Author: Rebekah Stovall

Weekly Energy Update (March 25, 2021)

Posted on by Rebekah Stovall

by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA | PDF

Here is an updated crude oil price chart.  Prices have declined over $10 per barrel since peaking on March 8.  Worries about slowing European growth and a slower than expected recovery in refinery operations after the Texas freeze have weighed on prices.

(Source: Barchart.com)

Crude oil inventories rose 1.9 mb compared to the 1.2 mb expected.  There was no change in the SPR.  Refinery operations, as noted below, continue to recover.

In the details, U.S. crude oil production rose 0.1 mbpd to 11.0 mbpd, meaning that U.S. production has recovered to pre-Texas disruption levels.  Exports were unchanged, while imports rose 0.3 mbpd.  Refining activity rose 5.5%.

(Sources: DOE, CIM)

The above chart shows the annual seasonal pattern for crude oil inventories.  Inventories remain at a seasonal deficit, but the gap did narrow, mostly due to disruptions surrounding the recent cold snap.  If we were following the normal seasonal pattern, oil inventories would be 17.1 mb higher.

Based on our oil inventory/price model, fair value is $40.25; using the euro/price model, fair value is $65.54.  The combined model, a broader analysis of the oil price, generates a fair value of $51.37.  The divergence continues between the EUR and oil inventory models, although recent dollar strength has reduced the projected fair value generated from the euro/price model.

Refinery operations continued to recover last week and are near pre-winter storm levels.  We would expect utilization to stabilize in the coming weeks.

(Source: DOE, CIM)

Market news:

Driving activity fell below trend during the Great Financial Crisis and plummeted during the pandemic.  It is highly unlikely we will ever return to trend.  This factor will tend to dampen either gasoline prices or force the refining industry to contract.  Recent IEA research supports this notion.

Geopolitical news:

  • A Biden administration goal was to return to the Obama-era nuclear deal.  However, very little progress has been made.  Iran wants the U.S. to roll back sanctions as a precondition for talks, while the U.S. wants Iran to cut back on nuclear activities as a precondition for talks.  Given the history, neither side trusts the other.  A complicating factor is that some parts of the 2015 agreement are coming to their negotiated end, meaning the return to the original deal doesn’t do much to address Iran’s threat to the region.  Our take is that Obama wanted Iran to become the regional hegemon, allowing the U.S. to then shift its focus to Asia.  Naturally, Israel and the Gulf States opposed this idea.  However, the nuclear deal was a small step in the process; Obama likely accepted this because he assumed a Democrat would succeed him and carry out the rest of the process.  This obviously didn’t occur.  Now, the Biden administration likely has the same goal―exiting the Middle East―but doesn’t have an obvious path to that end.

Alternative energy/policy news:

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Weekly Geopolitical Report – The Geopolitics of Central Bank Digital Currencies (CBDC): Part II (March 22, 2021)

Posted on by Rebekah Stovall

by Bill O’Grady | PDF

In Part I, we discussed the metaphysics of money.  This week, we will examine the current structure of money and the potentially complicated impact of CBDC.

The Current Structure
Here is a Venn diagram of the current structure of money in most developed markets.

(Source: Designing New Money: The Policy Trilemma of CBDC, Bjerg)

First, there are two forms of money that are electronic only—reserve money and bank account money.  Reserve money is part of the monetary base and it is money that banks “hold” at the central bank.  Only banks can access reserve money, or, put another way, only banks have direct access to the balance sheet of the central bank.

Bank account money is money held in household or firm bank accounts.  It is mostly created by banks through the lending process.  The central bank issues two forms of money—cash, which is an anonymous bearer instrument, and reserve money.  Finally, cash and bank account money are held by anyone, therefore they are universally accessible.

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Asset Allocation Weekly (March 19, 2021)

Posted on by Rebekah Stovall

by Asset Allocation Committee | PDF

When discussing the fiscal deficit in a meeting with then-President Bill Clinton and his Council of Economic Advisors, Chief Strategist James Carville was quoted as saying, “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.” As Carville suggested, rising 10-year T-note yields are currently shaking investor confidence in global stocks, particularly in the Technology sector. The primary concern for investors is that the next stimulus package could spark inflation over the next couple of years. In this report, we discuss why some of those fears may be misplaced.

The 10-year T-note yield has tripled from 0.51% last August to a little over 1.54% today. The surge in yields can be partly attributed to fears of accelerated inflation due to the federal government’s growing deficit. The new COVID-19 relief plan has drawn the ire of bondholders because they suspect it was bigger than necessary. The prospect of higher borrowing costs hurts equities because it lowers valuations. In other words, higher yields tend to depress P/E multiples.

In general, the relationship between fiscal deficits and inflation is not all that strong. Over the last 20 years, the U.S. budget deficit relative to GDP has been the largest during any period of peacetime. Throughout this period, however, inflation has never reached the levels seen in the 1970s and 1980s. In fact, core CPI for the last 20 years has grown around the Fed’s 2% target. The two primary drivers of the Consumer Price Index (CPI) have come from healthcare and shelter. Composing nearly 40% of the index, prices in these two sectors have consistently outpaced the overall index.

Inflation has been relatively muted over recent years because the conditions that allowed it to thrive in the 70s and 80s no longer exist today. Deregulation, globalization, and lower taxes have made it easier to cut costs, while making it difficult for firms to raise prices. Deregulation and globalization have made it easier for firms to outsource labor and remove costly regulations, while lower taxes incentivized firms to adopt cost-saving technologies. Additionally, increased competition meant that only companies with differentiated or specialized goods had any real pricing power. As a result, the prices for goods such as apparel and vehicles have been roughly unchanged over the last 20 years.

Instead of seeing inflation in goods and services, we suspect that deficit spending will likely find its way into financial assets. Government spending is paid for through the private sector (which includes businesses and households) and foreign savings. Much of those savings so far have come from households as higher levels of unemployment have deterred spending. These savings have been used to pay down debt and invest in equities (cue the Reddit army). Foreign savings will likely also pick up in the coming months as consumers begin to spend more. This should be supportive of financial assets as a rise in imports is generally funded by an increase of flows into the capital account.

Nearly every president since Nixon has governed with an eye on the bond market. That is because bondholders overestimate the impact that new presidents will typically have on the economy. The chart above shows the 10-year T-note yield along with the first quarter forecast for the next six quarters from the Philadelphia FRB’s survey of professional economists. When the forecast is generally correct, we mark it with dots; when in error, we use open boxes. In 12 of the past 20 years, the expectation has been for rising rates and has been incorrect. Thus, investors should be aware that expectations lean toward higher rates but are wrong more than half the time. Another way of thinking about the recent rise in rates is that most of the time, the consensus is that long-duration interest rates will rise. That being said, we suspect the rise in current rates probably won’t exceed 2% on the 10-year T-note and equity markets will be able to manage this level of increase.

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Weekly Energy Update (March 18, 2021)

Posted on by Rebekah Stovall

by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA | PDF

Here is an updated crude oil price chart.  Prices are consolidating in the low $60s.

(Source: Barchart.com)

Crude oil inventories rose 2.4 mb which was in line with forecast.  There was no change in the SPR.  We did see a recovery in refinery operations but not enough to prevent the rise in inventories.

In the details, U.S. crude oil production was unchanged at 10.9 mbpd.  Exports fell 0.1 mbpd, while imports fell 0.3 mbpd.  Refining activity rose 7.1%.

(Sources: DOE, CIM)

The above chart shows the annual seasonal pattern for crude oil inventories.  Inventories remain at a seasonal deficit, but the gap is narrowing, mostly due to disruptions surrounding the recent cold snap.  If we were following the normal seasonal pattern, oil inventories would be 13.5 mb higher.

Based on our oil inventory/price model, fair value is $40.87; using the euro/price model, fair value is $66.01.  The combined model, a broader analysis of the oil price, generates a fair value of $51.98.  The divergence continues between the EUR and oil inventory models, widening due to the distortions caused by the February cold snap.

Refinery operations jumped last week but still remain well below recovery levels and pre-Texas freeze levels.

(Source: DOE, CIM)

Market news:

  • Although it’s a bit wonky, Platts (SPGI, USD, 348.61), the company that creates pricing benchmarks for energy and other commodities, was considering making a change to freight pricing as part of a change to include WTI in its international benchmarks.  WTI was generally not considered an international price because it wasn’t exported until a few years ago.  The industry has pushed back hard on the change, meaning Platts will likely return to the drawing board to rethink its freight price position.
  • The IEA issued its forecasts for supply and demand through 2026.  Demand will likely return to previous peaks by early 2023 and reach 104.1 mbpd by 2026.  This forecast is remarkably optimistic, but, if accurate, would suggest that fossil fuels are still viable.
  • We continue to deal with the fallout from the February cold snap.  The latest problem is that the freeze shut down petrochemical plants in the Lone Star State, which is now causing a global plastics shortage.  Polypropylene and polyvinyl chloride are used in a variety of products, leading to supply problems in several industries.  Rising costs of inputs are raising inflation concerns across numerous markets.

Geopolitical news:

  • So far, despite attempts to restart talks with Iran, little progress has been made.  We doubt anything will occur before Iran holds presidential elections in June.

Alternative energy/policy news:

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Weekly Geopolitical Report – The Geopolitics of Central Bank Digital Currencies (CBDC): Part I (March 15, 2021)

Posted on by Rebekah Stovall

by Bill O’Grady | PDF

There has been a surge in interest in digital currencies among the world’s central banks.  The triggering event was probably Facebook’s (FB, USD, 264.28) unveiling of the LIBRA project in June 2019.  Digital currencies of various stripes have been around for some time; bitcoin (BTR, USD, 49,989.80), introduced in 2009, is one of the oldest.  For the most part, central banks have not felt threatened by bitcoin because the cryptocurrency fails to meet the standards of a currency (which we will discuss in greater detail below).  First, it is difficult to use in transactions.  Because bitcoin does not have a central repository for executing transactions, it relies on “miners” who receive bitcoins for verifying the accounts in a transaction.  Miners earn the right to execute the verification by cracking puzzles that use large and growing amounts of electricity.  In fact, the energy consumption has reached the point where China has halted mining in Inner Mongolia, an area of cheap electricity.  In addition, the price volatility of bitcoin makes it difficult to use as a store of value.  If bitcoin were your only currency, you would be facing rapid changes in prices and, for the most part, persistent deflation.  Finally, it may not be safe; the blockchain is vulnerable to being corrupted and its impermanent nature could lead to governments ending its existence.

However, when Facebook entered the cryptocurrency realm, central banks took notice.  Not only could the tech firm have the resources to manage a payment system, it has a widely adopted platform in place.  Therefore, interest began to grow among central banks who wanted to determine if they should begin offering a digital form of currency.

(Source: BIS)

This chart shows central bank speeches on the topic of CBDC.  They started in earnest after 2016; initially, the tone was negative, but it has steadily turned more positive beginning in 2018 and went net positive early last year.

Another factor that has fostered the interest in CBDC is the pandemic.  Social distancing and the goal of reducing virus transmission encouraged cashless payments which were not always available, especially to the less affluent.  In addition, the distribution of fiscal aid was hampered by the lack of financial services among the same groups.  It is thought that a digital currency may have helped resolve these two issues.

So, why is CBDC a geopolitical topic?  It is estimated that around 80% of the world’s central banks are considering and investigating the introduction of CBDC.  As we will detail in this report, central banks will have choices in how they structure their CBDC.  But these digital currencies won’t exist in a vacuum; firms and individual countries will likely use these currencies as well, so there will be an international impact to their issuances.

Part I of this series is an examination of what money is.  Part II will begin with a discussion of the current state of money and show how CBDC can act as money in multiple ways.  We will also examine how the digital currency’s structure could have significant effects on financial systems, fiscal policy, privacy, and data collection.  Part III will analyze the geopolitics of the introduction of CBDC, and Part IV will discuss potential market ramifications.

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Asset Allocation Weekly (March 12, 2021)

Posted on by Rebekah Stovall

by Asset Allocation Committee | PDF

With the U.S. dollar apparently poised for what could be a long phase of depreciation, investors are naturally looking more closely at foreign stocks for future growth.  Japan has been a prime focus, not only because it sports the world’s third-largest economy and the third-largest equity market, but also because Japanese stocks have recently performed well.  Over the last six months, for example, the MSCI Japan Index provided a total return of 17.3% (in dollar terms), almost double the return on the U.S. index.  But are Japanese stocks set for further gains over the long term?  Have Japanese stocks really overcome their long period of underperformance since the country’s “bubble economy” burst more than 30 years ago?  A close look at the Japanese economy and financial markets shows Japan has certain cyclical advantages that investors could currently take advantage of, but it is also facing longer-term headwinds that are likely to weigh on returns over time.

Countries that go through an investment bubble like Japan did in the 1980s are left with the challenge of adjustment once the bubble bursts.  Among the many possible strategies to deal with the excess investment and resulting overcapacity, the government can simply step back and allow asset prices to quickly adjust downward, putting lots of people out of work and leaving creditors empty-handed.  After the pain of the Great Depression, governments these days more often try to slow the process and spread the costs broadly.  Our analysis suggests Japan completed the slow process of repricing its assets and working through its excess investment in the early part of this century.  In the chart below, which shows the inflation-adjusted growth rate for each major category of Japan’s gross domestic product (GDP) by period, the red columns show how fixed investment swung dramatically from an average annual increase of 5.5% in the 1980s to average annual declines of 0.4% through the 1990s and 2.1% in the first decade of the 2000s.  However, the chart shows that Japanese investment finally started to grow again in about 2010 (we’ve excluded the data for 2020, since it is distorted by the coronavirus pandemic).

Besides the rebound in investment, Japan has also recently shown other improvements in economic policy and dynamics.  For example, the country has deepened its economic ties to China, helping boost its exports.  It has improved its corporate governance rules and brought more people into the workforce.  All the same, the chart above suggests why its stock market performance remained weak until recently.  As is typical for highly developed countries, personal consumption spending is the biggest driver of Japan’s economy, but the chart shows that this type of spending has been growing ever more slowly, even after investment rebounded and labor force participation increased.  This critical slowdown in consumer spending almost certainly reflects Japan’s major problem with low birth rates, a shrinking population, and population aging.  Taking a “glass half full” approach, you could say that the rebound in Japanese investment has come just in time to offset some of the country’s poor demographics.  From a “glass half empty” perspective, you could also argue that the positive impact of Japan’s investment rebound is being offset by worsening consumer spending trends.

The back-to-back problems of asset price adjustments and demographics have presented a continuing challenge for Japanese companies.  In addition, government policymakers have been unable to come up with ways to address the situation.  In some ways, they’ve even exacerbated it (especially by raising the national value-added levy, a type of sales tax).  As shown in the chart below, Japanese corporate profits have trended upward since the bursting of the bubble economy, but the average rate of increase has been anemic at about 2.5% per year, versus 7.5% per year in the U.S.

Because of its enormous economy and financial markets, Japan can’t be ignored by investors, but this analysis shows that the country continues to face big challenges to its economic growth and corporate profitability.  In the short term, we do think Japanese stocks could continue their recent short-term cyclical rebound because of factors like its corporate governance improvements, investors’ shift toward the “value” stocks that make up so much of the market, or the post-pandemic economic rebound around the world, which is boosting Japanese exports.  In the long term, however, it’s important to remember that Japanese stocks will probably continue to face continuing secular challenges from its poor demographics.

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Weekly Energy Update (March 11, 2021)

Posted on by Rebekah Stovall

by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA | PDF

Here is an updated crude oil price chart.  Prices are consolidating in the low $60s.

(Source: Barchart.com)

Crude oil inventories rose again, defying expectations of a draw.  Stockpiles increased 13.8 mb when a draw of 3.0 mb was forecast.  There was no change in the SPR.  The build in stockpiles was offset by declines in production.  We did see a recovery in refinery operations but not enough to prevent the rise in inventories.

In the details, U.S. crude oil production rose 0.9 mbpd to 10.9 mbpd, which is essentially a full recovery from the recent cold snap.  Exports rose 0.3 mbpd, while imports fell 0.6 mbpd.  Refining activity rose 13.0%.  The second week of falling refining activity led to the unanticipated rise in inventories.

(Sources: DOE, CIM)

The above chart shows the annual seasonal pattern for crude oil inventories.  Inventories remain at a seasonal deficit, but the gap is narrowing, mostly due to disruptions surrounding the recent cold snap.  If we were following the normal seasonal pattern, oil inventories would be 14.4 mb higher.

Based on our oil inventory/price model, fair value is $45.63; using the euro/price model, fair value is $66.72.  The combined model, a broader analysis of the oil price, generates a fair value of $41.61.  The divergence continues between the EUR and oil inventory models, widening due to the distortions caused by the February cold snap.

Refinery operations jumped last week but still remain well below recovery levels.

(Source: DOE, CIM)

Geopolitical news:

  • This year, the Hajj, the pilgrimage to Mecca that every able-bodied Muslim is required to make at least once in a lifetime, will be held July 17-22.  The KSA has announced that it will require proof of vaccination for pilgrims this year.

Alternative energy/policy news:

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