Author: Rebekah Stovall

Weekly Energy Update (July 23, 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 reversed part of last week’s unexpected draw, with stockpiles rising 4.9 mb compared to forecasts of a 0.8 mb draw.  The SPR was unchanged this week.

In the details, U.S. crude oil production rose 0.1 mbpd to 11.1 mbpd.  Exports rose 0.5 mbpd, while imports rose 0.4 mbpd.  Refining activity fell 0.2%, near expectations.

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 +857 kbpd.  This is a large number and suggests the DOE is still struggling to figure out what is going on in the domestic crude oil market.  The rise may be signaling that production is returning faster than the official figures indicate, but we will need to see more data to confirm that notion.

(Sources: DOE, CIM)

The above chart shows the annual seasonal pattern for crude oil inventories.  This week’s data showed a rise 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 $28.63; using the euro/price model, fair value is $54.37.  The combined model, a broader analysis of the oil price, generates a fair value of $41.68.  We are starting to see a wide divergence between the EUR and oil inventory models.  The weakness we are seeing in the dollar, which we believe may have “legs,” is bullish for crude oil and may overcome the bearish oil inventory overhang.

After a steady recovery since the trough in late April, gasoline consumption stalled this week.  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 geopolitics, we are seeing growing tensions in the Eastern Mediterranean between Turkey and Greece over natural gas deposits around Cyprus.  This dispute could involve multiple countries, including Egypt and Israel.  Complicating matters further is the current proxy war in Libya.

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Asset Allocation Quarterly (Third Quarter 2020)

Posted on by Rebekah Stovall

by the Asset Allocation Committee | PDF

  • We expect the current U.S. recession to be deep, yet brief, with a long period of recovery and the potential for expansion toward the latter portion of our forecast period.
  • The Federal Reserve has stabilized the financial markets and ensured the continued functioning of the corporate debt market.
  • Long-term Treasuries served the strategies well, especially through the first half of this year, but appear to have run their course and are now absent from all strategies.
  • We retain a favorable outlook for equities. Therefore, elevated exposures are maintained and the former overweight to growth has been brought to an even weight with value.
  • Valuations are favorable for lower capitalization stocks, which are represented in each of the strategies.
  • Precious metals occupy an increased weight in each strategy with gold supplemented by a modest exposure to silver.

ECONOMIC VIEWPOINTS

The coma into which the U.S. economy was placed created the deepest decline in GDP since the 1930s and in the shortest order ever recorded. Over a period of only a few weeks, seven years of employment gains were wiped away and unemployment rates surged to double-digit levels. The monetary and fiscal responses have been extraordinary, totaling over $4.5 trillion in the aggregate, inclusive of the $2.3 trillion Coronavirus Aid Relief and Economic Security Act and the Federal Reserve’s multitude of acronym laden programs designed to calm and ensure the integrity of financial markets. The effects have been encouraging as markets have rebounded. Perhaps the broadest direct and indirect impact on the markets has been the Fed’s shoring up of the corporate debt market through its purchases of broad-based ETFs as well as selected issues. This has had the effect of narrowing spreads on corporates from levels last seen in the Great Recession to more traditional levels, as  illustrated in this first chart.

Our earlier forecast was for a dramatic decline in U.S. GDP recorded for the second quarter of this year, with the potential to stretch into the third and fourth quarters should a second wave of the virus assert itself. Though we now believe that the worst of the economic damage is behind us, our expectations are that the recovery period will be of a long duration. The Fed should be extremely accommodative over the next three years as Chair Jerome Powell noted during his recent testimony to the House Finance Committee. In an effort to aggressively suppress financial stress, the Fed’s posture will keep fed funds rates near zero for the next two years and the Fed’s balance sheet bloated. Even with the accommodation, we do not believe that inflation will become an issue over our three-year forecast period despite the extraordinary measures employed not only by the Fed, but also other global central banks. Given a world awash in liquidity, we find the natural landing spots to be equities and gold, the latter benefitting from global geopolitical uncertainties.

STOCK MARKET OUTLOOK

The process we employ in our quarterly cyclical congress led to an extension of where we arrived last quarter relative to expectations for equities. While the pace at which equities recovered over the past quarter was dramatic, the direction was completely within our expectations. We find that the prospects for continued repair and even growth for equities are positive, despite near-term declines in earnings per share, which Confluence estimates to be at $113.70 on the S&P 500 for 2020. The unleashing of pent-up demand, adaptations to work and leisure, and the realigning of supply chains and resultant inventory adjustments all hold positive implications for the U.S. equity market over the next three years.  Naturally, there are inherent risks to this thesis, though we don’t count the November U.S. elections as holding an outsized risk. As the accompanying chart exhibits, our analysis of a change in government implies similar results over the course of our forecast period. Although a switch will certainly create winners and losers among companies, industries, and sectors, the overall market is relatively unaffected. Much more risk could result from a potential policy mistake. A rapid withdrawal of stimulus money, further weaponization of the U.S. dollar, or a full monetization of debt are among policies that could unhinge investor behavior and lead to problems among equities. Nevertheless, we view the potential for a policy mistake of large magnitude to be remote, and thereby remain positive on the equity markets over the next three years.

Among U.S. equities, we find lower capitalization stocks to hold more favorable valuations. Accordingly, mid-cap equities are overweight in each strategy. In the strategies with higher risk tolerances, small cap stocks are also overweight. Across the capitalization spectrum we removed the overweight to growth, and now have a neutral posture between value and growth. However, the continued sector overweights to Technology, Communications Services, and Consumer Discretionary create a de facto tilt toward growth, yet not as explicit as the prior quarter.

Beyond the U.S., foreign developed market equities generally hold attractive valuations relative to U.S. counterparts. However, our consensus view over the forecast period is that U.S.-based investors are better positioned with domestic equity exposure due to the lack of a catalyst for the waning value of the U.S. dollar from its current strength. Although developed non-U.S. markets are currently absent from the strategies, emerging market stocks are represented in risk-appropriate strategies. Our view on China, which represents over 37% of emerging market exposure, is that while it engenders significant geopolitical risk, the massive stimulus measures the Chinese government announced at the end of May hold potential advantages for not only Chinese stocks, but also for those in other emerging countries as it is designed for both infrastructure and stimulation of private consumption.

BOND MARKET OUTLOOK

Yields across the U.S. Treasury curve remain historically low and spreads on corporate bonds, including all ratings of investment grade and speculative grade, have narrowed dramatically over the course of the past quarter. The Fed’s entry as a market participant in corporate bonds, through its purchasing of broad-based ETFs and selected individual credits, implies a makeshift policy floor on prices and has instilled confidence in the bond market. Our consensus calls for low rates extending throughout the forecast period, with continued tightening of credit spreads. While we acknowledge the potential for a spike in default rates in high-yield credits as well as an elevated level of credit downgrades due to the effects of COVID-19, over the full forecast period we expect returns on short- and intermediate-term bonds to deliver coupon returns. The sole deviation from this expectation is in the long-term bond category. Although the strategies benefited handsomely from their exposures to long-term Treasuries, we don’t believe that potential returns outweigh duration risk faced by longer-term instruments. Accordingly, they are now absent from all strategies.

OTHER MARKETS

Our consensus view on REITs is that in the aggregate they will earn their dividend over the forecast period. The office/retail segment is certainly struggling but represents less than 20% of the REIT index. More impactful are the data centers, storage, and cell towers that represent a growing proportion of the REIT index. Consequently, we believe REITs provide a differentiated source of income and are thereby positioned accordingly in the strategies where income is a component.

Gold has been an element in each of the strategies over the past several quarters, and allocations were enhanced this quarter. Not only is gold an important diversifier in an era of increased global risk, but the price of gold stands to benefit in a world swimming in liquidity that is in search of a haven. Gold is supplemented in each of the strategies with exposure to silver. We find the advantages of having silver are two-fold—the industrial uses for silver make it desirable during an economic recovery and our research indicates that the gold/silver ratio is at its highest level since the period following World War II.

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Weekly Geopolitical Report – The Threat of Militarization in Brazil (July 20, 2020)

Posted on by Rebekah Stovall

by Patrick Fearon-Hernandez, CFA | PDF

When investors think about Latin American politics and policy, the various countries’ military forces often come to mind.  You’d almost think the region was a hotbed of international aggression, invasions, and state-to-state warfare.  The reality is that for the last century, national military organizations in Central and South America have mostly been used against indigenous insurgencies or opposition political movements.  In recent decades, even that role has been proscribed in most countries, raising hopes that the region has finally learned to solve its domestic political conflicts democratically instead of by force.

Current economic and social challenges in Brazil have prompted some officials to hint that the military should have a stronger role in guiding the state again.  Some people in the government have even issued veiled threats to reimpose a military dictatorship in the country.  In this report, we’ll examine what has led to the current threat and assess the likelihood of a military-backed government in Brasilia.  As always, we’ll end with a discussion of the likely ramifications for investors if the military does take a bigger role in Brazilian politics.

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Asset Allocation Weekly (July 17, 2020)

Posted on by Rebekah Stovall

by Asset Allocation Committee | PDF

One of the burning issues about the current path of policy is its inflationary impact.  In other words, will the massive increase in fiscal spending and the Fed’s balance sheet lead to higher price levels?  To discuss this issue, we return to the equation of exchange:

M x V = P x Q

The money supply times velocity is equal to the price level times goods and services produced.  This equation is an identity; simply put, it will always be true.  But, the direction of causality of the variables comes from theory.  Classical economists and their philosophic progeny, monetarists, argued that V and Q were fixed, so changes in price levels were due to changes in money supply.  Keynesians and their most recent variation, modern monetary theorists, argue that Q can be below its capacity and V is variable, so increases in M may not necessarily lead to higher price levels but could result in a decline in V or a rise in Q.  Essentially, the Keynesians and their modern versions argue that if Q is below capacity, increasing M can boost the economy without triggering inflation.

The problem with both of the major theories is that there is a psychological element to the equation that tends to be downplayed.  The problem for the Classical construct is that even at full employment (Q) rising M might simply lead to falling V.  Complacency about future inflation or fears about the future growth path of the economy might lead households and businesses to simply hold larger cash balances.  Confounding the Keynesians is the potential outcome where P rises even with Q below capacity when M is increased if economic actors fear future inflation.  In fact, higher price levels can result even without a rise in M if V rises.  The most extreme case of this condition is hyperinflation, where V rises rapidly as households and businesses rush to convert cash to real goods that will hold their value.

Therefore, determining if there is an inflation problem from current policy is tricky because there is a psychological element that is difficult to estimate.  It is easy to measure money supply, output or price levels, but the psychology of velocity is hard to measure and potentially prone to sudden shifts.

Reframing the question can simplify this problem.  If a household receives a notable sum of money, let’s say, $10,000, what does it do with it?  If the householder fears future price increases, it would make sense to use that money to buy inventory.  In other words, they may take part of it to buy food, perhaps consumer durables, art, gold, or other items that might hold their value.  On the other hand, if there is little fear of future inflation, the household may be content to simply hold the cash as savings or place it in other financial assets.

One way to answer this question is to compare the money supply to gold prices.  If some money supply, say, M2, rises faster than gold, it would suggest that economic actors are not afraid of future inflation.  A rising ratio of M2/gold would be a positive signal for financial assets; on the other hand, a falling ratio would likely be bearish.  Now, it is possible that a contracting money supply could distort the measure.  The monthly change in M2 since 1959 has only been negative 4.4% of the time.  Over that same time frame, it has never been negative on a yearly change basis.

Anyone familiar with financial market history can note that equity markets tend to outperform when this ratio rises, but equities tend to suffer when the ratio declines.  The ratio captures that when the supply of money is rising relative to gold (the proxy for real assets), economic actors tend to put this excess liquidity into financial assets.  A declining ratio suggests a preference for real assets.

In general, the ratio has been mostly steady for the past four years.  Despite a rally in gold, the ratio hasn’t declined.  Put another way, we haven’t seen households and firms show significant inflation fears despite a massive increase in liquidity.  Gold prices have been mostly rising with M2 but not accelerating faster than the money supply.  And so, in a portfolio, gold has been acting as a diversification asset without unduly hampering performance.  As the Fed has boosted liquidity, funds have been going into both stocks and gold at a pace where neither has signaled a particular bias.  If inflation fears escalate, we would expect this ratio to decline and equity markets to show signs of weakness.  But, for now, easy monetary policy is supportive for both gold and equities.

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Weekly Energy Update (July 16, 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 reversed last week’s unexpected rise, with stockpiles falling 7.5 mb compared to forecasts of a 1.8 mb draw.  The SPR added 0.1 mb this week.

In the details, U.S. crude oil production was unchanged at 11.0 mbpd.  Exports rose 0.2 mbpd, while imports declined 1.8 mbpd.  Refining activity rose 0.6%, near expectations.

High negative readings continue for unaccounted-for crude oil, although they are higher than what we saw a few weeks ago.

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 -768 kbpd.  This is a large number and suggests the DOE is still struggling to figure out what accounts for the missing barrels.  We suspect much of it is caused by the DOE overestimating production.

(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 $30.14; using the euro/price model, fair value is $53.25.  The combined model, a broader analysis of the oil price, generates a fair value of $40.42.  We are starting to see a wide divergence between the EUR and oil inventory models.  The weakness we are seeing in the dollar, which we believe may have “legs,” is bullish for crude oil and may overcome the bearish oil inventory overhang.

Gasoline consumption remains below average, but the recovery is unmistakable.

The oil and gas industry is facing a disinvestment movement from college and university endowments, driven by student activism.  In general, such movements tend to gain momentum when the cost of the action is low.  Current low oil prices make activism toward disinvestment relatively costless.  This action could become difficult to sustain if oil prices (and gasoline prices) rise in the future.

In light of last spring’s oil price collapse, the CFTC is getting involved in commodity ETPs.  The commodity regulator is pushing for greater disclosure of activity.  The ETPs were widely blamed for the negative prices for WTI (see the chart above) seen in April.

The recent rise in VAT in Saudi Arabia is calling into question the kingdom’s social contract.  For years, the House of Saud offered Saudi citizens a deal—the government would provide a deep safety net in return for not having a direct voice in how citizens are governed.  In essence, the Saudis created a rentier state that was funded from oil revenues.  In an attempt to diversify the economy in a period of low oil prices, CP Salman has moved to raise taxes to restore some of the lost revenue.  What remains to be seen is if common Saudis will tolerate “taxation without representation.”

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Shining a Light on Indexes: How to Help Investors Better Achieve Their Goals (July 2020)

Posted on by Rebekah Stovall

A Report from the Value Equities Investment Committee | PDF

“What is the appropriate benchmark for your strategy?”

This is a question frequently posed to an investment manager. Before this question can be answered, it is necessary to gain a solid understanding of the strategy by examining the manager’s investment philosophy and how it is applied in the investment process, and, more specifically, how it is expected to perform throughout a full business cycle.

At Confluence Investment Management, our investment philosophy for the domestic value equity strategies was adopted in mid-1994 at our predecessor firm and continues to be implemented more than 25 years later. The approach is focused on understanding and valuing individual businesses with the emphasis on owning competitively advantaged businesses at attractive prices. It is a fundamental approach that views risk as losing money, or more precisely, the probability of a permanent loss of capital. Today, it is the foundation for all six of our domestic value equity strategies.

It is an approach borne from the belief that as investment managers we manage risk, not returns.  Returns are the byproduct of an investment process and how well it is deployed. Our philosophy and process are centered around individual businesses with the intent of owning a collection of superior entities in a concentrated manner and then allowing them to compound over long periods.

Our energy has never been focused on managing to a benchmark or index as it is not additive to the investment process. Furthermore, we do not view tracking error as a measure of risk. Quite the contrary, active investors should welcome tracking error as it is the only way to outperform an index. This is not to say that we are not mindful of the indexes; we are, and it is perfectly reasonable to compare us to an index. But it is equally important to understand how an index is constructed to better understand the applications and limitations when using that index as a benchmark to measure an investment manager.

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