Asset Allocation Weekly (July 24, 2020)

Posted on July 23, 2020 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 July 23, 2020 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 July 23, 2020 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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Daily Comment (July 23, 2020)

Posted on July 23, 2020July 23, 2020 by Rebekah Stovall

by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA

[Posted: 9:30 AM EDT] | PDF

U.S. equity markets continue to tick higher, buoyed by expectations of continued stimulus. The stronger EUR is lifting European stocks, while Chinese equities fell on U.S./China tensions. Relations with China continue to deteriorate; that’s our lead-off story this morning. We update the latest policy news as a plethora of programs are due to end by July 31. We update the pandemic news, recap other foreign developments and wrap up with economic and market news. The new Weekly Energy Update is available. Off to the details:

China news:

Yesterday, the U.S. announced it was forcing the closure of a Chinese consulate office in Houston. The Houston fire department was on the scene of what appeared to be a massive burning of documents by consulate personnel. There have been accusations by the U.S. of Chinese espionage, especially related to medical information. The closure of the consulate is part of that issue and the burning of documents lends credence to that accusation.
There are reports that the Chinese consulate in San Francisco may be harboring a Chinese military researcher wanted for questioning by the FBI.
It is becoming obvious that tensions between Beijing and Washington are escalating. The reasons for the increase in tensions will be a topic of an upcoming WGR, but there is speculation that the upcoming elections may be a factor. China hawks within the administration may believe that they need to set the tone of the future relationship regardless of who occupies the White House. Since we tend to view history through the viewpoint that trends matter more than personalities, we expect relations with China will be fraught regardless of who is president. The problems are structural, not personal.
On that note, the Senate is working on legislation that would give policymakers additional tools to prevent the confiscation of intellectual property, which would be a lasting change.
Rules requiring supply chains to certify that imported goods are free of unpaid labor are raising worries among U.S. firms.
Railroad infrastructure firms are pressing the U.S. for sanctioning tools against Chinese firms who are said to have ties to the Chinese military.
China is arranging for charter flights to allow its citizens who have expiring visas to exit the U.S.
The PBOC, seemingly concerned about China’s huge debt levels, indicated it is pausing its stimulus.
We continue to monitor heavy flooding in southern China.

Policy news:

The GOP Senate leadership says it has an agreement with the White House and will announce the details later today. We will be watching to see the size of the next direct payment to households. We do note there is growing opposition to additional spending among GOP budget hawks; although we doubt their opposition will be enough to derail the bill, it could mean the GOP leadership will more closely track Democratic proposals to ensure passage.
The Fed is deliberating additional stimulus before its July 28-29 meeting. In the background, the Fed continues to debate structural policy changes that would adjust how the central bank reacts to inflation. In the aftermath of Paul Volcker, the Fed has tended to try to preempt inflation. The trauma of the high interest rate years led a generation of officials to try at all costs to prevent rising inflation expectations. The policy worked so well that they now find themselves in the position of feeling the need to signal that they will not act preemptively to prevent a rise in price levels. To some extent, future policy decisions will depend on this structural policy change.
- In related news, it does appear that Chris Waller and Judy Shelton will be confirmed by the Senate for the last two open positions on the FOMC. Waller will be a traditional dove, but Shelton appears to be more sensitive to politics. It may turn out that she doesn’t act as she has been portrayed, but, for now, we are assuming she will be dovish with a GOP president and hawkish with a Democratic president. However, if we are correct in our assessment, the impact of her dissents will likely be small.

COVID-19: The number of reported cases is 15,255,093 with 606,206 deaths and 8,670,684 recoveries. In the U.S., there are 3,971,343 confirmed cases with 143,193 deaths and 1,210,849 recoveries. For those who like to keep score at home, the FT has created a an interactive chart that allows one to compare cases across nations using similar scaling metrics. Axios has updated its state infection map; the pace of infections appears to have leveled off.

Virology:

Pfizer (38.56, +1.87) and the privately held German firm CureVac have received a $2.0 billion contract from the U.S. government for 100 million doses of their vaccine for December.
U.S. testing firms warn they will struggle to meet the demand for COVID-19 testing along with their other testing demands.
One interesting development to watch is the pace of influenza in the southern hemisphere. It’s winter there in the midst of flu season, but, so far, influenza infections are lower than normal. It appears that prophylactic measures to prevent the spread of COVID-19 have also worked to reduce the spread of the flu. There have been worries that the combination of COVID-19 and the usual influenza season this fall and winter would overburden U.S. hospitals. That may not be the case.
In the news surrounding vaccine testing, the focus tends to be on antibody production. That is the first reaction the human body has to the introduction of the virus or a vaccine. Reports have indicated that antibodies have dwindled rather quickly, raising worries that a vaccine may only offer limited benefits to COVID-19. However, there are other elements of disease resistance that tend to be more durable but take longer to emerge. Specifically, the body creates T cells and B cells that also counteract diseases, but these often don’t emerge for several months after infection. Unfortunately, we won’t be able to determine whether the proposed vaccines generate these secondary effects, but lasting immunity could develop if they do.
- If this is the case, what about reports of people getting infected a second time? Researchers are finding evidence that these apparent reinfections were much more likely to be the first infection that was long-lasting. In other words, a person was sick, seemingly got better, but wasn’t fully recovered and thus suffered a relapse. If this is true, it increases the likelihood that lasting immunity does occur.

Foreign news:

EU negotiators are warning the U.K. that time is dwindling to make a trade deal. We still expect the two sides will come to an agreement but would not be surprised if the agreement isn’t complete until the last minute.
Meanwhile, the U.K. is also trying to secure a trade agreement with the U.S. American negotiators are warning Westminster that the British digital tax puts the talks at risk. The U.S. is taking a strong anti-digital tax position, viewing it as a tactic to raise revenue and shift the incidence of the tax to foreign firms.
European trade negotiators are working on creating legislation that will give them power to levy trade sanctions similar to America’s Section 301.

Market and Economy news:

The WSJ does a recap of the new Eurobond and its potential to boost European economic growth.
- Related to the European fiscal package, the dollar has been weakening on expectations that the EUR will now be a more powerful alternative for reserve purposes. Dollar weakness and falling interest rates have given a boost to precious metals.
As the stimulus pipeline begins to dry up, small businesses are worried that decreased spending will force them to reduce workers or completely close. The next round of stimulus or the Fed could offset these concerns.

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Weekly Energy Update (July 23, 2020)

Posted on July 22, 2020 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.

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.

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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Daily Comment (July 22, 2020)

Posted on July 22, 2020July 22, 2020 by Rebekah Stovall

by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA

[Posted: 9:30 AM EDT] | PDF

Global financial markets are facing some headwinds today from new U.S.-China tensions and signs that the negotiations over the next U.S. coronavirus relief bill may be tougher than previously expected. We review all the key news below.

United States-China: Following the Justice Department’s indictment yesterday of two Chinese hackers for attempting to steal sensitive information from U.S. firms (see below), the State Department said it has ordered the Chinese government to close its consulate in Houston within 72 hours “to protect American intellectual property and Americans’ private information.” The Chinese government said it would retaliate if the move isn’t reversed. It also complained that the U.S. has been opening its confidential diplomatic pouches in recent months, and in a sign that it fears more intrusive moves by the U.S., media reports from Houston this morning said firefighters were called to the consulate after neighbors noticed people burning paper in trashcans within the consulate courtyard—evidence of emergency document destruction to protect secret information. The U.S. order to close the consulate represents a further escalation of tensions on top of the two countries’ trade war, disagreements over technology, and concerns about China’s aggressive geopolitical maneuvering. As Western countries wake up to the challenge of a rising China, they are adopting more and more measures to counter and contain it. Moves like the closure of the Chinese consulate in Houston provide evidence that those measures continue to be taken, and even more are likely in the pipeline as President Trump seeks to bolster his anti-China credentials for the November election and many foreign governments show signs of coalescing into a coordinated, allied approach to China. Further efforts to isolate China could be disruptive economically and geopolitically, so the U.S. move today has taken wind out of risk markets and pushed down the renminbi.

Chinese hackers: As mentioned above, the Department of Justice yesterday unsealed indictments against two Chinese hackers for trying to steal sensitive information worth hundreds of millions of dollars from U.S. defense contractors, research institutions, and healthcare companies, including at least two working on coronavirus vaccines and testing. The hackers, who sometimes worked privately but at other times worked under the direction of the Chinese Ministry of State Security, are evidently still in China and therefore out of the reach of U.S. law enforcement. Nevertheless, the indictment is likely a way to put pressure on China for its cyber warfare against the U.S. and to encourage U.S. firms to boost their cyber defenses.

COVID-19: Official data show confirmed cases have risen to 14,976,453 worldwide, with 617,297 deaths and 8,499,299 recoveries. In the United States, confirmed cases rose to 3,902,377, with 142,080 deaths and 1,182,018 recoveries. Here is the interactive chart from the Financial Times that allows you to compare cases and deaths among countries, scaled by population.

Virology

As President Trump resumed coronavirus briefings at the White House yesterday, he warned the crisis will “get worse before it gets better.” However, when questioned whether he would be held responsible for any worsening, he reverted back to his previous position that the virus will simply “disappear.” He also encouraged people to wear facemasks to combat the disease, though he didn’t wear one himself.
Meanwhile, even as the rate of newly identified infections appears to be stabilizing at a high level in the U.S., the rate of daily coronavirus deaths is now on a clear uptrend as experts have long predicted would happen. Over 1,000 coronavirus deaths were recorded in the U.S. yesterday.
The U.S. government has signed a commitment to spend $1.95 billion for 100 million doses of a potential vaccine being developed by Germany’s BioNTech (BNTX, 91.60) and U.S. pharmaceutical giant Pfizer (PFE, 36.69). The deal also includes an option to purchase a further 500 million doses, if needed. Once the vaccine receives regulatory approval and enters into mass production, the doses would be distributed free of charge to American citizens.
Japanese Economy Minister Yasutoshi Nishimura said the government will postpone relaxing attendance limits for major events until end of August in a bid to help curb the country’s recent rebound in coronavirus infections. Separately, reports today indicate Osaka has become the first prefecture outside of Tokyo to report more than 100 new infections in a single day.

Foreign Policy Response

New details on the €750 billion coronavirus relief program agreed upon by the EU yesterday provide some indication of how the funds will be allocated among the member countries. Since the funds will be disbursed to countries based on the damage they’ve suffered from the crisis, the allotted amounts will be a more significant share of GDP for the relatively smaller, harder-hit southern countries like Spain and Italy. Preliminary figures suggest those two countries would each receive almost 20% of the funds, while France would receive around 10% and Poland would receive about 8%.
- If the final allotment is anything close to the preliminary figures, the funding for Spain and Italy would equal around 10% of their GDP in 2019. That could be a significant boost to those economies, although it’s important to remember that the funding would be spread over three years.
- For most of the other EU countries, the allotments would amount to a much less significant share of economic activity.
As we’ve mentioned before, a key innovation in the new EU coronavirus relief program is the issuance of common EU bonds to finance it. Those bonds will be backed by the full faith and credit of the EU, rather than just individual countries. For a useful primer on these upcoming bonds, click here.
Despite the EU leaders’ approval of the coronavirus program, it’s becoming clear that at least one major political fault line remains. Some officials, led by European Commission President Ursula von der Leyen, insist that EU budget funding for countries will depend on their adherence to the EU’s rule-of-law standards, which would punish countries like Poland and Hungary. Other officials insist Brussels has backed down from those demands.

U.S. Policy Response

President Trump’s desire for a payroll tax cut is turning into a sticking point as the administration and congressional leaders work to hash out the next coronavirus relief bill. While the tax cut would help encourage hiring, many economists and lawmakers see it as inefficient because it would primarily benefit those who haven’t lost their jobs during the crisis.
Separately, a Senate Republican proposal for the next coronavirus bill will reportedly include $70 billion for K-12 schools, with half that amount reserved for schools that reopen fully for in-person instruction.

United States: The Senate Banking Committee yesterday approved President Trump’s latest nominees to the Federal Reserve’s Board of Governors and sent their nominations to the full Senate for a final confirmation vote. The vote was 18-7 for Christopher Waller, a mainstream economist and current director of research at the St. Louis Fed. It was a much closer 13-12 vote for Judy Shelton, an unorthodox gold bug with a reputation for more politicized policy positions. Shelton’s nomination has generated pushback from multiple observers, but it is important to remember that as only one of seven Fed governors, her influence on Fed policy would be limited. For example, emergency lending programs of the sort implemented during the coronavirus pandemic require the votes of at least five Fed governors, so Shelton alone couldn’t sway Fed policy into new directions unless two current governors depart.

United States-United Kingdom: Senior British officials have reportedly given up on their goal of reaching a comprehensive post-Brexit trade deal with the U.S. this summer. On top of the delays arising from the coronavirus crisis, the two sides are still struggling to deal with contentious issues such as the amount of U.S. agricultural products to be allowed into Britain. Perhaps more importantly, British officials see little hope of significant compromise on those issues ahead of the U.S. presidential election in November.

Russia: President Putin’s bid to snuff out protests in the far eastern region of Khabarovsk by naming an opposition politician as governor appears to be falling short. Hundreds of protestors continue to demonstrate today, marking the 11^th straight day of unrest.

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Asset Allocation Quarterly (Third Quarter 2020)

Posted on July 21, 2020July 21, 2020 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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Daily Comment (July 21, 2020)

Posted on July 21, 2020July 21, 2020 by Rebekah Stovall

by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA

[Posted: 9:30 AM EDT] | PDF

A new Confluence of Ideas podcast episode is available, titled “The 2020 Election: Part 3.” This is the final episode looking at the 2020 election. In this episode, we handicap the election based on the tools of prediction, polling and decision markets. We examine the geopolitics of the election, focusing on what countries are likely to intervene in our election, their capabilities and their goals. We also touch on what we expect to see in terms of policy if we get a new president or if the incumbent wins, and likely market reaction in either scenario.

Today’s upswing in risk assets comes in large part from yesterday’s good news regarding potential coronavirus vaccines and a massive new virus recovery program in Europe. We discuss each of those developments in detail below, in addition to discussing today’s other major news developments.

COVID-19: Official data show confirmed cases have risen to 14,729,037 worldwide, with 610,587 deaths and 8,323,901 recoveries. In the United States, confirmed cases rose to 3,831,430, with 140,909 deaths and 1,160,087 recoveries. Here is the interactive chart from the Financial Times that allows you to compare cases and deaths among countries, scaled by population.

Virology:

Echoing the good Phase II trial results announced for the Moderna (MRNA, 82.68) coronavirus vaccine last week, three other leading competitors yesterday posted trial results showing their vaccines successfully produced an immune response with little or no serious side effects.
- Besides the four leading prospects, more than a dozen other vaccine candidates have entered human testing. In total, about 160 potential vaccines are now in development.
- With the rapid success of multiple vaccine candidates so far, and with the numerous alternatives in development in case the top four candidates falter, investors will now have greater confidence that a protective shot could be ready later this year. Of course, unforeseen scientific issues with the vaccines could still arise. In addition, there could be challenges in ramping up production, distributing the vaccine worldwide, and making sure enough people get it. All the same, the news suggests humanity could well get control over the coronavirus in fairly short order and start to rebuild the global economy. The news is therefore bullish for stocks, as shown by the positive reaction in the markets yesterday and today.
Despite the good news on a potential vaccine, current infections and deaths continue to rise across the globe, with an especially heavy impact on Latin America. The economic strains there are raising concerns about a potential new Latin American debt crisis.
In the U.S., new infections rose by approximately 61,800 yesterday, although that was the lowest figure in a week. The mayor of Chicago announced tighter restrictions on restaurants, bars, and gyms, but the mayor of New York said his city would generally proceed to its Phase Four of reopening.
With the success that most major European nations have had in bringing the pandemic under control, some European sports organizations are opening for business again, in contrast to the continued shutdowns in the U.S.
Now that researchers have had more than six months to study the coronavirus, they’re finally getting a hand on just how deadly it is. Researchers now believe the disease kills from 0.3% to 1.5% of people infected, with most studies putting the death rate between 0.5% and 1.0%. That means that for every 1,000 people who get infected, five to 10 would die on average.
- The estimates suggest the new coronavirus is deadlier than the seasonal flu, though not as lethal as Ebola and other infectious diseases that have emerged in recent years.
- The coronavirus is killing more people than the deadlier diseases, in part because it is more infectious.

Foreign Policy Response:

On the policy front, the EU’s member states finally reached agreement this morning on a massive €750 billion coronavirus relief program that will not only channel funds to hard-hit countries like Spain and Italy to help them recover from the crisis, but will also involve the first large-scale issuance of common, mutualized EU debt. Key points of the “Next Generation EU” deal are as follows:
The approved financial assistance will include €390 billion in grants to hard-hit countries, supplemented by €360 billion in loans. That spending would be partially paid for by spending cuts in the EU’s budget of €1.074 trillion for the next seven years, which the leaders also approved.
- The grants will consist mostly of a “Recovery and Resilience Facility” totaling €312.5 billion. To access these funds, member states will need to prepare national recovery plans pledging to reform their economies. The funds will be distributed from 2021 to 2023.
  - Allocations of recovery money will be linked to the economic harm done by the pandemic, rather than relying on pre-crisis data regarding growth and unemployment.
  - To enforce some discipline on member states receiving the coronavirus aid, each EU member state has been given the right to raise concerns that another member is not honoring its economic reform commitments. In such cases, assistance funds can be halted for a period that “as a rule” should not last more than three months. The final decision is formally left in the hands of the commission.
- The remaining €77.5 billion of grants will be used to top up normal EU budgetary programs.
To fund the €750 billion coronavirus program, the European Commission will be granted new powers to borrow on capital markets.
- While most of the borrowed money will go to the new recovery fund, the remainder will be channeled through the EU’s normal budgetary programs in areas such as scientific research, rural development, and environmental protection.
- The funds available for debt service were left vague, but EU leaders have suggested new sources of funds for the EU bonds might include taxes on digital services or carbon emissions.
To overcome resistance from the Netherlands, Denmark, Sweden, and Austria, the leaders agreed that the “Frugal Four” nations will get more of their annual contributions to the EU budget rebated back to them.
As we’ve been arguing, the provision of assistance to the EU’s poorest countries should help buttress the European economy, while the issuance of hundreds of billions of euros of common EU debt should help make the euro a much more viable reserve currency to compete with the dollar. As reflected in today’s market action so far, the deal is therefore bullish for European equities, lower-rated European sovereign debt, and the euro.

U.S. Policy Response:

With the U.S. Congress now back in session and starting to work on a new economic support bill to repair the damage from the virus crisis, President Trump and Republican leaders met yesterday to hash out their initial negotiating position. Treasury Secretary Mnuchin said the White House favors a new package of $1 trillion in supplemental aid. However, he said the administration does not want to see enhanced unemployment benefits continue at their current level of $600 per week. Senate Republicans are expected to formally release their proposed bill later this week.

Financial Market Response:

Despite the good news on a potential vaccine and a slowing in U.S. infections, which might be assumed to take the wind out of safe-haven precious metals, gold and silver prices continue to trend upward, with silver hitting a multi-year high yesterday. Our research shows precious metals tend to move along with the gross size of the federal budget deficit, so today’s loose monetary and fiscal policy are likely to keep pushing gold and silver higher for the foreseeable future.

United Kingdom-Russia: A long-awaited parliamentary report into Russian interference in British politics has concluded that Moscow’s influence is “the new normal,” with senior figures linked to the Kremlin enjoying access to top business and political leaders.

Russia: To diffuse the massive anti-government protests that have broken out in Russia’s far eastern region of Khabarovsk after the arrest of its popular governor, President Putin has chosen a politician from Russia’s tightly controlled “systemic opposition” to take over the position. The new governor will be Mikhail Degtyarev, a 39-year-old lawmaker from the nationalist Liberal Democratic Party.

Egypt-Turkey: The Egyptian parliament has approved deploying troops to Libya in order to prevent the UN-recognized Government of National Accord from advancing eastward and capturing the strategic port of Sirte, a gateway to Libya’s oil installations. Such a deployment would raise the stakes in Libya’s proxy civil war by increasing the potential for direct clashes between Egypt and Turkey.

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Confluence of Ideas – #15 “The 2020 Election: Part 3” (Posted 7/21/20)

Posted on July 21, 2020June 12, 2023 by Rebekah Stovall