Weekly Geopolitical Report – The TTIP and the TPP: An Update (October 17, 2016)

by Bill O’Grady

In January 2014, we first discussed the Transatlantic Trade and Investment Partnership (TTIP) and the Trans-Pacific Partnership (TPP).[1]  Both pacts have moved from obscure trade proposals to highly controversial political issues.  In this report, we will begin by discussing the nations involved.  We will examine overall details of the proposals, focusing on how they are different from traditional trade agreements.  From there, we will present an analysis of the controversy surrounding these proposals.  A look at the geopolitical aims of the agreements will follow and the likelihood that these treaties will be enacted.  As always, we will conclude with potential market ramifications.

The TTIP and the TPP
The TTIP will include the U.S. and all the nations of the EU.[2]  The TPP, which initially started with four nations, Brunei, Chile, New Zealand and Singapore, has expanded to 12 nations.[3]  Taiwan expressed interest in the TPP last year, but it is unclear whether the current configuration is comfortable with engaging in the age-old dispute over Chinese sovereignty.  South Korea has also decided to hold talks about joining the TPP group.  Conspicuous in its absence is China.

View the full report

____________________________

[1] See WGR, The TTIP and the TPP, 1/27/2014.

[2] Austria, Belgium, Bulgaria, Croatia, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, Netherlands, Poland, Portugal, Romania, Slovakia, Slovenia, Spain, Sweden and the U.K.

[3] Australia, Canada, Japan, Malaysia, Mexico, Peru, U.S., Vietnam, Chile, Brunei, Singapore and New Zealand.

Asset Allocation Quarterly (Fourth Quarter 2016)

  • Although presidential elections gather a lot of attention from investors, we believe the specific person or party getting elected in this cycle may be less important than the forces driving the elections.
  • The Fed is likely to raise rates gradually and we don’t expect the tighter policy to create a recession.
  • Our equity allocations remain primarily domestic, although we believe emerging markets present an attractive return/risk opportunity for risk-tolerant investors.
  • We include a range of maturities in our fixed income allocations.
  • Our commodities allocation remains focused on gold to help address certain geopolitical and currency risks.
  • Our style guidance remains modestly in favor of growth over value at 60/40.

ECONOMIC VIEWPOINTS

For over 16 years, including many prior to forming Confluence, we’ve worked together providing quarterly reports about our asset allocation models. And every four years we face a presidential election that often attracts an outsized amount of attention from investors. We frame it as outsized because the outcome of most presidential elections alone is generally not of great consequence to the markets. Elections certainly do have broad consequences, but the financial markets usually adjust pretty quickly.

This isn’t to say presidential elections are insignificant. But right now, the specifics of who occupies the White House is perhaps less important than understanding the changing force voters are exerting on the U.S. political system. So, regardless of which party takes the helm, both are going to have to deal with this force, which we expect to continue and grow well beyond this election cycle. What does this force look like? It’s complex and multifaceted, but we think it’s essentially a transition. We believe our economic philosophy is shifting away from an emphasis on efficiency, and more toward one of equality. We expect this shift to take years, and last for perhaps decades. If we are near the beginning of the transition, as we believe we are, there a few things for an investor to monitor.

To begin, let’s consider what we mean by “efficiency” in the economy. With efficiency, tax rates and regulation are lower, fostering greater competition and innovation. Patent applications rise, along with technological developments that drive new products and processes. Business efficiency and profitability rise, while those building better mousetraps earn and keep significant wealth. Global trade rises as businesses seek to shift production to areas of lower cost, while simultaneously growing into new markets. Technology and globalization create obsolescence in the labor force, along with the creative destruction of existing plants, equipment and processes. Innovation and competition lower inflation, which benefits the broad population, but high returns on capital accrue disproportionately to those who have capital. In a nutshell, you get the Internet, iPhone and low prices, while workers are displaced and the wealthy become wealthier. We’ve been in the efficiency cycle for almost 40 years.

In contrast, with an “equality”-focused economy, tax rates and regulations rise, lowering incentives to innovate. Competition declines as a more rigid regulatory framework gains prominence. New product development declines, employment becomes more predictable and there’s less obsolescence. Global trade slows, creating more inflation. The income gap narrows between the wealthy and the poor. Here we see much longer cycles between the new iPhones, and they’re even more expensive with fewer meaningful upgrades. The retail industry is less threatened by Amazonian forces and participation in the labor market can stabilize and even grow. We may be heading into this environment. The chart on the next page illustrates the efficiency/equality transition.

A transition from efficiency to equality will take time and transcend several election cycles. The speed and depth of the transition are difficult to predict, but we feel the political parties are likely to feel ongoing pressure to change the established system of efficiency. Too many voters feel as though the current environment is unacceptable. Politicians and parties will adjust or lose their positions of governance.

Although we may be at the beginning of a transition, we don’t believe it’s likely to create a recession over our projected forecast period of three years.  On that front, we believe Fed policy is more immediately relevant.  Although the Fed has telegraphed a moderate pace of raising rates, forward interest rates indicate a broad expectation that the Fed will go even slower.  In this instance, our expectations are more aligned with the market, and we believe the economy is likely to continue along its path of slow growth for quite a while.

STOCK MARKET OUTLOOK

Although the aforementioned transition to equality may lower growth in corporate profits and increase inflation, we expect a gradual pace of change, allowing equities to perform reasonably well. Looking forward, we believe the return/risk profile of stocks is generally constructive and we continue to diversify across capitalization sizes. This quarter we trim the small cap exposure in some portfolios, recognizing its recent strong performance. We are also beginning to utilize emerging market equities across more portfolios as we see potential upside from favorable currency trends and low valuations.  Still, emerging market equities are highly volatile, so we utilize only a limited allocation, except where risk tolerance is high.

With regard to our large cap sector weights, we remain overweight energy but pare back the exposure after the sector’s very strong performance. We are also overweight the technology, industrial and consumer discretionary sectors, while being underweight financials, utilities and telecom. (We continue to allocate to real estate as a separate asset class; see comments in the Other Markets section below.) These sector views are formed from our work on valuations and industry fundamentals. Our growth/value posture remains at 60/40.

BOND MARKET OUTLOOK

As the economy shifts from efficiency to equality, we will be keeping close tabs on inflation, which tends to create significant risks for bond investors. However, we do not anticipate inflation to emerge quickly or without a measure of warning. Excess global supply capacity remains high for many industries and inflation is unlikely to build unless global trade is dialed down. Such a trend is possible but not yet in place. Accordingly, we continue to believe bond investors can utilize a combination of short, intermediate and long maturities in their portfolios. Bonds continue to provide excellent diversification and can help to address market volatility when combined with other asset classes.

At this point we do not anticipate a recession and do not expect large increases in bond defaults. Therefore, we continue to believe corporate bonds are relatively attractive. Still, our focus remains on investment grade corporate bonds, which we prefer over speculative grade bonds.

OTHER MARKETS

We expect real estate fundamentals to remain generally strong and believe this asset class can benefit from ongoing low interest rates. Still, this asset class has performed very well and we trim the exposure in some portfolios this quarter. Looking forward, the return/risk remains attractive, particularly where income is an objective.

Commodities continue to provide diversification and we focus our commodities allocation on gold. Gold helps to address some of the risks emerging from global central bank policies aimed at depreciating currencies. This precious metal can also help address certain geopolitical risks and can perform well in the event the U.S. dollar weakens relative to other major currencies.

View the complete PDF

Asset Allocation Weekly (October 14, 2016)

by Asset Allocation Committee

Given continued sluggish economic growth and fears that monetary policy has reached the point where it can no longer stimulate growth, a renewed attention has been brought to discretionary fiscal policy.  In the 1970s, discretionary fiscal policy fell out of favor due to a number of shortcomings:

  1. Public investment, if needed, should not be timed to offset recessions. In other words, if the Navy needs an aircraft carrier, one should be built without waiting for a recession.  Thus, public investment should be based on need, not designed as a countercyclical policy.
  2. Discretionary policy must pass through the legislative process. This tends to slow the outcome to the point that the recession may have passed by the time Congress allocates spending.
  3. Fiscal spending, especially fixed asset spending, can “crowd out” private spending. In functioning investment markets, investment spending should be generated by cutting interest rates rather than by directing public investment by government fiat.  In addition, private investment is forced to pass through the test of profitability, reducing the likelihood of malinvestment.

From the late 1970s, economists generally concluded that discretionary fiscal spending was unnecessary and that countercyclical monetary policy was sufficient to guide the economy through recessions.  Although there were occasional extraordinary fiscal measures taken during some downturns, such as tax rebates and extended unemployment insurance payments, for the most part, monetary policy was the measure of choice in terms of countercyclical policy.

However, the developed world now finds itself in a situation where monetary policy may have reached its point of diminishing returns.  The Bank of Japan (BOJ), the Swiss National Bank and the European Central Bank (ECB) have tried to implement negative interest rates.  In these cases, it appears that the damage to the banking system is offsetting any gains from lower rates.  Balance sheet expansions (QE) have been deployed by the aforementioned central banks and the Federal Reserve.  In general, balance sheet expansion has become less effective; a common complaint is that asset values have been extended in many markets without generating much economic growth.  Central banks are also struggling to find assets to purchase.  The BOJ has been buying equity ETFs and the ECB has added corporate bonds to its balance sheet, causing further financial market distortions.

This isn’t to say that the central banks have exhausted all their options, but the ones that remain cannot be implemented without help.  For example, central banks could implement quantitative easing by purchasing foreign bonds; this would likely lead to currency depreciation that would boost exports.  However, such “beggar thy neighbor” policies would likely bring retaliation and further reduce global trade.  The other option is “helicopter money,” which is the direct central bank financing of government spending.  Although this policy would be effective, it does require the participation of fiscal authorities.   In addition, central bank independence would almost certainly be compromised.

So, if fiscal policy is expanded, would we face the problems outlined above?  Generally speaking, the biggest risk would be point #2 above.  Getting spending plans through a divided Congress would be difficult.  In addition, avoiding malinvestment, regardless of whether it’s public or private, is always hard.  But in the current partisan environment, coming up with public investment that would foster future growth will be problematic.  However, there is evidence to suggest that public spending has been neglected for some time and that private investment is currently weak, reducing the problem of “crowding out”; in other words, concerns about points #1 and #3 are reduced.

This chart shows the net stock of fixed assets for both the public and private sectors.  We have log transformed the data and de-trended both series.  In general, a reading over zero indicates the net stock of fixed assets is above its long-term trend and vice versa.  Note that public sector assets were above trend from 1940 into the mid-1990s.  This was mostly due to elevated Cold War defense spending.  During this period, private sector fixed asset levels tended to remain under trend, although a surge that began in the mid-1960s did eventually lead to a rise above trend.  Note that the surge of both public and private spending on fixed assets in the 1970s probably led to crowding out and higher inflation.

Current conditions suggest that both private and public sector investment are well below trend.  In general, private sector investment tends to have a greater impact on future growth and would thus be preferred.  However, given an environment of weak asset formation from both sectors, the economy would likely benefit from increased investment in either sector.  Thus, promises of increased spending on infrastructure and defense would likely have a positive effect on the economy and be positive for equity markets.

View the PDF

Weekly Geopolitical Report – American Foreign Policy: A Review, Part II (October 10, 2016)

by Bill O’Grady

Last week, in Part I of this study, we examined the four imperatives of American policy with an elaboration of each one.  This week, we will discuss why each is important.  We will examine why there has been a “drift” in American foreign policy since the end of the Cold War.  This drift has now reached a critical point as the U.S. appears to be backing away from its postwar trade policies and the geopolitical imperatives that avoided WWIII.  As always, we will conclude with the impact on financial and commodity markets.

The Importance of the Imperatives

To review, the U.S. had four geopolitical imperatives after WWII.  They were:

  1. Deal with the Soviet Union, in particular, and the threat of global communism, in general
  2. Maintain peace in Europe
  3. Maintain stability in the Middle East
  4. Maintain peace in the Far East

All four of these imperatives were critical to maintaining global peace.  Preventing the expansion of communism was “job one,” but removing the “German problem” from Europe was also very important as was keeping tensions manageable between China and Japan.  Although it was difficult to justify supporting authoritarian regimes in the Middle East on moral or ethical grounds, it was necessary to maintain stability.  Essentially, American foreign policy was designed to contain communism and freeze three potential conflict zones in Europe, Asia and the Middle East.

View the full report

Asset Allocation Weekly (October 7, 2016)

by Asset Allocation Committee

With the elections about a month away, we are fielding an increasing number of questions about the market impact of the result. Although some market commentators are raising concerns about a Trump victory, so far, market data doesn’t seem to suggest a high level of correlation.

This chart shows Donald Trump’s average poll numbers on a weekly basis (using an inverted scale) along with the S&P 500 index on the same basis since the beginning of the year.  The weakness seen in the equity markets in Q1 did coincide with reasonably strong numbers for Trump, but most of that equity weakness probably had to do with monetary policy.  Note that as Trump’s poll numbers have improved, equities have also improved.  This could mean that (a) financial markets are not all that concerned about a Trump victory, (b) financial markets simply believe that there is no way Trump will win, or (c) the outcome of the election isn’t material, because the outcome of most elections are not material to the markets.  The correlation of the two series is a modest -1%, suggesting that the two are virtually uncorrelated.

Similar results are seen when comparing Trump’s poll numbers against the performance of gold and the 10-year Treasury yield.  So far, the most significant relationship is the Mexican peso.

The MXN/USD exchange rate is pesos per dollar, meaning the higher the reading on the above chart, the weaker the peso.  As Trump’s poll numbers have improved, the Mexican currency has weakened (the correlation is 54%).  This relationship makes sense.  Trump has promised to “build a wall” on the Mexican border and has called for a rewriting of the North American Free Trade Agreement (NAFTA).  A Trump win could be very disruptive to the Mexican economy and thus the peso has been very sensitive to the path of the election thus far.

We believe a Trump victory would be a bearish surprise to the financial markets.  Although he has promised many things, we suspect his priorities will start with immigration and then move to trade which is second on the list.  He has offered a large infrastructure spending package as well.  Although his tax policy has excited traditional supply-side Republicans, we doubt the tax policy is a high priority for Mr. Trump.  His policies would be potentially inflationary which could be bearish for both equities and debt.  Of course, proposing policy and getting measures through Congress are two different issues.  We have doubts he will be able to execute much of his platform.  But, the uncertainty alone could increase market turbulence.  Thus, as the election approaches we would expect increasing market volatility until the outcome is determined.

View the PDF

Weekly Geopolitical Report – American Foreign Policy: A Review, Part I (October 3, 2016)

by Bill O’Grady

In watching the political debates in the U.S. this election season, there appears to be a general misunderstanding of American foreign policy.  Although we have touched on this issue before, with the elections only about a month away, it seemed like a good time to review U.S. foreign policy since WWII.

This week, we will identify the four geopolitical imperatives of American policy, with an elaboration on each one.  We will note why each is important and why they were not fully articulated to the American public.  Most Americans have at least a vague understanding of the first imperative discussed below.  However, since the collapse of the Soviet Union, there has been a “drift” in policy that is due, in our opinion, to a lack of understanding about these imperatives.  This drift has now reached a critical point as the U.S. appears to be backing away from its postwar trade policies and the geopolitical imperatives that avoided WWIII.

In Part II, we will examine the importance of these imperatives, the rise of the populist backlash against the results of the policies that followed from meeting the imperatives, a summation of the issues and the role of the elections.  Next week, we will conclude with the impact on financial and commodity markets.

View the full report

Asset Allocation Weekly (September 30, 2016)

by Asset Allocation Committee

Last week, the FOMC left rates unchanged, as expected.  The statement was rather hawkish but the accompanying information, such as the “dots” chart, was mostly dovish.

(Source: Federal Reserve)

Note that three of the 17 members of the committee want to stand pat for the rest of the year and two want to raise rates only once next year.

This chart shows the average projected rate from the dots chart along with the projected fed funds rate from the Eurodollar futures market.  A couple interesting trends are emerging.  As we have seen for some time, the FOMC is steadily lowering its terminal rate, the policy rate where tightening ends.  They still hold out hope for a normalization in the long run, around 3%, but this expectation has been in the dots for some time.  It never actually seems to occur.  For this year, expectations are modest; on average, in fact, there is a chance that no hike will occur, even though the Eurodollar futures have one discounted.  However, the Eurodollar futures are also looking for a terminal fed funds rate of around 1.25% at its peak.  Simply put, the financial markets expect that the conditions that have led to low rates will continue well into 2019.

What would lead to rate normalization, which appears to be a rise to 3% for fed funds?  The most obvious catalyst would be a rise in inflation.  As long as the world remains awash in excess capacity, inflation will remain low (assuming trade remains open).  That’s why the presidential elections are important.  We expect Donald Trump to restrict trade, whereas Hillary Clinton will, for the most part, try to maintain the current trade structure.  For now, we expect that rates will rise, but expect a terminal rate of 1.25% for fed funds.

View the PDF

Weekly Geopolitical Report – Goodbye, Dilma. Hello, Michel. (September 26, 2016)

by Kaisa Stucke, CFA

On August 31, Brazilian President Dilma Rousseff was impeached on charges of breaking budgetary laws, ending nine months of political infighting.  The Brazilian Senate voted 61-20 to permanently remove her from her presidential post.  Rousseff’s former vice president, Michel Temer, led the impeachment process and has assumed the presidential duties.

This week we will look at the current political landscape of Brazil under the new president.  We will briefly describe the country’s recent political history and look at the specifics of Brazil’s economic development.  We will discuss the conditions that led to the impeachment and the new president’s possible policy path.  As usual, we will conclude with market ramifications.

View the full report

Asset Allocation Weekly (September 23, 2016)

by Asset Allocation Committee

Profit margins are off their highs but have started to improve.

This chart takes total S&P 500 operating earnings as a percentage of GDP.  Excluding the financial crisis, operating earnings have been running between 5% and 6% of GDP for most of the past decade and a half.  In the middle of last year, this percentage fell below 5% and has remained below that threshold for the past four quarters.  Falling energy prices appear to be the culprit for the drop in margins.

We have a model for this series that is critical to our forecasts for S&P earnings.  It includes unit labor costs, net exports as a percentage of GDP, LIBOR, fed funds, national income accounts profits as a percentage of GDP, a national corporate cash flow estimate from the Financial Accounts of the U.S.,[1] the EUR/USD exchange rate and oil prices.  Based on these variables (and the forecasts coming from the Philadelphia FRB’s Survey of Professional Forecasters), we estimate S&P 500 earnings as a percentage of GDP.

Here is our updated model.

By Q1 2017, margins should rise back to 5%.  Given the current divisor, S&P earnings for this year are expected at $107.09, and $113.89 for 2017.[2]  These are much lower than what is being discussed in the financial press, mostly due to the wide divergence between Thomson-Reuters and S&P’s earnings numbers.[3]

The key to the forecast is that the dollar will gradually weaken as the terminal rate is lowered for fed funds and as oil prices recover to $52 by mid-2017.  If the dollar unexpectedly strengthens, which would also lower oil prices, we would need to adjust our forecasts lower.  Of course, this also means that earnings will exceed our current estimates if the dollar weakens more than we expect (EUR/USD > $1.14) and/or oil prices rise more than forecast.  The actual recovery in margins is a welcome sign for earnings, although we believe that most of this good news is already reflected in current prices.  However, the good news is that, barring a recession, we should avoid a major market correction.

View the PDF

______________________

[1] Also known as the Flow of Funds report.

[2] This change reduces our estimate for 2016 from $107.82, but increases our forecast for 2017 from $109.32.

[3] We analyzed this issue in the AAW from 7/15/2016.