Author: Rebekah Stovall

Asset Allocation Weekly (February 26, 2021)

Posted on by Rebekah Stovall

by Asset Allocation Committee | PDF

The steady rise in the 10-year T-note has started to raise concerns about the impact of higher yields.  This week’s report will examine what impact the steady rise in yields may have on the economy and markets.  Essentially, the issue at hand is if, how, or when the FOMC will act to intervene in the rise of yields.  We suspect there are two factors that would sway policymakers.  The first would be if the rise in yields had an adverse impact on housing.  The second is if it would trigger a problem in the financial markets.  Equity markets are one potential clue; the other would be credit markets.  We will discuss housing and equity markets in this report, and cover credit spreads in the accompanying chartbook.

For starters, it makes sense to gauge the situation of current yields.

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.  Although yields are rising, they remain below the fair value yield, which is currently at 1.42%.  Note the red ellipse on the chart.  At that level of overvaluation, yields would be 1.90% to 2.00%.  In recent years, this level has been the peak yield.  For now, yields remain below their fundamental value but a rise to 2.00% is not out of the question.

If yields continue to rise, what are the risks?  For the real economy, the primary concern would be residential real estate.  Mortgage yields are closely tied to the 10-year T-note spread and rising yields could make housing less affordable.

The housing affordability index consists of mortgage rates, home prices, and household income.  The higher the reading of the index, the more affordable residential real estate is for the median buyer.  A simple model of this relationship suggests that a 2.00% 10-year yield would reduce the affordability index to 162.1.  That would be a rather modest decline and probably not one significant enough to warrant intervention by the FOMC.

Finally, there is a well-known relationship between P/Es and long-term interest rates.

This chart shows the cyclically adjusted P/E (CAPE) and the 10-year yield.  Although the CAPE is elevated, some of the lift is a function of lower yields.  It is important to note that some of the rise in long-duration interest rates is a function of stronger economic growth.  Better economic growth is affecting earnings.  Our most recent iteration of our earnings model generates S&P 500 earnings this year of $153.72, up from our initial forecast of $147.84.[1]  Earnings per share is being adversely affected by a rising divisor, a function of new share issuance.  Rising rates are triggering a decline in the fair value multiple to 25.4x (from 26.9x), yielding a fair value of 3905, which is modestly below the low end of our previously forecast range of 3918 to 4050.  A rise to 2.00% on the 10-year would reduce the fair value P/E to 24.8x, ceteris paribus.  Overall, though, we remain favorable toward equities simply due to the outstanding level of liquidity available to financial markets.

In closing, what form would Federal Reserve intervention take?  The most aggressive action the FOMC could take would be yield curve control, where the central bank would set the rate for Treasuries and allow its balance sheet to expand and contract to accommodate the fixing of interest rates.  There is, in our estimation, a good chance this will occur at some point. But the above analysis suggests that, barring a crisis, it would probably take a yield above 2.00% on the 10-year Treasury based on current conditions.  Will we reach that level?  Probably not in the near term.  Therefore, we expect the FOMC to continue to talk about policy accommodation for the foreseeable future but avoid the topic of yield curve control until forced to act.

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[1] This earnings number is based on Standard and Poor’s calculation method, which is more conservative than the widely reported Thomson/Reuters earnings.  In general, the former is usually about 7% less than the latter.

Business Cycle Report (February 25, 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 January, the diffusion index rose further above the recession indicator, signaling that the recovery continues. Financial markets were mixed as investor optimism about the economy and rising inflation concerns resulted in stronger equities and wider yield spreads. Meanwhile, the labor market worsened due to new COVID-19 restrictions, forcing firms to lay off workers. That being said, manufacturing activity continues to be a bright spot in the economy as factories were able to avoid many of the new restrictions. As a result, four out of the 11 indicators are in contraction territory. The reading for January 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 Energy Update (February 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 continue to rise.

(Source: Barchart.com)

Crude oil inventories rose 1.3 mb when a draw of 6.5 mb was forecast.  There was no change in the SPR.  Analysts (us included) expected production outages in Texas to lead to a decline in inventories.  Although production did decline, refinery operations fell double expectations.

In the details, U.S. crude oil production fell 1.1 mbpd to 9.7 mbpd.  Exports fell 1.5 mbpd, while imports declined 1.3 mbpd.  Refining activity plunged 14.5%.  The collapse in refining activity led to the unanticipated rise in inventories.  We also note that consumption eased as cold temperatures forced people to stay home.

(Sources: DOE, CIM)

The above chart shows the annual seasonal pattern for crude oil inventories.  This week’s rise is seasonally normal.  The usual seasonal pattern occurs due to refinery maintenance; in the past, the U.S. oil industry had limited ability to export, which contributed to the seasonal pattern.  With the potential for higher exports, the expected seasonal build may not occur, which would be bullish for prices.  If we were following the normal seasonal pattern, oil inventories would be 28.2 mb higher.

Based on our oil inventory/price model, fair value is $52.62; using the euro/price model, fair value is $68.79.  The combined model, a broader analysis of the oil price, generates a fair value of $59.72.  The divergence continues between the EUR and oil inventory models, although it is narrowing.

As we noted above, refinery utilization plunged last week.  The drop was similar to what we saw in the pandemic.

(Source:  DOE, CIM)

The energy sector has been on a tear after being weak for most of last year.  However, when compared to the S&P and oil prices, energy stocks have mostly marked time recently.

The blue deviation line shows the spread between the fair value calculation, based off the S&P and WTI, and the energy sector.  Even with the rally in the sector, it is failing to keep up with the independent variables.  This suggests that one is better off owning the commodity rather than the equities.  Or, put another way, even this rally in the energy sector is less than what we have seen in the past with this combination of equity performance and oil price increases.

Market news:  The markets are still dealing with the disruption caused by the recent cold snap which hit Texas hard.  This report, on natural gas, gives a detailed look at the cascade of problems caused by the weather.  The media tends to try to simplify such situations, looking for clear villains.  In reality, outcomes seen in Texas are rarely due to one decision but occur due to a whole series of logical steps that rest on a critical assumption.  In this case, the expectation was that natural gas flows would remain stable.  Deregulation has generally led to lower prices across many markets.  However, sometimes risks are shifted to those with the least ability to manage that risk.  That has been seen in Texas.

Geopolitical news:

  • Brazil was in the news this week as President Bolsonaro removed the head of Petrobras (PBR, USD, 8.72), the Brazilian state oil company.  Bolsonaro fired Castello Branco, who has a post-doc from the University of Chicago, replacing him with Gen. Joaquim Silva e Luna.  Like most parts of the world, fuel prices are politically sensitive; in 2018, rising diesel fuel costs triggered a truckers’ strike that reduced support for Michel Temer, Bolsonaro’s predecessor.  Shares in Petrobras tumbled on the news; the fear is that Bolsonaro will force the company to keep fuel prices low in the face of rising global crude oil prices, hurting margins.
  • Iran continues to send mixed signals to the Biden administration.  On the one hand, it is enriching uranium and restricting IAEA investigators.  On the other, it says it is open to talks.  Our take is that Iran thinks it is dealing with Obama 2.0 and assumes the new U.S. president wants a deal as badly as President Obama did.  We doubt this is the case, so this means that there probably won’t be much movement to restart talks.

Alternative energy/policy news:

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Weekly Geopolitical Report – The U.S.-China Balance of Power: Part V (February 22, 2021)

Posted on by Rebekah Stovall

by Patrick Fearon-Hernandez, CFA | PDF

As the U.S.-China rivalry intensifies in the 21st century, two questions arise. Which is stronger, the United States or China?  Which country is better positioned to protect its interests and achieve its goals?  To gauge the likely trajectory of their relationship in the coming years and assess the investment implications, Part I of this report discussed how the U.S. and China see their vital national interests and key goals.  Part II offered a head-to-head comparison of the armed forces available to each side as they work to achieve their objectives.  Part III compared the economic power of each country, and Part IV assessed their relative diplomatic influence.  We complete the series this week with Part V, where we assess the overall balance of power between the U.S. and China and offer some thoughts on how their rivalry might develop over time.  We conclude with a discussion of the associated opportunities and threats for U.S. investors, at least as long as President Biden is in power.

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Asset Allocation Weekly (February 19, 2021)

Posted on by Rebekah Stovall

by Asset Allocation Committee | PDF

A poor jobs report for January cast doubt about the strength of the recovery. There was only a 49K rise in non-farm payrolls, well below expectations of 105K. Making matters worse, the previous month’s jobs report was revised downward from a loss of 140K to a loss of 225K. The report has not gone unnoticed by the public as policymakers and citizens alike have urged Congress to do more to stimulate the economy. Although the report was generally underwhelming, there were some bright spots. In this report, we will focus on the strength of the labor market recovery and what it could mean for the economy going forward.

On its face, the employment report may be a bit misleading, especially if it is being compared to previous recessions. Due to the pandemic lockdowns, overall employment fell by more than 16% last year, by far the most in history. For comparison purposes, the second largest drop in payrolls was less than half as severe.  On top of that, when lockdown restrictions were lifted, employers were forced to adapt to additional restrictions and regulations designed to protect their consumers and workers. Thus, a return to normalcy was never going to be an easy task. That being said, the gains that we have seen so far are astounding, especially given the circumstances.

In less than a year since the recession started, the labor market has recovered over half of the jobs lost during the pandemic. This is much better than most economists had anticipated. In his remarks to the CFA Society of St. Louis this month, St. Louis Fed President James Bullard claimed that the U.S. labor market recovery is about four years ahead of schedule. Even industries that struggled prior to the pandemic have seen a vast improvement. Retail Trade, which was one of the hardest hit sectors, has recovered 84% of the jobs lost during the pandemic. On a state basis, the recovery is even more impressive as 28 states have outpaced the national recovery in payrolls. In fact, only five of the remaining 23 states (which includes Washington, D.C.) are below one standard deviation of the national average, and four of those states still have restrictions in place that limit business activities. Hence, this recovery has not only been strong but has also been well dispersed throughout the country and will likely improve.

A disproportionate share of the pandemic job losses came in the Leisure & Hospitality sector. By itself, this sector accounted for nearly 40% of the job losses in 2020. However, a deep dive into this data shows hidden surprises. For example, despite reports that restaurants and bars have struggled during the pandemic, dining places have fared far better than other industries within the sector. Since the start of the pandemic, Food & Drink Places have recovered 60% of their job losses, while Arts, Entertainment & Recreation and Accommodation have recovered 39% and 34%, respectively. As the weather improves and restrictions are lifted, we expect payrolls to expand within the Leisure & Hospitality sector as many people (including ourselves) are eager to attend sporting events, musical shows, and concerts again.

(Source: Larry Brown Sports)

A few industries have been able to exceed their pre-pandemic employment levels. For example, the surge in home improvement sales coincided with an all-time high in the number of employees working in Building Material & Garden Supply Stores. Another example can be seen in industries related to housing, where record-low mortgage rates have boosted home buying and residential construction. These outlier industries probably benefited from the fact that many consumers were able to keep their jobs during the pandemic and were willing to use their stimulus checks to purchase goods, homes, and home improvement projects. The additional spending from stimulus not only helped boost sales, but also supported employment.

Although we acknowledge that more needs to be done to aid the recovery, we do believe the labor market is much stronger than most people realize. In our view, the recent stall in payrolls was possibly a blip caused by an unforeseen rise in COVID-19 cases. Therefore, we are optimistic that payrolls will begin to strengthen throughout the year, especially as temperatures begin to rise and vaccines become more readily available. As a result, we anticipate the labor market will still provide a tailwind for equities in the coming months.

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Weekly Energy Update (February 19, 2021)

Posted on by Rebekah Stovall

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

This week’s report is being published on Friday as the DOE data was delayed due to the Presidents’ Day holiday.  Here is an updated crude oil price chart.  Prices continue to rise.

(Source: Barchart.com)

Crude oil inventories fell 7.4 mb when a draw of 2.0 mb was forecast.  The SPR fell 0.1 mb, meaning the draw in commercial inventories was 7.3 mb.

In the details, U.S. crude oil production fell 0.2 mb to 10.8 mbpd.  Exports rose 1.2 mbpd, while imports were unchanged.  Refining activity rose 0.1%.  Next week, we expect a significant drop in both production and refinery operations due to the cold snap.  The impact on crude oil inventories will likely be negative.

(Sources: DOE, CIM)

The above chart shows the annual seasonal pattern for crude oil inventories.  This week’s decline is contraseasonal.  The usual seasonal pattern occurs due to refinery maintenance; in the past, the U.S. oil industry had limited ability to export, which contributed to the seasonal pattern.  With the potential for higher exports, the expected seasonal build may not occur, which would be bullish for prices.  If we were following the normal seasonal pattern, oil inventories would be 28.3 mb higher.

Based on our oil inventory/price model, fair value is $53.02; using the euro/price model, fair value is $68.34.  The combined model, a broader analysis of the oil price, generates a fair value of $59.70.  The divergence continues between the EUR and oil inventory models, although it is narrowing.

Market news:  This week was driven by unusually cold weather that spread well into the South.  Texas, a major oil and gas producing state, was hit hard by the drop in temperatures, which brought havoc on energy production.  Oil output fell about 30% to 40% this week (which will be reflected in next week’s storage data).  At the same time, refinery operations were also affected, so the decline in stockpiles next week will be partially offset by that situation.  Fortunately, we are late in the heating season, and forecasts indicate rising temperatures in the coming days.

  • In response to higher oil prices and the supply problems in the U.S., the KSA announced it will increase oil production to stabilize the market.
  • An issue that pops up every so often is that there is a discrepancy between global oil supply and demand.  Currently, nearly 70% of some 1.4 billion barrels of oil is unaccounted for.  We suspect that some of it is being held in China, which isn’t part of the OECD and thus doesn’t always report its storage.  Another possibility is that it’s due to simple miscounting―either the oil was never there, or we are looking at a significant storage overhead somewhere in the world; if so, this would be a bearish factor.  On the other hand, if most of it is in China, the country would be inclined to hold it, making the storage market-neutral.
  • Royal Dutch Shell (RDS.A, USD, 40.56) has indicated its production has peaked.  This dovetails into our position that supplies will fall in the future, which should support oil prices.  Meanwhile, there are estimates that China’s demand may peak in 2025.
  • One of the risks from a rapid shift away from fossil fuels is that the incidence of the policy could fall disproportionately on the less affluent.  A political reaction will be difficult to avoid.

Geopolitical news:

Alternative energy/policy news:

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