After a six-week war, Armenia regretfully conceded some of the disputed region of Nagorno-Karabakh to its longtime rival Azerbaijan. Making matters worse, Armenian President Armen Sarkisyan admitted that he wasn’t even involved in discussions regarding his country’s surrender. As of today, ethnic Armenians have evacuated the conceded regions, while Russian peacekeepers have moved in to ensure a smooth transition. Although the peace treaty appears to be holding, it isn’t clear that this conflict is fully resolved. However, the Nagorno-Karabakh conflict does appear to have caused a seismic shift in the power dynamics within the Caucasus.
The Caucasus has long been dominated by the Russia, but regional conflicts appear to be undermining its standing. The most recent standoff between Armenia and Azerbaijan has not only allowed Turkey, a NATO member, to encroach on traditionally Russian territory, but it has also given Turkey a stage on which to demonstrate its improved military capabilities. Even though this is the third conflict in which Turkey and Russia have taken opposing sides, the others being Syria and Libya, it doesn’t appear the two countries are on course for direct conflict. That being said, as the West continues to withdraw from the region, it is likely that Turkey will look to fill the void.
In Part II of this report, we will focus on the significance of the Nagorno-Karabakh conflict in understanding the global shift in geopolitical dynamics. We will begin with a broad overview of frozen conflicts, particularly after the collapse of the Soviet Union. Afterwards, we will discuss the West’s influence and its subsequent decline in mediating conflicts outside of its borders. We will then discuss the rising prominence of regional powers in resolving these issues and what it could mean for the West going forward. As usual, we conclude this report by discussing possible market ramifications.
by Bill O’Grady, Mark Keller, and Dan Winter | PDF
To measure market capitalization, we use the Wilshire Large Cap and Wilshire Small Cap indices. The following chart shows the log-transformed ratio.
On this chart, a rising number indicates stronger large caps relative to small caps. In general, small caps tend to outperform coming out of recessions, which are shown on the chart with gray bars. The basic idea is that, going into recession, investors tend to prefer large cap stocks for the safety. Larger companies have better access to capital and can generally garner more resources to “weather the storm.” As the business cycle improves, smaller firms that have made it through the downturn are usually attractively priced and thus recover faster. Since we believe the recession is already over, we would expect smaller caps to outperform and, as the above chart suggests, there is evidence that this outperformance has already started.
Over the last business cycle, a couple of other cyclical indicators are supporting the case for small caps.
Over the decades, keen observers of the financial markets have developed a number of theories and strategies that serve as useful tools for understanding market dynamics. One of the most famous such tools is the Dow Theory, which explains longer-term market movements based on the writings of Wall Street Journal founder Charles H. Dow up to his death in 1902. Of the many interrelated concepts that make up the Dow Theory, one that we find especially useful is the idea that stock market averages, like a broad market index and an index of transportation-related stocks, must move in a similar way to confirm that a tradeable trend is in place. When they fail to confirm each other, it’s a signal that the trend may be ephemeral or ready to reverse course.
One quick, easy way to check on market-average confirmation is to compare the change in the S&P 500 Index of large cap U.S. stocks versus the change in a narrower indicator index like the Dow Jones Transportation Average (a purist would compare the Dow Jones Industrial Average against the DJTA, but the larger set of holdings in the S&P 500 probably makes it a better proxy for the broad market). Comparing the S&P 500 with the DJTA makes sense because a broad economic revival benefitting companies across most sectors should be associated with improved business conditions for railroads, truckers, airlines, and other firms involved with moving goods and people to facilitate that commerce. When there is an uptrend in the broad economy or the broad market index, but a decline in transportation activity or transport stocks, it would suggest that actual conditions are deteriorating and it may be time to look for a reversal in the stock market. While the change can be tracked over different time periods, a rolling period of three months makes sense to us.
As shown in the chart below, the uptrend in the broad market over the last three months has been nicely confirmed by an uptrend in transportation stocks. The S&P 500 (shown by the blue line) was up approximately 6.9% in the three months to the middle of this week, while the DJTA (shown by the red line) was up 11.3%. There were plenty of fundamental economic and financial reasons for the broad uptrend in stock prices over the period. Through the summer and early fall, coronavirus infections were declining and pandemic economic restrictions were being lifted in most of the country. Despite a resurgence of infections more recently, positive news on the development of safe and effective vaccines has boosted expectations that the pandemic could be overcome relatively soon. In addition, corporate profits have been recovering. All the same, the outsized gain in transportation-related stocks offered a welcome element of confirmation that provided greater confidence in the uptrend.
Another way to see the relationship is to graph the difference between the DJTA and the broad market index, as shown by the blue line in the chart below. The chart indicates that the three-month outperformance of the DJTA versus the S&P 500 peaked in mid-September, early in the period. Since then, the outperformance has gradually moderated, but it has remained positive.
It’s important to remember that market-average confirmation is just one aspect of Dow Theory. Other aspects of the theory, such as secondary confirmation provided by trading volume, are not addressed here. Nevertheless, the DJTA’s outperformance provides a welcome piece of evidence suggesting that the recent uptrend in stocks “has legs.” When added to other, more fundamental indicators, such as the resolution of the U.S. presidential election and continued monetary stimulus from the Federal Reserve, the evidence suggests that equities could continue to appreciate in the months going forward, validating our continued exposure to stocks in our asset allocation strategies.
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA | PDF
Here is an updated crude oil price chart. Positive news on a vaccine for COVID-19 led to a strong rally this week, taking prices to the upper end of the current trading range.
(Source: Barchart.com)
Commercial crude oil inventories fell 0.7 mb when a 1.7 mb draw was expected. The SPR was unchanged; there is still 3.2 mb of storage in excess of the 635.0 mb that existed before the pandemic.
In the details, U.S. crude oil production rose 0.1 mbpd to 11.1 mbpd. Exports rose 0.6 mbpd, while imports rose 0.2 mbpd. Refining activity fell -0.5%.
(Sources: DOE, CIM)
The above chart shows the annual seasonal pattern for crude oil inventories. This week’s data showed crude oil stockpiles were steady, which is somewhat contraseasonal. Inventories are past their second seasonal peak and usually decline into year’s end.
Based on our oil inventory/price model, fair value is $44.18; using the euro/price model, fair value is $63.55. The combined model, a broader analysis of the oil price, generates a fair value of $52.78. The wide divergence continues between the EUR and oil inventory models. However, current oil prices are below all three measures of fair value, suggesting that oil prices are likely undervalued. The most important support is dollar weakness.
The above chart shows weekly gasoline inventories. Beginning in early November, inventories begin their seasonal increase that lasts into early February. We are clearly seeing the usual seasonal pattern develop, which means that gasoline inventories should continue to rise for the next several weeks.
But the biggest problem facing OPEC+, and to some extent, all oil producers, is the issue of peak demand. If actions taken to manage climate change lead to less oil consumption, then oil reserve owners face the problem of stranded assets. If demand and prices are set to decline on a secular basis, then there is an incentive to produce now as the value of future oil will likely be less. It is important to remember that the reason for the collapse in oil prices in April was due, in part, to a market share war within OPEC+. Although it is difficult to parse out all the factors that played a role in the Saudis backing away from their policy of lifting market share (and, consequently, pushing down oil prices), there is a strong case to be made that President Trump’s intervention played a role. With Trump set to leave the White House next month and President-elect Biden’s policy of reducing carbon, the Saudis may be more inclined to return to their earlier policy. So far, Riyadh is holding the line on production cuts. But, if frictions rise high enough, Saudi Arabia may decide to restore discipline. We do find it interesting that, just a few short months from negative prices, the cartel is getting antsy to boost output. If OPEC+ fails to maintain production cuts, the U.S. energy industry, still struggling, will see further production declines.
Bitcoin prices have been surging recently; the “mining” of bitcoin requires massive computing power and, thus, electricity. Russians are being accused of using Abkhazia’s cheap electricity to establish server farms to mine bitcoin. In 2008, the region was invaded by Russia and is no longer under the control of Georgia. The region has claimed independence, but only a handful of nations recognize its independence. Bitcoin mining is leading to local power outages.
A massive solar project is being planned in Texas, the largest in the U.S. Of course, with solar and wind, battery storage remains an issue. Batteries are seeing new investment as well. And, there is new research in recycling oil EV batteries, which may further increase storage capacity. The commitment to EV by car companies appears to be increasing; General Motors (GM, USD, 44.68) has decided to exit the lawsuit it had joined against California over emissions standards.
Finally, the CFTC did not blame anyone for the oil price declining into negative territory in April. We suspect that passive investment played a major role in the decline, but government regulators were unable to make a determination. It is possible this decision could be revisited under the new administration.
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 October, the diffusion index rose further above contraction territory, signaling that the economy remains on track to expand in Q4. Financial markets were weaker as equities dipped and the yield spreads widened. Meanwhile, the labor market continues to show signs of improvement as firm hires remain strong. However, the lack of progress on additional fiscal stimulus continues to weigh on growth expectations as concerns over slowing consumer spending continue to mount. As a result, four out of the 11 indicators are in contraction territory. The reading for October rose from +0.1515 to +0.2121, above the recovery signal of -0.100.
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.
(Due to the Thanksgiving holiday, our next report will be published on December 7, 2020.)
On November 9, Armenia agreed to give up some of its territory to Azerbaijan in a deal brokered by Russia. After six weeks of fighting and three failed ceasefires, Azerbaijan and Armenia have ended their war over the disputed territory of Nagorno-Karabakh. In accordance with the agreement, Armenia vacated the disputed territory on November 15. Following the departure, Russia deployed 2,000 peacekeepers to the region to ensure a smooth transition. Turkey, which provided Azerbaijan with military support, was also able to stake its claim in the region. Unlike the previous three ceasefire attempts, this one appears to be holding.
The truce freezes conflict between the two rival nations, while bolstering Russia and Turkey’s influence in the region. The absence of the West’s involvement in negotiations suggests that its role as power broker could be shrinking in favor of regional competitors. Over the last several years, Turkey and Russia have expanded their reach into Eastern Europe, the Middle East, and Northern Africa, thus filling a leadership void left by the West. If this trend continues, we believe it could raise the likelihood of increased geopolitical tensions as regional powers compete for influence.
In Part I of this report, we will focus on the history of the tensions between Armenia and Azerbaijan. We will begin with a summary of the geography of the Nagorno-Karabakh territory, followed by a discussion of Russia’s invasion of the Caucasus during Russia’s Imperial era and its downfall. We will then examine the conflict between Azerbaijan and Armenia following the dissolution of the Soviet Union, with a more detailed summary of the recent conflict between the two regions.
In the aftermath of the election and favorable news on vaccine progress, we have seen a notable backup in interest rates. The 10-year T-note yield is flirting with 1%. In this report, we will examine the future path of long-duration interest rates.
We start with our 10-year T-note yield model.
The model, which uses fed funds, the 15-year average of CPI (an inflation expectations proxy), the JPY/USD exchange rate, oil prices, German 10-year bond yields, and the fiscal deficit, suggests the fair value yield is near 140 bps. Although this fair value is historically low, it is well above the current rate of around 90 bps. In the absence of outside interference, it would not be unreasonable to expect yields to continue to drift higher. However, we do expect weaker economic growth in Q4 2020 and Q1 2021, so the pace of increases may slow.
However, the potential for outside intervention is high. The issue comes down to Federal Reserve policy. The U.S. central bank has hinted at the possibility of yield curve control. So far, the Fed has not taken concrete steps to implement fixing long-duration interest rates. But a rapid rise in such rates would not be welcome because it would have an adverse effect on the mortgage and housing markets.
Mortgage rates, relative to the 10-year Treasury, spiked in April. The spread has narrowed since then but remains above 2%, which is elevated. If rising T-note rates lead to higher mortgage rates, it will tend to stifle part of the economy that is showing promise. This may lead the Fed to try to slow the rise in long-duration interest rates.
At the same time, a low interest rate regime tends to act as a headwind for banks. This factor may encourage the Fed to allow long-term rates to rise modestly. But we doubt that policymakers would be comfortable with a 10-year T-note yield in excess of 1.25%. If rates approach that level soon, we would not be surprised to see the Fed signal it isn’t pleased with the development. And so, we may see a further rise in long-term interest rates, but a move to revert to the rate levels seen before 2008 is improbable.
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA | PDF
(N.B. Due to the Thanksgiving Day holiday, the next report will be published on December 3.)
Here is an updated crude oil price chart. Positive news on a vaccine for COVID-19 led to a strong rally this week, taking prices to the upper end of the current trading range.
(Source: Barchart.com)
Commercial crude oil inventories rose 0.8 mb when a 1.6 mb draw was expected. The SPR declined 0.4 mb; since peaking at 656.1 mb in July, the SPR has drawn 17.7 mb. Given levels in April, we expect that another 4.7 mb will be withdrawn as this oil was placed in the SPR for temporary storage. Taking the SPR into account, storage rose 0.4 mb. The data was mostly unaffected by tropical activity this week.
In the details, U.S. crude oil production rose 0.4 mbpd to 10.9 mbpd. Exports were unchanged, while imports fell 0.2 mbpd. Refining activity rose 2.9%.
(Sources: DOE, CIM)
The above chart shows the annual seasonal pattern for crude oil inventories. This week’s data showed a rise in crude oil stockpiles, which is normal. Inventories are approaching their second seasonal peak. Thus, after next week we would expect a steady slide in oil inventories.
Based on our oil inventory/price model, fair value is $43.67; using the euro/price model, fair value is $62.98. The combined model, a broader analysis of the oil price, generates a fair value of $52.18. The wide divergence continues between the EUR and oil inventory models. However, current oil prices are below all three measures of fair value, suggesting that oil prices are likely undervalued.
Refinery operations did bounce back this week, rising 2.9%, well better than the 0.6% rise expected. We are in a period of the year when refinery operations are usually increasing, so we will see if this week’s increase has any follow through. If it does, it is supportive for oil prices.
(Sources: DOE, CIM)
In oil market news, there is hope that OPEC+ will do something to lift prices; technical meetings were held this week in anticipation of the ministerial meeting at the end of the month. Little emerged from the meetings, but that isn’t a surprise. We doubt the cartel will do much at the end of the month other than extend current production levels.
Oil companies are starting to face state-level lawsuits against them for climate mitigation. The industry is moving to push these suits into federal courts to manage them more easily.
Our working assumption is that Joe Biden will be the next president, but until the Electoral College meets next month the election isn’t over. And, until January 20, President Trump is still running the U.S. government. There is a lot of activity that will likely make it difficult for a new president to unwind. First, we are seeing the Department of the Interior call for nominations for drilling in ANWR for lease sales next month. Although this will be a hot button issue that will get much media play, we don’t expect aggressive bidding. Most oil companies are trying to “green” themselves and drilling in ANWR won’t help in those efforts.
For the first time since the Gulf War, the border crossing at Arar, on the Iraq/Saudi frontier, has reopened. The reopening is a potential signal of a decline in Iran’s influence on Baghdad.
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