Author: Rebekah Stovall

Weekly Geopolitical Report – Reflections on Globalization: Part III (April 23, 2018)

Posted on by Rebekah Stovall

by Bill O’Grady

This week, we will conclude our series on globalization with a discussion of how China and Russia threaten U.S. hegemony, the potential responses and close with market ramifications.

China, Russia, the U.S. and Hegemony
U.S. policymakers, heeding the Washington Consensus, assumed that developing nations would eventually adopt both market economics and representative democracy.  American policy toward China was thus based on the idea that integrating China’s economy into the world trading system, which was dominated by the U.S., would eventually lead Beijing to drop communism and adopt democracy.  After all, a string of other nations had made similar transformations, including Japan, Germany, South Korea and Taiwan.  Japan and Germany had to lose a mass mobilization war to make this shift, but South Korea and Taiwan eventually shelved authoritarian regimes in favor of democratic governments.

Based on this expectation, the U.S. gave China wide latitude in its trade policy.  Although obviously mercantilist, it was generally believed that China would eventually integrate into the world economic system on U.S. terms as its economy developed.  China has integrated into the world economy but not in a manner preferred by the U.S.

There was a serious flaw in this expectation.  Germany and Japan were willing to adjust to U.S. demands[1] because both nations were dependent on America’s security guarantee.  China, on the other hand, was not necessarily protected by the U.S.  Although Nixon’s opening to China was partly due to China’s worry about Soviet aggression, in reality, China didn’t face any serious outside threats after the collapse of the Soviet Union.  Its military was mostly concerned with internal control.

China is making it clear that it is a strategic competitor to the U.S.  It does not want to necessarily challenge the U.S. around the world but it does not want to be beholden to the whims of American policy.  In his recent work on Thucydides’s Trap,[2] Graham Allison noted that the U.S. threatened British hegemony in the Western Hemisphere in the early 20th century.  Although the British were uncomfortable not projecting power into that region, American power was overwhelming and the British faced another strategic threat from Germany.  Thus, the British ceded the Western Hemisphere to the U.S.  Part of the reason for taking this step was the cultural similarities between the two countries.  Both were market economies and democracies, which made Britain’s actions more reasonable.  And, Germany was becoming a more proximate threat (and proved to be a real one by 1914).

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[1] Examples include the 1985 Plaza Accord, the 1994 Halifax Accord and Japan’s “voluntary” export restraint on cars in the 1980s.

[2] Allison, G. (2017). Destined for War: Can America and China Escape Thucydides’s Trap? New York, NY: Houghton Mifflin Harcourt Publishing Company.

Asset Allocation Weekly (April 20, 2018)

Posted on by Rebekah Stovall

by Asset Allocation Committee

The Trump administration has made it a key policy goal to reduce the trade deficit.  The reasoning is that reducing the trade deficit will boost jobs in areas that have been adversely affected by foreign competition.  Although this might be true (trade is very complicated), the risk is that trade restrictions will likely result in higher inflation.

This chart shows net savings balances.  These are macroeconomic identities, which, like a balance sheet, total to zero.  However, how they reach zero is interesting.  Usually, government dissaving (more commonly called a fiscal deficit) is offset by the combination of private and public sector saving.  Foreign saving is the inverse of the current account; when a nation accumulates foreign saving, it is running a trade deficit.  Private sector saving comes from the household and business sectors.  For the former, it’s the difference between income and consumption.  For the latter, it’s the net of revenue after investment.  Thus, for the entire private sector, net saving is saving less investment.

Since the early 1980s, foreign saving has become a nearly permanent fixture.  Most pundits argue that the U.S. must “attract” foreign saving due to the fiscal deficit.  However, the direction of causality can be difficult to trace.  For instance, under conditions of free trade, if a foreign nation purposely builds excess saving, that excess saving will become a trade surplus and the rest of the world must absorb that excess production (saving).  If trade barriers exist, that excess saving is transformed into domestic investment, either by inventory accumulation or increased investment spending.

Because the U.S. is the provider of the reserve currency, it is the most likely target of foreign saving.  Note that in the late 1990s, the U.S. ran fiscal surpluses with rising foreign saving inflows.  There was a plunge in private saving, mostly due to business dissaving.  Some of that increased investment was due to Y2K spending but some ended up bidding up existing asset prices (the tech bubble was partly a beneficiary).  Ben Bernanke referred to a global “savings glut” in the last decade that is seen in the foreign inflows.

President Trump wants to reduce the trade deficit; if he is successful, he will also reduce foreign saving to the U.S.  With the fiscal deficit rising, the private sector will be required to make up the difference.  That can either come from falling consumption relative to income or falling investment relative to business saving.  Falling consumption usually comes from either increases in inflation (which reduces real spending) or unemployment.  Although reducing the trade deficit may benefit specific sectors of the economy, in reality, there are downsides to the policy.

This chart shows the yearly change in CPI with foreign saving into the U.S.  We have placed a vertical line on the chart, beginning in 1983, when foreign saving increased.  During the period of small trade deficits (low for negative foreign saving), inflation averaged 4.4%.  The onset of foreign saving has reduced inflation significantly.

The U.S. benefits from foreign saving inflows.  It keeps inflation low and allows the U.S. to run fiscal deficits that would not be possible for other nations.  For the most part, foreign nations accept this tradeoff to acquire the dollar for reserve purposes.  The cost to the U.S. economy is that the trade is clearly unfair; foreign nations purposely build saving through policies designed to boost household saving.  These include an undervalued exchange rate, consumption taxes, an inadequate or non-existent social safety net, tariffs and quotas.  In one sense, if a foreign nation wants to deprive its citizens of goods and services and force them to save,[1] then the U.S. should accept their “generosity” and repay them with Treasuries.  However, there are negative effects for some sectors of the economy that compete with imports.

These charts show the U.S. furniture industry.  The upper chart is employment.  It has fallen by more than a third from the peak.  The lower left-hand chart shows imports and exports (with the former rising rapidly) and the lower right-hand chart shows industrial output for furniture, which fell sharply during the last recession but has failed to recover anywhere near the previous peak.  Clearly, this industry has been harmed by imports.

The trade issue is really a matter of who bears the burden of trade adjustment.  Tariffs mean consumers bear the costs via higher prices.  Subsidies mean taxpayers bear the burden.  In the absence of either, the workers and owners in the U.S. bear the burden.  However, in a macroeconomic sense, acts that raise the cost of imports will tend to bring higher inflation.  If that becomes the favored policy, investors will face rising interest rates and falling P/E multiples.  Thus, we continue to closely watch the president’s trade policy to for widespread effects and the impact on price levels.

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[1] Something the U.S. did during wartime with rationing.

Keller Quarterly (April 2018)

Posted on by Rebekah Stovall

Letter to Investors

As you well know, the U.S. stock market has been selling off for about ten weeks now.  From some of the calls I’ve been getting, one would expect that another Great Crash is upon us.  There is little evidence to suggest, however, that this is anything more than a normal correction in the context of a bull market.  Rather, the emotional response we’ve been hearing is, in my opinion, largely a result of the lack of volatility we have experienced over the last two years.

As Ned Davis Research recently reported, over the last 90 years the stock market has averaged 3.4 corrections of 5% or greater per year.  Over the same time frame the market also averaged 1.1 corrections of 10% or greater per year.  From February 2016 to January 2018 (23 months), the market saw neither of these rather common contrary events.  It seems that during this time of stock market nirvana (consistently upward sloping with nary an adverse wiggle), investors began to believe this was normal.

It surely was not normal, but abnormal in the extreme.  The great financier J.P. Morgan was regularly asked what stock prices will do.  His standard response: “They will fluctuate.” Sometimes the simplest answers are the best. (This quote is included in Benjamin Graham’s classic work, The Intelligent Investor.  That book and many others are included in our new Reading List of recommended books that you can find on our website.)  Indeed, stock prices will and do fluctuate in wide ranges all the time.  Stock prices are among the most volatile asset prices most people will ever encounter.

This shouldn’t be a revelation, but corrections such as the current one always seem to catch people by surprise.  We rather welcome such downward volatility for a couple of reasons:

  1. When the market doesn’t sell-off periodically, investors do really crazy things like bid prices up to outrageous levels, resulting in eventual horrendous sell-offs. Examples of this phenomenon are 1998-2002 and 1987.
  2. We like to buy stocks of great companies at a discount. Sell-offs provide that opportunity.

But could this correction be the start of something much worse?  While we certainly cannot predict the future, our response is “probably not.”  Why?  Because stocks are a reflection of economic reality, not a perfect reflection, but a fairly reliable one.  And the economy is growing rather steadily, at a sustainable pace.  There are only a few evidences of excess, but that’s normal for an expansion over nine years old.  A recession a few years from now would not surprise us, but it is not imminent, in our opinion.

We are experiencing a completely normal correction for completely normal reasons, in our view.  Stocks sell off after an extended advance when investors worry about growth that might be too rapid, which might induce inflation, thus prompting the Fed to raise rates.  Throw in a government that’s unhappy with the behavior of trading partners and you have all the excuses you need for a correction.  This is the stuff of a healthy economy and a normal bull market.  Thus, we intend to treat it as such and look for opportunities to buy good companies at good prices in our equity portfolios, and add equity exposure, where appropriate, in our asset allocation portfolios.

As always, we appreciate your confidence in us.

 

Gratefully,

Mark A. Keller, CFA
CEO and Chief Investment Officer

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Asset Allocation Quarterly (Second Quarter 2018)

Posted on by Rebekah Stovall
  • Near-term expectations for earnings growth resulting from the Tax Cuts and Jobs Act of 2017 remain heightened.
  • Continued Fed policy tightening, through measured increases in the fed funds rate and reductions in the size of the Fed’s balance sheet, is not expected to weigh on the economy over the next two years.
  • Our outlook for a softer U.S. dollar is underscored by recently released CBO estimates of the projected budget deficit.
  • Equity exposures remain elevated across all strategies relative to our historic allocations.
  • Our sector and industry outlook favors a growth style bias among U.S. equities at 60%.
  • We initiate a position in precious metals to add diversification given the potential for global political instability and appreciation against a soft U.S. dollar

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ECONOMIC VIEWPOINTS

Measures of the U.S. economy continue to point to a continuation of the expansion, which is poised to tie for the second longest expansion on record and a year away from becoming the longest expansion dating back to 1854. Though the U.S. NFIB Business Optimism Index readings have moderated somewhat over recent months, the index remains elevated by historic standards. Similarly, consumer confidence has declined recently, as measured by the Conference Board’s Consumer Confidence Index and the University of Michigan’s Index of Consumer Sentiment, yet remains at high levels. The recent declines notwithstanding, the Federal Reserve’s efforts to reduce its balance sheet and raise the fed funds rate multiple times this year and next appear to continue unabated. While our view is for continued economic growth until nearing the end of our three-year forecast cycle, we remain wary of the potential for a misstep by the Fed that would lead to excessive tightening and increase the odds of a recession. Such wariness is balanced by the prospect for an uptick in GDP from its mild post-recession figures. The combination of the fiscal stimulus in the latest budget accord and the corporate and individual benefits unleashed by the Tax Cuts and Jobs Act of 2017 set the stage for potentially rapid growth over the next two years. With a higher level of GDP growth, we would expect the Fed to be more hawkish in its tightening over the next two years, which would thereby impede the nascent inflationary pressures that caused investor angst in early February.

The domestic economic environment we forecast for our three-year cyclical outlook is supportive of range-bound intermediate and long-term rates and equity valuations. Specifically, inflation expectations of 2.1%-2.2%, inferred by the breakeven rate of TIPS versus maturity-equivalent Treasuries, underscore our thesis of the current fair valuation for equities and bonds.

From a global perspective, the recent saber-rattling on trade and tariffs has the potential to be highly disruptive to global economic growth. While we harbor optimism that cooler heads will prevail on matters of trade, the rise in populism keeps our hopes for unfettered global trade in check. Although trade accords, such as NAFTA and TPP, offer the potential for improvement, we are less than sanguine that they will be resolved amicably, at least absent a high degree of histrionics. Among non-U.S. economies, Europe is three years into its economic expansion.  Though facing political headwinds, most recently illustrated by the Italian and Hungarian elections, the European economic climate is improving. In addition, our analysis of purchasing power parity of the U.S. dollar versus other major currencies indicates continued overvaluation despite recent softness, which should prove to be a tailwind for returns of non-U.S. equities for U.S.-based investors. As the accompanying chart illustrates, the environment for emerging market equities is particularly attractive.

STOCK MARKET OUTLOOK

Our views on U.S. equities are favorable. We expect inflation to remain contained, accompanied by low levels of unemployment. We also expect an increase in earnings spawned by last year’s corporate tax reduction, and an increase in share repurchases and M&A activity stemming from the repatriation of overseas assets. Our positive forecast for equities reflects our expectations for P/Es, as depicted on the accompanying chart, which encourages elevated exposures across all strategies relative to our historic allocations.

At this stage of the economic expansion, we retain a 60% tilt toward growth and 40% to value. In U.S. large caps, we overweight energy, financials and materials, while establishing an equal weight in technology and consumer discretionary in anticipation of their reconstitution as part of the new communications services sector in September. Mid-cap and small cap equities have an identical tilt to growth and are both overweight in the more growth-oriented strategies. Outside of the U.S., we retain our historic maximum exposure owing to our expectations of a continued soft U.S. dollar.

BOND MARKET OUTLOOK

As we noted last quarter, the rise in Treasury yields since the passage of the tax legislation has many commentators suggesting a bear market in bonds has developed. The jump in rates in early February added further fuel to their argument. While we understand and appreciate their premise, our view is that such a bear market will be secular and, accordingly, will require years to unfold. As evidence, we review the figures from the secular low in 1945 and the two decades that ensued prior to rates becoming a problem for financial markets. Absent inflationary pressures, we uphold our forecast for a gradual rise in rates that will be borne mostly by the front-end of the curve as the Fed maintains its tightening measures, inclusive of the reduction in its balance sheet. Accordingly, we expect the curve to continue to flatten, with the intermediate and long-term maturities being range-bound over our forecast period and a terminal fed funds rate of 2.50%-2.75%.

Our expectations for a gradual rise in rates reinforce our use of a bond ladder in strategies that have income as an investment element. Bond ladders hold the dual attraction of offering a degree of defense against rising rates through capturing the roll yield while also allowing maturing issues to be deployed at the longer rungs of the ladder, benefitting from the yield advantage farther out on the curve. The laddered nucleus will modestly reduce the overall duration from one quarter to the next until a new rung on the ladder becomes available later in the year. Relative to spread sectors, we maintain exposure to investment grade corporates in the ladder and a concentration in the intermediate segment of the yield curve through the use of an ETF containing mortgage-backed securities. Speculative grade bonds hold less allure as spreads have tightened and have double-digit exposure to telecommunications company debt. As a result, we substantially reduce exposure to speculative grade bonds.

OTHER MARKETS

We retain our allocation to real estate in the more income-oriented strategies given attractive and improving dividend yields, while reducing the REIT allocation in risk-tolerant portfolios. As a function of yield relative to potential risk, we view REITs more favorably than speculative bonds.

We introduce an allocation to gold this quarter within commodities, where we have been void for the past year. Recognizing that gold can serve as a safe haven during periods of heightened geopolitical and currency risks, we are incorporating a modest allocation as a means to temper these potential risks. Moreover, our analysis of the fair value price of gold indicates it is currently attractively priced, as depicted on the accompanying chart.

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Weekly Geopolitical Report – Reflections on Globalization: Part II (April 16, 2018)

Posted on by Rebekah Stovall

by Bill O’Grady

Last week, we introduced this topic by discussing the Cold War.  This week, we will continue our analysis with a reflection on markets, an examination of hegemony and a discussion of the expansion of globalization and the rise of meritocracy and its discontents.

What about Markets?
Market economics is based on how humans actually behave and has been proven to be a superior method of solving the economic problem.  However, it works best when those competing, negotiating or trading are doing so under conditions of near-equal footing.  According to David Hume’s analysis, justice can only occur among near equals.  Under these conditions, pitting self-interest against self-interest leads to the most optimal outcome.  However, when there are great differences in power between parties, justice doesn’t really occur and the weaker party is forced to rely upon the mercy of the powerful.[1]  Simply put, in unequal relationships, Hume calls for mercy but realizes there will be no justice.

Again, Adam Smith crystalizes Hume’s thought with regard to the economy in this famous quote:

People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or some contrivance to raise prices.[2]

This condition is a flaw of market economics.  Governments and society have attempted to address this situation through regulation and charity, respectively.  In other words, to improve the lot of the poor, regulation, which limits the power of capital, and charity, which gives the poor an opportunity to improve their situation, were supported.  During the Cold War, there was a clear effort to prove market economics and democracy were superior to communism by generally building the middle class and creating something of a “worker’s paradise.”

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[1] Hume, D. (1966). An Enquiry Concerning the Principles of Morals. La Salle, IL: Open Court Press (p. 23). “Were there a species of creatures intermingled with men, which, though rational, were possessed of such inferior strength, both of body and mind, that they were incapable of all resistance, and could never…make us feel the effects of their resentment; the necessary consequence…is that we should be bound by the laws of humanity to give gentle usage to these creatures, but should not…lie under any restraint of justice with regard to them, nor could they possess any right or property…our compassion and kindness is our only check, by which they curb our lawless will…the restraints of justice…would never have place in so unequal a confederacy.”

[2] Smith, op. cit., p. 128.

Asset Allocation Weekly (April 13, 2018)

Posted on by Rebekah Stovall

by Asset Allocation Committee

One of the great unknowns in this recovery and expansion is the proper measure of economic slack.  Although it’s a term that is rather easy to understand in the abstract, actually defining it is difficult.  The Congressional Budget Office (CBO) produces an estimate of potential GDP but it is, at best, a rough measure based on population growth, estimates of productivity and capital stock.  The famous “Taylor Rule[1]” uses the difference between actual and potential GDP in its calculation of the neutral policy rate.  However, due to the uncertainty surrounding potential GDP, Greg Mankiw, an economics professor at Harvard and Chair of Economic Advisors under President Bush, offered another version of the Taylor Rule, which we call the “Mankiw Rule.”  The Mankiw Rule substitutes the unemployment rate less the non-accelerating inflation rate of unemployment (NAIRU).  In other words, Mankiw proposes the labor markets are a better measure of slack.

The primary attraction of the Mankiw Rule for policymakers is that it fits well with the FOMC’s other working model, the Phillips Curve, which postulates that there is an inverse relationship between the unemployment rate and inflation.  The Mankiw Rule’s primary flaw is that NAIRU isn’t directly observable (although the CBO calculates it as well).  It also has a secondary flaw, which is that the unemployment rate may not be the best measure of slack in the labor markets.

This chart shows the relationship between the unemployment rate and the employment/population ratio (inverted scale).  From 1980 to 2010, the two series correlated at 94%.  But, the relationship has broken down in this recovery and expansion.

The problem for policymakers is determining which of these two series for the labor market best measures slack.  The unemployment rate is at levels that would usually be considered full employment, which would suggest that monetary policy should be tightening rapidly.  On the other hand, the employment/population ratio indicates ample slack in the labor market, which would argue for slow tightening at best.

The general consensus among economists is that the employment/population ratio is depressed due to baby boom retirements and structural unemployment caused by globalization and automation.  Thus, these workers are not really available for hiring.  The high level of long-term unemployment would tend to bolster that position.

This chart shows the average duration of unemployment.  Previous cycle highs were generally around 21 weeks; during expansions the trough is usually around 12 weeks, although the cycle low exceeded 15 weeks in the last expansion.  In the Great Financial Crisis, the average duration peaked at 40.7 weeks and remains elevated, but it has been declining.  The existence of long-term unemployment does support the idea that the unemployment rate is probably a more accurate measure of slack as the gap shown in the first chart is due to structural unemployment and baby boom retirements.

However, if slack is disappearing, it should be showing up in wages.  Thus, comparing the two measures of slack to wage growth should really be the ultimate determinant of which measure is best for policymakers.  In this regard, the employment/population ratio has outperformed recently.

This chart shows the forecast of annual wage growth for production and non-supervisory workers using the unemployment rate in one model and the employment/population ratio in the other.  Until 2012, neither model was clearly superior to the other.  However, since 2014, the employment/population ratio has been clearly superior.  Both independent variables tend to lead wages by nine months.  The employment/population ratio predicts that wage growth for this broad segment of workers should remain around 2.5% through the end of this year.

Our primary concern about monetary policy is determining the likelihood of a mistake that would lead to excessive tightening and raise the odds of a recession.  Studying the two variations of the Mankiw model, one that uses the unemployment rate and another that uses the employment/population ratio, should offer insights into the chances of a policy error.

This chart shows the two models.  The unemployment rate model suggests the FOMC is woefully behind the curve and needs to raise rates aggressively.  The employment/population ratio model suggests the FOMC has achieved policy neutrality and should only raise rates further with evidence of rising inflation.  The Fed dots chart average indicates the fed funds target will reach 2.25% by year’s end, or two more rate hikes this year.  If all variables remain stable, the unemployment rate model will still signal that policy is accommodative.  The employment/population ratio will not reach restrictive until rates reach 2.75%, which would be one standard error above the forecast.  The estimates from the dots chart suggest that scenario would happen in 2019, when another three hikes are expected.

Our analysis of comments from members of the FOMC suggests that policymakers believe the unemployment rate is the proper measure of slack.  Thus, the odds of a policy mistake are increasing.  However, the calculation of the employment/population ratio suggests we aren’t there quite yet.  Thus, it is probably too soon to become overly defensive in portfolios based on the domestic economy and monetary policy alone.  There may be other reasons (geopolitical and political) to be cautious but, for now, our Asset Allocation Committee remains optimist about risk assets.

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[1] Neutral nominal policy rate = neutral real rate + 0.5(actual vs. target inflation) + 0.5(real GDP – real potential GDP)

Weekly Geopolitical Report – Reflections on Globalization: Part I (April 9, 2018)

Posted on by Rebekah Stovall

by Bill O’Grady

For much of recorded human history, we have seen waves of globalization and deglobalization.[1]  Periods of globalization tend to be characterized by the emergence of either large regional hegemons or global hegemons.  When these hegemons see their power wane, deglobalization occurs.  Recently, globalization has come under fire.  In some circles, being called a “globalist” is a slur.  This new denigration of globalization should be viewed in a historical context.

Our position has been that we have experienced the apex of globalization and a steady cycle of deglobalization will occur over the next few decades.  This is the context in which we should view the current American political situation.  Political pundits tend to focus on personalities, which are important in the short term.  However, in the long term, it is no surprise to us that we have a president who is jaded on America’s superpower role given where we are in the globalization/deglobalization cycle.

Notwithstanding, we believe there are peculiar circumstances in the current environment that offer interesting insights into how conditions may evolve.  This evolution is important to investors as it will affect valuations of financial assets.  Inflation is a key depressant to financial asset values.  Deglobalization will almost certainly lead to higher price levels over time.  But, how that process develops is important.  For example, war would likely bring a rapid increase in inflation.  On the other hand, a steady contraction of supply chains and reduction in trade would lead to a much slower rise in inflation.

This chart shows British inflation from 1900 to 1950.  The war years show an obvious spike in inflation.

In Part I of this report, we will discuss the end of the Cold War and the reactions of U.S. policymakers to that event.  In Part II, we will begin with a reflection on markets, continue with an examination of hegemony and conclude with the expansion of globalization and the rise of meritocracy and its discontents.  In Part III, we will discuss how China and Russia threaten U.S. hegemony, the potential responses and conclude with market ramifications.

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[1] A good study of this history can be found in Kevin O’Rourke’s and Ronald Findlay’s book. O’Rourke, K. and Findlay, R. (2007). Power and Plenty: Trade, War and the World Economy in the Second Millennium. Princeton, NJ: Princeton University Press.

Asset Allocation Weekly (April 6, 2018)

Posted on by Rebekah Stovall

by Asset Allocation Committee

Recently, the three-month T-bill/Eurodollar spread (TED spread) has widened, raising concerns about financial stability.  In this report, we will offer a primer on the spread and discuss its recent rise.

The TED spread has two components; it’s a direction-of-rate spread and a flight-to-quality spread.  Eurodollars (also known as LIBOR) represent dollar borrowing that is not government-guaranteed.  It originally began when Europe accumulated dollars during the 1960s as part of Bretton Woods and the dollar’s reserve status.  As Europe ran trade surpluses with the U.S., they acquired dollars which they wanted to lend to earn interest.  At the time, U.S. interest rates were governed by “Regulation Q,” which set deposit rates for U.S. banks.  During periods of tight monetary policy, U.S. borrowers could find European dollar lenders willing to lend those dollars at a premium to domestic interest rates.  Thus, if banks found themselves unable to borrow from the Federal Reserve, they could use the Eurodollar market to acquire liquidity.  However, unlike the domestic market, Eurodollars offered no lender of last resort protections and thus carried premium interest rates.  Under normal circumstances, the yield premium was around 20%.  So, if domestic dollar borrowing rates were set at 5%, Eurodollars yielded 6%.  Obviously, if domestic rates doubled, to 10%, Eurodollars yielded 12%.  This pattern explains the TED spread’s direction-of-rate element; during a rising rate market, speculators would short Eurodollars and go long T-bills, profiting from a widening spread.  In a falling rate market, the reverse position would be implemented.

The other component is the flight-to-quality spread.  Because Eurodollars are not government-guaranteed and do not have direct support of a central bank, investors flock to T-bills and shun Eurodollars during periods of stress.  This widens the TED spread.

This chart shows the long-term TED spread.

 

As the chart shows, there was a great deal of volatility in the spread.  As we will discuss below, this was partly due to flight-to-quality incidents along with volatile monetary policy.  Under Chair Volcker, the Federal Reserve targeted the money supply instead of fed funds which led to rate volatility.  Spread volatility declined as interest rates fell and the Federal Reserve returned to fed funds targeting.  In addition, the end of Regulation Q in 1986 ended the government’s practice of setting maximum deposit rates.  This increased the government-guaranteed rate and essentially narrowed the spread.

To separate the direction of interest rate effects from the flight-to-quality factors in the spread, we regressed the Eurodollar (LIBOR) rate by the T-bill rate with a variable to account for Regulation Q.  This chart shows the results of that model.

 

The lower line on the chart shows the deviation in Eurodollar interest rates relative to T-bill rates.  A widening spread is represented by a rising lower line.  Clearly, financial, political and geopolitical events can widen the spread; we have marked the important ones.  The current spread is essentially at fair value, suggesting the widening of the TED spread isn’t due to any sort of financial crisis but is entirely due to rising yields.  In other words, the widening of the TED spread is consistent with increasing interest rates and, so far, does not indicate significant financial stress.

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Asset Allocation Weekly (March 29, 2018)

Posted on by Rebekah Stovall

by Asset Allocation Committee

After peaking at 2872.87 on January 26, the S&P 500 has been in a corrective phase.  The index fell just over 10% and has been range bound ever since, well below the aforementioned high.  Here are the primary reasons equities have struggled:

  1. Valuations became a bit stretched: The P/E, as we calculate it (trailing except for the current quarter, which includes two previous and two forecast quarters), reached 20.8x. This level is at the high end of the dispersion of the multiple for our P/E models and is no way inexpensive.  The rally seen after the tax cuts became rather excessive and a pause to consolidate would be normal.
  2. Trade war fears: The administration, which had put trade policy on the backburner as it tried to overturn the Affordable Care Act and enact the tax bill, has recently turned its attention to trade. Trade impediments and the pullback from globalization would weaken the policy commitment to low inflation that has been in place since the late 1970s.
  3. Political instability: It is common for the personnel in the White House to change over time. Under normal circumstances, when a party has been out of power for an extended period, a plethora of experienced officials are poised to join the new administration when the party regains power.  As time passes and the new president becomes more comfortable in his role, less powerful aides are recruited and the powerful, often with their own agendas, leave the White House.  President Trump was enough of an outsider to disrupt this process to some degree.  Still, the president did surround himself with some seasoned advisors from the military and business sectors.  Although the media probably overstated the case that these figures “corralled” the president’s instinctual management style, it does appear that the White House became less chaotic after Gen. Kelly took over as chief of staff.  In the past few weeks, however, there has been a wholesale change in personnel, including Secretary of State, Head of the CIA, and National Security Director. The replacements have hawkish reputations and could bring geopolitical instability.  These changes have increased uncertainty and weighed on market sentiment, as have the prospects for political disruption stemming from the upcoming midterm elections.
  4. Policy tightening: The Federal Reserve is steadily tightening monetary policy. Although current policy has not reached a point where it would be considered restrictive, the direction for interest rates is clear.  Monetary policy has tended to support financial asset prices since the 1987 crash, in that declines in equity prices have led Fed chairs to either reduce rates during pullbacks or promise to act if financial conditions deteriorate.  However, the new Fed chair, Jerome Powell, made no mention of current market volatility, raising concerns that the “Fed put” may no longer exist.

All these worries have some basis in fact.  However, we believe the bearish case is overstated based on what we know now.

  1. Earnings will be robust: The tax law will shift, in our estimation, about 1.3% of GDP to after-tax profits. If equity prices hold near current levels, valuations will improve in coming months.
  2. Trade policy: Although we are concerned about the turn toward protectionism, in the short run we have seen initially aggressive positions that have been adjusted to become less onerous. A retreat from globalization is probably underway but it hasn’t progressed enough yet to trigger higher inflation.
  3. Policy instability: President Trump will likely be considered one of the most unique presidents in history. His extensive use of social media has overturned the Washington order, for better or worse.  Future presidents will likely have to decide if they will continue to use microblogging as a way to message the country, unfiltered by the media.  At the same time, financial markets rapidly discern signal from noise.  If markets determine that a social media rant is not material to market action, the markets will begin to ignore what is coming out of the White House.  It is true that this president values flexibility and does not want to be contained.  And, a president with such characteristics can make unexpected decisions.  At the same time, it should be noted that President Trump’s period of greatest influence is coming to a close.  History shows that the bulk of a president’s political capital is exhausted within about 18 months after the election.  That’s because, in most cases, the midterms lead to a decline in congressional support and lawmakers realize that the influence of a president wanes once the midterm election season is underway.  Simply put, by early summer, President Trump’s ability to make major changes in domestic policy will decline rapidly.
  4. Monetary policy: The Federal Reserve has engineered three “soft landings” since becoming independent in the early 1950s. Every other tightening cycle generally resulted in a recession.  However, the timing from the end of the tightening cycle to the onset of recession can vary widely.

In many cases, especially prior to the 1981-82 recession, the onset of recession coincided with the peak in fed funds.  However, in the three recessions since 1982, the peak in rates has preceded the recession by an average of 14 months.  If the same pattern holds, we are probably at least 12 to 18 months away from the next recession[1] as policy tightening will likely continue into next year.

In conclusion, although the aforementioned concerns are legitimate, we think they are probably overdone, at least in the short run.  In addition, there appears to be ample liquidity to fuel higher equity prices.

This chart shows the level of retail money market fund holdings along with the S&P 500 Index.  The shaded areas show periods when money market funds are at levels of $920 bn or less.  These periods tend to coincide with sluggish equity performance.  Current fund levels exceed $1.0 trillion; unless investors now view returns on cash as adequate enough to consider it an asset class, we suspect the high levels of liquidity are an indication of caution.  If a degree of calm returns to the market environment, it appears there is enough liquidity to at least challenge the previous highs in equities.

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[1] Assuming a geopolitical event isn’t responsible for the next downturn.