Author: Rebekah Stovall
Asset Allocation Weekly (September 18, 2020)
by Asset Allocation Committee | PDF
In June, we published a WGR on the EU’s decision to issue a Eurobond, a financial instrument backed by the full faith and credit of all the member states of the European Union. One of the reasons the U.S. dollar remains the global reserve currency is because the world financial system works on a dollar/Treasury standard. The U.S. has open trade and capital markets. Because of America’s willingness to accept persistent trade deficits, foreign countries can acquire dollars through trade and easily hold those dollars in reserve in the deep American financial markets. The premier reserve instrument has been the U.S. Treasury; in fact, it could be argued that the Treasury is America’s greatest export product.
The attractiveness of the dollar as a reserve instrument is relative; American management of the reserve currency is far from ideal. When the world shifted from the dollar/gold to dollar/Treasury, Europeans complained that the U.S. was exporting inflation through a weaker currency. Treasury Secretary Connally noted that the dollar “is our currency but it’s your problem.” Volcker’s anti-inflation policies of the early 1980s was a major contributor to the Latin American debt crisis and the “lost decade” of the 1980s for South America. Since 9/11, the U.S. has used financial sanctions as a foreign policy tool. Restricting access to the U.S. financial system has proven to be very effective in crippling foreign economies.[1] But, these sanctions are not popular with foreign governments. Dissatisfaction with dollar management has not reached a level adequate to overcome the network effects that keep the dollar as the reserve asset.
It is important to note that we view the introduction of a Eurobond as a catalyst for a change in trend but the primary reason for a new dollar bear market is valuation. Against most major currencies, the dollar is deeply overvalued.
Our primary valuation model for currencies is purchasing power parity. This model uses relative inflation to value currencies. It is not a trading model; exchange rates tend to vacillate around the forecast parity level. But, at extremes, it can signal that the exchange rate is vulnerable to a reversal. In general, dollar bull markets tend to end with a catalyst. The 1970s dollar bear market began with the closing of the gold window. The 1985 bull market ended with the Plaza Accord. The 2002 trend reversal began with statements pressing for a weaker dollar from the U.S. Treasury secretary. As is true of many markets, valuation alone doesn’t cause reversals, but it creates conditions where a reversal is more likely.
Perhaps another way of thinking about the dollar is that the exchange rate creates winners and losers. A strong dollar adversely affects exporters and industries that compete with imports. It supports importers and solely domestic industries. A weak dollar has the opposite impact. Thus, over time, when a sector is harmed a political reaction will follow which leads to a reversal in trend. With the dollar, the cycles tend to be long, meaning that the level needs to be extreme to trigger a policy response.
This chart shows the JP Morgan Dollar Index, which is adjusted for inflation and is trade weighted.[2] Bull markets are colored in green, and bear markets in mauve. For a U.S. dollar investor, the path of the dollar’s exchange rate is a critical component of foreign investing.
This table uses the dollar cycle dates and compares the MSCI U.S. Index with the MSCI World ex-U.S. Index. We use the yearly change in monthly data, averaged over each cycle. On average, the latter index outperforms the U.S. in dollar bear markets, whereas the U.S. outperforms during dollar bull markets. There are two other characteristics of note. First, cycles last a while; the average dollar bear market lasts 111 months (just over nine years) and dollar bull markets last 88 months (eight years). Second, dollar bear markets tend to have higher levels of volatility.
If our postulate is correct and the dollar is about to enter a bear market, the outlook for foreign stocks relative to domestic stocks improves. Although there is no certainty that our position is correct, the combination of an overvalued currency, a lengthy bull market, and a Eurobond catalyst increases the odds that a reversal is likely. If so, the outlook for foreign equities should improve.
[1] Iran can attest to this assertion.
[2] Countries that conduct more trade with the U.S. are weighted more heavily in the index.
Weekly Energy Update (September 17, 2020)
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.
Crude oil inventories fell when a rise was expected. Commercial stockpiles declined 4.4 mb compared to forecasts of a 2.3 mb rise. The SPR declined 2.1 mb; since peaking at 656.1 mb in July, the SPR has drawn 10.2 mb. Given levels in April, we expect that another 10.9 mb will be withdrawn as this oil was placed in the SPR for temporary storage. Taking the SPR into account, storage fell 6.5 mb.
In the details, U.S. crude oil production rose 0.9 mbpd to 10.9 mbpd. Exports fell 0.3 mbpd, while imports rose 0.4 mbpd. Refining activity rose 4.0%.
The above chart shows the annual seasonal pattern for crude oil inventories. This week’s data showed a decline in crude oil stockpiles. We are starting the seasonal build period. Stockpiles remain well above seasonal norms and remain a bearish factor.
Based on our oil inventory/price model, fair value is $41.27; using the euro/price model, fair value is $64.17. The combined model, a broader analysis of the oil price, generates a fair value of $52.47. 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 rise, but without that result we should expect overall demand to fall through Q4.
On a long-term basis, we are seeing a profound decline in miles driven. This dovetails into the discussion below on peak oil demand.
The chart on the left shows miles driven on a rolling 12-month basis. The gray bars indicate periods when the number didn’t make a new high. There were three periods of significant stalls in driving activity. The first two were a combination of recession and high oil prices. The last one was mostly due to the Great Financial Crisis, although the high oil prices in 2008 did play a minor role. Of course, the pandemic has caused a steep decline. The chart on the right shows a simple trend model. Driving fell below-trend in 2009 and has remained below-trend ever since. This decline in driving is part of the peak oil discussion.
This was the week of peak oil demand, and a number of sources, including BP (BP, 19.66), are warning that the world may be close to the maximum of oil consumption. Continued electrification of transportation and improved consumption efficiency in oil use are the primary factors in bringing the peak. Meanwhile, for this and next year, major data providers, including OPEC, are projecting weaker than previously forecast consumption.
As we have noted in earlier reports, the Trump administration has been caught between two constituencies, farmers and the oil industry. The former wants to force the refining industry to meet the goals set by the EPA for biofuel consumption. The latter wants to avoid them. For the most part, the administration has been granting waivers to refiners to allow them to use less biofuels than mandated. The administration has decided to void exemptions to small refiners; electorally, this decision boosts Iowa at the expense of Texas.
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Weekly Geopolitical Report – The New Spain (September 14, 2020)
by Thomas Wash | PDF
Plaza de Toros de Las Ventas is the largest bullfighting arena in Spain and the third largest in the world. Located east of Central Madrid, the arena, with its almost 100-year history, attracts tourists from around the world who want to experience authentic Spanish culture. However, the pandemic has put Plaza de Toros on life support. Not only have lockdown restrictions prevented the arena from opening during peak season, but strict travel bans and quarantine measures will likely halt foreign tourism for the foreseeable future.
Bullfighting is not alone as other tourist destinations were also forced to close due to lockdowns. When the pandemic struck in early March, restrictions limited flights, closed restaurants, suspended hotel reservations, and stopped sporting and theatrical events. The accommodation and food services sector, which makes up a fifth of the Spanish economy, contracted 10% from the prior year. Unemployment claims have risen 29% since February.
As the fourth largest economy in Europe, Spain’s recovery will be critical for the European Union to get out of its economic slump. In this report, we will focus primarily on how the virus is affecting the Spanish economy. We will start our discussion with a broad overview of the economy. With this baseline, we will review the impact the virus has had on the country and possible changes going forward. We will conclude the report with potential market ramifications.
Weekly Energy Update (September 11, 2020)
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA | PDF
Here is an updated crude oil price chart. The oil market has come under pressure following the decline in equity prices this week. Although volatility has been falling since April, recent option market activity suggests traders are bracing for larger prices swings in the coming weeks.
Crude oil inventories rose when a decline was expected. Commercial stockpiles rose 2.0 mb compared to forecasts of a 3.2 mb decline. The SPR declined 0.2 mb; since peaking at 656.1 mb in July, the SPR has drawn 8.1 mb. Given levels in April, we expect that another 13.0 mb will be withdrawn as this oil was placed in the SPR for temporary storage. Taking the SPR into account, storage rose 1.7 mb.
In the details, U.S. crude oil production rose 0.3 mbpd to 10.0 mbpd. Exports fell 0.1 mbpd, while imports rose 0.5 mbpd. Refining activity fell 4.9%.
The above chart shows the annual seasonal pattern for crude oil inventories. This week’s data showed a modest rise in crude oil stockpiles. We are starting the seasonal build period. Stockpiles remain well above seasonal norms and remain a bearish factor.
Based on our oil inventory/price model, fair value is $40.31; using the euro/price model, fair value is $64.17. The combined model, a broader analysis of the oil price, generates a fair value of $51.77. 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 rise, but without that result we should expect overall demand to fall through Q4.
As the U.S. retreats from hegemony, China is extending its influence into the Middle East. The Middle Kingdom is now Iraq’s largest trading partner and is also a major consumer of Iranian oil. We have been waiting to see how other nations would respond to the change in U.S. status. China is clearly filling the gap, although it will be interesting to see how it avoids the messy areas (Syria, Turkey) of the region to protect the oil flows.
There is growing evidence that the Kingdom of Saudi Arabia (KSA) has concluded that additional supply cuts will simply lead to lost market share. Thus, it intends to maintain production levels even as prices show signs of weakening.
We continue to monitor what appear to be increasingly extreme weather events. Recent hurricanes have been strong and the current fire season on the West Coast has been catastrophic. Commodities markets are often used by traders to hedge or speculate on the impact of such events. The Commodity Futures Trading Commission (CFTC) has noticed this tendency and a special climate committee has issued a warning calling for measures to be taken to address climate risks. Carbon pricing markets could be part of the solution.
The Iranian tanker carrying gasoline bound for Venezuela that was seized in August has made its way to Texas this week. It is unclear what the government intends to do with the fuel.
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Asset Allocation Weekly – #10 (Posted 9/4/20)
Asset Allocation Weekly (September 4, 2020)
by Asset Allocation Committee | PDF
(NB: Due to the Labor Day holiday, the next report will be published on September 18.)
The U.S. economy is driven primarily by consumer spending. In 2019, for example, personal consumption expenditures on goods and services accounted for 67.9% of U.S. gross domestic product (GDP). For the economy to grow, consumers simply must boost their spending. But what allows consumers to do that? Generally, consumers need to fund their spending out of income, so one key to sustained growth in consumer spending is sustained growth in consumers’ income. The Commerce Department tracks the total volume of personal income in the economy, including wages and salaries (the large majority of income). It also counts proprietors’ income, dividends, interest, rent, and the like.
The problem is not all that income is available to be spent. As the saying goes, there is nothing certain in life but death and taxes. Since one can’t easily avoid paying the government’s take, economists typically focus on personal income after taxes, commonly referred to as “disposable income.” The graph below shows how the total volume of disposable income has grown at a slower and slower rate for most of the time since the mid-1980s. The slowdown reflects many factors, such as slower population growth, globalization, declining inflation, and changing tax policy. The slowdown in disposable income growth goes far toward explaining why U.S. economic growth has moderated over the last few decades.
We think it’s also useful to dive a bit deeper into the personal income story. Note, for example, that once a person takes on debt, they have an obligation to make debt service, i.e., interest and principal payments. That debt service might not be as hard to avoid as taxes but getting out of the obligation is onerous. Debt service limits how much discretion people really have over their spending, so we pay close attention to a measure that we think is a better gauge of truly discretionary income. Our measure consists of disposable income less debt service (in other words, total personal income after paying taxes, interest, and principal). To better approximate how discretionary income has grown from the perspective of an individual, we calculate it on a per-capita basis. In the chart below, the red line shows the rolling five-year rate of change in per-capita discretionary income based on our calculations.
Rising prices can take a bite out of people’s purchasing power, so we also compare how our measure of income has changed versus the consumer price index (CPI), which is shown by the blue line in the chart. Over the period shown in the chart, per-capita discretionary income has grown by an average of 1.56% over the rate of inflation. When the gap narrows—because of slowing income growth, accelerating inflation, or both—recessions often follow. More broadly, the big story here is that since the late 1980s, when per-capita discretionary income was growing almost 3% faster than consumer prices, income growth has generally exceeded inflation by a much narrower margin. Much of the reason was the dramatic rise in household debt and debt service as consumers struggled to maintain their lifestyles during the 1990s and early 2000s. In the midst of the Great Financial Crisis of 2008-2009, consumers were saddled with all the mortgage debt they took on during the housing boom, so the growth in per-capita discretionary income barely exceeded inflation at all. The disparity remained weak in the years immediately following the crisis until consumers were able to work down their debt.
The good news is that discretionary income accelerated far beyond inflation in the late 2010s. In the five years ended in December 2018, per-capita discretionary income grew at a rate 2.69% higher than CPI inflation, almost matching the best figure in the late 1980s and reflecting improved wage and salary growth, falling debt service costs, tax cuts, and stagnating population growth. Consumer finances looked very good before the coronavirus hit. Now, however, the pandemic is seriously pushing down income, and many people may take on increased debt to tide them over. That means that even if prices fall a bit more or remain stable, the disparity of discretionary income over inflation could weaken again and discourage spending growth.
Weekly Energy Update (September 3, 2020)
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA | PDF
Here is an updated crude oil price chart. The oil market has stabilized at higher levels after April’s historic collapse.
Crude oil inventories fell more than anticipated, declining 9.4 mb compared to forecasts of a 2.0 mb decline. The SPR declined 1.3 mb; since peaking at 656.1 mb in July, the SPR has drawn 7.9 mb. Given levels in April, we expect that another 13.2 mb will be withdrawn as this oil was placed in the SPR for temporary storage. Taking the SPR into account, storage dropped 10.7 mb.
In the details, U.S. crude oil production fell 1.1 mbpd to 9.7 mbpd. Exports fell 0.4 mbpd, while imports declined 1.0 mbpd. Refining activity fell 5.7%.
The data this week was affected by Hurricane Laura. Usually, the energy trade is disrupted when a large hurricane enters the Gulf of Mexico. Although oil exports and imports fell, the latter’s decline was much larger, supporting the decline in inventory levels. This drop occurred despite a sharp decline in refining activity. We expect the refiners that closed for precautionary reasons will reopen soon whereas those who suffered damage will be down for longer. Imports should resume in next week’s report and a rise in stockpiles is likely.
The above chart shows the annual seasonal pattern for crude oil inventories. This week’s data showed another decline in crude oil stockpiles. We are approaching the end of the seasonal withdrawal period. Although the declines of the last few weeks are supportive, stockpiles remain well above seasonal norms and remain a bearish factor.
Based on our oil inventory/price model, fair value is $41.00; using the euro/price model, fair value is $64.26. The combined model, a broader analysis of the oil price, generates a fair value of $52.74. 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 has started to edge higher. Although we probably won’t see the usual seasonal decline in consumption (there wasn’t much of a vacation season), the improvement we are seeing is consistent with a slow recovery of the economy.
In oil news, reflecting the above chart, data from Upwork shows there has been a significant decline in commuting due to the pandemic. The report suggests that some 890 MM fewer miles per day are being traveled.
Nuclear power has suffered from adverse public relations for years. Although it may be the greenest of electric power (it generates no CO2), the waste product is a problem. But, the tragedy of Chernobyl and the near miss of Three Mile Island undermined public confidence. And so, we note with great interest plans to produce small, self-contained nuclear reactors. In theory, these could be stacked to become larger reactors. It isn’t clear if these new reactors will solve the problem of nuclear waste, but these developments could lead to a new path for this power source.
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Weekly Geopolitical Report – Trump’s Foreign Policy in a Second Term (August 31, 2020)
by Patrick Fearon-Hernandez, CFA | PDF
(As is our custom, we will take a break for the Labor Day holiday. The next report will be published on September 7, 2020.)
In our WGR last week, we examined how U.S. foreign policy might look in the event that Democratic Party nominee Joe Biden wins the November presidential election. But, of course, the race remains competitive, and there is plenty of time for things to swing either way. In our report this week, we examine how foreign policy might look if President Trump wins a second term.
It’s tempting to think a second term would be a mere continuation of Trump’s first four years. In reality, it could differ significantly. Presidents in their second terms often rely on different advisors than they did when they first came to power. They’re also lame ducks from their reelection onward, so they have less power. On the other hand, since they no longer need to worry about the next election, they can feel less constrained and anxious to build their legacy. The result could be a noticeably different foreign policy from 2021 to 2025, with important ramifications for investors.