Author: Rebekah Stovall

Weekly Geopolitical Report – Turkey’s Predicament (August 10, 2015)

Posted on by Rebekah Stovall

by Bill O’Grady

In 2013, we wrote a WGR that looked at Turkey’s likely rise to regional hegemon status.  In that report, we made the case that Turkey was well positioned to return to its historic status as a dominant regional power.  This remains our view over the next few decades.  However, in the near term, the situation is much less clear.

Turkey has been trying to run a foreign policy of having “no problems” with its neighbors.  This stance has become impossible to maintain.  Unfortunately for its president, Recep Erdogan, Turkey is encircled by instability and is struggling to develop a response.  In this report, we will examine Turkey’s geopolitical situation, the risks it faces as conditions deteriorate and how the Erdogan government has responded thus far.  As always, we will conclude with market ramifications.

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Weekly Geopolitical Report – Reflections on the Iran Deal (August 3, 2015)

Posted on by Rebekah Stovall

by Bill O’Grady

Last month, the P5+1[1] and Iran concluded negotiations on a nuclear deal.  In this report, we will offer some reflections on the agreement, including why it occurred, and the major reason why the U.S. negotiated this agreement and the underlying issues.  As always, we will conclude with market ramifications.

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[1] These are the five permanent members of the UN Security Council (U.S., U.K., Russia, China and France) plus Germany.

Weekly Geopolitical Report – Imperial Germany (July 20, 2015)

Posted on by Rebekah Stovall

by Bill O’Grady

Last week, we analyzed the Greek/Eurozone negotiations using game theory as an explanatory tool.  In this report, we will review the basic geopolitics of Europe, the political response and the evolution of the Eurozone.  Using this background, we will examine Germany’s actions in the most recent Greek crisis.  As always, we will conclude with market ramifications.

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Asset Allocation Quarterly (Third Quarter 2015)

Posted on by Rebekah Stovall
  • Significant disruptions or financial stress from Greece’s debt problems appear to have been avoided, in the near term. However, structural problems that led to the Greek crisis have yet to be properly addressed and we expect the issue to emerge again in the future. It will be important to monitor how Greek creditors and other peripheral countries respond.
  • China’s equity market volatility has thus far been mostly contained within the country. However, China’s economic growth has already been slowing and if the recent volatility inhibits growth, then the impact could spread to other countries.
  • The Federal Reserve remains on a higher interest rate path, but determining how high and how soon is a complicated endeavor. We expect the Fed to move gradually and don’t believe this path will cause a recession. However, it will be important to closely monitor the Fed and how its actions affect the economy.
  • Our equity allocations remain focused on domestic stocks, which we believe have a superior return/risk profile relative to foreign equities for most investors. However, for aggressive investors, we introduce a limited foreign developed country allocation.
  • Real estate fundamentals appear solid and we expect foreign investors will continue to increase their allocations to real estate in the U.S. We believe real estate can play a constructive role, particularly where income is an objective.
  • Our style guidance remains in favor of growth over value (70/30).

ECONOMIC VIEWPOINTS

It’s summer, the time of year when Europe seems most likely to fester with a government debt problem.  And so it’s not surprising to find Greece on center stage, playing a familiar role.  We’ve seen this show before…too much debt, a weak economy and the need for more time and money.  The endings tend to be the same.  The hardest issues are not fully addressed, while debt and solvency problems are kicked down the road.  The upside is that Greek problems seem unlikely to create a widespread financial crisis, but we note that the challenges are chronic and unresolved.  We expect sequels to this play and will watch closely to see how Greece and other weak peripheral European states respond.

Another drama unfolding in a different theater is the enormous volatility in the Chinese equity market.  Following a meteoric rise, fueled in large part by margin-laden speculation, Chinese stocks have gyrated wildly, oftentimes collapsing in spectacular form.  It appears much of the movement, both up and down, has been caused inadvertently by governmental policy.  Command and control capitalism is oxymoronic, yet the Chinese government is attempting to displace Adam Smith’s invisible hand with the Communist Party’s iron fist.  It’s an odd situation, one that reveals the undeveloped nature of China’s financial system.  Fortunately, most of the volatility and downdrafts have been contained in China.  But China has the world’s second largest economy, and its growth rate has been slowing.  Therefore, we’ll continue to monitor how and if China’s equity challenges affect global economic growth and geopolitical risk.

Even as Greece and China are making headlines, we believe the more important story continues to be with the Fed.  U.S. economic data have been strong enough for the Fed to plan on raising short-term rates.  But it’s a difficult maneuver, one complicated by external factors—like Greece and China—but also by the unusual nature of U.S. economic expansion.  Inflation, wage growth and labor participation remain abnormally low given where we are in the economic cycle.  If the Fed moves too quickly or goes too far, it risks creating a recession, a condition that historically has been one of the greatest risks to equities.  On the other hand, if the Fed remains too easy with policy, it could set the stage for financial market “melt-ups” in which valuations spiral upward.  These melt-ups may be enjoyable on the way up, but usually end with high volatility, outsized losses and numerous bankruptcies.

The chart on the next page illustrates a model from the economist Greg Mankiw.  Using unemployment and inflation, his model does a good job of indicating where Fed policy may go.  With the decline in the unemployment rate, it indicates the Fed’s neutral policy rate could be close to three percent.

However, we have adjusted the model to account for the low labor participation rate and this modification indicates no need for the Fed to raise rates. Our work indicates the Fed is likely to choose a path in between, gradually raising rates in a manner that is unlikely to cause a recession. Still, we note that it will be very important to monitor the Fed’s actions and how the economy is affected.

STOCK MARKET OUTLOOK

Although stock returns in the first half of the year were quite limited, this condition is not necessarily a negative situation. Over the past several years, rising valuations have provided an additive lift to equities and were a significant part of the above-average returns delivered by the market. As a result, stocks have moved out of the “cheap” valuation range and crossed into the “moderately expensive” category.  This doesn’t necessarily mean a bubble has formed, but it does indicate returns are likely to be lower going forward.  The upside is that the recent sideways direction of equities can allow for earnings and other fundamentals to catch up with prices.  It also indicates that equity investors are exhibiting a measure of risk aversion, and aren’t necessarily willing to pay any price for stocks.  So while the near-term performance may be somewhat disappointing relative to the past few years, it helps set the stage for healthier equity markets in the long run.  This may be just what the Fed is seeking as it sets out to raise interest rates.

In this environment, we believe it is important to consider both valuation as well as growth potential.  Our work indicates that although foreign equities have generally underperformed those in the U.S., their valuations aren’t quite low enough to adequately compensate most investors for the lower growth we anticipate.  So, at this point, we remain out of both developed country and emerging market equities, except for aggressive growth investors.

The domestic equity allocations remain diversified across the spectrum of capitalization sizes to include large, mid and small caps.  Our bias remains toward mid and small caps, because their growth potential appears to be higher.  However, these equity asset classes also tend to have higher volatility relative to large caps, so we also include large caps.  Our sector guidance within large caps favors technology and consumer discretionary sectors, while we are underweight utilities, telecom and energy.  Our style guidance remains overweight growth versus value (70/30).  We continue to believe growth-oriented industries may perform relatively well as we move into the time frame when the Fed begins to raise interest rates.

BOND MARKET OUTLOOK

For both intermediate and longer term bonds, yields have become more volatile in recent months as investors digested the news coming out of Greece and China.  At the same time, bond investors have a close eye on the Fed, watching for guidance with regard to when and how much the Fed will tighten.  The various cross-currents generally pressured interest rates higher in the first half of the year, but our outlook for the overall bond market remains in place.  U.S. growth should remain below average, but is likely to be higher than most developed countries.  For these reasons, we don’t expect rates to move significantly higher and foreign interest in U.S. bonds should remain relatively strong.  Therefore, our bond allocations continue to involve intermediate and longer maturity bonds.

OTHER MARKETS

Real estate recently faced some headwinds as interest rates around the world moved upward, yet fundamentals remain strong and we believe foreign interest for U.S. real estate is likely to remain relatively high.  Still, we believe real estate at this point in the cycle appears most appropriate where income is a primary objective.  Therefore, we reduce the real estate allocation this quarter in growth-oriented portfolios.

Returns in the commodity asset class remain low and we don’t expect a turnaround anytime soon.  Global supply remains high and has yet to fully adjust to lower demand, especially from China, but also from many developed countries.  At this point, we remain completely out of the asset class.

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Weekly Geopolitical Report – Greek Games: An Update (July 13, 2015)

Posted on by Rebekah Stovall

by Bill O’Grady

On Sunday, July 5th, Greeks voted in a special referendum to decide whether to accept the troika’s most recent proposal to end the current debt and financial crisis.  Voters in Greece overwhelmingly rejected the EU’s offer.  Since the vote, EU and Greek officials have been meeting, trying to determine the path forward.  As of this morning, Greek PM Tsipras agreed to rather harsh measures to begin the bailout process.  However, nothing has been finalized yet.

In this report, we will update our views on the Greek situation, using game theory as a theoretical construct.  We used a similar construct in an earlier report on Greece but, in light of the referendum and subsequent negotiations, we believe that further clarification is necessary.  And so, in this report, we will review the “game of chicken,” which we believe best describes this situation.  After this description, we will discuss in detail the particular aspects of this game and why it leads to rash and aggressive behaviors in participants.  In the aftermath of the referendum, we will review the choices available to the troika and offer our expectations on the outcome, with the caveat that games of chicken do not necessarily lead to easily predictable outcomes.  As always, we will conclude with market ramifications.

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Keller Quarterly (July 2015)

Posted on by Rebekah Stovall

Letter to Investors

I once had a seventh grade teacher tell my class how lucky we were to be citizens of the United States.  Of course, we all took it for granted.  We didn’t know anything different…but she did.  You see, Mrs. Danishevsky, who taught us Russian, had emigrated from the Soviet Union and knew whereof she spoke.  She loved her new country (and she loved her students); she was literally “on top of the world” and wanted her young charges to understand just how fortunate they were simply to be born here.

I oftentimes think of that simple lesson, including recently in regard to the mundane field of investing.  There have been dual reminders: the Greek financial crisis and the Chinese stock market bubble (and subsequent collapse).  As these events have unfolded, more than one TV “talking head” has opined that the U.S. is next.  Do not be misled by such irresponsible talk.  While the U.S. is more than capable of a stock market bubble (2000) or of borrowing too much (2008), the size, stability, and resilience of the U.S. economy is on a completely different level than these two economies.

In the case of Greece, their primary problem is that they borrowed too much money in someone else’s currency: the euro.  “Wait!” you say, “Isn’t the euro their currency?”  It is the currency they use (for now), but they do not print or control it.  When they run dry, they have to get euros from the European Central Bank, which is tantamount to borrowing them from the Germans.  They do not control their own financial destiny.  The United States, on the other hand, borrows in U.S. dollars that it prints and controls.  And, as the world’s primary medium of exchange, the U.S. dollar and its debt instruments are always in great demand.  As the world’s largest economy (on a current dollar GDP basis) and the world’s largest consumer of goods, foreign countries are anxious to sell us stuff and take dollars in return (which they recycle into dollar-denominated debt).

In the case of China, their stock market essentially excludes foreign investors, who could provide great liquidity to their markets.  Instead, Chinese investors are now looking to their government to stabilize the stock market.  While it’s natural for investors in a stock market crash to look to the government for help, the Chinese government is viewed by the populace as omnipotent.  Their inability to halt the crash could have a devastating impact on Chinese confidence.  Won’t this hurt the U.S. economy and markets?  Only incidentally.  Since we run persistent trade deficits with China, they are much more dependent on our spending than we are on theirs.  If their economy falters, some U.S. exporters to China will suffer, but most U.S. businesses and individuals will not feel much pain, if any.

When it comes to the world economy, most financial blessings (and ills) flow out of the U.S. to the rest of the world, not the other way around.  Thus, while we watch these events closely, we are not losing sleep.  Rather, we’re looking for opportunities to take advantage of foreign volatility.

Thank you for your confidence in us.

 

Gratefully,

Mark A. Keller, CFA
CEO and Chief Investment Officer

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Weekly Geopolitical Report – The 2015 Mid-Year Geopolitical Outlook (June 29, 2015)

Posted on by Rebekah Stovall

by Bill O’Grady

As is our custom, at mid-year, we update our geopolitical outlook for the rest of the year.  This report is less a series of predictions as it is a list of potential geopolitical issues that we believe will dominate the international situation into year’s end.  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 South China Sea

Issue #2: Russia Returns

Issue #3: The End of Sykes-Picot

Issue #4: The Unwinding of the European Union

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Weekly Geopolitical Report – Cyber Security and Terrorism: Case Studies (June 22, 2015)

Posted on by Rebekah Stovall

by Kaisa Stucke, CFA

In April 2007, Estonian government workers found their internet connectivity interrupted and e-mail access compromised.  In hindsight, this marked the beginning of a three-week cyber attack on the country’s government and private servers.  The attacks forced many servers to block international connections.  At the same time, street riots by ethnic Russians were erupting in the country in response to the Estonian government’s decision to move a war memorial for fallen Soviet soldiers from the center of the capital to a military cemetery.  It is still unclear who was actually responsible for the cyber attacks, but these events are considered to be the first cyber attacks aimed at a sovereign nation, and were significant in setting a precedent for future cyber incidents.

In August 2008, the country of Georgia experienced multi-faceted cyber attacks targeted at government websites.  The country’s servers were overloaded with connection requests coming from abroad, forcing many servers to go offline.  Additionally, many government websites were defaced with images of various fascist leaders.  Concurrently, Georgia and Russia were involved in a military conflict in South Ossetia, in the northern regions of Georgia.  It is also still unclear who was responsible for these attacks, but this is considered to be the second large-scale organized attack against a sovereign nation.

This week we will look at these two case studies of cyber attacks aimed at sovereign nations.  We will then look at the current state of international cyber attack research, readiness and cooperation.  We have had the pleasure of talking to the NATO Cooperative Cyber Defence Center of Excellence about their work and will communicate their vision and challenges.

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Weekly Geopolitical Report – An Alternative to Gandhi (June 15, 2015)

Posted on by Rebekah Stovall

by Kaisa Stucke, CFA

Shortly after being elected into office last year, the new Indian Prime Minister, Narendra Modi, visited a memorial for Veer Savarkar, an Indian independence fighter, praising his lifetime of “tireless efforts toward the regeneration of our motherland.”  On its surface the move seems to be nothing out of the ordinary; however, the historical context of Savarkar as the father of the Hindu nationalist radicalism movement makes it somewhat controversial and a worry for the country’s religious minorities.  Savarkar was a contemporary of Mahatma Gandhi, although the two men took radically different views on fighting for Indian independence.  As is well known, Gandhi supported the peaceful non-compliance movement, and his ideology welcomed all the religions of India.  History is written by the victors thus Savarkar and his take on the struggle for independence have not received widespread attention.  Savarkar argued for a more aggressive fight against the British and had strong views that India should be 100% Hindu.  The Hindu radicalism movement is more significant than is generally recognized and is currently enjoying a revival.

Prime Minister Modi has been in power for a year now.  Although he represents the Bharatiya Janata Party (BJP), which is considered to be the Hindu nationalist party, he was elected on the promise of economic reform, including infrastructure spending and labor laws.  It is too early to judge his economic effectiveness on a national scale, but he has a successful track record as the former head of the Gujarat region.  He is well-liked by voters, but he makes minorities very nervous as evidenced by the large-scale, religion-based riots that took place under his leadership in the Gujarat region.  He was cleared of any wrongdoing in connection with the riots, and even received the support of some minority leaders during his campaign for his economic liberalization aptitude.  It does not help that some members of his party incite minority discrimination.  So far, Modi has been conspicuously silent in response to the inflammatory rhetoric from his party, which leaves observers wondering if he, in fact, agrees with it or is too weak of a leader to confront it.

There is no denying that Indian politics have been chiefly molded based on Gandhi’s peaceful non-compliance movement, which emphasizes equal acceptance of all religions within India.  It was a goal of the founders of the modern state of India to form a multi-religious constitution.  However, we could see a return to more Hindu-centric policies under the current trends.  This week, we will look at the resurgence of the Hindu nationalist movement.  We will start by briefly describing the political history of independent India, looking at Gandhi and Savarkar’s conflicting ideals.  Next, we will look at contemporary politics and explore the Hindu movement and its likely forms under Modi’s rule.  As always, we will conclude with market ramifications, both within India and for international markets, in general.

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