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.
Our Daily Comment today provides a short recap of last night’s presidential debate, as well as an update on the fighting in Nagorno-Karabakh. Next is a discussion of today’s positive economic data out of China. We also discuss some new developments in global monetary and regulatory policy, and finally, a few sundry other interesting tidbits.
U.S. Elections: President Trump and Joe Biden had their first debate of the presidential campaign last night, although you could be forgiven for thinking the debate was between Trump and moderator Chris Wallace, given their extended sparring. Our initial impression was that both Trump and Biden avoided any major campaign-killing gaffes, without scoring any knockout punches. Everyone from political analysts to individual citizens will now be assessing how things went, and a different consensus might arise over the coming day or two. For now, however, the most likely scenario is that the event will do relatively little to change the character of the race. All the same, the name-calling and insults did highlight the risk of political instability surrounding the election, which helps explain the modest pullback in stocks so far today.
Nagorno-Karabakh: For the fourth straight day fighting continues in Azerbaijan’s breakaway region of Nagorno-Karabakh, with Azeri forces and ethnic Armenian rebels launching attacks in several directions along the so-called Line of Contact dividing them. The fighting is now spreading well beyond the borders of the enclave and threatening to spill into all-out war between the former Soviet republics of Azerbaijan and Armenia. Even worse, the conflict has also threatened to draw in Russia, which has a security alliance with Armenia, and Turkey, which said today that it will back Azerbaijan with “every means available” in the conflict.
China: The country’s official Purchasing Managers’ Index for manufacturing rose to a seasonally adjusted 51.5 in September, beating both the expected level of 51.2 and the August reading of 51.0 (see data tables below). Like most major PMIs, the index is designed so that readings over 50 indicate expanding activity, so the gauge suggests the Chinese factory sector is continuing to recover from the coronavirus disruptions earlier this year. Since that means the Chinese economy could help power the global recovery, the news should be bullish for risk markets, although perhaps not enough to offset the growing concerns about resurgent infections and political tensions.
A separate private gauge of activity, the September Caixin Manufacturing PMI, fell slightly but was still robust at 53.0.
The official nonmanufacturing PMI, which includes both the service and construction sectors, jumped to 55.9 in September, its highest result since November 2013 and better than the previous month’s reading of 55.2.
Global Monetary Policy: For the first time, European Central Bank President Lagarde said the ECB would consider following the lead of the U.S. Federal Reserve by committing to let inflation overshoot its target after a period of sluggish price growth. However, she also sounded skeptical of the more flexible approach to monetary policy, adding, “Make-up strategies may be less successful when people are not perfectly rational in their decisions — which is probably a good approximation of the reality we face.” Of course, another concern with the new approach is that it could help fuel asset bubbles, as discussed recently by Dallas FRB President Kaplan.
European Union-United Kingdom: The U.K.’s chief Brexit negotiator, David Frost, conceded that the EU has refused to provide preferential import terms to British auto manufacturers in the trade deal he’s negotiating with Brussels. With four out of five British-made cars being exported, mostly to the EU, it raises prospects that the industry would face major disruptions even with a trade deal. The auto provision and other stumbling blocks continue to suggest a hard Brexit without a deal is becoming more and more likely.
Kuwait: The government announced that the country’s ruler, Sheikh Sabah al-Ahmad al-Jaber al-Sabah, died yesterday at the age of 91. He has been succeeded by his half-brother, Crown Prince Sheikh Nawaf al-Ahmad al-Jaber al-Sabah, but he is 83 and in poor health. He isn’t expected to make dramatic changes to Kuwaiti policies. The real issue for Kuwait is the battle to succeed him as crown prince, which could prove divisive and drawn out. A key question is whether Kuwait will now continue its steadfast support for Palestinian statehood or follow the lead of the United Arab Emirates and Bahrain in finally recognizing Israel.
Cuba: The Cuban government is stepping up plans to devalue the peso for the first time since the 1959 revolution, as a dire shortage of tradable currency sparks the gravest crisis in the communist-ruled island since the fall of the Soviet Union.
Confirmed U.S. infections rose by more than 40,000 yesterday, roughly in line with the seven-day moving average of new infections. The seven-day moving average of deaths related to the pandemic remained at about 750. Infections continue to surge in some areas, including parts of New York City and in the Upper Midwest.
The National Football League reported its first team breakout of the disease, with three players and five staff members in the Tennessee Titans organization testing positive. That prompted the Titans and the Minnesota Vikings, who played them on Sunday, to suspend all in-person club activities.
With infections rebounding strongly in Russia, and in Moscow in particular, Moscow Mayor Sergei Sobyanin said the city would extend regular school holidays in October to two weeks to help contain the spread of the virus. Last week, the mayor urged anyone aged 65 years old and older to stay home.
Food and Drug Administration Commissioner Stephen Hahn insisted yesterday that his officials would assess any coronavirus vaccine application against a previously published set of criteria that would make it all but impossible for a shot to be available in the U.S. before November’s election. The statement sets up possible new friction with President Trump, who has threatened to overrule those guidelines.
The Walt Disney Company (DIS, 125.40) said it would lay off about 28,000 employees at its U.S. theme parks who had been on furlough since April. In a statement, the firm said a key reason for the decision was the California state government’s pandemic restrictions, which would keep its Disneyland resort closed for the foreseeable future.
U.S. Policy Response
House Speaker Pelosi and Treasury Secretary Mnuchin had a lengthy telephone call yesterday about the Democrats’ latest proposal for additional pandemic relief, and they are scheduled to continue their discussions today. The Democrats’ bill, which would total about $2.2 trillion, described in detail in our Comment yesterday, could be voted on as early as today or tomorrow. Pelosi expressed confidence that the two sides could come to an agreement, but the bill would still face tough sledding in the Senate.
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.
It’s Friday and we are closing another week. Equity markets continue to struggle. We lead off with policy news from around the world (including the U.S.). China news is next. We update the pandemic news followed by international news. As promised, a bonus chart is presented. And, being Friday, a new Asset Allocation Weekly report, podcast, and chart book are available. Here are the details:
Policy news: There are a number of developments worldwide as the Northern Hemisphere prepares for winter under pandemic conditions.
U. K. lawmakers are shifting to a wage subsidy program, similar to Germany’s, and ending direct wage replacement. The new program shifts the burden of incidence to employers. The risk of the new program is that employers won’t keep workers on payrolls, but the government likes the lower cost. One interesting theme of the U.K. policy response is that it looks like the Johnson government is starting to prepare the country for a post-pandemic economy that will be fundamentally changed. There has been an underlying assumption in the West that the pandemic will fade, and everything will return to the pre-pandemic conditions. That assumption is slowly being replaced with the idea that even with a vaccine, the future world will not be the same.
The IRS is moving to improve tax reporting on cryptocurrencies. This action may force Congress and regulators to actually define what these “things” are. Although proponents want them classified as currencies, they look to us more like securities, and capital gains on securities are taxable. Interestingly enough, capital gains on cash are not. If we have deflation, the gains from cash are not taxed.
With the Turkish lira in a near freefall, the central bank finally moved to raise interest rates. President Erdogan tends to oppose such measures, so we will be watching to see if any members of the central bank “resign” in the near future.
China news:
FTSE/Russell has added Chinese sovereign debt to its bond indices, a move that will require passive managers to add some $100 billion of Chinese bonds to their portfolios. This action is further evidence of China’s growing inclusion into the global financial system.
The Evergrande Group (EGRNF, $2.05), China’s second-largest property developer, is reportedly facing a cash shortage. The company is heavily indebted and is working on restructuring. A reported leak of a letter suggests the company is lobbying the government for help in its restructuring. The firm is probably too big to fail, and thus will get government aid; however, the leadership of the company may not be spared.
Further evidence that the Xi government is deepening its hold on private business in China is that the government has released a strategic emerging industries plan to further its goals of technological independence.
COVID-19: The number of reported cases is 32,273,914 with 983,720 deaths and 22,261,136 recoveries. In the U.S., there are 6,979,973 confirmed cases with 202,827 deaths and 2,710,183 recoveries. 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 R0 data show 19 states with falling cases, and 31 with a rising trend. Ohio has the lowest infection rate, while Washington has the highest.
The EU wants to create a new policy for dealing with refugees. The plan is to distribute them across the union rather than housing them in the nation where the refugee disembarks. This is unpopular with the central European nations; in return, the EU is offering cash to encourage them to accept more foreigners.
Earlier this week, a South Korean official, apparently attempting to defect to North Korea, was captured by border control agents who killed the man and burned his remains. In a rare apology, Kim Jong Un said he was “very sorry” about the incident.
Mexico is no stranger to political corruption. Transparency International puts Mexico in the same league as Myanmar and Laos. It ranks 130 out of 191 countries. Ukraine is marginally less corrupt. Mexican presidents serve a single six-year term, and their successors usually don’t prosecute them for their corrupt actions during office. When the PRI dominated Mexico, the outgoing president selected his successor, ensuring the outgoing leader would be left to a quiet retirement. AMLO is ending this tradition, accusing five former presidents of corruption with the goal of bringing them to justice. It isn’t clear whether any of them will actually face prison time, but the move is politically popular.
Bonus Chart: In macroeconomic accounting, all saving has to net to zero. That’s because the process is a sort of balance sheet. The reason we look at net saving is to determine where the flows are moving. We have just received the data for Q2, and they are remarkable.
Due to the CARES Act, we saw massive dissaving from the government sector; another way of saying this is the deficit widened. Note that the bulk of the saving is being held by households, although the rise in the current account, which includes foreign saving, also rose. This data indicates that households are holding large saving balances that will eventually flow back into the economy as spending.
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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