Asset Allocation Bi-Weekly – The Federal Reserve’s Big Policy Mistake (September 19, 2022)

Posted on September 19, 2022September 16, 2022 by Amanda Ahne

by the Asset Allocation Committee | PDF

If you look at how stocks and other risk assets have lost value since Fed Chair Powell’s short, hawkish speech at Jackson Hole last month, it’s clear he has succeeded in resetting expectations for monetary policy. Investors now seem to accept that the Fed plans to hike interest rates much higher and then hold them there until consumer price inflation falls sharply. The drop in risk assets suggests investors now realize that monetary policymakers are willing to push the economy into recession if needed to re-establish their credentials as inflation fighters. That’s a huge change in sentiment. But has the change gone far enough? Multiple signs suggest investors expect any impending recession to be mild. For example, the S&P 500 price index is currently down just 19.2% from its most recent record high in early January versus a median decline of approximately 25% during recessions over the last few decades.

We are skeptical that the Fed can keep any impending slowdown mild, for several reasons. One key reason is that the Fed now has much weaker control over financial conditions than it did in the past. In the chart below, we show that the Chicago FRB’s broad measure of U.S. financial conditions had a very tight correlation with the Fed’s benchmark fed funds interest rate only up to about 1998. Since then, financial conditions have had almost no relation to the fed funds rate. At most, the chart suggests the Fed needs to keep hiking rates for a long time before financial conditions tighten, as in the years leading up to the housing crisis of 2007-2008. And even then, when financial conditions tighten, they do so quickly and dramatically. Why is that?

It’s hard to pinpoint exactly why the Fed’s interest rate policy lost its impact on financial conditions in the late 1990s, but one plausible explanation is that the U.S. economy by then had become “money market driven” and was no longer “bank driven.” By the late 1990s and ever since, those in need of capital and those holding excess capital (including international entities) have increasingly found each other via efficient, impersonal trading markets. Rather than borrowing from banks, sophisticated corporate or municipal borrowers now issue bonds directly to investors. Individuals borrow from both banks and specialized mortgage companies, both of which often package those loans into securities and sell them to third-party investors. Finally, any holder of high-quality assets like U.S. Treasury bills can pledge them in return for a loan via the “repo” market. The capital flows involved in these market transactions amount to trillions of dollars, and neither the banks nor the Fed has much control over them.

The problem is that Chair Powell and the other Fed policymakers may not understand or accept that in this new, internationalized money market-driven environment, the Fed may be better positioned to manage the economy by setting guardrails on the value of market-traded financial instruments like bonds and repos. The fed funds rate may no longer be the right tool to achieve the Fed’s goals of stable consumer prices and full employment. In fact, the Fed’s current aggressive rate hikes implicitly show this. In the chart below, we can see that the Fed’s current rate hikes have broken a 20-year tradition in which policymakers cut rates or refrained from hiking them when the VIX gauge of stock volatility was greater than 20. The Fed is now hiking rates despite the VIX being well above 20, just as it did in its bubble-popping mode during the late 1990s.

We all know how dangerous it is to try slicing an apple with a dull knife: you add more and more pressure until, suddenly, the blade crashes through and takes off the tip of your thumb. The fed funds rate is now a very dull knife, and Fed policymakers will likely have to press it much harder than people expect before it substantially tightens financial conditions and cuts inflation pressure. The danger is that the accumulation of rate hikes will suddenly gain traction and slide through the economy. Looking forward, the Fed may realize that a better policy tool now may be something like its emergency asset backstopping programs early in the coronavirus pandemic. With those programs, the Fed promised to buy a wide range of assets ranging from Treasuries and commercial paper to municipal bonds, if needed, to ensure their tradability, but the programs were so successful in calming the markets that they were little used. For the time being, however, Fed policymakers are still wedded to their old-school, dull-bladed fed funds rate and will likely keep ratcheting it up until it finally sparks a more substantial recession.

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Weekly Energy Update (September 15, 2022)

Posted on September 15, 2022December 13, 2022 by Amanda Ahne

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

Crude oil prices remain under pressure on recession fears.

(Source: Barchart.com)

Crude oil inventories rose 2.4 mb compared to a 2.5 mb build forecast. The SPR declined 8.4 mb, meaning the net draw was 6.0 mb.

In the details, U.S. crude oil production was steady at 12.1 mbpd. Exports rose 0.1 mbpd, while imports declined 1.0 mbpd. Refining activity rose 0.6% to 91.5% of capacity.

(Sources: DOE, CIM)

The above chart shows the seasonal pattern for crude oil inventories. The rise in stockpiles over the past two weeks is contra-seasonal. As the chart shows, we are nearing the seasonal trough in inventories. The build seen in October into November is usually due to refinery maintenance. With the SPR withdrawals continuing, the seasonal build could be exaggerated this year.

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 2003. Using total stocks since 2015, fair value is $106.07.

The SPR has been falling rapidly.

With so many crosscurrents in the oil markets, we are beginning to see some degree of normalization. The inventory/EUR model suggests oil prices should be around $66 per barrel, so we are seeing about $20 of risk premium in the market.

Natural Gas Update

Now that summer is behind us, it’s time to examine the state of the natural gas market as winter approaches. Currently, on a rolling 12-month basis, supply is exceeding consumption.

Some of the supply improvement has come from rising net imports. As the chart below shows, the U.S. was a net importer of natural gas until late 2017 (again, on a rolling 12-month basis). Since then, the U.S. is a net exporter, hence the negative net import reading. The recent rise in net imports appears to be tied to the Freeport LNG disruption, as LNG exports have fallen. By next spring, that facility is expected to be at full production, which will reduce American supplies, assuming steady production.

Although supply has been ample, hot summer weather has lifted consumption and puts the U.S. at a modest storage deficit going into autumn.

This model seasonally adjusts storage levels, and the deviation line shows the difference between current and normal storage.

Expectations of rising LNG exports have pushed U.S. natural gas prices well above seasonal norms. As always, the key to prices in the winter is temperature. One way to measure the impact of temperature on energy demand is using the concept of the degree day. The degree day measures the average temperature (high + low/2) compared to 65^o with the idea that no climate control is necessary at that temperature. If above 65^o, cooling is required while if below, heating is required. The temperature deviation is then adjusted by population. Below are the deviations from normal.

Heating degree day values tend to be higher than cooling because extreme cold is more common than extreme heat. A temperature of 0^o generates a heating degree day where the equivalent would be 130^o for a cooling degree day. Thus, on the above charts, we have scaled the degree days equally. Casual observation would suggest that winters have become milder as the last extreme cold month, December 2000, was a heating degree day of 200 which has not been exceeded since. Such readings were far more common in the 1970s. On the cooling side, there is a clear upward drift in deviations. It is quite possible that rising greenhouse gas levels are a factor in both warmer winters and hotter summers, but one cannot rule out longer cycle factors, such as sunspots. What this means for natural gas markets is that colder winters may not be as bullish a factor as it once was, but summers pay a larger role in demand.

Market news:

As autumn approaches, natural gas demand tends to decline. Moderate temperatures ease electric demand. There is always a risk of hurricane disruption in the Gulf of Mexico, but so far this year, the region has been spared from storms. Hurricane season peaks, on average, by September 10, so there is a growing chance that we will avoid a serious disruption from tropical activity. Although EU natural gas inventories have increased, it is important to remember that inventory is a supplement to production and imports. Thus, to ensure ample supplies, barring a mild winter, U.S. LNG flows, which have been critical to the inventory build, will need to continue. This means that U.S. natural gas prices will remain elevated, unless the U.S. decides to curtail exports.
A follow-on effect of high natural gas prices is high fertilizer prices as natural gas is an important feedstock for fertilizers, and tight supplies are hammering the European fertilizer industry. In response, Germany has been increasing chemical imports.
- In addition to fertilizer, vegetable growers often use greenhouses in Europe, and high natural gas prices are leading to production declines.
One of the surprises over the past 18 months has been the lack of supply response from the oil industry in the face of elevated prices. A key reason is the worry about policy changes leading to stranded assets. We expect this fear to cap the supply response and keep oil prices high.
Although the supply situation for crude oil remains bullish, demand is cyclical and as the odds of a recession rise, the potential for demand destruction is increased as well.
One of the key elements of recent legislation was permitting reforms. Environmentalists and other groups have been using the courts to prevent pipeline construction, for example. The Inflation Reduction Act is designed to reduce the time of objections to construction. Interestingly enough, it could work the other way. Although intermittency is a hinderance to using solar and wind power, long-range electricity distribution could, in theory, counter intermittency by allowing solar or wind power to be sent long distances when it might be dark and calm. This bill should help that process as well, as often proposals for electricity lines face local objections.

Geopolitical news:

It is looking increasingly like a return to the Iran nuclear deal isn’t going to occur. To some extent, it appears that Iran won’t take “yes” for an answer. The White House has generally accepted Iran’s demands, only to see new ones emerge. We suspect the Iranian leadership needs an enemy much like the Castros do in Cuba; it is hard to repress one’s population without an ever-present enemy. We have been skeptical of a deal and despite continued negotiations, it doesn’t look like one is coming.
Part of managing sanctions is the use of GPS and vessel transponders. Increasingly, software is spoofing this system, reducing the effectiveness of sanctions. Actual interdiction is still possible but would require a much larger military effort.
Lebanon has been in a financial crisis for some time. Things have gotten worse as the central bank has stopped supplying dollars to energy importers, leading to soaring product prices.

Alternative energy/policy news:

Uranium prices have been strong as interest in nuclear power continues to rise. Although nuclear electrical power has been an environmental pariah for a long time, the sources don’t create greenhouse gases. Unfortunately, Russia is a significant source of uranium.
Although the logic is questionable, the EU has promoted biomass, mostly wood burning, as a “green” alternative. The EU is now considering tightening the rules on wood burning (mostly pellets) due to the controversy surrounding its impact on the environment.
Solar power is a popular renewable energy source; however, California is finding that disposing of the panels once their useful life has expired (around 15-20 years) is becoming a problem. The panels contain heavy metals which if dumped in a leaky landfill, could contaminate groundwater.
- Disruptions in the solar panel supply chain are leading to greater coal consumption.
Some critical rare earths are mined in Myanmar and lax environmental practices are raising concerns about environmental damage to the country.
Renewable energy is facing a constraint due to the lack of skilled workers.

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Bi-Weekly Geopolitical Report – The Ukraine War at Six Months: Some Reflections (September 12, 2022)

Posted on September 12, 2022September 12, 2022 by Amanda Ahne

by Bill O’Grady | PDF

On February 24, Russian forces entered Ukraine. Despite warnings from U.S. intelligence about an invasion, the general consensus was that Moscow was merely threatening to act. Thus, when Russia invaded, Europe was mostly caught by surprise. Much of what followed was also unexpected.

As we reach the six-month mark of the conflict, we believe it’s worth taking some time to discuss what has surprised us about the war so far, some of the key risks going forward, and the most likely outcome of the conflict. We will also touch on the lasting changes this war will cause and one important narrative that will likely lose its power. We will close with our usual look at market ramifications.

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Note: There is no accompanying Geopolitical Podcast this week.

Previous episodes are always available on our website and most podcast platforms: Apple | Spotify | Google

Asset Allocation Bi-Weekly – Storm Warning (September 6, 2022)

Posted on September 6, 2022September 5, 2022 by Amanda Ahne

by the Asset Allocation Committee | PDF

Throughout this year, there has been much talk (and confusion) about recession. Officially, the National Bureau of Economic Research is the formal arbiter of recession. This private group of economists assesses when there is a broad-based decline in economic activity and when that activity recovers. It then tells us when the recession began and when it ended. It’s important to note that it can be months after the recovery is underway that the recession is made official. The NBER isn’t making real-time calls on the business cycle. Thus, it’s never wrong, but it isn’t timely, either.

In the absence of an official designation, economists (and others) offer their insights as to whether the economy is in recession. A common rule is that two consecutive quarters of negative real GDP growth signals a recession. As rules go, it’s not a bad one as every time we have seen this measure met, a recession was usually underway. But we have also had recessions where this rule was not triggered. It’s also important to note that the historical data has been revised numerous times, and it is possible that we could see one or both negative quarters reversed. Since the beginning of the year, a parade of pundits and economists have weighed in on the topic. Our take has been that conditions are deteriorating, but we aren’t in recession…yet.

However, evidence is rapidly accumulating that a recession is on the horizon. Since the business cycle is so important to financial markets, we use a wide variety of sources to update us on business conditions, some of which are protected by copyright. Although we cannot disclose them publicly, we do note they are signaling a downturn. We also have ones we can share and others we have created ourselves. The following are a couple of useful charts.

The yield curve is considered the most reliable signal of the business cycle available. Every inversion, where short-term interest rates rise above long-term interest rates, has preceded a downturn. However, this statement does not delineate “which” yield curve should be the determining one. After all, there are numerous permutations of yield curves available. To resolve this issue, we have created an indicator that uses 10 different yield curves^[1] and counts them as they invert. Over the past 45 years, when seven curves have inverted, a recession always follows. Currently, all 10 have inverted. On average, a recession occurs in roughly 15 months with the fastest occurring in just eight months.

The following chart combines two indictors from the New York FRB and the Atlanta FRB. The former (the red line on the chart) uses the yield curve, while the latter works off GDP (the blue line). The New York FRB signals a recession with a reading greater than 40, whereas the Atlanta FRB trigger is a reading over 30. Neither is signaling a downturn at the moment, but both are quite close to a recession signal.

Our best estimate is that a recession will likely be evident by late this year or, more likely, in Q1 2023.

The chart below shows weekly Friday closes for the S&P 500. The lower line shows the index value compared to the previous peak. The variance with recessions is notable. In three of the four deep recessions, declines of around 50% occurred. In normal recessions, the declines were usually less onerous, although the 1970 and 2001 recessions had rather sizeable pullbacks. Most of the time, recessions coincide with weaker equity markets, but the degree of weakness varies.

In general, odds favor a normal recession (shown on the above chart with gray bars). Deep recessions (shown with blue bars) tend to be characterized by unusual situations. For example, the 1937 recession was caused by premature and excessively tight monetary and fiscal policy when the Fed raised rates and the Roosevelt administration tried to run fiscal surpluses. The 1973 recession had an oil and geopolitical crisis. The 1981 recession was characterized by extremely tight monetary policy to end persistent inflation, and the 2007 recession had a financial crisis. Currently, the financial markets are not expecting any of these outcomes as monetary policy is expected to pivot quickly in response to a decline in growth, inflation is expected to moderate, and no financial or geopolitical crises are anticipated. Obviously, vigilance is required, because bad recessions tend to be “black swan” sorts of events and the downside would be significant. Given current geopolitical tensions and disruptions to supply chains, there is certainly a case to be made that the expected recession has the potential to be a deep one. However, the more likely outcome is a milder downturn for equities.

With a 20% decline already recorded, there has been some discussion that a recession is already discounted. Although this outcome is possible, we think that the earlier pullback was more of a reflection of the removal of extreme stimulus. Thus, another “leg” lower when the recession arrives is more likely. Currently, we think a drop to 3500 would not be unreasonable.

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[1] Specifically, we use the 10/1, 10/2, 10/3, 10/5, 5/1, 5/2, 5/3, 3/1, 3/2, and 2/1.

Weekly Energy Update (September 1, 2022)

Posted on September 1, 2022December 13, 2022 by Amanda Ahne

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

(The Weekly Energy Update will not be published next week. The report will return on September 15.)

Crude oil prices remain under pressure on fears of a deal with Iran and weakening economic growth.

(Source: Barchart.com)

Crude oil inventories fell 3.3 mb compared to a 2.5 mb draw forecast. The SPR declined 3.1 mb, meaning the net draw was 6.4 mb.

In the details, U.S. crude oil production fell 0.2 mbpd to 12.0 mbpd. Exports fell 0.8 mbpd, while imports were unchanged. Refining activity rose 0.3% to 93.8% of capacity.

(Sources: DOE, CIM)

The above chart shows the seasonal pattern for crude oil inventories. Clearly, this year is deviating from the normal path of commercial inventory levels although the past months’ inventory changes are more consistent with seasonal behavior. We will approach the usual seasonal trough for inventories in mid-September.

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 2003. Using total stocks since 2015, fair value is $107.69.

With so many crosscurrents in the oil markets, we are beginning to see some degree of normalization. The inventory/EUR model suggests oil prices should be around $64 per barrel, so we are seeing about $24 of risk premium in the market.

Market news:

There are grave concerns about how Europe will manage energy this winter. Natural gas inventories have been rising, but it is probable that the European economy, likely in recession now, will see weaker economic activity in the coming months. However, conditions are improving and it is possible that, barring an unusually cold winter or some other crisis, the situation might be more manageable than it looked earlier this year. Some of this improvement is due to European industrial consumers making adjustments.
- However, even with an improved supply situation, consumer costs will be very high this winter. The U.K. government is warning households to expect an 80% increase in their energy bills. Europeans are facing difficult choices over home heating or eating.
- Although the focus remains on this winter, policymakers are starting to realize that disruptions will likely continue for the next several years, meaning a broader response is necessary.
- As China’s economy slumps, it has been reselling LNG to Europe. Although the EU can certainly use the gas, the concern is that this development will make the EU increasingly dependent on Beijing.
Russia has halted flows of natural gas over the Nord Stream 1 pipeline for maintenance. The shutdown is supposed to last three days, although there are worries that it could be extended. One of the issues about these periodic shutdowns is that Russia doesn’t have extensive storage networks for natural gas. We have been concerned that if Russia starts closing in wells, there could be a permanent loss of production. Apparently, Russia is avoiding this outcome by massive flaring of natural gas. In effect, Russia is simply burning the gas into the atmosphere rather than put it in the pipeline. Flaring does avoid the issue of shutdowns.
- Russia has suspended natural gas flows to the French industrial company Engie (ENGIY, $11.97) over a contract dispute.
The Canadian natural gas market is mostly isolated. Although there are pipelines that interconnect to the U.S. system, they occasionally reach capacity, leading to large discounts on Canadian natural gas. We are seeing that situation now as the chart below shows the U.S. market trading at a nearly $7.00 premium.

(Source: Bloomberg)

Canada’s energy industry is heavily dependent on pipelines to the U.S. It is facing numerous threats to close ageing pipelines which, if these blocks are successful, would “bottle up” Canadian oil and natural gas and lead to lower prices.
Canada would benefit by building out an LNG infrastructure.
We have been reporting on the negative impact of ESG on oil and gas production. We note that the state of Texas is restricting investments in firms that support ESG investing.
As natural gas prices rise, ancillary gases are seeing price hikes too. In the U.K., high natural gas prices have made ammonia prices uneconomical. Carbon dioxide is a by-product of ammonia production and now that gas is in short supply. Carbon dioxide is used by beer and soft drink makers and is used by the meatpacking industry to stun animals before slaughter. This situation shows the ripple effects caused by excessively high natural gas prices.
- Although we haven’t said much about it in this report, we are closely monitoring the intersection of energy and agriculture. Drought is hurting crop yields, but high fertilizer costs look to cause food shortages.
Elevated natural gas prices are triggering a surge in LNG infrastructure investments. In the immediate term, however, Freeport LNG has pushed back its full recovery until March 2023.
So far, the Atlantic hurricane season has been quiet, which, given the tightness of energy markets, is remarkably fortunate. This report highlights the risk from tropical storms and how it could disrupt production and LNG exports.
In Europe, data centers are stockpiling diesel fuel to power local generators in case of blackouts. Major tourist attractions have been dimming the lights to reduce costs.
Semiconductor production is remarkably energy intensive.

Geopolitical news:

One issue we have been watching closely is the political tension caused by high U.S. energy prices juxtaposed with the geopolitical goal of supplying Europe with energy. With midterms looming, the administration is clearly sensitive to domestic energy prices. The massive SPR withdrawal, which we document each week in the above data, is part of the response. However, this goal of keeping domestic energy prices low is in conflict with exporting enough energy to keep European nations “onside” with supporting Ukraine. Over the past week, we have been starting to see signs of cracking. The U.S. energy secretary is warning U.S. refiners not to increase exports to Europe, and threatening “actions” for companies that don’t comply. At this point, we don’t think the administration would ban exports, but the idea remains under consideration.
- Energy nationalism isn’t just a U.S. issue as the U.K. has threatened to cut natural gas interconnecting pipelines to the continent.
On the other hand, the Russian economy appears to be doing better than expected. Appears is a key word, because the Kremlin hasn’t been forthcoming with economic data since the war started. A report out of Yale suggests the Russian economy has been crippled by sanctions, but there has been a notable pushback against this claim. An article in The Economist suggests the Russian economy is holding up, in part, because Russia is still selling oil and natural gas. Greek tankers seem to be the conduit of much of these sales; however, when the EU enforces new insurance rules later this year, those sales may dry up. There is no doubt that sanctions have had a negative impact on Russia, but Russia’s reaction to them has also had an ill effect on the West as well.
There are reports that Israeli warplanes (F-35s) penetrated Iranian airspace. Although unconfirmed, it appears this action was designed to test Iranian radar defenses. Along with reports that the U.S. and Israel held exercises over the Red Sea to simulate an attack on Iran, this news does suggest the idea of an attack on Iran remains a possibility.
We also note that tensions between Iraqi Kurds and Iran are escalating, with the latter trying to influence governance and policy in this region of Iraq. Although the Kurds themselves are divided, they are united on the goal of controlling oil and gas flows from their region. Baghdad has never been comfortable with this arrangement, but at times has been forced to tolerate it. At present, there is no national Iraqi government in place, and so it is likely that Iran is trying to keep the Kurds from expressing their independence.
- The U.S. and Iran rarely agree on much, but there are reports Washington and Tehran are not comfortable with the lack of a government in Iraq and Muqtada al-Sadr’s behavior in preventing a new administration from forming. Tensions between Shiite groups aligned with al-Sadr and with Iran led to riots and some fatalities. At present, the rioting has ended, but tensions remain high. The crux of this issue between al-Sadr and the other Shiite groups is that Iraq has been governed, since the fall of Saddam Hussein, by a Shiite-dominated legislature that apportions power to all the various Shiite groups. Much like Lebanon, those not part of al-Sadr’s group want to keep it that way. Al-Sadr dominated the last elections and wants to control the legislature without sharing power.
Despite the report above, the U.S., EU and Iran continue to negotiate a return to the JCPOA. The U.S. has responded to Iran’s recent demands, but it isn’t clear that Tehran will accept this proposal or call for additional negotiations. Iran continues to make demands, suggesting that it isn’t in a rush to resume the pact.
- Israel has sent its defense minister to Washington along with the head of the Mossad to discuss the negotiations. Israel has opposed the pact.
- Swedish and German intelligence suggest Iran has been trying to acquire nuclear technology for weapons.
- As we noted last week, Iran has been holding crude oil, condensate, and products offshore in tankers. It is estimated that this source could rapidly add around 90 mb of oil and related products to global oil supplies. This expansion is one reason why the administration is pursing a resumption of the deal.
- It is also becoming clear that the Kingdom of Saudi Arabia is leading an effort to offset the return of Iranian crude oil by pushing for OPEC+ production cuts. This is a clear sign from the KSA of its opposition to a resumption of the agreement. The drop in oil prices at mid-week was said to be due to OPEC+ signaling no output reductions, which may be an indication that the Iran nuclear deal is stalled.
- The U.S. Navy had a confrontation with Iranian naval forces in the Persian Gulf. The Iranians apparently tried to capture a U.S. surface drone.
The sanctions on Russia have mostly removed Moscow from the dollar system. India is starting to settle trade with Russia in INR. Although this decision clearly benefits India, it isn’t obvious what Russia will do with the INR.
Fighting has intensified in Libya, which has been in a civil conflict since Qaddafi was ousted in 2011. Often when conflict rises, oil flows are adversely affected.

Alternative energy/policy news:

Renewable energy consumption is rising rapidly, with China holding the position of largest consumer.
California is banning the sale of gasoline powered internal combustion engine vehicles by 2035. If the state holds to this plan, it will likely push automakers to expand EV production.
- Last week, we noted that Texas was banning firms from conducting business with the state if they had an ESG policy that curtailed investment in fossil fuels. This appears to be a bid to sway national policy via state regulations. California does similar actions, such as what the above bullet point suggests. Given that California’s state GDP is 14.6% of U.S. GDP compared to 8.8% for Texas, businesses tend to pay closer attention to the former.
EVs remain a high-cost vehicle choice. Although there are a few lower cost options, as the chart below suggests, getting into an EV is mostly a $40k+ purchase.

(Source: Axios)

- One factor driving the price of EVs higher is the goal of giving the cars the same range as a gasoline powered vehicle. However, when “fill up” of electricity can be done daily in one’s garage, an EV with a much smaller range might be more practical for everyday use and be cheaper to make.
- We remain bullish on metals required in the conversion away from fossil fuels because it doesn’t appear that the demand is impossible to fill. At the same time, miners continue to find that local opposition is delaying the building of new mines for the materials required for batteries.

Where are the hurricanes? So far, this has been a remarkably quiet Atlantic hurricane season. Strong wind shear in the Caribbean has dissipated tropical waves and there haven’t been a lot of squalls coming from Africa. It’s still too early to declare an “all clear” as the usual peak is around September 10, but, given the tightness of the energy markets, a slow hurricane season is a bit of good fortune.
The Western U.S. is facing a hot week.
China has seen some rain which has eased drought conditions, but energy conditions remain fraught. China has persistent water issues that appear to be worsening. The drought is leading to greater coal use.
Mexico announced the opening of a state-owned lithium miner.
Nuclear power is making a comeback. We noted recently that Japan is reopening reactors closed after the Fukushima incident. Germany is reconsidering its decision to end nuclear power. So is California. Although strong opposition will likely continue, nuclear offers carbon-free baseload electricity which is attractive.
One response to climate concerns is geoengineering. Geoengineering is the process of using engineering interventions to cool the planet, reduce carbon in the atmosphere, adjust rainfall, etc. These interventions are highly controversial because, in theory, they could change weather patterns that could disadvantage some areas of the world while supporting others. They could also have unanticipated side effects. Also, given that geoengineering could be introduced by private actors, there is grave concern about how to control the process. At the same time, we are already seeing efforts by nations in the Middle East to change rainfall patterns through cloud seeding and other techniques.
- Major oil companies are making further investments into carbon capture.
Coal is a dirty fuel in more than one way since not only is it the most carbon intensive of fossil fuels, but it also creates water pollution and solid waste. These wastes often are laced with heavy metals. However, researchers are taking that waste and are working to extract these metals for the potential use in batteries.
The Danish energy minister is calling for the streamlining of permits for wind farms. We note that permitting issues were a key part of the Inflation Reduction Act.
“Smart glass” a product that adjusts to light in a way to increase the efficiency of HVAC units in buildings, is expected to expand due to a provision in the Inflation Reduction Act.
China is expected to continue to dominate the solar panel industry. However, the emergence of U.S. industrial policy is expected to see the U.S. increase solar equipment manufacturing.

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Bi-Weekly Geopolitical Report – Agricultural Commodities in the Evolving Geopolitical Blocs (August 29, 2022)

Posted on August 29, 2022August 29, 2022 by Amanda Ahne

by Patrick Fearon-Hernandez, CFA | PDF

As regular readers of this report will know, Confluence has long predicted that as the United States steps back from its traditional role as global hegemon, the world will become much less globalized and countries will coalesce into at least two rival geopolitical and economic blocs—one led by the U.S. and one led by China. In our report from May 9, 2022, we described the results of our recent study that aimed to predict which countries will end up in each of the evolving blocs. Following that, in our report from June 6, 2022, we showed how key mineral commodities are unevenly distributed among the evolving blocs, and what that might mean for geopolitics and investment strategy.

In this report, we dive even deeper into the differences between the evolving blocs by looking closely at the international trade in key agricultural commodities within and between the groups. We explore what those differences and relationships might mean for geopolitics going forward, especially regarding the rivalry between the U.S. and China. We conclude with a discussion of the implications for investors.

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Don’t miss the accompanying Geopolitical Podcast, available on our website and most podcast platforms: Apple | Spotify | Google

Business Cycle Report (August 25, 2022)

Posted on August 25, 2022August 24, 2022 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 declined for the third consecutive month. The latest report showed that seven out of 11 benchmarks are in expansion territory. The diffusion index declined from +0.6364 to +0.3939 but remains above the recession signal of +0.2500.

Poor economic data weighed on financial market indicators
Goods production slowed due to a labor shortage and a decrease in business sentiment.
Labor conditions remain strong but show signs of softening.

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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Weekly Energy Update (August 25, 2022)

Posted on August 25, 2022December 13, 2022 by Amanda Ahne

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

Crude oil prices remain under pressure on fears of a deal with Iran and weakening economic growth.

(Source: Barchart.com)

Crude oil inventories fell 3.3 mb compared to a 2.5 mb draw forecast. The SPR declined 8.1 mb, meaning the net draw was 11.4 mb.

In the details, U.S. crude oil production fell 0.2 mbpd to 12.0 mbpd. Exports fell 0.8 mbpd, while imports were unchanged. Refining activity rose 0.3% to 93.8% of capacity.

(Sources: DOE, CIM)

The above chart shows the seasonal pattern for crude oil inventories. Clearly, this year is deviating from the normal path of commercial inventory levels although the past two weeks are consistent with seasonal behavior. We will approach the usual seasonal trough for inventories in mid-September.

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 2003. Using total stocks since 2015, fair value is $106.51.

Market news:

In a surprise move, OPEC+ is apparently mulling production cuts in response to weaker prices and an apparent “disconnect” between the physical and futures markets.
The Freeport LNG plant, which suffered a fire earlier this year, will be at 85% of capacity by late November and full capacity by March 2023. This restart is later and less than expected, leading to a decline in U.S. natural gas prices.
The courts giveth and taketh away. An appellate court ruled against the Biden administration’s pause on oil and gas leases on Federal lands. However, it isn’t clear if this ruling will lead to immediate new activity. On the other hand, another court ruled oil companies can be held accountable for the impact of climate change.
- We note that U.S. energy capital spending remains restrained.

(Source: Strategas)

Russia announced a three-day closure of the Nord Stream 1 pipeline in late August. By itself, this isn’t a huge issue, but with natural gas supplies tight, the fear is that the three day closure will be extended.
- There are rumors that German industry has stopped hedging natural gas for future purchases. This may suggest that (a) the costs of hedging have become prohibitive or (b) they intend to simply buy in the spot market and if the price is too high, they will stop buying. In any case, if true, it would suggest the potential for a near halt of German industrial activity.
- The primary link of European natural gas prices to the U.S. is through LNG and the earlier-mentioned Freeport news does dampen U.S. prices a bit. Still, American exports are lifting the price of U.S. natural gas. There is a risk of political blowback.
Santos Limited (STO, AUD, 7.52), an Australian oil company, announced a new project in Alaska.
The EU is ramping up oil imports from Russia in advance of the December 5 ban.
Canada and the EU are discussing future natural gas trade, with Canada building out LNG capacity on the Atlantic Coast for export to Europe. Although this idea might improve Europe’s natural gas situation in the long-term, it will probably not help the immediate need.
Maximizing shareholder value isn’t just a U.S. energy company position as Saudi Aramco (2222, SAR, 39.50) is doing something similar.
Norway is warning Germany it may be near its natural gas export capacity and won’t be able to increase supplies to the continent indefinitely.
Colombia’s new president has announced new taxes on the oil industry.
The Ukraine War has led the U.S. to increase oil exports to Europe.
Higher energy prices are becoming a major burden to U.K. households.
Aluminum is sometimes referred to as “molten electricity.” High electricity prices have led to a sharp drop in European aluminum output.
High natural gas prices along with higher mining costs have sent fertilizer prices soaring. The cost of fertilizer is exacerbating food shortages in Africa.
Despite talk about reducing carbon emissions, China is increasing investment in fossil fuel production.
Even with a concerted effort to reduce oil usage in transportation, the expansion of plastic use will underpin demand for oil.

Geopolitical news:

Iran continues to add conditions to the most recent “final offer” from the EU to bring Tehran back to the nuclear deal. Despite these conditions to a final offer, Tehran is blaming the U.S. for the lack of progress on a deal. As we noted last week, the market expects a jump in supplies if a deal is made, but we are not convinced. Sanctions regimes tend to deteriorate over time and reports suggest that Iranian oil is “leaking” into the market already.
- There are reports that the U.S. is “reassuring” Israel that resuming the nuclear deal won’t increase risks to the region.
- At the same time, the JCPOA is not popular in Congress on either side of the aisle. The administration is taking a chance that returning to the agreement will significantly lift oil supplies.
- Russia has been improving relations with Iran, and there is a risk that they could use Iran as a conduit to avoid sanctions.
Recently, we have been reporting on political divisions in Iraq. The political tensions could very well undermine Iran’s influence on the country.
Although the Gulf states, Israel, and perhaps Turkey are aligning against Iran, we do note that the Gulf nations are also cautiously opening diplomatic channels to Tehran. If the U.S. reduces its influence in the region, some degree of cooperation may be necessary. As the U.S. moves its emphasis elsewhere, Russia is attempting to fill the void.
Klaus Ernst, a Bundestag member from The Left party, is calling for “negotiations” with Russia not only to increase natural gas supplies but to open Nord Stream 2. The Left is not in the government and cooperating with Russia isn’t the policy of the current administration. However, his comments raise concerns that support for sanctions against Russia may be under pressure.
There is an interesting geopolitical ‘tug-of-war’ occurring between China and Russia over the Central Asian nations. Russia sees these nations as part of its sphere of influence whereas China wants them to feel free to export raw materials (include oil and natural gas) without concern over Moscow’s position. We note that there has been a suspension of oil loadings on the Caspian pipeline system, which may or may not be due to Russian interference.
Mexico’s President Andrés Manuel López Obrador is taking steps not just to intervene in the oil industry but also to undermine efforts to diversify with renewables. His policy of resource nationalism may not lead to more oil production (it isn’t clear the state oil company can do this without foreign assistance) but could lead to less overall energy supply.
There are reports that China is expanding its capacity to smuggle oil through tanker transfers in the open ocean. The U.S. is increasing efforts to tighten sanctions on Russia.
Poland banned Russian coal imports and is now scrambling to build stockpiles.

Alternative energy/policy news:

We continue to closely monitor drought, water levels, and temperatures around the world.
- In China, a tributary of the Yangtze River has run dry. Hot temperatures in China are boosting coal usage. Sichuan province has shut down all industrial activity for five days due to shortages of electricity. The province is increasing its consumption of coal for electricity, but that hasn’t been enough yet to overcome the drought and the loss of hydropower. Silicon production has been affected by the power outages. The Shanghai Bund light show has been cancelled due to electricity shortages and EV owners are finding supplies tight. Here are some pictures of China’s drought.
- In Europe, hot weather and low water levels have reduced hydropower from Norway, reduced nuclear power output, and cut coal shipments. Although the Rhine River levels have improved modestly recently, the chart below shows current levels relative to history.

(Source: Adam Tooze)

High temperatures, unexpected flooding, and other weather events are contributing to inflation. The weather has interrupted shipping, damaged crops, and reduced productivity. Adding to worries is that, so far, the Atlantic hurricane season has been quiet, but history shows that tropical storm activity tends to rise into mid-September.
One of our observations is that we live in a multi-variant world but create univariate narratives. Thus, that the current drought and heat are solely caused by greenhouse gases is a common theme. Clearly, this isn’t the sole cause otherwise how does one explain earlier drought periods when greenhouse gases were much less prevalent? This isn’t to say that greenhouse gases don’t matter as there is solid evidence that they do have an impact, but the current crisis is likely affected by other factors as well.
The Inflation Reduction Act has funding for carbon capture projects.
The SEC is proposing broad greenhouse gas rules for publicly traded companies. In their current form they would impose these rules on Europe as well.
Although there are numerous Gigafactory projects in Europe, nearly all of them are facing serious delays.
Lithium is the current state of the art for batteries, but research on other battery chemical mixes continues and there is growing evidence that sodium solid state batteries may prove to be a much better alternative. Not only is sodium plentiful and inexpensive, but the battery should last longer and charge much faster. However, the battery probably wouldn’t be used initially in transportation since salt is heavy, but could be used in industrial settings and for utilities. As the science improves, we could see this later used in transportation.
Although Australia and Chile dominate lithium mining, China dominates processing of the metal.
Will Germany close its remaining nuclear plants? The economics ministry says they will close on schedule, but there is a rising call to keep them running. Meanwhile, in the U.S., utilities with nuclear facilities are seeing better performance. Japan is turning the reactors back on to offset the risk of fewer LNG supplies.
The gas emissions from farming have become major news in Europe. The Netherlands is implementing nitrogen restrictions on dairy farming that will end up reducing milk supplies and put farmers out of business. We are seeing a strong negative reaction. A similar plan in Canada is also upsetting farmers.
Ford (F, $15.31) announced a workforce restructuring to shift toward EV production.
Greenland is drawing new attention for sourcing rare earths. European automakers are increasing their focus on Canada as a source for battery metals.

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Asset Allocation Bi-Weekly – The Inflation Surprise (August 22, 2022)

Posted on August 22, 2022August 17, 2022 by Amanda Ahne

by the Asset Allocation Committee | PDF

July inflation came in below expectations. On a yearly basis, the market expected an overall rate of 8.7%, while the actual reading was 8.5%. For core CPI, the actual was 5.9% compared to expectations of 6.1%. Perhaps the most bullish part of the report was the monthly change, where the overall rate was unchanged compared to June and the core rose by 0.3% compared to expectations of a 0.5% rise. This was the first monthly reading for the overall rate that was zero or less since May 2020.

The reaction of financial markets was swift and bullish. The S&P 500 rose over 2% on Wednesday, August 10. The dollar fell, commodities mostly rose, and the short end of the yield curve rallied. Why the strong reaction? The July data was the first time in months we have seen a modest rise in inflation and there is hope that we may be past “peak inflation.” This hope may be fulfilled. It’s clear the U.S. economy is slowing and there is evidence that supply chains are slowly improving.

Is this optimism justified? Although the news on inflation was positive, comparing the policy rate relative to CPI and unemployment suggests the FOMC still has a long way to go before achieving a neutral rate.

In the above chart, the independent variable is CPI less the unemployment rate. The blue line shows the difference from the model’s estimation of what the policy rate should be based on the difference between CPI and unemployment. Since 1957, the Federal Reserve has never conducted a policy this easy. Although recent tightening has somewhat narrowed the gap, the FOMC needs to see either a rise in unemployment or a sharp drop in inflation.

Financial markets, in contrast, are anticipating an end to this tightening cycle. Comparing the implied interest rate from the Eurodollar futures market, two years into the future, suggests the Fed will be easing in the coming months.

Eurodollar futures are already projecting a lower rate over the next two years. We have not reached the extremes of earlier tightening cycles, but another rate hike of 50 bps will push the deviation into easing territory.

So, why the difference in the two models? The financial markets are anticipating a change in economic conditions, either falling inflation, rising unemployment, or both. Why? In part, it’s because the financial markets are anticipating recessionary conditions. For example, the yield curve has inverted. The chart below depicts a study that looks at 10 different Treasury yield curves. History shows that when more than six of these curves invert, a recession occurs, on average, in 15 months. In July, eight of the curves inverted. As an aside, note that it is common for these curves to steepen after the inversion but before the recession develops. One should not take any comfort in fewer yield curves inverting once we exceed six.

What is unknown is how fast inflation will fall or unemployment will rise. Our concern is that the financial markets are anticipating a rapid adjustment in the first chart’s indicator that may not be borne out by the data. If that outcome occurs, the FOMC may tighten more than the market expects and maintain that tightness longer than anticipated. That outcome would likely be negative for equities, but for now, hopes of falling inflation and an easing response from policymakers have lifted risk assets. If this positive outcome fails to materialize, a downturn in risk assets is likely.

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