% and indicated it has plans to raise it further.  The U.S. economy is growing slowly and foreign economies are struggling due largely to the first two problems listed above. With growth sluggish and inflation very low, we are concerned that the Fed is committing an unforced error. Unlike the hand-wringing we see about the dollar’s reserve status, this is a potential problem that has real probability.  A single quarter-point increase won’t slow the economy dramatically all by itself, but markets have a way of compressing into the present what they think will happen in the future.  If longer term interest rates, which are set by the market, not the Fed, rise too quickly, the economy could stagger.  Thus, what is important is not that the Fed raised rates a little, but what the market thinks their intentions are for the future.  Here the Fed may be able to moderate the effects of its error by being very slow to raise rates in the future, or maybe by stopping the tightening process altogether. We still regard the likelihood of recession in the next year or two as small, but we are vigilant in our reconnaissance.

How does an investor protect his or her portfolio from such risks? There is no such thing as portfolio insurance, but it is possible to soften exposure to business cycle risk and interest rate risk in the construction of portfolios.  Our job as investment managers is not to “bury your money in a coffee can in the back yard,” but to take the steps we believe promote reasonable returns for your portfolio in the light of the negative scenarios that may have a measure of probability.

Each year starts with both promise and trepidation.  But, as we’ve noted before, “Worrying is a major part of the job.”

As always, we appreciate your confidence.

 

Gratefully,

Mark A. Keller, CFA
CEO and Chief Investment Officer

View the PDF

Weekly Geopolitical Report – The 2016 Geopolitical Outlook (December 14, 2015)

by Bill O’Grady

As is our custom, we close out the current year with our outlook for the next one.  This report is less a series of predictions as it is a list of potential geopolitical issues that we believe will dominate the international landscape in the upcoming year.  It is not designed to be exhaustive; instead, it focuses on the “big picture” conditions that we believe will affect policy and markets going forward.  They are listed in order of importance.

Issue #1: The Election Transition

Issue #2: Western Populism

Issue #3: Small-Scale Islamic Terrorism

Issue #4: The Weakening of the European Union

Issue #5: Trouble in the South China Sea

View the full report