Asset Allocation Weekly (January 8, 2021)

Posted on January 8, 2021January 7, 2021 by Rebekah Stovall

by Asset Allocation Committee | PDF

Although U.S. equity markets appear richly valued based on historical metrics, relative to interest rates, current values of relative earnings or sales are not extreme. Thus, the direction of interest rates and, more specifically, the direction of monetary policy, is a key element in equity values going forward. In other words, when does the Fed raise rates?

Over the past year, the FOMC has changed its reaction function. Since Volcker, the Fed has tended to tighten policy before full employment is achieved to “preempt” potential inflation. This policy has led analysts to focus on various forms of the “Taylor Rule,” which attempts to calculate the neutral rate of interest given the level of current inflation, the inflation target, and the level of slack in the economy. That policy has ended and has been replaced with a policy that promises to keep rates low until price levels above 2% annual growth are sustained.

Of course, the actual path of policy will be determined by the “buy-in” from the members of the FOMC. Although Chair Powell’s comments suggest he is fully committed to the new policy, it is not clear if it has universal acceptance. At this juncture, there are no dissents, but if inflation starts to rise, we could see some of the more traditional hawks grow uncomfortable with ZIRP. Since an uptick in inflation in 2021 is possible, given base effects alone, it does raise the question—will the Fed stay committed to low rates?

Obviously, it would be foolhardy to claim that rates will stay near zero forever, but it would make sense to have some idea of how long we can comfortably expect ZIRP to remain in place. First, for 2021, based on the composition of the FOMC, we can reasonably expect steady policy.

The above table shows the current members of the FOMC. The committee consists of seven governors and 12 regional Fed bank presidents. The governors are permanent voters as is the president of the New York FRB. Each year, four regional bank presidents also formally vote on policy. Our table shows the current governors on top and the regional presidents below. We rate each on our “hawk/dove” scale and have also categorized them by policy inclination. Moderates and Traditional Hawks rely on standard economic measures to set policy; the Hawks are more inclined to raise rates preemptively, whereas the Moderates tend to have higher tolerance for inflation uncertainty. Doves tend to only raise rates if the evidence is overwhelming for inflation. The Financial Sensitives will entertain rate hikes or other austerity measures when financial markets appear to be overheating. Otherwise, they tend to side with the Doves. We have also updated our estimates, with Powell and Clarida becoming more dovish. The addition of Governor Waller and the current roster of regional FRB presidents make it clear that the new FOMC is much more dovish than in 2020. That would suggest policy will remain steady with a bias for additional easing.

The other factor of note we find important is the relationship of the two-year deferred Eurodollar futures relative to fed funds. The current implied yield of the deferred Eurodollar futures suggests the market expects steady policy for the next 18 to 24 months.

Under normal circumstances, the implied deferred yield is higher than fed funds. In periods where the implied yield falls below fed funds, shown by a vertical line, policy easing tends to occur shortly thereafter. From 2007 into 2013, the level of the implied yield remained stubbornly elevated relative to the fed funds target, suggesting the financial markets didn’t trust the promises of Chair Bernanke to keep rates low. It wasn’t until early 2013 that markets finally accepted that policy would stay steady (and then Bernanke blew it up by announcing the slowing of the balance sheet expansion in 2013). Note the current level of the fed funds target and the implied LIBOR rate. The market completely believes the Fed will keep rates low for at least the next 18 to 24 months.

Overall, with equity valuations high, the key to maintaining these lofty expectations is the level of interest rates. As long as dovish expectations for monetary policy remain in place, these valuations will likely persist.

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Weekly Energy Update (January 7, 2021)

Posted on January 7, 2021January 7, 2021 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 moving higher on dollar weakness and the recent OPEC+ decision, discussed below.

Commercial crude oil inventories fell 8.0 mb, well below the -1.5 mb draw forecast. The SPR was unchanged; there is still 3.1 mb of storage in excess of the 635.0 mb that existed before the pandemic.

In the details, U.S. crude oil production was unchanged at 11.0 mbpd. Exports and imports were also unchanged. Refining activity rose 1.3%.

The above chart shows the annual seasonal pattern for crude oil inventories. Since this is the first reporting week of the year, the data overlaps. But it is important to note that inventories usually rise about 10% into mid-April.

Based on our oil inventory/price model, fair value is $45.18; using the euro/price model, fair value is $75.75. The combined model, a broader analysis of the oil price, generates a fair value of $57.32. The wide divergence continues between the EUR and oil inventory models. Although the inventory issue is a concern, as we note below, if the Saudis are going to play the role of swing producer then the dollar is probably a more important variable.

In geopolitical news, OPEC was in deep negotiations on output policy. The Russians wanted to increase output, while most of the rest of the cartel, including Saudi Arabia, want to hold production steady. Although the group has been able to manage output changes without roiling the market, the underlying problem is that Russia has less production flexibility than the Middle East producers. There are seasonal shut-ins that Russia can execute but closing production in other areas will lead to permanent loss of output. The Saudis resolved the issue, virtually single-handedly, by agreeing to a unilateral cut of 1.0 mbpd. We don’t expect the cartel reduction to be this size as other nations (Russia, Kazakhstan) will fill some of the gap. But, this does show that the Kingdom of Saudi Arabia (KSA) is committed to maintaining price levels at the cost of market share. This action is very bullish, at least for now. At some point, however, the KSA will want its market share back. In effect, the KSA is acting as swing producer as it did from 1973 to 1985. In December 1985, the KSA signaled it was no longer willing to cede market share to prop up prices. The end result was a 66% plunge in oil prices. We doubt the Saudis intend to return to the swing producer role on a permanent basis, but their actions create a precedent that will be hard to undo. One other interesting fact—for the first time in 35 years, the U.S. didn’t import any crude oil from Saudi Arabia.

In other geopolitical news:

Tensions with Iran remain elevated. The U.S. initially moved the U.S.S. Nimitz out of the region then sent it back; B-52s have been located into the area. Iran announced it will increase uranium enrichment, which will complicate the incoming Biden administration’s attempt to return to the Obama-era nuclear deal. It will complicate regional tensions as well.
Iraq has announced that China is prepaying a year’s worth of imports. This will relieve fiscal pressure on Baghdad and, at the same time, enhance China’s influence in the Middle East.
Qatar and Saudi Arabia are ending their feud that led to the border being sealed. Although we don’t think the issues have been fully resolved, it appears that the Saudis have concluded it isn’t in their interest to maintain hostile relations. The blockade simply allowed Turkey to increase its influence in the region and thus has to be seen as a foreign policy error.
Venezuelan President Maduro has solidified his power in the country by regaining control of the legislature. Although not a pressing problem, the regime in Caracas remains an unresolved problem. The UAE, usually an ally of the U.S., has become a key link in Venezuela’s sanction avoidance.
The World Bank reduced its GDP growth forecast for 2021; weaker growth is a negative factor for oil demand, and if the expected rebound fails to materialize this year then oil prices will face bearish pressure.

Here is what we are following in alternative energy news:

Carbon sequester has been part of climate policy for some time. There are two primary areas; the first is through biological methods, e.g., planting trees and carbon-absorbing crops. The second uses physical methods to pull carbon dioxide out of the air. On the former, we are seeing a surge in interest from the farm sector. In Europe, planting grasses in peat bogs is being considered. Peat tends to hold large amounts of CO₂; drying it out tends to release it into the atmosphere. Farmers are considering rewetting dried out peat bogs and planting new grasses for harvest. In the U.S., paying farmers to change practices to capture carbon is being discussed. Providing money to farmers for changes in agricultural practices will be politically popular and thus we would expect policy momentum to develop on this issue.
- Carbon capture was part of the omnibus government funding bill.
For the first time since 1885, the U.S. consumed more green energy last year than coal.
We continue to monitor developments on the hydrogen front.
- Geopolitically, the end of oil could be disastrous for Middle East oil producers. However, that is only true if they fail to adapt. There are discussions in the region about using solar energy to produce hydrogen and convert it to ammonia for cheap shipping.
- Using hydrogen for a shipping fuel is being investigated.
- Although hydrogen, by itself, is quite green, making it can be anything but environmentally friendly. Using coal-fired electricity to make hydrogen is hardly worth the effort. But, as we have discussed recently, turning to nuclear power for making hydrogen could create a fuel free of fossil fuels. Instead of the large reactors used for electricity, the industry is moving toward modular reactors than can be mass produced and moved to production areas. Improving the efficiency of catalysts to extract hydrogen from water is also being researched.
- Oil majors are starting to make larger investments in this area. Expanding scale is important to achieve the goal of lower cost.
On auto-electrification, the next “new thing” is the solid-state battery. Such a device would make the cars safer and allow for rapid recharging. Here is an update. Another area to watch is recycling. As more electric cars are produced, the need to recycle old batteries will become more important. If the recycling industry expands, it should reduce the need for metals mining.

Here is what we are following in energy policy:

As President Biden slowly moves toward the Oval Office, the energy industry braces for policy changes. Clearly, there will be more focus on reducing carbon emissions, which is not good news for the oil and gas industry. At the same time, Biden is a centrist and lacks the power to make sweeping changes to the industry. We would expect less direct intervention from the president compared to the Trump administration, but there will be changes that will likely help alternative energy and larger oil companies.
Another area we are watching is the impact of central banks on climate change policy. Although we are not seeing anything direct, it is clearly on the radar screen. One area where we could see intervention is in central bank buying of “green bonds.”

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Daily Comment (December 18, 2020)

Posted on December 18, 2020December 18, 2020 by Rebekah Stovall

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

[Posted: 9:30 AM EDT] | PDF

Good morning and happy Friday! Although Congress remains in session and Brexit could interfere with the MP’s Christmas, the rest of the world is winding down for the holidays. U.S. equity futures are mostly steady this morning. One thing to watch—Tesla (TSLA, USD, 655.90) joins the S&P 500 Index today. It is the largest firm by market value to be added to the index, so we could see some distortions. Adding to the “excitement” is that it’s a quadruple witching day, meaning stock index futures, options on those futures, regular stock options, and single stock futures all expire today.

We begin our coverage with the Russian hack; we don’t know much yet, but it looks widespread. We take a quick look at the Bank of Japan’s monetary policy. Policy and economics follow. China news is next; a battle between populists and the establishment regarding China policy is brewing. Pandemic news follows, and then an update on the EU and Brexit. Being Friday, the Asset Allocation Weekly, the last of 2020, is available, along with the associated podcast and chart book. As a reminder, starting in January, in a bid to shorten this report, we will no longer publish the AAW at the bottom of the Daily. It will be available only as a stand-alone report but linked within the Daily Comment. And, the Daily Comment will go on holiday hiatus starting Dec. 23 and return on Jan. 4. Here are the details:

The Hack: We are still in the early stages of this event, but it is shaping up to be significant. First, as we learn more, it is becoming clear this was a very sophisticated attack. Currently, it looks like at least 18 thousand companies and government agencies have been compromised, including Homeland Security and the Pentagon. Although SolarWinds (SWI, USD, 17.60) was a key path to inserting malicious software, it wasn’t the only tactic deployed. Second, researchers are expressing surprise at the degree of effort involved. The attackers focused on U.S. technology, which avoids the red flag of foreign origin. They didn’t reuse code, which is also a way that cyber analysts detect breaches. Third, there is a potentially great risk to infrastructure. At this point, we don’t know if the goal was merely to gather information or to disrupt operations. It may take years to discover the full depth of this intrusion.

The term “act of war” is starting to show up in the media. Although we don’t use this term loosely, this event has the characteristics of state conflict. We have been thinking about the entire notion of war for some time. Clausewitz postulated that the point of war was to convince an opponent’s civilian population that resistance is futile; cooperating with the aims of the victorious foreign power is the only alternative. Although militaries still matter, propaganda and cyberwar can directly affect the civilian population and may be an alternative to direct military conflict. For example, if a foreign power can control news flow or critical infrastructure, e.g., electricity, water, etc., the need to wage a military conflict may lessen. Given the U.S. dominance in military affairs, focusing on direct non-military intervention on civilians seems reasonable. The trick for a country being attacked is the response. The U.S. has ample cyber capabilities. We will be watching for retaliation. Where this situation leads remains unknown.

The BOJ: Meetings of Japan’s central bank tend to be interesting because the country has been something of a harbinger of where the rest of the world has moved. Despite massive expansions of the balance sheet, Japan has been completely stymied in its attempts to raise price levels. Today, the bank announced a policy review to look at its current policies to reflate the economy. Given our expectations of JPY appreciation, we will be watching to see just how radical the bank will go (What is most radical? Buying U.S. Treasuries to expand the balance sheet.)

Policy and economics: Congress continues to negotiate on a stimulus package; the latest wrinkle is an attempt by GOP lawmakers to restrict the Fed from restarting its emergency credit facilities that expire at year’s end. The worry among lawmakers is that a future Congress could use the Fed’s balance sheet for fiscal stimulus, removing lawmakers from such decisions.[1] As we have noted before, lawmakers have to exercise great care in how they approach this issue. On the one hand, there is a risk that the Fed could take a bond-buying program and use it to facilitate spending. It isn’t hard to imagine a muni bond backstop evolving into a program that supports the borrowing efforts of state and local governments. At the same time, there is a difference between directly lending to support spending and providing a market backstop. For a financial system that is dominated by shadow banking, there is a need for the Fed to act as a dealer of last resort. Shadow banking is essentially a carry trade—to use the colloquial, it’s “grabbing nickels in front of steamrollers.” 2008 proved it is impossible to know beforehand where the risks lie. Therefore, if a certain instrument has become repo’d to the point where the inability to make a market leads to a financial crisis, only the Fed can provide a two-sided market to maintain liquidity. These programs need to be readily available; although it may be ok to let them lapse in the short run, policymakers must understand that they may be needed at a moment’s notice. The risk is that Congress won’t act quickly enough. It would probably be preferable to leave the programs in place with Congressional oversight to ensure the central bank is only providing a backstop.

Although it may only last for a short time, we may see a government shutdown. Spending authorization ends today, but with Congress focused on a stimulus bill, the reauthorization has fallen by the wayside.
Amazon (AMZN, USD, 3236.08) is facing a union vote at an Alabama warehouse. Under normal circumstances, if the workers vote to unionize, we would expect the company to simply move operations elsewhere. However, in the current environment, that might not work.

China: There is a classic establishment versus populist dual setting up within the administration. Representing the establishment is the Treasury, seeking to limit the scope of President Trump’s executive order banning U.S. investors from purchasing equities of Chinese companies with links to the PLA. On the other side is the State Department and the Pentagon, who want to include affiliates and subsidiaries, thus widening the breadth of the order. Although there are obvious elements of the business v. the security organs, we also would frame this as establishment v. populists. The establishment supports globalization, and thus, wants to reduce the impact of investment limitations on China. The populists oppose globalization and want to expand restrictions. This current battle will end with a new president, but we will be watching to see how the Biden administration handles this issue. LWP will be just as opposed to a narrow reading as RWP. Early indications hint that the Biden administration leans more towards the establishment.

The U.S. is using its export blacklist to restrict Semiconductor Manufacturing International (SMICY, USD 13.34) purchases of American tech equipment. Without access to U.S. semiconductor manufacturing equipment, the company would not be able to build 10-nanometer circuits, effectively leaving them capable to make only older-generation chips.
China’s unmanned moon mission has returned carrying moon rocks. We will be awaiting word to see what they find out about their rocks; here is one explanation of what the U.S. found.
China is creating a fifth “bad bank.” Yesterday, we discussed how these worked in an EU context.

COVID-19: The number of reported cases is 75,096,337 with 1,665,211 fatalities. In the U.S., there are 17,215,045 confirmed cases with 310,801 deaths. For illustration purposes, the FT has created an interactive chart that allows one to compare cases across nations using similar scaling metrics. The FT has also issued an economic tracker that looks across countries with high-frequency data on various factors. The R_t data continues to show improvement, suggesting that the current surge in infections is peaking. Currently, 17 states have a reading of less than 1, compared to last week’s eight, suggesting a falling infection rate. Wyoming has the lowest reading, and Maine has the highest. Over the past seven days, the infection rate in the U.S. is 0.45% or one in 200.

Virology

It looks like we are seeing some logistical issues developing. Several states are reporting that they are not getting all the vaccine doses they were promised; at the same time, Pfizer (PFE, USD, 38.03) is suggesting it has ample doses in its warehouses. Although these headlines are alarming, it should be remembered that the distribution of this vaccine, which requires super-cold temperatures, was bound to have some initial snags. The fact that doses appear available should mean that this situation will be resolved.
The FDA is expected to approve the Moderna (MNRA, USD, 144.00) vaccine. It should be easier to distribute, as its storage requirements are less onerous.
Brazil says it won’t distribute China’s vaccines due to the lack of transparency.
There are reports that vaccine offers are being made on the dark web.
Sweden’s king admits his country’s virus strategy has been a failure.
One bright spot is that COVID-19 precautions have mostly contained the usual influenza season.

The EU and Brexit: China and the EU are working on an investment deal. If it does get done, it will be interesting to see the U.S. reaction. The Brexit talks have it a new snag; PM Johnson is arguing that the recently passed EU stimulus should not be exempt from the level playing field discussions. The GBP has eased on the reports.

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[1] MMT proponents have argued for similar ideas, such as the creation of a Fed-like body that would make fiscal spending decisions without the need for Congressional approval.

Asset Allocation Weekly – #22 (Posted 12/18/20)

Posted on December 18, 2020June 12, 2023 by Rebekah Stovall

Asset Allocation Weekly (December 18, 2020)

Posted on December 18, 2020December 17, 2020 by Rebekah Stovall

by Asset Allocation Committee | PDF

(N.B. Due to the upcoming holiday season, this report will be the last Asset Allocation Weekly for 2020. The next report will be published on January 8, 2021.)

While 2020 was a year in which the word “unprecedented” has been used a lot, there are many areas where the term is appropriate. One area of interest is in the growth of liquidity. The chart below is one we have featured often, showing retail money market fund levels (RMMK) and the S&P 500.

The gray bars show recessions, while the orange bars show periods where RMMK fell below $920 billion. Our position has been that when we are in the orange parts of the chart, there is a dearth of liquidity and equity markets tend to stall. On the other hand, periods of rapid RMMK accumulation have tended to be periods of equity weakness.

In 2018, as the trade war escalated, RMMK began to rise sharply. It continued to rise throughout 2019 into 2020. The pandemic led to another leg higher in RMMK. The level of RMMK has fallen from the highs set earlier in the year but it remains elevated. As noted above, when RMMK rises sharply, equities tend to suffer. We did see some evidence of that in 2018, but last year equities continued to trend higher despite the rise in RMMK. Pandemic worries and a brewing financial crisis led to a sharp selloff in the S&P 500, but the market turned as policymakers moved quickly to support the economy.

It is clear that the level of RMMK is high, but the difficulty is determining “how high.” For that, analysts usually try to scale the data to make it comparable across periods. A logical scale variable may be in comparing the level of RMMK to household financial assets. The problem with that variable is that it is very sensitive to the level of equities; in other works, cash levels seem to rise coincident with a fall in equity values. Most of the decline occurs due to the fall in equity values, not to cash accumulation. The other problem with scaling is finding the answer to the question at hand. What we want to know is if RMMK levels fall, will the funds go to stocks or elsewhere? We assume that RMMK is the closest asset to equities of fixed income; in other words, demand or savings deposits probably represent the desire to hold cash, whereas RMMK is where liquidated financial assets go before they are placed elsewhere.

The chart on the left shows the asset allocation of the top 10% of households. Note that about 50% of this income group’s assets are in equities. That is far larger than the middle income group (89% to 51%), which holds 25% in equities, and the bottom 50%, which has equity holdings of 10%. The chart on the right shows that the RMMK holdings for the top 10% group rose from 15% to near 20% from 2018 to 2020, coinciding with the rise in RMMK shown in the first chart.

These charts suggest that most of the RMMK accumulation occurred in an income group most inclined to buy equities. Accordingly, the elevated level of RMMK should be supportive for equities. At the same time, in 2008, RMMK held by the top 10% reached nearly 30%. Thus, we may not see as large of a recovery as we saw during 2009-11. Still, there does appear to be ample liquidity available for stocks, and given the low level of interest rates, flows should continue to be supportive for equities.

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Weekly Energy Update (December 17, 2020)

Posted on December 17, 2020December 16, 2020 by Rebekah Stovall

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

A note to readers: The Weekly Energy Update will go on holiday hiatus following today’s report and will return on January 7, 2021. From all of us at Confluence Investment Management, we want to wish you a Merry Christmas and Happy New Year! See you in 2021!

Here is an updated crude oil price chart. Prices are taking another leg higher on hopes of stronger demand.

Commercial crude oil inventories fell 3.1 mb, in line with the 3.0 mb draw forecast. The SPR was unchanged; there is still 3.1 mb of storage in excess of the 635.0 mb that existed before the pandemic.

In the details, U.S. crude oil production fell 0.1 mbpd to 11.0 mbpd. Exports rose 0.8 mbpd, while imports declined 1.1 mbpd. Refining activity fell 0.8%.

The above chart shows the annual seasonal pattern for crude oil inventories. This week’s data showed a decline in crude oil stockpiles, which is normal. Inventories usually decline into year-end.

Based on our oil inventory/price model, fair value is $40.30; using the euro/price model, fair value is $69.70. The combined model, a broader analysis of the oil price, generates a fair value of $53.42. The wide divergence continues between the EUR and oil inventory models. This week’s jump in oil inventories led to a large decline in the oil model forecast, while the weaker dollar boosted the EUR model forecast. Overall, the dollar probably has a greater impact on oil prices and thus should keep the market elevated despite high levels of supply.

The IEA report for December continued to paint a bleak outlook for oil as demand remains weak. For 2021, the group projects demand at 96.9 mbpd, still below the 100.1 mbpd seen pre-pandemic. At the same time, supply is creeping higher as U.S. production recovers, Libya comes back on-line, and OPEC begins retaking market share. Still, as we note above, the weaker dollar is a strong catalyst for higher prices and may overcome otherwise soft fundamentals.

Natural gas producers are becoming increasingly adept at adjusting production to market conditions. If this practice becomes widespread, it could lead to stable natural gas prices. Simply put, instead of prices adjusting, supply adjusts.

In geopolitical news:

There was an attack on an oil tanker in the Red Sea near the port Jiddah. It is suspected that a vessel controlled by Yemeni Houthis was likely behind the attack. A drone boat probably was deployed by the rebels. The U.S. added additional sanctions on Iran for the abduction and likely death of former FBI agent Robert Levinson. He was abducted in 2007 but this is the first formal action against Iran for the event.
Iran has been exporting more oil despite sanctions, with most of the oil going to China. Iran’s exports remain well below normal levels due to American sanctions.
Meanwhile, as Arab states normalize relations with Israel (likely creating a potent coalition to oppose Iran), Iran is moving some of its nuclear production to underground facilities to protect against attack.
Saudi Aramco (2222, SAR, 35.60) has a long reputation for being a good work environment for expat workers. However, a recent report from the FT suggests that may no longer be the case as financial pressures rise on the company. The report suggests the company is cutting corners on safety, likely to meet financial goals.
The kingdom is also introducing austerity to reduce its fiscal deficit; usually, such actions are reversed due to fears of civil unrest.

Here is the roundup of climate and alternative energy news:

Exxon (XOM, USD, 43.04) announced a series of carbon reduction measures. The company is promising to reduce emissions intensity (carbon per unit of production) rather than a full cut. In other words, if intensity falls but production rises, the overall output of carbon will continue to rise. Exxon is facing growing pressure from the investor community to reduce its carbon emissions. This is a factor affecting the energy sector; although we have seen a rise in equity values recently, it may be a mere recovery bounce.
- This brings us to a broader issue. How should investors treat the oil and gas sector? A case can be made that the future for oil and gas is in peril. Oil and gas are being hit from all sides between technology that reduces the need for travel, the electrification of transportation, the growing likelihood of a carbon tax, and investor pressure to reduce carbon. And yet, in the here and now, it is clear that we still need oil and gas. The last three months have seen a strong recovery; the question now is how long will this last?
- A key point to remember is that equity markets are anticipatory markets, whereas commodity markets are not. In other words, the value of a stock is ultimately based on future cash flows; if the future is “cloudy,” investors tend to reduce the value of cash flows into that unclear future. On the other hand, commodities don’t really pay a future stream of cash (despite academic studies that suggest one can generate cash from futures roll yield, it can just as easily turn into a cost depending on the shape of the futures curve) and the value of commodities is (a) the value of processing it into a product, and (b) changes in price between now and the future. In this situation, we could very easily see oil and gas equities underperform the commodity; in fact, this has been a feature of the market for the past few years.
- Industries in decline can still be investible. Tobacco proves that one can make money in a pariah group. On the other hand, coal has been a destroyer of capital. The difference is complicated, but industry concentration plays a role as does the ability to shape regulation. Tobacco did a masterful job, e.g., eventually turning the states into supporters of smoking. Coal did not. If the oil and gas sector takes steps to address climate change and carbon mitigation (e.g., support a carbon tax,[1] invest heavily in carbon capture, branch into alternative energy), the sector might do fine. If it fails to manage the situation, oil and gas could resemble the path of coal equities.
China is promising to reduce its carbon intensity (see above) by 65% by the end of the decade. We take these promises with a grain of salt. China is still the world’s largest consumer of coal, a fuel with a high carbon content, and the country is continually expanding its coal-fired electricity capacity. We view this as mostly a public relations move.
- At the same time, as we have noted in recent Daily Comments, China has been seeing a spate of corporate defaults, especially in the SOE sector. However, we note that the Xi government did rescue Tianqi Lithium (002466, CNY, 31.38) when it was facing a deadline on a bank loan. The company is the world’s largest lithium producer, and this move by the state suggests it is being treated as a national champion. The recent plunge in lithium prices has undermined the company’s ability to manage the default.
- One of the emerging themes is that the energy world is moving from oil and gas to metals. In other words, alternative energies and electrification of transportation will require lots more metal (e.g., lithium, cobalt, nickel, aluminum, copper) and much less oil and gas. Since the turn of the last century, oil has been a primary factor in geopolitics. That may not be the case in the future; instead, the pivot will be mines.
Although electric cars are still in the forefront, fuel cell vehicles, powered by hydrogen, may end up being the winner. Hydrogen can be produced from fossil fuels (gray), natural gas (blue), or electricity (green). Green hydrogen comes from generating electricity from a non-fossil fuel source (hydro, solar, wind, nuclear) and splitting water to get the hydrogen. A fuel cell takes the hydrogen, and its waste product is water.
- This is where nuclear comes in. Since the Three-Mile Island/Chernobyl/Fukushima disasters, nuclear power has been considered a pariah by environmentalists. However, we are starting to see a reassessment among this group that reducing carbon emissions is probably impossible without nuclear power. Like everything, the decision to use nuclear is a tradeoff; as the above referenced events show, nuclear power can be dangerous. At the same time, rising levels of carbon dioxide in the atmosphere is also considered a danger.
- The nuclear industry has been building smaller modular reactors that could be used to make green hydrogen. Modular technology could make permitting easier (once the model is approved, it can be replicated without another permit) and established where needed. If these reactors become commonplace, it could bring a renaissance to the nuclear industry.

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[1] And the level of the tax.

Weekly Geopolitical Report – The 2021 Geopolitical Outlook (December 14, 2020)

Posted on December 14, 2020 by Rebekah Stovall

by Bill O’Grady & Patrick Fearon-Hernandez, CFA | PDF

(This is the last report of 2020; the next report will be published on January 11, 2021.)

As is our custom, in mid-December, we publish our geopolitical outlook for the upcoming 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 landscape for 2021. 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 Establishment Strikes Back

Issue #2: Anti-China Alliance Building

Issue #3: The Middle East

Issue #4: North Korea

Issue #5: Inflation Up, Real Yields Down

Read the full report

2021 Outlook: The Recovery Year (December 14, 2020)

Posted on December 14, 2020December 14, 2020 by Rebekah Stovall

by Bill O’Grady & Mark Keller | PDF

Summary:

The economy is in recovery, but the expansion phase of the cycle (where economic output exceeds its prior peak) isn’t likely to begin until 2022. We look for weak first quarter growth followed by more notable strength for the remaining three quarters as the COVID-19 vaccines are distributed.
Monetary policy has made a historic shift:
1. Volcker’s policy of pre-emption to prevent the return of inflation expectations has ended. Thus, policy tightening won’t occur until there is clear evidence of sustainable inflation.
2. The Fed is actively taking steps to prevent asset runs across the non-bank financial system. This policy will stabilize the financial system at the cost of creating moral hazard.
3. To address inequality, the Fed will actively try to extend the business cycle.
The liquidity injection into the economy is unprecedented. Determining the flow of this liquidity is the key element to forecasting the economy and asset markets.
Inflation may rise in H2 2021 if vaccine distribution triggers pent-up spending. But we don’t expect a rise to exceed 3% of core PCE and it won’t bring a reversal in monetary policy. We also don’t expect the rise to be sustained due to the underlying factors dampening inflation.
Our forecast for 2021 S&P 500 earnings is $147.84 with a multiple of 26.5x. The forecast range for the index is 3918-4050.
1. Given the level of liquidity, there is a substantial likelihood of exceeding this forecast.
2. We favor small and mid-caps over large caps.
3. The growth/value ratio is at an extreme, favoring the former. If the economy improves as we expect, a reversal of this ratio is likely, although it may not favor the entire spectrum of value stocks. Cyclical stocks should perform well.
4. Our expectation of dollar weakness should support international stocks for dollar-based investors.
In fixed income, we favor investment-grade corporates. High yield appears fully valued and duration risk should be avoided.
Commodities should be supported by better economic growth and a weaker dollar. Oil prices will likely lag, holding in the low $50s for WTI. We favor other commodities, and view gold as attractive at current levels.

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Asset Allocation Weekly – #21 (Posted 12/11/20)

Posted on December 11, 2020June 12, 2023 by Rebekah Stovall