Weekly Geopolitical Report – Could the Coronavirus Pandemic Break Up the EU? – Part II (April 6, 2020)

Posted on April 6, 2020 by Rebekah Stovall

by Patrick Fearon-Hernandez, CFA

(Note: Due to the Easter holiday, our next report will be published on April 20.)

In Part I of this report we examined the history of the European Union (EU), how it works, and the political, economic, and social fissures that had already rendered it unstable when the COVID-19 pandemic took hold. This week, we look at several recent policy moves that various EU countries have taken in response to the pandemic, and we explain why those policy moves could potentially push the EU over the tipping point toward disintegration if they are carried too far. As always, we’ll wrap up with a discussion of the possible economic consequences of a break-up and the ramifications for investors.

The Temptation to Barricade
As we discussed in Part I, the founders of the EU believed that preventing another major war on European soil could be accomplished, in part, by an “ever-closer union among the peoples of Europe.” The EU is often seen mostly as an economic arrangement (i.e., a customs union coupled with a free-trade area), but its founding principles are broader than that. The EU aspires to the free movement of virtually all people, goods, services, and capital. Unfortunately, the COVID-19 pandemic has tempted EU leaders to erect barriers in these areas.

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Daily Comment (April 6, 2020)

Posted on April 6, 2020April 6, 2020 by Rebekah Stovall

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

[Posted: 9:30 AM EDT]

Happy Monday! Global equities are rising on hopes that the pandemic is stabilizing. We update the COVID-19 news. Here are the details:

COVID-19: The official number of global cases is 1,280,046, with 69,789 fatalities and 265,462 recoveries. Here is the updated FT chart:

We have received requests for a chart weighted by population. We found this one yesterday.

Note that Japan’s numbers are rising at a slow pace but showing no signs of “bending.” We suspect the recent action to declare a limited state of emergency (see below) is due to worries that an exponential rise may be in the offing.

The virus news:

PM Johnson, the first G-7 leader with a confirmed case of COVID-19, has been hospitalized. Foreign Secretary Raab is the designated successor if Johnson becomes incapacitated. The PM’s office is suggesting his hospitalization is just for observation but there are reports that his condition has worsened.
U.S. officials are warning that this will be a difficult week.
Some European nations are preparing to ease movement restrictions. Italy is considering serological testing to determine who can return to normal life and who must remain in lockdown. Essentially, the presence of antibodies will determine if one has been infected and is now immune.
Ventilators have been a point of discussion with COVID-19; this report suggests that being put on the device is a grave situation that the majority don’t survive.
Japan has declared a state of emergency for seven prefectures. The area includes Tokyo. There has been a surge of new cases in Japan.
A tiger at the Bronx Zoo has tested positive for COVID-19, an apparent case of humans infecting other mammals.
There have been a series of cell tower fires in the U.K. after rumors that 5G causes COVID-19 spread.
On a lighter note, a Finnish tradition appears to be catching on in the rest of the world.

The policy news:

Our position has been that the COVID-19 recession would be historically deep in terms of magnitude but short in duration. That belief was based on the expectation that policymakers would move quickly to support the economy and virus suppression efforts would relax by autumn. Like all our forecasts, they are always subject to re-evaluation. We have three immediate concerns:
- Although Congress moved with uncommon speed to pass a $2.0 trillion support package, passing is one thing…execution is another. On Friday, small businesses were able to apply for loans for the first time. Reports suggest the program has not gone well. First, the Treasury didn’t get rules to banks until late Thursday. Second, banks put their own restrictions on the loans. Borrowers went to banks to apply only to be turned away or faced with a myriad of rules. Compare this mess with how Switzerland executed its program. This stimulus will do little good if the process fails to deliver funding soon to small businesses. We also note that large restaurant and hotel chains can tap this program, which probably means it will run out of capacity quickly.
- While $2.0 trillion is a massive program, it probably isn’t enough. Here’s a way of thinking about it—nominal U.S. GDP is near $22.0 trillion. That means the U.S. economy generates around $418 billion per week. The stimulus will fund the U.S. economy for about five weeks. Obviously, we haven’t lost the entire economy; some level of business is still being conducted. At the same time, 80% of U.S. counties, representing 96% of GDP, are on lockdown. If the economy remains stalled beyond five or six weeks, additional help will probably be necessary. Congress needs to be working on this now, just in case.
- That being said, we do give credit to the Fed for moving rapidly and, so far, effectively. We still think that at some point the central bank will need to dip into the junk bond market and support at least down to “B,” simply because too many large companies have fallen into the category. Estimates now suggest the Fed’s balance sheet could end up at $9.0 trillion, well above its current $5.8 trillion, before things settle.
Meanwhile, Germany continues to push back against a Eurobond, instead calling for more emergency lending. If this continues, the Eurozone will be in grave danger.
The UN is warning that it is facing a budget crunch due to spending on COVID-19.

The economic news:

One observation from Friday’s March employment report is that there was significant divergence between the payroll survey and the household survey with reference to employment. As most of you are aware, the employment report consists of two different surveys, one gathered from employers and the other from households. The employer survey is where the non-farm payrolls number is generated. The household report is where the unemployment rate comes from. The two numbers often diverge; the payroll report will capture those working at traditional businesses, while the household report is better at capturing sole proprietors and gig workers. In March, payrolls fell 976k; employment from the household survey plunged 2.9 million. The household survey is sobering, suggesting conditions are much worse than they look.

Emerging market economies are reeling from COVID-19. Default risks are rising, reflected in recent dollar strength.
Supply chains are payment chains in reverse. Goods and services flow one direction, money the other. Supply chains work due to financing. There are growing worries, again seen in recent dollar strength, that these supply chains are being threatened by funding issues.
Texas is being especially hard hit from COVID-19.

Shipping firms are facing an employee problem. Some sailors are stuck in port due to lockdowns. This is leaving ship crews working extreme hours. Simply put, those on ships are being stretched to the limit, while others can’t get to their vessels.
Hoarding isn’t just for households. Countries are restricting food exports.

The market news:

Oil prices plunged overnight on news that a spat between Russia and the Kingdom of Saudi Arabia (KSA) has delayed today’s scheduled meeting on output reduction. The meeting will be held on Thursday. We have seen prices rally off the lows as the market is betting that a deal will be made at some point. However, the fact that a “you started it; no, you started it” fight between adult leaders of Russia and the KSA has led to a delay is a clear indication that managing these egos will be a challenge.
Meanwhile, President Trump has backed away from his threat to implement tariffs on oil. Although such ideas have been circulating for some time, it is important to note that a tariff might not be all that effective in propping up prices. Assume the U.S. puts a $10 per barrel tariff on imported oil. Foreign prices will likely fall in response, but perhaps even more importantly the dollar will soar. The dollar strength will have unintended consequences for the global financial system. If the government wants to support oil producers (after all, why should any government outside of OPEC want higher oil prices), a better tactic would be to do what we do for farmers. Simply set a price for oil and pay oil companies the difference between the world price and the desired price. Although this would require a massive “spend” of political capital, we could see it as part of a stimulus bill.
So, will we get a deal or not? We suspect that a deal will be struck and will likely collapse in short order. Both Russia and the KSA want a wide agreement with other producers to prevent the loss of market share. However, any reading of cartel behavior shows that the larger the cartel, the less likely it is that it will avoid free riders.
One interesting piece of evidence on how much oil demand has declined: air quality around the world is showing remarkable improvement.
One fallout from the virus is that Chinese household borrowing is slowing rapidly, and bad debt is rising.

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Asset Allocation Weekly (April 3, 2020)

Posted on April 3, 2020 by Rebekah Stovall

by Asset Allocation Committee

Earlier this year and late last year we recorded a series of podcast episodes that examined the issue of making decisions under conditions of uncertainty. Episode #5 discussed the issue in broad terms, offering a general framework for examining such decisions. In the end, the key to making these decisions comes down to process. Without a sound process, decision makers can swing wildly on new information or take unconsidered risks. In Episode #6, Mark Keller discussed this topic with a specific focus on how we make decisions in equity portfolio management. In Episode #9, Greg Ellston did the same for asset allocation.

Recently, the Asset Allocation Committee met to make portfolio adjustments. In the nearly two decades of being involved in such procedures, the current environment is perhaps the most unique for all members of the committee. Simply put, we are in an area of substantial uncertainty. The term “uncertainty” is not used lightly; we view the word in the sense analyzed by Frank Knight in his seminal work, Risk, Uncertainty and Profit. Risk is where known probabilities can be assigned; games of chance such as roulette fall into the category. Uncertainty occurs when probabilities cannot be accurately assigned. That is the world in which most portfolio management decisions are made.

In our recent reallocation, which is detailed in the Asset Allocation Quarterly, our general position is that the economy is almost certainly in recession, but financial markets have already discounted much of the damage of a downturn. Unlike most recessions, which occur due to policy error, geopolitical event, or inflation, this one is caused by a pandemic, which has almost no modern historical parallels. We have seen extreme and severe market moves already; the decline in equities is one of the fastest on record. New low yields have been established for long-duration Treasuries. Credit spreads have widened to levels not seen since the Great Financial Crisis. The key issue the committee had to determine was the likelihood that conditions would worsen beyond what the financial markets had already discounted. Our determination was that the odds that market conditions could get worse is possible but less likely than the prospect that much of the bad news is already factored into asset prices. That doesn’t mean that some element of caution isn’t appropriate but establishing the best positions to reduce portfolio risk is critical.

There were three themes that we applied to the asset allocation portfolio changes:

The sharp decline in long-duration Treasury yields reduces the utility of this asset class in reducing portfolio risk. Our earlier position in this asset class has served our asset allocation portfolios well, but the utility was deemed to be near exhaustion. There were two reasons for this determination. First, the expansion of the Federal Reserve’s balance sheet will tend to raise inflation fears and thus slow further declines in long-dated Treasury yields. Second, the Fed’s actions to narrow credit spreads will offer better opportunities in investment-grade credit. To that end, we shortened duration and increased corporate bond exposure.
The massive expansion of liquidity should favor precious metals. Although the dollar has been very strong due to the global scramble for dollars to service foreign-issued, dollar-denominated debt, the Fed has opened swap lines and other programs to improve global dollar liquidity. We expect these actions to temper the dollar eventually. The importance of gold as a portfolio hedge remains in place. An allocation to silver was introduced in the Growth and Aggressive Growth strategies.
We adjusted the portfolios regarding risk tolerance. Historically, steep declines in equities coupled with policy support have generally led to eventual recoveries in equities. There was an increase in equity exposure across all the strategies with the largest increases seen in the Growth and Aggressive Growth strategies. In these higher risk-tolerance portfolios, we added an allocation to emerging markets, which have fallen precipitously in this downturn.

Our CIO (and CEO) Mark Keller is fond of saying “we are not soothsayers, but oddsmakers.” We are not predicting with certainty that the bottom in equities is in place or that credit won’t deteriorate further. But, what we have seen from policymakers and our own analysis of how we believe the COVID-19 virus and the response will evolve over time leads us to the conclusion that the aforementioned three points are reasonable responses to current conditions.

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Daily Comment (April 3, 2020)

Posted on April 3, 2020April 3, 2020 by Rebekah Stovall

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

[Posted: 9:30 AM EDT]

Happy Friday! It’s employment Friday, although this may be one of the most irrelevant reports ever. Since the survey is conducted around the 10^th of the month, much of the jump in claims won’t be reflected in this report. But, our quick take is that the weakness was profound as payrolls plunged 701k and the unemployment rate jumped to 4.4%; we have the details below. We update the COVID-19 news. Global stocks are under pressure, while oil makes a historic rally. Here are the details:

COVID-19: The official number of global cases is 1,030,628, with 54,137 fatalities and 218,771 recoveries.

The virus news:

As the data above show, there are now over 1.0 million reported cases of the virus. We believe this is a deep undercount. A new concern has emerged: the tests for the virus may be much less reliable than we thought and could be generating false negatives. In one sense, if a person is sick and getting tested, a false negative probably won’t change their behavior. They don’t feel well in the first place, which is why they wanted to be tested. However, false negatives bring an undercount and will make the virus appear more deadly than it actually is.
The real fix is a vaccine; although there is hope that one might emerge by autumn, more likely we will see one by H1 2021.
NYC is looking increasingly grim. The city now has 45 mobile morgues in operation as the city’s death toll is now over 1,500.
Critical drugs necessary to treat patients of COVID-19 are in short supply, exacerbating difficulties. Having a ventilator but lacking the drugs to sedate a user makes the device less effective.

The policy news:

The special lending and cash distribution programs are starting to operate and the early read is not encouraging. The details of the small business loan program have not been fully determined. Community banks complained about the interest rate on the loans, so the administration lifted it to 1% instead of 0.5%. Meanwhile, distribution of virus checks may not be fully realized until September. Passing the laws to stimulate the economy was a major win, but execution is the next step and, given the scale of the programs, it will not be seamless. And, the administration has apparently eased regulations on paid leave, which could reduce its effectiveness.
One of the problems in managing a crisis is that it is hard to determine how intertwined an area of the market is to the entire system. If Bush administration officials had realized how important Lehman debt was to the money market sector, we doubt they would have let the firm fail. At the same time, there is always a worry that if you bail out everyone, you create moral hazard; in other words, policymakers reward bad behavior.
- We are seeing a dramatic spike in credit downgrades, leading to a cascade of fallen angels.[1]

The chart shows that for the month ending March 20, $32 billion has left investment grade. The past two weeks have been far worse. A net $560 billion of corporate debt has been downgraded, with $97 billion now officially fallen angels.

The Fed’s various support programs purposely exclude high yield. Bill Dudley, the former NY FRB president, recently argued that the Fed should not include such bonds on the basis of moral hazard. We understand the sentiment but would argue that now is not the time to enforce market discipline because it is very difficult to know which debtor will trigger systemic problems and which won’t.
We have been generally optimistic, all things considered, because of the aggressive policy response. Although we remain so, we are worried that the combination of the lack of execution and short-sighted reluctance to support all borrowers will trigger unanticipated negative outcomes. To quote the recently departed Kenny Rogers, “…there will be time enough for countin’ when the dealin’s done.”
Another area to watch is mortgages; defaults are almost certain to spike, and we doubt the nation would tolerate another response like we saw after the Great Financial Crisis.
Members of the FOMC are pressing for more fiscal stimulus.

The economic news:

As we continue to digest the incoming U.S. economic data and how it’s starting to reflect COVID-19, we think it’s important to emphasize that the March ISM Manufacturing Index released this week probably overstated the health of the factory sector. The overall index fell to 49.1 in March, only modestly below the 50 level that indicates expansion, and not dramatically weaker than the readings of 50.1 in February and 50.9 in January. The figure for March was actually above every reading from August through December 2019. The problem is that the overall figure is the average of five subindexes (new orders, production, employment, supplier deliveries, and inventories), and the subindex on supplier deliveries has been distorting the overall number for several months running. That subindex measures how long it takes for manufacturers to get their supplies delivered once they’ve placed their orders, with the idea that delayed deliveries are a sign of high demand and strong factory activity. When the subindex is higher, it means more manufacturers are experiencing delayed deliveries. The problem is that the recent high numbers for the subindex are more a reflection of supply chain disruptions from last year’s trade war and this year’s virus shutdowns rather than high demand or strong manufacturing activity. Excluding the distorted supplier delivery subindex from the calculation, the overall ISM Manufacturing Index for March would have been just 45.2, its lowest reading since May 2009. That’s additional evidence that the economy has now slipped into a deep contraction. Since the virus shutdowns are sure to keep the subindex on supplier deliveries high over at least the next couple of months, we’ll continue to focus on our adjusted measure of the ISM index to get a better sense of how the factory sector is faring.

The chart above shows how the ISM Manufacturing Index, if computed excluding the subindex on supplier deliveries, is now at its lowest level since late in the Great Recession of 2008-2009.
We are seeing a steady stream of reports of layoffs, buyouts, and furloughs. We are also seeing reports of wage cuts to maintain employment.

The market news:

The key market news is oil. Prices leaped yesterday on reports that President Trump had engineered a meeting of OPEC and Russia with tentative promises of production cuts. Prices are higher this morning on reports that OPEC+ will hold a virtual meeting on Monday to discuss output reductions.
It appears the KSA is trying to get as broad of a group as possible to agree to reductions. This makes sense. The wider the agreement, the better the chances of success…with one caveat. Cartels always suffer from free riders. Although all participants benefit from output constraints, an individual member has a great incentive to cheat. We do expect some sort of deal on Monday, with promises of 10.0 mbpd of production cuts. We do not expect cuts of this magnitude to be achieved. At best, 3.0 to 5.0 mbpd is about all that can be expected, and we seriously doubt Russia will actually cut anything. Failing to make any sort of deal at this meeting would be a disaster but it would be naïve to expect that compliance will be anywhere near what is promised. This doesn’t mean a deal won’t have an impact; if the KSA doesn’t raise output to 12.0 mbpd, we probably avoid single-digit oil prices. But, even with a deal, demand destruction is still a reality and prices in the $20s will be with us for a while.
Add this industry to others that have found fortune in the era of COVID-19.

Foreign policy:

Russia has extended its stay-at-home order, while Brazil continues to shun such measures.
It appears the U.S. and China have engineered a truce of sorts in their recent rhetoric battle.
The IMF is poised to support the EM markets with a $1.0 trillion loan package.

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[1] A fallen angel is an investment-grade bond that has been downgraded to junk status and can no longer be held in an investment-grade bond portfolio.

Daily Comment (April 2, 2020)

Posted on April 2, 2020April 2, 2020 by Rebekah Stovall

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

[Posted: 9:30 AM EDT]

Good morning! After a drubbing yesterday, we are seeing a rebound in global markets this morning. One of the factors helping sentiment is a 10% jump in crude oil prices. The White House is continuing to talk to Russia and the KSA, and the president is meeting with energy executives. However, Moscow has indicated it won’t change its policy anytime soon. China announced it is buying oil for its strategic reserves. Linked here is our updated Weekly Energy Update. We update all the COVID-19 news, including some charts on what is happening in the economy. Here are the details:

COVID-19: The official number of global cases is 951,901 with 48,284 fatalities and 202,342 recoveries. The FT did not issue an infection chart; we will try to find one for tomorrow.

The virus news:

One of the characteristics of COVID-19 is a high number of asymptomatic cases. Sampling in Iceland suggests 50% of those who tested positive had no symptoms. It may turn out that the disease is much more widespread than we think and we may achieve herd immunity quicker. However, until testing becomes widespread and, perhaps even more importantly, serological testing is developed to determine who has immunity, nations are stuck with implementing difficult quarantine measures. At the same time, those who are asymptomatic, during their infectious phase, become innocent carriers of the disease.
Viruses mutate; China is warning that some patients seem to have a form that has very mild symptoms but shed the virus for long periods of time. If this mutation is real and spreads, the only hope is a vaccine.
U.S. intelligence agencies are claiming that China concealed the extent of the outbreak; the fact that the U.S. has more cases with one-third of the population supports this theory.
Latin America is becoming the next hotspot for infections. Brazil has been adamant about not implementing social distancing measures. Although this policy runs counter to how most of the rest of the world is dealing with the crisis, poor nations with high levels of informal workers may not have much choice. There are really two methods of dealing with a pandemic—one is to try to “flatten the curve” via social distancing measures so that the health care system can cope with the influx of infections. This approach reduces infections but tends to extend the impact of the pandemic because herd immunity is slower to develop. The other method is to simply accept that mortality will be really high but the impact will be short. In developed nation democracies, the political impact of doing nothing is probably not feasible. But, in the emerging world, allowing the disease to run its course may be a possible option. Brazil appears to be a test case, although Mexico is operating similar policies.
Italy is probably undercounting its death toll.
As we learn more about the impact of the virus, it appears to have greater impact on men.
Wimbledon has been canceled.
Most U.S. states have now issued stay-at-home orders.
Although China has been getting back to work, we are hearing reports of renewed quarantine efforts as new infections appear.

The policy news:

While the White House is discussing an infrastructure package and House Democrats are preparing a fourth stimulus package, it doesn’t appear the Senate is ready to do anything further. We suspect another fiscal injection will be required.
As we noted in the last WGR (which will be wrapped up in next week’s report), the EU is under tremendous strain. Italy desperately needs Germany to act as a benevolent regional hegemon. Meanwhile, France is making aggressive efforts to maintain employment by giving aid to companies who are, in turn, required to keep workers on the payroll.
The Fed continues to aggressively address liquidity issues; its last action is to ease reserve calculations by excluding Treasuries up to a year and central bank deposits when establishing leverage ratios. As we noted yesterday, the Fed is also showing itself as the world’s central bank. This role was generally unspoken before; now it is explicit.

The economic news:

Initial claims jumped to 6.65 million, a new record. We cover the data below. There has been a surge in layoffs reported recently and the data confirm it.
We are seeing a surge in worker revolt. Production workers, delivery drivers, health care workers, warehouse employees, and grocery clerks are starting to push back against what they see are unsafe working conditions. They have high leverage at this moment.

The market news:

China is expecting a surge of bad loans due to the COVID-19 downturn; in response, it is setting up a distressed debt market to manage this problem. The numbers are staggering, perhaps $1.5 trillion.
Increasing oil shipments and storage is boosting tanker rates.

Foreign policy:

Mask diplomacy is becoming a big deal. China is sending masks around the world and using this action to project soft power. Russia is engaging in similar activities. Meanwhile, Congress is pushing to collapse medical supply chains away from China.
The machinery of U.S. bureaucracy grinds slowly; as U.S. states and cities scramble for medical protective gear, the U.S. is sending such goods overseas. This is simply a case of the bureaucracy acting as it normally does and the executive branch not keeping up. It does appear the White House is getting in front of these shipments and halting them.

Iran: There are reports that Iran is planning attacks on U.S. military bases in Iraq. The U.S. is warning Tehran against such actions.

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Weekly Energy Update (April 2, 2020)

Posted on April 2, 2020April 1, 2020 by Rebekah Stovall

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

Crude oil inventories rose 13.0 mb compared to the forecast rise of 3.5 mb.

In the details, U.S. crude oil production was unchanged at 13.0 mbpd. Exports fell 0.7 mbpd, while imports declined 0.1 mbpd. Refining activity fell 5.0%, well more than the 0.1% decline forecast. The inventory build was due to a combination of falling exports and a severe decline in refinery operations.

The above chart shows the annual seasonal pattern for crude oil inventories. This week’s report has lifted stockpiles well above seasonal norms. Although not totally unexpected, this is the first week where the impact of COVID-19 and the oil war has started to affect the weekly data.

Based on our oil inventory/price model, fair value is $50.98; using the euro/price model, fair value is $48.95. The combined model, a broader analysis of the oil price, generates a fair value of $48.59. Usually, the fair value from the combined model falls within the values generated by the individual models. Recent volatility has led to some model instability, so the combined model is generating the lowest forecast price. As we noted recently, the model output is less relevant unless Russia and the Kingdom of Saudi Arabia (KSA) come to an agreement on supply.

In the coming weeks, there are two key factors we will be monitoring. First, we will start looking at the impact of the virus on demand. This week, we are seeing the first signs that the virus has affected product demand. The chart below shows the four-week average of gasoline supplied to the distribution system. As the chart shows, shipments have cratered. Distillate demand is holding up better, reflecting the increases in delivery of goods.

We also note that refinery activity is rolling over.

This sort of decline is usually seen during severe weather events, such as hurricanes. The COVID-19 crisis will almost certainly last longer and thus will negatively impact crude oil consumption.

Second, estimated primary U.S. commercial crude oil storage is around 510.0 mb. An additional 110.0 mb is available at refineries and in pipelines. The total capacity of the Strategic Petroleum Reserve (SPR) is 713.5 mb, of which 635 mb is already being utilized, meaning there is an additional 77.5 mb. Once primary storage is filled, secondary storage will be utilized. However, it tends to have a higher cost and is less accessible than primary storage. Producers fund storage costs via the calendar spreads in crude oil. When the spread is positive, they produce oil today to sell in the future. Currently, producers can earn $4 per barrel by producing oil now and selling it six months into the future. The chart below shows the rolling six-month crude oil calendar spread.

Since mid-2013, the correlation between the six-month calendar spread and oil inventories has been at 74.6%, with the spread leading inventories by two months. The current spread suggests that oil inventories will rise at least another 10 mb over the next two months.

Adding to inventory pressure are two other factors. First, rising U.S. crude oil exports have been a key factor in reducing U.S. crude oil inventories. As OPEC+Russia boost output and exports, it will be difficult for exports to be maintained. If exports decline, that crude oil will need to be stored.

On the international front, so far, the U.S. has had little success in getting either Russia or the KSA to back away from their adversarial positions. The KSA is poised to dramatically ramp up output. The U.S. is considering easing Iranian sanctions due to COVID-19.

On the domestic front, the White House is considering restricting oil imports in a bid to protect domestic producers. Texas regulators are reopening the debate on having the Texas Railroad Commission return to its role of regulating oil production. Although Congress did not include funding for SPR purchases, the White House is considering a program to allow firms to lease the SPR for additional storage.

In conclusion, the current market fundamentals are about as bearish as we have ever seen. It will take significant government and OPEC intervention to stop the downdraft. History suggests that such actions rarely occur until prices reach unfathomable levels. Although we are friendly to a number of different asset classes, oil isn’t one of them. Somewhere between now and Labor Day, some sort of resolution is likely, but it probably gets much worse before it improves.

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Daily Comment (April 1, 2020)

Posted on April 1, 2020April 1, 2020 by Rebekah Stovall

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

[Posted: 9:30 AM EDT]

Happy April Fool’s Day! But please don’t expect any foolishness here! As always, we soberly review the latest U.S. projections on the course of the COVID-19 pandemic, which have rattled the markets so far this morning. We also note the Fed has come out of the closet as the world’s central bank (see detailed discussion below), while Europe continues to struggle with a way to support its economy.

COVID-19: Official data show confirmed cases have risen to 874,081 worldwide, with 43,537 deaths and 185,194 recoveries. In the United States, confirmed cases rose to 189,633, with 4,081 deaths and 7,136 recoveries (though the recovery data is lagging). Here is the main chart of infections now being published by the Financial Times:

Virology. In its daily news conference yesterday, the Trump administration laid out the projections that prompted the president to back down from his goal to end the nation’s lockdowns as early as April 12. If strict social distancing is maintained, the projections call for a total U.S. death toll of 100,000 to 240,000, versus as many as 2.2 million if social distancing is abandoned. The projected number of serious cases is many times greater, so the key issue will be how badly local health systems are overwhelmed. The statements appear to be a major factor in pushing U.S. equities sharply lower so far today.

- Highlighting the political danger from mismanaging the pressure on a health system, British Prime Minister Johnson is being criticized for insufficiently testing NHS doctors and other workers in self-quarantine. The few tests done to date indicate only some are actually infected, suggesting they’ve been pulled from the front lines for no good reason.
- Several European countries have adopted the Asian strategy of urging everyone to wear masks in public, based on growing evidence that people experiencing no symptoms can spread the disease more widely than previously thought. In the U.S., CDC Director Dr. Robert Redfield said his agency is reviewing its recommendation that healthy people who aren’t hospital workers should refrain from using masks.
- About 70 crew members on the U.S.S. Theodore Roosevelt have now tested positive for COVID-19, prompting the aircraft carrier’s commander to order the remaining 5,000 or so sailors into quarantine in vacant hotels on Guam.
- Now that China has gotten egg on its face from the faulty masks and test kits some Chinese firms have sold abroad, the government has banned firms from exporting medical supplies if they’re not licensed to sell them domestically.

Real Economy. IHS Markit said its final March PMI for the Eurozone manufacturing sector came in at a seasonally adjusted 44.5, modestly lower than the flash estimate of 44.8 and the final February reading of 49.2 (see data tables below). In the U.K., the IHS Markit/CIPS manufacturing PMI fell to a three-month low of 47.8 in March versus 51.7 in February. As with all major PMIs, readings under 50 point to falling activity.
Financial System. In a welcome sign that the junk bond market may be stabilizing after seizing up in early March, junk bond prices have improved a bit this week. At least two major firms have also been able to float riskier debt. Below-investment grade obligations are still trading at elevated spreads over U.S. Treasuries, but the improved market dynamics suggest that aggressive fiscal and monetary policy may have turned the tide. All the same:

- Reports note a massive shriveling in the market for unconventional mortgages, which aren’t backed by the government and therefore aren’t being bought by the Fed. Multiple firms have stopped offering the mortgages, denying financing for many irregular or self-employed people who find it difficult to qualify for a conventional mortgage.
- Under pressure from the Bank of England, most of the U.K.’s major banks have agreed to suspend their dividends and stock buybacks in order to preserve capital during the crisis. The regulators also expect them to refrain from paying bonuses. As might be expected, the news has driven British bank shares sharply lower so far today.

U.S. Fiscal Policy Response. President Trump has called for $2 trillion in new spending on infrastructure to help rekindle economic growth after the coronavirus crisis passes. The new spending, which would follow the three major economic support bills already passed into law, would be paid for by borrowing at today’s super low interest rates. House Speaker Pelosi has also been calling for a “Phase 4” economic bill that includes infrastructure investment, but Senate Majority Leader McConnell hasn’t been supportive. Separately:

- Major private-equity funds are lobbying hard for their portfolio companies to be deemed eligible for the $350 billion in small-business rescue loans included in last month’s economic support package.
- Flight attendant unions are urging Treasury Secretary Mnuchin not to make airline rescue grants contingent on transferring an equity stake to the government, as allowed in the Phase 3 package. The flight attendants fear the stake provision amounts to a “poison pill” that would discourage airline executives from accepting the money and result in mass layoffs.

U.S. Monetary Policy Response. Launching yet another new rescue program, the Fed said it will temporarily allow approximately 170 foreign central banks and international monetary authorities to borrow dollars by pledging the U.S. Treasuries they hold at the New York FRB. The new “FIMA Repo Facility” will supplement the currency swap facilities already in place with more than a dozen major central banks. Amid the global scramble for dollars touched off by the coronavirus crisis, the Fed said a key aim of the facility is to give foreign central banks access to the dollars they need without forcing them into disruptive sales of their Treasury holdings. The facility will likely be considered especially helpful for smaller emerging markets, though China was probably the key country under consideration. In a broader sense, the facility may be one of the most radical, risky, and controversial of the Fed’s many moves to counter the crisis as it amounts to a full, unabashed embrace of being the world’s central bank or the global lender of last resort. That role is clearly at odds with the broader U.S. trend toward deglobalization, and it is out of sync with the administration’s policy of withdrawing from the traditional U.S. role as global hegemon.
Foreign Fiscal Policy Response. The EU continues to struggle to come up with fiscal programs that can cushion the blow from the crisis without generating pushback from the northern creditor members.

- European Commission President Ursula von der Leyen formally proposed the creation of a new EU unemployment reinsurance program to help national governments finance short-time wage subsidies, which are designed to discourage firms from laying off workers when orders dry up.
- To help Europe recover from the coronavirus, French Finance Minister Le Maire proposed an EU-wide facility funded by common EU debt, but the program would be limited to five or 10 years and focused strictly on economic recovery to head off German and Dutch objections to mutualizing obligations.

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IDEA Dividend Update (March 31, 2020)

Posted on March 31, 2020August 17, 2021 by Rebekah Stovall

A Report from the Value Equities Investment Committee | PDF

Growing dividends are at the core of Confluence’s Increasing Dividend Equity Account (IDEA) strategy. Given the unprecedented nature of a national economic shutdown to combat COVID-19, it is likely that many companies, including some that may be held in the IDEA portfolio, will choose to not grow their dividends and some may even choose to temporarily suspend or decrease their dividends during the economic shutdown. With this possibility in mind we thought it would be helpful to proactively discuss the situation and our planned response prior to any changes companies might make with their dividends.

Why are growing dividends beneficial?

First, it would probably be helpful to review why owning companies with growing dividends is a good investment strategy. When you purchase a stock, you are buying a fractional portion of a company with the expectation of receiving a share of its ongoing cash flow. Each year a company’s earnings (cash flow) may be used to reinvest to grow the company, repurchase shares, pay dividends to the owners, or possibly do all three.

Over the long term, a stock’s total return will be determined by the cash flow growth and dividends paid out to the owners. As a result, a company with a history of consistent and growing dividends indicates a company with consistent and growing cash flow – a recipe for good long-term investment returns.

The team at Confluence has a long track record of identifying and investing in companies that not only have histories of growing dividends but also have solid prospects that those dividends should continue to grow well into the future.

Why would a company temporarily suspend or decrease its dividend in the current environment?

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Asset Allocation Quarterly (Second Quarter 2020)

Posted on March 31, 2020April 21, 2020 by Rebekah Stovall

The prospect of a recession in the U.S. is nearly a foregone conclusion. The depth will likely be severe, but the duration could be brief.
Actions over the past two weeks by the U.S. Federal Reserve should help mitigate the economic crisis, potentially avoiding problems faced in past downturns.
The stimulus package signed into law on March 27 offers further assistance for lessening the duration of the contraction.
Our three-year forecast is for a recovery and even the potential for expansion toward the end of the forecast period.
Risk assets, especially U.S. equities and even corporate bonds, are at attractive valuations in our view.
Each strategy now has elevated exposure to equities with a tilt toward growth over value.
Though long-term Treasuries have likely run their course, the use of gold as a stabilizer for the strategies remains appropriate.

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ECONOMIC VIEWPOINTS

The COVID-19 virus has plunged the U.S. and global economies into a recession faster and more violently than anyone had forecasted even a month ago. Sheltering at home has ground economic activity to a near-standstill and has resulted in an astounding increase in unemployment claims and consequent business inactivity. Nearly simultaneously, the price of oil has collapsed, owing to the market share battle waged between the Kingdom of Saudi Arabia [KSA] and Russia. A third concern, that of increasing financial stress, has been addressed and potentially allayed by the recent actions of the Fed. Since the beginning of March, the Fed has responded with the following, among other measures:

Cutting fed funds by 1.50% to 0.00%-0.25%;
Expanding its repo operations, effectively offering an unlimited amount;
Resuming Quantitative Easing as open-ended, announcing thee intention to buy $375 billion in Treasuries and $250 billion in mortgage-backed securities for the week of March 23 alone;
Supporting money market funds through the Money Market Mutual Fund Liquidity Facility, allowing banks to pledge collateral they purchase from prime money market funds.
Resurrecting the Primary Dealer Credit Facility, offering rates as low as 25 basis points to primary dealers with investment-grade debt, including municipals, and equities being used as collateral;
Encouraging bank lending by lowering the discount window rate to 25 basis points and extending the term to 90 days from overnight;
Relaxing regulatory capital requirements and liquidity buffers in an effort to stimulate lending;
Establishing two new facilities to support high-grade U.S. corporations: the Primary Market Corporate Credit Facility – allowing the Fed to buy new corporate bond issues and extending loans; and the Secondary Market Corporate Credit Facility – allowing purchases of not only existing corporate bonds, but also ETFs holding investment-grade rated bonds.

These historic measures by the Fed have the potential to avoid the issues associated with most prior recessions where the financial system exacerbated the problems.

Despite the Fed’s actions, the magnitude of the impact of COVID-19 on the economy remains to be seen. Due to the lag in data reporting, many indicators won’t turn decidedly negative until reports are released in April and May. However, we have noted a sudden decline in financial conditions as measured by the Bloomberg Financial Conditions Index for the U.S., which is compiled daily and comprises eight variables.[1] The more negative the reading, the greater the level of financial stress. It clearly indicates a substantial impact from the economic inactivity inflicted by the disease.

Our forecast is 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 in autumn. However, over the full three-year forecast period, we anticipate that a U-shaped recovery will engage, accompanied by an unleashing of pent-up demand from businesses and households awash in liquidity.

[1] The eight variables contained in the index are the TED spread, LIBOR/OIS spread, commercial paper/T-bill spread, Baa/10-Year T-Note spread, Muni/10-Year T-Note spread, swap volatility, S&P 500 and VIX.

STOCK MARKET OUTLOOK

Although our near-term view is that domestic and overseas equity markets will be in search of new footing, we believe that in the absence of a policy mistake equity markets should recover over the course of our three-year forecast period. That is not to imply that in the interim all will be roses and buttercups for corporations and equity investors. The combination of the pandemic, the “oil war” between Russia and the KSA, and the global recession will naturally cripple corporate earnings. Our updated EPS estimate for the S&P 500 is $127 for 2020. A resurgence of the virus in autumn and/or a policy mistake, such as a failure to follow the $2 trillion stimulus bill with additional legislation in the event of a more severe and durable economic contraction, could plunge equity prices even lower. However, the policy responses thus far have been heartening.

The downturn may provide an opportunity for companies to write down some inflated assets, such as intangibles, and revise compensation structures to appease governance-focused institutional investors. In addition, share repurchase programs are likely to be curtailed, reducing this form of demand for shares, and in the near term, dividends may be suspended by a number of firms as they address the business impact over the next several months. However, over our forecast period, dividends are likely to become the preferred means by which to reward shareholders, thereby replacing share repurchases. Over the course of the next three years we anticipate that pent-up demand, the realignment of supply chains, and builds in corporate inventories will lead to a recovery in equity prices from today’s attractive valuations.

In summary, current pressures associated with COVID-19 and the oil war may continue to build over the next several months, placing more downward pressure on equities. However, we find valuations to be enticing, even factoring in a temporary plunge in EPS for this year. Accordingly, over our forecast period we believe that stocks hold remarkable appeal and will be viewed as such when we look in the rearview mirror in 2023.

Among U.S. equities, a tilt now exists in favor of growth over value and we increase the allocation to the quality factor focusing on profitability, earnings quality, and lower leverage. Within large cap sectors, we established an overweight to Consumer Discretionary, given expectations for performance once constrained demand from COVID-19 is revived, while maintaining the overweight to Technology and Communication Services.

In contrast, overseas developed markets hold lesser appeal, given the current and anticipated continued strength of the U.S. dollar. Until a durable catalyst for weakening the U.S. dollar becomes evident, the strategies will continue to exclude non-U.S. developed market exposure. For the more aggressive strategies, however, we find that emerging markets have largely discounted the effects of a strong dollar, COVID-19, and the oil war. Emerging markets ex-China are trading one-third lower than they were at the end of last year. Accordingly, we have introduced exposure to emerging markets in the higher risk strategies, Growth and Aggressive Growth.

BOND MARKET OUTLOOK

The extraordinary measures employed by the Fed have helped to ratchet down yields across the curve and thus far have effectively rescued the commercial paper and investment-grade corporate bond market. While these measures excluded the high-yield bond market, the stimulus package passed by Congress on March 27 provides the potential for remedy. Within the package is a tax carryback provision allowing companies to use losses incurred from 2018-2020 to offset profits from prior years. This may provide continued life support for a number of high-yield entities. As the chart shows, spreads for both investment-grade and high-yield corporate bonds rapidly widened over the course of the past month yet have declined over the past week due to both Fed intervention and anticipated assistance from the stimulus package.

While the Asset Allocation strategies benefited from employing long-term Treasuries as stabilizers through last quarter’s equity market turbulence, we find continued upside to be limited as there is a risk that the U.S. encounters a lift in inflation this summer from surging demand, which would pressure the long-end of the curve. The potential for an increase in rates over the full three-year forecast period encourages our substantial reduction of long-term bonds in the income-oriented strategies and their elimination from the Growth and Aggressive Growth strategies.

OTHER MARKETS

The combination of our forecast for rates and the significantly attractive pricing caused by the market decline leads to the continued exposure to REITs in the more conservative Income with Growth strategy. Although the office/retail segment will obviously struggle this year, the more diversified pool of REIT enterprises including data storage, cell towers, and timber lessens the impact retail and office formerly held.

We retain the prior elevated allocation to gold given its ability to offer a potential hedge against geopolitical risk. In the more risk-seeking strategies of Growth and Aggressive Growth, gold is complemented by small positions in silver, which we find can magnify the advantages of gold. Another potential advantage of silver is that roughly half of its demand is from industrial uses, which can be supportive of its price during an economic recovery.

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