Author: Rebekah Stovall
Asset Allocation Weekly (March 26, 2021)
by Asset Allocation Committee | PDF
(Note: Due to the upcoming Good Friday holiday, the next report will be published on April 9.)
Since peaking in August, gold prices have been under pressure.
Technically, prices broke support around 1750 in early March and have been attempting to consolidate.
We have been holding gold in our asset allocation portfolios since 2018, although the level was reduced in the most recent rebalance to add a position in broader commodities. As the price languishes, how should investors view gold? What is the outlook?
The long-term outlook for gold remains positive. Our basic gold model, which uses the balance sheets of the Federal Reserve and the European Central Bank, the EUR/USD exchange rate, and real two-year T-note yields, suggests that prices are significantly undervalued.
On the other hand, there are several short-term factors that are weighing on prices. The most important is rising long-duration Treasury yields.
This chart shows the real 10-year yield derived from the TIPS spread against Treasuries. The real yield is inverted on the chart scale. Note that recently the real yield began to rise (become less negative). Regressing the relationship generates a fair value of 1716.65, which is around where gold is trading now. In addition, we have seen gold flows into exchange-traded products wane recently, adding additional pressure.
If the FOMC is serious about boosting employment, monetary policy should remain accommodative; the problem for policymakers is that a steepening yield curve will tend to lift long-term interest rates further. If the Fed allows the 10-year T-note to “find its natural level,” then we would expect rates to reach 1.90% to 2.00%. That likely means additional short-term pressure on gold prices. At some point, we do expect the FOMC to take steps to halt the rise in long-term Treasury rates which will likely lift gold prices. But, until that happens, gold will likely struggle to rally.
Business Cycle Report (March 25, 2021)
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 February, the diffusion index rose further above the recession indicator, signaling that the recovery is continuing. Another round of fiscal stimulus elevated equities but led to a modest sell-off in Treasuries. Meanwhile, a slowdown in COVID-19 cases and easing restrictions made it easier to hire workers, thus last month saw an improvement in labor market conditions. However, poor weather conditions and supply constraints, particularly lack of semiconductors and lumber, led to a pullback in manufacturing and construction activity. As a result, four out of the 11 indicators are in contraction territory. The reading for February 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.
Weekly Energy Update (March 25, 2021)
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA | PDF
Here is an updated crude oil price chart. Prices have declined over $10 per barrel since peaking on March 8. Worries about slowing European growth and a slower than expected recovery in refinery operations after the Texas freeze have weighed on prices.
Crude oil inventories rose 1.9 mb compared to the 1.2 mb expected. There was no change in the SPR. Refinery operations, as noted below, continue to recover.
In the details, U.S. crude oil production rose 0.1 mbpd to 11.0 mbpd, meaning that U.S. production has recovered to pre-Texas disruption levels. Exports were unchanged, while imports rose 0.3 mbpd. Refining activity rose 5.5%.
The above chart shows the annual seasonal pattern for crude oil inventories. Inventories remain at a seasonal deficit, but the gap did narrow, mostly due to disruptions surrounding the recent cold snap. If we were following the normal seasonal pattern, oil inventories would be 17.1 mb higher.
Based on our oil inventory/price model, fair value is $40.25; using the euro/price model, fair value is $65.54. The combined model, a broader analysis of the oil price, generates a fair value of $51.37. The divergence continues between the EUR and oil inventory models, although recent dollar strength has reduced the projected fair value generated from the euro/price model.
Refinery operations continued to recover last week and are near pre-winter storm levels. We would expect utilization to stabilize in the coming weeks.
Market news:
- Oil prices rallied after a large container ship blocked the Suez Canal. More than 100 ships are backed up at this critical shipping chokepoint. About 10% of world shipping traffic passes through the canal. The vessel ran aground in a sandstorm, which not only blocked visibility but made steering the ship difficult.
- Canadian Pacific Railway (CP, USD, 355.82) has agreed to buy Kansas City Southern (KSU, USD, 248.96) railroad. The concept behind the merger (which still needs regulatory approval) is to create a rail line from Mexico to Canada, effectively consolidating the USMCA trading bloc. A side effect of this merger could be that it allows Canadian tar sands oil to have another outlet to the U.S. via rail shipping. Pipelines have become increasingly difficult to build due to environmental regulations; we will be watching to see if these same groups try to block the merger.
- Companies that are considered risky credits have been able to issue new debt. This factor should reduce bankruptcies in the system and help maintain production. Although companies have been promising better output discipline, the combination of strong prices and available credit may lead to higher output.
- Despite banks making pledges to support the greening of the economy, they continue to make loans to fossil fuel companies. Globally, loans of $750 billion were made last year.
- The impact of the Texas freeze is slowly dissipating, but we are still seeing a notable impact on petrochemical markets.
- Saudi Aramco (2222, SAR, 34.90) announced it would maintain its dividend despite falling oil prices. The company had to borrow to meet this dividend. This factor suggests that the House of Saud continues to use the company as a source of funding and is not allowing it to act as a fully private, profit-seeking entity.
- As the U.S. increases vaccinations, we would expect that gasoline demand will continue to recover. Rising consumption, coupled with a slowly recovering refining sector, will likely lead to higher gasoline prices. This rise will likely be a political issue for the current administration. However, we do note that driving activity remains historically low, not just on a cyclical basis, but on a secular basis as well.
Driving activity fell below trend during the Great Financial Crisis and plummeted during the pandemic. It is highly unlikely we will ever return to trend. This factor will tend to dampen either gasoline prices or force the refining industry to contract. Recent IEA research supports this notion.
- The SEC is forcing energy companies to entertain investor votes on emissions targets. This factor will complicate company management.
Geopolitical news:
- A Biden administration goal was to return to the Obama-era nuclear deal. However, very little progress has been made. Iran wants the U.S. to roll back sanctions as a precondition for talks, while the U.S. wants Iran to cut back on nuclear activities as a precondition for talks. Given the history, neither side trusts the other. A complicating factor is that some parts of the 2015 agreement are coming to their negotiated end, meaning the return to the original deal doesn’t do much to address Iran’s threat to the region. Our take is that Obama wanted Iran to become the regional hegemon, allowing the U.S. to then shift its focus to Asia. Naturally, Israel and the Gulf States opposed this idea. However, the nuclear deal was a small step in the process; Obama likely accepted this because he assumed a Democrat would succeed him and carry out the rest of the process. This obviously didn’t occur. Now, the Biden administration likely has the same goal―exiting the Middle East―but doesn’t have an obvious path to that end.
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- Despite this problem, left-wing populists (LWP) are getting agitated with the lack of progress. The LWP is concerned about the humanitarian impact of U.S. sanctions and wants to see this situation resolved.
- Iranian presidential elections will be held in June; the U.S. insists this isn’t a factor, but we fail to see how it wouldn’t affect negotiations.
- It is clear that sanctions have severely harmed the Iranian economy but have done little to move its leadership to talks. The longer sanctions are in place, the better Iran gets at undermining them.
- The Saudis have offered a ceasefire to Houthi rebels and a lifting of the blockade in a bid to start talks. So far, there has been little movement to end the conflict despite these offers.
- China is expanding its refining industry in a bid to dominate Asian product trade. This decision flies in the face of “greening” energy.
Alternative energy/policy news:
- An interesting area of battery research is in creating “massless” batteries. This isn’t a battery that has no mass but one that is part of the structure of the product. For example, if one could put the battery into the frame of a car, the battery would no longer be dead weight. Researchers claim they are making progress in this area; if true, it would open up new options for transportation, e.g., battery aircraft.
- India is considering a 2050 net-zero carbon goal. Given its current heavy use of coal for electricity, if met, it would be more negative news for coal. We note it would be a decade before China has promised to reach this level.
- Global oil company leaders are supporting a plan for pricing carbon. Without a carbon price, it will be difficult to use the market to allocate toward cleaner energy.
- After languishing for years, uranium prices are rising, boosting the prospects for uranium miners. If modular nuclear reactors become popular, the outlook would be even brighter.
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Weekly Geopolitical Report – The Geopolitics of Central Bank Digital Currencies (CBDC): Part II (March 22, 2021)
by Bill O’Grady | PDF
In Part I, we discussed the metaphysics of money. This week, we will examine the current structure of money and the potentially complicated impact of CBDC.
The Current Structure
Here is a Venn diagram of the current structure of money in most developed markets.
First, there are two forms of money that are electronic only—reserve money and bank account money. Reserve money is part of the monetary base and it is money that banks “hold” at the central bank. Only banks can access reserve money, or, put another way, only banks have direct access to the balance sheet of the central bank.
Bank account money is money held in household or firm bank accounts. It is mostly created by banks through the lending process. The central bank issues two forms of money—cash, which is an anonymous bearer instrument, and reserve money. Finally, cash and bank account money are held by anyone, therefore they are universally accessible.
Asset Allocation Weekly – #32 (Posted 3/19/21)
Asset Allocation Weekly (March 19, 2021)
by Asset Allocation Committee | PDF
When discussing the fiscal deficit in a meeting with then-President Bill Clinton and his Council of Economic Advisors, Chief Strategist James Carville was quoted as saying, “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.” As Carville suggested, rising 10-year T-note yields are currently shaking investor confidence in global stocks, particularly in the Technology sector. The primary concern for investors is that the next stimulus package could spark inflation over the next couple of years. In this report, we discuss why some of those fears may be misplaced.
The 10-year T-note yield has tripled from 0.51% last August to a little over 1.54% today. The surge in yields can be partly attributed to fears of accelerated inflation due to the federal government’s growing deficit. The new COVID-19 relief plan has drawn the ire of bondholders because they suspect it was bigger than necessary. The prospect of higher borrowing costs hurts equities because it lowers valuations. In other words, higher yields tend to depress P/E multiples.
In general, the relationship between fiscal deficits and inflation is not all that strong. Over the last 20 years, the U.S. budget deficit relative to GDP has been the largest during any period of peacetime. Throughout this period, however, inflation has never reached the levels seen in the 1970s and 1980s. In fact, core CPI for the last 20 years has grown around the Fed’s 2% target. The two primary drivers of the Consumer Price Index (CPI) have come from healthcare and shelter. Composing nearly 40% of the index, prices in these two sectors have consistently outpaced the overall index.
Inflation has been relatively muted over recent years because the conditions that allowed it to thrive in the 70s and 80s no longer exist today. Deregulation, globalization, and lower taxes have made it easier to cut costs, while making it difficult for firms to raise prices. Deregulation and globalization have made it easier for firms to outsource labor and remove costly regulations, while lower taxes incentivized firms to adopt cost-saving technologies. Additionally, increased competition meant that only companies with differentiated or specialized goods had any real pricing power. As a result, the prices for goods such as apparel and vehicles have been roughly unchanged over the last 20 years.
Instead of seeing inflation in goods and services, we suspect that deficit spending will likely find its way into financial assets. Government spending is paid for through the private sector (which includes businesses and households) and foreign savings. Much of those savings so far have come from households as higher levels of unemployment have deterred spending. These savings have been used to pay down debt and invest in equities (cue the Reddit army). Foreign savings will likely also pick up in the coming months as consumers begin to spend more. This should be supportive of financial assets as a rise in imports is generally funded by an increase of flows into the capital account.
Nearly every president since Nixon has governed with an eye on the bond market. That is because bondholders overestimate the impact that new presidents will typically have on the economy. The chart above shows the 10-year T-note yield along with the first quarter forecast for the next six quarters from the Philadelphia FRB’s survey of professional economists. When the forecast is generally correct, we mark it with dots; when in error, we use open boxes. In 12 of the past 20 years, the expectation has been for rising rates and has been incorrect. Thus, investors should be aware that expectations lean toward higher rates but are wrong more than half the time. Another way of thinking about the recent rise in rates is that most of the time, the consensus is that long-duration interest rates will rise. That being said, we suspect the rise in current rates probably won’t exceed 2% on the 10-year T-note and equity markets will be able to manage this level of increase.
Weekly Energy Update (March 18, 2021)
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 low $60s.
Crude oil inventories rose 2.4 mb which was in line with forecast. There was no change in the SPR. We did see a recovery in refinery operations but not enough to prevent the rise in inventories.
In the details, U.S. crude oil production was unchanged at 10.9 mbpd. Exports fell 0.1 mbpd, while imports fell 0.3 mbpd. Refining activity rose 7.1%.
The above chart shows the annual seasonal pattern for crude oil inventories. Inventories remain at a seasonal deficit, but the gap is narrowing, mostly due to disruptions surrounding the recent cold snap. If we were following the normal seasonal pattern, oil inventories would be 13.5 mb higher.
Based on our oil inventory/price model, fair value is $40.87; using the euro/price model, fair value is $66.01. The combined model, a broader analysis of the oil price, generates a fair value of $51.98. The divergence continues between the EUR and oil inventory models, widening due to the distortions caused by the February cold snap.
Refinery operations jumped last week but still remain well below recovery levels and pre-Texas freeze levels.
Market news:
- Although it’s a bit wonky, Platts (SPGI, USD, 348.61), the company that creates pricing benchmarks for energy and other commodities, was considering making a change to freight pricing as part of a change to include WTI in its international benchmarks. WTI was generally not considered an international price because it wasn’t exported until a few years ago. The industry has pushed back hard on the change, meaning Platts will likely return to the drawing board to rethink its freight price position.
- The IEA issued its forecasts for supply and demand through 2026. Demand will likely return to previous peaks by early 2023 and reach 104.1 mbpd by 2026. This forecast is remarkably optimistic, but, if accurate, would suggest that fossil fuels are still viable.
- We continue to deal with the fallout from the February cold snap. The latest problem is that the freeze shut down petrochemical plants in the Lone Star State, which is now causing a global plastics shortage. Polypropylene and polyvinyl chloride are used in a variety of products, leading to supply problems in several industries. Rising costs of inputs are raising inflation concerns across numerous markets.
Geopolitical news:
- So far, despite attempts to restart talks with Iran, little progress has been made. We doubt anything will occur before Iran holds presidential elections in June.
Alternative energy/policy news:
- Hydrogen continues to attract interest. The Financial Times is running a series on hydrogen. The most promising areas are using the fuel for steel production, airplane fuel (batteries are probably too heavy for planes), and centralized fleets. For cars, batteries look to be the winner.
- Battery metals are seeing a surge in demand. Essentially, the electrification of automobiles is a swap of hydrocarbons for metals. This rise in demand is affecting prices of these metals.
- The supermajor oil companies are trying to adapt to an ESG world. Chevron (CVX, USD, 107.61) is facing criticism from environmental groups for “greenwashing,” which is the charge that the company’s environmental announcements are inadequate. A complaint has been filed with the FTC.
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Daily Comment (March 16, 2021)
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA
[Posted: 9:30 AM EDT] | PDF
Today’s Comment opens with a review of the Federal Reserve policy meeting that begins this morning (spoiler alert: no policy change is expected). We then review several important new items from overseas, including signs that the Chinese government is taking even more steps to reign in private technology companies. We end with the latest developments on the coronavirus pandemic.
U.S. Monetary Policy: The Fed opens a two-day policy meeting today. No significant change in policy is expected, especially since policymakers over the last couple of weeks have insisted that the U.S. economic outlook is still very uncertain, and both unemployment and inflation remain far from their goals. All the same, investors will be looking for any hint of an earlier-than-expected monetary tightening when the decision is released on Wednesday. One topic that might be addressed is the rapid runup in corporate bond yields, which could potentially pose a hurdle for economic recovery down the line.
United States-China: In a potential new source of friction between the U.S. and China, some of China’s biggest technology companies, including ByteDance and Tencent (TCEHY, 82.62), are testing a tool to bypass new privacy safeguards being developed by Apple (AAPL, 123.99) for use on its iPhones. With the new tools, the Chinese firms’ apps would be able to continue tracking iPhone users without their consent to serve them targeted mobile advertisements.
Chinese Tech Sector: In a sign that Beijing is redoubling its effort to rein in the country’s powerful technology firms, a Communist Party leadership meeting chaired by President Xi issued a warning that “Some platform companies are growing in an inappropriate manner and therefore bear risks.” As if to illustrate what the government will do in response, Chinese internet companies were apparently forced to take down the popular UC Browser offered by Alibaba (BABA, 230.28). Separately, messaging app Signal became unusable for many people, stifling one of the last widely used apps that could send and receive encrypted messages in the country without a virtual private network.
Chinese Agriculture Sector: A resurgence of African swine fever is putting a new strain on China’s efforts to rebuild its herds and threatening U.S. farmers’ hopes to sell more soybeans there this year. Because of the recent outbreak, analysts say China’s sow herd has been falling 3% to 5% each month since December.
China-Russia: The Chinese and Russian governments last week signed an agreement to work together to develop a lunar research station on or orbiting the Moon. After decades of Russian cooperation with the U.S. in space, the move allies Moscow with a nation that is increasingly competing against the U.S. in the extraterrestrial realm. It also marks a warming of ties between Beijing and Moscow.
United States-North Korea: The Biden administration announced that it has reached out to North Korea to launch a dialogue on Pyongyang’s nuclear-weapons and ballistic-missile programs, but it has yet to receive a response.
Libya: The country’s first unity government in seven years was sworn in before parliament yesterday. The new government, which replaces two rival administrations, offers the chance to end the chaos that has engulfed Libya since Muammar Gaddafi was overthrown following a NATO-backed uprising in 2011.
COVID-19: Official data show confirmed cases have risen to 120,320,804 worldwide, with 2,662,878 deaths. In the United States, confirmed cases rose to 29,496,142 with 535,657 deaths. Vaccine doses delivered in the U.S. now total 135,847,835, while the number of people who have received at least their first shot totals 71,054,445. Finally, here is the interactive chart from the Financial Times that allows you to compare cases and deaths among countries, scaled by population.
Virology
- Newly confirmed U.S infections rose to approximately 55,000 yesterday, surpassing the seven-day moving average but still below the 14-day average and far lower than the rates seen at the beginning of the year. The figures reflect a general plateauing of new infections following the steep declines in February and early March. Meanwhile, new deaths related to the virus totaled only 741. Hospitalization rates and intensive-care cases also remain far below their levels at the turn of the year.
- In New York City, the percentage of people testing positive for COVID-19 over an average of seven days has hovered between 6% and 7% for the past several weeks, a plateau that epidemiologists warn will be difficult to push down. People are fatigued with isolating, more of the city has opened and continues to open, and some people are less scared of the virus and changing their behavior.
- Mississippi and Connecticut announced plans to expand vaccine availability to virtually their entire adult populations, as Alaska and Michigan did last week. CDC data show 14.8% of U.S. adults are now fully vaccinated against the disease.
- Moderna (MRNA, 143.66) announced that it is studying its COVID-19 vaccine in children aged six months to 11 years in the U.S. and Canada. The new trials mark the latest effort to broaden the mass-vaccination campaign beyond adults and could help ensure that schools can open and stay open.
- In another setback for the EU’s vaccination program, Germany, France, Italy, and Spain joined a number of smaller EU countries in pausing the use of the vaccine from AstraZeneca (AZN, 48.77) due to concerns about serious blood clotting in a small number of those vaccinated with it.
- The European Medicines Agency is reviewing the reported cases and is expected to give its verdict by Thursday regarding the safety and potential risks of that vaccine.
- The agency yesterday repeated an advisory from last week that, for now, it is recommending countries continue to use the vaccine, saying the benefits outweigh possible risks.
- The U.K.’s medicines regulator, the first to green-light the shot for mass use in late December, maintains that stance as well, telling Britons to get their shots as planned.
- The World Health Organization also recommended vaccinations go forward as normal to avoid unnecessary deaths. The WHO is also probing the blood-clotting reports but so far has found no evidence the conditions are linked to the vaccine.
- According to AstraZeneca, the number of blood-clotting cases among the roughly 17 million people in the EU and U.K. who have received the shot is lower than for the general population. Large-scale human trials also didn’t raise flags about blood clotting as a risk.
- Fearing that the strong U.S. push for vaccinations could lead it to restrict the export of critical vaccine inputs, the EU is taking steps to establish its own domestic manufacturing capacity for medical products ranging from specialized plastic bags used in drug factories to vaccine vials and certain chemicals. The move highlights how the pandemic is undermining the global supply chains that have helped drive down inflation and boosted corporate profits over the last several decades.
- Japanese Prime Minister Suga finally received his first dose of a COVID-19 vaccine. The shot was provided as part of Suga’s preparations to visit President Biden next month at the White House.
- In Brazil, President Bolsonaro announced he will replace the country’s health minister for the third time since the pandemic started. Army General Eduardo Pazuello, who has been criticized for record-high deaths and a plodding immunization effort, will be replaced by cardiologist Marcelo Queiroga.
Economic and Financial Market Impacts
- Even though the pandemic and government policies to combat it have helped spark a new housing boom, a review of the housing market’s fundamentals shows this boom is much different from the one right before the Great Financial Crisis.
- Reports over the last few days indicate airline bookings and traffic through airports are on the upswing. Two major airlines said they may stop bleeding cash as early as this month. In addition, many hotels are now reopening, hiring back workers, and welcoming guests again. The news gave a big boost to airline and other travel stocks yesterday. If the service sector continues to open up, it could have a major impact on overall hiring and economic activity, which should support continued firmness in equity prices.