Author: Rebekah Stovall

Weekly Geopolitical Report – Rethinking China: Part II (August 3, 2020)

Posted on by Rebekah Stovall

by Bill O’Grady | PDF

In Part I, we described China’s situation using Japan as a historical analog.  This week, we will complete the analogy and examine in some detail the potential motivations of Chinese and U.S. policymakers. As always, we will conclude the discussion with potential market ramifications.

China’s Situation
Similar to Japan in the 1930s, China has become a large economy showing geopolitical power that is threatening the established order.  Similar to Japan in the 1980s, it has an economy overly reliant on investment, trade and debt.  And, like Japan, it is dependent on sea lanes it does not control.  Finally, as was the case with Japan during both the 1930s and 1980s, China has reached a point where the U.S. is refusing to accommodate its rise.  However, unlike Japan, China is not as dependent on the U.S. for its security (although it is quite vulnerable to a blockade).

It is arguable that Deng realized China would eventually reach this state and thus encouraged Chinese leaders to bide their time.  Simply put, Deng wanted to extend China’s ability to stay “under the radar” for as long as possible before it would inevitably trigger a response from the U.S.

It is important to realize China is not acting in a vacuum.  The U.S. has a clear role in how this situation evolves.  The American response to China’s rise appeared to be guided by two principles.  The first is that eventually China would accept U.S. hegemony and the trading system America had created after WWII.  The second was that communism was fundamentally flawed and China would eventually develop into a capitalist democracy.

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Asset Allocation Weekly (July 31, 2020)

Posted on by Rebekah Stovall

by Asset Allocation Committee | PDF

The pandemic has clearly affected the economy.  The decline in economic activity in Q2 will be historic.  However, it is still unclear what effects will be temporary and what will be long-lasting.  A recent paper suggests that one permanent change may be a reduction in older workers.  COVID-19 has a disproportionately negative impact on older people; studies have shown that nearly 75% of fatalities have occurred among those over the age of 65.  That age falls roughly in the middle of the baby boom generation.  Anyone born in 1955 or earlier falls into this high-risk category.

Americans working past 65 years old, at least as a percentage of the total labor force, was common after WWII.  Social Security was still relatively new.  But, from 1947 to 1985, the participation rate for Americans over the age of 65 fell from the 28.6% peak in October 1949 to a low of 10.4% in June 1984.  The number of Americans in the labor force over the age of 65 peaked at 10.8 MM in February.  It has fallen sharply since.

This chart shows both the actual number of civilians employed over the age of 65 and the percentage of these workers compared to the labor force of 65-year-olds and older.  Participation has been rising since the early 1990s.  Some of this rise is simply due to a rising population of Americans aged 65 years and older relative to the total population.

This chart shows the actual and projected level of 65-year-olds and older compared to the total population.  The percentage has been rising since 2003 and is forecast to plateau in 2040.  The entire baby boom generation will be 65 years or older by the end of the decade.

It is possible that the tendency for COVID-19 to be a greater risk to older workers may mean that the drop in employment for adults 65 and over will be lasting.  These workers have the option of taking Social Security and don’t necessarily need to take the risk of returning to work.  If they do leave the workforce for an extended period, perhaps 18 to 24 months for a widely available vaccine, employers may be less open to hiring this age of worker when a younger one can be found.

What impact would a decline in workers aged 65 and older have?  Since older workers are often paid more due to their years of service, losing these workers will, at least initially, improve margins.  It will almost certainly lead to some increased hiring of younger workers and may accelerate lowering the age of the workforce.  It may also lead these older households to lower the risk in their portfolios by reducing equity positioning.  Of course, given current paltry interest rates on low-risk fixed income, investors striving for yield will be forced to take on equity-like risk at times.  It is still unclear whether the pandemic will lead to a permanent shift, but there is a good chance it will.  Thus, we will continue to monitor this development.

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Weekly Energy Update (July 30, 2020)

Posted on by Rebekah Stovall

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.

(Source: Barchart.com)

Crude oil inventories unexpectedly fell, declining 10.6 mb compared to forecasts of a 1.0 mb rise.  The SPR was unchanged this week.

In the details, U.S. crude oil production was steady at 11.1 mbpd.  Exports rose 0.2 mbpd, while imports fell 0.8 mbpd.  Refining activity rose 1.6%, well above expectations.  The drop in imports may have been affected by tropical storm activity; if so, we should see a rebound next week.

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 +43 kbpd.  Although this is one week’s report, stabilization would suggest the DOE is getting a better handle on production and inventory.

(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.  We are well into the seasonal draw for crude oil.  By this time of the summer, we have usually seen a 5% decline in commercial storage.  The fact that inventories are mostly steady is a bearish factor.

Based on our oil inventory/price model, fair value is $31.95; using the euro/price model, fair value is $56.08.  The combined model, a broader analysis of the oil price, generates a fair value of $44.17.  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.

After a steady recovery since the trough in late April, gasoline consumption has stalled.  We suspect this is related to the surge in COVID-19 infections; if it continues, it is a bearish factor for crude oil prices.

In energy news, U.S. oil companies are reporting a return of production as shale output returns.  Although it is unlikely that we will see a return to the peak levels of production for a while, the backlog of “drilled but uncompleted” wells offer ample opportunity for rising oil production.

The DOE has updated its data for April (the official data has a rather long lag), and as one would expect the decline in consumption of energy was historic, falling to three-decade lows.  Petroleum consumption fell to its lowest level since 1983 and coal consumption declined to its lowest level since the DOE began collecting data.

Russia has been supporting Gen. Haftar in Libya.  A “private” mercenary group, based in Russia, known as the Wagner Group, has captured Libya’s largest oil field and the Es Sider export facility.  There are increasing concerns that Russia’s proxies are moving to take full control of Libya’s oil industry.  Libya is becoming a new point of friction between the U.S. and Russia.  The primary opposition to Russia’s aims in Libya is Turkey, which is supporting Islamist groups in the country.

VP Biden’s energy policy has led to concerns in the energy sector that he will support an aggressive “green” policy.  However, in his plans for climate, we note a call for increased funding for carbon capture.  A successful carbon capture regime would support both coal and natural gas.  Although a Biden presidency would not be considered friendly for the energy sector, it is also possible that the outcome may not be as dire as some might suspect (and also disappointing for left-wing populists).  We note that oil and gas groups have suggested there is “common ground” in the Biden energy plan.

Carbon credits, a European market that allows firms to trade carbon emissions, has become a significant bull market.  The rising price of credits is putting pressure on European coal.

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Weekly Geopolitical Report – Rethinking China: Part I (July 27, 2020)

Posted on by Rebekah Stovall

by Bill O’Grady | PDF

President and General Secretary Xi Jingping has changed the course of Chinese governance.  Deng Xiaoping Peng created a collective leadership model to prevent the rise of another Mao.  Leaders were carefully selected and surrounded by leading figures of the various factions of the Communist Party of China (CPC).  Term limits were put in place to restrict a President/General Secretary to two five-year terms. Deng established a structure of government which was somewhat decentralized.  Cults of personality were discouraged.

Xi Jinping has reversed these measures.  He has ended the restrictions on term limits.  The Standing Committee of the Politburo is mostly composed of allies.  Instead of using the structure of government that diffused power, Xi has created a series of informal committees that actually execute policy; this gives him nearly complete control of the government.  “Xi Jinping thought” is now discussed in party and academic circles; although no one has bound them into a little red book, it would not be a surprise if that were to occur.

Xi is also changing China’s foreign policy.  Under Deng, foreign policy was all about “hide your ambitions and disguise your claws.”  Under Xi, foreign policy has been more assertive.  However, over the past 18 months, we have seen aggressive and, perhaps more importantly, widespread actions.  China seems to be willing to create tensions across a broad spectrum, which does appear to be a new development.

There are two broad themes to this report.  In Part I, we will frame China’s situation using Japan as an analog.  In Part II, we will continue the analog, discuss recent Chinese aggression and offer a detailed analysis of the potential motivations of Chinese and U.S. policymakers.  As always, we will conclude the discussion with potential market ramifications.

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Asset Allocation Weekly (July 24, 2020)

Posted on by Rebekah Stovall

by Asset Allocation Committee | PDF

In the Federal Reserve’s 107-year history, it has used a number of different methods to manage monetary policy.  In its early years, it relied on the discount rate and reserve requirement adjustments as policy tools.  During WWII, it managed the yield curve to a specific interest rate to support Treasury borrowing to fund the war effort.  In the early 1950s, monetary policy became independent of government borrowing.  From this period into the late 1970s, the Fed managed monetary policy by setting a target rate for fed funds.  Chair Volcker moved to target the money supply in a bid to bring down inflation; monetary targeting ended by 1987.  From 1987 until 2008, the primary tool of monetary policy was the fed funds policy rate.  If the banking system was oversupplied with reserves, the fed funds rate would decline below target.  The Fed would engage in open market operations to reduce the level of reserves to lift the effective fed funds rate.  Under conditions of an undersupplied market, banks would be bidding up rates to acquire reserves; the Fed would inject money into the banking system to prevent the effective fed funds rate from overshooting the target rate.  During the Great Financial Crisis, the U.S. central bank flooded the banking system with reserves to ensure ample liquidity; this action led to a massive level of bank reserves rendering the traditional fed funds rate management impossible.   The level of reserves would have anchored the fed funds rate at zero.  To allow for rate flexibility, the Fed began paying interest on reserves.

In March, when the pandemic triggered financial stress, the FOMC responded quickly.  Not only were rates cut but the Fed announced a series of actions designed to provide liquidity to various parts of the financial system.  In an unprecedented step, the central bank bought corporate bonds, including some that were below investment grade.  It purchased municipal bonds.  It also offered broad support for money markets and commercial paper.  And, it increased and broadened swap lines with foreign central banks to provide global dollar liquidity.  All these actions led to a massive rise in the Fed’s balance sheet.

This chart shows the Federal Reserve’s balance sheet relative to nominal GDP.  Note that the current level of the balance sheet is at all-time highs.

Recently, the Fed’s balance sheet has contracted; this change has raised concerns that the central bank may be withdrawing stimulus which would be bearish for the economy and financial markets.

This fear is misplaced, but understandable.  This chart shows the balance sheet along with the Chicago FRB’s National Financial Conditions Index.  A rising index number indicates increasing financial system stress.  We have shaded three periods of quantitative easing.  It is notable that the first two cycles had specific levels of asset purchases.  In other words, a given level of buying and a definitive end date was established.  The third cycle was more open ended in time but initially fixed in terms of purchases.

The recent rise in the balance sheet is less about supporting the economy and more about suppressing financial stress.  And so, as the level of stress has declined, the demand for Fed support has as well, leading to a decline in the balance sheet.  This isn’t due to the Fed withdrawing support; it is, in fact, evidence of the Fed’s success.  It should be noted, however, that the facilities remain in place.  If stress rises, the Fed has policies in place to suppress it.

The central bank’s next step will likely be to add accommodation.  In other words, additional actions will likely be necessary to encourage economic recovery.  Potential policies might entail yield curve control, “QE for people,” or direct payment from the Fed to households.  The important point is that one should not mistake the recent decline in the balance sheet as a sign of tightening.

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Business Cycle Report (July 23, 2020)

Posted on by Rebekah Stovall

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 June, the diffusion index stayed in recession territory as improvements in several indicators could not outweigh the negative impact of the previous three months. That being said, it does appear that the worst is now behind us. Financial markets continued to show signs of improvement as Fed Chair Jerome Powell testified before Congress that the Fed will not remove stimulus prematurely. Additionally, fiscal stimulus and monetary easing led to a sharp rise in equities. Meanwhile, the labor market showed signs of improvement as an increase in consumption, following the reduction in lockdown restrictions, allowed firms to hire workers in record numbers. However, economic uncertainty has weighed on consumer and investor confidence as a rise in virus cases toward the end of the month has hindered efforts to further ease restrictions. As a result, six out of the 11 indicators are in contraction territory. The reading for June remains unchanged from the previous month, at -0.1515, well below the recession signal of +0.250.

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.

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Keller Quarterly (July 2020)

Posted on by Rebekah Stovall

Letter to Investors | PDF

Thus far, the year 2020 has not been one most of us would like to repeat.  A pandemic, a sharp and deep recession, social distancing, civil unrest, and political uncertainty have left most people, much less investors, with severe anxieties.  I’ve mentioned before that a professional investor is, or should be, a professional worrier.  In that regard, this year has filled the plate of most investors.  On the other hand, we have long subscribed to Mr. Buffett’s maxim that, in order to successfully invest, “one must be cautious when the majority are bold and bold when the majority are cautious.”  This year, likewise, has supplied large portions of caution and, recently, even a little boldness.

So, where are we now?  We believe it is obvious that the economy hit bottom in April and has begun to recover.  It was a quick, but devastating, two-month recession that saw the economy come to a virtual standstill, the result of governmental and social efforts to mitigate the impact of COVID-19.  Since May, the economy has been battling to reopen, although a resurgence of infections in many regions and lasting damage done to many service industries is producing a slower-moving recovery than anyone would like.  Our economists have been telling us, however, that virtually all recoveries from recessions disappoint as to speed, and the peculiarities of the current situation will not change that.

We are indeed in recovery, but all recoveries are also uneven.  In other words, we shouldn’t be surprised if “a few steps forward” are followed by “one step back” every now and then.  This rhythm disappoints many who want a quick, straight-line recovery, but that’s even contrary to human nature.  I’m reminded of one of C.S. Lewis’ most memorable characters, the old demon, Screwtape, who wrote to his young apprentice, Wormwood, “Has no one ever told you about the law of Undulation? … [Humans’] nearest approach to constancy … is undulation – the repeated return to a level from which they repeatedly fall back, a series of troughs and peaks.  If you had watched your patient carefully, you would have seen this undulation in every department of his life – his interest in his work, his affection for his friends, his physical appetites, all go up and down.”  And, we might add, his mood about the economic and investment future.

It’s the stock market that has surprised most occasional observers.  “How can the market be going up when there is so much trouble around?”  I refer to the above-noted Law of Undulation.  Did the value of American businesses really drop by 35% during four weeks in February-March?  No, in my estimation, but market prices did so drop, affected as they are by undulating emotions.  Market prices have risen sharply since then.  A little good news triggers that classically American emotion: optimism.  Will pessimism return, at least for a little while?  Of course, this is how economies and stock markets always work: they undulate as they make forward progress.  A pandemic merely adds a new factor to the undulation.

Last night I had the pleasure of watching my oldest grandchild graduate from high school, employing virus-safe practices, on a video broadcast via the internet.  As I saw my grandson and his friends, one after the other, take off their masks momentarily to pick up their diplomas off the table and smile for the camera, I was thrilled.  These hard-working young people are sustaining extraordinary difficulties and yet are enduring them with aplomb, full of the optimism of youth.  We need that.  It’s what keeps us, and the nation, going.

Our country has been through many troubles in the past, and we are going through more now.  But through all these undulations we’ve managed to make quite a bit of forward progress along the way.  I fully expect more of the same.  We are investing that way.

We appreciate your confidence in us.

 

Gratefully,

Mark A. Keller, CFA
CEO and Chief Investment Officer

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