Category: zerohedge

Authored by David Robertson via RealInvestmentAdvice.com,

Every once in a while it can be helpful to take a step back from frenetic daily routines, to revisit assumptions and beliefs, and to just experience things afresh. Watch a good movie that you haven’t seen for a while or re-read a book and new details will emerge. There might be entire scenes you don’t remember very well that enhance the richness of the narrative. The experience can be enjoyable, even enlightening.

The same case can be made for revisiting investment principles and this is exactly what three different pieces of recent research do. Some insights are new. Some are useful reminders. All are relevant for investors who are navigating difficult markets.

The first body of research comprises two papers [here] and [here] by Edward F. McQuarrie, Professor Emeritus at Santa Clara University. Working with data collected by Richard Sylla (co-author of A History of Interest Rates), Jack Wilson, and Robert Wright, McQuarrie expands the range of holding period returns for bonds to the 1793-1857 period. With this, he significantly expands the historical perspective of asset returns and opens the door to a fresh interpretation of it.

His simple summary of the new bond return data is:

“1) returns for the period were well above the long-term average cited by Siegel (2014); 2) bonds are as subject to bull and bear markets as stocks; 3) bond returns can be depressed or super-charged over periods decades in length.”

Indeed, the chart “The First Fifty Years of the US Stock and Bond Markets” shows a striking similarity between stocks and bonds.

With the added perspective of the new data, McQuarrie also endeavors to take a fresh look at the value proposition of stocks in a portfolio. As McQuarrie describes:

“The goal is to challenge shibboleths about the expected outcomes of buy-and-hold stock market investing, and to raise questions about the expected performance of stocks versus bonds over long periods.”

Grant’s Interest Rate Observer, which noted the papers in both its November 16, 2018 and November 30, 2018 editions, describes one shibboleth:

“The [Jeremy] Siegel thesis animates (if not enslaves) many a stock-market dip-buyer, retirement planner and endowment-fund trustee. If there were such a thing as Street writ, it would run something like this: ‘Equities never disappoint in relation to bonds and cash over a multi-decade holding period’.”

The implication, as Grants notes, is:

“If McQuarrie is right, as we believe him to be, Wall Street has some explaining to do—certitudes to discard, expectations to reset, portfolios to re-build.”

As a result of the data work, McQuarrie adds valuable perspective to the history of stock and bond returns. For certain, he reports:

“There remains an important asymmetry: the much greater volatility of stocks relative to bonds. Stocks can go up much faster and reach much higher peaks than bonds. But this fact only helps investors who are capable of market timing: investors who know how to get out at the top, before the flip side of volatility takes hold, and stocks plunge further and faster than investment grade bonds ever could.”

This perspective paints the value proposition of stocks (relative to bonds) as far less alluring than many believe. Specifically, McQuarrie reports:

“There are also almost a dozen cases of negative equity premia, lasting for as long as forty years. Collectively, these periods of rough equivalence (between stocks and bonds) cover about two-thirds of the 210 years. The best one sentence summary of the 210 year record would be that sometimes, stocks outperformed bonds, but at other times, bonds out-performed stocks; while much of the time, stocks and bonds performed about the same.”

The second piece of research addresses the issue of diversification. Sébastien Page, CFA and Robert A. Panariello, CFA tackle an important investment challenge in the Financial Analysts Journal [here]:

“One of the most vexing problems in investment management is that diversification seems to disappear when investors need it the most. Studies have shown this effect [the disappearance of diversification benefits] to be pervasive for a large variety of financial assets, including individual stocks, country equity markets, global equity industries, hedge funds, currencies, and international bond markets.”

Even though “most of these studies were published before the 2008 global financial crisis,” the authors highlight the fact that, “the failure of diversification during the crisis … seemed to surprise investors.”

Under the heading, “The myth of diversification”, Page and Panariello remind investors:

“Leibowitz and Bova (2009) showed that during the 2008 global financial crisis, a portfolio diversified across US stocks, US bonds, international stocks, emerging market stocks, and REITs saw its equity beta rise from 0.65 to 0.95.”

In other words, a portfolio consisting of the types of assets that comprise the vast majority of many portfolios saw diversification benefits fall to almost zero in the heat of the crisis. The authors state bluntly:

“Diversification fails across styles, sizes, geographies and alternative assets!”

This is interesting partly because some asset allocators employ alternative assets explicitly for the purpose of increasing diversification. It certainly makes a good story because it is intuitively obvious that hedge funds would be hedged. Indeed, the authors recognize such efforts:

“Beyond traditional asset classes, investors have increasingly looked to alternatives for new or specialized sources of diversification.” 

The evidence refutes the intuition, however:

“[A]ll the styles [seven different hedge funds styles were examined], including the market-neutral funds, exhibit significantly higher left-tail than right-tail correlations.”

The same results hold for private equity:

“Pedersen, Page, and He (2014) showed that the private assets’ diversification advantage is almost entirely illusory.”

To be sure, Page and Panariello “are not arguing against diversification across traditional asset classes.” They do make clear, however:

“[I]nvestors should be aware that traditional measures of diversification may belie exposure to loss in times of stress.”

In other words, it’s not a good idea to rely exclusively on diversification as a risk management tool.

Yet another piece of research dovetails nicely with the preceding two. Eugene Fama and Kenneth French report [here],

“The high volatility of stock returns is common knowledge, but many professional investors seem unaware of its implications. Negative equity premiums and negative premiums of value and small stock returns relative to market are commonplace for 3- to 5-year periods; and they are far from rare for 10-year periods.”

One interesting aspect of each of these pieces of research is that they come from very credible sources. Fama, for example, won the Nobel prize for economics for his work on portfolio theory, asset pricing and the efficient market hypothesis. In fact, one would be hard-pressed to find any single person more responsible for conventional finance theory.

Another interesting aspect is that none of the pieces is cutting edge research per se. This is not at all to disparage the efforts, but rather to recognize that each of them treads on a great deal of familiar territory. Collectively, they beg the question: Why revisit these topics now?

Gillian Tett describes one possible explanation in the FT [here]. She notes that Seth Klarman from Baupost Group is intrigued by the concept of “psychological leverage” which is described as:

“A situation in which everybody is so heavily invested in the assumption that markets will move in one way that a small reversal can spark a self-reinforcing panic.”

This is fairly consistent with the view of Ray Dalio, founder of Bridgewater fund, who assessed:

“The world by and large is leveraged long. When there is a downturn, I don’t think there’s much to protect investors.”

In other words, it appears as if investors have become habituated to taking on risk. After all, the financial crisis was ten years ago. Comforted by the passage of time and by recency bias (the tendency to place too much emphasis on things that have happened recently and not enough on those that happened longer ago), many investors have brushed off the financial crisis as an aberration.

This tendency is also exacerbated by the growing number of investors who have never experienced the visceral fear of a financial crisis. Terry Duffy, chief executive of the Chicago Mercantile Exchange, noted:

“Seventy-one million people in America are millennials and never saw a downtick in their lives. So if the market wobbles they don’t know how to handle it, particularly since information moves so fast.” 

Further, as James Montier has described, too many investors will not be able to rely on their providers when the going gets tough. Back in the heat of the financial crisis he stated unequivocally in the FT [here],

“New research shows that career risk (losing your job) and business risk (losing funds under management) are the prime drivers of most professional investors. They don’t even try to outperform.”

Nor do they guard against material losses if that effort conflicts with career risk or business risk.

As a result, it will largely be up to investors and conscientious advisers to ensure that investment decisions are made with the full breadth of insights and resources available. Fortunately, each of the three pieces of research provide useful suggestions.

The lesson from McQuarrie is straightforward: The conventional focus on asset returns from the post-1926 era is misleading and misleading in a way that is especially harmful for retirees. The reason is, as McQuarrie points out:

“The twentieth century US data, especially following WW II when the US economy bestrode the world as a colossus, paints a very sunny picture for stocks, and a sad cloudy picture for bonds, memorialized in Siegel (2014).”

As it turns out, this period is more the exception than the rule.

The broader context of history paints a cloudier picture not just for stock returns, but even more importantly, for the probability that stocks will outperform bonds. The issue is that even though a prototypical investment horizon of forty years is a long time, it’s not nearly long enough to guarantee the benefits of excess stock returns.

In fact, with the 210 year history of US capital markets as a guide, investors can expect stocks to outperform bonds less than half the time. Performance for stocks and bonds was comparable in several multi decade periods  As it turns out, equities do disappoint in relation to bonds over multi decade holding periods.

So, one important takeaway for those who are investing for retirement is to temper expectations for both the total return of stocks and the likelihood of excess returns of stocks versus bonds over the course of their investment horizon.

Likewise, the work by Page and Panariello provides useful lessons as well. While many investors and advisors take comfort from the practice of diversification to weather storms, Page and Panariello suggest:

“[I]nvestors should look beyond diversification to manage portfolio risk.” At very least, they recommend, “Scenario analysis, either historical or forward looking, should take a bigger role in asset allocation than it does. Significant emphasis should be put on the stock-bond correlation and consideration of whether it will continue to be negative in the future. Shocks to interest rates or inflation can turn this correlation positive.”

Further, as McQuarrie illustrated, there absolutely have been periods of time in which stocks and bonds are positively correlated.

If/when investors observe the potential increase for interest rate or inflationary shocks, they can prepare by de-risking the portfolio by raising cash or by employing any of several tail risk hedging or dynamic risk management strategies.

Finally, Fama and French conclude their paper in fairly straightforward terms as well:

“The high volatility of monthly stock returns and premiums means that for the three- and five-year periods used by many professional investors to evaluate asset allocations, the probabilities that premiums are negative on a purely chance basis are substantial, and they are nontrivial even for 10- and 20-year periods.”

In other words, investors should do what professional investors do not do: accept that there is a great deal of uncertainty in returns and moderate views in a way that is commensurate with the level of uncertainty.

Taking a step back by reviewing these research pieces reveals that much of what passes for conventional investment advice needs to be updated. Stocks are not the “no-brainer” decision for retirement plans that they are made out to be. Diversification often fails which requires more active and dynamic risk management. It is very hard to disentangle skill from luck and decisions should reflect that uncertainty. As such, there absolutely are “certitudes to discard, expectations to reset, portfolios to re-build.”

Taking a step back also serves another purpose which is to shine a bright light on the investment industry itself. It is odd that three different pieces of research would each revisit familiar investment theory. It is also strange that highly reputable academics such as Fama and French would go to the effort of calling out “many professional investors” for being unaware of the implications of “common knowledge”. Finally, it is odd that it takes a retired marketing professor to meaningfully expand the database of asset returns and to objectively interpret the expanded series.

Perhaps, just perhaps, the business risk and career risk of many investment professionals has become so enmeshed with ‘psychological leverage’ that they are not really capable of taking a step back and re-evaluating what is best for their clients. If this is true, a similar set of changes could also be in store for the investment services industry – with certitudes to discard, expectations to reset, and businesses to re-build.

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It seems the Facebook buyback program is going to have work a little harder.

Zuck’s net worth is tumbling again – after a opening buying spree – on reports that Facebook is being sued by the District of Columbia over a privacy breach in which personal information was transferred by an app developer to Cambridge Analytica, a political consulting firm that worked for President Donald Trump’s 2016 campaign.

The suit was filed Wednesday in Superior Court in the District of Columbia by the district’s attorney general, Karl Racine:

“Facebook failed to protect the privacy of its users and deceived them about who had access to their data and how it was used,” Racine said in a Dec. 19 statement.

“Facebook put users at risk of manipulation by allowing companies like Cambridge Analytica and other third-party applications to collect personal data without users’ permission,” he said.

The lawsuit marks the first time that regulators in the United States have sought to penalize Facebook for how it was used during the 2016 US presidential election.

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What was once supposed to be a year-end Santa rally has turned into the second-worst December on record for stocks. In fact, the plunge in stocks has been so dramatic it has taken even the bears by surprise, and as a result even some of the biggest skeptics are calling for a rebound.

Take BMO’s Russ Visch: the technical analyst had correctly been calling for a drop into year end, and yet in his latest note writes that the widespread and price indescriminate hedge fund liquidations may have taken things too far. As Visch explains, historically December is not only the strongest month of the year for the S&P 500 but also the most consistently positive, which has created some confusion around the “Santa Claus rally” phenomenon.

As he further notes, while people assume that stocks should go straight up throughout the month from start to finish, in fact, the first half of the month is typically flat at best with most of the gains coming in the last two weeks. And after the sharp plunge in the first half of the month, Visch is now expecting something similar to develop again this year as daily breadth and momentum gauges are now oversold enough to support a solid bounce into the end of the year.

To give readers an idea of how ugly the latest data has been, the BMO strategist points out that short-term breadth oscillators are actually more oversold now than at any point since early 2016.

That said, in terms of upside potential Visch is not looking for anything more than a partial retracement of the recent decline. Some targets: the First resistance for the S&P 500 is the breakdown level at 2630, then its 50-day moving average at 2715.

But before he is accused of turning bullish, Visch makes it clear that “this is a countertrend bounce within a bigger downtrend”  as “stresses in the bond market continue to get worse, bullish sentiment continues to contract and overall breadth remains terrible.”

As such, until we see heavily negative capitulative type data, he urges investors to stay defensive.

Separately, Nomura quant Masanari Takada voices similar sentiment, and looking ahead at today’s main events writes that if the FOMC announcement is surprisingly more dovish than expected, speculative investors are likely to try to rebuild long equity positions on the basis that US long-term interest rates are expected to be subdued (which would be favourable to the equity market in general). However, here there is the catch 22 that we discussed yesterday: the fact that the Street’s anxiety over a possible US economic slowdown would be “officially” confirmed by the Fed would be a psychological burden, and Nomura would therefore expect most hedge funds to prefer to tilt towards defensive sectors or low-volatility names over cyclical sectors or high-beta names.

Nomura’s lukewarm conclusion: “given the limited capacity of HFs overall to take on equity risk at the moment, a feasible equity market rally driven by a dovish Fed would likely only last a relatively short period of time.“

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Yesterday’s furious selloff in crude prompted even more confusion amid the trading community, recently whipsawed by seemingly chaotic moves across all asset classes, and desperate for the reason behind the sharp dump.

Some, such as DB’s Jim Reid attributed the violent selling to the publication of Saudi Arabia’s budget plan, which as we discussed overnight  includes ambitious oil revenue targets of $177 billion for next year. To reach that number, the Kingdom is either assuming very unrealistic oil prices of around $80 per barrel, or it plans to pump more than the 10.2 million barrels per day target agreed earlier this month. Since the $80 per barrel figure is around 30% more than consensus estimates, the latter scenario looks more probable, which would equate to a significant increase in global supply and would end up being more bearish for prices.

Others speculated that in the same vein as commodity trader Pierre Andurand, who closed out most of his positions after suffering a historic loss in 2018, the selling was merely hedge funds liquidating deep underwater positions ahead of the new year.

Now, according to a third theory – and one which Treasury Secretary Steven Mnuchin would approve of – Nomura is blaming the sharp sell off in WTI on algo-investors such as CTAs and Risk Parityfunds, which in recent times have become the go to scapegoat to explain any otherwise inexplicable market moves.

According to Nomura’s Masanari Takada, CTAs quickly swept away the small amount of long WTI positions they held, and flipped to the short side by selling WTI crude futures. Furthermore, Takada notes that the “actual” speculative position data released by the CFTC as of last week shows that not only systematic trend-followers like CTAs but other short-term investors also cut their existing long positions aggressively.

As Nomura further adds, selling of commodities by RiskParity investors for the purpose of deleveraging is one such example of existing long positions. Apart from a regular rebalancing which tends to occur during the final week of the month, RiskParity can also adjust their portfolio leverage ratio at any time given changes in overall market volatility. As a result, the Takada currently identifies some selling pressure on the broad commodity market, mainly in crude oil futures, from quick sales by RiskParity funds that are “long-only”, to reduce their leverage ratios.

The silver lining, for oil bulls, is that if indeed this was a forced liquidation by the quants, with much of the selling overhang gone, any reversal in price momentum will quickly see the CTAs reverse their bias and start buying to the upside, forcing a short squeeze in the process, and restarting the entire price cycle from square one.

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Authored by Michael Snyder via The Economic Collapse blog,

The Federal Reserve is responsible for creating the stock market boom that we have witnessed in recent years.  Are they now also setting the stage for a stock market bust?

After hitting an all-time high earlier this year, the Dow has plunged more than 3,000 points from the peak of the market, and it would appear that it would be extremely irresponsible for the Fed to raise interest rates in such a chaotic environment.  In addition, evidence continues to mount that the U.S. economy is slowing down, and everyone knows that raising interest rates tends to depress economic activity.  So it would seem that it would not be logical for the Federal Reserve to raise interest rates at this time.  In fact, economist Stephen Moore told Fox Business that if the Fed raises interest rates “they should all be fired for economic malpractice”…

“The Fed has been way too tight. They made a major blunder three months ago with raising the rates. It’s caused a deflation in commodity prices. And I will say this, David, if the Fed raises interest rates tomorrow they should all be fired for economic malpractice.”

If the Federal Reserve raises interest rates and indicates that more rate hikes are coming in 2019, it is quite likely that the markets will throw another huge temper tantrum.

But as Jim Cramer has noted, if the Federal Reserve make the right choice and leaves rates where they currently are, we could potentially see a significant market rally…

“Today was a dress rehearsal for the kind of rally we can get if the Fed does the right thing tomorrow and repudiates the idea that we need a series of rate hikes in 2019, not just one more tomorrow,” Cramer said Tuesday. “If we get the Fed on board, expect more positive action like we had this morning before the market gave up much of its gains.”

Unfortunately, there is a factor that is complicating things.

In recent weeks, President Trump has been extremely critical of the Federal Reserve and Fed Chair Jerome Powell.  If the Fed decides to leave interest rates where they are, that could be interpreted as them giving Trump exactly what he wants, and it is likely that they do not want to be viewed as siding with Trump.

This is yet another reason why we need to end the Fed.  The Fed has become just another player in the game of politics, and the truth is that the Federal Reserve is a deeply un-American institution.  Our founders intended for us to have a free market capitalist system, but instead we have an unelected panel of central planners setting our interest rates and running our economy.

Since the Federal Reserve was created in 1913, there have been 18 major economic downturns, and now we are heading into another one.  Central banking manipulation endlessly causes boom and bust cycles, and hopefully this time around the American people will finally decide that enough is enough.

As losses on Wall Street mount, hedge funds are starting to go down like dominoes, and that is going to cause huge problems for some of our largest financial institutions.  For example, we just found out that Citigroup could potentially lose 180 million dollars due to bad loans that it made to a prominent Asian hedge fund…

It’s not just hedge funds that are blowing up left and right: so are the banks that are lending them money.

Citigroup is facing losses of up to $180 million on loans made to an unnamed Asian hedge fund which saw major losses on its FX trades Bloomberg reports citing a person briefed on the matter. The hedge fund and Citi “are in discussions on the positions and how they should be valued” which is usually a bad sign as when it comes to FX the mark to market is, at least, instantaneous. Bloomberg adds that the situation is fluid and the eventual losses may end up being smaller depending on how the trades are unwound.

We haven’t seen anything like this in 10 years, and if the Fed raises interest rates this new financial crisis could begin to escalate quite rapidly.

At this point, even former Fed chair Alan Greenspan is urging investors to “run for cover”…

The former Federal Reserve chairman who famously warned more than two decades ago about “irrational exuberance” in the stock market doesn’t see equity prices going any higher than they are now.

“It would be very surprising to see it sort of stabilize here, and then take off,” Greenspan said in an interview with CNN anchor Julia Chatterley.

He added that markets could still go up further — but warned investors that the correction would be painful: “At the end of that run, run for cover.”

The markets were calmer on Tuesday because everyone was kind of waiting to see what the Fed would do today.

The decision should be obvious, but unfortunately things are never that simple.

We live in very uncertain times, and the shaking of our financial system has begun.

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While market commentators seem convinced The Fed will hike rates today, the market is less convinced – assigning a two-thirds chance to it, the lowest for an FOMC Day in years.

The bigger question is just how ‘dovish’-ly can Powell hike? And, more importantly for world harmony, can he avoid the appearance of kow-towing to the President (because god forbid, establishment elitists would be forced to agree with the current White House resident’s views).

His dovishness bar is set extremely high already, as former fund manager and FX trader Richard Breslow notes, the shift in forecasts as to what the FOMC might do later today has been changing day by day. With every downdraft in equity prices the degree to which the Fed is expected to infuse its decision with dovishness has increased.

We have even managed to convince ourselves that the stock market knows best. And in an investing world that has become long-only, it is easy to understand why people would think that way.

At the end of the third quarter, when stocks were making new highs, the interpretation of economic data tended to err on seeing the brighter side whenever a number missed or was ambiguous in its message. After this sell-off, that has clearly reversed. We see recessions lurking behind every turn of the calendar.

Suddenly, the various financial-conditions indexes have become the most widely discussed economic data points. It had to because while some numbers have been squishy, you can’t justify the extent of this change in sentiment by the “slowdown” in economic growth and employment that has been posted.

The base case for today’s outcome has become a dovish hike with an optimistic spin. Something for everyone. That’s not easy to deliver. Especially with the burden of those dot plots they continue to carry around, try to de-emphasize and which are universally fixated upon. You can’t really be convincingly data-dependent when you have to justify everything around a meaningless exercise.

It is not a coincidence that the highest price of the year in S&P 500 futures occurred on the same day as the high in WTI crude. And at the time, while investors were willing to acknowledge that equities might have some of the characteristics of a bubble, was anyone calling for the collapse in oil prices?

Back then oil futures were still in backwardation. And, for lack of a better thing, most central banks go right to the futures curve for their forecasts. Pity the traders who think they are gospel truths.

Be especially leery of predictions about how various markets will trade based upon what we will hear. Especially a week before the end of the year. The 2s10s yield spread has widened a bit since the beginning of the month and investment-grade credit spreads have stabilized. Both in anticipation of a more accommodating Fed. But so far, people have continued to look for any excuse to reduce exposure to high-yield. And it is surprising how non-existent the bounce has been in equities if people really think this will be a game- changer.

Given how far these markets have moved, they can have sizable corrections within the context of larger trends. But you can be sure whatever happens will be assumed to define the way forward.

At the end of the day, an extra 25 basis points either way will make little difference to the economy. Especially since so many of the prevailing “headwinds” have nothing to do with U.S. monetary policy.

But, as Breslow notes, the FOMC will face two big challenges with ongoing significance. Chairman Jerome Powell will need to be sufficiently even-handed so as to not have investors conclude that this is the end of the tightening cycle, yet market- friendly enough to avoid the inevitable and ridiculous taper tantrum. And the much greater challenge of convincing anyone a dovish lurch isn’t just where the new Fed put is struck and the party can begin again.

Especially as “dovish hike” mentions on Twitter are taking off

h/t @Sentio

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Authored by Mike Shedlock via MishTalk,

As of the 2017 City of Chicago Actuarial Report, each Chicagoan would have to pony up $140,000 to make pensions solvent.

WirePoints reports Chicago Mayor Rahm Emmanuel wants a Constitutional Amendment to address Illinois Pension Woes.

The mayor’s plan cannot possibly work because Chicago is far too deep in pension debt to do anything but default.

Nonetheless there is some benefit in the idea for the simple reason it may force the legislature to think about things as they are, not as they want them to be.

Kudos to Rahm Emanuel for broaching the subject of a constitutional amendment for pensions and for using cost-of-living adjustments as an example of why the amendment is so necessary.

The possibility of an amendment in Illinois has experienced a revival of sorts since Arizona recently amended its constitution for a second time. Already, the Chicago Tribune, Crain’s and Mayoral candidate Bill Daley have supported an amendment in some form. And COLAs are finally being recognized as a key driver of Illinois’ pension crisis.

However, it would be a mistake – as some may be tempted to do – to think that an Illinois fix is as simple as COLA reforms via a narrow, Arizona-style constitutional amendment. Instead, Illinois needs an amendment that’s as broad as possible if it hopes to fix the pension crises playing out all over the state.

Collectively, Illinois governments owe more than $400 billion in pension debts alone, based on Moody’s most recent methodology.

Its a particular problem for Rahm Emanuel, as Chicagoans are the most swamped of all. Each city household is on the hook for $140,000 in overlapping state and local retirement debts.

Piecemeal Approach Cannot Work

WirePoints discusses changes in Arizona and accurately concludes piecemeal changes won’t work for Illinois.

Here’s a hint, they won’t work for Arizona or any other state or municipality either. Ridiculous COLA adjustments are only a tiny piece of the problem.

More Substantial Fixes Needed

WirePoints concludes and I agree:

“Any Illinois amendment should repeal the protection clause and say expressly that the state may modify past and future pension benefits notwithstanding the state constitutional contract clause or anything else in the Illinois constitution that might conflict.”

Of course, Labour unions could and would appeal that, all the way to the US Supreme Court. The process could take years.

In Wirepoints’ view such appeals would fail.

Mish’s Better Approach

I have a far simpler approach that is 100% certain to work, and work faster.

1. Illinois can allow municipal bankruptcies

2. The Federal government can pass national legislation allowing municipal and even state bankruptcies

Q. How does that fix the problem?

A. As we have seen in Detroit, Michigan; Central Falls, Rhode Island; and numerous cities in California, pension promises are not sacrosanct in bankruptcy.

As it stands, states can allow or prohibit municipal bankruptcies, but if allowed, Federal laws take precedence over state rules. In bankruptcy, pension obligations can be reduced. They were hammered in Central Falls.

In Illinois, I would expect the City of Rockford to file bankruptcy the moment it could. Rockford is Illinois’ third largest city.

Such a bankruptcy would send shock waves through the bond markets, but also where reform is needed most: Illinois pension plans.

Bankruptcy reform would put huge pressure on unions to reduce demands in a fair manner (highest pensioners get the biggest cuts), rather than leaving matters to the courts to decide where the cuts happen.

Bankruptcy reform would in and of itself likely ensure that the state would get around to fixing, via constitutional amendments, its other pension problems.

The advantage of my approach is we would not have to wait for a constitutional amendment. It would come later.

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With equities, bond yields and federal funds target rate expectations collapsing, FOMC expectations are changing daily, Standard Chartered’s Steve Englander writes overnight describing prevailing market sentiment as “fear and loathing in asset markets.”

Yet with economic data reasonably strong, investors are trying to gauge how the FOMC will balance asset market fears and softening growth abroad against still-robust incoming economic data, which the NYT profiled overnight.

Investor perception is that the FOMC will back off sharply from the hawkish stance of September/October, but there is a recognition that the Fed is reluctant to make big policy shifts based on asset markets and foreign growth. Amusingly, as Englander writes, “the FOMC is aware that there are more 130/30 long/short funds than 30/130 long/short funds.”

In terms of how the Fed will achieve the gradual lowering of its dot plot, Bank of America expects the dots will shift lower by 1 hike across the forecast horizon, with the median shifting to 2 hikes for 2019 vs. 3 hikes previously. If newly appointed Governor Bowman is in the 3 hike camp, then we would need 2 Fed officials to shift from 3 to 2 hikes in order to move the median. If Bowman is a 2-hiker – which is possible given that she is a community banker who may naturally lean more dovish- we would only need one additional member to revise down. In our view, the potential candidates to shift their views are Powell, Williams, Evans and Brainard.

Looking further ahead, BofA notes that the story for 2020 is less clear, stating that the bank’s baseline is that the median expectations will be for one hike in 2020 but it is possible that we see a shift up to 2 hikes. If so, it would show that Fed officials are maintaining the same terminal rate but expect to get there slower given the lack of inflation pressure which allows the Fed to slow the cycle. Incidentally, it is the opinion of BofA’s chief economist Michelle Meyer that removing one additional hike is more dovish than if the Fed just pushed it forward.

Even with a dovish move in the short-end, BofA does not expect the long-run dot to move. It has gradually shifted higher over the course of this year and the bank does not think we have seen any evidence to suggest that expectations have moved too much in this respect:

The long-run dot is sticky and it would be surprising if we saw a rapid reversal. However, the risks are for the median dot to shift lower as it would only take one dot to move down from 3% or Governor Bowman to pencil in a long-run rate that is below 3%.

That said, on the economic outlook BofA expects downward revisions to headline and core PCE inflation projections for this year reflecting the decline in energy prices and the relatively weaker string of core PCE inflation prints of late. Looking ahead, Meyer thinks that the growth and headline inflation forecast for 2019 are likely to be revised modestly lower and there are risks to the downside for the core inflation forecast.

So going back to what the market expects, here is how Englander frames consensus:

• Few investors think the FOMC can back off a December hike
• Two 2019 hikes in the dot plot, nothing beyond
• Significant changes in the statement language to indicate a pause is likely after a small number of hikes
• Once neutral is hit, any hikes become very conditional on strong inflation and activity outcomes

There is some debate on whether this “consensus” would be considered sufficiently dovish given current economic and asset market fears and the Std Chartered strategist suspects that it will work to calm markets, but possibly not immediately. It is likely that investors will ultimately be convinced by the Fed’s stress on conditionality of future hikes, but two hikes in the dots may be read in the short term as Fed indifference to market conditions.

* * *

The ultimate dovish market reaction is based on the following logic. Markets now price in only 17bps of hikes for 2019 and 8bps of easing for 2020 – investors tend to view the Fed dots as reflecting a relatively optimistic scenario. Two 2019 hikes in the dots would be read as saying – “three hikes are likely out; two are aspirational but possible; the Fed would settle on one if economic outcomes show ambiguity, but do not suggest it has to stop altogether.”

This is likely acceptable in terms of market pricing. If the Fed points to c.2.87% as the peak of the FFTR (hiking on Wednesday and twice in 2019) and stresses conditionality, market pricing of 2.5-2.6% for a FFTR peak is reasonable. That would still seem to leave room for US long-term yields to come down from current levels of 2.84%.

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A surprise crude build from API sent WTI briefly lower but as the dollar has tumbled this morning, crude prices have rallied back above $47.50, helped by optimistic jawboning from Saudi Arabian Energy Minister Khalid Al-Falih.

“We will meet in April and I’m certain that we will extend it,” Al-Falih told reporters in Riyadh, referring to the next meeting of OPEC+ members to discuss whether to extend the December agreement to reduce output. “We need more time to achieve the result.”

Additionally, Al-Falih said the current price dip isn’t based on supply and demand of oil, and has plenty of blame to go around:

“What has happened in my opinion recently is a confluence of many non-oil fundamental issues including the geopolitical issues, especially around the sanctions and the waivers that were granted by the United States,” Al-Falih said.

“It also includes the trade tension between the U.S. and China.”

But for now inventories are what is driving price action.

API

• Crude +3.45mm (-3.25mm exp)

• Cushing +1.063mm (+1.3mm exp)

• Gasoline +1.76mm

• Distillates -3.442mm

DOE

• Crude -497k (-3.25mm exp)

• Cushing +1.091mm (+1.3mm exp)

• Gasoline +1.766mm

• Distillates -4.237mm – biggest draw since March

After two weekly draws, last night’s build from API surprised traders, and DOE reported only a small crude draw of 497k (well below the 3.25mm draw expected). Distillates saw the biggest draw since March

Crude production is unchanged on the week.

WTI remains well below $50 still…

“The market is experiencing price carnage, maximum pain and considerable downside pressure,” technical analyst Robin Bieber said in a report for PVM Oil Associates. The space between the flat price and the 5-day MA is unsustainable and “begs for a temporary ‘cooling off’ reaction higher to relieve some of the recent pressure.”

Still, the market is “weak and very exposed to lower numbers”

Hovering around $47.50 ahead of the DOE data, energy stocks also rallied into the print on whisp[ers and kneejerked up to $48 on the confirmed crude draw…

But downside risk remains:

“The market’s judgment on the most recent cuts deal, even before it starts, is now pretty clear — it was too vague, lacked some credibility, and the April review date suggested it might be too short,” said Derek Brower, a director at consultant RS Energy Group.

“So it makes sense that producers are already fretting. But it is also pretty early to be saying what OPEC will do in April – lots can change by then.”

Concerns about oversupply and the slowing global economy seemingly grow by the day.

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Senate Majority Leader Mitch McConnell announced Wednesday that he will introduce a stopgap spending bill to keep the government open until February 8, after Democrats pushed back on Tuesday against a proposal which would allocate $1 billion to President Trump’s immigration policies. 

If passed into law, the measure would prevent a partial government shutdown set to begin Saturday. According to The Hill, McConnell’s proposal will keep funding for border fencing flat. 

The White House had previously backed down on a demand for $5 billion in funding for President Trump’s wall, with Press Secretary Sarah Sanders claiming “We have other ways that we can get to that $5 billion.” 

“At the end of the day we don’t want to shut down the government, we want to shut down the border,” she added. 

Earlier Wednesday President Trump tweeted: “In our Country, so much money has been poured down the drain, for so many years, but when it comes to Border Security and the Military, the Democrats fight to the death. We won on the Military, which is being completely rebuilt. One way or the other, we will win on the Wall!”

In our Country, so much money has been poured down the drain, for so many years, but when it comes to Border Security and the Military, the Democrats fight to the death. We won on the Military, which is being completely rebuilt. One way or the other, we will win on the Wall!

— Donald J. Trump (@realDonaldTrump) December 19, 2018

The details of McConnell’s stopgap proposal will be released later Wednesday. 

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