Author: Amanda Ahne

Weekly Energy Update (July 27, 2023)

Posted on by Amanda Ahne

by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA | PDF

Oil prices have moved into the upper end of the trading range.

(Source: Barchart.com)

Commercial crude oil inventories fell 0.6 mb, less than the 2.0 mb draw forecast.  The SPR was unchanged.

In the details, U.S. crude oil production fell 0.1 mbpd to 12.2 mbpd.  Exports rose 0.8 mbpd, while imports declined 0.8 mbpd.  Refining activity fell 0.9% to 93.4% of capacity.

(Sources: DOE, CIM)

The above chart shows the seasonal pattern for crude oil inventories.  Current inventories are falling but at a slower-than-normal pace.  If we follow the seasonal pattern, stockpiles should continue to fall into mid-September.

Fair value, using commercial inventories and the EUR for independent variables, yields a price of $60.14.  Commercial inventory levels are a bearish factor for oil prices, but with the unprecedented withdrawal of SPR oil, we think that the total-stocks number is more relevant.

Since the SPR is being used, to some extent, as a buffer stock, we have constructed oil inventory charts incorporating both the SPR and commercial inventories.

Total stockpiles peaked in 2017 and are now at levels last seen in 2002.  Using total stocks since 2015, fair value is $93.10.

Market News:

 Geopolitical News:

Alternative Energy/Policy News:

  • When China restricted Japan’s access to rare earth minerals in 2010, it highlighted China’s dominance in this market. In reality, rare earths are not all that rare.  What allowed China to dominate the market was that the mining and processing of these minerals tend to be disruptive.  China was simply willing to suffer the environmental costs.  But as other nations realized the vulnerability they faced from Beijing’s whims, we have seen a concerted effort to build mining capacity outside of China.  This report on Sweden’s mining activity is an example.
  • The Inflation Reduction Act (IRA) provides subsidies to firms building clean energy facilities in the U.S. Foreign firms have been aggressively taking advantage of the opportunity.  This outcome suggests foreign firms are participating in the reindustrialization of the U.S.
  • One of the favorable factors of markets is that prices signal to both consumers and producers to adjust their behavior. The decentralized characteristic of markets creates efficiencies that central planning, to date, hasn’t been able to duplicate.  The EV revolution will increase demand for copper, and as copper prices have increased, producers are looking for ways to use less copper.  Most of the adjustments, so far, have been in modest engineering changes.  We still expect copper demand to be strong in the coming years, but the simple extrapolation of demand from current use is probably overestimating future consumption.
  • The Greens in Germany are part of the currency ruling coalition. Ostensibly an environmental party, it has moderated its positions over the years to increase its political power.  However, true to its roots, it has supported an aggressive policy stance of replacing boilers in German homes with heat pumps.  The plan has turned out to be very unpopular and may undermine the current coalition.
  • EVs are fair weather vehicles, as it turns out. It’s well known that extreme cold weather reduces battery range.  Evidently, hot weather has an even greater negative effect.
  • The environmental movement is plagued by a purity constraint as virtually every technical solution to an environmental problem will create an adverse impact on some part of the ecosystem. A recent lawsuit against the EPA argues that biofuels likely violate the endangered species act.

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Daily Comment (July 26, 2023)

Posted on by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with news that China is making new progress toward developing a network of naval facilities in the waters of the Indo-Pacific region.  We next review a range of other international and U.S. developments with the potential to affect the financial markets today, including continued political unrest in Israel and a discussion of today’s upcoming decision on U.S. interest rates from the Federal Reserve.

China-Cambodia:  New commercial satellite imagery shows China has made considerable progress in its construction of naval facilities at Cambodia’s Ream Naval Base.  The imagery shows the Chinese have now nearly completed a pier that is strikingly similar in size and design to one the Chinese military already uses at its only official overseas naval base in Djibouti.  Importantly, both piers are big enough to berth Chinese aircraft carriers.

  • The report provides more evidence of China’s large-scale, if secret, effort to build a network of dual civilian-military port facilities it could access in time of international conflict. Other such Chinese facilities include the Port of Hambantota in Sri Lanka and the Port of Gwadar in Pakistan.
  • China continues trying to hide the extent of its military build-up, including by masking the military potential of the ostensibly civilian infrastructure it is helping to build. All the same, as Western leaders increasingly appreciate the scale of the Chinese build-up, we suspect it will worsen China’s tensions with the West and make it even harder to maintain trade, investment, and technology flows.

Russia-Ukraine-European Union:  Following Russia’s pullout from the deal in which it allowed Ukraine to export grain from its southeastern ports, both Poland and Hungary are threatening to block Ukrainian shipments to the West unless the European Union extends restrictions on selling the Ukrainian products in their territory.  The actions threaten to weaken Ukraine’s economic resilience in the face of Russia’s invasion and further complicate the EU’s effort to support Ukraine.

Spain:  As expected, Alberto Núñez Feijóo and his center-right Popular Party have been left with no apparent route to forming a government after two key regional parties rejected his invitation to form a coalition.  Even though the PP won the most seats in Sunday’s elections, and even though it has the support of the controversial hard-right Vox Party, it looks like it will be unable to control parliament.  The most likely scenarios now would be for incumbent Prime Minister Sánchez and his Socialist Party to form a government with left-wing and regional parties, or for Spain to hold new elections in August.

Israel:  Protests and strikes continue to disrupt the economy and push stock prices lower following this week’s passage of a measure that would limit the supreme court’s ability to block Knesset legislation.  Ironically, the supreme court itself said today that it would hear a case challenging the constitutionality of the law.  Obviously, the optics of the court striking down a law limiting its powers would not be good, so it’s unclear whether the court would really do so.  In any case, the political and social instability in Israel looks set to continue in the near term.

U.S. Monetary Policy:  Officials at the Federal Reserve will wrap up their latest two-day policy meeting today, with their decision due to be released at 2:00 PM EDT.  Fed Chairman Powell will also hold a news conference at 2:30 PM EDT.  Along with most other analysts, we suspect that continued strong wage gains and price pressures will prompt the officials to hike their benchmark fed funds interest rate further after pausing last month.  All the same, some other analysts think recent signs of modest economic slowing could convince them to hold rates steady again and simply signal the potential for more rate hikes later.

U.S. Labor Market:  Yesterday, United Parcel Service (UPS, $184.69) and the Teamsters Union reached a tentative deal on a new contract.  If approved by the firm’s 340,000 union workers in a vote on August 3, the agreement will avert a massive strike that could have noticeably affected the economy.

  • Under the deal:
    • Full-time workers will get wage increases that will bring their average top rate to $49 per hour, making them the highest-paid delivery drivers in the U.S.
    • New part-time hires would start at $21 per hour, up from $15 in the previous contract.
    • A much-hated two-tier worker classification system, where some were paid less for doing essentially the same work, will be ended.
    • For the first time, union workers would get Martin Luther King Day off as a paid holiday.
  • The agreement is likely to encourage other unions to strike a hard bargain in their negotiations with employers, potentially increasing average wages across the economy and helping boost consumer price inflation.

U.S. Artificial Intelligence Market:  New reporting indicates investors are snapping up shares of small biotechnology companies that are using artificial intelligence to aid in drug discovery.  Some of those stocks have doubled or even tripled in value this year, even as the broad healthcare sector has lagged the overall market.  For investors who worry they’ve missed the initial run-up in AI stocks, this development is a reminder that specialized, proprietary AI models and tools for specific industries or uses could well be the source of huge value creation in the coming years.

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Daily Comment (July 25, 2023)

Posted on by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with China news, including signals of economic support from a meeting of the Communist Party’s Politburo.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a discussion of the U.K.’s high interest burden and a new survey on the attitudes of U.S. retirement investors.

China:  At its monthly meeting yesterday, the Communist Party’s powerful Politburo took a number of key decisions that could have sweeping impacts on the Chinese economy and foreign relations.  Most important for investors, the Politburo acknowledged the headwinds holding back economic growth, announced its intent to address them, and signaled several measures related to key sectors.  The measures did not include the major fiscal stimulus that many investors have come to expect in China, but they did include promises to increase the number of affordable housing units built and signaled that the government will loosen its restrictions on buying homes for investment purposes.  Even though the announced measures were modest, the positive tone of the announcement has given a strong boost to stocks in China and Hong Kong so far today.

  • Separately, Pan Gongsheng was named as the new chief of the People’s Bank of China, less than a month after being named as the central bank’s Communist Party chief. The appointment of Pan, who was previously the head of the State Administration for Foreign Exchange, will further solidify President Xi’s control over the institution.
  • Finally, Chinese state media said top party foreign affairs official Wang Yi would reclaim his prior job as foreign minister, replacing Qin Gang, the fast-rising protégé of President Xi who was China’s ambassador to the U.S. until he was named foreign minister this spring. Qin hasn’t been seen in public for about a month, so speculation has been high that he might be in trouble.  The announcement merely said that he had been replaced for “health reasons.”

China-United States:  After CIA Director Bill Burns said in a speech last week that his agency was making progress in rebuilding its spy network in China, the Chinese foreign ministry yesterday issued an angry statement denying that China spies on the U.S. and vowed to protect itself from the CIA’s efforts.  The Burns statement referred to a catastrophic loss of CIA agents in China between 2010 and 2012 due to a mole at the agency.

China-India:  The Indian government has rejected a bid by leading Chinese electric-vehicle maker BYD (BYDDY, $68.55) to build a car and battery factory in Hyderabad, citing security concerns.  The rejection reflects India’s tough stance on trade with China following the two countries’ Himalayan border skirmishes three years ago.  The rejection also throws a wrench in BYD’s effort to rapidly build up its foreign sales under Beijing’s “Made in China 2025” industrial plan.  In response, Chinese Foreign Minister Wang criticized New Delhi and called for the two countries to “enhance strategic mutual trust.”

Pakistan:  The national election commission issued a new, non-bailable arrest warrant for Former Prime Minister Imran Khan, who was ousted last April and arrested on corruption charges in May before being bailed.  The new warrant suggests the country will continue to face political instability and mass demonstrations for the foreseeable future.

Israel:  As we flagged in our Comment yesterday, Prime Minister Netanyahu and his right-wing coalition pushed a key plank of their judicial reform through the Knesset yesterday.  The law, which limits the grounds on which the supreme court can nullify acts of parliament, has sparked mass protests, strikes, and warnings that key businesses will relocate out of the country.  In recent years, Israel and Israeli stocks have become investor darlings, but the new political instability and concerns about Israeli democracy threaten to undermine the country’s asset values in the near term.

United Kingdom:  In a report on government debt burdens around the world, bond rater Fitch said the U.K. will face the highest debt interest burden among major developed countries this year.  Because of the central bank’s interest-rate hikes to bring down inflation, high debt levels, and a large proportion of that debt in inflation-protected bonds, the U.K. government will spend an estimated 110 billion GBP on interest in 2023, equal to 10.4% of government revenue.

United States-Russia:  The Defense Department said a Russian fighter jet deliberately released flares close to a U.S. drone flying over Syria, causing damage to the U.S. craft.  The incident is the latest in a series of moves that suggest Russia is trying to pressure the U.S. into reducing its activity in Syria.  In any case, the incidents are further raising U.S.-Russia tensions.

U.S. Monetary Policy:  Officials at the Federal Reserve today begin their latest two-day policy meeting, with their decision due to be released at 2:00 PM EDT on Wednesday.  Along with most other analysts, we suspect that continued strong wage gains and price pressures will prompt the officials to hike their benchmark fed funds interest rate further after pausing last month.  All the same, some other analysts think recent signs of modest economic slowing could convince them to hold rates steady again and simply signal the potential for more rate hikes later.

U.S. Investment Markets:  A new survey by BlackRock (BLK, $756.58) found that the share of U.S. retirement savers who feel they are “on track” has fallen to 56%, down from 69% in 2021.  The share of savers who feel they are “off track” has more than doubled to 24% in the same period.  The changing attitudes reportedly reflect concerns about high inflation and volatile markets. In response, almost 30% of survey respondents said they now plan to work longer than they previously expected to.

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Bi-Weekly Geopolitical Report – China’s Collapsing Population (July 24, 2023)

Posted on by Amanda Ahne

Patrick Fearon-Hernandez, CFA | PDF

In early 2020, we published a detailed, multi-part analysis of global demographic trends (see our Weekly Geopolitical Report from February 10, 2020).  That report showed how falling birth rates and rising life expectancies have led to slower population growth, population aging, and weaker economic activity in countries ranging from China and India to the United States and Japan.  These demographic trends will have big implications for economic growth, price inflation, interest rates, and relative military power in future years.

In this report, we take a deep dive into China’s worsening demographics, based on the UN Population Division’s updated projections from late last year and other recent revelations.  As we show, China is now facing what could be considered an outright demographic collapse.  We also discuss the many negative implications of this demographic collapse for the Chinese people and for global investors.

Read the full report

Don’t miss our accompanying podcasts, available on our website and most podcast platforms: Apple | Spotify | Google
The podcast episode for this particular edition is posted under the Confluence of Ideas series.

Daily Comment (July 24, 2023)

Posted on by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with several notes on China’s worsening relations with the U.S. and other members of the U.S. geopolitical and economic bloc.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including news of an inconclusive election in Spain, growing protests against a judicial reform in Israel, and a blockbuster weekend at the movies in the U.S.

China-United States:  The Chinese government has opened an anti-dumping investigation into U.S. propionic acid, an important preservative for products ranging from foods to medicines.  The probe will last for one year, but it could be extended to as late as January 2025, at which point the government could take steps to block or reduce U.S. sales of the chemical in China.

  • The anti-dumping investigation follows fast on the heels of the government’s recent move to require a license for the export of gallium and germanium, key metals for the production of high-technology goods such as semiconductors. It also follows an enforcement action that limited the Chinese sale of products from U.S. technology firm Micron Technology (MU, $65.65).
  • Along with those actions, the anti-dumping probe appears to be retaliation for last year’s U.S. clamp down on sending advanced semiconductor technology to China.
  • In any case, the Chinese move is just the latest evidence that U.S.-China tensions continue to worsen, presenting challenges and risks for investors.

China-Canada:  The Canadian government on Friday charged a retired Royal Canadian Mounted Police officer with foreign interference, saying he helped China “identify and intimidate” someone in Canada at the behest of the Chinese government.  The case appears to be another example of China trying to secretly extend its policing power and Communist Party discipline against Chinese people living abroad, sometimes through secret foreign police stations.

  • Just as China’s Ministry of State Security often pressures ethnic Chinese abroad to spy for it, the latest Canadian case also involved an ethnic Chinese.
  • The charged RCMP officer reportedly emigrated to Canada from Hong Kong.

China-Taiwan:  New satellite imagery of Chinese military bases and defense industry factories shows the country has been rapidly replacing its short-range missile arsenal on the southeastern coast facing Taiwan with much more capable medium-range missiles.  The new missiles being deployed include the DF-17 and DF-24, which can not only travel more than 1,000 miles, but are also fitted with hypersonic glide vehicles that could evade U.S. air defense systems.

  • If the Chinese military launches an effort to take control of Taiwan, analysts suspect its first step will be to send waves of these missiles to take out U.S. and allied bases in places like Guam and Japan. The missiles could also be used to take out capital warships, such as aircraft carriers.
  • The reports also indicate the new medium-range missiles are sometimes being deployed in close proximity to China’s strategic nuclear bases. That likely aims at discouraging the U.S. from any effort to destroy the missiles preemptively, since any such attack might damage Chinese strategic forces and increase the risk of a counterattack against the U.S.
  • As with China’s aggressive build-up of its inter-continental ballistic missile force, which looks set to give China as many strategic nuclear weapons as the U.S., the roll-out of more medium-range missiles is likely to increase the bipartisan U.S. effort to address China’s growing military threat.

Russia-Ukraine War:  Following fast on Russia’s withdrawal last week from the deal allowing Ukraine to export grain from its southern ports, Russian forces have redoubled their missile attacks on Ukraine’s grain storage and export facilities.  The Russian strikes today hit a key terminal close to the border with NATO member Romania, raising the risk of escalation.  Meanwhile, the Ukrainians apparently launched a number of drone strikes against targets in central Moscow and in Crimea.  So far this morning, the result has been a further boost to global grain prices.  At this writing, U.S. wheat prices are up 5.2% to $7.34 per bushel.  Corn prices are up 4.0% to $5.56 per bushel.

European Union:  Hamburg Commercial Bank said its “flash” HCOB purchasing managers’ index for the eurozone fell to an eight-month low of 48.9, well below the expected reading of 49.7 and the June reading of 49.9.  Like all major PMIs, the HCOB index is designed so that readings below 50 indicate contracting activity.  Today’s release showed that the main weakness in the eurozone is in the manufacturing sector.  The subindex on factory activity fell all the way to a 38-month low of 42.7.

  • The reading points to worsening recessionary conditions in the eurozone in the coming months. In turn, that could convince the European Central Bank to halt or pause its interest-rate hikes following an expected 25-basis point increase this Thursday.
  • Reflecting that, European bond yields are dropping today, and the value of the euro has declined 0.3% to $1.1088.

Spain:  In elections yesterday, Alberto Núñez Feijóo and his center-right People’s Party won the most seats in parliament, but not enough to give it a clear shot at forming a governing coalition even if it teams up with the far-right Vox Party.  In contrast, Prime Minister Pedro Sánchez and his Socialist Party out-performed expectations and won enough seats to give it a fighting chance at a forming a majority grouping.  The results are an unexpected setback for right-wing populism in Europe and will set the stage for a period of inter-party wrangling and potential new elections in Spain.

Israel:  Prime Minister Netanyahu and his right-wing coalition in parliament will press ahead with a vote on a controversial judicial reform today.  The renewed push to limit the supreme court’s power to nix legislation has sparked mass protests and strikes.  The potential for political unrest and economic disruptions could weigh on Israeli assets in the coming days and weeks.

U.S. Monetary Policy:  Officials at the Federal Reserve will hold their latest two-day policy meeting this week, with their decision due to be released at 2:00 PM EDT on Wednesday.  Along with most other analysts, we suspect that continued strong wage gains and price pressures will prompt them to hike the benchmark fed funds interest rate further after pausing last month.  All the same, some other analysts think recent signs of modest economic slowing could convince them to hold rates steady again and simply signal the potential for more rate hikes later.

U.S. Stock Market:  After an 18-month drought in initial public offerings, a wildly successful IPO last week is raising hopes for a revival of deals in the coming months.  Based on last week’s strong performance of Oddity Tech (ODD, $52.56), the parent of direct-to-consumer beauty brand Il Makiage, it appears that investor demand for new companies is strong.  Moreover, the group of companies looking to come to market appears to be stronger than usual, since the hiatus in deals allowed many small firms to focus on consolidating their business and cutting costs.

U.S. Movie Theater Industry:  Despite ongoing concerns that the movie theater industry may never recover from the pandemic, the latest data suggests Barbie generated gross revenues of $155 million and Oppenheimer grossed $80 million over the weekend.  That would mark the first time in history that a three-day weekend has seen one movie open to $100 million or more and another to $50 million or more. It would also mark the fourth-biggest weekend of all time at the domestic box office.

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Daily Comment (July 21, 2023)

Posted on by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment begins with an explanation of why today could be a rocky day for markets. Next, we will discuss two major developments that may reshape international finance. Finally, we will share our thoughts on the Spanish elections occurring on Sunday.

Triple the Effect: A trifecta of events will weigh on market activity on Friday: a reshuffling of a popular tech index, the expiration of option contracts, and the release of corporate earnings.

  • The tech-heavy Nasdaq 100 index is undergoing a special rebalance today to address concerns about the weighting of mega tech companies. The index is typically rebalanced quarterly, but an exception was made earlier this month due to the growing dominance of these companies. Boosted by the excitement of artificial intelligence, the top five tech companies now account for over 50% of the index, significantly higher than the 40% cap typically preferred by the providers. The special rebalance will reduce the weightings of these companies and increase the influence of smaller companies. This will likely lead to increased volatility in the market as investors adjust their portfolios accordingly.
  • In addition to the Nasdaq 100 rebalance, an estimated $2.4 trillion worth of options tied to stocks and indexes are set to mature. The expiration of these contracts will likely impact trading activity as investors decide whether they would like to roll over existing positions or start new ones. July has been the slowest month of trading in two years, and there is speculation that investors may be sitting on the sidelines until there is more clarity about the future direction of monetary policy. If investors do decide to roll over their options, it could lead to a surge in trading volume and volatility. However, if investors decide to start new positions, it could lead to more sustained performance.

  • Finally, the day is likely to be heavily influenced by corporate earnings releases. Several companies are expected to report their results, including regional lenders Comerica (CMA, $52.93) and Regions (RF, $20.35), as well as credit card company American Express (AXP, $177.11). Comerica and Regions are expected to give insights into the deposit market, important information given the fears of disintermediation. At the same time, American Express’s earnings will provide information on the discretionary spending habits of consumers. The results could have a significant impact on the direction of the market in the coming weeks as it may give investors a better sense of the state of the economy.

Institutional Shifts: The World Bank and the Federal Reserve have made major announcements that suggest both organizations are looking to modernize.

  • These two developments show how the world is slowly adapting to a new normal. China is one of the world’s largest creditors, and its partnership with the World Bank makes sense given its influence in developing countries. Meanwhile, the U.S.’s current payment system is antiquated and needed to be improved to keep up with the demands of a world that is increasingly dominated by digital transactions. Taken together, these reports reflect how difficult it is for the financial system to keep up with changing trends as one could argue that both events should have happened much earlier.

¿A La Derecha? The upcoming Spanish election is widely expected to result in a rightward shift in the country’s political landscape.

  • The European Union’s inability to adapt to each country’s individual needs is a major weakness that could undermine the bloc’s ability to function in the future. This is evident in the fact that Spain will be subject to tighter monetary policy despite the fact that it is making better progress in its inflation fight than other countries. This lack of flexibility could lead to more populist leaders being elected in the EU, who would likely look to protect their countries’ interests, even if it means going against the bloc. As a result, if this trend continues, it could lead to a much weaker euro in the future.

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Asset Allocation Quarterly (Third Quarter 2023)

Posted on by Amanda Ahne

by the Asset Allocation Committee | PDF

  • Our three-year forecast still includes a relatively mild recession followed by a recovery and the potential for an economic expansion.
  • We expect inflation to moderate in the near-term but modestly re-accelerate in the back half of the forecast period given underlying structural influences.
  • The Fed’s monetary policy is likely to ease as economic conditions slow. Additionally, we expect a measured and careful approach by the FOMC as the presidential elections draw nearer.
  • The duration posture remains short-term. We anticipate the yield curve will begin flattening from its current inverted state.
  • In domestic equities, we maintain our value bias as well as large cap cyclical sectors and quality factors within lower market capitalizations.
  • International developed markets include an overweight to Japan. We maintain emerging markets exposure in the most risk-accepting portfolio but exclude China.
  • Gold exposure is maintained for its benefits as a low-correlation asset along with its potential to act as a haven during economic turmoil and as a hedge against geopolitical risk.

ECONOMIC VIEWPOINTS

The economy has generally remained resilient despite the Fed’s tightening actions and a widely anticipated recession. While fiscal spending has supported the economy, consumer spending has carried the expansion on the back of strong household balance sheets. However, we are seeing the first signs of slowdown in consumer sentiment. As this chart indicates, household non-mortgage debt-to-cash ratios have crept higher recently, indicating weakening balance sheets which could negatively affect spending. Savings that were bolstered by stimulus payments have now been depleted by strong discretionary spending and inflationary pressures on the overall consumer basket. Early signs of slowing consumer spending are emerging from the Consumer Staples and Discretionary categories, which we believe are due to price elasticities of demand in response to higher inflation. It is significant to note that we are seeing household balance sheets deteriorate even before the resumption of student debt payments. An estimated 37 million borrowers had a three-year reprieve in student debt payments and reports indicate this primarily supported consumption and did not accrue into savings. We expect these debt payments to further suppress spending.

At the same time, labor markets have remained strong with unemployment near cycle lows. The unemployment rate may be artificially understated as employers are hoarding labor in fear of labor shortages even when consumer demand is slowing. Here, again, we are seeing early signs of a slowdown in hours worked and falling rates of wage growth.

Macro headwinds combined with monetary policy tightening reinforce our forecast for a mild recession, which is likely to be uneven  among different segments of the economy. For example, the increased cost of capital is likely to weigh more heavily upon more highly leveraged companies and those embarking on new projects or expansionary efforts. The overall recession is not expected to be severe since it has been widely anticipated and elevated levels of liquidity on the sidelines should provide support to risk markets. As this chart shows, we continue to see historically high levels of money market and ultra-short bond fund assets. These levels are high for two main reasons. First, the inverted yield curve is offering attractive yields in the short end of the curve with low levels of risk. Second, accruing this yield is attractive for investors waiting on the sidelines for a dip in the market, providing support to risk markets.

Inflation is already showing signs of slowing. We believe this is primarily in response to the short-term smoothing of the supply-chain problems and is only secondarily affected by slower demand caused by tightening monetary policy. Our expectation is that inflation will return toward the end of the forecast period due to underlying structural issues, such as deglobalization and aging demographics. We also expect the new inflation regime to be higher than during the ZIRP epoch but lower than it has been since the pandemic.

One of the mega-trends supporting domestic economic activity longer-term is the re-shoring of manufacturing capacity and generally shortening supply-chains. Geopolitical tensions are likely to remain elevated and further support international polarization into regional blocs. Reliability of supply is now prioritized over the absolute lowest cost of manufacturing. Capacity buildouts are multi-year endeavors, which will place increasing demands on construction labor and materials initially and skilled labor to operate in the long-term. We believe these pressures, alongside general supply-chain complications, will further reveal inflationary bottlenecks in the economy and could lead to the resurgence of inflation.

We expect the path of monetary policy to be measured and careful over the forecast period, especially as we head into the 2024 presidential elections. Fed fund rates are likely to settle higher following the recession as the FOMC attempts to control a systemically higher inflationary regime.

STOCK MARKET OUTLOOK

A mild recession is generally discounted into current equity fundamentals, especially lower capitalization stocks. Domestic large cap stock valuations remain near cycle highs, with the expansionary cycle extended by excitement around AI and machine learning. We remain cautious regarding large cap exposure as concentration remains at historic highs. For example, the top 10 names in the S&P 500 accounted for roughly 30% of that index at quarter end. To guard against concentration risk, we lean our style tilt toward value over growth. Additionally, we retain our Aerospace & Defense position and cyclical sector overweights as we project that deglobalization and re-militarization of foreign countries is a sustainable long-term trend. We maintain our sector overweights to Mining, Energy, and Industrials in most strategies. The Mining and Energy sectors are likely to benefit from electrification/green energy policies as electrification is metals heavy.

We believe small and mid-capitalization stock valuations remain attractive, while fundamental earnings power remains healthy. Mid-cap stocks, specifically, remain at historically wide valuation discounts to large cap stocks. Last quarter, we introduced a quality factor in our mid-cap exposure. Similarly, we remain in a quality-screening vehicle on the small cap side. The quality factor screens for profitability, leverage, and cash flows, which should support the group through economic volatility.

We continue leaning into the value bias across all market capitalizations. We view the sustainability of earnings growth as more attractive in equities categorized as value and the fundamental valuation multiples are modest compared to historical data. In addition, value style has a lower exposure to sectors that we view as overpriced. Although growth has vastly outperformed value year-to-date, we anticipate that we are in the early stages of a value outperformance cycle.

International developed equities remain attractively valued, while their earnings potential remains healthy. This quarter, we added a country-specific overweight to Japan as shareholder-friendly reforms are starting to take hold in the country and as capital flows are moving out of the rest of Asia and into Japan, which could potentially lead to earnings multiple expansion. We also forecast positive returns from emerging market stocks on the back of U.S. dollar weakness, although exposure to this asset class is limited to only the most risk-accepting strategy. Given the potential economic slowdown and geopolitical risks stemming from China, we have directed our exposure to an emerging market ex-China investment vehicle.

BOND MARKET OUTLOOK

With the anticipated decline in the fed funds rate (the Fed’s reaction to the recession) and a more docile near-term level of inflation, the most attractive segment of the Treasury curve is in short duration. While our base case is for a flat yield curve to reign by the end of the three-year forecast period, we harbor concerns regarding intermediate-term bonds and especially long-duration bonds. Should inflation reassert itself within the forecast period, yields on long-term debt could rise, exerting downward pressure on prices and resulting in a traditionally shaped yield curve. Consequently, the duration posture of the strategies with income as a component remain short-duration with a concentration in one-year Treasuries.

Among investment-grade corporate bonds, it is notable that spreads have not compressed beyond historic averages, underscoring the absence of investor concern even in the face of the much-anticipated recession. Moreover, corporate debt issuance has been subdued over the past few years and has not led to excessive debt levels on most corporate balance sheets. Nevertheless, it would be consistent with our thesis for spreads to widen modestly as the recession takes hold and the maturing of low coupon debt to be refinanced with bonds reflecting higher rates than what prevailed during the years prior to 2022. As a result, corporate bond exposure in the strategies represents a lower proportion than popular market indices.

In the speculative-grade corporate bond category, we find caution is warranted due to the sizable increase over the past 15 months in the cost of capital for highly leveraged companies that are refinancing debt. As with investment-grade corporates, spreads have been relatively contained. However, an uneven recession is likely to cause spreads on lesser rated corporates rated B or lower, especially those in the distressed category, to widen markedly. Accordingly, all exposures to speculative-grade bonds in the strategies are exclusively in BB-rated debt.

OTHER MARKETS

Allocations to REITs are absent as our forecast for the sector over the near-term calls for continued headwinds and low levels of demand for office and retail space, compounded by the difficulty in arranging financing. Although the strategies similarly avoid broad-based commodities owing to recession-induced pressure on prices, we maintain the allocation to gold across the strategies. We favor the continued gold exposure as it can act as a haven during economic contractions and as a hedge against geopolitical risk. Furthermore, gold can be beneficial due to the potential strength it offers during periods of U.S. dollar weakness and its use as a reserve asset for global central banks.

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Asset Allocation Fact Sheet

Daily Comment (July 20, 2023)

Posted on by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment begins with our concerns about the banking sector. We then discuss how the war in Ukraine and El Niño could impact Fed policy. Finally, we explain why the recent improvement in U.S.-China relations may be short-lived.

Deposit Flight: While banks have mostly recovered from the March fiasco, disintermediation remains a challenge.

  • Three of the country’s biggest banks by assets were able to beat expectations in the second quarter. JP Morgan (JPM, $154.25), Citigroup (C, $47.52), and Wells Fargo (WFC, $46.26) made a combined profit of $22.3 billion going into the year’s second half, thanks in part to hawkish Fed policy. The surge in interest rates have benefited banks in two ways. First, they were able to charge more for loans, which increased their net interest income. Second, the banking crisis in March led to an increase in deposits at major banks as savers fled regional banks. This surge in new clients made it easier for banks to lend out capital. However, it is unclear whether this trend will continue into the third quarter.
  • Several major headwinds are expected to plague banks over the next few months. First, as interest rates rise, customers are pushing for more compensation for their deposits. In fact, institutional depositors are already moving their savings to higher-yielding accounts. Second, the prospect of new regulations and loan losses from commercial real estate is forcing banks to shore up their balance sheets. For example, U.S. Bancorp (USB, $38.68) announced that it has increased its Common Equity Tier 1 (CET1) by 60 basis points, offloaded assets, and securitized auto loans in order to reduce its balance sheet exposure. On top of that, banks have noticed that households are holding back on spending, and credit card losses are increasing.

  • The good news is that deposits at commercial banks have stabilized since the fall of Silicon Valley Bank. However, these holdings will be under threat as long as the Fed keeps raising rates. Regional lenders are the most sensitive to interest rate changes, as evidenced by the deposit outflows reported by U.S. Bancorp, Citizens (CFG, $31.06), M&T Bank (MTB, $138.08), and Charles Schwab (SCHW, $66.00) in the second quarter. Even Bank of America (BAC, $31.40), the second-largest bank by assets, saw a deposit flight. If bankers are forced to pay more on deposits, it could lead to even higher borrowing costs and further weigh on consumer spending. As a result, we are still paying close attention to the banking system.

It’s Hot in Here: Adverse weather conditions and the war in Ukraine could complicate Fed efforts to ease monetary policy.

  • Temperatures in the United States, Europe, and Asia have reached record highs this year, driven by relatively strong El Niño conditions. Global ocean temperatures have exceeded the 20th-century average by 1.89 F, according to the National Oceanic and Atmospheric Administration. The unusually hot weather has pushed up energy consumption in the United States, with power demand in Texas and Arizona expected to set records. The unprecedented heatwave has also led to wildfires in Greece and Canada. Additionally, there are concerns that poor conditions could hurt crop yields.
  • At the same time, the war in Ukraine is also leading to uncertainty regarding food prices. On Wednesday, Russia announced it would consider all vessels headed to Ukrainian ports to be military threats. The declaration comes a week after Moscow pulled out of the Black Sea grain deal. Wheat futures surged 8% following the report as investors expect grain supply to fall. So far, grain prices remain lower than at the start of the year; however, they could rise if shipments are disrupted or become more expensive to insure. This may lead to an increase in food inflation just as cost pressures were trending downward.

  • Adverse weather conditions and the war in Ukraine are likely to dissuade talks of policy cuts. Central banks appear to be indifferent as to whether inflation is supply- or demand-driven. They are instead focused on containing price pressures, regardless of the source. As the chart above shows, most of the progress made in U.S. inflation has come from supply-side factors. Hence, supply disruptions could reverse some of the gains made in the inflation fight. While this does not necessarily mean that they will continue to raise interest rates, they are less likely to consider a cut if there is a chance of inflation accelerating.

There Is a Glimmer: Despite ongoing friction between the two global superpowers, there are signs that both sides are willing to de-escalate and avoid direct conflict.

  • That said, the two largest economies in the world will continue to take steps to protect their own interests. On Wednesday, China’s envoy to Washington warned that his country would respond if the U.S. proceeds with pushing through laws that hurt China’s advancement in military technology. The threat comes amidst speculation that the Biden administration is considering limiting investment into companies linked to the Chinese defense industry. Although White House officials maintain that the restrictions will be limited in scope, it is possible that the measure could pave the way for more discussion regarding the topic, especially going into the 2024 election.

  • A deceleration in the global economy is likely to slow the pace of the decoupling between the United States and China, but it is unlikely to disrupt it entirely. The two countries are deeply interconnected, and both would suffer if there were a complete break in economic ties. China’s economic recovery will receive a boost from an increase in exports to the United States and maintaining access to China’s supply chains and materials will help the United States with its green energy transition and prevent trade disruptions. However, trade between the two countries is unlikely to return to its pre-pandemic pace anytime soon.

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Weekly Energy Update (July 20, 2023)

Posted on by Amanda Ahne

by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA | PDF

On Monday, oil prices spiked on reports that the Kingdom of Saudi Arabia (KSA) was going to extend its voluntary production cuts until year’s end.  The report was incorrect but does show the power that the news has on the oil markets.

(Source: Barchart.com)

Commercial crude oil inventories fell 0.7 mb, less than the 2.5 mb draw forecast.  The SPR was unchanged.

In the details, U.S. crude oil production was steady at 12.3 mbpd.  Exports rose 1.7 mbpd, while imports increased 1.3 mbpd.  Refining activity rose 0.6% to 94.3% of capacity.

(Sources: DOE, CIM)

The above chart shows the seasonal pattern for crude oil inventories.  After accumulating oil inventory at a rapid pace in the first quarter, stockpiles have moved into a pattern consistent with the seasonal.  Current inventories are in line with seasonal levels.

Fair value, using commercial inventories and the EUR for independent variables, yields a price of $59.94.  Commercial inventory levels are a bearish factor for oil prices, but with the unprecedented withdrawal of SPR oil, we think that the total-stocks number is more relevant.

Since the SPR is being used, to some extent, as a buffer stock, we have constructed oil inventory charts incorporating both the SPR and commercial inventories.

Total stockpiles peaked in 2017 and are now at levels last seen in 2002.  Using total stocks since 2015, fair value is $92.96.

About the Heat:  We have been commenting on the unusually warm temperatures currently in the Northern hemisphere.  Europe, unaccustomed to such heat, is having a very difficult time adjusting.  In the U.S. the southern tier of states has experienced extreme heat, especially in the Southwest.  China is seeing hot weather as well.  Temperature reporting is now front and center in the media.  Although climate change is being blamed for much of it, our experience with climate is that it’s complicated.  There are two complications that are important to mention:

  • Sunspot cycles: The sun plays a major role in the earth’s climate.  Sunspots are the result of magnetic activity on the sun that causes flares and ejections from the sun’s surface.  The scientific community is divided on the impact of sunspots on climate.  Some argue that it is an important factor, others dismiss the activity as negligible.  We are not climate scientists but interested observers.  Our take is that the cycles likely amplify the normal variation.  That means that sunspot cycles probably don’t drive climate by themselves but do play a role.
    • Sunspot cycles run 22 years, from trough to trough. The current cycle will peak in 2025.  In general, increased activity tends to lead to higher temperatures.  Thus, we are in the part of the cycle that should lift global temperatures.  The current cycle isn’t unusually amplified, but its current readings exceed the peaks observed in the last cycle.

(Source:  NOAA)

The combination of elevated sunspot activity and an El Niño ENSO cycle indicates that hot weather will continue.  In the developed world, this climate condition tends to be bullish for summertime natural gas prices, as it boosts air conditioning demand and consequently, electricity consumption.  So far, U.S. natural gas production has been robust enough to keep injections on par with seasonal norms.  This factor has kept natural gas prices low.  If winters are mild, it could be bearish for natural gas prices going forward.  There have been other effects as well:

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