Author: Amanda Ahne

Business Cycle Report (September 26, 2024)

Posted on by Amanda Ahne

by Thomas Wash | PDF

The business cycle has a major impact on financial markets; recessions usually accompany bear markets in equities.  The intention of this report is to keep our readers apprised of the potential for recession, updated on a monthly basis.  Although it isn’t the final word on our views about recession, it is part of our process in signaling the potential for a downturn.

The Confluence Diffusion Index remained in contraction. The August report showed that six out of 11 benchmarks are in contraction territory. Last month, the diffusion index improved slightly from -0.2727 to -0.2152 but is still below the recovery signal of -0.1000.

  • Financial conditions eased as investors anticipated a potential shift in Federal Reserve policy.
  • The manufacturing sector showed signs of a modest recovery but remained fragile.
  • The labor market remained robust despite emerging indications of cooling.

The chart above shows the Confluence Diffusion Index. It uses a three-month moving average of 11 leading indicators to track the state of the business cycle. The red line signals when the business cycle is headed toward a contraction, while the blue line signals when the business cycle is in recovery. The diffusion index currently provides about six months of lead time for a contraction and five months of lead time for recovery. Continue reading for an in-depth understanding of how the indicators are performing. At the end of the report, the Glossary of Charts describes each chart and its measures. In addition, a chart title listed in red indicates that the index is signaling recession.

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Bi-Weekly Geopolitical Report – Eight Megatrends Every Investor Should Know (September 23, 2024)

Posted on by Amanda Ahne

by Patrick Fearon-Hernandez, CFA | PDF

One of the defining characteristics of our investment strategy work here at Confluence is that we pay close attention to big, global trends in geopolitics, economics and trade, demographics, technology, and even social and political developments. We then try to determine how to incorporate those trends into our strategies, either by managing the risks they impose or identifying and investing in the associated opportunities. We think this discipline can be fruitful because big, global trends are often long lasting and relatively predictable. Shorter-term, idiosyncratic forces can still make asset prices volatile from time to time, but the impact of “megatrends” often comes back to the fore relatively quickly.

Our regular readers know that we pay especially close attention to geopolitical trends. However, in this report, we want to provide a broader survey of several megatrends that are likely to remain in place for at least the next decade and be especially salient to investors. This list isn’t necessarily comprehensive; another writer could easily come up with an alternative set. All the same, we think it will be interesting for investors to consider the wide range of global trends that could affect their investments.

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Don’t miss our accompanying podcasts, available on our website and most podcast platforms: Apple | Spotify 

Asset Allocation Bi-Weekly – The Benjamin Button Dividend (September 16, 2024)

Posted on by Amanda Ahne

by the Asset Allocation Committee | PDF

A company’s journey to industry prominence typically involves several stages: launch, growth, shakeout, maturity, and decline. Historically, large capitalization stocks were often considered to be in the maturity stage of their development. Many investors therefore assumed that these companies had strong enough earnings to initiate or maintain dividend payments, making them seem more attractive than their smaller counterparts that were primarily considered for their capital gains potential. However, recent trends suggest that times have changed.

Over the past seven years, small cap stocks have consistently surpassed their mid-cap and large cap counterparts in terms of estimated dividend yields. This gap can be attributed to both relative price appreciation and dividend policy. During this period, the large cap S&P 500 stock price index grew nearly twice as fast as the mid-cap S&P 400 price index and the small cap S&P 600 price index. Additionally, small firms have significantly increased their dividend payout ratios relative to their larger peers, from just under 40% to over 60% in the last decade. In contrast, large cap firms have maintained relatively stable dividend policies over the same period.

The primary shift in the relationship between the small cap and large cap indexes has been driven by a changing sectoral composition, largely due to the survivorship and maturation of technology companies. As smaller tech companies have grown and become more successful, they have been rebalanced into the large cap index or were bought out. Meanwhile, those that failed to move up were removed. This dynamic has led to a significant increase in the weight of the tech sector within the large cap index at the expense of the small cap index.

Over the past decade, information technology and communication companies have significantly increased their share of the large cap S&P 500 index, rising from 22.0% to 39.0%. In contrast, the small cap S&P 600’s exposure to tech companies has declined from 20.0% to 16.5%. As a result, the broad large cap index now exhibits more growth-like characteristics than its smaller counterparts. The S&P 500’s price-to-earnings ratio of 25.1 is substantially higher than those of the S&P 400 and S&P 600, which are each around 19.0. Moreover, the large cap index has become increasingly susceptible to price fluctuations in a select group of companies.

While tech companies have lost share within the small cap index, financial services and real estate firms have largely filled the void. Their rise was driven in part by low interest rates, which incentivized investors to seek assets with capital gains potential. This preference led to a surge in demand for large cap tech companies, which were perceived to have strong growth potential, at the expense of financial services and real estate firms, which paid dividends but were seen as less likely to appreciate significantly over time.

The substantial increase in the small cap index’s exposure to the Financials and Real Estate sectors is primarily attributable to reclassifications. Beginning in 2018, larger financial and real estate firms began to decline in market value, leading to their reclassification from the S&P 500 to the S&P 400. This trend intensified following the pandemic as many of these companies experienced further declines and they then made their way into the S&P 600.

These changes have resulted in a relative increase in the number of firms paying out substantial dividends within the small cap index. Over the past six years, the S&P 600’s exposure to financial and real estate companies has increased from 22.1% to 27.6%, while the S&P 500’s share has decreased from 17.6% to 15.7%. The S&P 400 saw a slight decline from 26.1% to 25.0% in its holdings of these sectors. Notably, the small cap index now has as many financial services and real estate firms as the large and mid-cap indexes had combined just 10 years ago.

Contrary to popular belief, a company’s size is not a reliable indicator of maturity. In fact, the average lifespan of S&P 500 companies has dramatically decreased in recent decades. The influx of tech companies into the large cap space has further accelerated this trend. In 1984, the average company survived 36 years, whereas today that figure is barely over 18 years. To put it into perspective, these companies are barely old enough to vote and not yet old enough to drink. This shorter tenure may explain why larger firms often exhibit less mature behavior than some of their smaller, dividend-paying counterparts, which have a weighted average lifespan of at least 32 years. In sum, investors seeking dividend income may now need to focus more on small cap companies than they did in the past.

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Business Cycle Report (August 29, 2024)

Posted on by Amanda Ahne

by Thomas Wash | PDF

The business cycle has a major impact on financial markets; recessions usually accompany bear markets in equities.  The intention of this report is to keep our readers apprised of the potential for recession, updated on a monthly basis.  Although it isn’t the final word on our views about recession, it is part of our process in signaling the potential for a downturn.

The Confluence Diffusion Index remained in contraction. The July report showed that seven out of 11 benchmarks are in contraction territory. Last month, the diffusion index fell slightly from -0.2727 to -0.2818, below the recovery signal of -0.1000.

  • Fed rate cut speculation helped push down interest rates.
  • The goods-producing sector showed slight improvement but remains weak.
  • The labor market showed signs of deterioration.

The chart above shows the Confluence Diffusion Index. It uses a three-month moving average of 11 leading indicators to track the state of the business cycle. The red line signals when the business cycle is headed toward a contraction, while the blue line signals when the business cycle is in recovery. The diffusion index currently provides about six months of lead time for a contraction and five months of lead time for recovery. Continue reading for an in-depth understanding of how the indicators are performing. At the end of the report, the Glossary of Charts describes each chart and its measures. In addition, a chart title listed in red indicates that the index is signaling recession.

Read the full report

Asset Allocation Bi-Weekly – Activist vs. Accommodative Treasury Issuance (August 26, 2024)

Posted on by Amanda Ahne

by the Asset Allocation Committee | PDF

The Federal Reserve and the US Treasury are independent government agencies with the shared objective of economic prosperity. While the Treasury manages government finances and executes fiscal policy, the Fed focuses on monetary policy as it aims to maintain price stability and full employment. Despite the Fed and the Treasury having distinct roles, there is an ongoing debate over whether they should coordinate their policies or whether it’s appropriate for one to work at cross-purposes with the other, particularly in the context of the big US budget deficit and growing debt load.

A recent report has accused the Treasury of intentionally shifting its debt issuance strategy to favor shorter-term bills over longer-term notes to the detriment of the country. Economists Nouriel Roubini and Stephen Miran, both Treasury veterans, contend in their paper, “ATI: Activist Treasury Issuance and the Tug-of-War Over Monetary Policy,” that this strategy is a deliberate attempt to counteract the Fed’s tightening measures and artificially stimulate the economy.

The Roubini and Miran paper argues that the Treasury’s strategy effectively amounts to a covert form of quantitative easing (QE). When the Fed employs QE to stimulate the economy, it purchases long-term bonds, thereby suppressing interest rates. The Treasury can achieve a similar outcome by shifting toward shorter-term debt issuance. By reducing the supply of longer-term bonds, the Treasury can indirectly push up their prices and lower their yields, effectively loosening financial conditions.

Roubini and Miran contend that the Treasury’s shift toward more bill issuance has counteracted the Fed’s effort to tighten monetary policy, contributing to the robust economic growth and elevated inflation seen in Q1 2024. According to Roubini and Miran, Treasury bills serve as a near-cash asset, enabling financial institutions, institutional investors, and corporations to secure loans by using them as collateral. In essence, the issuance of new Treasury bills can amplify the money supply through the money multiplier effect, which increases market liquidity.

While they acknowledge the typical shift toward shorter-term Treasury issuance in economic downturns, Roubini and Miran argue that the current pronounced bias for bills over notes is exceptional and may be politically motivated. By prioritizing bill issuance, the Treasury may have sought to avert a surge in long-term interest rates typically associated with bond sales. This strategy is credited with contributing to a decline in 10-year yields, which, in turn, has fueled risk appetites and inflated stock valuations in the lead-up to the election.

However, an alternative explanation for the Treasury’s issuance reallocation lies in the market’s response to rising interest rates. When the Fed initiated rate hikes in 2022, demand for longer-term bonds weakened due to increased interest rate risk. Conversely, demand for shorter-term Treasury bills surged, primarily driven by money market funds and institutional investors seeking higher yields on short-term assets. This market dynamic is reflected in the results of Treasury auctions, with 10-year bonds consistently undersubscribed and two-year bills frequently oversubscribed.

Moreover, the Treasury’s issuance strategy may not be as counterproductive as Roubini and Miran imply, since the sale of bills has mitigated the need for extraordinary Fed intervention in the economy. Prior to the change, the banking sector faced severe liquidity challenges following the collapse of Silicon Valley Bank in 2023 due to heavy investments in low-yielding, long-duration bonds. As interest rates rose, bond values fell and hindered banks’ ability to use them as collateral to meet short-term cash needs. In response, the Fed established new lending facilities, which helped address the immediate crisis but hampered its balance sheet reduction efforts.

By significantly increasing bill issuance, the Treasury provided the banking system with high-quality collateral, therefore mitigating the risk of a liquidity crunch within the repo market. This buffer has made it easier for the Fed to maintain its policy tightening without hurting the financial system. As interest rates begin to decline, the urgency of this allocation strategy will lessen, leading to a gradual reduction in Treasury bill issuance as a share of total issuance.

Contrary to Roubini and Miran’s assertion, the Treasury’s allocation strategy has actually seemed to support the Fed’s objectives. It has enabled the Fed to prolong quantitative tightening and maintain higher interest rates for an extended period and has increased the likelihood of a soft landing. However, this cooperative stance could potentially embolden the Fed to adopt a more gradual easing path, which would benefit short to intermediate bond yields.

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