Asset Allocation Quarterly (Fourth Quarter 2017)

Posted on October 24, 2017January 2, 2018 by Rebekah Stovall

Our inflation outlook remains benign and economic data continues to be modestly positive.
We do not anticipate a recession in the near term.
Though the composition of the Fed will change over the next four months, we expect policy to continue toward tightening through increases in the fed funds rate and a reduction in the size of the Fed’s balance sheet.
The larger allocation to intermediate-term investment grade bonds remains intact. However, we reduce exposure to speculative grade bonds due to spreads grinding to their tightest post-recession levels.
Our growth/value even weight of 50/50 remains unchanged.
We increase our exposure to non-U.S. developed and emerging market equities, the former with a tilt toward Europe, due to expectations for continued U.S. dollar softness and attractive valuations overseas.

ECONOMIC VIEWPOINTS

There are a number of potential pending changes to the policy and complexion of the U.S. Federal Reserve as of this writing. First, there are currently three, and soon to be four, open positions on the Board of Governors, the most important of which is the Fed chair. Though we are not expecting a dramatic near-term shift in the trajectory the current Fed has taken, the new arrangement could alter its policies as it is absorbed over the next few quarters. Second, the process of normalizing the nearly $4.5 trillion balance sheet is expected to commence in October as the Fed begins to slowly stop reinvesting the proceeds it receives from maturing bonds. Though the Fed stated it will start with a reduction of just $10 billion a month, over the next year the Fed’s current intention is to increase the amount to $50 billion each month. As this chart illustrates, a level of $50 billion each month will soon have the effect of shrinking the balance sheet.

With the recent publication of the Fed’s minutes from the September meeting, the near-term trajectory seems fairly certain with expectations for another hike in the fed funds rate in December already priced into the market. Fed fund futures currently have an implied 80% probability of a December rate hike. However, the prospect for increases in the rate through 2018 as well as further implementation of quantitative tightening through the reduction in the balance sheet are dependent upon the composition of the Fed’s board. Given the Trump administration’s desire to strike a more populist appeal, it would not be surprising if the Fed adopts a more dovish posture in 2018. Such a pose would imply an extension of softness for the U.S. dollar versus other currencies.

Regarding other domestic economic themes, inflation and unemployment remain at low levels, while consumer and business sentiment are elevated. Although the effects of the disastrous hurricane season and wildfires in northern California will likely weigh on GDP and employment over the next several quarters, we believe the dislocations will prove temporary.

Outside the U.S., the European Central Bank (ECB) announced its intention to begin tapering the amount of its bond purchase program, but also indicated it would be extended further by nine months. We view this as the ECB maintaining its accommodative positioning while recognizing the strength in the underlying economy. It also underscores the ECB’s caution toward the myriad political developments in Europe, including Brexit, German and Austrian election results, the separatist movement in Spain and Italian elections in early 2018. The consequent economic impact holds a large degree of uncertainty, leading the ECB to lengthen its stimulus timeline.

In the realm of geopolitics, though concerns attract headlines, we do not think the current issues hold meaningful implications for asset prices. Naturally, the prospect of armed conflicts with North Korea and/or Iran, or a complete revision of NAFTA, would have tremendous economic impact, but at this stage we do not find reason to be less than sanguine. Accordingly, our allocation of assets among each of the strategies currently reflects an accommodation of risk.

STOCK MARKET OUTLOOK

The benign inflationary environment has been a positive backdrop for equity valuations and our expectations are that it should remain favorable. Though this year’s equity market advances thus far have been stronger than many experts expected, we remain positive on the outlook for equities over the forecast period absent an exogenous event or a surprising change in inflation expectations. While we recognize that equity pricing, particularly in large caps, remains close to historical highs as measured by traditional valuation metrics of Price/Earnings, Price/Book and Price/Cash Flow, we remain optimistic over the near term. Moreover, we harbor some concerns that equity markets could exhibit a “melt up” over the next 1-2 years as investors who have remained on the sidelines since the beginning of this bull market capitulate and put their excess cash to work, thereby fueling demand for equities and inflating prices further.

As we recently published in our Asset Allocation Weekly (10/13/17), the parameters surrounding long-term S&P 500 trends remain supportive. Although a recession or geopolitical event would carry consequent risk to equity prices, the regression trend lines on the accompanying charts indicate that the S&P 500 is trading within one-half standard error of the 6% average yearly trend. For context, the top chart displays log-transformed weekly Friday closes of index data since 1929, while the lower chart shows a more recent period beginning in 1990. The same regression trend lines are used on both charts.

The Confluence Asset Allocation Committee recognizes that the U.S. economy is well advanced in terms of the economic cycle. In fact, the end of October will mark the 100th month for the current economic expansion, making this the third longest on record. However, economic conditions and associated market values fail to conform to the rigor of a calendar. We remain cognizant of the length of the expansion and are wary of the potential of a slowdown in economic growth over the forecast period. Nevertheless, as equity markets continue to advance, the Confluence Cyclical Asset Allocation strategies retain their historically high allocations to equities, inclusive of non-U.S. equities. It should be noted that this quarter’s rebalance further increases non-U.S. equity exposure, owing to the committee’s prevailing view that there is a likelihood of continued softness in the U.S. dollar coupled with favorable non-U.S. equity valuation metrics as compared to U.S. counterparts.

Within U.S. large caps, we favor energy, health care, industrials and materials and underweight telecom, utilities and consumer staples. We maintain a neutral growth/value style bias.

BOND MARKET OUTLOOK

Despite the Fed’s decision to leave the fed funds rate unchanged at its September meeting, the probability for a 0.25% hike in December has increased. Over the forecast period, we envision the terminal rate of fed funds to be between 1.75% and 2.50%, with the differential dependent upon the make-up of the Fed’s Board of Governors and overall economic conditions. Given these expectations, there is the increased likelihood of a continued flattening of the Treasury yield curve due to tighter monetary conditions. Among corporate bonds, spreads for both investment grade and speculative grade bonds versus maturity equivalent Treasuries have tightened to post-recession lows.

Considering current conditions and expectations, we lengthen the overall duration slightly, though with an increase in Treasury exposure and a continued concentration in the intermediate segment of the yield curve. In addition, we decrease the overall exposure to speculative grade bonds, a position we find appropriate given tighter spreads and as the Fed embarks upon normalizing its balance sheet.

OTHER MARKETS

Similar to last quarter, we determined that commodities do not hold near-term appeal. Commodities can be helpful to a diversified portfolio in an environment of faster economic growth and/or a surge in inflation expectations; however, as these conditions remain absent, commodities are not currently represented in the strategies.

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Daily Comment (October 24, 2017)

Posted on October 24, 2017December 13, 2017 by Rebekah Stovall

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Here is a recap of what we are watching this morning:

Xi elevated: Although the news is rather obscure to Western eyes, “Xi Jinping Thought on Socialism with Chinese Characteristics for a New Era” was added to the Chinese constitution today. Such thoughts, such as Jiang Zemin’s “Three Represents” or Deng’s “Theory on Socialism with Chinese Characteristics,” are also part of the constitution. For the first time since Mao, such theories have been added to the constitution for a sitting general secretary. Essentially, this elevates Xi to the same level as Mao in terms of leadership status. Deng Xiaoping wanted to ensure that China would never have to deal with a cult of personality like Mao had created and thus built a consensus leadership structure that elevated the Standing Committee of the Politburo to the leadership of the Communist Party of China (CPC) and the general secretary was primus inter pares (first among equals). This pronouncement about Xi suggests that the Deng era is now over. As we noted yesterday, Xi’s speech jettisoned Deng’s concept of a quiet rise of China; instead, Xi is now signaling that China intends to act as a major power on the world stage. How this actually plays out will be something to watch. History isn’t encouraging.[1] We will get the Standing Committee announcement around 11:45 EDT. However, with this announcement, it doesn’t really matter who is on the committee. We don’t expect a successor to be established and our operating assumption is that Xi will remain general secretary until late next decade, although he will legally be required to give up the president title.

EU labor rule change: Currently, within the EU, a worker from a poorer part of the union can take a job in a richer part but accept less pay than the prevailing wage in the richer nation. These are known as “posted jobs.” Posted jobs give “imported” labor an advantage in the richer parts of Europe. The issue has divided the EU. Not surprisingly, the richer nations, led by France, want to cap the time a posted worker can accept lower pay to 18 months. Transportation would not be part of the agreement. Needless to say, the EU’s periphery nations aren’t happy about the proposed changes, while the core of the EU (Germany, Netherlands, France) support them. Meanwhile, Hungary’s PM Viktor Orban praised Central Europe as a “migrant-free zone.”

Merkel and the U.K.: We noted last week that Chancellor Merkel seemed to turn dovish on Brexit. Germany apparently has discovered that it runs a large trade surplus with the U.K.; some €50.4 bn last year, or about 1.6% of Germany’s GDP. This is the largest bilateral surplus with any other nation, even exceeding the U.S. Merkel seemingly wants to avoid a sudden shock of disrupting trade flows. In addition, because of the CDU/CSU’s lackluster showing in the last elections, Merkel will be forced to engage in fiscal spending or tax cuts to gain coalition partners. Thus, Germany will be less able to spend on EU goals and thus can’t easily fill a gap if the U.K. decides to stop paying its EU contributions. Consequently, Merkel has decided that if the U.K. will pay a fair share of its EU obligations then she will give May some slack in trade negotiations. As a side note, coalition-building fiscal spending will tend to turn the ECB hawkish sooner than it otherwise would have and thus is EUR bullish.

Differences in vision: Over the past week, we have seen two ex-presidents offer thinly veiled criticisms of the current president. The criticism was fairly wide-ranging but included the foreign policy of this president, which can be both interventionist and isolationist at the same time. As we have discussed before, the Trump policy model is Jacksonian.[2] Jacksonians shun the global policing role of a superpower. They only go to war when honor is besmirched or when an existential threat to the homeland develops. Yesterday, at the Hudson Institute, Gen. David Petraeus and Steve Bannon offered dueling visions of American foreign policy. At heart, however, is a key difference of opinion on policy—Petraeus is defending the traditional superpower role while Bannon is wanting to jettison those burdens. We suspect Bannon’s position is becoming increasingly dominant.[3]

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[1] https://www.amazon.com/Destined-War-America-Escape-Thucydidess-ebook/dp/B01IAS9FZY

[2] https://www.confluenceinvestment.com/weekly-geopolitical-report-april-4-2016/ and https://www.confluenceinvestment.com/weekly-geopolitical-report-president-trump-preliminary-analysis-november-14-2016/

[3] https://s2.washingtonpost.com/camp-rw/?e=Ym9ncmFkeUBjb25mbHVlbmNlaW0uY29t&s=59ef2311fe1ff6159ed3f073

Weekly Geopolitical Report – North Korea and China: A Difficult History, Part II (October 23, 2017)

Posted on October 23, 2017December 13, 2017 by Rebekah Stovall

by Bill O’Grady

Last week, we examined the Minsaengdan Incident and the onset of the Korean War. This week, we will discuss the final phase of the Korean War, the ceasefire, the introduction of Juche and the impact of the Cultural Revolution.

The Korean War: The Latter Stages of the War and the Ceasefire
Among the issues that caused tensions between China and Korea was the management of the railroads during the war. Chinese troops encountered difficulties when using roads to supply their forces. The roads were not in good shape and their war materials were vulnerable to American air attacks. Given that most of the rolling stock and crews were Chinese, Chinese Volunteer Army (CVA) Commander Peng Dehuai wanted to gain control over the railroads to deliver war materials. However, Kim Il-sung didn’t want China to take over North Korea’s rail system for two reasons. First, the regime was trying to start reconstruction and didn’t want to divert rolling stock for war materials, and second, Kim was offended by the loss of sovereignty. Nevertheless, China and the U.S.S.R. coerced the North Koreans into giving up control of their railways to China for the duration of the war.

The final indignity the Kim government had to face was the ceasefire determination. Stalin and Mao wanted to keep the war going. Both wanted to keep the U.S. occupied with the fighting in Korea as this would reduce America’s ability to defend other parts of the world. In addition, Mao was receiving military aid from the Soviets and feared that the war’s end would end the flow of aid. On the other hand, Kim wanted a ceasefire. His country was being steadily bombed by the U.S. and North Korea couldn’t really begin reconstruction without an end to hostilities.

A second issue involved prisoners of war (POWs). Chinese troops didn’t aggressively capture POWs. Their military experience was mostly derived in the Chinese Civil War where they didn’t pursue POWs and they continued that behavior during the Korean War. On the other hand, the Korean People’s Army (KPA) tried to capture as many prisoners as they could with the idea that they would be used as forced labor for reconstruction.[1] Thus, the sides couldn’t agree on how to resolve the return of POWs; it wasn’t important for China, but it was critical for the Democratic People’s Republic of Korea (DPRK).

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[1] Zhihua, S. (2004.) Sino-North Korean Conflict and its Resolution during the Korean War. Cold War International History Project Bulletin, Winter/Spring (Issue 14/15), page 20.

Daily Comment (October 23, 2017)

Posted on October 23, 2017December 13, 2017 by Rebekah Stovall

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] There was (and is) lots of news. Let’s dig in:

Abe in a landslide: PM Abe’s gamble to call early elections looks like a winner. The LDP and the rest of Abe’s ruling coalition will take 313 seats, giving him a “supermajority” of more than 310 seats, which is the level that will allow him to make changes to the constitution. Japanese equities rose on the news and the JPY declined modestly (it has been weaker on expectations that Abe would prevail and thus Abenomics would continue). However, on the economic front, we don’t see much more from Abenomics. The “three arrows” were really all about a weaker JPY; that has been achieved and it’s probably not possible to weaken the currency much further without prompting a negative reaction from Washington. BOJ Governor Kuroda will probably get reappointed. We look for Abe’s focus to shift toward adjusting the constitution to allow Japan to project military power. As U.S. isolationism develops, this is a necessary step to deal with a growing Chinese threat.

Xi and the Party Congress: Today, we expect Chairman Xi to reveal the new members of the Standing Committee of the Politburo, the most powerful body in China. But, for now, the real story is that Xi is ending Deng’s foreign policy. The PRC’s foreign policy has evolved, starting with Mao, who was essentially isolationist. He turned the nation inward to stabilize the persistent tensions between the insular interior and the cosmopolitan coasts. This led to unity and income equality with weak economic growth. Deng allowed the coasts to flourish to lift the economy at the expense of regional divergence and rising income inequality. Deng called for China to avoid projecting power globally to allow for uninterrupted economic development. Because the economic development was based on export promotion, workable relations with the U.S. were imperative. The 2008 Great Financial Crisis and uncertainty about the U.S. role in the world has led Chinese leaders to sense a vacuum, and Xi has indicated over this Congress that he wants China to fill it. China is facing the problems of the late stages of a “high growth/low cost nation,” which are unbalanced development (too much productive capacity with inadequate household share of GDP) and too much debt. Xi is making it clear he intends to follow imperialism to resolve this problem, the paths the British and the Dutch took when they faced this point in their development. The problem for China is that it doesn’t have the military power to pull this off; thus, it must try to develop economic colonies under the protection of the U.S. military. When Japan faced this issue in the 1930s, it invaded China and eventually bombed Pearl Harbor.[1] An assertive China is going to be a growing problem for global stability.

Spain: PM Rajoy appears poised to take direct control of Catalonia. If the current provincial leadership declares independence, they may all end up in jail. Rajoy has the state apparatus to take control; what he doesn’t have is the political legitimacy to enforce his will. In other words, he will find that it’s one thing to establish control but it’s another to maintain it. Rajoy will face overt and covert opposition to taking away Catalan autonomy and disruption will prove to be costly given that the province represents 20% of Spain’s GDP.

Another populist win: As we noted last week, the Czech Republic has elected a populist slate of candidates, with the Ano Party winning nearly 30% of the vote, almost 20 points higher than the closest rival. The Social Democrats, the center-left, saw their support collapse from 20.5% to 7.3%. It should be noted that the next largest parties in this vote lean Euro-skeptic, suggesting that the EU is becoming rather unpopular. Along with recent elections in Austria and the rise of the AfD in Germany, we are seeing a nationalist, anti-immigrant surge in Europe. Meanwhile, we note that Lombardy and Veneto, regions in Italy, have voted for more autonomy from Rome. Although neither are pushing for independence, Europe appears to be moving away from centralization, which has been the primary trend in Europe since WWII.

Iran: SOS Tillerson has warned European firms that doing business with Iran might be risky as new U.S. sanctions are being considered.[2] This move by the Trump administration comes with evidence that the Iranian government has used the removal of sanctions to undermine the economic power of the Iranian Republican Guard Corps (IRGC).[3] During sanctions, the IRGC took over large swaths of the economy to maintain growth and evade sanctions. This allowed the IRGC to develop power independently of the clerical government. President Rouhani and the Ayatollah Khamenei have been trying to weaken the IRGC’s economic power to prevent them from becoming a political threat. If the Trump administration puts sanctions back in place, Iran will have no recourse other than to allow the IRGC to resume its activities.

Jimmy to the rescue? In a curious op-ed in the NYT, Maureen Dowd interviewed former President Jimmy Carter. The interview was wide-ranging but a couple of items stick out. First, the former president would be willing to help negotiate with the North Koreans. He is credited with the 1994 Agreed Framework, which diffused a crisis over North Korea’s nuclear program, although we now know Pyongyang simply moved to another method to attain a nuclear weapon. Still, Carter did likely prevent a war on the peninsula. Essentially, it appears Carter is sending a signal to the Trump administration that he is available. We note Carter said some rather flattering things about the president and also that he didn’t vote for Mrs. Clinton during the primary (he voted for Sen. Sanders). Second, there is a clear element of animosity in his tone toward the Clintons and Obama. We are not sure what exactly is going on there but Carter may be one to watch. Trump likes unconventional “out of the box” surprises. Nothing would be closer to an unexpected outcome than sending Carter to North Korea. This is happening as we are hearing reports that the U.S. is considering the involuntary call-up of reserve pilots.[4]

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[1] https://www.youtube.com/watch?v=yKHUGvde7KU

[2] https://www.nytimes.com/2017/10/22/world/middleeast/tillerson-iran-europe.html?emc=edit_mbe_20171023&nl=morning-briefing-europe&nlid=5677267&te=1

[3] https://www.nytimes.com/2017/10/21/world/middleeast/iran-revolutionary-guards.html

[4] http://www.foxnews.com/politics/2017/10/21/air-force-could-recall-up-to-1000-retired-pilots-after-trump-order.html?utm_source=Sailthru&utm_medium=email&utm_campaign=New%20Campaign&utm_term=%2ASituation%20Report and http://www.defenseone.com/threats/2017/10/exclusive-us-preparing-put-nuclear-bombers-back-24-hour-alert/141957/?utm_source=Sailthru&utm_medium=email&utm_campaign=New%20Campaign&utm_term=%2ASituation%20Report

Asset Allocation Weekly (October 20, 2017)

Posted on October 20, 2017October 19, 2017 by Rebekah Stovall

by Asset Allocation Committee

The Financial Accounts of the United States (formerly known as the Flow of Funds Report) is published by the Federal Reserve and provides data on the level of financial assets and liabilities by sector. Using this data, we can approximate the average asset allocation of American households over different periods. This accounting of assets is broad; for example, the equity portion includes equities held in defined benefit plans and insurance policies. In addition, the Federal Reserve includes non-profits in its data. In our view, non-profits are not material to the overall calculations.

The data goes back to the 1950s. On average, 50% of household assets are held in some sort of fixed income, while equity assets average 16% and non-financial assets average 34%. A casual observation of the data suggests that allocations to fixed income and non-financial assets (likely housing) are favored during periods of high levels of inflation and elevated nominal interest rates. On the other hand, equity allocations are higher during periods of low inflation and low nominal interest rates. The allocation to non-financial assets rose sharply after 2000 as part of the housing bubble. After the Great Financial Crisis, non-financial asset holdings declined; initially, fixed income rose and equities fell, but since 2010, that trend has steadily reversed as equities have taken a large share of assets.

Some of the gains in the various asset classes have come from price appreciation and other parts from reallocation of assets. It isn’t completely obvious how much is coming from which part, although in future reports we will examine this issue more fully. However, the chart does suggest that equities have benefited from being “the only game in town.” Historically low interest rates and the aftermath of the housing crisis have undermined allocations to fixed income and housing. Historical patterns suggest that allocations to fixed income don’t increase until 10-year Treasury rates exceed 6%.

This chart shows a scatterplot of the percentage of total assets held in fixed income and the 10-year T-note yield. We have plotted a nearest neighbor fit study to the data. We have seen high fixed income levels along with low rates (shown in the circle), but these mostly occurred during the Great Financial Crisis. Although the current level of fixed income is low (shown by the arrow), a consistent rise above 50% generally has been seen with interest rates in excess of 6%. Thus, history suggests that it would take a more significant rise in interest rates to trigger a flight to fixed income.

Of course, recessions or geopolitical events could trigger a move out of equities. At 25%, the current allocation to equities is elevated. This level is similar to where it was in Q3 1999 and not far from the peak of 27% in Q1 2000. At the same time, the liquidity does need another place to go. After the 2000 tech crash, the primary beneficiary was housing. We don’t expect that pattern to repeat itself. Thus, without an event to scare households out of equities or a sizeable rise in interest rates, equities should maintain their favored status for the time being.

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Daily Comment (October 20, 2017)

Posted on October 20, 2017December 13, 2017 by Rebekah Stovall

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Risk-on returned to the financial markets this morning, with the dollar and equities higher and Treasuries and gold lower. The possibility that John Taylor could be the next Fed chair along with hopes of tax reform are boosting risk assets this morning.

Chair talk: There are a series of dueling stories in the media this morning on who the president will select for the Fed chair position. The current conventional wisdom suggests that Powell is the front-runner, while John Taylor is running second. Below is the latest on the topic from PredictIt, the decision-betting site.

Warsh was the front-runner until about two weeks ago; since then, his star has fallen rather quickly. Powell makes sense as a chair. He favors deregulation and is considered a moderate on policy. However, he does not fit the “shake things up” framework of the president, so a surprise is possible.

Here is the history of the target and the Taylor Rule, calculated using core PCE:

There has been an interesting trend in the relationship of the rule to the policy rate. From 1983 to 2000, the policy rate target exceeded the Taylor Rule by an average of 178 bps. Since 2000, it has averaged -136 bps. The current Taylor Rule rate would be 3.25%, roughly the level of the Mankiw Rule using involuntary part-time employment. Greenspan mostly exceeded the Taylor Rule rate until the 2000 tech crash. He and Bernanke clearly lagged the rule rate during the last tightening cycle. Note that the FOMC moved much more quickly to lower rates during the last recession than did the Taylor Rule. In fact, it’s rather clear the FOMC performed better than the Taylor Rule during the downturn by acting faster to cut rates, recognizing the gravity of the situation. If one reads the meeting transcripts from 2008, there was a growing call to raise rates in August 2008. We suspect the Taylor Rule was one of the reasons why some hawks were leaning in that direction. In hindsight, that increase would have been toxic.

We are leaning toward Powell but it should be noted that the other open governor spots are important, too. If Taylor and Warsh are offered governor positions as a consolation prize, Powell’s ability to manage to a consensus will be significantly undermined.

A budget deal: By a 51-49 vote, the Senate passed a fiscal 2018 budget resolution and the House has agreed to accept. The vote was nearly by party line, with Rand Paul (R-KY) the only Republican voting against the measure. The resolution is important because now that one is in place Congress can consider tax law changes without fear of filibuster in the Senate. Although this is a first step toward tax reform, it is a rather small one; tax reform remains a difficult task.

More non-centrist political developments: If polls are accurate, the next PM of the Czech Republic will be Andrej Babis, a right-wing populist businessman. Although the overall economic data from the country is rather good, rising inequality and political corruption is lending support to Babis. He has run on an anti-corruption, anti-EU and anti-immigrant platform. If elections pan out as expected, another EU government will have moved to the political fringe. Meanwhile, in New Zealand, Jacinda Ardern, aged 37, will be the next PM; she is the leader of the hard-left Labour Party and another young figure at the helm of an important Western government. She was able to gain power after the New Zealand Party, a party dedicated to providing government funding to the elderly, joined Arden to form a majority coalition. Arden’s platform calls for social spending but is also anti-immigrant and wants to ban foreigners from buying property.[1] Like many nations in the region, New Zealand has been favored by foreign capital flight. In the election, the center-right (and former government leader) National Party received 56 seats, Labour won 46, the New Zealand Party won nine and the Greens eight. The Greens didn’t join the coalition but agreed to caucus with it, giving it a majority. The NZD dropped 2% yesterday on the news.

Merkel gives May a lifeline: Chancellor Merkel welcomed PM May’s initial offer of £20 bn and a transition deal on the EU’s terms to facilitate a smooth Brexit. Although the hardliners in the EU want something closer to £60 bn or more, Merkel’s reaction probably means that a less onerous package can be negotiated. The GBP rose on the news.

Retail MMK update: Yesterday’s market action in equities was consistent with recent patterns, which is that each pullback has been shallow and met with almost immediate buying. Thus, pullbacks have been consistently unsustainable. We attribute that characteristic to high levels of cash among investors waiting for the opportunity to invest. As a result, small market declines are seen as rare opportunities for purchasing. We have noted that the level of retail money market holdings has been a fairly good indicator of buying power.

This chart shows the weekly Friday close for the S&P 500 along with the level of retail money market funds. We have applied areas to the chart in orange—these represent periods when money market levels fell below $920 bn. In general, when money market funds held by retail fall to “low” levels, which we define as $920 bn, equity markets tend to decline or stall. We believe this occurs due to the lack of “fuel” for new buying. Current levels are near $985 bn, meaning there is ample cash for buying and thus, barring a geopolitical event, elevated levels of liquidity would be consistent with shallow pullbacks and a “buy the dip” mentality, exhibited yesterday.

Energy recap: U.S. crude oil inventories fell 5.7 mb compared to market expectations of a 3.0 mb decline.

This chart shows current crude oil inventories, both over the long term and the last decade. We have added the estimated level of lease stocks to maintain the consistency of the data. As the chart shows, inventories remain historically high but have declined. The impact of Hurricane Harvey is diminishing as refinery operations recover. We also note the SPR fell by 0.7 mb, meaning the total draw was 6.4 mb.

As the seasonal chart below shows, inventories fell this week. It appears we have started the inventory rebuild period sooner than normal this year due to the hurricanes. However, inventories have declined over the past three weeks, which is a surprise based on the seasonal pattern. Crude oil inventories usually rise into mid-November, so if this decline phase continues it should be supportive for crude oil prices.

Refinery operations fell sharply last week in line with seasonal norms. This week usually represents the low in seasonal refinery activity, meaning that demand should rise on a seasonal basis going forward. What was interesting this week was that U.S. production appears to have declined by 1.1 mbpd. It isn’t obvious why this would have occurred and so we will be watching to see if this is a one-week event or part of a larger drop in oil production. If production remains low, it is also a bullish factor for prices.

Based on inventories alone, oil prices are undervalued with the fair value price of $54.33. Meanwhile, the EUR/WTI model generates a fair value of $63.44. Together (which is a more sound methodology), fair value is $60.01, meaning that current prices remain below fair value. For the past few months, the oil market has not fully accounted for dollar weakness. However, now the markets are not even taking tightening inventories into account. In general, without the expected seasonal lift in crude oil inventories, oil prices at current levels are attractive.

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[1] We suspect terror has just erupted in Silicon Valley!

Daily Comment (October 19, 2017)

Posted on October 19, 2017 by Rebekah Stovall

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Something unusual is happening this morning…equity futures are pointing to a lower opening. At the time of this writing, S&P futures are indicating about a 0.5% decline. In the sea of calm we have been operating in, such a modest decline does look rather different. We also note that other flight to safety assets are rising this morning—the JPY and EUR are higher, and Treasuries and gold are rising, too. Here is what we are watching today:

What’s behind this morning’s weakness? Although the proximate cause is the rising threat of state action by Spain against Catalonia, this probably isn’t it. The Catalonian government refuses to back down from independence and PM Rajoy appears ready to take steps to remove the provincial government from power and take control of the region. However, this isn’t really news as this action has been expected for some time. A good part of today’s weakness is probably just simply that we are due for some profit-taking. However, there are a few items that are worrying enough to remove some of the confidence in equities. Here is our list:

China and debt: Although Xi Jinping gave a long speech yesterday outlining his view of China as a rising power (long enough that a tea break was necessary), the other news out of China was far more sobering. The People’s Bank of China (PBOC) Governor, Zhou Xiaochuan, said in a talk today that excessive debt growth is raising the risk of a “Minsky moment” in China. Zhou may be replaced at the current party congress; if not, his term will end a year from December, so he is probably in the last 15 months of his career. He has been running China’s central bank since 2002, the longest serving governor of the PBOC in China’s history. So, what’s his concern about a “Minsky moment”? Hyman Minsky, who spent most of his career in St. Louis at Washington University, theorized that stability breeds instability, a condition known as the “financial instability hypothesis.” In other words, the longer an economy is stable, the more confident investors, firms and households become and the more likely they are to take on more risk and leverage. Zhou indicated this morning that, in his opinion, corporate debt is too high and household debt is rising rapidly. His worry is that leverage will magnify the cyclical variations in China’s economy in a pro-cyclical fashion, meaning that it will lead to stronger growth in expansions and deeper recessions in downturns. In a nation run by a communist authoritarian regime that desires stability, Zhou’s concerns are a significant concern. China needs to lower its debt; although it promises it can, history shows countries that have recently achieved development through debt investment have two paths to adjustment. They can either follow the U.S. depression model, which rapidly lowered U.S. private debt during the Great Depression through liquidation and foreclosure, or the Japanese model, which reduces private sector debt slowly by cutting growth to a sustainable level. Neither is pleasant but we don’t see a way for China to maintain stability, cut debt growth and maintain 6.5% GDP growth (as noted below, China grew 6.8% in Q3). We expect China to take the Japan option but try to get a bit better growth at 2.5% to 3.0% growth. That wasn’t the tenor of President Xi’’s speech. Thus, talking about China’s debt introduces a new risk to the global economy.

North Korea: The U.S.S. Ronald Reagan carrier group has moved to the Sea of Japan off Korea’s northeastern coast. According to reports, ships in this group have been given a warning order and prepared Tomahawk cruise missiles to fire on North Korean targets. There has been growing speculation that North Korea may either launch missile tests or detonate another nuclear device (or even both—an airborne test of a nuclear warhead over the open sea) during China’s 19^th Party Congress. The U.S. is apparently prepared to retaliate if a test or a North Korean attack on American military assets in Japan, Guam or South Korea are part of North Korea’s actions to spoil Chairman Xi’s “party.” We note that the U.S.S. Theodore Roosevelt carrier group is near Hawaii and could move toward Korea, giving the U.S. two carrier groups if hostilities escalate. Although we don’t expect a conflict, tensions are high and the potential for a mishap is elevated.

Yellen and Trump today: Chair Yellen will meet with President Trump today. Although the president has indicated he likes Yellen’s low interest rate policy, he does favor looser regulation. Given the desire for less regulation and opposition to Yellen from Congressional Republicans, we doubt she will get another term. The best combination of easy policy and deregulation is probably Jerome Powell, who is favored for the chair position by Treasury Secretary Mnuchin. However, Trump may want a “name” and John Taylor would be the highest profile candidate among those mentioned. Taylor would probably be more hawkish on policy, which the president wouldn’t necessarily like, but he would also favor less regulation. We will be watching for post-meeting comments from the White House.

[Ed. note: we will update the energy recap in tomorrow’s report.]

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Daily Comment (October 18, 2017)

Posted on October 18, 2017December 13, 2017 by Rebekah Stovall

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT]

Tax reform: Senate Republicans are moving closer to tax reform as 50 senators have agreed to begin debate on a budget resolution. In order for tax reform to happen, the Senate must first pass a budget appropriations bill. Currently, there appear to be a few holdouts that might prevent the budget resolution from passing through the Senate. Senator Rand Paul is the most vocal Republican holdout, stating that the bill fails to meet the budget cap requirement established in the 2011 Budget Control Act; Senator Bob Corker has also voiced similar concerns. In addition, there are still concerns about whether Senator Thad Cochran is healthy enough to vote as he has been recovering from an infection over the past few weeks. The GOP can only afford to lose two votes if they plan on passing a tax bill without help from the Democrats. That being said, there is growing speculation that tax reform will not get done by the end of the year. We continue to closely monitor this situation.

Return of the subsidies: Senators Lamar Alexander and Patty Murray reached a bipartisan deal that would fund healthcare subsidies for two years in exchange for giving states more regulatory flexibility with the law. Last week, Trump signed an executive order that would have ended subsidies that reimburse insurance companies for lowering deductibles, co-payments and other out-of-pocket costs for low income customers. At this moment, it is uncertain if it has enough support to become law; Senator McCain has expressed his support of the bill, while President Trump has backtracked on his initial support.[1] It is unclear whether Democrats are in favor of the bill, but it is widely perceived that Republicans will largely oppose it.

NAFTA stalemate: Renegotiations between the three-member trade alliance NAFTA ended at an impasse on Tuesday as Canada and Mexico were unwilling to give into U.S. trade demands. The countries will meet again next month for continued negotiations. During the negotiations, the U.S. asked for more flexibility to place import tariffs on certain goods such as automobiles, dairy and seasonal produce. The U.S. trade representative, Robert Lighthizer, told reporters that Canada and Mexico were being obstructionist and should be willing to “give up a little bit of candy” in order to secure a deal. We believe that this administration is possibly positioning itself for an eventual withdrawal from NAFTA. Furthermore, the Washington Post reported[2] that Peter Navarro, director of the White House Office of Trade and Manufacturing Policy, circulated a memo alleging that manufacturing jobs lost through trade contribute to increased abortions, divorces and spousal abuse; there was no data supporting the claim in the memo. A withdrawal from NAFTA could be bearish for U.S. equities.

Raqqa falls, what’s next? An American-backed militia, the Syrian Democratic Forces, claimed to have recaptured the northern Syrian city of Raqqa from the Islamic State. Raqqa is considered the capital for ISIS and its recapture represents a stunning blow to the dwindling group. The United States Central Command stopped short of claiming victory over ISIS, but has stated that the American-backed forces have wrested control away from ISIS. Despite the victory, there are concerns about how the U.S. plans to rebuild the areas formerly under ISIS control. Many fear that the defeat of ISIS could lead to a new power vacuum that could be filled by another militant group hostile to the U.S. As of right now, it appears that there are no detailed plans to rebuild the areas. President Trump’s insistence that the U.S. will no longer participate in nation-building further complicates the issue. We will continue to monitor this situation.

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[1] http://thehill.com/homenews/administration/355985-trump-reverses-course-indicates-opposition-to-obamacare-deal

[2] https://www.washingtonpost.com/news/business/wp/2017/10/17/internal-white-house-documents-allege-manufacturing-decline-increases-abortions-infertility-and-spousal-abuse/?utm_term=.3b993b21ad12

Daily Comment (October 17, 2017)

Posted on October 17, 2017 by Rebekah Stovall

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] U.S. financial markets are quiet, but there is a lot going on again today. Here’s what we are watching this morning:

Taylor to the Chair? John Taylor, the creator of the “Taylor Rule,” visited President Trump yesterday and, according to news reports, the president was very impressed. Taylor is a well-respected economist with a good deal of government and academic experience. What makes him a bit of a surprise is that he is considered rather hawkish. When these reports emerged yesterday, the dollar rallied and Treasuries dipped. We would be surprised if Taylor gets the nod for chair, although it wouldn’t be a shock to see him appointed to the FOMC. In general, Trump favors lower interest rates; Taylor is on the record calling for a 2% real fed funds rate, or, assuming 2% CPI, a 4% nominal fed funds rate. Eurodollar futures are nowhere near that level and so we would view Taylor as a bearish event for equities and Treasuries, and bullish for the greenback.

Friends Again! Yesterday, Senate Majority Whip McConnell and President Trump stood side-by-side in the rose garden in a sign of unity as they prepare to pass tax reform. It has been reported that the two had a falling out after the Senate failed to repeal Obamacare. This display of friendship should be taken with a grain of salt as there have been reports that officials in Trump’s administration believe that Senate Republicans are an impediment to Trump’s legislative agenda. It is also worth noting that while speaking on their improved relationship Trump mentioned that he would talk Steve Bannon out of setting up primary challenges to Senate Republicans; earlier this month, Bannon stated that he is willing to go to war with establishment Republicans. We would interpret this gesture as a final olive branch before Trump gives up on the GOP and tries to pass legislation on his own. We will continue to monitor this situation.

More Headaches for the Catalan President: Yesterday, Spain’s high court sentenced the leaders of the Catalan National Assembly (ANC) and Omnium Cultural, Jordi Sanchez and Jordi Cuixart, to prison without bail pending an investigation of alleged sedition. The two men were accused of sedition due to their involvement in setting up massive protests to counter the Civil Guard’s crackdown on the October 1st referendum. As the two men were escorted from the courthouse, they were given a hero’s welcome from separatist supporters.

This event will likely put more pressure on Catalan President Carles Puigdemont to clarify his position on whether Catalonia has declared independence from Spain. Following the results of the referendum, Puigdemont stated that he has the mandate to declare independence but will suspend doing so in order to set up negotiations with the Spanish government. In response, the Spanish government has stated that it will not consider negotiating with Catalonia as long as it insists on becoming an independent state. In addition, Spain has given Puigdemont until Thursday to clarify his position or risk having his government dissolved. In rebuke of the Spanish government, the ANC sent a letter to Puigdemont urging him to immediately end the suspension of Catalan independence. Puigdeomnt appears to be in a lose-lose situation; if he formally declares independence he risks being removed from office, and if he does not declare independence he will likely lose the support of his base. Currently, Spanish equities are up but are trading slightly lower than last week.

So, you’re saying there’s a chance? Yesterday, CNN reported that a North Korean official stated that the region would only be willing to engage in diplomacy with the Trump administration if it has the capability to strike the East Coast of the U.S. Given all of its bluster, this statement represents a victory for SOS Rex Tillerson, who has maintained that sanctions will help bring North Korea to the negotiating table regarding its nuclear program. Over the past few weeks, SOS Tillerson and President Trump have offered differing strategies on how to deal with North Korea’s nuclear program. Tillerson would prefer to curb the program through diplomacy, while the president has advocated for ending the program militarily. These comments could be a prelude to possible negotiations but we are not prepared to rule out the likelihood of a U.S. preliminary strike. We will continue to monitor this situation.

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