The death of Ruth Bader Ginsburg was yet another political shock for 2020 in a year rife with unusual events. The year began with the first official case of COVID-19 in Washington State on January 20. The pandemic and subsequent measures to contain the virus have led to unprecedented levels of economic volatility. President Trump was acquitted of impeachment on February 5. Relations with China have deteriorated.
As we head into the election, investors’ fears are high. For example, retail money market funds (RMMK) remain elevated, though off their earlier peaks.
Our political cycle monitor suggests that a Biden win could result in a decline in equities into October.
Barring an unexpected landslide, it is quite possible that this election could be disputed. The last time this occurred, in 2000, the election wasn’t decided until December 12, when the Supreme Court effectively ended the recount. George Bush won a narrow victory in Florida and in the Electoral College (271/266). The financial markets were affected by the outcome; in the period from the election on November 7 until the Supreme Court decision, the S&P 500 range from high (made on November 8) to low (made on December 1) was 9.9%. A decline of this magnitude would probably not be enough to warrant substantial portfolio adjustments.
Voter attitudes were not nearly as hardened then as they are now. A Pew survey suggested that 45% of voters thought that the winner really mattered, while 49% believed “things would remain about the same.” Currently, 83% of voters think it really matters who wins and only 16% believe that “things would remain about the same.” The Pew survey suggests that this election is being viewed as zero-sum; losing is perceived as devastating, so both sides are primed to contest a close election.
Although equity markets have performed quite well from their March lows, the recent weakness does appear to be starting the process of discounting a Biden victory. Although we would not necessarily expect a decline to the 90% level implied on the above chart,[1] a period of weakness in the next few weeks is likely.
Is there a precedent for the current election? The best analog is the 1876 election, which was won by Rutherford B. Hayes in the electoral college by a single vote, 185-184 over Samuel J. Tilden. And, that result only occurred weeks after the November ballot. Hayes was given the presidency in return for ending Reconstruction. An analysis of this election will be the subject of an upcoming WGR, but the following chart offers some idea of the impact of an uncertain election outcome when it is perceived as zero-sum.
From March 1876 to March 1877 (when Hayes was inaugurated), the index, on a monthly average basis, fell 29.7%. Although the recovery from the lows was robust, the March 1876 level was not exceeded until October 1879. As we will discuss in the upcoming WGR, the 1876 election occurred during the long depression that began with the Panic of 1873, which was considered the worst economic downturn until the Great Depression. Thus, the disputed election cannot be blamed for the entire decline, but it likely contributed. Increased tensions in the November election is a factor the Asset Allocation Committee will grapple with in the upcoming portfolio rebalance.
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA | PDF
Here is an updated crude oil price chart. The recent dip in prices remains, although we are seeing some recovery.
(Source: Barchart.com)
Crude oil inventories fell when a build was expected. Commercial stockpiles declined 2.0 mb compared to forecasts of a 2.0 mb rise. The SPR declined 8.8 mb; since peaking at 656.1 mb in July, the SPR has drawn 12.8 mb. Given levels in April, we expect that another 8.2 mb will be withdrawn as this oil was placed in the SPR for temporary storage. Taking the SPR into account, storage fell 3.8 mb.
In the details, U.S. crude oil production was unchanged at 10.7 mbpd. Exports rose 0.5 mbpd, while imports were steady. Refining activity rose 1.0%.
(Sources: DOE, CIM)
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 contra-seasonal. Inventories tend to make their second seasonal peak in the coming weeks. Tropical activity has started to wane (it usually ends by Halloween), so the continued decline is bullish for oil prices.
Based on our oil inventory/price model, fair value is $42.90; using the euro/price model, fair value is $63.11. The combined model, a broader analysis of the oil price, generates a fair value of $52.56. The wide divergence continues between the EUR and oil inventory models. As the trend in the dollar rolls over, it is bullish for crude oil. Any supportive news on reducing the inventory overhang could be very bullish for crude oil.
Gasoline consumption continued to decline this week. Seasonally, this is normal. Driving tends to slow as vacation season ends. As the chart shows, consumption declines slowly into mid-January. This year may be different; if a vaccine is developed that increases commuting then we could see driving levels rise, but without that result we should expect overall demand to fall through Q4.
Kuwait’s emir, Sheikh Sabah al-Ahmad al-Jaber al-Sabah, died this week at 91 years old. He was the ruler of Kuwait when Saddam Hussein invaded in 1990. After that event, Kuwait became a close ally of the U.S. He will be succeeded by his half-brother, Crown Prince Sheikh Nawaf al-Ahmad al-Jaber al-Sabah; however, the incoming emir is advanced in age (83 years old) and in poor health. There is a potential leadership conflict that may develop once he dies or becomes incapacitated. The emir opposed normalizing relations with Israel, but with his passing there would be a higher likelihood of Kuwait joining the UAE and of Bahrain recognizing Israel.
Last week, we discussed the growing fear that oil demand has peaked. Demand concerns have kept prices in a tight range, offsetting the bullish impact of dollar weakness. California’s new ban to prevent the sale of internal combustion engine cars by 2035 is further evidence that peak demand may be, at best, coming in the near future. Russian oil companies are criticizing the “green” direction of European oil companies, suggesting it is creating an “existential crisis” for oil supplies. Perhaps another way of thinking about this issue is that it is creating an existential crisis for Russian oil companies.
Background and Summary
In this report, we use the term “commodities” to imply “hard assets.” In our definition, the latter is a commodity that requires multiple years to generate a supply response. This definition excludes agricultural commodities, which tend to create a supply response on an annual basis. That doesn’t mean all agricultural commodities have short-term supply responses. Coffee trees, for example, take three to four years to mature. But, once a tree is mature, a new crop occurs annually. Compare that to a mine which takes years from inception to producing ore. Even oil wells take about a year to drill (from pre-drilling work and actual drilling). Thus, a portfolio based on hard asset commodities will tend to have less supply volatility compared to soft asset commodities.
Secular markets are defined as long-term trends in an asset. There are both secular bear and bull markets. For example, a secular bull market in bonds is characterized by falling inflation expectations that trigger steady declines in interest rates. A secular bear market in bonds is caused by the opposite condition―rising inflation expectations which lead to consistently rising interest rates.
Commodity markets have secular cycles as well. Commodity demand is mostly a function of economic and population growth. Commodity supply comes from agriculture, ranching, mining, and drilling. In capitalist economies, technology usually acts to reduce demand and increase supply. Over time, we have seen consumption per unit fall for many commodities. Technology tends to reduce our per unit consumption; we get more output from consuming less commodities. Technology also enhances production. For example, agricultural technologies have improved production and reduced inputs. The impact of shale technology has revolutionized the oil and natural gas industry. Although globalization and trade can improve commodity demand, it also can make supplies more secure and lead to reduced inventories.
As a general rule, peace, stable economic growth, and orthodox monetary and fiscal policy tend to act as depressants on commodity prices. War, unusually strong economic growth, a breakdown in global order, and unorthodox policy are usually bullish for commodity prices.
When talking about international relations, it’s tempting to describe each country as a monolithic, rational decisionmaker with a settled set of concerns, goals, strategies, and tactics. Examples of such descriptions include: China wants to solidify its claim to the South China Sea; Russia is trying to undermine Western democracies; and the U.S. has tired of global hegemony. This convenient shorthand makes it easier to talk about geopolitics, but it can mask the reality that a country’s behavior is driven by the decisions and initiatives of powerful individuals. Those decisions and initiatives may reflect the country’s traditional perspectives, lessons from history, and habits developed over centuries. They may incorporate today’s popular opinion or the preferences of the ruling classes. But a country’s policies still reflect the decisions of individuals in power as constrained by their personal, political, and bureaucratic environment. Without Napoleon, it’s unlikely that post-revolutionary France would have embarked on its aggression against the rest of Europe in the way that it did. Without Adolf Hitler, neither would post-World War I Germany have done so.
If leaders and leadership really do count, a good example today is Turkish President Recep Tayyip Erdoğan and the way he’s deploying Turkey’s power in Asia Minor. In Part I of this report, we provide a deep dive into Erdoğan’s perspectives, goals, power, initiatives, and constraints. Next week, in Part II, we’ll show how Erdoğan is trying to make Turkey a player in the newly discovered, rich natural gas fields of the Eastern Mediterranean. Since that initiative could lead to a confrontation with other countries, Part II will also explore the potential implications for investors.
For more than a decade, U.S. investors who diversified their risk assets to include foreign equities have been sorely disappointed in the results. Since September 2010, for example, the S&P 500 Index of large cap U.S. stocks has provided an average annual total return of approximately 13.9%, but the MSCI ACWI ex-U.S. Index of foreign stocks has provided a total return averaging just 4.6%. At those rates of return, an all-U.S. stock portfolio would have doubled in value every 5.2 years or so, whereas an all-foreign stock portfolio would have taken about 15.7 years to double. Even a broad index of U.S. corporate bonds would have beaten the broad foreign stock market over the last decade, with only about one-third as much volatility! It should be no wonder that many investors have chosen to exclude foreign stocks from their portfolios.
But if you understand the key drivers behind the U.S. outperformance and foreign underperformance in recent years, it can clarify your thinking about the proper asset allocation strategy for the coming years. As we’ve argued repeatedly, much of the difference in U.S. versus foreign stock returns can be traced to the foreign exchange value of the U.S. dollar. When the greenback is strong and appreciating, the broad U.S. stock indexes tend to show better returns than the foreign indexes. Indeed, the dollar was generally rising from mid-2011 to mid-2020, explaining much of the U.S. outperformance over the last decade. In contrast, when the greenback is weak and falling, foreign indexes tend to outperform. That’s important because it appears the dollar has recently rolled over and begun what could well be an extended slide. If so, the coming period is likely to strongly favor foreign stocks.
Of course, some of the recent outperformance of U.S. stocks simply reflects the preponderance of large cap Technology and Health Care names in the U.S. indexes. Those stocks have been particularly in vogue and have shown extraordinary growth in recent years. Nevertheless, taking a deeper dive into the relative performance of U.S. and foreign stock market sectors shows that the strength of the dollar is the predominant factor. If foreign stocks outperform U.S. stocks across a wide variety of sectors during a weak-dollar period, it should help confirm that the relationship is the most useful guidepost, and that is indeed what the data shows. This can be seen by examining the first chart below, which shows the outperformance of U.S. stocks (represented by striped red columns) versus foreign stocks (solid blue columns) over the last two strong-dollar periods from May 1995 to February 2002 and from May 2011 to July 2020. During these periods, U.S. total returns roundly beat foreign stock returns in all sectors for which comparable data was available (the data exclude real estate).
In contrast, the chart below shows how dramatically foreign stocks turned the tables during the period of dollar weakness from February 2002 to May 2011. In this period, foreign stocks handily beat U.S. returns in almost all sectors. The sectors are shown, from left to right, in the order by which the foreign returns beat the U.S. returns. The graph clearly demonstrates how dramatically foreign Materials, Financials, Communication Services, and Industrials stocks outperformed their U.S. counterparts as the dollar declined. Given the significantly greater exposure to Materials, Financials, and Industrials in the foreign indexes, those sectors account for most of the overall foreign outperformance during the weak-dollar period. In the high-growth Information Technology and Health Care sectors, foreign stocks also outperformed their U.S. counterparts as the dollar declined, but the relative underrepresentation of those stocks abroad kept the foreign outperformance smaller than it otherwise would have been.
Although the data set used in this study only began in 1995, covering just two rising-dollar periods and one falling-dollar period, the relationships described above make logical sense. For example, a low or falling dollar tends to support commodity prices, so foreign Materials firms should see improved finances when the greenback is sliding. Our analysis also indicates that foreign emerging market stocks have an even more pronounced advantage in a falling-dollar phase. In sum, the analysis indicates that if the dollar is indeed falling into a prolonged downtrend like we think, the new investment environment is likely to favor a wide swath of foreign equities in the coming years.
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 August, the diffusion index rose further above contraction territory, signaling that the economy remains on track to expand in Q3. Financial markets were sending positive signals as equities surged, while the yield curve steepened. Meanwhile, the labor market continues to show signs of improvement as hires continue to surpass the pre-pandemic high. Markets responded positively to news regarding the stage of development of various vaccines. However, the lack of progress on additional fiscal stimulus continues to weigh on growth expectations as concerns over slowing consumer spending continue to mount. As a result, five out of the 11 indicators are in contraction territory. The reading for August rose from 0.0303 to 0.0909, above the recovery signal of -0.100.
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.
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA | PDF
Here is an updated crude oil price chart. The recent dip in prices remains, although we are seeing some recovery.
(Source: Barchart.com)
Crude oil inventories fell a bit less than expected. Commercial stockpiles declined 1.6 mb compared to forecasts of a 2.8 mb decline. The SPR declined 0.8 mb; since peaking at 656.1 mb in July, the SPR has drawn 11.0 mb. Given levels in April, we expect that another 10.1 mb will be withdrawn as this oil was placed in the SPR for temporary storage. Taking the SPR into account, storage fell 2.4 mb.
In the details, U.S. crude oil production fell 0.2 mbpd to 10.7 mbpd. Exports rose 0.4 mbpd, while imports rose 0.2 mbpd. Refining activity fell 1.0%.
(Sources: DOE, CIM)
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 contra-seasonal. Inventories tend to make their second seasonal peak in the coming weeks. Tropical activity has been elevated this year and has distorted the data; we won’t get a really clear picture of oil flows for a few weeks.
Based on our oil inventory/price model, fair value is $42.25; using the euro/price model, fair value is $63.79. The combined model, a broader analysis of the oil price, generates a fair value of $52.57. The wide divergence continues between the EUR and oil inventory models. As the trend in the dollar rolls over, it is bullish for crude oil. Any supportive news on reducing the inventory overhang could be very bullish for crude oil.
Gasoline consumption fell a bit this week. Seasonally, this is normal. Driving tends to slow as vacation season ends. As the chart shows, consumption declines slowly into mid-January. This year may be different; if a vaccine is developed that increases commuting then we could see driving levels rise, but without that result we should expect overall demand to fall through Q4.
As we noted last week, the most potent bearish factor for oil prices has been weak demand. The response to the pandemic has led to a sharp drop in consumption around the world. The uneven path of the virus spread has made demand forecasting especially difficult. In general, as the virus situation improves, we should see demand improve. However, the recovery has been slow, especially since emerging markets seem to be the source of much of the slide in consumption. Emerging market economies tend to use more oil per unit of GDP because their economies lean toward goods production. Thus, economic weakness in this sector of the world economy tends to have a disproportionate impact on oil demand. In the long run, rising concern about climate issues is a bearish demand factor for oil. The Business Roundtable’s recent call for carbon pricing, a harbinger for a carbon tax, shows that business leaders are moving on this issue even if the political leadership remains divided. The industry is starting to grapple with the idea of peak oil demand; managing contraction is very difficult. Although the timing of the drop is difficult to discern, the likelihood that demand will fall over time is rising. One of the worries is that if oil reserve owners conclude they are holding a wasting asset, there will be a drive to “dump” their asset at any price. One technology that could save the oil industry is carbon capture. Large oil companies are funding research but, so far, no commercially viable technology has emerged. Given the level of CO2 in the atmosphere already, carbon capture may be necessary even if we reduce oil consumption.
At this week’s U.N. video gathering on the 75th anniversary of the founding of the body, General Secretary Xi said his country would achieve “carbon neutrality” by 2060. National promises on such issues are easy to make but hard to achieve. And, that promise will certainly not be fulfilled in Xi’s lifetime. Nevertheless, if the CPC is serious on this issue, it is bad for the oil demand outlook. Interestingly enough, we doubt this is achievable without a serious expansion of nuclear energy. Nuclear energy has become nearly impossible in the developed world, but it very well could expand in authoritarian China.
This isn’t to say that supply hasn’t played a role in keeping prices depressed; Saudi Arabia is calling out OPEC members who are exceeding quota. Unfortunately, short of triggering another price collapse, there is little the kingdom can do to force compliance.
In Libya, which is in the midst of a civil war, it appears the current oil blockade is going to be lifted. Although this action could increase global oil supplies, in reality, the situation in Libya is so unstable that any flows will likely be intermittent.
Meanwhile, financing conditions in the U.S. oil patch remain perilous. Bankruptcies are rising and companies continue to outspend their revenue, a condition that can only continue with a steady source of funding. One area that has seen a reversal for fortune is the Permian. The lack of pipeline capacity pre-pandemic was a constant problem, leading to wide price differentials as producers faced bottlenecks in getting their oil to refiners. Now they have the opposite problem; the industry responded by building takeaway capacity, only to find now there is more pipeline capacity than production.
The Nord Stream 2 project that will take natural gas directly to Germany has been a point of contention between Washington and Berlin for years. The pipeline is very close to completion and elements within Germany and Russia want to see it finished. The pipeline purposely avoids Ukraine; in the past, when Russia and Ukraine have had issues, Russia would often close or curtail natural gas supplies which would reduce gas to much of Europe. This new pipeline is designed to avoid this problem. The U.S. isn’t fond of Nord Stream 2 because it gives Russia leverage over Germany, so American administrations have consistently tried to get Germany to abandon the project. The recent poisoning of Alexei Navalny increased calls for Germany to scotch the pipeline. Instead, Berlin is offering to support the construction of two new LNG terminals in return for allowing the pipeline to be completed. The idea is that these facilities would allow the U.S. to also supply Germany with natural gas. Therefore, despite everything, it does appear the pipeline will be finished.
Because of Japan’s enormous role in the world, investors need to pay attention whenever the country undergoes a change of leadership as it did last week. After all, Japan currently accounts for some 7% of global stock market capitalization and 6% of the world’s gross domestic product. Not bad for a country whose 126 million people make up just 1.7% of the world’s population! Japan is also a key U.S. ally in the military and diplomatic spheres. It hosts huge U.S. military bases, allowing the U.S. to mount a robust “forward defense” in the Western Pacific, and it’s a vital partner in countering aggression from nations like China and North Korea. With its stable, vibrant democracy and dynamic consumer culture, Japan is a natural partner for the U.S. in East Asia.
But who is Japan’s new prime minister? In this report, we’ll sketch out the biography of Yoshihide Suga and examine how he’s likely to govern in the years ahead. We’ll focus especially on his probable policies in the areas of diplomacy, defense, economics, and finance, and we’ll discuss how effective he might be as a leader. As always, we’ll wrap up with a discussion of what the new prime minister might mean for investors.
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