Author: Rebekah Stovall

Asset Allocation Weekly (June 2, 2017)

Posted on by Rebekah Stovall

by Asset Allocation Committee

In the last FOMC minutes, policymakers signaled another hike at the upcoming June 14th meeting.  We continue to closely monitor financial conditions but, so far, financial markets are rather sanguine about the impact of policy tightening.

The blue line on the chart shows the Chicago FRB Financial Conditions Index, which measures the level of stress in the financial system.  It is constructed of 105 variables, including the level of interest rates, credit spreads, equity and debt market volatility, delinquencies, borrower and lender surveys, debt and equity issuance, debt levels, equity levels and various commodity prices (including gold).  A rising line indicates increasing financial stress.  The red line is the effective fed funds rate.  Until 1998, the two series were positively and closely correlated.  When the Fed raised rates, financial stress rose; when the Fed lowered rates, stress declined.

We believe there are two factors that changed this relationship.  The first is policy transparency.  Starting in the late 1980s, the Fed became increasingly transparent.  For example, before 1988, the FOMC would meet but issue no statement about what it had decided to do.  Investors and the financial system had to guess whether policy had been changed.  Starting in 1988, the central bank began publishing its target rate.  In the 1990s, it began issuing a statement when rates changed.  Eventually, a statement followed all meetings.  As the FOMC has become more transparent, the correlation between stress and the level of fed funds has changed.  Essentially, the markets now know with a high degree of certainty when rate changes are likely.  This is especially true of tightening.  The FOMC appears to avoid making rate hikes that surprise the market.

The second factor is financial system stability.  From the Great Depression into the 1980s, policymakers put a high premium on system stability at the expense of efficiency.  Bank failures were rare and there were a large number of rather small institutions.  In addition, commercial banks were separated from investment banks.  The drive to improve efficiency led to consolidation among commercial banks and a breakdown of the barriers between commercial and investment banks.  Although this made the system more efficient, it also undermined stability.  Thus, when raising rates, the Fed must pay close attention to system stability to prevent crises, which has tended to lead to gradual and measured policies; this behavior maintains stability…until it doesn’t!

Essentially, policymakers and investors face the Minsky Paradox; the more stable markets become the more risks investors take, leading to conditions that cannot be sustained.  Unfortunately, it’s hard to know in advance when rate hikes become problematic.  It is likely that as rates rise, factors that may have been manageable at lower rates become dangerous at higher rates.  Those conditions can change faster than policymakers can likely react.  For now, there isn’t much evidence of trouble but the fact that policy is tightening raises the likelihood, however small, that problems could develop.

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Asset Allocation Weekly (May 26, 2017)

Posted on by Rebekah Stovall

by Asset Allocation Committee

The dollar is in its third major bull market since currencies began floating in 1971.

This chart shows the JPM dollar index which adjusts for relative inflation and trade.  The previous two bull markets exhibited greater strength than the current one.  Because of the dollar’s reserve currency role, there will always be an underlying demand for dollars for foreign reserve purposes.  Thus, U.S. policymakers can run fiscal deficits and tax policies that penalize saving (for example, we tax income instead of consumption) and not suffer from foreign exchange crises.  At the same time, dollar strength can act as a drag on the economy; it tends to make imports more attractive and can undermine the competitiveness of domestic firms.

The previous two dollar rallies were tied to specific fundamental factors.  The 1978-85 bull market was mostly attributable to the Volcker Federal Reserve.  Paul Volcker instituted monetary policy based on money supply growth instead of interest rate targets.  This allowed interest rates to rise to extraordinary levels (fed funds peaked at 19.1% in June 1981) and made the dollar very attractive.  The 1995-2002 bull market was mostly caused by productivity gains, although fiscal surpluses likely contributed as well.  Technology investment began to boost the economy in the latter half of the 1990s and made the U.S. an attractive investment venue.  The surplus reduced available Treasuries and made it difficult to build reserves without bidding the dollar higher.  The current bull market is similar to the Volcker bull market in that it appears to be mostly due to monetary policy.  The Federal Reserve began to reverse its unconventional monetary policy measures before the other major G-7 economies, boosting the greenback.

Valuing currencies is difficult as it is generally true that the currency markets focus on different factors over time.  There are periods when relative inflation is dominant.  During other periods, the external accounts drive the exchange rates, while other times interest rate differentials are key.  The valuation model with the longest history is purchasing power parity, which is based on relative inflation rates.  The thesis is that the exchange rate should act to balance prices between nations and so a country with higher inflation relative to another should have a weaker exchange rate to unify prices across countries.  In practice, we find that not all goods are tradeable, inflation indices are not the same across countries and relative pricing parity models don’t account for capital flows.  Although parity models often deviate from fair value, they can be useful when parity reaches an extreme.

This chart shows the German/U.S. parity model, which uses CPI from Germany and the U.S. to establish parity.  Currently, the exchange rate is nearly two standard errors below parity, meaning the D-mark (or the euro) is undervalued relative to the dollar.  As the chart shows, the exchange rate rarely stays around purchasing power parity.  However, when it reaches the two-standard error level in either direction, it usually means the exchange rate will eventually reverse.  It isn’t uncommon for the exchange rate to remain over or undervalued for a long period of time.  However, we eventually do see a reversal from extreme levels.  Usually, there is a catalyst that brings an adjustment to valuation.  In 1985, it was the Plaza Accord which was specifically designed to weaken the dollar.  The end of the second bull market was likely due to the end of the tech bubble in equities and the Bush tax cuts, which reduced the fiscal surplus.

It appears we are seeing two catalysts that may be signaling the end of this dollar bull market.

The reversal of monetary policy: The dollar initially rallied on the divergence of monetary policy.  The Federal Reserve was ending QE and beginning to raise rates, while the Bank of Japan (BOJ) was expanding QE and the European Central Bank (ECB) was implementing QE and experimenting with negative interest rates.  This kicked off the current dollar bull market that began in mid-2014.  Although the FOMC is planning to raise rates further that action has been well telegraphed.  At the same time, it appears the ECB is poised to raise rates and end its QE program.  And, European economic growth has been strengthening, which will likely accelerate policy tightening.  Even the BOJ is considering easing some of its support.  Given the degree of dollar overvaluation, foreign policy tightening will likely weaken the dollar in the coming months.

Political turmoil is favoring foreign currencies: There is no lack of political turmoil in the developed countries.  We have had two major elections in Europe thus far, with upcoming German elections in the fall and Italian elections expected in February.  Brexit continues to roil Europe.  Tensions are rising in the Far East as North Korea continues to test missiles and threaten its neighbors.  When President Trump won the election in November, the dollar rose on expectations of trade restrictions, tax reform that would support repatriation and infrastructure spending which would boost growth.  As the Trump administration has gotten sidetracked on other issues, these expectations have dwindled.  Even though political risk remains high throughout the developed markets, the high dollar valuation and disappointment surrounding the president’s policies appear to be undermining the dollar.

If the dollar’s bull market is coming to a close, what can we expect?  First, it gives a tailwind to foreign investment.  Emerging markets, which have been strong this year, would likely receive further support if the dollar begins to weaken.  Second, commodities would benefit.  For example, our oil inventory/EUR model for oil prices indicates that a €1.30 would generate a fair value for oil near $78 per barrel, even with the current elevated level of inventories.  Gold prices are traditionally supported by dollar weakness as well.  The asset allocation committee will be weighing the likelihood of dollar weakness and take appropriate measures in the coming months.

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Weekly Geopolitical Report – Reflections on Trade: Part IV (May 22, 2017)

Posted on by Rebekah Stovall

by Bill O’Grady

(Due to the Memorial Day holiday, our next report will be published on June 5.)

This is the final report of our four-part series on trade.  This week, our discussion on trade continues with a look at the relationship between trade, employment and inflation.  We will also conclude the series with market ramifications.

What are the tradeoffs of trade?
Trade is part of a broader societal tradeoff between equality and efficiency.[1]  To function, societies need some degree of both.  Nations with a high level of inequality tend to become politically unstable.  At the same time, perfect equality tends to stifle initiative and prevent the building of productive capacity.  Efficiency helps an economy provide goods and services at reasonable costs.  Complete inefficiency makes everyone poor.

Okun’s insight is that societies balance equality and efficiency to maintain order.  What we observe in history is that there doesn’t appear to be a balance point; in other words, this isn’t an optimization problem.  Instead, we see broad periods of oscillation where one goal or the other is waxing or waning.

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[1] Okun, A. (1972). Equality and Efficiency: The Big Tradeoff. Washington, D.C.: Brookings Institute.

Asset Allocation Weekly (May 19, 2017)

Posted on by Rebekah Stovall

by Asset Allocation Committee

One of the significant “known/unknowns” is the true condition of the labor market.  The below chart highlights the issue.

The blue line is the unemployment rate, while the red line is the employment/population ratio (scale inverted).  From 1980 until 2010, these two series closely tracked each other.  During the period since the last recession, the two have clearly diverged.  The current unemployment rate is 4.4%; if the relationship from 1980 to 2010 had held constant, the unemployment rate would be approximately 7.5%.

For policymakers, the problem is determining which measure of the labor market best characterizes the degree of slack in the economy.  If the employment/population ratio is correct, then ample slack exists and policymakers should keep policy accommodative.  If the unemployment rate is the better measure, then labor markets are tight and the FOMC needs to be raising rates.

To determine the degree of accommodation, we use four variations of the Mankiw Rule.  The Mankiw Rule models attempt to determine the neutral rate for fed funds, which is a rate that is neither accommodative nor stimulative.  Mankiw’s model is a variation of the Taylor Rule.  The latter measures the neutral rate using core CPI and the difference between GDP and potential GDP, which is an estimate of slack in the economy.  Potential GDP cannot be directly observed, only estimated.  To overcome this problem with potential GDP, Mankiw used the unemployment rate as a proxy for economic slack.  We have created four versions of the rule, one that follows the original construction by using the unemployment rate as a measure of slack, a second that uses the employment/population ratio, a third using involuntary part-time workers as a percentage of the total labor force and a fourth using yearly wage growth for non-supervisory workers.

Using the unemployment rate, the neutral rate is now 3.29%.  Using the employment/population ratio, the neutral rate is 1.13%.  Using involuntary part-time employment, the neutral rate is 2.60%.  Using wage growth for non-supervisory workers, the neutral rate is 1.15%.  Note that for two of the variations, wage growth and the employment/population ratio, the FOMC is already near the neutral rate.  The fact that policymakers appear driven to lift rates further suggests they believe that some other measure is a proper measure of slack.

Since the Great Financial Crisis, it has been unclear which measure of employment accurately characterizes the labor market.  Because the Fed had been conducting very easy monetary policy, the debate was mostly academic; that isn’t the case anymore.  If the most accurate measure is actually the employment/population ratio or wage growth, but the Fed thinks either the unemployment rate or involuntary part-time employment is the correct indicator of slack, then policymakers could run the risk of overtightening and potentially risking a recession.

This chart shows the issue; this is the Mankiw model variation using wage growth.  The lower line on the chart shows the deviation from the neutral rate as projected by the model.  When the rate is below zero, policy is leaning toward accommodative.  Note the parallel lines on the lower part of the chart; these lines measure a standard error on either side of the neutral rate.  When the deviation is within the parallel lines, it suggests policy is mostly neutral.  Thus, based on wage growth, we are close enough to neutral policy that the Fed could stand pat until either wage growth accelerates or core CPI rises.

Thus, the coming months will be key.  If this model is the most accurate measure of slack then the Fed needs, at most, one more hike.  Policy would be tight at a fed funds target of 2.40%, so there is some margin for error.  Based on the dots chart, we would be at this level by the end of next year.  Simply put, we could be approaching a period where monetary policy shifts to a headwind.

The path of monetary policy has been a key element in the asset allocation committee’s analysis of the economy and markets.  We are moving into a more critical phase where the potential for a policy error is rising.  By year’s end, we could have a fed funds rate that would be modestly higher than neutral using at least two of the four variations of the Mankiw Rule model.  That would increase the potential for a recession which we would expect to have a negative impact on equity markets.  Thus, this is an issue we will be closely monitoring into the second half of 2017.

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Weekly Geopolitical Report – Reflections on Trade: Part III (May 15, 2017)

Posted on by Rebekah Stovall

by Bill O’Grady

This week, we continue our discussion on trade by examining the reserve currency issue.

What is the reserve currency?
When a country runs a trade surplus, it creates excess saving that must be either invested overseas or held as foreign reserves.  If a gold standard is being used, the excess saving/foreign reserves can be held as gold (or other precious metals).  In theory, reserve managers can hold just about any asset as foreign reserves.  However, if the ultimate goal of generating saving is to build the productive capacity of the economy, then the best foreign reserve assets should be safe and easily convertible, with broad acceptability in markets.

Here is an example we often use to describe why the reserve currency is important.  Imagine that a chocolatier in Paraguay wants to purchase a ton of cocoa beans.  He calls a dealer in Côte d’Ivoire for a price; the seller offers $1,800 per ton.  The buyer in Paraguay notes he does not have U.S. dollars but does have Paraguayan guaraní.  The seller does not want the Paraguayan currency because it would limit his purchases to Paraguay because the guaraní isn’t widely accepted.  The seller in Côte d’Ivoire would be able to buy a wider variety of goods (or have wider avenues for investment) from selling cocoa if he receives U.S. dollars instead.

So, how does the chocolatier in Paraguay get dollars?  The most efficient way would be to export chocolate to a U.S. buyer, then use the dollars he receives to buy cocoa beans from Côte d’Ivoire.  Because the reserve currency has widespread acceptance, non-reserve currency nations have an incentive to run trade surpluses with the reserve currency nation to accumulate the reserve currency, which allows them to pay for imports from around the world.

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Asset Allocation Weekly (May 12, 2017)

Posted on by Rebekah Stovall

by Asset Allocation Committee

Slow economic growth has plagued the West.  Although the concern has been acute since the Great Financial Crisis (GFC), worries about slowing growth predated that event.  Perhaps the most important factor contributing to sluggish growth has been tepid productivity growth.

This chart shows the five-year change in productivity; we use this longer term rate of change to more clearly show the trend in productivity growth.  As the chart indicates, productivity growth is remarkably weak; in fact, in the postwar era, only the weakness seen in the depths of the 1981-82 recession recorded lower productivity growth by this measure.

Economic theory holds that production comes from the combination of land, labor, capital and entrepreneurship.  Most models focus on capital and labor.  The Cobb-Douglas production function[1] is a canonical expression of how economists think about forecasting output.  Production is the combination of capital and labor, scaled by productivity.  If productivity is constant, growth comes by adding capital (investment in plant and equipment, etc.) and workers (or, specifically, hours worked).  If an economy increases its productivity, more output is gained for each additional unit of labor and capital.  That’s why falling productivity is such a problem; it means that additional labor and capital resources must be deployed just to keep production steady.

Productivity is something of the holy grail of economics.  Theories of what boosts productivity abound; deregulation and competition are thought to increase it, supporting entrepreneurship with low taxes could be a factor, education and immigration could support increases and, of course, technological progress is a necessary ingredient.  However, no economist has yet been able to definitively say what causes productivity to universally rise under all conditions.

However, we can say that an economy with weak productivity growth will struggle.  Capital and labor essentially divide total output and low productivity makes that division difficult.  On the other hand, rising productivity can allow both capital and labor to enjoy a rising absolute share of output.  Social peace is much easier to achieve with rising productivity.  It is probably no accident that the rise of populism in the West has coincided with weak productivity growth.

From the mid-1970s into the GFC, the relationship between corporate profits and the five-year growth rate of productivity was fairly consistent.

This chart shows pre-tax corporate profits, on a national income product accounts basis, as a percentage of GDP along with the five-year growth rate of productivity.  From the mid-1970s into 2007, the two series were highly correlated at 75.8%, with trend productivity leading profits by four years.  Since 2007, the two are inversely correlated at the 53.3% level.  Clearly, profits have remained elevated despite weak trend productivity, which begs the question—how did profits hold up in the face of falling productivity?

What has occurred is that relative labor compensation has fallen.

The upper line on this chart shows pre-tax profits as a percentage of GDP.  The lower line shows labor’s share of output along with a time trend calculated from 1947 to 2004.  From 1947 through 2004, the share held fairly steady; although there was a clear downtrend, the slope was fairly benign.  Clearly after 2004 the share fell well below trend, and the labor share plummeted after the GFC.  It has recovered some of its losses since 2015 but the data is still well below trend.  A falling share to labor has allowed firms to overcome weak productivity trends and retain high margins.

Why has labor’s share of output declined?  The media discusses a litany of reasons…technology and globalization have given firms market power over labor and allowed companies to keep wages contained despite tightening labor markets.  Although this condition has been a boon for profit margins, it has been difficult for workers and we suspect the rise of populism is a direct result of wage pressures.

As the first chart shows, because of the lagged effect of trend productivity, the effects of weak productivity will become acute starting around mid-2018.  Without a decline in the labor share of output, profit margins will come under growing pressure.  Using a simple regression of trend productivity and labor share, to maintain pre-tax profits of 12% would require the labor share to fall to 55% by the end of 2018.  If the labor share remains constant, profit margins will decline to 9.6% of GDP.  This level is still historically high but, given market expectations of continued strong profit margins, even this decline will be problematic.

The Trump administration continues to straddle the line between a traditional GOP stance that favors business and capital and a populist variant that calls for trade protection and immigration restrictions.  If President Trump decides to favor his working class supporters, which would likely boost the labor share, profit margins would come under even more pressure.  This is a factor we will be monitoring closely as the year progresses.

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[1] P(L, K) = bLαKβ, where:  • P = total production (the monetary value of all goods produced in a year) • L = labor input (the total number of person-hours worked in a year) • K = capital input (the monetary worth of all machinery, equipment and buildings) • b = total factor productivity • α and β are the output elasticities of labor and capital, respectively.  These values are constants determined by available technology.

Weekly Geopolitical Report – Reflections on Trade: Part II (May 8, 2017)

Posted on by Rebekah Stovall

by Bill O’Grady

In this multi-part report, we offer several reflections on trade that we hope can provide some insight into how to use macroeconomics to judge the veracity of certain claims.  In Part I, we laid out the basic macroeconomics of trade.  This week, in Part II, we will discuss the impact of exchange rates and examine the two models of economic development, the “Japan Model”[1] and the “American Model.”[2]

The Japan Model of development calls for policies that drive up household saving.  This is usually done through financial repression and wage suppression.  This model is designed to provide cheap investment funds to build up the productive capacity of the country.

In contrast, the American Model of development relies on foreign investment.  In this arrangement, the trade deficit is an import of foreign saving for investment.

As a review from Part I of our report, the following saving identity means that the private investment/savings balance (I-S) plus the public spending balance (Govt-Taxes) is equal to the trade account, M-X (Imports less Exports).

(M – X) = (I – S) + (G – Tx)

If a nation’s saving equals its investment and it runs a balanced fiscal budget, then it will run a balanced trade account.  It doesn’t matter what the exchange rate is or what trade policy is in place; if the private and public sector balances, there will also be balanced trade.

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[1] We call this the Japan Model because it has been adopted by Asian nations for development.

[2] We call this the American Model because it is how the U.S. acquired saving during its industrial revolution, which began in earnest in 1870.

Asset Allocation Weekly (May 5, 2017)

Posted on by Rebekah Stovall

by Asset Allocation Committee

In our most recent quarterly asset allocation meetings, our analysis determined that emerging markets would not be added to the portfolios.  Since this asset class has been this year’s best performer, some explanation is in order.  One of the primary reasons we have refrained from adding emerging markets is the dollar’s strength.

The blue line on this chart looks at the relative performance of emerging markets to the S&P 500.  When the line is rising, the S&P is outperforming emerging markets.  The red line is the JPM real dollar index.  The two series are positively correlated at 80.8%, meaning that a stronger dollar tends to reflect the S&P 500 outperforming the emerging markets.  This correlation has weakened modestly recently, but is still quite elevated.

The second reason we have been reluctant to add emerging markets is because the relative outperformance is occurring with weaker commodity prices.

Although the correlation isn’t as strong as with the dollar, rising commodity prices tends to coincide with stronger relative emerging market performance.  Although commodities are off their lows, they remain depressed. Thus, the current level of commodity prices seems to support weaker relative emerging market equities.

This chart shows a model of the emerging market/S&P 500 relative performance regressed against the JPM dollar index, the CRB index and fed funds (advanced six months).  Currently, the model is suggesting that emerging market equities are overvalued relative to the S&P against these three independent variables.

Despite this overvaluation, it is possible that the strong relative performance of emerging markets is anticipating a recovery in commodities, a slowing of monetary policy tightening or a weaker dollar.  The dollar lifted on expectations of tighter policy and if the FOMC does not raise rates as much as expected or if foreign central banks reverse their current easy policy stances, then the dollar could weaken.  However, this model suggests that emerging market equities have already discounted that outcome.  Thus, we are concerned that emerging market equities may be ahead of the fundamentals.  If this is true, the current strong performance of emerging markets could stall even with dollar weakness, rising commodities or a stall in Fed tightening.  And, if the dollar rises, commodities fall further or the FOMC raises rates according to the “dots plot,” emerging markets could be quite vulnerable.  For now, we believe the risks exceed the potential return from these levels.

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Weekly Geopolitical Report – Reflections on Trade: Part I (May 1, 2017)

Posted on by Rebekah Stovall

by Bill O’Grady

Donald Trump ran on a platform opposing free trade.  Although Congressional support for free trade has been waning for some time, the general consensus among economists is that free trade makes the economy more efficient and supports global stability.

However, the steady erosion of manufacturing jobs in the U.S. and the shrinking of the middle class[1] have called the consensus view into question.  It is clear that President Trump’s anti-trade rhetoric resonated with voters and was one of the factors that led to his election.

Since the election, there have been a number of assertions made about trade, both positive and negative, that appear to us to be only partially true and perhaps designed to support a particular position.  Trade can be negative for participants facing competition from abroad; for the overall economy, it does seem to bring more variety and lower prices.

In this multi-part report, we will offer several reflections on trade that we hope can provide some insight into how to use macroeconomics to judge the veracity of certain claims.  It is our goal to present a fair reading of economic theory that will help readers make sense of what the media reports.  This topic is worthy of a geopolitical report because American trade policy has been a critical element in how the U.S. manages its superpower role.  In Part I, we will lay out the basic macroeconomics of trade.  In Part II, we will discuss the impact of exchange rates and further examine the two models of economic development.  Part III will analyze the reserve currency’s effect on trade.  Part IV will look at some real world examples and conclude with market ramifications.

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[1] https://www.nytimes.com/2017/04/24/business/economy/middle-class-united-states-europe-pew.html?_r=0