Author: Rebekah Stovall

Weekly Geopolitical Report – The Economic Triangle: Part II (July 29, 2019)

Posted on by Rebekah Stovall

by Bill O’Grady

The Economic Triangle: Part II

 Last week, we referenced the basic philosophies of David Hume and Adam Smith and how their writings evolved into the economic theory of supply and demand.  From there, we examined the weakness of supply and demand at the macro level and discussed an alternative model, the Economic Triangle, as a different means of explaining how various economic participants operate and the way in which political factors affect the triangle.  This week, we will show how the Economic Triangle fits into the major economic systems, offer two contemporary examples and conclude with market ramifications.

The Theories
The history of economic thought and political economics has generated a plethora of theories and paradigms for balancing these interests.  Here are some of the important ones:

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Asset Allocation Weekly (July 26, 2019)

Posted on by Rebekah Stovall

by Asset Allocation Committee

How much attention is the FOMC paying to international factors?  It appears to be quite a lot.  We have documented that the financial markets are clamoring for a rate cut.  We have seen some of the more popular yield curves invert and the implied LIBOR rate from the Eurodollar futures market, two years deferred, has moved into easing territory.

The chart on the left shows the aforementioned implied LIBOR rate.  In Q3 last year, the implied rate was 3.30%; it has fallen to just above 1.60%, a decline of 170 bps.  The chart on the right compares the implied rate to the fed funds target.  When this implied rate falls below the target, it is a signal to policymakers that monetary policy is too tight.  The Bernanke Fed mostly ignored this indicator, unlike his predecessor, and Bernanke had to deal with the deep 2007-09 recession.  This indicator is giving clear evidence that the Fed should be cutting rates aggressively.

However, the signals from the domestic economy are not supporting a rate cut.  The ISM Manufacturing Index is well above 50; since the Federal Reserve began confirming the policy rate, it is rare to see rate cuts when the index is above 50.

We have indicated when the ISM index falls below the 50-expansion line with vertical lines.  The only time we saw significant rate cuts without the ISM index below 50 was in 2007, when financial markets were under clear stress.  In May 2007, the Chicago FRB National Financial Conditions Index, an index of financial stress, was reading -0.67.[1]  By August, it had risen to -0.13 and turned positive in November.

In this cycle, international pressures seem to be guiding policymakers to act.

This chart shows the fed funds target with the Global Economic Policy Index.  This index measures mentions of economic or policy uncertainty in 20 nations; the index is weighted by GDP, adjusted for purchase power parity.  A rising reading suggests increases in policy uncertainty.  This chart supports Chair Powell’s continued references to overseas issues when calling for easing.

To some extent, there is a worry among market participants that the Fed is simply creating a narrative to allow it to ease, reducing pressure from the White House while maintaining some element of independence.  The third chart suggests the Fed does have good reasons for acting to lower rates.  With trade wars, the immigration crisis in Europe and the U.S., the potential for conflict in the Middle East and worries about a currency war, the level of global policy uncertainty is historically elevated.  This factor, we believe, reflected in the financial markets, is what is prompting the desire to cut rates.  We do expect a significant level of dissent among FOMC voters but, in the end, we look for two rate cuts this year, unless global stress levels unexpectedly diminish.

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[1] A reading under zero suggests low levels of stress.

Business Cycle Report (July 24, 2019)

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.

Economic data released for June suggests the economy remains strong but is showing some signs of weakness. Currently, our diffusion index shows that 9 out of 11 indicators are in expansion territory, with several indicators approaching warning territory. The index currently sits at +0.757.[1]

 

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 provides about four months of lead time for a contraction and two months of lag time for a recovery. Continue reading for a more in-depth understanding of how the indicators are performing.

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[1] The diffusion index looks slightly different from last month due to adjustments we made to the formula and revisions in certain data sets.

Keller Quarterly (July 2019)

Posted on by Rebekah Stovall

Letter to Investors

I’m writing to you at the end of a week in which the Dow Jones Industrial Average crossed 27,000 for the first time ever and in which the S&P 500 crossed 3,000 for the first time ever.  There’s something about these market averages reaching “all-time highs” that increases fears in the hearts of investors.  Now, this isn’t necessarily a bad thing.  After all, the formula for successful investing is not just buying low, but selling high.  By the way, many investors seem to get those activities confused, particularly when they let their emotions get the best of them and “run with the herd.”  Emotional investing inevitably leads to buying high and selling low.  So, there’s a sense in which it’s nice to find someone leaning the right way when prices are high.

I’d like to point out, however, that high prices don’t necessarily equate to high valuations.  Years ago, I read a piece by Warren Buffett that made this clear to me.  On this subject of all-time high prices, he noted that a passbook savings account, where the interest is compounded daily, hits an all-time high price every day!  No one would argue that this savings account is over-valued; it is simply growing on plan.  Over the long-term, that is exactly what the U.S. stock market does, albeit with more volatility.  As the U.S. economy grows over the decades, and the profits of American businesses grow with it, the market prices of U.S. stocks should regularly hit all-time highs.  The year-to-year irregularities of profit-growth, combined with the ebbing and flowing of investor sentiment, mean that the all-time highs don’t occur daily, as with your savings account, but we shouldn’t be shocked when they periodically occur.

In the past I’ve referred to Oscar Wilde’s famous saying that, “A cynic is a man who knows the price of everything, and the value of nothing.” Knowing the price is easy: it’s reported every day!  Thus, journalists write stories about the S&P 500 crossing 3,000.  Everyone with a smartphone knows when it happens.  But not nearly as many stories are written about the value of the S&P 500, as to whether at 3,000 it’s over-valued, fairly valued, or under-valued.  Your smartphone can’t tell you that.  Knowing the value of anything (stocks, bonds, real estate, artwork, etc.) requires diligent study into both the nature of the item to be valued and the market for it.  When studying the market for an item, one must study both the prevailing market and the historical market.  This is the hard stuff of investing.

So, you may ask, is the S&P 500 overvalued at 3,000?  In our opinion, no, it’s fairly priced.  As we noted in our January letter, we thought the fourth quarter 2018 sell-off had reduced the market to prices that reflected excess pessimism about the future of profits, and therefore represented a buying opportunity.  Thus, it was under-valued.  By our April letter, that discount had been erased by a strong first quarter rally, taking the market averages back to where they had been the previous September.  We thought then that stocks were fairly valued. Three months later, the S&P 500 is now just 3.5% higher than it was in April.  Relative to expected earnings, dividends, the economic climate, and the interest rate environment, we continue to think the market averages are fairly valued.  They’re not “dirt-cheap,” but they’re not “over-priced” either.  This is where stock market valuations usually dwell, where the short-term upside opportunity and downside risk are in balance.  This is why we at Confluence don’t play a short-term game.  For short-term investors, the risk and return structure usually offers difficult odds.

We much prefer the long-term game.  The only way to enjoy the long-term compounding effect of the U.S. economy, as described above, is to take a long-term perspective of investing; the odds in this game are much better.  And you may enjoy the all-time highs.

We appreciate your confidence in us.

 

Gratefully,

Mark A. Keller, CFA
CEO and Chief Investment Officer

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Weekly Geopolitical Report – The Economic Triangle: Part I (July 22, 2019)

Posted on by Rebekah Stovall

by Bill O’Grady

In mid-August 2016, I published a two-part series titled “Thinking about Thinking” (see Part I and II).  Occasionally, I will be asked which WGR is my favorite or most important.  I generally refer readers to the aforementioned reports.

One facet of that report is the three statements of knowledge—a priori analytic statements, a posteriori synthetic statements and a priori synthetic statements.  The first are logic statements, where the subject is contained in the predicate.  These statements are always true but generally trivial, essentially tautologies.  To say “all unmarried men are bachelors” is true if one defines all bachelors as unmarried men.  The second type of statements are inductive in nature.  We observe the world and draw generalized conclusions about it.  Such statements are always conditional.  The concept of such statements was well described by Nicholas Taleb in The Black Swan.[1]  Ornithologists in Europe suggested that black swans didn’t exist because no one had ever seen one.  Then, someone from Europe traveled to Australia and, lo and behold, black swans exist.  A posteriori statements are true only until contrary evidence is found.  Since science is built on induction, the notion of “settled science” is faulty; what we know from science is true based only on what we know now.  But, if contrary evidence emerges, concepts based on induction must adjust.

The real battleground in philosophy are a priori synthetic statements.  These are essentially “self-evident truths” that we believe to be true in all cases and are not derived from experience.  The skeptical Scottish philosopher David Hume argued that a priori synthetic statements were not possible.  Instead, he suggested that such statements were based on experience and thus a posteriori.  Emmanuel Kant tried to rescue a priori synthetic statements by suggesting that humans were born with the ability to impose patterns of thinking on the world.  In other words, we don’t actually perceive the world directly but we do so through the filter of one’s mind.  This filter essentially impresses our views on reality and allows us to make a priori synthetic statements.

Although Kant’s attempt to “save” a priori synthetic statements has generally thought to have failed, there is an insight from Kant’s thought that is useful.  Essentially, people tend to think in paradigms.  In other words, we adopt a certain worldview or narrative for how things work and then impose them on reality.  The problem is, of course, that our worldview or paradigm may not be true.  In fact, almost by design, paradigms of reality are mere models and thus will be incomplete.  At the same time, the paradigms we adopt shape how we interpret the world.  Thus, it makes sense that we understand the models that we adopt to be aware of their strengths and weaknesses.

In this report, we will examine supply and demand as a model of markets and suggest that at the macro level a different model, the “Economic Triangle,” might offer better insights into how the political economy actually operates.  We will discuss how the Economic Triangle explains the way various economic participants operate and how political factors affect the triangle.  Next week, we will show how the Economic Triangle fits into the major economic systems, offer two contemporary examples, and conclude with market ramifications.

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[1] Taleb, Nassim Nicholas. (2007). The Black Swan: The Impact of the Highly Improbable. New York, NY: Random House.

Asset Allocation Weekly (July 19, 2019)

Posted on by Rebekah Stovall

by Asset Allocation Committee

In his last testimony to Congress, Chair Powell agreed with Representative Ocasio-Cortez (D-NY) that the relationship between unemployment and inflation appears to have been broken.  This relationship, usually referred to as the Phillips Curve, suggests there is an inverse relationship between the two variables.  If one desires low inflation, then the tradeoff is higher unemployment.

The Phillips Curve has a controversial history.  There is nothing in economic theory that necessarily supports the tradeoff.  In fact, in its original construction by the economist A.W.H. Phillips, the relationship was between wages and unemployment and was developed by observation.  On the one hand, the relationship makes intuitive sense.  The unemployment rate should offer some insight into the supply/demand balance for labor and it would be reasonable to expect that the relative scarcity of labor should increase wages.  Economists then took the next step and assumed that rising wages would lead to higher price levels.  There are periods when the relationship between prices and unemployment is stable.  But, history shows the relationship is far from consistent.

Both charts are scatterplots of the unemployment rate and the yearly change in CPI.  The chart on the left shows the relationship from 1960 through 1969.  It exhibits what the theory suggests—declines in unemployment are consistent with higher inflation.  It also suggests a non-linear relationship, in that when the unemployment rate declines below a certain point then inflation tends to rise quickly with little improvement in the labor markets.  This chart was part of the development of the theory of the “natural unemployment rate,” which suggested there was a long-term unemployment rate and falling below that rate would lead to sharply higher prices, thus limiting the impact of policy.

The chart on the right suggests something quite different.  In the data since 2010, the relationship is positive, meaning that higher levels of prices are consistent with high unemployment.  Although that relationship is due, in part, to the distortions caused by the Great Financial Crisis, the fact that the curve slopes upward does suggest the relationship between price levels and unemployment may be sensitive to other factors.

It is no great secret that the relationship between unemployment and price levels is inconsistent.  So, in light of this problem, why has the Federal Reserve clung to the Phillips Curve in policymaking?  As the linked article above notes, Chair Powell appears to have given up on the relationship but others on the FOMC have not.  We suspect the Phillips Curve served an important narrative for the Federal Reserve tied to its dual mandate.  The Fed is expected to execute monetary policy that yields stable prices and full employment.  The Phillips Curve made it clear that this mandate had a tradeoff; if the Fed delivered low unemployment, there was an inherent risk of rising price levels.  The belief in the Phillips Curve allowed the Fed to avoid policies that brought very low unemployment that might risk higher price levels.

For the Federal Reserve, the Phillips Curve was a useful theory even if it wasn’t always consistent.  But, if there is a belief that the Phillips Curve doesn’t work anymore, then one could see Congress demanding ever lower levels of unemployment.  If the theory really doesn’t hold, there is no risk of inflation coming from falling unemployment.  However, there may be other issues.  For example, very low interest rates could distort financial markets.  It could lead to malinvestment in the economy.  Perhaps the most potent problem is that terms such as “stable prices” and “full employment” are not fully defined.  Former Fed Chair Allen Greenspan defined stable prices as inflation that is low enough to where consumers and firms do not take inflation into account when making investment and purchase decisions.  Although workable, Greenspan’s definition is clearly ad hoc.  It is arguable that any level of inflation is inappropriate.  Defining full employment has been difficult as well.  Part of the Phillips Curve theory is the concept of Non-Accelerating Inflation Rate of Unemployment (NAIRU), which suggests there is a minimum rate of unemployment consistent with steady prices.  Policymakers have used NAIRU as a proxy for full employment, even though it changes over time.  Most elected members of Congress would describe full employment as every likely voter in their district or state has a job if they want one.

The problem for the Fed is that if the Phillips Curve is jettisoned, there could be a focus on the unemployment rate of the mandate and the inflation mandate could become secondary.   After all, if inflation isn’t affected by the unemployment rate, the political class would generally want a rate as close to zero as possible.  Since inflation is affected by the degree of deregulation and globalization, it may be possible that inflation will remain low even at historically low levels of unemployment.  Unfortunately, it is also possible that the Phillips Curve relationship has become dormant for a myriad of reasons, including the aforementioned globalization and deregulation policies, demographics, and custom.  One observation we have noted is that the level of service seems to decline when the unemployment rate falls significantly.  Businesses note that they don’t have much pricing power and, in the face of rising wages, firms may opt to simply deliver less in terms of normal service.  In other words, hotel rooms may not be available at check-in time due to the lack of housekeeping staff or tables in restaurants may not be bussed as quickly due to the lack of entry level staff.  Such deterioration is not technically “inflation” but can occur in response to factors that otherwise would trigger rising price levels.

In the end, the Fed may find itself without an adequate response to Congress when it demands ever lower levels of unemployment.  The Phillips Curve was useful for the FOMC to avoid being forced into extreme policy positions.  Without the Phillips Curve, there is the potential that the Fed will be forced to engage in persistently accommodative monetary policy, with outcomes that could either lead to inflation or significantly distorted financial markets.

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Asset Allocation Quarterly (Third Quarter 2019)

Posted on by Rebekah Stovall
  • We maintain our sanguine view of the economy and markets, though it is more guarded than last quarter.
  • We expect the Federal Reserve to implement easier policy in the third quarter, marking its first rate reduction since 2008.
  • In the absence of a recession, which is not in our forecast, the rate reduction should lead to a healthy environment for U.S. equities.
  • Although economic weakness abroad is forecast to persist in the near-term, such weakness will only modestly impact the U.S. economy.
  • The Fed’s accommodation and our expectations for continued, albeit muted, U.S. growth encourages our decision to maintain historically high allocations to U.S. equities in the strategies.

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ECONOMIC VIEWPOINTS

Although several indicators show increased potential for a recession and several metrics have softened, our consensus forecast is that recession in the U.S. is not imminent, and the economic expansion, already in record territory,[1] may continue beyond our three-year forecast period. While some factors, such as the inverted yield curve, the two-year forward LIBOR rate lower than fed funds, and softening in the composite index of 10 leading indicators, have led to an increase in the probability of a recession, this rise is from a level that was close to zero several months ago. Our expectation is that the Fed will be successful in engineering a soft landing, or at least forestalling a recession. One of the principal arguments for our anticipation of continued, albeit muted, growth is the lack of excesses that exist in the economy. Credit creation, housing values, and equity valuations are certainly elevated relative to the depth of the Great Financial Crisis a little over 10 years ago, yet are far from being stretched. Moreover, the Fed retains some room for maneuvering that can assist in its efforts to maintain the expansion, inclusive of further rate cuts and curtailment of its balance sheet reduction.

Beyond the U.S., significant leadership and economic uncertainties remain unresolved for the balance of the year. These include the probability of a hard Brexit, Christine Lagarde’s ability to steer the European Central Bank, Italy’s flirtation with broaching the EU’s fiscal rules, the new German chancellor, the replacement of Mark Carney as governor of the Bank of England, the potential for a large reduction in the Bank of Japan’s quantitative easing, and the ability of the People’s Bank of China to continue stimulus measures. Though difficulties beyond our shores can impact the U.S. economy, as the global hegemon it is unlikely that a global slowdown, or even a recession in certain jurisdictions, would cause a recession in the U.S.

The U.S. economy continues to grow, albeit at a muted pace relative to its long-term average. Given the absence of overt inflationary pressures, the Fed is likely to lower the fed funds rate at its meeting in the third quarter, marking its first reduction since 2008. The elevated level of fed funds relative to the implied LIBOR rate, two years deferred, is supportive of a rate reduction as the Fed attempts to engineer a soft-landing in a fashion similar to 1997.

[1] Assuming this is confirmed by the National Bureau of Economic Research, Inc.

STOCK MARKET OUTLOOK

In every instance following an initial reduction in the fed funds rate that was not accompanied by a recession, equity investors were rewarded. However, as the accompanying chart indicates, each business cycle has its own unique characteristics. Those cycles where the initial reduction in fed funds were concurrent with a recession are indicated by dots on the associated lines.

Our position is that the accommodative posture of the Fed will continue to propel the economy and risk-based assets through the end of this year and into next year’s election cycle. In addition, our estimates for S&P 500 earnings are $157.30 in 2019, increasing to $161.32 for 2020.[2] Obviously, a 2.5% increase is far from a cause for celebration, but it does represent an improvement from year-over-year declines recorded over the first half of 2019. Additionally, such growth corresponds with our consensus forecast for positive, though muted, GDP growth. Nevertheless, the potential for a policy mistake, intensifying trade impediments, or building inflationary pressures necessitate vigilance and the willingness to trim equity exposure should conditions warrant.

All risk assets within the strategies remain in the U.S. As noted in the Economic Viewpoints section on the previous page, we remain cautious on non-U.S. exposure over the near-term. Although relative valuations are promising, the range of uncertainties encourage our purely domestic exposure. Within investing styles, we maintain our neutral posture between value and growth. Among sectors, Industrials, Technology, and Materials continue to be overweight. While the allocations to equities remain at historically high levels in the strategies, with an overweight to lower capitalization stocks, we trimmed a portion of the small cap position in three of the strategies in favor of increasing the exposure to mid-caps in all strategies. The rationale for this change is due to our view that the latter stages of an economic cycle coupled with pronounced M&A activity is normally favorable for mid-cap stocks.

[2] Using Standard and Poor’s method of calculating operating earnings

BOND MARKET OUTLOOK

The prospect for an increasingly accommodative Fed going into the election season guides our view that the yield curve will return to its traditional slope over the course of the year, principally through a reduction in short-term rates. Through our full three-year forecast period, we are positive on longer term rates as long Treasuries have significantly attractive yields relative to those from other developed countries. Though we have some concerns regarding the nearly $5 trillion in corporate debt maturing before 2023, this concern is offset by the $12 trillion of bonds outstanding globally with negative yields, representing 24% of the global bond market. This fact supports the notion of an adequate appetite for the maturing investment grade corporate credits. In the speculative bond space, however, we expect spread widening over the full forecast period owing to a slower economy being less supportive of lesser rated bonds.

The duration of bond holdings in the strategies with income objectives has been extended slightly accruing from our forecast for an accommodative Fed, a slowing economy, lack of inflationary pressure, and global demand for bonds. We retain the laddered structure as a nucleus beyond the short-term segment in these strategies.

OTHER MARKETS

Although REITs have enjoyed outsized returns thus far this year, our forecast for rates combined with a lack of excesses in the commercial real estate segment leads to our sanguine view on REITs. Thus, the small exposure remains in the Income with Growth strategy due to the diversified income stream that REITs provide.

Gold is retained at a modest allocation given its ability to offer a hedge against geopolitical risks combined with the safe haven it can afford during an uncertain climate for the U.S. dollar.

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Weekly Geopolitical Report – Russia’s Local Elections (July 15, 2019)

Posted on by Rebekah Stovall

by Patrick Fearon-Hernandez, CFA

Although Russia hasn’t been in the Western news very much recently, there’s been plenty of action “under the radar” related to the country’s regional and municipal elections this fall. On September 8, governors will be elected in 16 of the country’s 85 regions, including the important city of St. Petersburg.  Legislative assemblies will also be elected in 14 regions, the capitol Moscow, and many other municipalities.  In this week’s report, we’ll review the Russian government’s security goals and show how domestic political security is one of its most important priorities.  We’ll also discuss the domestic political challenges faced by the government and how it is attempting to control the regional and local elections to ensure President Putin and his United Russia Party retain power.  As always, we’ll conclude with market ramifications.

Russia’s Traditional Security Goals
In recent years, we’ve explored Russia’s security concerns in detail (see our Weekly Geopolitical Report from February 8, 2016).  We’ve emphasized that Russian security concerns stem largely from the fact that the country has few natural defenses and is essentially landlocked.  Russia’s European territory is open to invasion through the northern European plain, as illustrated by the invasions of Napoleonic France and Nazi Germany.  Meanwhile, Russia’s primary outlets to the sea can be blocked with relative ease.  Such landlocked isolation, restrained foreign trade, and limited arable land have left Russia relatively insular and poor, with an economy focused on natural resources.

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Asset Allocation Weekly (July 12, 2019)

Posted on by Rebekah Stovall

by Asset Allocation Committee

The recent testimony from Chair Powell to Congress made it quite clear that the U.S. central bank is likely to cut rates at the end of July.  For the equity markets, the key issue is whether the shift away from tightening to easing will be enough to avoid recession.  If the rate cut(s) in the coming months reduce the odds of recession, we could see the expansion continue and the Fed may have engineered a rare “soft landing.”  On the other hand, it is quite possible that monetary authorities have raised rates too much and have waited too long to ease policy; if so, then a recession may be unavoidable.

This chart shows two business cycle indicators, one from the New York FRB and the other from the Atlanta FRB.  The former predicts the business cycle a year ahead and is based on the yield curve; the latter is coincident and based on GDP.  We overlay the two, using the New York number as a warning and the Atlanta index as confirmation.  The New York number has crossed the 30 threshold, which has been a signal of recession in the past with no false positives.  And, even rate cuts haven’t prevented recession once the 30 threshold has been crossed.  At the same time, we have not seen confirming data in the national accounts (GDP) data.  Thus, recession may be in the cards, although the risk isn’t imminent; the downturn may still be two years away and it is possible it could be avoided.  After all, every cycle is unique.

This chart shows the dilemma for equity investors.  In this chart we examine the average total return for the S&P 500 on a yearly basis, with the data indexed to the first rate cut, a year in advance of the cut and two years subsequent.  The data shows that equities tend to perform very well if recession is avoided, roughly earning 20% in the first year after the cut and nearly 50% over two years.  However, if a recession occurs, declines in excess of 20% are possible.

Although the NY Fed’s indicator has a strong track record, each business cycle is different, and it is possible that a recession can be avoided.  This analysis does suggest caution, although most safety assets have performed very well already, thus it may be too soon to fully de-risk portfolios.  In the immediate term, however, there is little cause to exit the equity markets, but vigilance is clearly necessary.

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