Keller Quarterly (April 2017)

Posted on April 25, 2017April 25, 2017 by Rebekah Stovall

Letter to Investors

Perhaps you’ve heard it or felt it, but fear of financial market decline has become palpable among the public. It’s not just fear as reflected by TV shows or internet social media I’m talking about, but fear reflected by real people in conversation. I travel rather extensively, speaking to both advisors and their clients, and hear directly from the public such fear of a stock market collapse. The advisors report, and the clients confirm, that it’s the norm for their clients to hold more than 20% of their investable assets in cash. Considering that cash now earns sub-1% yields, there really isn’t an investment reason to hold such a high proportion of one’s investments in cash unless one fears a financial panic.

Is such a panic likely? Well, I cannot predict the future, but as one who has been advising investors for over 38 years and studying the stock market for longer, market declines rarely begin with such prevalent pessimism. Major stock market declines proceed from periods of extraordinary optimism about the future, when seemingly no one can imagine that the economy and the market do anything but surge ahead. Public sentiment clearly is not at that point.

But didn’t the market recently hit an all-time high? Yes, but that’s not a predictor of market decline. The stock market’s price regularly hits all-time highs because the economy is growing virtually every year. It was Warren Buffet who once noted that a bank certificate of deposit whose interest is compounded daily hits an all-time high every day! The market should be marching ahead similarly, as long as the economy and the businesses undergirding it are growing, and they are.

But isn’t the market’s price-to-earnings (P/E) ratio rather high? Yes, as it has been for most of the last 20 years. The reason for the high P/E ratio (and other high valuation measures) is that inflation is very low. Inflation “steals” away investment returns by paying you back in dollars that are worth less than you originally invested. Thus, in a rising inflation environment, the market eventually corrects for this “theft” by valuing stocks at lower P/E ratios. On the flip-side, when inflation is low (as it has been for over 20 years), after-inflation returns are better than expected because very little of this “theft” occurs. Therefore, stocks adjust by trading up to higher P/E ratios because investors become confident that they’ll actually get to keep their returns. We wrote last quarter of some things that make us worry about inflation, but we are not seeing it “perk up” yet.

So, we’ve got nothing to worry about? No, there are always things to worry about, but economic disaster is usually not a high probability item, and we don’t think it is today, either. But all the financial markets are the products of human decisions and, as a result, emotions can become embedded in those decisions and thus into prices. A 5 to 10 percent decline in stock prices never surprises us any more than a similar rise; it happens every year. The “sentiment pendulum” of optimism/pessimism can swing rather widely and quickly, much more quickly, in fact, than the economy moves. Rather than being “swung around” by this pendulum, a wise investor should take advantage of the swings. This is what we seek to do: take advantage of excessive pessimism and optimism in the markets.

We appreciate your confidence in us.

Gratefully,

Mark A. Keller, CFA
CEO and Chief Investment Officer

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Daily Comment (April 25, 2017)

Posted on April 25, 2017 by Rebekah Stovall

by Bill O’Grady, Kaisa Stucke, and Thomas Wash

[Posted: 9:30 AM EDT] We are seeing some follow through from yesterday’s French election rally, although the magnitude is understandably less. The financial markets appear comfortable that Macron will win in the runoff, and with good reason. It would be a real shocker to see Le Pen overcome a 25-point deficit in the polls. To give this lead some context, most reliable polls put Dewey ahead of Truman by 17 points in late September 1948. However, this lead narrowed to a mere five points by the end of October. Macron’s lead is clearly more than what Dewey enjoyed and the time for Le Pen to narrow the gap is shorter.

Still, if the past year has told us anything it’s that surprises are possible. The European media is noting that Le Pen is out aggressively campaigning while Macron appears to be taking a breather. Dewey’s campaign was also low key. The elements of an upset are in place. Macron is a political novice; his support is broad but not very committed and he has no real party apparatus to boost the usual politicking that goes with elections. If the mainstream parties decide to adopt Macron as one of their own, which is what we expect, he will probably be the winner. But, if the wide margin breeds complacency, this election may be closer than expected. The one factor to watch, which is consistent with the Truman/Dewey contest, is a narrowing of the polls. If an upset is to come, look for the 25-point lead to narrow significantly going into the election on May 7.

The Trump administration has indicated that it wants a major corporate tax cut, lowering the highest rate to 15%. This is a massive cut.

As the horizontal line shows, this would be the lowest rate since 1937. Unlike the House plan, it doesn’t appear that Trump has offered any revenue offsets. A simple cut is estimated to boost the deficit by $2.4 trillion[1] over the next decade. We suspect this proposal will land with a “thud” on Capitol Hill. Most Republicans will be quite uncomfortable with expanding the deficit, while Democrats will view the cut as a giveaway to upper income households and won’t support it.

Most public finance analysis suggests the incidence (who pays) of the corporate tax falls on households in the form of either higher prices or reduced dividends. Although the research is somewhat mixed, most analysis suggests that the incidence of the corporate tax falls more on upper income households.

This chart shows the effective corporate tax rate by selected household income groups. Clearly, most of the tax falls on the highest income brackets.

Meanwhile, on trade, the administration announced it is implementing new tariffs on Canadian softwood. This issue has been a controversial one for some time. U.S. producers complain that Canadian softwood is subsidized by provincial governments. The tariffs will range from 3% to 24%. This dispute follows one in which the Canadians complained that the U.S. is subsidizing milk; a product from the milk used in cheese and yogurt is being exported to Canadian processors. Currently, Canada has decided to support its own dairy farmers to thwart U.S. dairy exports. These disputes indicate rising trade tensions. Reducing the trade deficit is something the president campaigned on and he appears to be taking increasingly aggressive steps in this direction. Given that these actions don’t require Congressional approval, quick action is possible in this arena. We will have more to say on this issue in the coming weeks.

Although a government shutdown on Saturday is possible, it does appear unlikely. President Trump offered “flexibility” on the border wall, suggesting he will accept just about anything that promises something with regard to the proposal. At this point, neither party appears keen on taking the potential blame for a closure. In past shutdowns, the Freedom Caucus was more than willing to accept responsibility for this action. Since no one wants to bear the blame, it’s unlikely that a shutdown will happen. Instead, look for a continuing resolution to keep the government funded.

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[1] https://www.washingtonpost.com/business/economy/trump-seeks-15-percent-corporate-tax-rate-even-if-it-swells-the-national-debt/2017/04/24/0c78a35c-2923-11e7-be51-b3fc6ff7faee_story.html?hpid=hp_hp-top-table-main_trumptax-130pm:homepage/story&utm_term=.2c81aecfaee2

Weekly Geopolitical Report – Between a Rock and a Hard Place: The Gibraltar Dilemma (April 24, 2017)

Posted on April 24, 2017May 1, 2017 by Rebekah Stovall

by Thomas Wash

Days after Theresa May triggered Article 50 of the Lisbon Treaty, Brussels issued a nine-page document outlining its guidelines for Brexit negotiations. One of the guidelines gave Spain the authority to veto any deal between Gibraltar and the European Union (EU). The U.K. is currently recognized as holding sovereignty over Gibraltar and thus took exception to this provision, vowing to defend the will of the people of Gibraltar.

The provision is likely the result of heavy lobbying by the Spanish government, who would like to end this 300-year dispute once and for all. A war of words between Spain and the U.K. has already started in response to the announcement. Former Tory leader Michael Howard stated that the U.K. is willing to fight for Gibraltar. Although not responding to the threat, Spain has hinted that it would not block Scotland if it were to apply to the European Union upon a potential Scexit.[1]

Despite the bravado, it is likely that the two countries will come to some sort of agreement as they have deep trade ties. In fact, Spain has been the most vocal backer of a soft Brexit. That being said, the people of Gibraltar are stuck at a crossroads regarding the dispute. On the one hand, they voted 96% to remain in the EU, but on the other hand, they voted 99% against joint sovereignty with Spain. The situation becomes even murkier when its economy is taken into account. Gibraltar is dependent upon the U.K. for trade and Spain for labor. Nevertheless, it is unlikely that Gibraltar would have emerged from Brexit unscathed as its labor force is dependent on the free movement of immigrants permitted under the EU. Ironically, it was the free movement of immigrants that mostly caused British voters to leave the EU.

In this report, we will focus on the significance of Gibraltar, its historical context and the impact of the current dispute. We will conclude with possible market ramifications.

View the full report

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[1] During the run-up to the Scottish referendum, it was believed that Spain would oppose any immediate transition by Scotland into the EU if it decided to leave the U.K. because it could encourage Catalonia to move toward independence as well.

Asset Allocation Quarterly (Second Quarter 2017)

Posted on April 24, 2017May 2, 2017 by Rebekah Stovall

The economy continues on a stable path, along with relatively low levels of inflation.
In this cycle, tighter Fed policy involves not only raising short-term rates, but also reducing the size of the Fed’s balance sheet.
The magnitude of growth of the Fed’s balance sheet in recent years was unprecedented. Its reduction is also unprecedented.
We expect the Fed to move gradually and telegraph its policy, allowing markets time to adjust without harmful disruptions.
Our equity allocations are unchanged this quarter and remain entirely domestic. We utilize large caps for conservative portfolios, while including mid and small caps where risk tolerance is higher.
Our bond allocations include short, intermediate and long maturities. We also believe speculative grade bonds are helpful in pursuing income objectives.
Our growth/value style bias shifts from 30/70 to an even weight of 50/50.

ECONOMIC VIEWPOINTS

The economy remains on a stable trend so far in 2017. Unemployment remains low, while consumer and business sentiment are improving. Accordingly, the Fed has continued on its path of gradually raising short-term interest rates. At this point, it appears the pace of tightening is appropriate, and isn’t tipping the economy toward a recession. Still, we’re keeping a close eye on monetary policy, because there’s a unique issue the Fed is managing in this cycle: the reduction of its own balance sheet.

What exactly is the Fed’s balance sheet? Without getting into too many details, the Fed’s balance sheet reflects the value of assets it has purchased in the financial markets, most of which are bonds. When the Fed buys assets, it pays for them by simply creating money. It’s sort of like a digital printing press that increases money supply. Conversely, when the Fed sells assets, the proceeds are taken out of the economy, lowering the supply of money. The Fed normally expands and shrinks its balance sheet by buying and selling short-maturity bonds, thereby directing short-term interest rates, according to its desired policy.

However, during the financial crisis in 2008, the Fed altered the kinds of assets it would purchase in order to help stabilize the markets. Then, after stabilizing markets, the Fed began purchasing long-maturity Treasury and mortgage bonds (a policy called “Quantitative Easing,” or “QE” for short) in an attempt to stimulate the economy by driving long-term interest rates lower. In this graph, we can see the total assets of the Fed. In 2008, its balance sheet had assets worth about $900 billion. Although this was a large number, it was a function of multi-decade growth, having risen along with the overall size of the economy.

Through three rounds of QE, the Fed’s balance sheet growth accelerated rapidly, ultimately quintupling assets to almost $4.5 trillion. Unfortunately, the economic stimulus from QE didn’t materialize. Most of the increase in money supply remained parked as excess reserves in the banking system. Lending stalled as financial regulations made banks very cautious to lend, while at the same time most qualified borrowers were simply not interested in more debt.

So, today, as the Fed guides short-term rates gradually higher, it is also contemplating how to lower the size of its balance sheet. If most of the increase in money supply is parked as excess reserves in the U.S. banking system, a gradual decline in the Fed’s balance sheet shouldn’t be too disruptive to the availability of credit and shouldn’t harm the economy…in theory. The problem is, nobody really knows how to shrink a balance sheet of this size. How much? How fast? When? It’s an unprecedented endeavor.

Fortunately, the Fed has significant leeway in how it moves forward. It has already had success in telegraphing its interest rate policy, and we expect the Fed to communicate its balance sheet plan in a way that fosters gradual adjustments by financial markets, borrowers and lenders. It’s worth noting this leeway is derived from a stable economy. In the event the economy begins to falter, or is disrupted by geopolitical events, the Fed’s efforts will become much more complicated.

It’s also worth mentioning that uncertainty regarding White House policies may also cloud the economic landscape. We have not yet ascertained whether the president will favor traditional supply-side economics, or if populist priorities will rule the day. Generally speaking, a supply-side bias would create more predictability for the Fed, whereas populist policies toward protectionism would tend to create more inflation, geopolitical risk and uncertainty for the Fed. Accordingly, we’ll be closely monitoring economic trends, geopolitical risk, White House policies and how the Fed decides to navigate the unprecedented reduction of its balance sheet.

STOCK MARKET OUTLOOK

Even as the post-election euphoria leveled off, equities were still able to begin 2017 on a positive trend, with large caps delivering some of the best returns. We believe the environment for equities should remain generally good, although we are a bit more cautious given that valuations have risen over the past few years. Our work indicates there has been a close relationship between increases in the Fed’s balance sheet and equity valuations (stock P/E ratios rose during periods of QE), so we are monitoring equities to see if a shrinking balance sheet has the opposite effect. Our early work indicates that a gradual decline in the Fed’s balance sheet may not be overly disruptive to equities.

We maintain our focus on domestic equities, with no foreign developed or emerging equity exposure. We continue to believe the return/risk profile is more favorable for U.S. equities against the backdrop of potential earnings, valuations, currency risk and geopolitical uncertainty. We utilize large caps for more conservative models, while including more exposure to mid and small caps where risk tolerance is higher. Within large caps, we are overweight financials, industrials and utilities, while being underweight telecom and consumer staples. We are adjusting our style bias from 30/70 growth/value to an evenly balanced 50/50, based upon our views toward sectors and industries within each style.

BOND MARKET OUTLOOK

After rising in the latter half of 2016, Treasury yields were generally stable in the first quarter of 2017. Seemingly, as the optimism for higher growth mellowed, so too did concerns for future inflation and more aggressive tightening by the Fed. Our expectation is for both growth and inflation to remain generally in line with current levels, with the potential to rise modestly over the next few quarters. A wildcard here may be trade policy. If protectionist policies were to actually manifest, they would likely drive inflation higher. We are also watching to see how the decline in the Fed’s balance sheet affects bond yields.

Against this backdrop, we feel it is appropriate for most bond investors to include a variety of maturities, sectors and credit qualities in their bond allocations. These include short, intermediate and long-maturities, including Treasury, corporate and MBS. We also include speculative grade bonds, where the default rates appear relatively benign. It is worth mentioning that we continue to see important diversification benefits from longer maturity bonds as this asset class has a tendency to rise when equities decline, helping to address overall portfolio risk.

OTHER MARKETS

Fundamentals in real estate are generally good, although we prefer to limit or avoid exposure to retailing, where certain markets may face ongoing challenges. Broadly speaking, real estate capital costs and financing should remain relatively low, while occupancy and rental rates are likely to be constructive. We also expect foreign capital to continue flowing into U.S. real estate.

We remain out of commodities where the return/risk does not appear as favorable. China continues to be the marginal source of demand for most commodities, and we have concerns regarding the stability of the country’s growth rate. In addition, we expect energy commodities to have a negative bias given significant global supply capacity.

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Daily Comment (April 24, 2017)

Posted on April 24, 2017 by Rebekah Stovall

by Bill O’Grady, Kaisa Stucke, and Thomas Wash

[Posted: 9:30 AM EDT] Financial markets breathed a great sigh of relief as the first round of the French presidential election went about as expected. Macron and Le Pen will square off on May 7^th to decide the presidency. Current polls show Macron with a commanding lead, generally 20 points or more. Although we have seen electoral surprises recently, they have all been within the margin of error. For Le Pen to make up 20 to 25 points would require a significant event, e.g., major terrorist attack, political scandal of epic proportions or campaign error that seriously undermines Macron’s character.[1] Although we do expect Macron to win, we also expect a tighter vote than the current polls suggest. Macron has no real party and so he will not have the usual “get out the vote” apparatus in place. It’s important to note that nearly 40% of the first round votes went center-right and far-left; it isn’t inconceivable that turnout could be low. Current polling suggests that Le Pen will only gather a small part of Mélenchon’s 19%, with the majority going with Macron and a rather large number spoiling their ballots by abstaining. Most of Fillon’s voters will end up with Macron as well.

Although Macron will keep France in the EU and the Eurozone, which is a market-friendly outcome compared to Le Pen, he is far from an ideal candidate. First, he has no party; there is no framework in the Fifth Republic for when a president has no representation in the Assembly. He will be forced to select a PM that will be acceptable to whichever party wins in the June legislative elections. Thus far, we haven’t seen any reliable polling for the legislative elections but, given the collapse of the center-left in this election, the most likely outcome will be a center-right domination of the Assembly. Macron can probably function with that outcome. Second, Macron is a political novice. French voters wanted change in this election, something we saw in the U.S. (arguably since 2008) and with Brexit. Assuming a Macron win, it is simply unknown whether France is in competent hands.

Therefore, we believe the worst outcome has been avoided but this outcome isn’t necessarily good for financial markets because it is further evidence that the center-left and center-right coalitions that have mostly ruled the West since WWII are struggling to maintain their hold on power. The strong rally we are seeing in equities (with one exception, discussed below) along with the drop in gold, the JPY and Treasuries is consistent with “risk on.” However, much of this rally is probably due to investors reversing positions designed to protect themselves from a negative outcome in these elections. If that is all it is, the rise should mostly be contained within the next few days.

The one interesting divergence from the global equity rally is China. The Shanghai Composite has been stumbling recently in what seems to be caused by growing worries of rising interest rates.

Note that Chinese equities have been coming under pressure over the past two weeks. The drop coincides with rising interest rates.

The Xi government is worried about the high levels of Chinese debt and reports of rising non-performing loans. As the PBOC clamps down on lending, rates are rising which appears to be pressuring equities lower. The Xi government is working to maintain stability and growth as the CPC conference that will elect him to a second term convenes in October. Thus, we don’t expect the regime to allow for a major market drop or a financial crisis to develop…at least if it can control such things. So far, the drop in Chinese equities appears to be nothing more than a normal market retracement, but more significant declines may be forthcoming if we break the 3100 level on the Shanghai Composite.

Finally, President Trump surprised his aides by indicating that a tax proposal will be outlined on Wednesday. We don’t expect anything other than the broadest of brush strokes but this announcement does suggest he is trying to make a splash around his first 100-day mark. We also don’t expect a government shutdown on Saturday, although we have to say that negotiations don’t seem to be going well. The opposition isn’t planning on voting for a border wall and the GOP may reduce funding for the ACA’s subsidies so the potential for a closure is in place. We believe the president doesn’t want a shutdown this early on his watch so he will likely stand down, but anything is possible given the mercurial nature of Mr. Trump. We continue to watch the markets but clearly today there are no concerns about a government closure.

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[1] https://www.youtube.com/watch?v=yTO5AYl1zCs

Asset Allocation Weekly (April 21, 2017)

Posted on April 21, 2017April 21, 2017 by Rebekah Stovall

by Asset Allocation Committee

Last week, we discussed the impact of reducing the size of the Federal Reserve’s balance sheet on the economy. This week we will discuss the effects of QE on financial markets.

The relationship between the balance sheet and equities seems rather straightforward; expanding the balance sheet appears to be clearly supportive for equities.

This chart shows the S&P 500 Index regressed against the Fed’s balance sheet. From 2009 until last year, this equity index closely tracked the level of the balance sheet. Equities have lifted above the forecast level of the balance sheet recently. If the relationship holds, equities are vulnerable to a large decline. On the other hand, there is no evidence to suggest that bank reserves somehow found their way into the equity market. Comparing the Shiller P/E (CAPE) suggests that the effect of QE was probably psychological; after fed funds reached the zero bound, QE signaled to investors that policy was still easy.

This chart regresses the CAPE against the Fed’s balance sheet; the CAPE’s behavior is similar to that of the overall equity market. After the election, the market has mostly risen on multiple expansion, rising well above the model’s fair value.

It should be noted that low interest rates could have a similar effect. However, the fact that equities and the P/E seemed to track the balance sheet does suggest that QE had an impact on market psychology.

The impact on bonds is rather interesting.

The gray bars show periods when QE was implemented. Especially after QE 1, periods of QE tended to coincide with rising rates. When QE was ending (shown by the decline in the yearly growth rate of the balance sheet), rates tended to decline. Despite the FOMC bond buying, rates rose mostly on fears of inflation. Once QE ended, those fears eased and bond yields declined. The most recent rise is likely due to expectations of fiscal stimulus that will boost growth and potentially raise inflation.

If the Fed’s expanding balance sheet was a supportive psychological factor for bonds and stocks, will the contraction have the opposite impact? Simply put, we don’t know. If the economy and earnings are improving, the drop in the balance sheet probably won’t matter. Unfortunately, if the economy disappoints, cutting the balance sheet could have a bearish impact on these assets.

Next week we will examine the impact of the Fed’s balance sheet on monetary policy.

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Daily Comment (April 21, 2017)

Posted on April 21, 2017April 24, 2017 by Rebekah Stovall

by Bill O’Grady, Kaisa Stucke, and Thomas Wash

[Posted: 9:30 AM EDT] On Sunday, the French go to the polls. The most recent polling shows Macron as the most popular candidate at 24.0%, with Le Pen second at 21.5%, Fillon at 20.0% and Mélenchon at 19.5%. Polls open at 8:00 am (CEST), which is 2:00 am EDT, and close at 7:00 pm, or 1:00 pm EDT. Exit polls are technically not legal but usually information begins to emerge from other European nations throughout the day. Final results could take a few days so we may not know the outcome on Monday. The president needs a majority to win and if no candidate gets more than 50% then a runoff election will be held on May 7.

Until recently, it looked like a two-person race, with Le Pen and Macron likely to face each other in a runoff. However, polls have tightened considerably and it is possible that either Fillon or Mélenchon could make it to the second round. For the financial markets, the best outcome would be Fillon, who is center-right, facing Macron, a centrist. Neither man has called for a withdrawal from the Eurozone or the EU. The worst outcome would be Le Pen and Mélenchon in a runoff. Both are populists, with the former coming from the right and the latter from the left. Both have an anti-euro and anti-EU policy platform. The most likely outcome is still Le Pen and Macron, but turnout will be key. Polling suggests that Macron’s support is shallow and a low turnout will tend to support the more radical candidates and lead to a Le Pen/Mélenchon runoff. It should also be noted that undecided voters make up about one-third of the electorate; to be undecided at this stage may signal a low turnout.

What has been lost in the focus on the presidency is that legislative elections are scheduled for June 11. Both the National Assembly (lower house) and Senate (upper house) hold elections on this day. The voting is rather complicated and usually leads to a runoff that will be held on June 18. The bottom line is that the president’s powers are affected by legislative support. If the president’s party fails to gain a majority in the Assembly, the president’s ability to affect policy is severely limited. The French system is “semi-presidential” in that the domestic agenda is run by the prime minister, while foreign and defense policy lies with the president. The president appoints the PM but the Assembly has the ability to force out any PM they don’t like. Thus, without a secure majority in the National Assembly, the president is essentially forced to choose a PM that may be in the opposition.

Only Fillon comes from a large national party. The other three leading candidates represent small parties, with Macron having recently created his. Accordingly, if one of these three candidate wins, it is highly likely they will be forced to select a PM that doesn’t really represent their policy positions.

Even if the worst outcome occurs, in reality, the ability of the new president to force through a radical agenda will be limited. At present, polling is limited but it appears that no party will gain a majority in the Assembly, meaning that the president will likely need to govern with a coalition and appoint a PM that is amenable to the newly elected members. The most likely outcome is gridlock. At the same time, the election of Le Pen or Mélenchon would upset the financial markets because it would show rising discontent with the EU and Eurozone and provide further evidence of rising populism.

From the beginning of the Trump administration, we have postulated that the president would need to vacillate between two poles, the establishment and the right-wing populists. And, for all the fury and noise, that is what he has done so far. On financial regulation and reducing government oversight, Trump is executing a mostly establishment GOP position of smaller government. At the same time, on immigration and trade, the president is clearly populist. Border walls and enhanced deportations show his position on immigration. Yesterday, we saw more evidence on trade as the administration prepared actions to protect steel. We expect this pattern to continue.

As we approach the 100-day mark of Trump’s presidency, there are reports of a flurry of activity coming from the White House. These include a new attempt to overturn the ACA, money for a border wall and more executive orders on regulation. The problem is that we are also facing a funding deadline which requires legislation in order to keep the government functioning. These initiatives from the White House are reportedly interfering with efforts to keep the government running. Although we don’t expect a government shutdown, we do expect a “Twitter storm” from those saying the administration got a lot accomplished in its first 100 days and from those who suggest it was a bust. In reality, the 100-day mark is not all that important but the charges and countercharges would be a distraction in the coming days.

Yesterday, equities got a boost from SOT Mnuchin’s promise that the administration will have tax reform completed by year’s end. Although we doubt there will be any major reforms by then, we would not be surprised to see “reform lite,” which would likely include a modest cut to rates (5% max) and a repatriation deal. Even that could lead to a widening of the deficit. To counter this problem, it appears the administration will rely on faster future growth to fund the tax cuts, a process formally called “dynamic scoring.”[1] If the growth fails to materialize, the deficit would widen.

Finally, tensions on the Korean peninsula remain high as North Korea appears poised for a nuclear test. There are unconfirmed reports that the Chinese and Russian militaries are on alert. All we are seeing is rhetoric and some degree of preparation, but there is always the potential for a mistake. So far, the financial markets have ignored this issue, mostly because there is always some degree of tension in this part of the world. Still, as we have noted before, we have a young leader in North Korea who appears insecure in his position and thus may be prone to rash actions.

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[1] http://www.reuters.com/article/us-usa-tax-trump-idUSKBN17M2PQ

Daily Comment (April 20, 2017)

Posted on April 20, 2017April 20, 2017 by Rebekah Stovall

by Bill O’Grady, Kaisa Stucke, and Thomas Wash

[Posted: 9:30 AM EDT] The euphoria surrounding the election of President Trump appears to be waning. Although the sentiment polls remain elevated, we note the fixed income markets are clearly showing some jitters.

This chart shows the two-year/10-year Treasury spread. Although the curve is steeper than it was prior to the election, it has been flattening rather rapidly recently. If this isn’t arrested soon, worries over the economy will increase and likely weigh on risk assets.

There were massive protests in Venezuela yesterday as those opposed to President Maduro braved security officials and the irregular Maduro forces armed by the president to call for elections and democratic reforms. At least seven people died. More rallies are expected today. Oil production appears to be down to 2.0 mbpd; the country was traditionally a 3.0 mbpd producer. Unrest there is a minor, but supportive factor, for crude oil prices.

U.S. crude oil inventories fell 1.0 mb compared to market expectations of a 1.7 mb draw.

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.

As the seasonal chart below shows, inventories are near their seasonal peak and should begin falling as rising refinery operations lower stockpiles. This week’s decline puts us further below normal. Although inventories remain high, this seasonal level is consistent with July, meaning that we may be on the way to an easing of the inventory overhang.

Based on inventories alone, oil prices are overvalued with the fair value price of $29.65. Meanwhile, the EUR/WTI model generates a fair value of $40.35. Together (which is a more sound methodology), fair value is $36.43, meaning that current prices are well above fair value.

Yesterday, oil prices fell sharply, with the rise in gasoline inventories cited as the catalyst. Although gasoline inventories usually decline from their February peaks, the pace of the decline is reaching its nadir and stockpiles normally stabilize through the summer.

This chart shows gasoline inventories. The five-year average shows the seasonal pattern; however, this year’s data is closely tracking last year. If this pattern continues, we will see mostly steady inventory levels until late July. That isn’t necessarily bad news for oil prices but it isn’t supportive, either.

Saudi Arabia is pressing OPEC to extend its production cuts and there are reports that the cartel is going along with it. This is the factor keeping prices higher. At the same time, rising U.S. production is taking share away from OPEC. As we have stated before, the oil market is being supported by what we would describe as epic “window dressing” in front of the Saudi Aramco IPO next year.

A secondary factor helping U.S. oil production, beyond OPEC propping up oil prices, is lower yields on junk bonds.

Since 2011, the correlation is a respectable -55% between the two series, with yields leading production by eight months. Obviously, oil prices play a larger role but the combination of higher oil prices and a favorable financing environment will tend to support higher U.S. production. Although higher U.S. output may be modestly negative for oil prices, it is supportive for U.S.-oriented oil producers…at least until the Saudis decide to retake market share.

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Daily Comment (April 19, 2017)

Posted on April 19, 2017 by Rebekah Stovall

by Bill O’Grady, Kaisa Stucke, and Thomas Wash

[Posted: 9:30 AM EDT] In Georgia, Jon Ossoff fell short of achieving the 50% threshold needed for him to win the vacant House of Representatives seat in Georgia. As a result, Ossoff will face Karen Handel, the Republican candidate, in a run-off on June 8. His surprise showing has breathed fresh life into the Democrat Party, which sees Ossoff’s success as a sign of growing dissatisfaction with the GOP. As mentioned in yesterday’s report, the seat is inconsequential in terms of a power shift in the House, but it could be a positive sign for what Democrats can expect in the 2018 mid-term elections. There are 34 Senate seats up for grabs in 2018, 25 of which are held by Democrats.

On Tuesday, the Trump administration informed Congress via letter that Iran has complied with the nuclear agreement, also referred to as the Joint Comprehensive Plan of Action (JCPOA), but the administration is concerned about Iran’s role as a state sponsor of terror. Under the terms of the deal, the White House is required to notify Congress every 90 days of Iran’s compliance. During the election, Trump referred to the JCPOA as “the worst deal ever negotiated” and imposed new sanctions on Iran in February after evidence surfaced of ballistic missile tests. The letter goes on to say that the National Security Council will continue to evaluate whether sanctions should be suspended and would only do so if it is in the best interests of national security.

In other news, Trump signed a new executive order broken into two parts, “Buy American” and “Hire American.” The first part is aimed at preventing abuses of the H-1B program, in which tech firms look to cut costs by hiring highly skilled foreign workers. It also seeks advice for changes in the program that would favor highly skilled workers with advanced degrees. Currently, the program admits 65,000 temporary immigrants with at least a bachelor’s degree in addition to 20,000 immigrants with advanced degrees. The second part of the order requires federal agencies to purchase more U.S.-made goods when possible. The executive order appears to be a response to recent criticism of perceived policy reversals by the Trump administration.

In Japan, VP Mike Pence reassured leaders of the U.S. commitment to reigning in North Korea as well as promoting economic ties. Pence stated that the U.S. is looking into additional economic sanctions that would deter North Korea’s nuclear program. His visit was seen as a success by many leaders who feared Pence would use the occasion to express disappointment in the current trade relationship. Japan currently has a trade surplus of $10 billion with the U.S. and Trump has frequently criticized it for unfair trade policies. It is worth noting that earlier this week Pence had criticized South Korea for its treatment of American businesses.

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