Author: Rebekah Stovall

Asset Allocation Weekly (March 5, 2021)

Posted on by Rebekah Stovall

by Asset Allocation Committee | PDF

In our 2021 Outlook, we had a forecast for the S&P 500 of 3918/4050.  Since the index is close to that level, we have received questions about whether we are expecting little upside from here or if we intend to calibrate our expectations.  This week’s Asset Allocation Weekly is a preliminary look at what we intend as an update of our forecast.

Optimism surrounding economic growth in 2021 is rising rapidly.  A number of private economists have dramatically upgraded their forecasts.  The Atlanta FRB’s GDPNow forecast for Q1 is estimating real GDP at 9.5%.  We do expect that growth estimate to decline from these levels (e.g., rising consumption will lift imports, which are a drag on GDP), but a reading above 5% is clearly possible.  There are two factors driving optimism; the first is that the virus appears to be coming under control.  The combination of widespread infections and increasing vaccinations means the U.S. is probably achieving some degree of herd immunity.  Although caution won’t be necessarily thrown to the winds, a steady relaxation of restrictions will boost services consumption.  Second, fiscal spending will tend to boost the economy.

This optimism could be misplaced.  The virus could mutate into a form that renders current vaccines less effective.  Even after the risk of infection has been reduced, it still may take some time for fear to be reduced.  It should also be noted that much of the fiscal spending is direct transfers to households instead of the government purchasing goods and services.  Although this aid may be spent, we would not be shocked to see some of these funds used for debt reduction or saving.  After all, inflation has been low, households are still over leveraged, and many households are in arrears over rent or mortgage payments.  It isn’t certain that this optimism is appropriate, but for now, the financial markets are leaning in that direction.  So, what do we know so far?

We are seeing a drift away from sectors that benefited from the pandemic to those who will do better in recovery.  The easiest way to see this is by comparing the S&P 500 to its equal-weighted compatriot.

In the long run, the equal-weighted index outperforms the capitalization-weighted index.  For example, from 1990 through 2020, the former rose at a compound annual growth rate of 14.3%.  Over the same time frame, the latter rose 12.5%.  However, there are occasions when the capitalization-weighted index outperforms.  For example, during the tech bubble, it did better than the equal-weighted index.  It also outperformed during the pandemic.  As the above chart shows, as equities fell due to the pandemic shutdown, the capitalization-weighted index did better.  The difference line on the lower part of the graph, which represents the spread between the capitalization-weighted index and the equal-weighted index, widened in favor of the former.  We have put two boxes on the chart.  The first, which shows the late second quarter, shows the spread narrowing as the economy recovered.  The second box is the period after the election.  After the election, optimism over additional fiscal stimulus rose.  In general, what we are seeing is that the equal-weighted index tends to perform better in the currency cycle when economic expectations improve.

Commodity prices are rising.  The five-year change in the CRB index is rising rapidly.

The yield curve is steepening.

This chart shows the spread between the 10-year T-note and fed funds.  Inversions (a reading less than zero) is a consistent indicator of recession.  As this curve steepens, note that in the last four business cycles, the spread exceeded 200 bps.  If this were to occur again, the 10-year T-note yield would exceed 2.00%.

So, what does this all mean?  First, we might be in a situation where the S&P 500 doesn’t move much higher from here but sectors and areas of the market that have lagged show improvement.  Investing performance may be less about owning an index than focusing on other areas of the market.  Second, areas outside of stocks are poised to do well―commodities, for example.  Third, the risk to equities probably comes from rising interest rates.  At the same time, not all parts of the equity market struggle with higher rates, and these areas should show promise.

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Weekly Energy Update (March 4, 2021)

Posted on by Rebekah Stovall

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

Here is an updated crude oil price chart.  Prices are consolidating in the high $50s to the mid-$60s.

(Source: Barchart.com)

Crude oil inventories jumped 21.6 mb when a draw of 4.0 mb was forecast.  There was no change in the SPR.  The build in stockpiles was offset by declines in product but the report outlier was the 12.6% drop in refinery operations which prompted the rise in inventories.

In the details, U.S. crude oil production rose 0.3 mbpd to 10.0 mbpd.  Exports were unchanged, while imports rose 1.7 mbpd.  Refining activity plunged 12.6%.  The second week of falling refining activity led to the unanticipated rise in inventories.

(Sources: DOE, CIM)

The above chart shows the annual seasonal pattern for crude oil inventories.  This week’s rise is seasonally normal but clearly outsized.  The usual seasonal pattern occurs due to refinery maintenance; in the past, the U.S. oil industry had limited ability to export, which contributed to the seasonal pattern.  With the potential for higher exports, the expected seasonal build may not occur, which would be bullish for prices.  If we were following the normal seasonal pattern, oil inventories would be 34.5 mb higher.

Based on our oil inventory/price model, fair value is $45.63; using the euro/price model, fair value is $68.88.  The combined model, a broader analysis of the oil price, generates a fair value of $59.83.  The divergence continues between the EUR and oil inventory models, although it is narrowing.

As we noted above, refinery utilization plunged last week.  This is the lowest weekly utilization on record dating back to 1986.

(Source:  DOE, CIM)

Market news:  As the data show, the oil markets are still adjusting to the February cold snap.  We would expect normalization to begin with next week’s report.  Sadly, the financial fallout will likely last much longer.

Geopolitical news:

  • Iran continues to try to improve its negotiating position with the U.S.  The key unknown for Tehran is how badly does Biden want a deal with Iran?  Given Iran’s behavior, it would appear it believes Washington really wants an agreement.  We suspect this is a mistake; the administration would like to return to the nuclear deal struck under President Obama but it isn’t as high of a priority as the Iranians seem to think.  We doubt the U.S. will meet Iran’s demands to end sanctions as a precondition for talks.  If so, it is likely that nothing happens.
  • Former KSA oil minister Zaki Yamani has died.  Perhaps this is his most famous quote: “The stone age did not end because the world ran out of stone,” Yamani said, “and the oil age will end long before the world runs out of oil.”
  • The Biden administration is considering “green tariffs” for carbon adjustment fees on imports.  This measure would apply tariffs to equalize the price between higher cost “green” commodities and lower cost “dirty” ones.
  • China is dominating the supply chain for clean energy.

Alternative energy/policy news:

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Weekly Geopolitical Report – The Western Sahara: Part I (March 1, 2021)

Posted on by Rebekah Stovall

by Thomas Wash | PDF

To facilitate a restoration of diplomatic relations between Morocco and Israel, the Trump administration acknowledged Morocco’s sovereignty over the Western Sahara territory on December 10, reversing the three-decade U.S. policy of supporting self-determination for the Sahrawi People who make up most of the region’s population. The reconciliation between Morocco and Israel was part of the so-called “Abraham Accords,” which seek to normalize relations between Israel and various Muslim countries in the Middle East and North Africa. However, the decision to recognize Moroccan sovereignty over Western Sahara has drawn scrutiny from across the world as it marks a departure from the traditional U.S. approach of resolving conflicts through mediation. Rather, the Trump administration’s Abraham Accords process reflects a more transactional approach that attempted to solve conflicts through ultimatums.

In this week’s report, we discuss the dispute over Western Sahara and the possibility of a broader conflict. We begin with a short history of the conflict between Morocco and Western Sahara. Afterward, we discuss the truce between the two sides and why it has been difficult to come to a resolution. We will conclude the report next week in Part II with a discussion of how the next administration might deal with this shift in policy. As usual, we will close with possible market ramifications.

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Asset Allocation Weekly (February 26, 2021)

Posted on by Rebekah Stovall

by Asset Allocation Committee | PDF

The steady rise in the 10-year T-note has started to raise concerns about the impact of higher yields.  This week’s report will examine what impact the steady rise in yields may have on the economy and markets.  Essentially, the issue at hand is if, how, or when the FOMC will act to intervene in the rise of yields.  We suspect there are two factors that would sway policymakers.  The first would be if the rise in yields had an adverse impact on housing.  The second is if it would trigger a problem in the financial markets.  Equity markets are one potential clue; the other would be credit markets.  We will discuss housing and equity markets in this report, and cover credit spreads in the accompanying chartbook.

For starters, it makes sense to gauge the situation of current yields.

The two most important variables in the model are fed funds and the 15-year average of the yearly change in CPI.  The latter acts as a proxy for inflation expectations.  We add the yen’s exchange rate, oil prices, German Bund yields, and the fiscal deficit scaled to GDP.  Although yields are rising, they remain below the fair value yield, which is currently at 1.42%.  Note the red ellipse on the chart.  At that level of overvaluation, yields would be 1.90% to 2.00%.  In recent years, this level has been the peak yield.  For now, yields remain below their fundamental value but a rise to 2.00% is not out of the question.

If yields continue to rise, what are the risks?  For the real economy, the primary concern would be residential real estate.  Mortgage yields are closely tied to the 10-year T-note spread and rising yields could make housing less affordable.

The housing affordability index consists of mortgage rates, home prices, and household income.  The higher the reading of the index, the more affordable residential real estate is for the median buyer.  A simple model of this relationship suggests that a 2.00% 10-year yield would reduce the affordability index to 162.1.  That would be a rather modest decline and probably not one significant enough to warrant intervention by the FOMC.

Finally, there is a well-known relationship between P/Es and long-term interest rates.

This chart shows the cyclically adjusted P/E (CAPE) and the 10-year yield.  Although the CAPE is elevated, some of the lift is a function of lower yields.  It is important to note that some of the rise in long-duration interest rates is a function of stronger economic growth.  Better economic growth is affecting earnings.  Our most recent iteration of our earnings model generates S&P 500 earnings this year of $153.72, up from our initial forecast of $147.84.[1]  Earnings per share is being adversely affected by a rising divisor, a function of new share issuance.  Rising rates are triggering a decline in the fair value multiple to 25.4x (from 26.9x), yielding a fair value of 3905, which is modestly below the low end of our previously forecast range of 3918 to 4050.  A rise to 2.00% on the 10-year would reduce the fair value P/E to 24.8x, ceteris paribus.  Overall, though, we remain favorable toward equities simply due to the outstanding level of liquidity available to financial markets.

In closing, what form would Federal Reserve intervention take?  The most aggressive action the FOMC could take would be yield curve control, where the central bank would set the rate for Treasuries and allow its balance sheet to expand and contract to accommodate the fixing of interest rates.  There is, in our estimation, a good chance this will occur at some point. But the above analysis suggests that, barring a crisis, it would probably take a yield above 2.00% on the 10-year Treasury based on current conditions.  Will we reach that level?  Probably not in the near term.  Therefore, we expect the FOMC to continue to talk about policy accommodation for the foreseeable future but avoid the topic of yield curve control until forced to act.

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[1] This earnings number is based on Standard and Poor’s calculation method, which is more conservative than the widely reported Thomson/Reuters earnings.  In general, the former is usually about 7% less than the latter.

Business Cycle Report (February 25, 2021)

Posted on by Rebekah Stovall

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.

In January, the diffusion index rose further above the recession indicator, signaling that the recovery continues. Financial markets were mixed as investor optimism about the economy and rising inflation concerns resulted in stronger equities and wider yield spreads. Meanwhile, the labor market worsened due to new COVID-19 restrictions, forcing firms to lay off workers. That being said, manufacturing activity continues to be a bright spot in the economy as factories were able to avoid many of the new restrictions. As a result, four out of the 11 indicators are in contraction territory. The reading for January was unchanged from the previous month at +0.2727, above the recession signal of +0.2500.

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 headed toward a recovery. On average, the diffusion index is currently providing about six months of lead time for a contraction and five months of lead time for a recovery. Continue reading for a more in-depth understanding of how the indicators are performing and refer to our Glossary of Charts at the back of this report for a description of each chart and what it measures. A chart title listed in red indicates that indicator is signaling recession.

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Weekly Energy Update (February 25, 2021)

Posted on by Rebekah Stovall

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

Here is an updated crude oil price chart.  Prices continue to rise.

(Source: Barchart.com)

Crude oil inventories rose 1.3 mb when a draw of 6.5 mb was forecast.  There was no change in the SPR.  Analysts (us included) expected production outages in Texas to lead to a decline in inventories.  Although production did decline, refinery operations fell double expectations.

In the details, U.S. crude oil production fell 1.1 mbpd to 9.7 mbpd.  Exports fell 1.5 mbpd, while imports declined 1.3 mbpd.  Refining activity plunged 14.5%.  The collapse in refining activity led to the unanticipated rise in inventories.  We also note that consumption eased as cold temperatures forced people to stay home.

(Sources: DOE, CIM)

The above chart shows the annual seasonal pattern for crude oil inventories.  This week’s rise is seasonally normal.  The usual seasonal pattern occurs due to refinery maintenance; in the past, the U.S. oil industry had limited ability to export, which contributed to the seasonal pattern.  With the potential for higher exports, the expected seasonal build may not occur, which would be bullish for prices.  If we were following the normal seasonal pattern, oil inventories would be 28.2 mb higher.

Based on our oil inventory/price model, fair value is $52.62; using the euro/price model, fair value is $68.79.  The combined model, a broader analysis of the oil price, generates a fair value of $59.72.  The divergence continues between the EUR and oil inventory models, although it is narrowing.

As we noted above, refinery utilization plunged last week.  The drop was similar to what we saw in the pandemic.

(Source:  DOE, CIM)

The energy sector has been on a tear after being weak for most of last year.  However, when compared to the S&P and oil prices, energy stocks have mostly marked time recently.

The blue deviation line shows the spread between the fair value calculation, based off the S&P and WTI, and the energy sector.  Even with the rally in the sector, it is failing to keep up with the independent variables.  This suggests that one is better off owning the commodity rather than the equities.  Or, put another way, even this rally in the energy sector is less than what we have seen in the past with this combination of equity performance and oil price increases.

Market news:  The markets are still dealing with the disruption caused by the recent cold snap which hit Texas hard.  This report, on natural gas, gives a detailed look at the cascade of problems caused by the weather.  The media tends to try to simplify such situations, looking for clear villains.  In reality, outcomes seen in Texas are rarely due to one decision but occur due to a whole series of logical steps that rest on a critical assumption.  In this case, the expectation was that natural gas flows would remain stable.  Deregulation has generally led to lower prices across many markets.  However, sometimes risks are shifted to those with the least ability to manage that risk.  That has been seen in Texas.

Geopolitical news:

  • Brazil was in the news this week as President Bolsonaro removed the head of Petrobras (PBR, USD, 8.72), the Brazilian state oil company.  Bolsonaro fired Castello Branco, who has a post-doc from the University of Chicago, replacing him with Gen. Joaquim Silva e Luna.  Like most parts of the world, fuel prices are politically sensitive; in 2018, rising diesel fuel costs triggered a truckers’ strike that reduced support for Michel Temer, Bolsonaro’s predecessor.  Shares in Petrobras tumbled on the news; the fear is that Bolsonaro will force the company to keep fuel prices low in the face of rising global crude oil prices, hurting margins.
  • Iran continues to send mixed signals to the Biden administration.  On the one hand, it is enriching uranium and restricting IAEA investigators.  On the other, it says it is open to talks.  Our take is that Iran thinks it is dealing with Obama 2.0 and assumes the new U.S. president wants a deal as badly as President Obama did.  We doubt this is the case, so this means that there probably won’t be much movement to restart talks.

Alternative energy/policy news:

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Weekly Geopolitical Report – The U.S.-China Balance of Power: Part V (February 22, 2021)

Posted on by Rebekah Stovall

by Patrick Fearon-Hernandez, CFA | PDF

As the U.S.-China rivalry intensifies in the 21st century, two questions arise. Which is stronger, the United States or China?  Which country is better positioned to protect its interests and achieve its goals?  To gauge the likely trajectory of their relationship in the coming years and assess the investment implications, Part I of this report discussed how the U.S. and China see their vital national interests and key goals.  Part II offered a head-to-head comparison of the armed forces available to each side as they work to achieve their objectives.  Part III compared the economic power of each country, and Part IV assessed their relative diplomatic influence.  We complete the series this week with Part V, where we assess the overall balance of power between the U.S. and China and offer some thoughts on how their rivalry might develop over time.  We conclude with a discussion of the associated opportunities and threats for U.S. investors, at least as long as President Biden is in power.

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