Author: Amanda Ahne
Asset Allocation Bi-Weekly – The Price of Central Bank Independence (July 29, 2024)
by the Asset Allocation Committee | PDF
Despite the formal separation of the Federal Reserve and Treasury Department in 1951, the two bodies continued to collaborate closely on economic policy for nearly two decades. The coordination aimed to improve the effectiveness of initiatives like stimulating economic growth or preventing the overheating of the economy. While this balancing act worked well under Bretton Woods, the system’s collapse in the 1970s strained the relationship between the two institutions.
The end of the gold-dollar exchange system in the early 1970s left the United States struggling to maintain confidence in its currency. Foreign leaders, like Charles de Gaulle of France, had previously been critical of America’s inability to control spending and argued that it devalued the dollar held by other countries. This anxiety surrounding the dollar likely played a role in Saudi Arabia’s decision to hike oil prices and impose an oil embargo on the US in response to its involvement in the Arab-Israeli War. This move significantly contributed to a surge in US inflation.
To address this, President Jimmy Carter delivered his now-famous “malaise” speech and requested resignations from his White House staff and cabinet. As part of this reshuffle, he appointed Paul Volcker as Fed Chair. This decision, though, cost him his presidency and established a precedent for the Fed to prioritize its monetary policy goals, even if they diverged from fiscal policy during economic expansions.
Investors tend to favor policies that nurture economic growth while also keeping inflation in check. This balancing act can be tricky, but the Federal Reserve’s approach exemplifies how it’s done. As the chart below shows, the Fed typically lowers interest rates during recessions to jumpstart the economy. Conversely, during economic booms, it usually tightens policy to slow borrowing and spending, keep the economy from overheating, and prevent inflation. This strategy resonates with investors because it ensures that they’re compensated for potential inflation and the risks associated with rising government debt.
However, what benefits financial markets doesn’t always translate to political popularity. Lawmakers, especially populists, have clashed with the Fed when its actions run counter to their agendas. Former President Donald Trump frequently lambasted the Fed for raising rates while he was working to stimulate economic growth through lower tax rates. Meanwhile, Massachusetts Senator Elizabeth Warren has accused the central bank of raising interest rates to the detriment of its inflation target, suggesting that its hiking cycle contributed to rising shelter and insurance prices.
Rising debt has further strained the relationship between the central bank and lawmakers. The gross federal debt as a percentage of GDP rose from 100.5% in 2019 to 126.4% in 2020. While some progress has been made in reducing the debt, Fed officials have warned that the government should do more to rein in its spending to prevent a rising debt problem. The Congressional Budget Office projects that weaker economic growth and higher interest rates could push the debt to 140% of GDP by 2034.
The government’s recent shift toward issuing more short-term bills exposes it to greater interest rate fluctuations, further complicating the Fed’s ability to shield itself from scrutiny. According to one estimate, the government issued 70% of its Treasury debt in bills this year. This means future rate hikes by the Fed could significantly increase the government’s borrowing costs. Highlighting the urgency of the issue, the cost of servicing the debt (net interest) has surpassed military spending in the first seven months of fiscal year 2024, as shown in the chart below.
The rising tensions between the Fed and the government have likely fueled concerns about the effectiveness of their independent roles, prompting some to question whether the Fed and the government should return to their pre-Volcker relationship. Some lawmakers have pushed for the executive branch to have more say in future monetary policy. The new framework would require central bankers to consult with the president on interest rate decisions and grant him the authority to dismiss the central bank head if he disapproves.
A weakened central bank could lose its ability to act as a critical check on excessive government spending. This scenario raises concerns for bondholders, who could face the brunt of rising inflation if fiscal spending spirals out of control. Further compounding the uncertainty, foreign entities may be hesitant to hold US dollars due to a perceived lack of clear policy direction. This could lead them to diversify their reserves, seeking assets like gold that might offer a more stable store of value.
Despite no direct challenges to Fed independence from the current presidential candidates, anxieties linger about potential meddling. This could dampen investor enthusiasm for US financial assets and exacerbate market volatility as the election nears. However, a silver lining exists for some. International companies and US companies with foreign currency exposure could benefit from a potentially weaker dollar, translating to higher returns.
Business Cycle Report (July 25, 2024)
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 territory. The June report showed that seven out of 11 benchmarks are in contraction territory. Last month, the diffusion index was unchanged at -0.2727, below the recovery signal of -0.1000.
- Financial conditions eased due to interest rate cut expectations.
- Consumer confidence faded as households expressed concerns about their future.
- There was a slowdown in hiring throughout the private sector.
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.
Bi-Weekly Geopolitical Podcast – #51 “Meet Ferdinand Marcos Jr., President of the Philippines” (Posted 7/22/24)
Bi-Weekly Geopolitical Report – Meet Ferdinand Marcos Jr., President of the Philippines (July 22, 2024)
by Daniel Ortwerth, CFA | PDF
Seven short weeks ago, we published a report on the brewing tensions between China and the Philippines in the South China Sea, focusing on their dispute over the Second Thomas Shoal. Despite the tight time interval since that report, the brisk pace of continuing developments in the area and the ever-present risk of escalation bid us to return to the subject. This time we direct our attention to a key individual who sits at the focal point of the crisis: Ferdinand Marcos Jr., the president of the Philippines.
This report begins with a quick review of the geopolitical context that makes the Philippines-China dispute so important. We then outline the life and career of President Marcos Jr., and we review the relevant elements of the broader Philippine political landscape. Within that context, we will explain the key traits and actions of President Marcos Jr. as they relate to the present geopolitical concern, followed by an assessment of his likely course of action. Finally, we update the investment implications from the previous report.
Don’t miss our accompanying podcasts, available on our website and most podcast platforms: Apple | Spotify
Keller Quarterly (July 2024)
Letter to Investors | PDF
We are in a season when the average investor is not thinking much about the normal factors of investment risk and return, such as interest rates or economic growth. Investors are now focused on politics, first and foremost. This is understandable, and not just because this is a presidential election year. Heightened attention to the potential changes an election may bring usually occurs after Labor Day of an election year. In this year, however, the early June 27th debate, followed by Democratic Party consternation over whether to replace President Biden at the top of the ticket, and (horribly) the assassination attempt on former President Trump has galvanized public attention on the upcoming election in a way we haven’t seen in decades. This attention has many investors wondering what these events will mean for their portfolios.
Political instability always creates worry among investors. In the United States, such instability tends to have less impact than investors perceive at the time, simply because the US has such a solid foundation for investment. By this we mean a government and constitution that respects property rights and legal contracts and that confers great personal liberties upon its citizens (including the right to start a business or to move it to a more favorable location). We take these rights and liberties for granted, but they are anything but common in the world. They are, thankfully, common in the United States, which is what makes it such a fertile ground for investment.
Often overlooked also are the resources necessary for successful investment that are readily found here. First and foremost are the people. No other nation has such a large and talented workforce that is readily replenished by the best and brightest who come here from all over the world. Probably everyone who is reading this letter is descended from ambitious and determined immigrants who came here to build a better life. On top of the US’s extraordinary human resource, no other nation can claim the quantity and quality of natural resources available here. Put together, these human and natural resources give investments made here an uncommonly good probability of success.
The result of these incredible advantages is that investments here have performed well through the centuries, even in the face of extraordinary political instability. A civil war, world wars, assassinations, depressions, and pandemics have buffeted the republic, but these persistent advantages have carried us through and kept our investments remarkably stable by world standards.
Just before the last presidential election, I wrote in this letter:
I realize that elections have consequences, and that many of those consequences are very important, even if they have little or nothing to do with your investment plans. Yet, it is my experience that most of us tend to overestimate the impact of presidential elections on our investment portfolios, often by a lot.
This opinion has not changed.
While the consequences of elections may bring changes in regulation, tax policy, and other matters that affect investments, the foundational advantages that US investors have will not change. Now, I realize that some of you may question even that last sentence, but I believe that any objective study of the history of the US and its investment fundamentals reveals that our nation’s foundational advantages have survived worse upheavals than any rational investor is contemplating now.
The most worrisome long-term risk that US investors must address is rising inflation, something we at Confluence have written much about in recent years. I won’t review that concern here, except to say that it will not change because of the election, no matter which party wins the presidency or controls Congress. We have experience investing in inflationary environments and managing that risk.
I will conclude with another paragraph written four years ago, which remains my view today:
The above opinions are not borne of “cock-eyed” optimism, but from decades of observations of both economic and presidential cycles. The stock market is neither Republican nor Democrat but is solely interested in making money. In my opinion, the current environment is well-suited to doing just that, regardless of who wins the election.
We appreciate your confidence in us.
Gratefully,
Mark A. Keller, CFA
CEO and Chief Investment Officer
Asset Allocation Bi-Weekly – #122 “A New Factor for Gold Prices” (Posted 7/15/24)
Asset Allocation Bi-Weekly – A New Factor for Gold Prices (July 15, 2024)
by the Asset Allocation Committee | PDF
The standard regression model is as follows:
Y = α +β(X) + ε
Where Y is the dependent variable, X is the independent variable, α is the intercept, β is slope and ε is the error term. No model, no matter how many independent variables are added, can capture the complete relationship to the dependent variable. However, a well-constructed model will account for most of the variation in the behavior of the dependent variable.
Although it tends to get short shrift in statistics classes, the error term is rather interesting, especially with regard to time series models. Essentially, the error term, or epsilon, is where the unspecified causal factors that affect the dependent variable are housed. The goal of modeling is to select the most meaningful independent variables and then assume the ones that are not specified are not important enough to dramatically affect the dependent variable. It may be that the unspecified terms are not all that important, or if they are, they are offset by other unspecified variables so that the model’s performance isn’t adversely affected.
Sometimes, a dependent variable begins to exhibit deviations to the model’s estimate; this may be caused by several factors. One is that the relationship between an already specified independent variable and the dependent variable has changed. The relationship may have rested on some other factor, such as policy, that has made it more or less important. Over time, the β, or the correlation coefficient, will adjust to this new relationship. In other cases, a previously unimportant variable, contained in epsilon, becomes important.
We think this latter situation is affecting the gold market.
The chart above is our basic gold price model. As the chart shows, the model’s estimation occasionally deviates from the actual price. If nothing has changed, this deviation may suggest an over or undervalued market. The recent spike in gold prices is clearly running well above our model’s estimation. However, we think we have isolated a change that accounts for this deviation.
The upper line on the above chart shows the model’s residuals since 2012. The lower line shows the spread between gold prices in Shanghai and New York. The history of this spread shows some deviation, but in general, this condition invites arbitrage if prices are higher or lower in one market compared to the other. Note that the New York prices far exceeded those in Shanghai during the pandemic. We can assume the mechanisms for arbitraging that market were disrupted by the pandemic, and the spread narrowed when these mechanisms returned. The area on the chart above in yellow indicates the Russian invasion of Ukraine. Note that gold prices in Shanghai have been persistently elevated relative to those of New York.
The G-7 implemented sanctions on Russia in the wake of the invasion, and perhaps the most draconian of those was the move to freeze Russian foreign reserves. This move raised fears in other nations that if they were to see relations with the US deteriorate, then similar actions might be deployed against them as well. So, in response, foreign governments have been increasing their gold purchases. Since the Chinese are concerned about the vulnerability of their massive US Treasury holdings, it appears they have been aggressively buying gold to the point where the Shanghai price has been persistently above the New York price.
It’s still too early to determine what impact this spread relationship will have on the overall gold price in the future, but this situation is a good example of when a previously quiescent variable, well contained in epsilon, suddenly becomes important. Faced with a model that is deviating from its past performance, the challenge for the analyst is to determine the cause. We believe that Asian buying, both from central banks and private investors, is the cause in this case. This condition could mean that when traditional bullish conditions for gold return (e.g., lower interest rates, weaker dollar, central bank balance sheet expansion), the price of gold could move sharply higher, bolstered by this new factor — enhanced Asian buying.