by Asset Allocation Committee

The financial markets have been roiled recently by the apparent shortage of liquidity in the repo markets.  Our take is that the problem is twofold—there are regulatory problems that mean the banking system requires more in reserves than it did prior to the Great Financial Crisis, and there are likely industry concentration issues that are exacerbating the issue.  Although we don’t expect the repo situation to become a systemic problem, there are potential second order effects that could affect financial markets.

Ultimately, the repo situation makes it clear that the Fed has reduced its balance sheet more than it should have.  Therefore, the fix will require expanding the balance sheet again.  As a result, other than to calm the short-term money markets, we have been searching to figure out what other markets might be affected by a new expansion of the balance sheet.

When the Bernanke Fed implemented the three phases of quantitative easing (QE), one of the overlooked areas of impact was the dollar.

The areas in gray show periods of QE; in the first two events, the dollar clearly weakened.  In the third episode, the dollar did weaken going into the event but mainly was steady at low levels.  However, the dollar soared as the Fed signaled the end of QE.

One way to examine the effect of the balance sheet on the banking system is to monitor free reserves.  These are banking reserves that are above the level of required reserves.

This chart examines the relationship between the four-year change in free reserves and the JPM dollar index.  The key point is that the level of reserves matters less to the dollar than the direction of change.  If the Fed begins to reflate its balance sheet, it will likely cause free reserves to rise.  That action will likely be dollar bearish.  Although monetary aggregates are not the sole driver of the path of the dollar, given that other measures have suggested the dollar is overvalued, a return to some sort of QE should be considered a bearish event for the greenback.  In general, a weaker dollar is bullish for gold and commodities, along with foreign equities, especially emerging markets.

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by Asset Allocation Committee

Although the convention for measuring earnings is compared to shares, Standard and Poor’s also calculates the level of operating earnings for all the stocks in the S&P 500.

The per-share value is calculated by dividing this number by the S&P divisor.  The advantage of this number versus the per-share data is that it is easier to compare total operating earnings of the S&P to the profits data compiled by the Bureau of Economic Analysis (BEA) as part of the National Product Account data.[1]  The BEA data measures total corporate profitability.

The BEA makes occasional revisions to the GDP and related reports, and recently we had a significant revision to the profits calculation.

The BEA made a meaningful revision to its profit calculation.[2]  We use this data and forecasts from the Survey of Economists conducted by the Philadelphia FRB in calculating our earnings forecast.

This chart is a model that estimates S&P operating earnings using the BEA profits data.  The value of comparing the BEA profits data to S&P operating earnings is that it does give us a warning when earnings for the index are “frothy” and probably due to decline.  In 2000 and 2006, S&P total operating earnings far exceeded the model’s fair value forecast and, as the recession approached, the index’s earnings fell to or exceeded the BEA-based model forecast.

Until the revisions, the S&P total operating earnings data was a bit high but not outside model ranges.  The revisions now suggest that current operating earnings are high and will likely decline in the coming quarters.  We still have other factors to take into account (the path of the divisor and the business cycle are two important ones) but, overall, earnings are likely to decline in the coming quarters. 

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[1] The GDP data comes from this effort.

[2] For reference, we use after-tax profits with inventory and depreciation adjustment.

by Asset Allocation Committee

Over the past few months, we have been on “recession watch.”  Our position is that the odds of a downturn are elevated but it is too soon to fully position for a downturn.   The inversion of yield curves is a reliable recession warning.  On the other hand, the economic data continues to signal a slow U.S. economy but not one seeing negative growth.  As long as the economy continues to expand, it does not make sense to underweight equities.

However, there is another possibility to consider.  Investors appear to have become overly cautious recently.

This chart shows retail money market levels on a weekly basis along with the Friday closes of the S&P 500.  The gray bars show recessions, whereas the orange bars show periods when retail money markets (RMMK) fall below $920 bn.  In general, when RMMK fall to $920 bn or below, the uptrend in equities tends to stall.  It would seem there is a certain level of desired cash, and when that level falls below $920 bn, households try to rebuild cash by either slowing their purchases of equities or selling stocks to build liquidity.

The chart shows that, in early 2018, households began to aggressively build RMMK, which would coincide with rising trade tensions.

This chart shows RMMK with the 12-month average of the Policy Uncertainty Index for trade policy.  The fit is rather obvious.  If the U.S. and China come to a short-term agreement that reduces trade worries, it might free up significant liquidity that would find its way into equities.  The potential for such flows, coupled with the usual positive seasonal trend in Q4, could lead to a strong close in equities for 2019.  This doesn’t mean that investors should not continue to watch for recession signals, but de-risking portfolios too quickly may very well be counterproductive.

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by Asset Allocation Committee

Interest rates have increased since early September.

The 10-year T-note yield dipped to 1.45% in early September but has risen strongly since then.  What has prompted this rise?  Some of the rise appears to be caused by a revaluation of the path of monetary policy.

The chart on the left shows the implied three-month LIBOR rate, two-years deferred, from the Eurodollar futures market.  After falling to a low near 1.15%, the yield has jumped to 1.58%.  The chart on the right shows this implied rate compared to the fed funds target.  Although the backup in the implied rate has reduced the expected decline in fed funds from nearly 100 bps to around 60 bps, the spread remains inverted, meaning the market still expects the Federal Reserve to cut rates somewhere between 50 bps and 75 bps over the next two years.

Our 10-year T-note model suggests that long-duration yields are too low, or prices on these instruments are too high.

This chart shows our 10-year T-note yield model.  The deviation line is at the one-standard error level.  Essentially, the bond market yield is consistent with recession.  If the bond market is right and a recession is coming, the chart above suggests that if that recession is a “garden-variety” type, like those seen in the 1990-91 and 2001 downturns, then it would be unlikely that we will see further yield declines.  On the other hand, when the model suggests long-dated Treasuries are overvalued and a recession doesn’t follow, the backup in yields is notable.  It’s still too early to tell if a recession is coming, but the evidence that one could develop is increasing.  Our analysis suggests, however, that the protection that long-duration Treasuries usually offer in a recession and bear market may not be all that significant at current yields.  If the above LIBOR analysis is correct, the recent backup in those yields would suggest a fed funds rate of around 1.50% and a fair value 10-year Treasury yield of 2.27%.  Thus, the recent backup in yields likely has further to run.

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