Author: Rebekah Stovall

Asset Allocation Weekly (February 17, 2017)

Posted on by Rebekah Stovall

by Asset Allocation Committee

A regular question we are asked by financial advisors and clients is, what is the impact of the Trump presidency on financial markets?  The simple response is that we don’t know for sure, but a pattern is starting to emerge.  And that pattern has to do with the perceptions of Trump’s two main constituencies.

President Trump has two primary constituencies, the right-wing populists (RWP) and the right-wing establishment (RWE).  The primary goal of the RWP is to create a surfeit of high paying, moderately skilled jobs.  History suggests that these jobs are often created in the manufacturing sector, so policies are being promoted that protect and expand these positions.  In general, policies favoring trade protection, immigration restrictions, infrastructure spending and the support of incoming foreign direct investment are being discussed.  In addition, protection for entitlements, especially the universal ones (those that are not granted due to means testing or favor a specific group) such as Social Security, Medicare and Disability, are favored.  There is little concern for fiscal deficits.  The RWE, on the other hand, prefer tax cuts, deregulation, entitlement reform and lax immigration policies.  Infrastructure spending is opposed and concern about fiscal deficits is high.

The problem the president faces is that there isn’t much overlap between the policy preferences of these two groups.  That isn’t to say there isn’t any overlap.  The House GOP is trying to build support for its corporate tax reform by including a border adjustment tax that would leave revenue from exports untaxed while taxing the revenue derived from imports.  The border adjustment tax, in theory, would be attractive to the RWP due to its impact on trade.  At the same time, it would lift revenue and partially pay for corporate tax cuts.  But, for the most part, policies that the RWE want will not be backed by the RWP and vice versa.

So far, equities and the dollar have risen when policies championed by the RWE appear to be advancing.  Gold, commodities and Treasuries perform better when the president seems to be supporting the RWP policies.  Lately, most of the policy direction seems to be favoring the RWE.  This is because more members of the cabinet being approved are coming from the GOP establishment.  It is unlikely this pattern will continue indefinitely; we would expect Trump to vacillate between the two groups in order to stay in power.

However, at some point, the financial markets will determine where the president’s priorities lie.  If it turns out he is truly a populist, inflation expectations will rise, which will likely be bearish for equities and fixed income markets.  If the Federal Reserve remains independent, under these conditions, the dollar will rally while commodity prices will suffer.  On the other hand, if the U.S. central bank’s independence is compromised, commodity prices will rise and the dollar will fall.  If Trump turns out to be an establishment figure at heart, equities will perform well, interest rates will rise modestly and the Federal Reserve will remain independent.  We would not expect a runaway bull market in any asset class.

Is it possible to know when the financial markets make this determination?  In reality, it behooves the president to maintain enough strategic ambiguity to keep both sides on board.  But, history does offer some guidance.  So far, the S&P 500 Index is tracking the path usually seen with new GOP presidents.

The blue line on this chart takes the average weekly performance of the S&P 500 Index rebased to the first Friday close in the election year of a new Republican president until the next presidential election year.  The data begins in 1928.  Note that performance for last year and this year mostly follows the historical average pattern.  If this situation continues, the S&P 500 Index will reach the 2375-2400 level by late Q3.

The drop seen in the average at the end of the first full year could represent disappointment in the ability of a Republican president to actually deliver the policy changes promised during the election.  In other words, a degree of realism develops which leads to a correction in equities.  Again, this analysis is simply an average and, if anything, the current president is clearly unique.  However, if the financial markets conclude that Trump is mostly a populist, it would not be surprising to see equities pull back.  Thus, for now, we remain confident that equity markets will continue to trend higher.  This position could be tested later this year.

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Weekly Geopolitical Report – Nuclear Blackmail (February 13, 2017)

Posted on by Rebekah Stovall

by Bill O’Grady

(N.B.  Due to the upcoming President’s Day holiday, the next report will be published on Feb. 27th)

During the 1950s, in the early days of nuclear weapons, there was much discussion about the potential for nuclear blackmail.  The world had recently defeated fascism but the problem of an aggressive and amoral leader like Hitler worried geopolitical strategists.  If Hitler had developed a nuclear weapon, would the war have ended the way it did?  And, if a similar leader emerged and possessed nuclear weapons, would he engage in blackmail by using the threat of a nuclear attack?

As the Cold War evolved, the U.S. and U.S.S.R. (the superpowers during the Cold War) created a workable solution to reduce the chances of a nuclear exchange.  Both parties built formidable nuclear arsenals that had second strike capabilities, meaning that either side could not “win” such a war by attacking first.  By treaty, defense mechanisms against nuclear missiles were limited, reducing the likelihood that either party would conclude it could strike without fear of retribution.  Although the U.S. was not the only free world power to have nuclear weapons (the U.K. and France did, too), and China had developed nuclear weapons within the Communist bloc, the two superpowers generally controlled the decision to deploy a nuclear strike.  In other words, nuclear proliferation was limited and thus controlling the global nuclear arsenal was manageable.

As time passed, nuclear strategists became less concerned with nuclear blackmail.  The world was divided into areas of influence.  The U.S. managed and protected the free world and the Soviets did the same for the Communist bloc.

People usually explain outcomes in terms of narratives.  Stories are powerful tools for helping us understand why outcomes occurred.  Two characteristics often emerge from narratives.  First, the simplest narrative becomes the most powerful.  Second, because the narrative is simple, outcomes can sometimes be seen as inevitable.  A well-developed narrative not only explains why an event occurred but also critically examines the factors that might have led to a different outcome.

The Cold War narrative suggests that nuclear weapons are primarily defensive because of the threat of a second strike and nuclear annihilation.  Thus, unless a nation fears regime change, there is little reason to develop a nuclear weapons program.  However, this thesis assumes that nuclear weapons decisions will always follow the Cold War pattern.  Just because nuclear blackmail did not develop during the Cold War doesn’t mean it won’t happen in the future.

In this report, we will define nuclear blackmail and differentiate it from blackmail in a nuclear context.  We will discuss why this didn’t develop during the Cold War but why it could happen now.  We will also analyze how nuclear blackmail might be used as part of coercive diplomacy as well as part of conventional conflict.  Finally, we will examine the likelihood of either form of blackmail occurring in the future and how it may change international relations.  As always, we will conclude with potential market ramifications.

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Asset Allocation Weekly (February 10, 2017)

Posted on by Rebekah Stovall

by Asset Allocation Committee

For better or worse, the Federal Reserve tends to conduct policy based on some variant of the Taylor Rule, which essentially means that the FED sets the policy interest rate based upon changes in the inflation rate and the level of slack in the economy.  The rule suggests that if there is little available capacity in an economy, continued growth will lead to higher inflation, as such, tighter monetary policy is necessary to bring inflation back to target levels.  On the other hand, if slack exists, rising growth is less of an inflation risk and the central bank can avoid rushing to raise interest rates.

The hard part of this approach is measuring slack.  Some models, including the one John Taylor created, use the difference between GDP and potential GDP to measure slack in the economy.  The problem is that potential GDP can only be estimated, not measured.  Greg Mankiw created an alternative to the Taylor Rule using the unemployment rate as a proxy for slack.  We have expanded on Mankiw’s original idea by creating three other variations, one that uses the employment/population ratio, another using involuntary part-time workers as a percentage of the total labor force and a third using yearly wage growth for non-supervisory workers.

Using the different variations, the FOMC is either modestly behind the curve (the employment/ population ratio puts the neutral policy rate at 1.36%) or well behind the curve (the unemployment rate version puts the neutral policy rate at 3.67%).  The question for policymakers, in particular, and economists and strategists, in general, is which variation best reflects the level of economic slack?

This pair of charts offers an insight into what may be the best answer.

The chart on the left shows the relationship of wages to the unemployment rate, while the chart on the right shows the relationship of wages to the employment/population ratio.  From the late 1980s until the last recession, the two employment-related series generally tracked wages but they have diverged broadly in this recovery.  One of the mysteries of the recovery is the weakness in wage growth despite the low unemployment rate.  In fact, a simple model of the two suggests that wage growth should be 3.5% by Q3, well over the current 2.4%.  However, relative to the employment/population ratio, wage growth should only be around the current level of 2.4% by September, which is equal to current wage growth.

In other words, the employment/population ratio appears to be, at present, a better indicator of slack.  The low ratio suggests that the large number of those not working is somehow acting as a dampener on wages, meaning that, perhaps, the low ratio is either signaling to employers that they don’t have to bid up wages to attract workers, or telling employees that there are enough people looking for jobs to prevent them from asking for higher pay.

We know that anecdotal evidence is mixed.  Two articles from the Wall Street Journal show the divergence.  One headline reads, “Skilled Workers are Scarce in a Tight Labor Market.”[1]  A second says, “Higher Jobless Rate Suggests Economy has Room to Run.”[2]  Although we are sympathetic to the former article, the data seem to confirm the latter one.  In other words, there are regional and industry pockets where wages are being bid up due to the lack of workers.  However, on a national level, that doesn’t appear to be the case.  There is evidence that labor market mobility has declined[3] which may be leading to wider regional pay divergences, but overall the above analysis does tend to suggest that wage growth remains stifled and the employment/population ratio is probably a better measure of slack in the economy.

If this is the case, the Mankiw Rule version using the employment/population ratio is probably the guide to Fed policy.  This would imply that the FOMC does need to raise rates if it desires a neutral policy, but not much more than the three hikes expected this year.  Our analysis of the 10-year Treasury market suggests that, assuming current oil prices, inflation trends, German 10-year sovereign yields and the yen/dollar exchange rate, current yields have discounted a fed funds target of 1.75%.  If the FOMC does not raise fed funds to that level, long-duration assets may become attractive as the year unfolds.  Of course, part of the problem is that those other variables will likely not remain constant.  For now, we maintain our mostly negative view toward long-duration fixed income but acknowledge that the FOMC may not lift rates to levels projected by the markets unless wage growth rises.  In our estimation, for that to occur, the employment/population ratio must rise.

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[1] https://www.wsj.com/articles/skilled-workers-are-scarce-in-tight-labor-market-1486047602 (paywall)

[2] https://www.wsj.com/articles/u-s-added-a-robust-227-000-jobs-in-january-1486128784 (paywall)

[3] http://equitablegrowth.org/equitablog/declining-u-s-labor-mobility-is-about-more-than-geography/

Weekly Geopolitical Report – Exit the Shark (February 6, 2017)

Posted on by Rebekah Stovall

by Bill O’Grady

On January 8, Akbar Hashemi Rafsanjani died of a heart attack.  The 82-year-old cleric was a major political figure in Iran and his passing is a significant event for Iran and the region.

Analyses of history usually follow one of two lines—the “Great Man” or the “Great Wave.”[1]  The former postulates that the progression of history is shaped by strong personalities that bend the path of society through the force of their will.  The latter says that history is a progression of impersonal forces which shape society and the people who participate are simply playing their role.  In reality, both describe history, although we tend to lean toward the Great Wave explanation.  This is because there are trends that develop in economies, societies and institutions that affect how history evolves, and the great people are usually those who correctly figure out the trends and move them forward.  There are always those who resist; if the wave is strong enough, they tend to fail.

However, people do matter.  Some personalities are so strong that even though they may not be “on the right side of history,” they slow the progression of a trend.  And, if they are part of the trend, history suggests their support accelerates the movement.

Rafsanjani was this sort of figure, and so we want to mark his passing with a dedicated report.  We are not suggesting that he was a good man; if anything, he was involved in many activities that harmed the U.S.  Still, as we will discuss below, he was a pivotal figure in Iranian history and his death changes how Iran’s leaders will act going forward.

Our analysis will begin with a description of the structure of Iran’s government.  A short biography of Rafsanjani will follow.  We will discuss his influence on Iranian society and the political system, then examine how his death may affect future Iranian activities.   We will conclude with potential market ramifications.

View the full report

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[1] See WGR, The Great Man or the Great Wave, 1/13/2014.

Asset Allocation Weekly (February 3, 2017)

Posted on by Rebekah Stovall

by Asset Allocation Committee

Although our current allocation models exclude emerging markets, we still monitor various emerging market nations for potential opportunities.  A country that has been in the news recently is Mexico.  President Trump has been targeting Mexico and the North American Free Trade Agreement (NAFTA) for Mexico’s persistent trade surpluses with the U.S.

This chart shows the rolling 12-month trade account with Mexico; the vertical line on the chart shows the month when NAFTA was enacted.  As the chart clearly shows, the trade deficit with Mexico has widened significantly, although it is interesting to note that it hasn’t worsened since the last recession.

Trade deficits act as a drag on GDP; the tradeoff is microeconomic.  Imports tend to improve the competitiveness of an economy.

Until the 1980s, the U.S. tended to run modest current account surpluses.[1]  Note that inflation steadily declined after 1980.  From 1960 to 1980, inflation averaged 5.1%.  From 1980 to the present, it has averaged 3.3%, and since 1990, 2.1%.  Competition from foreign trade forces domestic firms to be more competitive and cost efficient.  At the same time, since the U.S. provides the reserve currency, there is an incentive for other nations to implement policies designed to run trade surpluses with the U.S. in order to acquire dollars.  These policies tend to suppress domestic consumption and expand investment, with the global effect of boosting growth through trade.

The peso/dollar exchange rate has a strong impact on the performance of investments into Mexico.  Currently, our model of the exchange rate suggests the peso is deeply undervalued.

This model uses relative inflation and the trade account as independent variables.  It suggests the peso is 33% undervalued relative to the dollar.  Note that this undervaluation began in mid-2014 as the dollar began to rise across most currencies due to expectations of U.S. monetary policy tightening.  The peso weakened further due to the election of Donald Trump, who promised to build a wall across the southern border of the U.S.

The weak peso has had an effect on Mexican equity values; in peso terms, the MSCI Mexico Index is up 10.1% since mid-2014, an annual gain of 3.8%.  In U.S. dollar terms, it is down 28.1%, or -12.0% annualized.

Although the peso is quite competitive with the U.S. at current levels, the degree of political risk is so elevated at present that we are not ready to allocate to Mexican equity markets.  However, at some point, the currency should stabilize and offer an opportunity for our asset allocation accounts.  Until then, we continue to closely monitor this market.

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[1] The current account is the merchandise trade account plus private and public transfers and remittances.

Weekly Geopolitical Report – Future of the Euro (January 30, 2017)

Posted on by Rebekah Stovall

by Thomas Wash

January 1, 2017, marked the 18th anniversary of the induction of the euro, the European single currency. Once praised as the uniting force among European countries, the euro has become a source of populist backlash. From Greece to France, populist politicians have increased their political clout to the chagrin of the establishment.

The primary motivation of the European Union was to create a unified European identity so that countries would not be tempted to fight wars with one another. Special attention was paid to Germany, which had tried to dominate Europe in the past. Ensuring peace throughout Europe meant Germany had to be subdued. In order for this to happen, Germany had to become dependent on its neighbors such that waging war would be against its own interests. Although this worked in the beginning, the 2008 financial crisis exposed the flaws in this plan. Germany’s excess savings and fiscal discipline led to it assuming the dual role as creditor and lender of last resort within the European Union. This gave Germany unparalleled leverage to dictate fiscal and foreign policies over other European countries.

In this report, we will take a deeper look into the factors that contributed to the formation of the European Union, as well as the negative effects the single currency has had on certain countries, particularly those located in southern Europe. As always, we will conclude with ramifications on the financial markets.

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Asset Allocation Weekly (January 27, 2017)

Posted on by Rebekah Stovall

by Asset Allocation Committee

The consensus estimate for Q4 2016 S&P 500 operating earnings growth is 3.2%, which translates into a forecast of $118.35 per share for the S&P 500, using Thomson/Reuters data.  Using a similar growth rate, the Standard and Poor’s calculation of operating earnings generates annual earnings of $102.16.  Simply put, these two sources currently have a rather wide divergence.

This chart shows the two series from 1994, with the lower line showing their ratio.  The official explanation for the divergence is that S&P earnings are closer to Generally Accepted Accounting Principles (GAAP), which usually don’t include “unusual items.”  The Thomson/Reuters earnings data excludes more of these non-recurring costs, resulting in higher operating earnings.

What concerns us about the current divergence is that two of the past divergences occurred during recessions.  Thus, it is possible that the recent event is signaling that a downturn could be coming.  However, we have also noted that another factor may help explain the widening—oil prices.

This chart overlays the ratio of the two earnings series with oil prices.  Note that the three major divergences coincide with significant declines in oil prices.  It is not unusual for recessions to bring lower oil prices; however, oil prices can fall for other reasons, as we have seen since 2014.  This means that with the recovery in oil prices, we could very well see a narrowing of the ratio between the two series.

To the extent that the markets usually focus on the Thomson/Reuters data, a narrowing of the ratio won’t matter too much.  The growth in earnings as reported by S&P could be quite robust next year whereas the growth already estimated by I/B/E/S[1] of about 10.6%, while impressive, won’t be as strong as S&P if the ratio approaches one.  That would entail a greater than 29% rise in what S&P reports.  Still, convergence of the two series does give us more confidence in the veracity of the earnings data.

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[1] A part of Thomson/Reuters.

Keller Quarterly (January 2017)

Posted on by Rebekah Stovall

Letter to Investors

2016 was full of surprises, and we expect that 2017 will be just as surprising. As we discussed in last quarter’s letter, the job of an investment manager is to navigate the world that is, not the world that we would like to have. Thus, rather than try to correctly predict what will happen next (an impossible task), we need to think through all the probable outcomes and be ready for whatever happens next. For instance, we have a policy mix in Washington, D.C. that not many predicted just a few months ago: a Republican president and Republican control of both houses of Congress. But the Republican president is not your “standard issue” Republican hard money, free-trading supply-sider. He is an apparent populist, who, as such, likely favors easy money, exports over imports, and policies that benefit domestic employment over capital. This is a policy mix we haven’t often seen in modern American history. What will be the impact on financial markets if policies move in this direction?

As we have noted in many of our commentaries, policies that roll back trade globalization, even a little bit, will likely result in higher inflation, simply because in this scenario the prices of imported goods would rise. Such higher prices would permit the prices of domestic goods to rise also as foreign competition would be less onerous. If successful, such policies are not all bad: the goal would be for these higher prices to permit more production in the U.S., which means more domestic employment and more sales and earnings for U.S.-based companies. The downside would be higher inflation in the U.S., which would result in higher interest rates on bonds and lower price/earnings ratios for equities. Commodity prices would likely respond well to this policy mix, but foreign producers of goods, especially emerging markets, would suffer.

Will all these things happen? We don’t know, but these policy proposals would be quite a break from those of all administrations of the last 40 years, Republican or Democrat. Thus, they have the potential to change financial markets by a little or a lot, depending on how (and by how much) they are implemented. Indeed, the bond market has sold off sharply since the election, resulting in higher interest rates. The stock market has risen during this time, likely on expectations of higher growth ahead (a common post-election reaction).

There is often a trade-off between low inflation and broad-based economic growth. As investors, we interpret the events of the presidential campaigns just concluded (in both parties) to mean that the American public has decided that the benefits of low inflation are not worth the low earnings power that is the experience of most American workers. That is a sea change. We don’t say that lightly.

How would we manage our portfolios differently if these changes occur? The leadership of Confluence started their careers in the high-inflation days of the 1970s and early 1980s and, as a result, our methodologies incorporate a respect for rising inflation. Since the guiding principle of our equity investment philosophy is that we target companies with powerful competitive advantages that result in pricing power, the companies we seek to invest in have the ability to raise prices (when necessary) with less push-back from customers than average businesses. This ability to raise prices is an important reason why such businesses are good hedges against inflation. We also seek to invest in companies that possess excellent management talent. Adept managers can respond to changes in the economic and policy climates, which is why well-chosen stocks can generally outpace bonds and other fixed-rate investments in a rising inflation environment. Of course, rising inflation would bring valuation headwinds, and thus we must stay true to our valuation discipline.

In general, on the fixed income side of our portfolios, we would keep our durations shorter than we have in years past. The potential for higher rates in the future would lead us to protect capital by avoiding low-coupon, long-term bonds. We will also tend to favor credit risk in fixed income as inflation will lower the real debt service cost for corporate borrowers. We’re not sure how policies might change or how all this will work out, but we are watching it closely and will respond to meaningful changes accordingly.

One thing never changes in the investment business: the world will surprise you, so prepare for it. Our wish for you is a Happy and Healthy New Year!

Thank you for your confidence in us.

 

Gratefully,

Mark A. Keller, CFA
CEO and Chief Investment Officer

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Weekly Geopolitical Report – War Gaming: Part II (January 23, 2017)

Posted on by Rebekah Stovall

by Bill O’Grady

Two weeks ago, we began this two-part report by examining America’s geographic situation and how it is conducive to superpower status.  This condition is problematic for foreign powers because it can be almost impossible to significantly damage America’s industrial base in a conventional war with the U.S.  In addition, it would be very difficult to launch a conventional attack against the U.S. (a) with any element of surprise, and (b) without significant logistical challenges.  The premise of this report is a “thought experiment” of sorts that examines the unconventional options foreign nations have to attack the U.S.  Although these may not lead to regime change in America, such attacks may distract U.S. policymakers enough that foreign powers could engage in regional hegemonic actions that would otherwise be opposed by the U.S.

In Part I of this report, we discussed two potential tactics to attack the U.S., a nuclear strike and a terrorist attack.  This week, we will examine cyberwarfare and disinformation.  We will conclude with market effects.

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