Author: Rebekah Stovall
Asset Allocation Weekly (August 28, 2020)
by Asset Allocation Committee | PDF
As people think about the supplemental federal unemployment benefit of $600 per week that was in place through July, most would assume that if the total benefits exceed a person’s actual wages, they will choose to be unemployed instead of accepting employment. Anecdotal reports suggest that companies are running into this problem. In fact, Dallas FRB President Robert Kaplan, in an interview with Bloomberg’s Mike McKee, noted that he was hearing of this problem from his business contacts in the 11th Federal Reserve District. However, he also noted that there was little evidence in the data of this phenomena. So, why isn’t this seen in the data? The answer may have something to do with a person’s economic outlook.
Accepting unemployment benefits, even with the added booster, may be a costlier choice than most people realize. Because employment benefits are temporary, people must weigh whether it is in their best interest to accept benefits with the opportunity cost of giving up work tenure and experience, even at lower compensation compared to not working. During an expansion, it might make sense to accept benefits, especially if it comes with a booster, as people would have an easier time finding work once the entitlements run out. However, the same is not true when an economy is in recession.
In a recession, having a job provides workers a relatively reliable and potentially long-lasting source of income during a time of uncertainty. Unemployment benefits, particularly with the added booster, are not only temporary but are also subject to change. Hence, workers may be less receptive to generous benefits if they suspect that a job won’t be available when they need it. This dilemma may partially explain why many economists failed to find conclusive evidence in the data to suggest that getting rid of the added benefits would lead to lower unemployment.[1], [2]
Our own research found evidence to suggest that the opposite may be true. Looking at the top 10 states by the number of continuing claims, we found that unemployment benefits and the unemployment rate were inversely correlated. Thus, the more generous the benefits, the lower the unemployment rate. One possible explanation for this inverse relationship may be due to the fact that people who live in or near a megalopolis are more confident in finding new opportunities than people who don’t, hence people living in those areas are more likely to accept the benefit.
The chart above shows the unemployment rate and the pandemic unemployment insurance replacement rate by state.[3] The bubble size represents the amount of people receiving unemployment benefits. Eight of these 10 states, listed on the above graph, are the highest in population and the two that are not, New Jersey and Massachusetts, are near major population centers. It is possible that employment opportunities are better in these larger states.
In no way are we arguing that higher unemployment benefits will lead to lower unemployment. In fact, the full chart,[4] which includes all 50 states, clearly shows that the unemployment rate and the replacement rate are uncorrelated. However, this chart may be a reflection of workers’ unwillingness to turn down a job today when there is no guarantee that there will be a job in the future.
This thesis is further supported by the jobs report. From May through July, the industries offering the lowest average weekly wage saw the biggest expansion in their respective payrolls. In fact, the two lowest-paying industries, “leisure and hospitality” and “retail trade,” accounted for nearly 60% of the jobs created in that time frame. Therefore, wages clearly aren’t being prioritized for those choosing to return to work.
The chart above shows the average weekly earnings and the three-month change in employment by industry. The size of the bubble represents the employment level. With the exception of transportation and warehousing, every industry in which average weekly earnings were below the national average added more jobs than the industries in which average weekly earnings were above the national average.
We are clearly in the midst of an anomalous event. As a result, things may not always be as they appear. If we were to push both charts to their logical conclusions, it would suggest that the key to bringing down the unemployment rate would be for the government to raise unemployment benefits to infinity and for employers to reduce wages to zero. That conclusion would clearly be absurd. That being said, it does suggest that lawmakers and policymakers alike should be cautious when deciding whether to scale back stimulus as it will likely have unknown and unintended consequences. Under normal circumstances, when jobs are easy to get, taking a break to collect outsized unemployment benefits might be an attractive option. But, if jobs are scarce, there is a risk to not returning to a job. Anecdotal evidence is true as far as it goes, but may not be generalizable, so policymakers should exercise care in shaping policy based on “what they are hearing.” The consensus among economists is that the supplemental benefit likely does more good than harm as it contributes to consumption spending.[5] In summary, the costs of the higher supplement to unemployment insurance may be lower than generally believed in terms of discouraging employment, and it may have an outsized impact on consumption if it is reduced.
[1] https://tobin.yale.edu/sites/default/files/files/C-19%20Articles/CARES-UI_identification_vF(1).pdf
[2] https://www.wsj.com/articles/economists-vs-common-sense-11596398926
[3] The pandemic unemployment insurance replacement rate is calculated by dividing the amount of insurance employment benefits plus the booster divided by the average weekly rate by state.
[4] Included in this week’s AAW chart book.
[5] https://www.wsj.com/articles/wsj-survey-benefits-of-extra-unemployment-aid-outweigh-work-disincentive-11597327200?st=y030ojqt1zyug3h
Business Cycle Report (August 27, 2020)
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 July, the diffusion index surged into recovery territory signaling that the economy may be on track to grow in Q3. Financial markets were sending mixed signals as equities surged while the yield curve flattened. Meanwhile, the labor market showed signs of improvement as firms hired workers in record numbers. Firms were likely optimistic about the economy as the month saw an increase in consumption resulting from the reduction in lockdown restrictions. However, economic uncertainty has weighed on consumer and investor confidence as a rise in virus cases has hindered efforts to further ease restrictions. As a result, five out of the 11 indicators are in contraction territory. The reading for July rose from -0.1515 to -0.0303, 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.
Weekly Energy Update (August 27, 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 4.7 mb compared to forecasts of a 3.0 mb decline. The SPR declined 1.8 mb; since peaking at 656.1 mb in July, the SPR has drawn 6.6 mb. Given levels in April, we expect that another 14.5 mb will be withdrawn as this oil was placed in the SPR for temporary storage. Taking the SPR into account, storage dropped 6.5 mb.
In the details, U.S. crude oil production rose 0.1 mbpd to 10.8 mbpd. Exports jumped 1.2 mbpd, while imports rose 0.2 mbpd. Refining activity rose 1.1%.
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.
Next week’s data, and data for the next few weeks, will likely be affected by Hurricane Laura. The storm will disrupt refinery operations and seaborne trade for the next few weeks. In 2005, the combination of Hurricanes Katrina and Rita took refinery operations from 95% to just below 70%. Although we don’t expect a repeat of that situation, we will see a drop in refinery operations. Currently, the nation is well stocked with crude oil and distillates (diesel). A bit worrisome is that gasoline stockpiles are less ample, although demand remains low enough that we don’t expect a sustained jump in prices due to the hurricane.
Based on our oil inventory/price model, fair value is $37.99; using the euro/price model, fair value is $64.09. The combined model, a broader analysis of the oil price, generates a fair value of $51.16. 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 better economy.
In oil news, Kuwait and the Kingdom of Saudi Arabia (KSA), with the support of the U.S., are looking to link the power grid of these Gulf States to Iraq. Baghdad has mostly fallen under the sway of Iran since most U.S. forces have left Iraq, but the dominance isn’t complete. The hope is that if Iraq’s economy is tied more closely to the Arab states, Iranian influence can be weakened.
Massive public investment projects continue in the KSA despite weak oil prices. It is clear that CP Salman is moving quickly to diversify the Saudi economy away from oil and believes these megaprojects are the path to foster this goal. Although we do agree that we are probably now past the era of peak oil (the removal of Exxon (XOM, 40.03) from the Dow Jones is a symbol of this trend), we are not sure that these projects will give the KSA the ability to diversify from oil. At the same time, the existence and high priority of these projects indicate Riyadh does see that its current economic structure won’t last indefinitely.
The UN Security Council has rejected a U.S. bid to “snapback” suspended sanctions on Iran for violating the terms of the Iran nuclear deal. After pulling out of the arrangement and implementing unilateral sanctions on Iran, the U.S. wanted to reinstate the international ones that existed before the deal was made in 2015. Although American sanctions are potent, they lack the international credibility of the UN imprimatur, and thus the odds are increased that other nations may violate American sanctions.
Economists have argued for some time that the most efficient way to reduce hydrocarbon consumption is with a carbon tax. Creating a price for carbon gives signals to consumers and producers that support changes in behavior. California is the only U.S. state with a modified version of a carbon tax (it uses a “cap and trade” model that is similar to a tax), where preserving forests, which pull carbon dioxide out of the atmosphere, can offset carbon production in other parts of the economy. This gives trees an economic value other than for tourism and lumber.
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Confluence of Ideas – #17 “The Dollar and the Eurobond” (Posted 8/25/20)
Weekly Geopolitical Report – Biden’s Foreign Policy (August 24, 2020)
by Bill O’Grady | PDF
Traditionally, Labor Day is considered the point when an increasing number of Americans start paying attention to the November elections. As part of our analysis of the candidates, we create dossiers of the candidates and the leading figures with whom they surround themselves. In this report, we will comment on those we see as potentially taking positions in the foreign policy team of a Biden presidency. First-term presidents tend to lean heavily on foreign policy experts, so the people selected to fill these roles would have a hand in shaping policy.
There is an old saying in politics that “personnel equals policy.” Although not completely the case, it does matter who is in the important cabinet and advisory posts. Because this is a geopolitical report, we will focus on foreign policy positions—Secretary of State, Secretary of Defense, Secretary of Treasury, Director of the CIA, and National Security Advisor. We have no insider information about who will get these roles; our predictions are based on open sources and our own analysis. But, based off these conjectures, we will attempt to determine what Biden’s foreign policy would look like.
We will begin with an overview of what we would expect in terms of foreign policy from a Biden presidency. We will follow that discussion with a short biography of who we think are the leading candidates for the aforementioned positions and name other potential candidates for the positions. Using this information, we will attempt to indicate what the sum of these positions would mean for the direction of Biden’s foreign policy. As always, we will conclude with market ramifications.
Next week, we will do the same for President Trump. Second terms are different than first terms. First-term presidents are learning their job and tend to be dependent on the experts they appoint. In the second term, presidents have more experience and the people they appoint to key positions are there mostly to execute the president’s policy preferences, not to offer advice. In addition, by the second term, the party’s leading functionaries have served (and moved on) and the team that replaces them is usually second tier. All that will be covered next week.
Asset Allocation Weekly – #8 (Posted 8/21/20)
Asset Allocation Weekly (August 21, 2020)
by Asset Allocation Committee | PDF
One of the relationships we monitor is retail money market levels (RMMKs). In theory, any available liquidity could conceivably end up purchasing equities. But, RMMKs are used by investors in their brokerage accounts and thus are probably “closer” to equities compared to other forms of “near money,” such as checking accounts, savings accounts and certificates of deposit. The chart below shows the most current reading.
This chart shows retail money market levels on a weekly basis along with the Friday closes of the S&P 500. The gray bars show recessions, whereas the orange bars show periods when retail money market levels fall below $920 billion. In general, when RMMKs fall to $920 billion or below, the uptrend in equities tends to stall. It would seem there is a certain level of desired cash, and when that level falls below $920 billion, households try to rebuild cash by either slowing their purchases of equities or selling stocks to build liquidity.
During the runup to the Financial Crisis, we saw a rise in RMMKs. The peak in liquidity was reasonably close to the trough in the S&P 500. In early 2018, we saw a notable rise in RMMKs that persisted despite the rally in equities. As the pandemic hit and the Federal Reserve aggressively eased monetary policy, RMMKs soared. The rise in RMMKs initially coincided with the sharp decline in stocks, although the pace slowed as equities recovered. It peaked in the second half of May and has been trending lower. When RMMKs fall, that liquidity must go to some other asset, real or financial.
Although scaling RMMK is difficult, we do note that the ratio of M2 excluding RMMK does tend to track the fed funds target with a lag. This makes sense. Holding “cash” outside of a period of crisis is usually driven by interest rates. As rates fall, and hopefully the crisis eases, the current elevated level of RMMK will start to look for higher returns.
The chart suggests that RMMKs should begin to decline in earnest by December; where that liquidity finds a home is uncertain, but we would expect a good portion of it to go into equities if inflation fears remain muted.
Weekly Energy Update (August 20, 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 less than anticipated, declining 1.6 mb compared to forecasts of a 2.9 mb decline. The SPR declined 2.7 mb as oil that was placed in the SPR for temporary storage is now being put back into the commercial system. Taking the SPR into account, storage dropped 4.2 mb.
In the details, U.S. crude oil production was steady at 10.7 mbpd. Exports plunged 1.0 mbpd, while imports rose 0.1 mbpd. Refining activity fell 0.1%.
Unaccounted-for crude oil is a balancing item in the weekly energy balance sheet. To make the data balance, this line item is a plug figure, but that doesn’t mean it doesn’t matter. This week’s number is -421 kbpd. Although the volatility of this number is elevated, the trend is slowly stabilizing.
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 $36.48; using the euro/price model, fair value is $64.08. The combined model, a broader analysis of the oil price, generates a fair value of $50.41. 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 remains stalled. Although we probably won’t see the usual seasonal decline in consumption (there wasn’t much of a vacation season), the slowing of consumption does suggest a weaker economy.
In oil news, the Trump administration is postponing a politically fraught decision on ethanol. There is a mandate from the EPA on ethanol blending. The original law mandated that 36MM gallons of biofuels would be part of the transportation fuel mix by the early 2020s. The industry has not been able to hit that number; last year, there was 15.8MM gallons produced, down slightly from the prior year. The farming industry wants to force the mandate, whereas the petroleum industry, especially refiners, want to avoid it. What happens in practice is that the government maintains the mandate but liberally grants waivers to refiners, meaning that the growth in ethanol production has been flat. When the bill was signed by President Bush in 2007, it was assumed that gasoline demand would continue to rise. In that way, the mandate could have been met without increasing the percentage of ethanol blended into gasoline. But, the 2007-09 recession and the sluggish recovery that followed led to flattening gasoline consumption, meaning the only way to achieve the law’s goals is by increasing the blend percentage.
This year’s recession is likely to weaken demand further. Not only was the drop in growth historic, the work from home trend that the pandemic triggered could fundamentally alter commuting. Although public transportation demand has slowed, it is likely that at least some workers will work from home at least part time. That means the mandate will become even more difficult to meet. The administration is faced with displeasing two constituents—farmers and the oil industry. There is really no solution that will please both. So, we would not expect a resolution before November.
Often in political trends, we see an emerging development that faces a counter movement. In other words, “the Empire strikes back.” During the Reformation, for example, there was a counter-Reformation that eventually led to a kind of cold peace within Christendom. Sometimes, the countertrend only slows the emerging one. We may be seeing something in the latter with regard to oil energy. The current administration is pro-petroleum, but the broader societal trend is heading in the opposite direction. One item that tends to support this idea is that drilling activity remains soft even with the recovery in oil prices. Major oil companies are rethinking their long-term strategies and governments are nudging them in this direction. Whenever we observe potential inflection points, we try to look for items that both support and dispute the potential change in trend. For example, the U.S. has taken steps to open more of Alaska for drilling. If oil companies jump at the chance, the “death of oil” is probably premature. On the other hand, if no actions are taken, it would bolster the case that the oil industry is on a long-term downtrend. Here’s another bit of evidence contrary to the death of oil. Chevron (CVX, 89.48) is looking to invest in Iraq. If one thought that oil demand was going to decline, it is highly unlikely they would take the risk of drilling in a volatile political environment like Iraq. So, the jury is still out, although the weak performance of oil stocks overall would suggest that the death of oil trend may still win out. Another item supporting oil’s continued dominance is that the Democrats have removed language calling for the end of fossil fuel subsidies and tax breaks from the final party platform. At the same time, we have seen a surge in “green” equity performance, suggesting the trend against oil may be gaining momentum.
Working in the oil industry, like any profession, has its good and bad points. To the former, the work often pays very well. It also can be interesting, taking its workers to different parts of the world in challenging environments. Cutting edge technology is also part of the business. On the downside, it is brutally cyclical; when its good, its great, but the troughs can be difficult.
This chart shows the percentage of oil and gas workers to total non-farm payrolls compared to inflation-adjusted oil prices. As the chart shows, employment is sensitive to the price of oil.
A number of commodity industries are struggling to attract younger workers. The average age of farmers has been rising for some time. The reputation of the oil industry has been under pressure over the issue of climate change; it appears that younger workers are shunning the industry over those concerns. If this trend continues, the industry can only survive by improving productivity.
Although reducing carbon emissions is helpful in offsetting the potential impact of climate change, in reality, even if all carbon emissions stopped today, the existing levels will continue to affect the climate for decades. To truly reverse the impact of carbon in the atmosphere, we would need to remove the carbon that already exists. Scientists and engineers have been working for some time on such technologies. We note reports that Occidental Petroleum (OXY, 13.95) is working with privately held Carbon Engineering to build a carbon capture plant in the Permian basin. If this technology develops, it is probably the most promising route to dealing with climate change.
The Trump administration is attempting to trigger the “snapback” provisions of the Iran nuclear deal even after its withdrawal from it. The U.S. is claiming that it is still a “participant” despite its withdrawal and thus can request a return to earlier weapons embargoes that were part of the original agreement if Iran failed to comply. We doubt this will go anywhere, meaning that the conventional weapons ban will likely expire in October. It remains to be seen how the administration will react if states begin selling arms to Iran. Russia and China could both decide to sell arms to thwart U.S. goals with Iran.