Author: Rebekah Stovall
Asset Allocation Weekly (August 6, 2021)
by the Asset Allocation Committee | PDF
In last week’s report, we updated our views on long-duration Treasuries, using our standard 10-year T-note model. This week we are going to examine the impact of policy on long-duration Treasuries.
First, let’s start with the model.
The two most important variables in the model are fed funds and the 15-year average of the yearly change in CPI. The latter acts as a proxy for inflation expectations. We add the yen’s exchange rate, oil prices, German Bund yields, and the fiscal deficit scaled to GDP. So, there are two policy variables in the model, fed funds and the fiscal deficit.
A truism that has developed in recent years is that divided government is good for financial markets because different parties in the White House and Congress means it is harder to enact major legislative changes. To test this thesis, we created a binary variable that signaled if one party controlled the legislature and the executive branch, or not. When we added the variable to the model, it was not statistically significant, nor did it change the model’s forecast.
Regression models are sensitive to initial conditions; simply put, where you start a model in time has a notable impact. Jim Bullard, the president of the St. Louis FRB, likes to think of eras with certain conditions as “regimes.” Applying Bullard’s notion of regimes, we next broke down the data by attitudes toward government. In other words, the truism that divided government was good for financial markets may not have always been true. To test this idea, we first ran the model from 1960 to 1982; attitudes toward the government were once positive. For the generation that lived through WWII, the government was not seen as an obstacle to overcome but as a support. The model did change; the government variable was statistically significant and showed that when the same party held both branches of government, yields were 50 bps lower. From 1983 to the present, the government variable was also statistically significant, but the sign changed. Unified government increased bond yields by 31 bps. We propose that the Reagan/Thatcher revolution changed the views of government compared to the earlier era.
Another interesting factor is that in the earlier regime, deficits were bearish for bonds; in other words, a deficit led to higher yields. In the current regime, deficits are less significant but the sign on the coefficient changed here as well. Deficits now lead to lower yields, although the impact is quite modest.
Finally, the model from 1983 has a current fair value of 1.70%, which is a bit higher than the full model shown above. Thus, its fair value is close enough to give us confidence that it is giving proper signals. The other important takeaway from this analysis is that if the Democrats lose one of the houses of Congress in November 2022, caeteris paribus, the fair value yield would decline by nearly 50 bps.
Weekly Geopolitical Report – Power, Influence, and Leadership in Geopolitics (August 2, 2021)
by Patrick Fearon-Hernandez, CFA | PDF
Xi Jinping. Donald Trump. Vladimir Putin. Ronald Reagan. Nelson Mandela. When it comes to understanding geopolitics, most of us probably focus on the powerful, visionary leaders who can drive events forward toward their goals. But few of us really try to think systematically about the characteristics that make a leader successful or the tactics he or she can use to shape the world. This report offers a framework for assessing foreign leaders’ power and prospects, based on a recent book on the science of influence. We show some of the ways we analyze political leaders’ ability to affect the geopolitical environment and, therefore, global investment prospects. The concepts discussed may even be useful in other aspects of life, from marketing to career development or personal relationships.
Asset Allocation Weekly – #47 (Posted 7/30/21)
Asset Allocation Weekly (July 30, 2021)
by the Asset Allocation Committee | PDF
One of the key developments in financial markets recently has been the quick rebound in bond prices and the associated drop in yields. As investors started to sense faster economic growth and the prospect of rising inflation in the first quarter, they eagerly sold down their bond holdings, driving yields higher. The yield on the benchmark 10-year Treasury note jumped from 0.92% at the end of 2020 to an intraday high of more than 1.75% in late March (see following chart). Since then, however, bond buying has gradually strengthened again, and yields trended downward throughout the second quarter. Even when the Federal Reserve surprised markets in mid-June by hinting that the next interest rate hike might come by 2023, the resulting bond sell-off and yield jump was quickly reversed. In July, investors began buying bonds and driving down yields even faster, with the 10-year Treasury yield falling below 1.13% on July 19. This report looks at why yields are falling again and whether the downtrend is likely to continue.
It’s one thing to know where yields have been; it’s quite another thing to understand where they should be and where they may be going. To get at that issue, our bond model estimates where the 10-year Treasury yield should be based on several variables. The most important variables are the Fed’s “fed funds” interest rate and, as a proxy for inflation expectations, the 15-year average of the yearly change in the consumer price index (CPI). Other variables in our model include the yen/dollar exchange rate, oil prices, German Bund yields, and the U.S. fiscal deficit scaled to gross domestic product (GDP). As shown in the chart below, the jump on bond yields early this year merely brought the 10-year Treasury yield up to the fair value estimated by our model. With the recent rebound in bond prices, yields have again fallen below their fair value, which the model currently puts at 1.65%.
In other words, bonds once again look expensive―not as expensive as at the beginning of 2021, but enough to suggest bond investors see reason for caution regarding monetary policy and economic prospects. Many investors think the Fed will eventually tighten monetary policy just enough to smoothly bring down today’s high inflation rate. A less benign view among other investors is that the Fed might tighten policy too soon or too quickly. Those investors are worried about a policy mistake that could trip up the economic recovery and produce another recession. Still other investors think longstanding structural factors such as globalization and population aging will eventually reassert themselves and push down growth and inflation to the levels seen before the coronavirus pandemic. Such an environment of rising interest rates in the near term coupled with an eventual moderation in rates is consistent with the recent flattening in the yield curve. For example, the chart below shows how the yield curve, represented by the difference between the 10-year and the two-year Treasury rates, has changed recently.
In any case, we think our model’s call for higher interest rates should be respected, especially given the risk that inflation could stay high for longer than anticipated and gradually push up longer-term inflation expectations. We note that the 15-year average of CPI inflation that serves as a proxy for inflation expectations in our model is just under 1.90%. Other measures of inflation expectations, such as consumer surveys and the difference between nominal and inflation-protected bond yields, point to even higher future inflation. Even if the 10-year Treasury yield rebounds in the near term, we still believe it probably wouldn’t go much past 2.00%, but the risk of rising yields (and falling bond prices) has prompted us to reduce our exposure to longer-term bonds in several of our strategies for the third quarter.
Business Cycle Report (July 29, 2021)
by Thomas Wash | PDF
The business cycle has a major impact on financial markets; recessions usually accompany bear markets in equities. The intention of this report is to keep our readers apprised of the potential for recession, updated on a monthly basis. Although it isn’t the final word on our views about recession, it is part of our process in signaling the potential for a downturn.
In June, the diffusion index rose further above the recession indicator, signaling that the recovery continues. In the financial markets, a sharp rise in inflation expectations led to a modest sell-off in equities in the middle of the month. Meanwhile, construction and manufacturing activity slowed as increasing costs for materials are becoming a problem for homebuilders and factories. Lastly, the labor market remains strong as payrolls rose at the fastest pace in 10 months. As a result, eight out of the 11 indicators are in expansion territory. The diffusion index rose from +0.3939 to +0.4545, above the recession signal of +0.2500.
The chart above shows the Confluence Diffusion Index. It uses a three-month moving average of 11 leading indicators to track the state of the business cycle. The red line signals when the business cycle is headed toward a contraction, while the blue line signals when the business cycle is headed toward a recovery. On average, the diffusion index is currently providing about six months of lead time for a contraction and five months of lead time for a recovery. Continue reading for a more in-depth understanding of how the indicators are performing and refer to our Glossary of Charts at the back of this report for a description of each chart and what it measures. A chart title listed in red indicates that indicator is signaling recession.
Weekly Geopolitical Report – The Protests in Cuba (July 26, 2021)
by Bill O’Grady | PDF
Over the past two weeks, Cuba has been racked with widespread protests. As this map suggests, the civil unrest was scattered across the island nation.
The widespread nature of the protests suggests some degree of coordination (and, it appears there was). Two groups, the San Isidro Movement and the 27N Movement, used social media to organize marches and protests. At the same time, the size of the protests also suggests widespread dissatisfaction with the regime. Even the elderly turned out. The regime blamed outside forces (read: U.S.), but this uprising seems to be a home-grown response to a deteriorating economy.
The government’s response was typical. It arrested hundreds, shut down the internet on July 11, and promised to do better. After switching the internet back on a few days later, the world got a peek at the repression of the Cuban security forces.
Cuba has geopolitical significance.[1] For the U.S., the risk of a foreign power controlling Cuba means that trade could be stifled at the Port of New Orleans, which is where the agricultural and industrial abundance of the Mississippi River system finds its way to the world. In addition, it could bottle up the Port of Houston which is critical for the American oil industry. Thus, the U.S. has been interested in Cuba since the Louisiana Purchase.
In this report, we will begin by discussing the underlying structural problems of the Cuban political system and its economy. Next, we will examine the specific factors that have negatively affected the Cuban economy and created conditions that have led to the current unrest. We will close with the U.S. response to the protests and market ramifications.
[1] For a review of Cuban geopolitics and history, see our WGR from 1/5/2015, “The Cuban Thaw.”
Keller Quarterly (July 2021)
Letter to Investors | PDF
Judging by the questions we’ve received in the last couple of months, the stock and bond markets have confused many. This is OK. Trying to explain why the markets have recently done something is an impossible task. In a former life I was regularly asked by business reporters why the stock market had done “thus-and-such” on a given day. I was sympathetic to their plight: they had to write something for their newspaper’s morning edition, even if there really wasn’t a good explanation for the market’s movement. The problem is that, often, the market doesn’t move on a real change in conditions, but on what market participants think the next round of changes might be. And that thinking may be wrong.
Investors often believe that when they delve into the stock market they are participating in a sort of beauty contest, by which they are judging which contestant (stock) is the most beautiful. But they are really participating in a derivative of a beauty contest: they are making a judgment about which contestant others will believe is most beautiful. And others may be wrong! This phenomenon is what led Warren Buffett to once say: “In the short run the stock market is a voting machine, but in the long run it is a weighing machine.” How true! In the short run, the investment market is a sort of popularity contest, but in the long run a truly good investment will stand out from all the rest.
Last month, the stock and bond markets reversed course because of changes the members of the Federal Open Market Committee (FOMC) made in their forecasts of interest rates, as displayed quarterly in their so-called “dots chart.” Many investors thought these forecasts meant that the Fed would begin raising interest rates in late 2022, about a year earlier than expected. These investors immediately jumped to the conclusion that the Fed would tighten too soon, sending the economy into a premature recession, leading these investors to sell stocks and buy Treasury bonds. All this occurred without the Fed actually raising rates, or even setting a date to raise rates. It was all due to guesswork by investors as to what may happen a year-plus down the road, guesswork that may change. (Indeed, it seems to have already changed.)
This behavior is nothing new, in fact, we have observed it in markets for centuries. The near impossibility of correctly guessing what the “crowd” will do next is why trading strategies rarely work. We’ve always thought it better to get on the “weighing machine” side of the market, that is, to focus on investments that have the sort of positive characteristics that are recognized over the long term.
In the near term, our decision-making is guided by our conviction that the U.S. and developed world economies are in recovery mode from last year’s pandemic-induced recession. This is a good place for investors to be: companies are seeing a return to business that helps their earnings, dividends, and credit ratings, which is good for both their stocks and bonds. While there are many other things affecting the markets, all these are of lesser importance, in our opinion, than this key trend.
The factor most likely to imperil this economic and market trend is, in my opinion, a resurgence of the pandemic to levels we saw a year ago. We watch pandemic developments closely, as readers of our Daily Comment are aware. While the delta variant of COVID is surging worldwide, it appears to be less lethal than the original version. With almost half the population vaccinated in most developed economies and with the mRNA vaccines proving to be very effective against this variant, we believe it is unlikely that economic progress will reverse. Not only that, but the medical community has learned so much about how to treat those infected that we don’t expect this variant to be anywhere near the disruptive force the original version was. Thus, even regarding COVID, we believe the long-term weighing machine of the markets should work in investors’ favor.
We appreciate your confidence in us.
Gratefully,
Mark A. Keller, CFA
CEO and Chief Investment Officer