Author: Rebekah Stovall

Asset Allocation Weekly (April 30, 2021)

Posted on by Rebekah Stovall

by Asset Allocation Committee | PDF

(Due to staff vacations, there will not be an accompanying podcast and chart book this week. The multimedia offerings associated with this report will resume next week, May 7.)

In our asset allocation strategies, we continue to have a separate provision to homebuilders.  The reason for this particular position is due to our belief that homebuilding and associated industries are poised for a multiple-quarter expansion.  One reason for this expectation is that housing and homebuilding are still recovering from the housing bubble that peaked in 2005.  The aftermath of that bubble caused a decline in homebuilding.

This chart shows housing starts from 1953 to the present.  From 1953 to 2000, the average was 1.048MM single-family starts per month on a seasonally adjusted annualized basis.  Note that starts rose well above average during the housing bubble and then plunged during the Great Financial Crisis.  They only returned to their earlier average last August.  Given that the population was smaller in the past, existing sales per capita would be even lower now.

The shortage of single-family homes relative to starts is even more stark when compared to the single-family home vacancy rate.

This chart shows single-family housing starts compared to the vacancy rate.  We have marked low vacancy levels with teal circles.  In the 1970s, vacancies at the current level led to starts between 1.3MM and 1.4MM starts.  We are currently around 1.1MM, which suggests a boom in homebuilding is not only likely, but probably necessary to meet the demand for housing.  Thus, our outlook for the homebuilding sector remains especially positive.

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Business Cycle Report (April 29, 2021)

Posted on by Rebekah Stovall

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 March, the diffusion index rose further above the recession indicator, signaling that the recovery is continuing. In the financial markets, heightened inflation fears led to a sell-off in equities and 10-year Treasuries. Meanwhile, a slowdown in COVID-19 cases and easing restrictions made it easier to hire workers; thus, last month saw an improvement in labor market conditions. However, poor weather conditions and supply constraints, particularly the lack of semiconductors and lumber, led to a pullback in manufacturing activity. As a result, four out of the 11 indicators are in contraction territory. The reading for March was unchanged from the previous month at +0.2727, 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.

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Weekly Geopolitical Report – Irish Border Revisited (April 26, 2021)

Posted on by Rebekah Stovall

by Thomas Wash | PDF

It has been more than a year since the U.K. and European Union (EU) came to terms with the Withdrawal Agreement, yet questions remain on how it will impact Northern Ireland, which was granted an exception to remain in the EU. Having decisively voted 56% to 44% to remain a part of the EU during the Brexit referendum, it is unclear whether Northern Ireland allegiance lies with the U.K. or the EU.

The exception, which went into effect earlier this year, keeps the Northern Ireland economy in the EU to prevent a hard border between Northern Ireland and the Republic of Ireland. This has angered pro-British Unionists who believe that the exception ostracizes Northern Ireland from the U.K. and draws it closer to Ireland. As a result, the Unionists have protested the decision and violence has erupted between competing factions in Northern Ireland. However, demographic trends have shown that the pro-British faction seems to be slowly dwindling, likely heightening concerns.

In this report, we will focus on the current relationship between Northern Ireland, the U.K., and the EU, and summarize the Good Friday Agreement. Next, we will discuss the impact of demographic changes on reunification efforts and what we expect to happen going forward. As usual, we will conclude with potential market ramifications.

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Asset Allocation Weekly (April 23, 2021)

Posted on by Rebekah Stovall

by Asset Allocation Committee | PDF

A decade ago, the Rent Is Too Damn High Party became a viral sensation after a candidate for the New York governorship, Jimmy McMillan, announced lowering New York rent as his central platform. Now, over a decade later, rent prices in New York have finally started to fall. The pandemic-driven moratorium on evictions has likely played a role in declining prices in New York, but more of this change can likely be attributed to the phenomenon of people leaving cities in favor of suburban and rural areas. In fact, this migration out of major cities into the suburban and rural areas has been so pronounced that national rent prices have risen. Additionally, this increase in rental rates has led some economists to speculate that the uptick in rent prices is a sign that inflation is on the horizon. In this report, we will discuss how the rise in rental rates, and home prices for that matter, may not have as big of an impact on the Consumer Price Index (CPI) as many would claim.

The real estate market has changed dramatically since the start of the pandemic. Rent prices have dropped in the most populated cities, while suburban and rural areas have seen an increase. Since last year, the top 30 cities by population have seen a decline of roughly 6% in rent prices, while the rest of the country has seen a 4% rise. Purchase prices for homes have also risen sharply during the pandemic, with the S&P CoreLogic Case-Shiller index showing an 11% rise since January 2020. Because shelter is heavily weighted in the CPI, there have been concerns that increasing rental and home prices could push the overall CPI higher.

The CPI estimates the total cost of shelter for the urban areas in the country. Shelter prices account for approximately one-third of headline CPI and about 40% of core CPI. Its heavy weighting is due to the fact that it is the one service most consumers cannot avoid. Because of its weight, a significant movement in shelter prices can lead to huge swings in the index. This is one of the reasons people have been paying close attention to rental and home prices. Shelter has two major components: rent for primary residence and owners’ equivalent rent. Owners’ equivalent rent accounts for approximately 73% of the shelter price, while rent for primary residence accounts for 24%.[1]

Since homes are a capital investment, they are excluded from CPI. As a substitute, the index uses owners’ equivalent rent, which is the implicit rent that homeowners believe they would have to pay if they were to rent their own home. In order to gauge what the prospective rent went would be, the BLS asks consumers who own their primary residence the question, “If someone were to rent your home today, how much do you think it would rent for monthly, unfurnished and without utilities?” This approach reduces the impact home prices could have on CPI because the consumers have to take into account actual economic conditions when responding. Thus, consumers cannot simply answer the question by stating their mortgage payment.

In addition, the way shelter is calculated may also contribute to why CPI doesn’t seem to reflect the upturn in rental and home prices. Because 88% of the population lives in urban areas, CPI primarily tracks prices in cities. In fact, the top five heavily weighted cities ― New York, Los Angeles, Dallas, Philadelphia, and Chicago ― account for about one-fifth of the sample size. Therefore, any increase in rent prices and owners’ equivalent rent in areas outside these cities will not likely swing the index significantly. This helps explain why shelter prices in the CPI have waned in recent months, despite the rise in real estate purchase prices. Put another way, the BLS, which calculates CPI, has to create a weighted average for the entire economy. The problem of averaging is that there is a dispersion around an average that may be wide, but the average masks that issue.[2] It also makes sense to weight the average by population; after all, the central bank would probably not want to react to rising rent prices in Salina, KS, when rents are not rising in New York, NY.

In short, due to the way the CPI is constructed and sampled, increases in rental and home prices may not have a strong impact on the index, depending on the dispersion of pricing changes. Furthermore, the slowdown in the rise in shelter prices, as determined by CPI, is due to people moving out of major cities in favor of suburban and rural areas. Thus, we suspect inflation fears about the rise in rental prices are likely overblown, at least in terms of the CPI. On the other hand, because each person purchases their own unique basket of goods and services, some people may be experiencing rising prices in a way that is different from the average experience across the economy.        

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[1] The other two components are lodging away from home and tenants’ and household insurance.

[2] Often this situation is highlighted in statistics classes by the example of a person with their head in a 350o oven and foot in an ice bucket; on average, the person’s temperature is normal.

Keller Quarterly (April 2021)

Posted on by Rebekah Stovall

Letter to Investors | PDF

Here we are again, with the U.S. stock market rising nicely and hitting new highs.  I am getting two questions almost daily.  The first is: “Is this real?”  That’s a way of asking, “Can you trust this rally?”  Our firm has, since the middle of last year, been consistent in arguing that the market would move higher.  Thus, we do believe this advance is justified.  This belief required neither a bold prediction of the future nor a heroic level of optimism on our part.  Rather, we’ve simply lived long enough that we’ve watched many economic cycles and have observed how the markets usually behave in and around them.

Cyclical bear markets begin as soon as the stock market “sniffs” a recession is on the horizon.  They usually don’t last long (six to nine months is normal), but they can do real damage.  Cyclical bull markets, on the other hand, usually begin as soon as the market senses that the economic trough is near.  These usually last much longer, simply because recovery from recession almost always transitions into a new economic expansion, which usually lasts several years.  Our optimism for the stock market was driven by our understanding of the probabilities.  (You probably recall me writing in the past that we are not forecasters, but odds-makers.)

As we wrote in our last quarterly letter, the current rally is driven by “the economic recovery underway, the Fed’s extraordinarily favorable monetary policy, and the likelihood that COVID-19 will recede over the next two years.”  To those three factors that argue positively for growing economic activity, we can add a fourth: extraordinary fiscal stimulus from the federal government.  President Biden recently signed a $1.9 trillion stimulus bill (called the American Rescue Plan Act).  This is an astounding sum of money slated to leave the U.S. Treasury and to be spent in the economy.  Now, Congress is trying to pass yet another stimulus bill, reportedly focused on infrastructure spending, in the range of anywhere from $800 million to over $2.0 trillion.  While such spending programs rarely achieve the specific objectives they aspire to, from an economic perspective this rate of spending cannot help but stimulate additional economic growth.  (Of course, the president and Congress are also talking about taking funds out of the economy through increased taxes.  If passed, these taxes could be a depressant on economic activity, an action we are watching closely.)

All this economic and governmental activity is generating the second question I’m hearing daily: “Aren’t we going to see inflation come roaring back?”  This is an important question: it reveals that the questioner understands inflation to be a real threat to investors.  Rising inflation silently confiscates an investor’s returns.  For example, in an environment of 2% annual inflation, a 6% nominal return produces a 4% real return.  But in a time of 4% inflation, that same 6% nominal return results in a real return of just 2%, that is, it is cut in half from the prior example.

I like the old, homespun definition of inflation: too much money chasing too few goods.  This definition properly brings our attention to three things: the supply of money, the supply of goods, and the velocity of money (the “chasing” part, i.e., how rapidly consumers spend their money).  Most of us focus on the supply of money.  This is easier to measure than the other two items, and we boomers remember that the high inflation of the 1970s was accompanied by high money supply growth.  Given the rather dramatic increase in money supply we are now seeing, this inflation question is logical.

We at Confluence believe that, while we will likely see spurts of inflation in the near term, inflation will remain subdued in the long run (about 2% or less).  Why are we so sanguine about inflation?  The answer lies in the other two elements of the homespun definition.  There is still no shortage of goods.  While the re-opening of the economy has revealed bottlenecks here and there (e.g., semiconductor chips, certain food items, etc.), we expect these shortages to clear over the next year.  In a globalized economy with rapid application of new technologies, any shortage of goods isn’t likely to last very long.  Major reductions in economic globalism and the application of technology would cause us to revisit our opinion of inflation.

Finally, the velocity of money remains historically low.  Consumers are not afflicted with the inflation mentality of the 1970s.  That mentality (“buy today because it will be much more expensive tomorrow”) took about 30 years to develop.  It’s rarely seen today.  Statistics show that Americans are not spending their higher levels of cash, but rather saving it.  Many are investing it; some are speculating with it.  The inflation we are seeing today is asset inflation, an increase in the prices of stocks, real estate, and other forms of investment.  That is a potential problem that worries us more than consumer price inflation.  For the time being, however, we are simply glad to see the economy and the markets in recovery mode.

We appreciate your confidence in us.

 

Gratefully,

Mark A. Keller, CFA
CEO and Chief Investment Officer

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Asset Allocation Quarterly (Second Quarter 2021)

Posted on by Rebekah Stovall

by the Asset Allocation Committee | PDF

  • Monetary and fiscal stimulus are expected to help propel the U.S. economy through recovery into expansion over our three-year forecast period.
  • Global central banks have been, and should continue to be, excessively accommodative as the world emerges from lockdowns caused by the pandemic.
  • Inflation numbers may appear stark over the next several months, but we expect overall inflation to settle below the Fed’s threshold over the full forecast period.
  • The allocation to equities among all strategies remains elevated with an increased tilt toward value and an overweight to small capitalization stocks, where risk appropriate.
  • More risk-tolerant strategies have a higher allocation this quarter to international stocks due to our expectations of overseas growth combined with the potential for a waning value of the U.S. dollar.
  • Commodity exposure is retained across all strategies, with heavier concentration in the more risk-averse strategies.

ECONOMIC VIEWPOINTS

With the benefits of monetary and fiscal stimulus, we expect the U.S. economic recovery to gain momentum and become an outright expansion within our three-year forecast period. Therefore, prior to 2024, real GDP should exceed the pre-pandemic numbers compiled at the end of 2019. The Fed’s current posture of being excessively accommodative by keeping fed funds rates near the zero-bound and continuing to expand its balance sheet should continue through 2023, if not beyond. Along with the Fed’s monetary actions and the stimulus relief package enacted in the U.S. in early March, there is the potential for further stimulus in the form of infrastructure spending. Even if an infrastructure bill fails to pass, the fiscal benefits conferred upon household balance sheets and state and local budgets from March’s stimulus produce a heavy dose of support for substantial elements of the economy.

Although much has been written about inflation recently, with many market participants expecting a persistent upsurge, we expect inflation numbers to crest in the latter half of the year and prove transitory. The year-to-year comparisons will certainly be stark when released in the second and third quarters of this year. In addition, we believe current news items that are viewed as harbingers of inflation, such as semiconductor shortages and difficulties of finding truck drivers at affordable rates, will lend themselves to the rules of supply and demand and equilibrium prices will be reached. Accordingly, we don’t expect the Fed’s 2% target level to be broached for more than a few quarters and believe that core inflation will settle comfortably within that threshold over the full forecast period. However, as we stated last quarter, we believe that asset inflation will continue given Fed accommodation, fiscal stimulus, an economic recovery, and an abundance of cash among investors.

Echoing expectations for the U.S., we believe global economies will continue to recover, albeit with a lag to that of the U.S. The IMF recently revised its global growth forecast upward to 6%, in excess of the OECD’s estimate of 5.6% in mid-March. Much of the improvement is forecast for the latter portion of the year, when, for example, the EU’s €750 billion recovery fund is expected to be distributed. Helping to make the prospects for growth on the continent more durable is the EU’s €1.1 trillion multi-year budget that extends to 2027, with at least half earmarked for modernization. Similar monetary and fiscal accommodations are being adopted throughout not only the developed world, but also in many emerging markets.

A final element that leads to our domestic and global recovery and expansion thesis is the potential unleashing of pent-up demand by consumers stemming from a post-COVID-19 reopening. Vaccine rollouts, although uneven, are progressing. As of mid-April, the Financial Times daily vaccine tracker indicated a first dose of 58.8 people per 100 residents in the U.S. and 23.1 in the EU. The U.K. was even further ahead at 60.6, while Japan lagged significantly at 1.4. In essence, developed economies are pushing toward an easing of lockdown restrictions, leading to elevated consumer sentiment with positive implications for economic activity.

STOCK MARKET OUTLOOK

Due to our positive economic outlook, we believe elevated exposure to risk assets such as equities is warranted. With the retrenchment last year, annual earnings comparisons will appear stunning over the next several quarters. Beyond this year, corporate profits should remain at double-digits as a percentage of GDP. We expect the combination of monetary accommodation by the Fed, a fiscally permissive federal government, and elevated business and consumer sentiment to create an appealing backdrop for equities. Although higher inflation at the back end of this year may temper equity prices at some point, over our three-year forecast period we expect inflation will remain subdued, thereby helping P/E ratios stay elevated.

Despite positive prospects for equities overall, we expect that returns will be uneven, favoring cyclical entities that typically perform well as a full recovery gains traction. Last year, we began to orient the Asset Allocation strategies toward a more cyclical posture with an overweight to the Industrials and Materials sectors. Earlier this year, we augmented that posture by adding an overweight to Financials and a tilt in favor of value at 60% versus 40% for growth, which we further reinforced this quarter through an additional lean into value at 65%. While we are not anticipating the entire growth equity complex to retrench, there are a number of entities that have stretched valuations and are arguably overbought. In contrast, we believe that opportunities abound in the more cyclically exposed companies, which encourages our increased overweight to value. Regarding market capitalizations, we note that the S&P 500 may not harbor the greatest potential over the next three years as it has morphed into more of a mega-cap growth index. Rather, market performance is broadening, mimicking the economy, which underscores our belief that smaller capitalization, cyclically exposed companies hold greater potential at this stage of the economic cycle. As a consequence, U.S. small caps are heavily represented in the strategies where we find them to be risk appropriate.

Beyond the U.S., equity valuations in developed and emerging markets are compelling, especially given the prospect of a weaker U.S. dollar. For U.S.-based investors, a decline in the value of the dollar relative to other currencies acts as a strong tail wind. As alluded to in the Economic Viewpoints section of this document, we believe that developed market economies, particularly the EU and U.K., are lagging the U.S. recovery by roughly six months and are poised for growth. The EU fiscal stimulus in the form of an enormous multi-year budget, the monetary stimulus stemming from the €750 billion issuance of EU debt to finance their recovery fund, and the benefits conferred on the euro as a competitive currency through the issuance of this debt all operate to produce favorable conditions for European equities. As a result, we retain elevated allocations in the more risk-averse strategies and increased in the others, where there is now an overt emphasis on U.K. stocks. With regard to emerging markets, relative valuations have become more attractive this year, encouraging an increased weight to this asset class in the more risk-accepting strategies. As concerns surrounding Chinese equities persist, the increased allocations to emerging markets in these strategies use an ETF that excludes mainland Chinese equities.

BOND MARKET OUTLOOK

An extraordinarily accommodative Fed in conjunction with a strong economic recovery has sown the seeds of inflationary concerns among many investors. Although we acknowledge that somewhat persistent inflation is a possibility, our base case is that a spike in reported inflation over the next two quarters will prove to be transitory and core CPI will soon return to levels below the Fed’s 2% target. In the event that inflation is elevated for a longer period of time, or the efforts of bond vigilantes take hold, the Fed could engage in a form of yield curve control. In this event, the combination of quantitative easing and forward guidance would likely lead to a lower and flatter yield curve. Either case encourages a slight relaxation of the short-duration posture we previously held. Moreover, steepening of the yield curve beyond three years of maturity over the past eight months has increased the utility of bonds, with intermediate maturities as a foundation in the more risk-averse strategies.

Spreads on corporate bonds have continued to narrow relative to Treasuries since this time last year, reflecting investors’ acceptance of credit versus duration risk. Although our expectation is for corporate spreads to remain tight over our three-year forecast period given an economic recovery and expansion, we reduced overall corporate exposure relative to both Treasuries and mortgage-backed securities (MBS) due to the less appealing risk/return potential of corporate bonds. In contrast, we increased MBS exposure owing to our expectations for prepayment speeds to remain low, rates to remain relatively stable, and the Fed’s continuing purchases of MBS as part of its balance sheet expansion.

OTHER MARKETS

The valuations among REIT segments have become varied, with the more recent entrants to the category, such as data centers and cell towers, outperforming, while the more traditional segments of offices, retail, and hospitality are disproportionately affected by the consequences of the pandemic. Although the more traditional segments hold promise in a recovering economy and REITs are still attractive as a varied source of income, they were removed from all strategies with growth as a component. Our belief that data centers and cell towers are fully valued combined with our healthier expectations for more cyclically oriented, smaller capitalization companies encouraged the reallocation in these strategies.

Commodities continue to be used across the spectrum of strategies, with heavier allocations to the more risk-averse strategies. These strategies also continue to hold a position in a broad basket of commodities containing a majority weight to energy components such as crude oil, natural gas, and heating oil, as well as industrial metals. An allocation to gold is included in all strategies given its appeal in a world where excessive monetary accommodation prevails and serves as a haven in the event of geopolitical difficulties. Unchanged from last quarter is the position in silver in strategies designed for growth as we believe it is risk-appropriate and its industrial uses make it attractive in an economic recovery.

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Weekly Geopolitical Report – What Population Aging Means for Global Inflation and Growth (April 19, 2021)

Posted on by Rebekah Stovall

by Patrick Fearon-Hernandez, CFA | PDF

One key worry for investors these days is whether fiscal stimulus, loose monetary policy, and accelerating economic growth will spark runaway inflation.  That concern has been a major factor in driving down fixed income prices and boosting bond yields since the start of the year.  However, we’ve been arguing that any acceleration in consumer prices this year is likely to be fleeting.  Much of the expected rise in inflation will simply reflect “base effects” as current prices are compared to the weak prices at the beginning of the coronavirus pandemic one year ago.  Despite recent supply chain disruptions, such as the February freeze in Texas and the grounding of the Ever Given container ship in the Suez Canal, a lot of excess industrial capacity and unused labor exists in the U.S. and other major countries.  The overall high availability of resources should help keep a lid on inflation for some time to come.  In this report, we discuss yet another factor that will probably hamper inflation: population aging.

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