The business cycle has a major impact on financial markets; recessions usually accompany bear markets in equities. We have created this report to keep our readers apprised of the potential for recession, which we plan to update on a monthly basis. Although it isn’t the final word on our views about recession, it is part of our process in signaling the potential for a downturn.
December brought a wave of positive news about the economy. U.S. large and mid-cap equities ended the year at record highs largely due to strong performance in the Technology sector.[1] Moreover, the U.S. and China announced an agreement for the “Phase One” trade deal. Additionally, strong retail sales around the holiday break offered reassurance that U.S. consumption, which is the largest contributor to GDP, remains strong. However, not all was positive. The manufacturing sector continued to show signs of weakness that will likely persist into 2020. Last month, Boeing (BA, 323.89), arguably the largest U.S. manufacturing exporter, announced that it will suspend production of its Boeing 737 Max starting in January. It is estimated that the production cut will reduce annualized GDP by 30 to 50 bps. That being said, our diffusion index has remained unchanged from the previous month with nine out of 11 indicators in expansion territory. The reading for this month came in at +0.575.
The chart above shows the Confluence Diffusion Index. It uses a three-month moving average of 11 leading indicators to track the state of the business cycle. The red line signals when the business cycle is headed toward a contraction, while the blue line signals when the business cycle is headed toward a recovery. On average, the diffusion index is currently providing about six months of lead time for a contraction and five months of lead time for a recovery. Continue reading for a more in-depth understanding of how the indicators are performing and refer to our Glossary of Charts at the back of this report for a description of each chart and what it measures. A chart title listed in red indicates that indicator is signaling recession.
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA
[Posted: 9:30 AM EST]
It’s GDP Thursday! We cover the data in detail below but the report came in at 2.0% which was close to forecast. Risk-off returns as global equity markets slump. We update the latest on the Coronavirus. The BOE surprises; the Fed does not. The EU officially accepts Brexit; the U.K. does tomorrow. We cover yesterday’s DOE data. Here are the details:
Coronavirus: We now have more than 7,711 cases confirmed along with 170 fatalities. The World Health Organization (WHO) will meet today; they may decide to declare the virus as a world public health emergency after declining to do so last week. Russia has partially closed its border with China. Some interesting research has emerged on the virus. First, the New England Journal of Medicine has calculated that the average incubation period is just over five days, not the 14 that was estimated earlier. That shorter period will likely reduce the dispersion as people get sicker sooner than thought and thus are not “out and about.” Second, the report suggests the R0 is more like 2.2 instead of the 2.5 that has been earlier estimated. That reduction means that the actual spread should be less than some earlier estimates. SARS, for example, had a R0 of 3.0, meaning that every case meant that three others were also infected. Third, the disease is primarily affecting older people; in reported cases (those sick enough to notice), over 50% were aged 60 or older, and there are very few reported cases among children of 15 years or less.
The BOE: The Bank of England held its benchmark short-term interest rate unchanged at 0.75%, as expected, based on the policymakers’ view that improved business sentiment since the December election has pushed off the need for stimulus. However, the policymakers also cut their economic forecast to the weakest since World War II. They now see the British GDP growing just 1.1% per year in the coming three years, compared with the government’s forecast of 2.8%.
U.K. equities and debt prices fell, while the GBP rallied.
The Fed: In some respects the FOMC did exactly what we expected. The changes in the statement were minimal. In fact, only three words were changed in the body of the statement and one of those referred to the month of the year. Housing spending was downgraded a bit, from “strong” to “moderate,” and inflation was changed from “near” to “returning to” the 2% target. The Fed did raise the Interest on Excess Reserves (IOER) by 5 bps, so one might be able to argue there was a modest tightening, but even this would be a stretch. However, despite the lack of change, financial markets took the response with a bearish tone. Equities fell off their highs and bonds rallied. Perhaps the moderate position on future growth dampened investor optimism.
Here is our take. First, the increase on IOER is designed to push the effective fed funds rate (the actual rate banks borrow) towards the middle of the target range.
These charts show effective fed funds and the target range. The left-hand chart shows the data from 2008 to the present, while the right-hand chart shows the data from Q4 2018. On the right-hand chart, there are two issues we want to highlight. First, the Fed has tried to keep the effective rate near the midpoint of the range; because it has been running near the low end, it is lifting the IOER to push the effective fed funds rate to the midrange. Thus, it is technically a tightening but clearly not much of one. Second, note the spike in fed funds in late Q3. That was spawned by the repo crisis.
The second item of interest is that the financial markets are starting to signal further easing might be in order.
The implied LIBOR rate from the two-year deferred Eurodollar futures contract has been a good guide to policy easing. In general, when the implied rate falls below the fed funds target, easing usually follows. Last summer the spread widened out to excessive levels; the FOMC responded with rate cuts which narrowed the spread back to zero. However, in the past two weeks, the spread has widened to near 30 bps. Although the Fed will almost certainly wait, this data would suggest the next move by the central bank will be to ease. It is possible that the recent behavior of the financial markets raised hopes that the chair would have taken a more obvious dovish stance. Perhaps the lack of action is what led to the hawkish market response.
Mexico: Preliminary figures show Mexican GDP contracted by a seasonally-adjusted 0.3% in the fourth quarter of 2019. Not only was the decline worse than expected, but it also marked the third straight quarterly contraction and confirmed that the Mexican economy remains in recession. Since the three straight quarters of decline were just enough to offset a growth in the first quarter, GDP in the fourth quarter was unchanged from the same period one year earlier.
Odds and ends: There is an oil tanker on fire in the Persian Gulf; however, it appears to be empty and this may be a case of mutiny. According the reports, the crew has been stuck on board the vessel for more than a year due to an ownership dispute. The fire many have been set by the crew to get off the ship. Since they were evacuated, we would have to say it appears to have worked. USCMA is official. And, some good news…U.S. life expectancy has reversed a four-year decline and rose in 2019.
Energy update: Crude oil inventories rose 3.5 mb compared to a forecast rise to 0.1 mb.
In the details, U.S. crude oil production was unchanged at 13.0 mbpd. Exports rose 0.1 mbpd while imports rose 0.2 mbpd. The rise in stockpiles exceeded forecasts.
(Sources: DOE, CIM)
This chart shows the annual seasonal pattern for crude oil inventories. This week’s rise was consistent with seasonal patterns, although the level of inventory accumulation continues to lag historical norms. As the chart shows, oil inventories usually rise into late spring and then decline significantly into late summer. Last year, this pattern was disrupted to some extent because of exports.
The biggest surprise in the data was the sharp drop in refinery operations, which plunged 3.3% relative to expectations of a 0.7% drop.
(Sources: DOE, CIM)
The seasonal trough usually occurs in mid-February. Refinery demand will likely remain soft until early May, which is a bearish factor for oil prices.
Based on our oil inventory/price model, fair value is $63.37; using the euro/price model, fair value is $50.47. The combined model, a broader analysis of the oil price, generates a fair value of $54.41. We are seeing a steady fall in all of the fair value calculations, as the dollar strengthens and oil inventories rise. However, the combined model is now in line with current prices so we may see some consolidation in the coming weeks.
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA
[Posted: 9:30 AM EST]
BREAKING: Houthi rebels claim they launched a drone and missile attack on Saudi oil facilities; oil prices have rallied on the news.
It’s FOMC Day! As we noted yesterday, we don’t expect much from the statement, but the press conference could be interesting. Developed equity markets continue to recover. We update on the coronavirus. More on the U.K. The CBO projects the deficit. We are also monitoring some reports out of Afghanistan. An update on Spain. Here are the details:
The Fed: To recap, we don’t expect any change in policy. In fact, in the statement, we shouldn’t see any reference to balance sheet expansion, since the Fed continues to insist that it isn’t QE. However, we could see some hard questioning on the balance sheet in the press conference. One potentially bearish factor would be if the Chair signals that the expansion will be taken away anytime soon. There should also be some discussion of the coronavirus and the potential impact on monetary policy. We expect Powell to suggest that the FOMC is watching developments and will move to lower rates if the virus negatively affects growth. Overall, this one should be a snoozer, but if a surprise is going to happen it will be in the press conference.
U.K.: We continue to monitor for fallout from the Johnson government’s decision to accept Huawei (002502, CNY 2.99), defying a U.S. ban. The fear is that if the U.S. doesn’t retaliate strongly, the EU will likely follow the same path. Germany is considering accepting equipment from the Chinese firm under threat from Beijing that it will face auto tariffs if it complies with U.S. demands. In some respects, Europe is in a very difficult spot. The Eurozone has essentially become a “greater Germany” in economic terms. In other words, as Germany has become dependent on exports, so has the rest of the Eurozone. That means other nations can affect the Eurozone economy by reducing the amount of goods they buy from the region. At the same time, its defense capabilities are modest at best, so the EU still depends on the U.S. for security. Europe seems to be betting that the U.S. won’t inflict costs high enough compared to the loss of future 5G.
Bolivia: Last October, Evo Morales, the former president of the country, fled into exile in Mexico after he was denied the right to run again for office. Jeanine Anez took over as interim president with promises to step down once elections occurred. Apparently, she has developed a fondness of the office as she has announced her candidacy. This decision will be controversial, as she is seen as a divisive figure. Elections are not due until Oct. 20.
The deficit: The Congressional Budget Office has updated its forecast for the deficit. The numbers are large.
In general, deficits around 5% of the GDP are usually associated with recessions. To have deficits at this level late in an expansion suggests the deficit will expand even further when the inevitable recession occurs. Still, it’s important to remember that the impact of deficits is dependent upon the level of unused resources in the economy. The fact that we can run deficits of this magnitude without serious inflation ramifications suggests that there is still ample slack in the economy. The dollar’s strength in the face of these deficits suggests there are no concerns about capacity to service the debt. So, for now, this situation isn’t a problem.
Troubles in Catalonia: Unity among pro-Catalan independence parties suffered a blow on Wednesday, after Catalan President Quim Torra called for new regional elections. The move is in response to the President being stripped of his voting rights after the Spanish Court and Central Electoral board found him guilty of disobeying electoral rules. In December, President Torra was found guilty of disobedience for his refusal to remove banners in support of jailed pro-independence leaders. New elections highlight the growing fractions between separatist parties, the Republican Left of Catalonia (ERC) and Junts Per Catalonia (JxCAT). Although the two sides agree on Catalan independence, the groups represent opposite sides of the political spectrum. The political storm has yet to cause uncertainty within Spain, but highlights the growing differences between the two sides.
You don’t need me to tell you this, but 2019 was an unusually good year for the public financial markets. Virtually every market rebounded nicely from the sharp sell-offs that occurred in late 2018. How broad was the advance? Confluence Investment Management’s Asset Allocation team tracks 12 major asset classes globally, consisting generally of domestic and foreign stocks, domestic bonds, real estate, commodities, and cash. In 2018 only two of these asset classes had positive total returns: U.S. Treasury bonds and cash.[1] 2019 was a different story entirely: all 12 asset classes had positive returns in the calendar year. In fact, only three of the 12 asset classes failed to provide a total return of at least 10% (U.S. Treasury bonds, commodities, and cash). Yes, 2019 was truly an unusual year.
Such a year raises expectations for the following year, inasmuch as most investors seem to peg their expectations to the market. So, what’s ahead for 2020? If you read my October 2019 letter, you know I can’t answer that question. We cannot predict the future. As I noted in that last quarterly letter, it seems odd to have to say that, but so many people seem to believe that investing is all about making accurate forecasts of future events. We believe that to invest according to a prediction of the future is pure speculation. Rather, we hold that investing in an uncertain world does not depend upon a prediction, but upon a process. It is our view that a successful investment process is one that enhances the probability of favorable outcomes.
Confluence has recently begun producing podcasts, which are available on our website. I would particularly encourage you to listen to podcast episodes #5 and #6, which discuss the importance of utilizing a repeatable investment process in order to enhance the probability of success in an uncertain investment world. At Confluence, we have worked hard over the years to create processes that we believe improve the probabilities of good investment returns. We work equally hard to consistently apply those processes day after day, year after year.
In episode #6, I liken a good investment process to that of a good batter in baseball. Good batting form and approach improve the odds of success, but don’t guarantee it. (Indeed, an excellent batsman still fails in about 70% of his at-bats!) Likewise, in investing, a good process improves the odds of success, but doesn’t guarantee it.
The reason there are no guarantees in investing is that randomness is always with us. (Statisticians say randomness for what most of us call luck.) A good batter may put a good swing on a pitch and hit the “daylights” out of the ball yet hit it right at a fielder. But, often, a good batting approach will result in a hit. We seek to do the same in investing. A good investment process may still result in a less-than-good outcome due to the vagaries inherent in the world of investing, but we believe the probabilities of good outcomes are enhanced by a consistently applied process.
Thus, even though we don’t know what will happen in 2020, we feel confident that consistent adherence to good processes will improve the probabilities of good outcomes. We don’t know whether the economy will fall into a recession this year or who will be elected president in November, but we must manage client assets regardless of how these events unfold. Success, or the lack thereof, will not depend on whether we “guessed right,” but on whether we stuck to our processes. That’s how we look at the coming year. It may not be as exciting as a newsworthy forecast, but, unlike predicting the future, it is something we can do.
We appreciate your confidence in us.
Gratefully,
Mark A. Keller, CFA CEO and Chief Investment Officer
[1] This and all other references to asset class performance in this letter are based on total returns of generally accepted market indices for each asset class.
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA
[Posted: 9:30 AM EST]
Update on the coronavirus and the FOMC meeting begins today. Asian equity markets remain under pressure, but Europe and the U.S. are stabilizing. U.K. defies U.S. on Huawei (002502, CNY 2.99) Here is what we are watching this morning:
Coronavirus: The infection rate and death toll continue to mount. Infections are now over 4,500 and the death toll is over 100. Hong Kong is increasing travel restrictions from the mainland. The quarantine hospital in Beijing has reopened to deal with the Wuhan virus. In what could be a significant disclosure, the mayor of Wuhan, Zhou Xianwang, reports that rules imposed by the central government limited what could be disclosed in the early stages of the outbreak. This puts the Xi government in a bad light, suggesting it is making similar errors to the SARS crisis and exacerbating the spread of the disease. Japan reported its first domestic transmission of the virus. Meanwhile, governments are moving to evacuate citizens from Wuhan; the worry is that they may be inadvertently spreading the disease, although it would be a true “own goal” if these evacuees are not monitored closely. The CDC has expanded its travel warning to all of China. In a rather curious development, China has been receiving donations from Western firms. As the virus spreads, worries about the hit to global growth are rising as well. We suspect this event will reduce growth; the collapse in oil prices is clear evidence that market participants think so too. However, it is also important to remember that one of the functions of the financial markets is to offer a place where such events can be discounted. It is quite possible that some markets are underestimating the impact, while others are overdoing it a bit. The fact that European and U.S. equity markets are stabilizing is probably an example of properly discounting the impact of distance from the epicenter of the pandemic. What remains to be seen is if the Asian equity markets (or oil prices, for that matter) have overestimated the effect.
Britain: The U.K. has officially defied the U.S. and will allow a limited level of Huawei products into its telecommunications system. The Johnson government believes it can restrict the use of Huawei products and thus reduce the chances that the equipment could compromise security. This will not be taken well by Washington because the policy will likely be adopted by the rest of Europe as well. We will be watching to see what sort of retaliation will be delivered by the U.S. At a minimum, the decision could put the British on the defensive as they try to negotiate a new, post-Brexit trade deal with the U.S.
United States-Japan-South Korea-France: The “Five Eyes” intelligence-sharing alliance (the U.S., the U.K., Canada, Australia and New Zealand) has reportedly begun to coordinate with Japan, South Korea and France to better track North Korea’s missile program and sanctions busting. The “Five Eyes Plus” framework also includes Germany on issues related to the cyberthreat from China. In spite of the trade and defense budget tensions among the allies, the expanded intelligence sharing is a welcome sign that the countries can still cooperate against clear threats.
Eurozone: The ECB said six Eurozone banks have failed to meet their capital requirements, up from just one bank last year. Most concerning, the report said that because of bad business models and poor internal governance, “most significant institutions” in the Eurozone don’t even generate enough earnings to cover their cost of capital, which naturally impedes their ability to build internal capital, or raise new equity. That goes far toward explaining the weak investment performance of many Eurozone banks over the last decade. Given the prevalence of banks in the European stock market indices (and in the broader international indices as well), it also helps explain the outperformance of U.S. stocks over the same period.
Russia: Kremlin-controlled natural gas monopoly Gazprom said it will complete the NordStream 2 gas pipeline from Russia to Germany by itself, after several European firms pulled out of the project. The decision is being reported as a victory for the U.S. sanctions announced last month, which were designed to impede Europe’s increasing dependence on Russian gas. It now looks like the project will be completed anyway, which will also reduce the potential market for U.S. gas exports.
Odds and ends: Tech firms are becoming increasingly worried they will face a patchwork of regulations, so they are pushing for a global regulator; of course, a single regulator is easier to capture. The EU is warning the U.K. that it should not try to make deals with individual nations in trade negotiations. Although this is technically impossible (individual nations in the EU give up their right to make their own trade pacts) the U.K. could use threats on various industries to sway talks. The U.S. is telling the EU that if they want a trade deal, they are going to import the “boogeyman” of agricultural products, the chlorinated chicken. The ceasefire in Libya is breaking down.
After months of negotiations, the U.S. and China signed “Phase One” of what is expected to be a multiple-phase trade deal. After noting media response to the agreement, we were struck by the dismissive consensus narrative that has developed. Our careful review of the document seemed to suggest a much more substantial arrangement had been struck and the general analysis missed a good deal of nuance. In this report, we will offer a detailed recap of the official agreement. We usually don’t engage in this sort of point-by-point analysis but, in this case, we feel it is necessary because points may have been overlooked. Next week, in Part II, we will examine the implications of the deal, and, as always, close with market ramifications.
Intellectual Property
Even though President Trump has touted China’s commitment to ramp up U.S. imports under the deal, and media analysts have emphasized the U.S. promise to postpone or roll back its tariffs against China, the first 16 pages of the 94-page agreement focus on protecting intellectual property. That suggests U.S. Trade Representative Lighthizer’s top priority was to rein in China’s longstanding efforts to soak up foreign technology and industrial secrets by hook or by crook. It probably also signals the U.S. intention to pursue fundamental changes in China’s legal system and industrial structure over time. The key provisions agreed upon include:
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA
[Posted: 9:30 AM EST]
Global equity and commodity markets continue to sink on the Wuhan virus. The U.K. prepares to officially leave the EU on Friday. The Fed meets this week as it considers new tools. Italian markets get some positive news. Here is what we are watching this morning:
So, what is to be done…at least for investors? First, these sorts of events usually have a three to five month period where they have a significant impact on financial markets. There is always a fear that this one will be different, and it is possible that it will be. However, more than likely, the Wuhan virus will peak in the next six weeks and then the recovery will start. Second, it’s important to note that the operative factor affecting financial markets from this virus is fear. The CDC estimates that between 291k to 646k die each year from influenza. It is highly unlikely the Wuhan virus will be as lethal. Still, there is a level of familiarity from the flu[1] that reduces the uncertainty surrounding it, so the market effects are usually muted. Overall, the Wuhan virus is a big deal but investors should not overreact.
Italy: On Sunday, local elections were held in the region of Emilia-Romagna. Such elections would not usually be a matter of concern outside of Italy, but Matteo Salvini of the League entered the race to restart his plans to capture the government. Interestingly enough, he was defeated by the center-left incumbent governor Stefano Bonaccini. With the national government consisting of the Democrats, and the left-wing Five Star Movement now looking more secure in the short term, investors are aggressively bidding up Italian bonds. So far today, the yield on the benchmark 10-year note is down 16 basis points to just 1.07%. Across the West we are seeing political alignments in flux; in Europe, conservatives are joining up with environmental parties, and center-left parties are flirting with communists. It is unlikely that any of these “odd couple” arrangements will hold, but the fact they are occurring at all shows the degree of political stress that is affecting Western democracies.
A “new” Fed tool: The FOMC meets this week; no change in anything is expected. According to reports, the Fed is dusting off an old tool. During WWII, the Treasury would inform the Fed of its borrowing needs and the rate it wanted to pay; the central bank would expand its balance sheet to accommodate the government’s borrowing. This process continued in some forms until the Fed became independent in 1951. Essentially, what the Fed is considering is fixing Treasury rates across the yield curve to ensure that rates will remain low. This policy could become very important if fiscal funding followed an MMT structure; the worry about MMT is that the deficits could trigger a jump in bond yield brought on by “bond vigilantes.” Under this policy, there would be no bond vigilantes. Of course, other rates might rise; however, in this period, we note that corporate rates also tended to fall.
This chart shows the 10-year T-note and Baa corporate bond yields of similar duration from 1935 through 1958. Note that the spread consistently declined then slowly rose as the Fed lifted interest rates to cool inflation. The 1934-51 period is financial repression at its finest; what was missing in this earlier period is the current level of financial engineering. The creation of various products to generate higher yield would be the real “bull market” if the Fed “goes back to the future.”
India: The government said it plans to sell its entire stake in Air India after its proposal two years ago to unload 76% garnered no interest. Officials also lowered the amount of debt that would be passed on to any buyer. The proposal is positive for Indian stocks, as it appears to show the government’s commitment to push through meaningful privatizations.
Iraq: Cleric Moqtada al-Sadr reversed course and withdrew his support for antigovernment protestors, after many of them criticized him for trying to hijack their movement for his own political gain. Despite al-Sadr’s withdrawal of support, and a new effort by police to get control of the situation, mass demonstrations against the government are being held again today. Separately, a suspected militia rocket attack struck the U.S. Embassy and injured one person yesterday. It was reportedly the first known direct hit on the Embassy compound.
One of the risks we noted in the 2020 Outlook: Storm Watch was the potential for a “melt-up.” On the one hand, seeing a parabolic rise in equities seems like a positive. On the other, a rise of significant magnitude only occurs because of a surge of late buyers; these latecomers usually suffer large losses and become something of a cautionary tale for future investors. The decline in equities that follows a melt-up is usually large too, more than it would have been had the rally not occurred.
The idea of the melt-up is due to the fact that equities have been rising with little evidence of strong retail participation.
This chart shows weekly flows into mutual funds and equity ETFs. We have added a 12-week average through the data. On average, flows into equities have been negative since May 2018. A similar calculation for bond funds shows strong inflows since last January.
On a longer-term basis, the recent divergence between retail flows into equities and the S&P 500 is notable.
On this chart, we overlay the S&P 500 along with monthly flows into equities from retail mutual funds and ETFs. We have generated a trend line in the data to show the underlying behavior of this series. The divergence became an outlier in late 2017 and, since then, the index has continued to rise with falling retail flows. Why is this happening? The continued rise in equities is clearly coming from institutional buyers. Some of the lift might be due to a falling level of equities themselves. The S&P 500 divisor, which takes into account buybacks, mergers and new entrants into the index, has been declining since 2010. With fewer stocks available, the same level of liquidity can lead to higher prices. Still, even buybacks cannot fully account for this divergence.
Our fear is that if retail investors decide that missing out is too painful, the influx of liquidity could send prices up strongly. At this point, there is little evidence to suggest this is happening. Not only are flows depressed but retail liquidity remains elevated.
Retail money market levels are similar to where they were during the Great Financial Crisis. When the equity markets began to recover in 2009, the levels of money markets declined, helping fuel the recovery. Although this level of liquidity may exist as a hedge against uncertainty, if confidence rises, there are ample resources for a strong rally in stocks. Again, as we said earlier, there has been little evidence that sentiment is becoming bullish, but, if it does, the melt-up we discussed in our Outlook is more probable.
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA
[Posted: 9:30 AM EST]
Happy Friday! Davos continues, and the coronavirus continues to dominate the news on the eve of the “year of the rat.” Here is what we are watching this morning:
The underlying market questions from this event are how deep and how long? In other words, how big of a decline will this trigger and how long will it last? The SARS history does offer some clues and it suggests that it will have a rather large impact but it won’t last long. Note the pattern of China’s consumer confidence:
SARS occurred in 2003; it clearly had a short-term impact on consumer confidence. On the other hand, industrial production did drop but also recovered quickly.
The comparisons to 2003 do have problems; the Chinese economy was in a robust growth phase. That is not the case now. But, the most likely outcome is that this will be a short-term event.
Eurozone: IHS Markit today said its composite purchasing managers’ index for the Eurozone came in at a seasonally adjusted 50.9 in January, matching the December reading but falling short of the expected reading of 51.2. The index is designed so that readings over 50 point to expanding activity, so the January figure suggests the Eurozone economy continues to grow at a lethargic pace. One bright spot, however, was that the manufacturing PMI rose to 47.8. That still points to contraction in the factory sector, but it is better than the reading of 46.3 in December and it beat the expected reading of 46.8. IHS Markit also released its single-country indexes, which showed significant improvement in the all-important German manufacturing sector. Germany’s manufacturing PMI beat expectations by rising to 45.2 from 43.7 previously. France’s manufacturing PMI was better as well, rising to 51.0 from 50.4. In sum, the figures provide a glimmer of hope that the Eurozone economy could be turning the corner. The figures are therefore boosting European stocks so far today.
United Kingdom: The flash IHS Markit/CIPS composite purchasing managers’ index for the U.K. rose to a seasonally adjusted 52.4, smashing the December reading of 49.3 and handily beating the expected reading of 50.7. The January index for manufacturing beat with a rise to 49.8, but, because of the dominance of Britain’s service sector, the key index for the country is its services PMI. That index jumped to 52.9 in January, reaching its highest level since mid-2018. The figures suggest the British economy is bouncing back nicely from the Brexit debate. Even though the figures undermine any expectations for a new cut in interest rates, they should be positive for British stocks going forward.
United States-China: The Commerce Department’s proposed rule that would make it harder for U.S. firms to sell to Chinese telecom giant Huawei (002502.SZ, 2.99) from their overseas factories is reportedly being resisted by the Defense Department on grounds that hurting the U.S. firms’ sales would damage their ability to conduct research and development. The news highlights the split within the Trump administration when it comes to China policy.
Europe-Iran: Even though Germany, France and Britain last week triggered a dispute-settlement mechanism under the 2015 nuclear deal with Iran, European diplomats now say they won’t reimpose sanctions on the country unless it significantly ramps up its violations of the agreement. However, it’s not clear whether Iran would hold the line on its nuclear activities, given that its leaders are probably still itching to take revenge for the U.S. killing of Gen. Qassem Soleimani earlier this month.
United States-Iraq: In protest against the U.S. killing of Gen. Soleimani on Iraqi soil, tens of thousands of Iraqis have launched a demonstration calling for U.S. troops to be expelled from the country. The protest is being led by an old foe of the U.S., the Shiite cleric Moqtada al-Sadr, who was the first Shiite leader to call for armed resistance after the U.S. invasion of Iraq in 2003. We suspect he is being egged on by the Iranians, who would likely consider a U.S. expulsion from Iraq to be sweet revenge for the killing of Gen. Soleimani.
A tale of railroads: Union Pacific (UNP, 187.19) is adopting “precision-scheduling railroading,” which is a plan to run fewer trains on tighter timetables with more cars. It is improving efficiency at the cost of 3,000 jobs. This is a truism of economics; productivity improvements coupled with slow growth usually mean that the benefits of the productivity enhancement goes to capital. Labor’s participation in the improvement is usually reliant on a stronger expansion. In other words, if the economy is robust, those 3,000 workers will easily find other work. But, if it’s not, they may become unemployed. In the current situation, the most likely problem is that these displaced workers will find jobs but at a lower pay than their current ones.
FICO: The FICO score is the backbone of modern consumer finance. Prior to the development and adoption of the FICO score, the creditworthiness of households was determined by individual loan officers. The officers relied on the specific knowledge of the community; the system generally worked well but was inefficient. The FICO score allowed a lender to quickly ascertain a borrower’s creditworthiness without community knowledge. This not only fostered national lending (as opposed to local lending only) for households, but it also gave financial firms the ability to efficiently securitize loans to build bonds that could be sold to investors. For consumers, the FICO score can determine access to credit and the cost of borrowing. The Fair Isaac Corporation (FICO, 415.08) is adjusting its scoring system to pay closer attention to rising debt levels and trigger downgrades faster for borrowers in arrears. The expected outcome will be a wider gap between safe and risky borrowers and make it more difficult for risky borrowers to access credit. It remains to be seen if this change will affect consumption.
Energy update: Crude oil inventories fell 0.4 mb compared to the forecast rise of 1.0 mb.
In the details, U.S. crude oil production was unchanged at 13.0 mbpd. Exports fell 0.1 mbpd, while imports fell the same amount. The decline in stockpiles was unexpected.
(Sources: DOE, CIM)
This chart shows the annual seasonal pattern for crude oil inventories. This week’s decline was a bit below normal. As the chart shows, oil inventories usually rise into late spring and then decline significantly into late summer. Last year, this pattern was disrupted to some extent because of exports.
Based our oil inventory/price model, fair value is $64.53; using the euro/price model, fair value is $50.92. The combined model, a broader analysis of the oil price, generates a fair value of $55.18. We are seeing the divergence between dollar and oil inventories narrow as dollar weakness persists. Given the level of geopolitical risk, prices have not moved significantly above the inventory fair value price, although the combined model would suggest a richly valued market. With inventories poised to rise seasonally and tensions seemingly easing, softer prices are more likely in the coming weeks. The recent epidemic in China has been a bearish event for oil prices.
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