Keller Quarterly (March 16, 2020)

Posted on March 16, 2020 by Rebekah Stovall

Letter to Investors

The last three weeks of financial market turbulence have been among the most harrowing I’ve ever seen. To my memory it’s been a combination of October 1987 and October 2008, two months I’d prefer to forget. While the stock market was dropping sharply and quickly, U.S. Treasury bonds were soaring almost as fast.[1] In my last two quarterly letters I’ve noted the impossibility of seeing into the future. I think we’ve now established beyond a reasonable doubt that neither we nor anyone else can forecast future events. Within a surprisingly short period of time, the U.S. economy (and the global economy) has moved from a period of steady growth and low unemployment to a position of great vulnerability. How did this happen? Three things have quickly conspired to bring us to this point. The first two were both new and invisible until quite recently. The third was a known concern lurking out of sight (but always there in a long economic expansion). These three causes of our troubles are:

The coronavirus known as SARS-CoV-2, which produces a serious and sometimes fatal disease known as COVID-19, has spread around the world. This virus began in China in December 2019 and began moving across that country in the first two months of this year. From there the virus moved east and west across the world (as almost all viruses do). This virus has proven to be particularly dangerous because it is virtually as contagious as the common cold but has a mortality factor somewhat worse than seasonal influenza. Our chief market strategist, Bill O’Grady, and his team have been tracking the path of this virus since January. As it has neared the U.S. it has become apparent that it will cause an economic slowdown here, since the most effective way to combat this virus is social isolation, which translates to much lower economic activity. Because the virus seems to have an arc of virulence roughly two to three months in length, it has been our view that the virus alone was not enough to cause a recession here or cause lasting economic damage. Over the last week, that view has changed due to the second causal factor.
An oil price war has broken out between OPEC, led by the Kingdom of Saudi Arabia (KSA), and the Russian government. Both governments are oil-dependent and thus benefit from higher (but not too high) oil prices. This mutual goal has been frustrated in the last decade by increasing oil supplies from outside of OPEC and Russia, mostly from the United States. In a meeting that concluded on March 7, the KSA tried to convince Russia to agree to a set of production cuts that would keep prices high. Russia declined to reduce oil production and instead announced its intention to increase production to drive prices down. The KSA has since also announced production increases. These two petrostates appear to be intent on driving prices down in order to: a) maintain and grow market share in China, the world’s #1 importer, and b) reduce U.S. shale producers’ share of world markets by moving oil prices below their costs of production. Once relieved of the U.S.’s large oil production, they hope that prices will rise more permanently. This is a high-stakes game, where the loser is the U.S. oil industry. If the U.S. government cannot force the end of this price war quickly, the probability of a recession in the U.S. rises substantially when combined with the virus-related slowdown. It so happens that right now the U.S. is vulnerable to a recession for a very ordinary reason, our third factor.
Private sector debt always grows as an economic expansion ages. The reason for this is that investors and businesspeople become more bold as an expansion gets old. The further a recession recedes into the rear-view mirror, the more people believe it won’t happen again. Thus, they become bolder in their investments. We are fortunate that, unlike 2008, the debt growth this time is not concentrated in the consumer sector like it was then. Twelve years ago, residential mortgage debt was the big problem. This time the debt problem is corporate debt. This has been something we’ve been monitoring for a while. Both our Market Strategy team and our Asset Allocation team have noted a heightened probability of economic difficulties in their recent publications.[2] Much of this debt, especially that below-investment grade, is tied to the energy industry. Thus, the price war in oil has increased the probability of financial troubles in the oil patch and on Wall Street. Much of this debt is outside of the U.S. banking system. Post-2008 reforms required U.S. banks to hold higher levels of equity capital and reserves, reducing their ability to lend. The demand for debt capital grew, however, as both the economy and the energy industry grew. Non-bank lenders grew dramatically over this decade to meet the demand for money, with the result that financial risk also grew. The “staying power” of energy companies through this likely oil price “valley” is thus reduced by their debt loads, and the lenders who serve them could become impaired as well.

In my opinion, any one of these factors would have been unlikely to produce a recession. For instance, factor #2 did occur just five years ago, when oil prices declined from near $100 per barrel to about $30 over 15 months. While the oil industry suffered its own recession, the U.S. avoided a general recession. The coincidence of all three of these factors within the same short time frame raises substantially and quickly the probability of a recession.

Bill O’Grady publishes every Friday an Asset Allocation Weekly report that is appended to the end of the Confluence Daily Comment. This past Friday Bill published one of the most important pieces he’s ever written.[3] In this report Bill explained why, within the space of a week, the probability of a recession this year has risen from low to high. In a lengthier 2020 Outlook Update published today we explain how the three factors noted above have changed our base case for the year to one of recession.[4] The sharp sell-off in the stock market and the rise in the treasury bond market were not simply due to panic about the coronavirus. We presume that we were not alone in ratcheting up dramatically our expectation of a recession last week. The result is that the U.S. stock market, basis the S&P 500, has dropped 27.0% from its top-tick on February 19 to its bottom tick on March 12. It presently stands at 2711, or 20.1% below its high. Bill’s work (in the AAW report noted) indicates a likely low of about 2300, which is 15.2% below our current level. This estimate presumes a recession of normal length and depth, which is our current expectation. Given that estimate, the market would appear to have, in a period of about three weeks, sold off roughly two-thirds of what we would have expected for the entire cyclical bear market. This is consistent with market behavior over the last few decades, wherein market discounting for rapid changes in expectations has become an extremely quick affair.

What is Confluence doing? Confluence provides both equity strategies (utilizing individual stocks) and asset allocation strategies (utilizing exchange-traded funds, or ETFs). Our equity strategies are fully invested strategies with low turnover, which we believe provide long-term investors (those with a greater than five-year time horizon) the best opportunity to build wealth. We do not asset allocate within an equity portfolio, which means we do not target cash to “time the market.” We don’t do that because we deem it impossible to do so successfully and consistently. This means that our equity portfolios do usually decline in price when the general market heads south. Our goal is not to sit out bear markets, but to survive them by owning shares in companies that not only survive recessions but come out of them with stronger competitive positions. For long-term taxable investors, this strategy is especially valuable, in our opinion.

While we always emphasize company quality according to specific and proprietary guidelines, as the probability of a recession rises, we test each position again regarding its survivability in the sort of recession we anticipate. Any companies that concern us are removed and replaced, even if bought in recent months. In other cases, shares of outstanding businesses we do not own because of prohibitively high valuations become available to us at what we consider to be bargain prices. Thus, again, we will sell shares of companies we consider to be lesser businesses and replace them with what we believe is a quality upgrade. Investors are sometimes troubled when we sell a stock in a down market, even at a loss, but when we do so we have the eventual economic recovery in mind. The goal is to put the portfolio in an optimal position to benefit from that recovery. As a wise old investor once said, “The goal in a falling market is to own tennis balls rather than tomatoes.” Economies and stock markets do recover. We aim to both give up as little as possible on the downside and to pick up as much as possible on the upside.

Confluence’s asset allocation strategies take a medium-term view of investing, that is, a three-year forward time frame. In an era when changes in market prices occur quickly and severely as economic outlooks change, asset allocation is an investor’s best tool to protect oneself. This is a preventative, rather than tactical, maneuver, but it’s by far the most effective. An investor should set a balance between asset classes that fits his or her risk profile when markets are tranquil. After markets have adjusted dramatically, such as at present, it makes sense to reevaluate the asset allocation. If an investor’s risk profile is unchanged, it makes sense for most investors to rebalance the asset allocation.

For clients in our asset allocation and balanced strategies, an investor, with the counsel of their financial advisor, can select the appropriate asset allocation at the outset. If personal circumstances change, the asset allocation can be changed by giving us instructions. Otherwise, we manage the asset allocation according to our investment team’s outlook. When markets move dramatically, the rebalancing occurs automatically in our asset allocation and balanced portfolios.

Given an increasingly dour outlook in recent quarters, we increased the relative duration and investment quality of our fixed income allocations and have increased our allocations to gold in those strategies for which commodity allocations are appropriate. These allocations have cushioned some, but not all, of the downside in the equity allocations. At some point in the economic cycle, we expect to reverse some of those moves. Until that time, rebalancing asset allocations will still occur.

Regardless of the strategy, our investment teams are attentive to the rapid changes that have occurred and are occurring. As noted above, we cannot forecast the future, but new and, sometimes, unexpected changes are par for the course. When dramatically new challenges occur, we react accordingly, if necessary. We encourage you to stay in touch with the changing investment landscape by reading our Daily Comment and other publications on our website.

We appreciate your confidence in us.

Gratefully,

Mark A. Keller, CFA
CEO and Chief Investment Officer

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[1] This is a reminder, by the way, of the value of utilizing both stocks and bonds in a portfolio.

[2] 2020 Outlook: Storm Watch (12/19/2019); Asset Allocation Quarterly (Q1 2020)

[3] Asset Allocation Weekly (3/13/2020)

[4] 2020 Outlook Update: Storm Warning (3/16/2020)

2020 Outlook Update: Storm Warning (March 16, 2020)

Posted on March 16, 2020December 14, 2020 by Rebekah Stovall

by Bill O’Grady & Mark Keller | PDF

Summary—High Probability of Recession:

The economy is facing three simultaneous problems:
1. A public health crisis—COVID-19 and the economic impact of containing it;
2. An oil price war and a regional economic slump;
3. Rapidly rising financial stress caused by (a) and (b) along with underlying unresolved issues.
We estimate the odds of recession are now 80%, although there is a slim chance the economy avoids a recession.
1. There is very little economic data to confirm the economic slump, but the anecdotal evidence is near overwhelming;
2. Given the timing of economic reporting, clear evidence of a downturn won’t be available for several weeks;
3. This report will update our thoughts on how the next few months will unfold.
The content of this report:
1. An overview of how recessions look compared to expansions;
2. A discussion of the three threats the expansion faces;
3. The market impact of these three threats.

Read the full report

Daily Comment (March 16, 2020)

Posted on March 16, 2020March 16, 2020 by Rebekah Stovall

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

[Posted: 9:30 AM EST]

It has been a very busy three days. We update the COVID-19 news. Risk assets reacted favorably to Friday’s press conference at the White House. However, we are not seeing any follow-through today; global equities are lower and bond yields are down across the board. Gold continues to sell off. The Fed moved aggressively, cutting the policy rate and opening QE4. Other central banks are following along. Here are the details:

COVID-19: The world now has 169,387 reported cases of COVID-19, with 6,513 fatalities and 77,257 recoveries. The following is a chart of infections from FT.

Assuming the U.S. continues to track Italy, cases will be up to 25k in a week or so. Here are some bullet points for today:

The U.K.’s natural experiment may be ending: The Johnson administration was bucking the trend of most Western nations by not ordering gathering places to close. The idea was that the virus can’t be contained anyway, so instead the government allowed movement to take place. As infections rose, a “herd immunity” would develop faster. For the population under the age of 50, this policy arguably makes sense. Most younger people are not threatened by the disease. However, for those over 60 it could be deadly. His government is rethinking the policy.
Shutdowns increase: Schools, restaurants, theaters, churches and sporting events are all closing. Nearly 30 million school-aged children are now home. The administration is instructing Americans to “hunker down.” The same is true across Europe. Spain and Italy have been most aggressive as infection rates rise.
All this is having an economic impact: The airline industry is reeling. In Europe, the automobile industry is starting to shut down. The restaurant industry is getting hit hard. In the U.S., this industry represents about 4.75% of GDP.

As economic data from China rolls out, the impact is stunning. Industrial output fell 13.5% for January and February compared to a year earlier. Retail sales plunged 20.5% for the same period and fixed asset investment dropped 24.5%.

Nationalism is on the rise: Border closings are being announced across Europe, undermining the free movement of the past three decades. Travel bans are being extended. Germany is being rocked by reports that the U.S. tried to buy exclusive rights to a COVID-19 vaccine from a German company. Nations within Europe are trying to ban the export of protective gear; the EU is trying to stop that, but it is willing to prevent the export outside the EU.
There is some good news: Vaccine trials are starting.

We will have much more to say on the virus and other issues in the next day or so; an update to our 2020 Outlook is coming soon. Suffice it to say, the odds of recession have increased dramatically in recent days and may be unavoidable.

The Fed: In a surprise move, the FOMC decided to skip the formalities of Tuesday and Wednesday’s meeting and cut to the chase. It cut the policy rate of a range of 0% to 0.25% and announced QE4 by planning to purchase $700 billion of Treasury and mortgage paper. Specifically, it plans to buy $500 billion of Treasuries and $200 billion of mortgage-backed securities; this will take the balance sheet to over $5.0 trillion. In addition to these measures, the Fed reduced the discount rate to 25 bps and encouraged banks and primary dealers to use the window. Using the discount window mechanism would help support liquidity issues in the repo market. It also reduced the reserve requirement ratio to 0%. The FOMC also lowered prices on dollar swap rates with other central banks in a bid to reduce global liquidity issues. It is not clear in the statement how quickly the Fed intends to increase its balance sheet. There was one dissenter: Cleveland’s Loretta Mester opposed the rate cut but did support the other policy actions. The Fed did have “friends” as other central banks took action as well.

The Fed continues to guide policy based on financial risk. We note that the policy rate tends to be cut when the 12-week average of the VIX rises above 20.

We also note that credit has been hit hard.

This chart shows rates on selected corporate yields of various credit quality. Funding strains are evident in the “hockey stick” turns in recent days; there is a clear rush for cash.

The question now is, “what’s left?” There are two other directions the Fed could take. Currently, it cannot buy assets other than Treasuries or mortgages. It could ask Congress to buy other assets, e.g., corporate bonds, and perhaps equities. Or, it could consider buying foreign bonds, which would weaken the dollar. We do note the dollar fell on the move to ZIRP and a weaker dollar should support net exports. For the time being, monetary policy is mostly exhausted.

What about fiscal policy? This is the next line of defense. We are starting to see a consensus among both conservative and liberal-leaning economists on the wisdom of direct payments to households. Sending money directly was done in Hong Kong recently and tax rebates in the U.S. were implemented by the Carter administration. The worry is that political divisions will prevent actions from being taken. We suspect that direct action will likely occur but only after conditions deteriorate further.

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Asset Allocation Weekly (March 13, 2020)

Posted on March 13, 2020March 14, 2020 by Rebekah Stovall

by Asset Allocation Committee

Our baseline position has been that the COVID-19 virus would have a significant impact in terms of magnitude but be of limited duration and thus would probably not put the economy into recession. Over the past week, two events have occurred which put this position into question. The first is the oil market collapse triggered by a market share war between Russia and Saudi Arabia.[1] The second issue is that the financial system is exhibiting symptoms of liquidity problems.

We have noted a sudden decline in financial conditions as measured by the Bloomberg Financial Conditions Index for the U.S.

Our data uses the Friday closes for the index. The index is composed of eight variables[2] which are standardized and totaled. The more negative the reading, the greater the level of financial stress. The index was positive until the last week of February. The current level of stress is about on par with March 2008 during the collapse of Bear Stearns.

This data suggests a serious level of financial problems in the financial system. We have noted difficulties in the funding markets since September. Although the Fed has consistently claimed there was nothing systemic in the rise of repo rates, the persistence of the funding shortages despite the expansion of the Fed’s balance sheet by $400 billion argues otherwise.

What is the nature of the financial stress? Its roots most likely lay with interest rates being too low for too long; investors had to extend their portfolio risk to find attractive yields. The financial services industry took steps to provide financial products with more attractive yields. Some of this product creation went to the non-bank financing system which funds itself in the repo markets. If repo markets are disrupted, they can no longer service the debt they used to own the higher yielding assets and liquidations occur. If no liquid market exists for these products, the owners may be forced to sell other assets (gold, Treasuries, equities, investment grade bonds) to find necessary liquidity. Recent weakness in “risk off” assets would tend to confirm rising levels of financial stress. A contributing factor is the plunge in oil prices, which raises default risk among energy companies.

The Federal Reserve should be able to corral this problem if it moves aggressively enough to force liquidity into the financial system. Unfortunately, as we saw in 2008, it may be difficult to pinpoint exactly where the funding problems lie. But, the key lesson from 2008 is that enforcing moral hazard is a bad idea; we doubt such a policy will be executed in this event. Although a few of our economic indicators have moved to signal recession, the preponderance have not. On the other hand, the yield curve did invert last year, and we have been on “recession watch” for some time.[3]

How does all this affect equity markets? The chart below can offer some guidance. This chart shows the weekly close of the S&P 500 going back to late 1927. We log-transform the index and regress a time trend through the data. The parallel lines represent various standard error levels from trend; the gray bars show recessions. It is obvious that, with the exception of 1945, every recession has led to some degree of stock market weakness.

To compare recessions, we measured the high reached before the recession to the low in the index during the downturn in terms of movements in standard errors. Here is a table of the events.

Range represents the change in standard error from high to low. So, the Great Depression saw the market fall nearly six standard errors, a true “six-sigma” event. The current decline is consistent with a normal recession, so if policymakers can secure the financial system and absorb the quarantine effect of COVID-19, then equity markets should stabilize soon. A deep recession (but not including the Great Depression) would put the S&P 500 around 1640, a much more profound decline.

The postwar experience doesn’t support two consecutive deep recessions, which is why we have argued that another 2008 is unlikely. Of course, we did have consecutive deep recessions in the 1930s: the 1936-37 recession was caused by profoundly inept policy when the Roosevelt administration tightened fiscal policy while the Federal Reserve raised rates. The odds of a similar event occurring in the current situation is improbable; both fiscal and monetary policy are accommodative and will almost certainly become more so. About the only way we have a deep recession is if the policy response is strikingly underwhelming. Although possible, that is a low probability outcome.

So, the bottom line is that we will likely see a few weeks of churning and perhaps a decline toward 2300, but the worst of this downturn is probably over. Liquidity injections and the natural waning of COVID-19 should improve sentiment over time. We are probably very close to the low in terms of price but not in terms of time. It will probably take a few weeks of basing before a durable recovery can develop.

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[1] We discussed this issue in our most recent Weekly Energy Update.

[2] TED spread, LIBOR/OIS spread, commercial paper/T-bill spread, Baa/10-year T-Note spread, Muni/10-year T-Note spread, swap volatility, the S&P 500 and the VIX. There are other similar indices with a larger set of variables, but the Bloomberg variation is calculated daily, whereas the others are calculated weekly or monthly.

[3] Hence the title of our outlook for 2020, “Storm Watch.”

Daily Comment (March 13, 2020)

Posted on March 13, 2020March 13, 2020 by Rebekah Stovall

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

[Posted: 9:30 AM EST]

Happy Friday the 13^th! Let’s not bury the lede—equities are enjoying a strong recovery this morning after a historic decline yesterday. Europe is lifting as well. As is our usual practice, we update news on COVID-19. We also discuss how the virus crisis is rapidly revealing financial turmoil. Here are the details:

COVID-19: The total number of reported cases is 135,232, with 4,981 fatalities and 69,645 recoveries. Here is the latest:

The entertainment industry has been rocked over the past 24 hours:
- MLB has closed spring training and will delay the season opener. The NHL has followed suit and the NCAA has cancelled March Madness. Minor leagues have closed as well; both MiLB and the NBA-G league have ceased playing. The XFL is done for the year. We haven’t looked at ESPN so far, but it will be interesting to see how sports channels handle a period with no sports.
- Broadway has gone dark.
- Select theme parks have closed.
Relations between the U.S. and China are taking a dark turn. Chinese social media is swirling with rumors that COVID-19 came from the U.S. The reports came from China’s foreign ministry and have not been discouraged by Chairman Xi. In response, the White House and members of Congress are firing back. The notion that this virus started in the U.S. is patently silly; China is the fount of viruses such as coronavirus and influenza due to its geography. It lies in the temperate zone where migratory birds move. These viruses fester in wildlife and occasionally cross the species to become a problem for humans. The CPC’s propaganda machine is clearly trying to divert attention, but these attempts will weaken already frayed relations.
As the U.S. steadily locks down with school closings, Europe is doing the same. The epicenter remains in Italy, where the health system is struggling to respond. Policymakers on both sides of the Atlantic are trying to cope with the spread of the virus. Satellite images show mass graves being dug in Iran, likely for COVID-19 victims.

Overall, the virus continues to spread. The pattern that has emerged suggests the U.S. has a couple more weeks of rapidly rising cases before the growth rate begins to taper.

Financial concerns: In this week’s Asset Allocation Weekly (AAW; see section below, p.7), we make the case that the chances of recession have increased to probably 80%. We still haven’t seen confirmation from most of our data signals, but we expect the signals will be forthcoming. Thus, we aren’t certain, but it is probably safe to assume that there is at least a 4/5 chance of a downturn. What has happened here is that the economy has succumbed to three problems. First, the disruptions from COVID-19 will weaken consumption; as we noted in our Outlook 2020 report, GDP growth has become extraordinarily dependent on consumption so it will be hard to maintain positive GDP growth under measures being taken to isolate the virus. Second, the Saudi/Russia oil war will dampen demand in the oil patch and further weaken growth. The third head of this hydra that has emerged is what appears to be liquidity problems in the financial system. As the chart in the AAW shows, the Bloomberg Financial Conditions Index is at levels last seen when Bear Sterns collapsed. Evidence of stress has been surfacing in recent days. Spreads in the Treasury market have widened, suggesting that those holding the paper are not willing to lend it to those who need the collateral. Credit default swap rates have soared.

As we noted yesterday, banks are reporting that rarely tapped credit lines are suddenly being hit, suggesting corporations are facing cash shortages. Margin calls are rising. The need for liquidity has led to participants selling what they can, not what they should. This phenomenon likely explains why gold prices have been falling in the face of a bear market in stocks and aggressive central bank action. Corporate lawyers are reporting a jump in business. We have been reporting on issues in the repo markets since September and have not seen convincing evidence that the Fed has resolved them. So far, its actions have prevented bigger problems but not fixed the “plumbing.” Perhaps now it will get the problem resolved.

Central banks are responding to the immediate crisis. We had a brief respite to equity selling yesterday when the Fed announced a massive $1.5 trillion injection of liquidity to ease problems in the repo market. The ECB responded as well, although Legarde disappointed the market, which was hoping for a “whatever it takes” approach. Her comment of “I am not here to close rate gaps” was a rookie error. Other central banks have moved as well. The Bank of Canada expanded its bond-buying and repo operations. The BOJ added liquidity ($19 billion). The PBOC cut reserve requirements. The Bank of Norway cut rates, and the Riksbank injected liquidity. The BOE says it will continue to support markets. There is action on the fiscal front as well. The House leadership, working with Treasury Secretary Mnuchin, have put together a fiscal package. We will be watching to see how the Senate responds.

Although today’s recovery is obviously welcome, the most likely outcome for the next several weeks is a choppy basing process.

This chart shows how the S&P responded to 1987 and post-Lehman. It suggests a long period of basing. We discuss our views on the path of equities in this week’s AAW below.

So the bottom line is that this expansion has probably come to an end due to the combined impact of COVID-19, the oil market share war and financial fragility.

Conflict in the Middle East: On Thursday, the U.S. conducted airstrikes against an Iran-backed militia. The airstrike was in response to a rocket attack that killed two Americans soldiers and a British service member earlier this week. This was the first attack from the U.S. since the drone strike that killed Qassem Soleimani, and the Pentagon has warned of possible additional actions.

Putin forever: President Putin is backing a measure that would allow him to stay in office until 2036, or until age 83. This isn’t a huge surprise; the only suspense was how he would remain in office.

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Daily Comment (March 12, 2020)

Posted on March 12, 2020March 12, 2020 by Rebekah Stovall

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

[Posted: 9:30 AM EST]

Welcome to the bear market. The Dow Jones Industrials entered a bear market yesterday and the other two major indices, the S&P 500 and the NASDAQ, will certainly enter bear market territory on the open. We cover COVID-19 this morning. The ECB is meeting at the time of this writing; capital restrictions have been eased and QE was lifted but rates were not cut. We also have the Weekly Energy Update report, where we have expanded our thoughts on the market share war. Here are the details:

COVID-19: The number of confirmed cases has reached 127,749, with 4,717 fatalities and 68,305 recoveries. This handy chart from the FT gives a glimpse of what the U.S. will be facing over the next couple of weeks.

If we follow the general trend seen elsewhere, we will be at 8k to 10k cases by the third week of March. The U.S. currently has 1,323 cases. The experience seen overseas suggests exponential growth in infections in the coming days. We note that Dr. Brian Monahan, the attending physician for Congress, warned lawmakers that 70-150 million (yes, millions) of Americans will be infected. However, he didn’t give a time frame, so this headline may not be as dire as its seems. And, in behavior similar to bond rating agencies, the WHO has declared a pandemic.

Not what we were looking for: The president held a rare address to the nation to announce measures to counter COVID-19. The speech began at 8:00pm EDT. This chart of the overnight S&P 500 futures shows the reaction.

The financial markets were looking for “shock and awe.” They wanted to see payroll tax holidays, grants to households, loans and lots of spending. They got a travel ban from Europe, a tax deadline delay and talk that something might be coming. In fact, the speech initially suggested that air cargo trade with Europe would be halted; that had to be clarified. Needless to say, it didn’t go well. What we are experiencing is why Western democracies have shied away from fiscal policy and relied on monetary policy for the past 40 years; in a polarized political environment, getting fiscal policy done is nearly impossible. It is important to note that the first time TARP was put before the House it was voted down. It was only when conditions were spiraling into another Great Depression that Congress acted. The House Democrats have introduced a package of measures which mostly focus on households. The proposal includes food assistance and sick leave pay. There isn’t much help for businesses at this point, although industries being hit will likely, at some point, get relief. We do expect the White House and Congress to get something together in the coming weeks but, if history is any guide, it will only happen when conditions deteriorate further. Meanwhile, pressure on the Fed is mounting; there is increasing talk that the policy rate will fall to zero.

What others are doing on economic support policies: In the U.K., the Johnson government and the BOE are combining efforts to support the economy. We note that to offset some of the spending, businesses are losing an important tax break. This action, by a Conservative government, shows how populism is shifting the “Overton Window” on policy. Australia announced fiscal measures. Germany has announced it will boost spending.
Meanwhile, on combatting COVID-19, here is a list of headlines that have affected sentiment:
- France is banning visitors to nursing homes.
- Italy continues to restrict movement. Hospitals there report they have adopted triage measures to address shortages of beds for those seriously afflicted.
- Poland (with 47 official cases) has shut down its schools.
- Tom Hanks and his wife announced they have tested positive for COVID-19. So did a staffer of Sen. Maria Cantwell (D-WA).
- The CME has closed its trading floor (wait—there was a trading floor?) and the NYSE is considering following suit.
- The NBA has suspended its games after a Utah Jazz player tested positive. The NCAA announced its conference tournaments will not allow general admission tickets; in other words, the “crowds” will be strictly limited.
- The NY Patrick’s Day parade was cancelled.
- China’s car sales fell nearly 80% from last year in February.
We are getting increasingly worried about the economy; our position has been that a recession would likely be avoided. However, two developments have increased the likelihood of an official downturn. First, the oil collapse will put pressure on investment, which is already depressed. Second, it appears that fiscal support is probably farther off than we expected. Even without these developments, the risk of recession was increasing. We are facing both a supply and demand shock. The other worry is in credit. Credit spreads have widened; although banks are in good shape, their businesses are taking a hit as rates fall. The non-bank financial sector is another matter. The Fed is boosting operations to support the repo markets to try to maintain liquidity. There are reports that companies are tapping bank credit lines, which normally sit dormant as a liquidity backstop. So far, this downturn isn’t triggering a financial crisis, but tensions in repo and the use of credit lines are a worry.

Iraq: A rocket attack at Camp Taji killed two U.S. soldiers and one U.K. soldier. It isn’t certain who was responsible for the attack; however, a similar attack in January led to the counterattack that killed Iranian Gen. Qassem Soleimani. Given the current situation, we are not sure we will see a similar level of retaliation to this attack.

Energy update: We are now updating our weekly energy recap from the DOE in a separate document published on our website, the Weekly Energy Update. Going forward, we will be linking to the report here after the data is released.

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Weekly Energy Update (March 12, 2020)

Posted on March 12, 2020March 12, 2020 by Rebekah Stovall

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

Crude oil inventories rose 7.7 mb compared to the forecast rise of 1.7 mb.

In the details, U.S. crude oil production fell 0.1 mbpd to 13.0 mbpd. Exports fell 0.7 mbpd, while imports rose 0.2 mbpd. The inventory build was more than forecast due to falling exports and rising imports.

This chart shows the annual seasonal pattern for crude oil inventories. This week’s report rose to seasonal norms. Inventories will be expected to rise steady into late May. We will be watching the above chart closely in the coming weeks for signs that inventories are rising abnormally due to the market share war described below.

Based on our oil inventory/price model, fair value is $56.46; using the euro/price model, fair value is $53.22. The combined model, a broader analysis of the oil price, generates a fair value of $53.57. The model has lifted its fair value calculations due to dollar weakness; however, under current circumstances, the model output is less relevant unless Russia and the Kingdom of Saudi Arabia (KSA) come to an agreement on supply.

The big news in oil is the market share war that has emerged from the recent OPEC+Russia meeting. The KSA was unable to convince Russia to contribute to supply restrictions and Riyadh has announced an all-out supply war. Prices plunged this week in response.

The following two charts show the KSA’s thinking. The Saudis have, in their history, had one market they keyed on where they wanted either to be the largest or second largest supplier. In the 1970s through the 1990s, that market was the U.S. There were two reasons for this. The U.S. was the largest importer of crude oil and provided security for the KSA. Thus, the kingdom did not want to lose share in the U.S. because (a) it was the most important market in the world, and (b) it feared the U.S. would view providing security as less critical if the KSA was seen as less important. During two previous market share wars, in 1986 and 1997-99, the loss of share was a triggering event. The chart below shows WTI along with the Saudi rank as foreign supplier to the U.S. market. The gray bars are designated as market share wars.

Until 1986, the KSA acted as “swing producer” for OPEC.[1] This led to a near-catastrophic loss of market share in the U.S. In December 1985, the KSA signaled it was abandoning the swing producer role and would retake market share. Oil prices fell from the low $30s to near $10 per barrel before the rest of OPEC capitulated and agreed to output cuts. In the mid-to-late 1990s, the KSA was losing market share in the U.S. to Venezuela, which had invited foreign company oil investment in order to boost output capacity. The KSA retaliated with supply increases into the Asian Financial Crisis. Prices fell from the mid-$20s to near $10. The war ended when Venezuelan President-elect Hugo Chavez signaled an end to the supply war, eventually ending the policy of using foreign investment to lift capacity. Prices rapidly recovered.

This time around, the U.S. is not the target of the KSA. The U.S. has made it clear that it is reducing its security footprint in the Middle East and, with the onset of shale production and a “captured” Canadian oil market,[2] the KSA can’t really defend its U.S. share. Instead, it has staked its future on rising Chinese oil demand, and likely hopes that, at some point, it will be able to receive security support from China as well.[3] Therefore, the KSA is committed to be the preeminent oil supplier to Beijing. Russia is threatening that position.

This chart shows the share of China’s oil imports from the KSA, Russia and Iran. From 2006 to 2012, the KSA held a dominant share. But, since 2014 (when the KSA reversed its policy on trying to drive down shale oil production via lower prices), Russia’s share has been competing with the KSA.

So, given this background, how do we expect this to play out? Most OPEC nations are rentier states; they use revenue from oil to support government spending. In addition, these nations tend to suffer from the “Dutch disease,” a condition where a commodity export tends to boost exchange rates, making domestic industries less competitive. This process tends to lift imports and consumers become used to low-priced goods from abroad. As a result, currency depreciation tends to be politically unpopular. When the KSA fought for market share in the past, its competitors tended to avoid currency depreciation, which is an effective buffer to the costs of the market share war. In other words, a foreign oil company sells its product for dollars but pays its workers in local currency. If the currency depreciates, then its production costs compared to output prices decline. Russia has shown a tendency to depreciate the RUB when oil prices decline. The next chart shows that tendency.

This chart shows Brent crude oil prices and the RUB/USD exchange rate (inverted scale). Note that as oil prices decline, the RUB falls with it. If Russia engages in similar behavior, it will give it more “staying power” in the share war.

How much will this event affect employment? In the oil patch, it will be signficant.

Assuming we see $25 WTI, we will likely see nearly 40k jobs lost in oil and gas extraction. But, as the chart shows, it will take about 18 months to occur.

The bottom line is that this share war will likely get rather ugly. The KSA is pushing supply into the world market and it has no place to go. The U.S. oil industry will suffer greatly, but production probably won’t start to decline until autumn, when price hedges will likely roll off. Iran will also be crushed by this move; the little oil it is selling will fall dramatically in price. We look for prices to fall into the low $20s in the coming months.

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[1] A swing producer adjusts output to fix a price.

[2] Canada’s pipeline system is limited, so most of its output ends up in the U.S. market. This means, at least in terms of the oil market, that Canadian production can be thought of as U.S. supply.

[3] This is a bit of a pipedream. Although China’s military is growing rapidly, it is still years away from being able to project power beyond its borders.

Daily Comment (March 11, 2020)

Posted on March 11, 2020March 11, 2020 by Rebekah Stovall

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

[Posted: 9:30 AM EST]

On this day in 1918, the first cases of Spanish influenza were reported in Ft. Riley, Kansas. How ironic it is that we’re now dealing with another big epidemic, though there is still no indication that it will be a mass killer like the Spanish flu. As always, below we provide an update on COVID-19, its economic impact and the evolving policy responses. We also discuss the escalating Saudi-Russia oil price war and the results of yesterday’s primary elections.

COVID-19: Official data show confirmed cases have risen to 121,061 worldwide, with 4,368 deaths and 66,216 recoveries. New cases continue to slow in China, but the epidemic is accelerating elsewhere. In the United States, confirmed cases rose to 1,039, with 29 deaths and eight recoveries. In the hot spot around Seattle, authorities say COVID-19 has now spread to at least 11 elder care facilities; at least three have reported fatalities. Separately, New York Gov. Andrew Cuomo called out the national guard to help set up a “containment area” in a New York City suburb that has had a rash of cases. Residents will be free to walk around the three square mile area, but significant public gatherings will be banned for two weeks. Illustrating one important way the epidemic could impact the political process, former Vice President Biden and Vermont Sen. Bernie Sanders canceled campaign rallies yesterday on concerns about spreading the virus. Across the pond, even Britain’s junior Health Minister Nadine Dorries has been diagnosed with COVID-19, less than a week after she attended a reception with Prime Minister Johnson. In South Korea, a new cluster of infections discovered at a call center led to a surge in new cases that ended a four-day string of declines. Italy had its deadliest day of the crisis, with its death toll rising by 168 to a total of 631 dead.

Economic Impact. People are becoming more aware that the epidemic’s dual impact on both the supply side of the economy and the demand side will make the economic harm deeper and longer lasting than initially thought. Some businesses are expecting the impact to last even into the third quarter. In terms of the spreading economic impact, today Poland said it will close its schools, universities, cultural institutions and other mass events for next week. In Japan, worries about the effects of the epidemic have made many major firms reluctant to offer base pay hikes in their annual wage talks beginning today. Toyota (TM, 126.99) is forgoing its uniform monthly pay scale increase for the first time since 2013. The moves could hold down Japanese incomes for some time to come.
Fiscal Policy Response. Precisely as we warned in our Comment yesterday, the administration’s Tuesday discussions with congressional leaders regarding an economic support package fell flat as both Republican and Democratic legislators apparently want to focus on smaller, more targeted measures instead of broad measures like a payroll tax cut. For Democrats, that may be because of a perception that the White House is overreaching. Reports say President Trump has privately floated ideas ranging from eliminating the payroll tax permanently to offering massive tax cuts to the oil and gas industry. For Republicans, the resistance seems to be rooted in ideological antipathy for big government programs to support the broad working class. In any case, we suspect the pushback against the program is a key reason for the weakness in stocks this morning. Still, we note that Democrats in the House reportedly are preparing to propose some targeted measures as early as Wednesday in order to start the ball rolling before Congress starts a one-week break on Thursday. In terms of administrative action, sources say the Treasury Department is also likely to extend this year’s April 15 tax filing deadline.

- Italy ramped up the size of its emergency economic support to €25 billion from the €7.5 billion approved just last week.
- In a video call with EU leaders, ECB Chief Christine Lagarde urged a stronger, more coordinated fiscal response across the Eurozone. A prominent group of German economists also urged Chancellor Merkel’s government to abandon its commitment to a balanced budget in order to boost the COVID-19 fight.
Monetary Policy Response. The Bank of England announced an emergency cut in its benchmark short-term interest rate, reducing it to just 0.25% from 0.75% previously. The central bank also introduced a host of measures aimed at maintaining the flow of credit to British businesses. The unexpected support for the economy has been a key factor in boosting European stocks so far this morning.

Oil market: In a further escalation of the oil price war with Russia, the Saudi government said it would boost its crude production capacity to 13 million barrels per day from 12 million previously. The announcement has put additional significant downward pressure on oil prices so far today. However, as the threat of lower oil prices continues to suggest reduced U.S. shale drilling, investors are realizing that would likely also cut natural gas production (often a by-product of oil output). Natural gas prices have therefore surged in recent days.

Russia: President Putin said he would support a legislative proposal to lift the country’s term limits so could remain in power until at least 2036, which we discussed in yesterday’s Comment. The Duma has already approved the change.

Super Tuesday II: In yesterday’s Democratic primary elections, former Vice President Biden again put in a strong showing with convincing wins over Sen. Sanders in Michigan, Missouri, Mississippi and Idaho. The race in Washington State is too close to call at the moment. Based on current estimates of how many pledged delegates each candidate has won, we estimate Biden would only have to win 46.8% of the remaining delegates to lock up the party’s nomination on the first vote at the summer convention. That suggests Sen. Sanders could well drop out in the coming days. By removing the threat of Sanders-style “democratic socialism,” such a move would likely be positive for equities. Just as important, Biden seems to be forming a broad, durable coalition consisting primarily of African Americans, white suburbanites and older voters. That coalition would likely be potent in much of the Midwest and South. In other words, Biden is positioning himself to be a strong rival to President Trump in the November elections. If momentum keeps swinging toward Biden, we would look for many foreign leaders to push back stronger against Trump’s foreign and trade policies on hopes of waiting him out until January.

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Daily Comment (March 10, 2020)

Posted on March 10, 2020March 10, 2020 by Rebekah Stovall

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

[Posted: 9:30 AM EST]

Happy Tuesday! The markets are looking better than yesterday, largely based on signs that the White House has swung behind the idea of significant fiscal measures to offset the negative impact of the COVID-19 panic. We update the latest news on the coronavirus and discuss prospects for the relief package. Separately, the oil price war between Saudi Arabia and Russia is intensifying, though crude is for now being swept up in the positive sentiment about the fiscal response to the coronavirus.

COVID-19: Official data show confirmed cases have risen to 115,855 worldwide, with 4,087 deaths and 64,046 recoveries. In the United States, confirmed cases rose to 755, with 26 deaths and 8 recoveries. However, the data continue to suggest the epidemic is peaking in China. The country reported only 19 new cases today, and President Xi finally visited the epicenter of the outbreak in Wuhan and claimed “victory is near.” That’s consistent with our view that the outbreak may follow a roughly two-to-three-month cycle when it hits a country. With the epidemic apparently peaking in China, attention will now focus on the accelerating outbreaks in other countries. The WHO now says the COVID-19 outbreak is “very close” to becoming a pandemic. All the same, the two-to-three-month cycle would suggest those outbreaks could slow dramatically by late April, even if the impact on the economy and economic data extends into early summer.

Economic Impact. Not only did President Xi visit Wuhan, but local government officials said people in some areas would soon be allowed to travel within Hubei province. In contrast, the Italian government extended its public health restrictions and ban on non-essential travel to the whole country. The restrictions will be in place until April 3.
Fiscal Policy Response. In a statement yesterday, President Trump said administration officials will meet on Tuesday with Republican leaders in Congress to discuss coronavirus economic measures. He said a news conference on Tuesday afternoon will include the announcement of “major” steps like a cut in payroll taxes, financial support for hourly employees who can’t work and loans for small businesses. That news has given risk assets a strong boost so far this morning. However, since Trump didn’t discuss broader steps and some congressional Republicans previously pushed back against early action, we think there is a risk that the total package ultimately won’t satisfy the markets. Besides, if the Republicans can’t resist the temptation to pepper any required legislation with measures inimical to the Democratic majority in the House – such as draconian new regulations on immigration or immigrants – passage through Congress could be delayed or stopped. Another issue to watch is any risk that President Trump himself might be exposed to the virus. Trump was reportedly in contact with two congressmen who later went into self-quarantine because of previous contact with a coronavirus patient, and at a news conference following Trump’s statement, officials were either unwilling or unable to say whether Trump has been tested for infection. Separately:

- The Italian government said it would boost its fiscal measures to €10.0 billion from the original €7.5 billion, and also suspend mortgage payments. To help ease such measures, European Commission officials said they will consider loosening their rules governing state aid to businesses.
- The Japanese government adopted a fresh emergency package valued at almost $10 billion, including no-interest loans for small and medium businesses facing lost sales.

Stock Market Action. Stock selling was brutal and merciless around the world yesterday, but in the key U.S. market it still wasn’t quite enough to produce a bear market in terms of the broad indices. At market close, the S&P 500 price index was down 18.9% from its record close in mid-February. All the same, if today’s nascent rebound doesn’t hold, the index could easily fall below the 2,708.92 level that would officially mark a bear market and put an end to the bull market that began back in early 2009.

- One saving grace is that retail investors have been cautious ever since the late-2018 correction. Although the data are volatile, the charts below show a net inflow of funds into bond mutual funds and ETFs during 2019, along with net outflows from stock funds. Since retail investors were already cautious going into the current downturn, the usual negative impact of a major decline in equities may not be as pronounced this time around.

- Another saving grace is that retail money market fund assets have now risen above $1.4 trillion, as shown in the chart below. There has also been a big rise in fund assets as a share of stock market capitalization (not shown). Either way you cut it, there seems to be sufficient fuel to support a strong recovery in equities if investors see the kind of fiscal shock and awe they’re looking for.

Bond Market Action. With equities looking set to enter a bear market, government bonds continue to surge. The yield on the benchmark 10-year Treasury dropped to a record low close of 0.50%. Market indicators continue to suggest investors are looking for the Fed to cut its benchmark fed funds rate by about 0.75% and for inflation pressures to crater for some time to come, giving a big bid to longer-term obligations.

Oil Market: In a dramatic escalation of its price war with Russia, the Saudi government said it will boost its oil supply to 12.3 million barrels per day (bpd) by next month. That would be 2.5 million bpd above its recent supply, and 300,000 bpd above its previously declared maximum production (suggesting the Saudis will release supply out of inventory). Russian Energy Minister Novak responded with a threat to boost Russia’s oil supply by 500,000 bpd. By itself, the Saudi effort to inflict maximum pain on Russia and force it to agree to production cuts would be bearish for oil prices. However, traders today are more focused on signs of fiscal measures to tackle the COVID-19 panic; thus, prices so far this morning are rebounding.

Russia: Legislators considering President Putin’s constitutional changes, which would let him keep exercising power even after his term expires in 2024, have proposed simply resetting the country’s term limits so he could remain president potentially until at least 2036. The proposal comes after Putin last week said he wouldn’t take the leadership of the proposed new State Council on grounds that doing so would be “destructive” for Russia. Importantly, the pro-Putin United Russia Party said it would support the change to term limits.

United States-Iran: The Pentagon has begun withdrawing some of the troops it sent to the Middle East after the assassination of IRGC Commander Soleimani in January. Officials have reportedly concluded there is now less risk of Iranian reprisal strikes. If the assessment is correct, the improved security outlook would likely be positive for global risk assets but negative for oil.

Turkey-Syria-EU: Turkish President Erdogan began meeting with EU officials about shoring up their 2016 migrant deal, under which Turkey harbors refugees from Syria’s civil war in return for EU financial assistance. However, there was no sign of a breakthrough that would prompt Erdogan to reverse his move last week to allow refugees to cross from Turkey into Greece. The threat of a new European migrant crisis remains a political risk for European assets.

United States: In what’s being called “Super Tuesday II,” primary elections are being held in six states today. In the key Democratic Party contests, the largest number of convention delegates at stake are in Michigan and Washington. Also voting are Missouri, Mississippi, North Dakota and Idaho. If former Vice President Biden polls well against Vermont Sen. Bernie Sanders and his “democratic socialist” message, the results could be reassuring and positive for stocks tomorrow.

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