Author: Amanda Ahne
Bi-Weekly Geopolitical Report – Investment Implications of the Israel-Hamas Conflict (October 30, 2023)
Patrick Fearon-Hernandez, CFA | PDF
For investors, geopolitical risks today center on the Great Power competition involving countries like the United States, China, and Russia. Nevertheless, terrorism by non-state actors can still be destabilizing, as shown by the October 7 attacks on Israel by Hamas, the Palestinian terrorist group that controls the Gaza Strip. The attacks resulted in the largest mass killing of Jews since the Holocaust and the seizure of over 200 hostages, prompting the Israeli government to launch military reprisals aimed at destroying Hamas as a political and economic power and raising the risk of a broader regional conflict. This report discusses how the Israeli-Palestinian fighting could play out in the coming weeks and months and what the implications are likely to be for investors.
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Business Cycle Report (October 26, 2023)
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 declined for the second consecutive month in a sign that the economy is losing momentum. The September report showed that seven out of 11 benchmarks are in contraction territory. Last month, the diffusion index declined from a revised reading of -0.2121 to -0.2727, below the recovery signal of -0.1000.
- Equities accelerated due to base effects, offsetting the monthly decline.
- Pessimism about the future has weighed on consumer confidence.
- Despite tighter financial conditions, the labor market remains robust.
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.
Asset Allocation Bi-Weekly – #108 “A Regime Change in Bonds?” (Posted 10/23/23)
Asset Allocation Bi-Weekly – A Regime Change in Bonds? (October 23, 2023)
by the Asset Allocation Committee | PDF
Jim Bullard, former president of the St. Louis Federal Reserve Bank, based his policy votes and economic analysis, in part, on a concept known as regimes. Our take on his concept is that an edifice of factors underly clearly observable correlations in markets, and when this edifice changes, the former rules of thumb no longer hold. Regime changes are jarring for investors as previous relationships no longer hold, and there is a sense that the world no longer makes sense. However, over time, new rules of the road emerge, and markets tend to become understandable again.
We think that something similar is occurring in long-duration fixed income. Since the early 1980s, low inflation volatility (supported by globalization and deregulation) and strong confidence in the Federal Reserve’s ability to give value to the dollar and suppress inflation, led to steadily falling long-term bond yields. Consequently, this allowed investors to use bonds as a buffer in portfolios, fostering solid performance of the 60/40 portfolio. However, as we have been detailing for some time, the steady erosion of U.S. hegemony is undermining globalization and as the world factures, national security concerns are overriding efficiency. This set of circumstances are expected to lead to higher and more volatile inflation.
In an attempt to quantify what this means for investors going forward, we use a reduced form of our 10-year T-note model. First, let’s look at the model from 1960 through the present:
The model includes the fed funds rate, oil prices (WTI), the 15-year average of yearly CPI (which is our inflation expectations proxy), the five-year standard deviation of yearly CPI, the deficit to GDP ratio, and a binary variable for periods when Congress and the White House are controlled by the same political party. There are a few unexpected outcomes. First, oil prices carry a negative coefficient, meaning that higher oil prices lead to lower yields. Second, the coefficient on the deficit is also positive, meaning that larger deficits bring lower yields. Both are contrary to common expectations.
Now, let’s look at the model from 1960 through 1982. This was the pre-Volcker era, where it was generally held that monetary and fiscal policies should work in concert, and after the gold standard was ended in 1971, there was uncertainty surrounding what would give value to fiat currency.
Note the differences from the overall model. First, the oil price and deficit coefficients are positive, which means that rising oil prices and deficits led to higher interest rates. Also, a unified government led to lower yields. We suspect the government variable reflects a period when there was greater confidence in government, and thus, a clear mandate (expressed by single party dominance) led to lower yields.
Now for the 1983 through the current period model:
Some major changes have emerged. First, the oil coefficient sign flipped, meaning higher oil prices have led to lower yields. The best explanation of this circumstance is that investors had faith that the Fed would see high oil prices as an inflation threat and would move to tighten policy to ensure oil price increases didn’t lead to persistent inflation. Second, the trend in inflation has had a much greater impact on yields when compared to the earlier period. This change likely reflects the “scars” of the high inflation period of the 1970s. At the same time, the deficit variable’s sign also flipped as higher deficits led to lower yields. This change likely reflects faith that the Fed will lean against deficit spending. In other words, Volcker was seen to have implemented Fed independence, which, along with a clear inflation target, replaced gold as the factor that gave credibility to the dollar. Finally, the lack of faith in government is reflected in the sign flip of that variable. Since 1983, a unified government has led to higher yields on the expectations that an administration with such a mandate would use it to spend money and potentially bring inflation. Or, put another way, a divided government was considered a positive.
Recent market behavior has raised concerns that the regime that began in 1983 could be ending. Large fiscal deficits have led to fears of rising debt service costs. There is increasing worry that we could be approaching fiscal dominance, where the Fed is no longer independent because it must partially monetize Treasury spending to maintain order in the Treasury bond market. This outcome may not materialize since it’s possible that policymakers would implement austerity measures to reduce deficits, although there is some evidence to suggest that investors doubt the resolve of policymakers. If the Fed’s independence is compromised, we would likely see oil prices become positively related to yields again.
What will be important going forward is that the truism of the past forty years may not hold to the same degree. That doesn’t mean we will completely revert to relationships last seen in the 1960-82 period, but it probably means that a breakdown in variable relationships from the most recent period is likely. Investors should be prepared for new relationships to emerge over time.
Weekly Energy Update (October 19, 2023)
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA | PDF
Continued tensions in the Middle East are supporting crude oil prices.
(Source: Barchart.com)
Commercial crude oil inventories fell 4.5 mb compared to forecasts of a 0.6 mb draw. The SPR was unchanged, which puts the net draw at 4.5 mb.
In the details, U.S. crude oil production was steady at 13.2 mbpd. Exports rose 2.3 mbpd, while imports fell 0.4 mbpd. Refining activity rose 0.4% to 86.1% of capacity. The rise likely signals that we are coming to the end of the autumn refinery maintenance period, which should lift oil demand.
(Sources: DOE, CIM)
The above chart shows the seasonal pattern for crude oil inventories. Last week’s is contrary to seasonal patterns, but we do note that refinery operations rose this week.
(Sources: DOE, CIM)
Fair value, using commercial inventories and the EUR for independent variables, yields a price of $74.38. However, given the level of geopolitical risk in the market, we are not surprised that oil prices are well above this model’s fair value.
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 late 1984. Using total stocks since 2015, fair value is $94.45.
Market News:
- Rising prices for diesel fuel are creating an opportunity for China to expand product exports. Although China is dependent on foreign oil supplies, it has expanded its refining capacity, giving it the ability to export product. It is worth noting that China has been buying sanctioned oil from Iran and Russia at discounts and in its own currency, likely creating attractive refining margins. Russia has been curtailing diesel exports to secure domestic supplies which is giving China an export opportunity.
- For the first time in history, crude oil is poised to become America’s largest export. The combination of rising production and higher prices, along with demand from Europe, have led to this development.
- At the same time, environmental activists are working to create impediments to U.S. LNG exports.
- Canada is nearing the completion of its Trans-Mountain Pipeline, which will allow it to send oil from central Canada to the Pacific coast. This development will likely raise prices on Canadian oil exported to the U.S. At the same time, it should also reduce prices to Asia.
Geopolitical News:
- As Israel begins its ground offensive in Gaza, we continue to watch for signs of escalation. Iran is warning Israel not to expand its offensive into Gaza, while the U.S. is warning Iran not to escalate the current conflict into a regional war. In the wake of the missile strike on a Gaza hospital, Iran has called for an oil embargo on Israel and is warning of pre-emptive strikes. There is a dispute over who is responsible for the attack on the hospital: Israel claims it was a misguided missile launched by either Hamas or Islamic Jihad, while Hamas accuses Israel.
- The U.S. has issued new sanctions on Iran, mostly targeting Iranian firms tied to supporting Iran’s missile and drone programs. The firms are based in Iran, Hong Kong, China, and Venezuela.
- The U.S. has sent a second carrier strike force into the region, suggesting rising concern about a widening conflict.
- Last week, we speculated that the Hamas invasion and Israeli response would likely lead to at least a suspension of Israel/KSA talks. The Saudis have confirmed that the talks are on hold for now.
- China and Russia are decidedly siding with Hamas, likely to undermine U.S. influence in the Middle East.
- At the onset of the war in Ukraine, there were widespread concerns that the global fertilizer market would be disrupted. Russia, Belarus, and Ukraine were all significant producers of fertilizer. In addition, one of the key feedstocks of fertilizer is natural gas, which has seen a jump in prices. We are now seeing reports of fertilizer shortages, which will reduce crop yields, especially in the emerging economies.
- As the U.S. moves to tighten sanctions on Russia, Washington is also moving to ease them on Venezuela, likely to restrain oil prices. The Maduro government is agreeing to hold elections under international observation.
- The House of Representatives is planning to issue a subpoena to Robert Malley, the former Biden administration official who is under scrutiny on concerns he may be acting in the interests of Iran.
Alternative Energy/Policy News:
- For EVs to be a viable replacement for ICE (internal combustion engine) cars, the issue of range anxiety will need to be addressed. Currently, the range is about 350 miles, which is serviceable, but recharging can take a long time and finding places to recharge can be a challenge. However, Toyota (TM, $177.68) may have the ultimate solution: a solid state battery that has a range in excess of 900 miles with a 10 minute recharge. Such a combination would be an improvement over ICE vehicles and would likely resolve much of the range concern. Toyota is working to mass produce these batteries, which are expected to be in its cars by the end of the decade.
- Meanwhile, EV sales have started to fade in the U.S. due to rising costs coupled with range anxiety.
- Although there is general agreement among environmentalists that fossil fuel use needs to be curtailed, there is persistent opposition to the mining of the metals needed to make the transition. Often, these resources reside in environmentally sensitive areas. Although we understand the concern, if areas where the metals can be found continue to be excluded, it may become difficult to accelerate the transition away from fossil fuels.
- As Britain contemplates achieving net zero by 2050, it is starting to count the costs of decommissioning its natural gas distribution network. These costs will be formidable.
- A recent study by the Dallas Federal Reserve is a “good news, bad news” story for wind and solar. There is clear evidence that these alternative power sources helped Texas avoid brownouts this summer. The bad news is that the intermittency of these two sources have made managing the grid difficult as solar and wind power tend to increase in the daytime and taper off in the evening. This pattern requires grid operators to adjust other power sources to accommodate this pattern. Ramping up other sources, primarily natural gas fired turbines, tends to increase maintenance costs. Battery storage may help grid operators deal with the intermittency issue.
- Within the EU, France and Germany are at loggerheads over the nuclear power issue. The former wants nuclear power to be included as a green alternative. Germany, which has decided to close its reactors, opposes this characterization.
Note: The next edition of this report will be published on November 2.
Keller Quarterly (October 2023)
Letter to Investors | PDF
One quarter ago I discussed the inadvisability of living in the future (or the past), at least as far as investing goes. Much better, we said, to stay in the present, investing in what is, not what if. Today we deal with the difficulty of investing in the present. The recent past has delivered a decade’s worth of crises: a global pandemic, war in Ukraine, a resurgence of inflation, rising interest rates, a U.S. banking crisis, political polarization and paralysis, possible government shutdown, an auto industry strike, increasing “great power” tensions, and now…a war in the Middle East.
Go, go, go, said the bird: human kind
Cannot bear very much reality.
(Burnt Norton, I, 44-45. I promise to quote a poet other than T.S. Eliot in future letters.)
Investors, like most people, prefer to have reality approach little by little, rather than all at once. But, as my colleagues are probably tired of hearing, “We don’t get to invest in the world that we wish we had, only in the world we have.”
So, how is an investor to deal with such an onslaught of reality? Today, we sing an ode to Asset Allocation. By asset allocation, we mean the practice of diversifying one’s entire portfolio of investments by asset type. The reason to do this is that different classes of assets not only perform differently over time, but also respond differently to events. This is essential because no one can predict the future. While the recent run of extraordinary events appears unusual to many, our experience is that, in the world of investing, the extraordinary is ordinary. One must be prepared for anything.
We believe the best way for an investor to be prepared for anything is to have one’s assets diversified by type. And we’re not just speaking of stocks and bonds (or even different types of stocks and bonds), but all assets, including commodities, currencies (most easily accessed via assets denominated in foreign currencies), gold (more of a currency than a commodity), real estate, and even “good old-fashioned” cash.
As noted above, not all assets respond to reality in the same way. In almost any of the myriad of possible economic, geopolitical, and market environments, some assets will do meaningfully better than others. For example, when war breaks out in the Middle East, the prices of oil, gold, defense stocks, Treasury bonds, and the dollar usually rise, even while the prices of many other assets decline. Sensible diversification by asset class can bring a measure of stability to a portfolio even on days of crisis.
If we knew that today’s winning stocks would continue to work forever, we would not need asset allocation; there would be no need to own multiple asset classes if we knew precisely what was going to happen a year from now. But since we don’t know the future, we diversify by asset class. This is the same reason that we buy insurance on our cars. If we knew for a fact that we would never have an accident, such insurance would be a waste of money. But we don’t know that, so keeping the car insured is prudent.
Asset allocation is for every investor. And you do have an asset allocation, even if you’ve never thought about it. But thinking about it is the first step toward modifying it to best fit your needs. Regardless of which Confluence strategies (Value Equity, International Equity, Alternative Investment, or Asset Allocation) you might be invested in or what other investments you may have, it is important that you thoughtfully evaluate your asset allocation. We encourage you to sit down with your financial advisor to plan an asset allocation strategy that is right for your risk tolerance and long-term objectives. At Confluence, we believe asset allocation is the most prudent way to maintain investment stability when reality seems too much to bear.
We appreciate your confidence in us.
Gratefully,
Mark A. Keller, CFA
CEO and Chief Investment Officer
Bi-Weekly Geopolitical Report – What Shall We Call the New Era? (October 16, 2023)
Patrick Fearon-Hernandez, CFA | PDF
Whether you’re a policymaker, an investor, a small business owner, or simply a student of world history and international affairs, it’s useful to have meaningful labels for various epochs. Ideally, such a label is widely accepted and captures some essential aspect of the era you’re thinking about, making it easier to talk about that era with others. The Elizabethan Age, The Progressive Era, World War I, World War II, and The Cold War are all terms that suit that purpose quite well. Each immediately conveys not only the period you’re talking about, but it also conjures up something of the political, economic, and military landscape of the period.
The world has just concluded a great epoch that ran for nearly three decades from the fall of the Berlin Wall and the collapse of Soviet Communism to Donald Trump’s term as U.S. president. During that epoch and in the years since it has ended, the labels used to describe it have been unsatisfying, probably because we were still unsure about which of its aspects were defining and which were not. Now that that world has ebbed, there seems to be a growing consensus toward calling it the post-Cold War period or the period of Globalization. Both terms capture the sense that it was a time of relative peace, which encouraged global trade and investment.
But what about the new era that is now taking hold as China and its evolving geopolitical and economic bloc increasingly assert themselves against the global hegemony of the United States? In this report, we explore some ways to describe this new world epoch in hopes that it will help sharpen investors’ understanding of what really differentiates it from the post-Cold War globalization period that has now come to an end.