Author: Rebekah Stovall

Business Cycle Report (January 30, 2020)

Posted on by Rebekah Stovall

by Thomas Wash

The business cycle has a major impact on financial markets; recessions usually accompany bear markets in equities.  We have created this report to keep our readers apprised of the potential for recession, which we plan to update 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.

December brought a wave of positive news about the economy. U.S. large and mid-cap equities ended the year at record highs largely due to strong performance in the Technology sector.[1] Moreover, the U.S. and China announced an agreement for the “Phase One” trade deal. Additionally, strong retail sales around the holiday break offered reassurance that U.S. consumption, which is the largest contributor to GDP, remains strong. However, not all was positive. The manufacturing sector continued to show signs of weakness that will likely persist into 2020. Last month, Boeing (BA, 323.89), arguably the largest U.S. manufacturing exporter, announced that it will suspend production of its Boeing 737 Max starting in January. It is estimated that the production cut will reduce annualized GDP by 30 to 50 bps. That being said, our diffusion index has remained unchanged from the previous month with nine out of 11 indicators in expansion territory. The reading for this month came in at +0.575.

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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[1] The basis used is the S&P 500 and S&P 400.

Keller Quarterly (January 2020)

Posted on by Rebekah Stovall

Letter to Investors

You don’t need me to tell you this, but 2019 was an unusually good year for the public financial markets.  Virtually every market rebounded nicely from the sharp sell-offs that occurred in late 2018.  How broad was the advance?  Confluence Investment Management’s Asset Allocation team tracks 12 major asset classes globally, consisting generally of domestic and foreign stocks, domestic bonds, real estate, commodities, and cash.  In 2018 only two of these asset classes had positive total returns: U.S. Treasury bonds and cash.[1]  2019 was a different story entirely: all 12 asset classes had positive returns in the calendar year.  In fact, only three of the 12 asset classes failed to provide a total return of at least 10% (U.S. Treasury bonds, commodities, and cash).  Yes, 2019 was truly an unusual year.

Such a year raises expectations for the following year, inasmuch as most investors seem to peg their expectations to the market.  So, what’s ahead for 2020?  If you read my October 2019 letter, you know I can’t answer that question.  We cannot predict the future.  As I noted in that last quarterly letter, it seems odd to have to say that, but so many people seem to believe that investing is all about making accurate forecasts of future events.  We believe that to invest according to a prediction of the future is pure speculation.  Rather, we hold that investing in an uncertain world does not depend upon a prediction, but upon a process.  It is our view that a successful investment process is one that enhances the probability of favorable outcomes.

Confluence has recently begun producing podcasts, which are available on our website.  I would particularly encourage you to listen to podcast episodes #5 and #6, which discuss the importance of utilizing a repeatable investment process in order to enhance the probability of success in an uncertain investment world.  At Confluence, we have worked hard over the years to create processes that we believe improve the probabilities of good investment returns.  We work equally hard to consistently apply those processes day after day, year after year.

In episode #6, I liken a good investment process to that of a good batter in baseball.  Good batting form and approach improve the odds of success, but don’t guarantee it.  (Indeed, an excellent batsman still fails in about 70% of his at-bats!)  Likewise, in investing, a good process improves the odds of success, but doesn’t guarantee it.

The reason there are no guarantees in investing is that randomness is always with us.  (Statisticians say randomness for what most of us call luck.)  A good batter may put a good swing on a pitch and hit the “daylights” out of the ball yet hit it right at a fielder.  But, often, a good batting approach will result in a hit.  We seek to do the same in investing.  A good investment process may still result in a less-than-good outcome due to the vagaries inherent in the world of investing, but we believe the probabilities of good outcomes are enhanced by a consistently applied process.

Thus, even though we don’t know what will happen in 2020, we feel confident that consistent adherence to good processes will improve the probabilities of good outcomes.  We don’t know whether the economy will fall into a recession this year or who will be elected president in November, but we must manage client assets regardless of how these events unfold.  Success, or the lack thereof, will not depend on whether we “guessed right,” but on whether we stuck to our processes.  That’s how we look at the coming year.  It may not be as exciting as a newsworthy forecast, but, unlike predicting the future, it is something we can do.

We appreciate your confidence in us.

 

Gratefully,

Mark A. Keller, CFA
CEO and Chief Investment Officer

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[1] This and all other references to asset class performance in this letter are based on total returns of generally accepted market indices for each asset class.

Weekly Geopolitical Report – The U.S.-China “Phase One” Trade Deal: Part I (January 27, 2020)

Posted on by Rebekah Stovall

by Patrick Fearon-Hernandez, CFA

After months of negotiations, the U.S. and China signed “Phase One” of what is expected to be a multiple-phase trade deal.  After noting media response to the agreement, we were struck by the dismissive consensus narrative that has developed.  Our careful review of the document seemed to suggest a much more substantial arrangement had been struck and the general analysis missed a good deal of nuance.  In this report, we will offer a detailed recap of the official agreement.  We usually don’t engage in this sort of point-by-point analysis but, in this case, we feel it is necessary because points may have been overlooked.  Next week, in Part II, we will examine the implications of the deal, and, as always, close with market ramifications.

Intellectual Property
Even though President Trump has touted China’s commitment to ramp up U.S. imports under the deal, and media analysts have emphasized the U.S. promise to postpone or roll back its tariffs against China, the first 16 pages of the 94-page agreement focus on protecting intellectual property.  That suggests U.S. Trade Representative Lighthizer’s top priority was to rein in China’s longstanding efforts to soak up foreign technology and industrial secrets by hook or by crook.  It probably also signals the U.S. intention to pursue fundamental changes in China’s legal system and industrial structure over time.  The key provisions agreed upon include:

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Asset Allocation Weekly (January 24, 2020)

Posted on by Rebekah Stovall

by Asset Allocation Committee

One of the risks we noted in the 2020 Outlook: Storm Watch was the potential for a “melt-up.”  On the one hand, seeing a parabolic rise in equities seems like a positive.  On the other, a rise of significant magnitude only occurs because of a surge of late buyers; these latecomers usually suffer large losses and become something of a cautionary tale for future investors.  The decline in equities that follows a melt-up is usually large too, more than it would have been had the rally not occurred.

The idea of the melt-up is due to the fact that equities have been rising with little evidence of strong retail participation.

This chart shows weekly flows into mutual funds and equity ETFs.  We have added a 12-week average through the data.  On average, flows into equities have been negative since May 2018.  A similar calculation for bond funds shows strong inflows since last January.

On a longer-term basis, the recent divergence between retail flows into equities and the S&P 500 is notable.

On this chart, we overlay the S&P 500 along with monthly flows into equities from retail mutual funds and ETFs.  We have generated a trend line in the data to show the underlying behavior of this series.  The divergence became an outlier in late 2017 and, since then, the index has continued to rise with falling retail flows.  Why is this happening?  The continued rise in equities is clearly coming from institutional buyers.  Some of the lift might be due to a falling level of equities themselves.  The S&P 500 divisor, which takes into account buybacks, mergers and new entrants into the index, has been declining since 2010.  With fewer stocks available, the same level of liquidity can lead to higher prices.  Still, even buybacks cannot fully account for this divergence.

Our fear is that if retail investors decide that missing out is too painful, the influx of liquidity could send prices up strongly.  At this point, there is little evidence to suggest this is happening.  Not only are flows depressed but retail liquidity remains elevated.

Retail money market levels are similar to where they were during the Great Financial Crisis.  When the equity markets began to recover in 2009, the levels of money markets declined, helping fuel the recovery.  Although this level of liquidity may exist as a hedge against uncertainty, if confidence rises, there are ample resources for a strong rally in stocks.  Again, as we said earlier, there has been little evidence that sentiment is becoming bullish, but, if it does, the melt-up we discussed in our Outlook is more probable.

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Asset Allocation Quarterly (First Quarter 2020)

Posted on by Rebekah Stovall
  • The U.S. election season and the more dovish composition of the Federal Reserve Board of Governors should ensure policy accommodation continues in the near-term.
  • The recent resolution of trade policies with China and the prospect for finalization of USMCA produces an environment where corporate capital can be deployed with less uncertainty.
  • Although we hold a somewhat sanguine view of the U.S. economy over our three-year cyclical forecast period, we recognize there is the increased potential for a policy mistake that could lead to economic difficulty.
  • Each strategy reflects a neutral posture, with all risk assets continuing to reside in the U.S. and an equity style exposure of 60% value/40% growth, with an emphasis on larger market capitalizations.
  • The potential for elevated volatility in global equity markets encourages an allocation to long-term U.S. Treasuries and gold.

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ECONOMIC VIEWPOINTS

The recently signed initial trade deal with China, as well as the expectation for enactment of the new North American Trade Pact [USMCA], have helped propel U.S. equities to all-time highs. The trade resolutions hold the potential to encourage businesses to deploy capital toward long-term projects. As evidence, the recently released Q4 2019 Duke University CFO Global Business Outlook finds 12-month capital spending expectations increasing to 4.7% from 0.6% last quarter and R&D spending increasing to 2.7% from 0.6% the prior quarter.[1] Among consumers, the University of Michigan Index of Consumer Sentiment has similarly ratcheted up from 95.5 at the beginning of last quarter to its recent level of 99.1.[2] The business outlook and consumer sentiment figures have also been influenced by the accommodative posture of the U.S. Federal Reserve. The anticipation of two dovish nominees to the Fed’s Board of Governors encourages the expectation of continued accommodation through the U.S. election season. The relationship of the fed funds rate versus the implied LIBOR rate two years out underscores the notion that the Fed has reduced rates and stretched its balance sheet to the degree necessary to accommodate favorable economic conditions.

Despite the current rosy economic backdrop, there remain several lingering concerns. The first concern regards corporate profitability. Although broad indices have been propelled higher, corporate earnings have trended lower as the effects of the Tax Cuts and Jobs Act of 2018 roll off, making year-to-year comparisons more challenging. As this chart indicates, prior to taxes, inventory valuation adjustments [IVA] and depreciation, corporate profits as a percentage of GDP have been declining.

A second concern involves the rally in equities to spur hitherto reluctant retail investors to experience the fear of missing out [FOMO] and lead to performance chasing. While investors pulled $600 billion out of U.S. equity funds and separately managed accounts in 2019, over the past month the trend has reversed and flows have turned markedly positive, according to Morningstar’s asset flow data. Should this be the first salvo in a rush to invest, a true melt-up in equity markets could occur. If history is any guide, FOMO is notorious for leading to self-destructive investor tendencies. The third concern is that the Fed, in conjunction with the U.S. Treasury, begins to use exchange rates as a policy tool. Although this would make future tariff threats more potent, adjustments in terms of trade have deleterious ramifications for corporate and investor behavior.

Although these factors of concern are present, they do not reflect our base case for continued economic health and extension of the record economic expansion. Rather, they are intended to underscore the importance of continually monitoring data to ascertain whether our asset allocations are appropriate or in need of adjustment. While diversification among asset classes is a hallmark of modern portfolio theory, allocations based upon stagnant assumptions may yield spurious results. Accordingly, expected returns, risk, and yields require regular updates to provide proper diversification among asset classes, which is the crux of our asset allocation process.

[1] https://www.cfosurvey.org/wp-content/uploads/2019/12/2019-Q4-US-Key-Numbers.pdf

[2] http://www.sca.isr.umich.edu/

STOCK MARKET OUTLOOK

While we hold a favorable view of the equity markets near-term, we recognize that beyond the next 12 months pressures may continue to mount in terms of corporate earnings growth. In addition, should the potential for investors to yield to FOMO be realized, a market melt-up could ensue. In such an event, valuations would become extremely stretched, leading to the potential for a subsequent significant retrenchment in equity prices. Finally, a politicized Fed in conjunction with the U.S. Treasury to incorporate exchange rates as a policy tool would have serious implications for corporate and investor behavior. Although we have a neutral allocation to U.S. equities, our concentration in each of the strategies is on large capitalization, higher quality segments of U.S. stocks. Within large cap sectors, we established an overweight to Communication Services and retain the overweights to Technology and Health Care.

 

The concentration on higher quality also leads to a continuation of the skew to value relative to growth, as well as the retention of a quality factor geared toward companies that meet the required criteria of profitability, quality of earnings, and low leverage. The particular elements of the quality factor include return on equity, as a measure of profitability, changes to net operating assets over the past two years as a criterion for earnings quality, and the ratio of debt-to-book value of equity to determine financial leverage.

Beyond the U.S., despite attractive valuations and solid fundamentals among many non-U.S. companies, the weighting remains void until a durable catalyst for U.S. dollar weakness is recognized. As that occurs, tailwinds associated with a decline in the U.S. dollar will be extremely beneficial for U.S.-based investors.

BOND MARKET OUTLOOK

The Fed’s increasingly accommodative posture combined with the global appetite for yield will likely lead to a continuation of a normally sloped and range-bound yield curve over the course of the next several quarters. Over our three-year forecast period, we regard long-term Treasuries as relatively attractive given the global yield appetite and the potential for gravitational pull exerted by the sheer amount of global bonds outstanding with negative yields. Additionally, should we experience more volatile markets for global equities, longer term U.S. Treasuries should prove resilient. Although nearly $5 trillion of corporate debt will be maturing before 2023, according to Moody’s, our caution is directed toward speculative grade, or high yield, corporate bonds where we expect spread widening to occur.

The duration of bond holdings in the strategies remains relatively long, stemming from our forecast for an accommodative Fed, a lack of inflationary pressure, and global demand for bonds. In the strategies with income objectives we retain the laddered structure as the core beyond the short-term segment in these strategies.

OTHER MARKETS

The combination of our forecast for rates, the lack of excesses in the real estate segment, and the more diversified pool of REIT enterprises leads to our constructive view on the segment. As a result, REITs are included across the array of the strategies.

The prior elevated allocation to gold is retained given its ability to offer a hedge against geopolitical risks combined with the safe haven it can afford during an uncertain climate for both equities and the U.S. dollar.

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Asset Allocation Weekly (January 17, 2020)

Posted on by Rebekah Stovall

by Asset Allocation Committee

The December employment data showed three interesting developments that are worth discussing.  They are wage growth, hours worked and the level of “out of the workforce.”

Wage growth:  For most of last year, production and non-supervisory wage growth was outpacing that of overall workers.  This development suggested that ordinary workers were finally benefiting from the long expansion.  However, it was uncertain if the growth was due more to changes in state and local minimum wage laws or due to tight labor markets.  It appears we have our answer.  Many of the changes to local and state minimum wage laws occurred after the 2018 midterm elections.  December’s data would be 13 months after many of these new laws came into effect, so if legislation was the primary cause of the rise in ordinary worker pay then we should have seen a drop in December’s wage growth.

In fact, that’s exactly what we saw.  In November, wage growth for this class of worker rose 3.4%; it fell 40 bps to 3.0% in December.  Thus, the divergence between total private wages and production and non-supervisory worker wages appears to be solely a function of minimum wage laws.  Without additional measures, it seems unlikely that the divergence will continue.

Hours worked:  The growth rate of hours worked by production and non-supervisory workers fell to its lowest level since June 2010.

The combination of fewer hours and falling wage growth will tend to further dampen available liquidity for the majority of households.  The weekly hours data isn’t recessionary, but it is headed in that direction.

Out of the workforce:  When the Bureau of Labor Statistics calculates the labor force, it includes those working and looking for work.  Some citizens purposely decide to stay out of the labor force for a myriad of reasons, with age being the most likely.  In other words, as the number of citizens reaching retirement age increases, the percentage of the population that can continue to work will tend to decline as will the potential labor force.  Nevertheless, as the expansion continues, the potential pool of those out of the labor force tends to decrease until a point is reached where it becomes nearly impossible to draw down this group any further.  At that point, wage growth is expected to rise; at the same time, the unemployment rate can’t decline any further because potential new workers become increasingly difficult to find.

The economy may be nearing that point.

The blue line shows the percentage of those not in the labor force relative to the non-institutional population over the age of 16.  The red line is the percentage of the total U.S. population older than 65, with Census Bureau forecasts.  The area in yellow represents the baby boom generation.  The start of this area is when the last baby boomer turned 16, and the end is when the first baby boomer hit the age of 65.  In the yellow area, the percentage not in the labor force fell and stabilized.  As baby boomers headed into retirement age the percentage not in the labor force began to climb.  However, this percentage has recently stalled, mostly due to the extended economic expansion.  This trend will be difficult to sustain as the 65+ population continues to rise.  Although we are seeing workers delay retirement, the recent trend should reverse over time.  That factor will tend to keep the unemployment rate lower than it has been historically.

What is important about these three trends is that two of them are suggesting some softening in the labor market, whereas the last one might mask that weakness by showing a low unemployment rate.  In other words, older workers, facing a weaker labor market, may simply opt for retirement and leave the labor force entirely.  That will reduce the labor force and keep the unemployment rate low, suggesting the labor market is tighter than it really is.  That factor could increase the potential for a policy error.

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Weekly Geopolitical Report – After Soleimani (January 13, 2020)

Posted on by Rebekah Stovall

by Bill O’Grady

(Due to the Martin Luther King Jr. Day holiday, our next report will be published on January 27.)

On January 3rd, the U.S. launched a missile strike that killed Major General Qassem Soleimani, the leader of the Quds Force of the Islamic Revolutionary Guard Corps (IRGC).  As a high-profile commander, his death rocked the region and raised fears of a broader confrontation.

Although the situation remains fluid, Iran and the U.S. appear to have come to a point of stasis; in other words, the odds of further immediate escalation have declined.  In this report, we will discuss recent events and examine the context surrounding these events.  As always, we will conclude with market ramifications.

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Asset Allocation Weekly (January 10, 2020)

Posted on by Rebekah Stovall

by Asset Allocation Committee

In our 2020 Outlook, we discussed three risks to the forecast, with one of them being a “melt-up” or a dramatic rise in stock prices.  One of the key factors that could bolster higher prices for risk assets would be the idea that the FOMC has engineered a soft landing, which is best defined as a tightening cycle that doesn’t result in a recession.

In December 2015, the Fed raised the policy rate by 25 bps, lifting the rate from 0.125% to 0.375%.  The conventional policy models, mostly based on the Taylor Rule, suggested that a series of rate hikes was likely.

This chart shows four variations of the Mankiw Rule, which is different from the Taylor Rule in how it measures slack in the economy.  The former used the unemployment rate, while the latter uses the difference between actual and potential GDP.  We prefer the Mankiw Rule because labor market measures are easily observable, whereas potential GDP is not.  We have created four variations of the Mankiw Rule using various measures of the labor market.  In the chart above, the area highlighted in yellow shows that all the Mankiw variations were suggesting the policy rate was too low and the Fed needed to raise rates aggressively.  The financial markets feared tighter monetary policy but, as the chart shows, after an initial hike the Yellen Fed paused for a year before raising rates again.

Why did this pause occur?  A contributing factor appears to be fragility in the financial markets.

This chart shows the 12-week average of the VIX index of S&P 500 volatility and the fed funds target.  Note that the VIX rose above 20 with the rate hike in December 2015.  It is possible the FOMC worried about triggering broader financial problems by raising rates and thus paused to allow financial markets to “calm down” before raising rates further.

In the recent tightening cycle, the Powell Fed raised rates until the VIX broke 20; soon after, the Fed lowered rates even though the Mankiw Rules would suggest further tightening was in order.  The Fed would be loath for the financial markets to conclude there is a “Fed put,” but, given how sensitive consumption has become to asset values, avoiding a recession may require guiding policy to prevent volatility from rising.

So, if this is what the Fed is doing, what does it mean for equities?  We indexed the S&P 500 to early February 2016, when it became clear that Yellen would keep policy on hold, and January 2019, when Powell signaled at least a pause in tightening.  The idea is that equities should benefit if the Fed avoids a “hard landing.”

The two periods are generally tracking each other; if this pattern continues, the current S&P 500 would end up at 3532.56 by late November.  This analysis is clearly not foolproof as one episode of a soft landing won’t necessarily generate a repeat performance.  Nevertheless, we are tracking relatively closely so further gains in stocks are possible if a recession is avoided.  The trick is avoiding recession; accommodative monetary policy is probably a necessary, but not completely sufficient, condition for avoiding a downturn.

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