• "Kee" Points with Jim Kee, Ph.D.


    • US Economy
    • North Korea
    • Policy-Based Evidence


    US Economy: Here in mid-September, in the third (and final) month of the third quarter, it looks like we are not going to see a repeat of the second quarter’s 3% growth rate. The most recent calculation of the Atlanta Fed’s GDPNow model for third quarter GDP is 2.2%, with the New York Fed’s model estimating 1.34% (“Blue Chip Consensus” reported by the Atlanta Fed in the 2.25%-3% range). Estimates from both models have come down through the quarter as new data has come in. Although most people don’t believe it, statistically one quarter’s GDP growth rate tells you very little (i.e. is a poor predictor) about what the next quarter’s growth rate will be. With a 1.2% first quarter number and a 3% second quarter number, what I see is an economy still growing below its long-term 3% average.


    North Korea: I am seeing an increasing number of people citing a quote attributed to Lord Nathan Rothschild, that, “One must buy to the sound of cannons, sell to the sound of trumpets.” Rothschild was one of the richest men in the world at the time of the Napoleonic Wars (early 1800s), and this would seem an apt description of today’s strong market in the face of rising global tensions with North Korea. Many US markets closed at all-time highs last week, something the S&P 500 has done 33 times this year, which is twice the annual average since 1945 according to Sam Stovall at Standard and Poor’s. As an aside, I think an important point from Stovall’s work for investors is that the market averages over 15 record closes a year, so obviously they are not sell signals! In truth, I think Lord Rothschild was speaking to buying opportunities when markets sell off because of war, and that is not what we are seeing today. Certainly, low yields or returns on other investments continue to enhance the attractiveness of equities (Financial Times). And so have the prospects for tax reform, which have increased some in recent weeks (CNBC).


    President Trump addressed the United Nations (UN) today, and as expected issued a condemnation of North Korea and a restatement of Trump’s “America First” agenda. The UN has exercised limited use of force (including Naval blockades) several times over the past 25 years (for example in Iraq, Haiti, Somalia, Democratic Republic of the Congo, Kosovo). Unfortunately, UN documents are pretty clear on the legal basis for using force in the case of self-defense for member countries (i.e. in the event of being attacked), but a little vague on rules for pre-emptive military action. Of interest with regards to North Korea is the fact that China and Russia can effectively veto or limit NATO actions (BrookingsInstitute), and those are the same countries that are alleged (but not proven) to be providing technology to North Korea. I think Kim Jong-un sees this playing out with two possible conclusions. Namely, that it comes down to either the US launching a pre-emptive strike which unavoidably kills innocent people, or North Korea develops nuclear missile capability, and I think Jong-un is betting on the latter.


    "Policy-based evidence" is the name of a clever journal article I saw last week (National Affairs), a play on words to the politically fashionable “Evidence-based Policy” (who can be against that?). The gist of the article was that social scientists can and will manufacture evidence to support policies, rather than the other way around(manufacturing policies supported by evidence). I see this in my field(economics) all of the time, and I think a little of it will always be inevitable. For example, in being familiar with the work of many academic economists I can guess their conclusions on newly published research (i.e. trade good/grade bad; tax cuts good/tax cuts bad; deficits good/deficits bad, etc.) before reading the articles. I am sure many of you see this in your own fields. 


    I hope Kee Points doesn’t come across that way. What we do at STMM is consistent and fact-based, not fact-blind. We don’t get completely in and out of the market because we know that such attempts at market timing have been among the biggest threats to investors reaching their goals, as much as we would like it to be otherwise. Narrow, large-cap growth markets like the one we’ve been in don’t surprise us; we expect them, we just can’t predict them (nor can anyone else). That’s why we aren’t 100% invested in value stocks, or growth stocks for that matter, but rather always own both. We know that the term “bubble” can be overused-code for “I don’t know.” But observation and research at firms like McKinsey have shown that where actual market bubbles are most common is at the sector level, i.e. the Technology Sector, or Financials Sector, or Energy, etc. So, we always control our exposure to any one sector. We don’t own too much stock of any one company (i.e. too much company-specific risk), or in any one country (always own some international stocks). On the bond side, it is a low yield or interest rate environment, but bonds are rewarding investors more than cash. And owning individual bonds helps control risk and to guard against some of the more unsettling properties of bond funds. For example, when bond holders pull money out of those funds, and the fund managers sell their highest quality bonds first- because they have held their values the most- leaving the remaining bond fund investors with a portfolio of lower quality bonds.



  • "Kee" Points with Jim Kee, PhD.


    • US Update
    • Global Update
    • Oil Update

    US Update:  Two big storms in just a few weeks’ time will certainly muddle the economic data for a quarter or two, as the negatives of disruption evolve into the positives of rebuilding. Fortunately, “nowcasting models” that update weekly with fresh data release sallow for timely audits of how the economy is doing. Combined with more conventional tools like the Conference Board’s (and the Federal Reserve’s) Leading Economic Index, these help to measure the impact of various economic shocks on the economy. I’ll be sharing all of this with you in Kee Points as events unfold, but right now everything looks pretty solid. That is, the economic data continues to point to economic expansion, both here and abroad. US stocks seem to reflect this (up big Monday), and perhaps some weekend relief over events like Hurricane Irma (perhaps not as bad as expected) and no North Korea missile tests in commemoration of its 69th anniversary. Proposed new economic sanctions (trade restrictions) on North Korea (to be voted upon by the United Nations) were opposed by Russia and China, which I put in the “some things never change” category. In the US, I would say the most underreported story has been the increase in business investment spending this year, particularly on information technology equipment and software. The first two quarters have been strong, and that’s one of things I’m watching more closely as the year goes by.  Another development in the US was the sudden resignation of Fed Vice Chair Stanley Fischer, ostensibly for personal reasons. Fischer was highly respected, but at the end of the day I see this as neither here nor there.


    Global Update: In Europe, there has been a surge in manufacturing (Financial Times) even as the euro hit a two-and-half-year high against the dollar at $1.20 per euro (which makes it difficult for European exporters). I think it is better put to say that a stronger European economy has led to a strengthening euro, particularly with expectations of an October tightening on the part of the European Central Bank (ECB), and lower expectations – due to hurricanes –of another US federal reserve rate hike this year by the US Federal Reserve (the Fed surprised many and raised rates following Katrina). Germany goes to the polls in a few weeks, with Angela Merkel the odds-on favorite to earn a fourth four-year term on September 24 (WSJ). I liked The Wall Street Journal’s headline, “Germany’s Boring Election is Nothing to Snore At,” making the point that the lack of drama there is a good thing. In France, President Emmanuel Macron has stated his intentions to free up the job market there through employer-friendly reforms. These are intended, in Macron’s words, “to boost job creation by giving more security and visibility to employers and more guarantees to workers.” Among these reforms are policies making it easier to dismiss workers, which also makes it less risky to hire them. In the rest of the world (e.g. Japan and emerging markets) growth seems to be a little stronger than what was expected at the beginning of the year, a fact reflected in things like higher copper prices (driven by China) and in the Commodities Research Bureau’s Raw Industrials index (the “Rind”).


    Oil Update: Crude oil rose to a five-month high last week, with prices for a barrel of oil closing in the high forties. Saudi Arabia (OPEC’s largest member) continues to express an interest in pursuing OPEC’s desire, reached last year, to cap production and drain global oversupply (MarketWatch).  I like Barry Bannister’s characterization of Saudi Arabia as reasserting its ‘central bank of oil’ role (Stifel). The relationship between oil prices and stocks over the past several years has been more vague than what you would expect given the commentary in the press (i.e. higher oil means higher stock prices). Looking at percentage changes, oil has been much more volatile than stocks. Conceptually, the impact of oil prices on stocks depends upon what’s driving them; a higher oil price due to higher growth (early 2000s) tends to be bullish or positive for stocks, while a higher price driven by supply restrictions (1970s), tends to be bearish or negative. I’ve stated in the past my view that, overall, the recent supply-driven oil price decline, which is due to US fracking and OPEC factioning, is a positive for the global economy. That’s because most of the world’s output is produced by net importers of oil (they consume more than they produce). But there is a price below which oil becomes destabilizing to the regions that produce oil, and that can be destabilizing to the world in general. So, the sense I get from watching the interaction between stocks and oil prices is, “low is good, but not too low.”

  • "Kee Points" with Jim Kee, Ph.D.


    • Expertise
    • Gasoline Shortages
    • Texas Muni Update


    Expertise Wanted if the Conclusion is Right!


    Expert opinion: The internet, which has dramatically increased the world’s access to information, has also been deemed responsible for what is called “the cult of the amateur” by helping to blur the distinction between professionals and laymen. For example, physicians often remark that many patients have self-diagnosed themselves before coming to see them, feeling fully competent to second-guess years of medical school training and on-the-job experience after a five-minute Google search. It is also true in my field (economics), where it is often said that, “people don’t really want an economists opinion as much as they want to have their own prejudices justified.” I noticed this early on in my career during discussions on inflation. As long as my answer was “it is going up,” or “inflation is actually higher than the official measures show,” everything was fine. But if I stated otherwise, my opinion was no longer valued, regardless of the fact that I wrote my dissertation on the subject and had a doctorate in economics.


    San Antonio’s Gasoline Shortage


    And so it is with San Antonio’s gasoline shortage. There is a commonality with “panics,” whether bank runs or at gasoline stations, because suddenly more people want more of something than what is available at the current price (perhaps because, as in the case of gasoline, of fears of gasoline being diverted to storm-affected areas). The last part of that sentence is important, for while laymen might argue over whether or not there is really a shortage, an economist will point out that there is a shortage any time the quantity demanded exceeds the quantity supplied at the current price (for whatever reason). Under such situations prices usually rise substantially until the quantity demand no longer exceeds the quantity supplied at the current price (like the price of a hot stock, for example). And of course higher prices encourage people to make a lot of money by trucking in new supplies from everywhere (which eventually brings prices back down). To an economist, saying that there is a shortage is the same thing as saying there is a “stuck price.” But in politics, allowing prices to rise and thus convey demand and supply conditions is called “price gauging,” and it is illegal. That’s why you didn’t see gas stations charging, say, a $50-$100 surcharge to fill up, or why you didn’t see gasoline rise to $10 per gallon. That’s also why gas stations were empty and why you had to stay home. But to wrap up with the first paragraph, I found no one over the weekend who was sympathetic with this view! Most of the people I talked to would rather not be able to get gasoline at all than have the option of paying $10 a gallon for it. (In all fairness, fear over public outrage regarding higher prices might have caused gas stations just to sell all they had and close the pumps anyway, even if it were legal).

     


    Market Solutions Not Always Well Received


    Perhaps the strongest example that I have seen of this distaste for market mechanisms, where prices communicate information about supply and demand conditions, is in the area of cadaveric organ markets. One of my old professors, David Kaserman, himself on the organ transplant waiting list, practically pioneered the idea of having a market for the organs of deceased individuals. Such a thing was made illegal by the 1984 National Organ Transplant Act, which according to Kaserman was a key reason why people died in line waiting for organs (quantity demand exceeded quantity supplied at the mandated zero price). Kaserman envisioned a professional “organ procurement” specialty arising from such a market, as few people now have an incentive to take on the disagreeable task of approaching the relatives of the deceased (hoping instead that they’ve signed a donor card). To Kaserman, allowing families of deceased organ donors to receive compensation (for charities, bills, whatever) made the same amount of sense as allowing compensation from other input providers, like healthcare workers, drug and medical device makers, etc. He died about 10 years ago, and I sense he found little acceptance for his ideas. He was always arguing with medical ethicists and I don’t think he could overcome the distaste for using markets in an area like organ procurement. And that makes sense, I suppose, unless you are on the waiting list for a liver or kidney.


    Update on Texas Munis


    A Barron’s article over the weekend cited several credit analysts describing trade in Houston municipal bonds as pretty normal, which has been our experience as well. Bloomberg points out that a similar, muted reaction followed Hurricanes Katrina and Sandy. That’s because, to cite Barron’s:


    “As devastating as the losses are, local governments will receive federal relief funds, stat support, and insurance claims to allow them to recover. Texas enjoys a top-notch triple-A credit rating, which means it has the reserves to fund operations and make debt payments until additional funds become available or revenues return.”


    The article states that property and casualty insurers, which hold tax exempt bonds to lower their tax burdens, will probably sell many of them to pay claims because the storm means losses for them, and tax exemptions are only useful if you have positive taxable income (rather than losses). However, given the low issuance (supply) of municipal bonds relative to the strong demand for them in recent years, most of these bonds sold by insurance companies would be expected to be snapped up right away by market participants.


    But overall it is still just too early to say. For example, the impact on “MUDs” (Municipal Utility Districts), which issue property tax-backed bonds to finance infrastructure for new housing developments (Stifel Nicolaus & Co.), really depends upon how many people permanently abandon their houses/neighborhoods and never return. We won’t know that for quite a while. As far as downgrades go, where credit rating agencies lower the credit ratings of existing bonds (which puts downward pressure on their price), JP Morgan securities issued a piece today stating that the majority of credit downgrades following recent storms were temporary and confined to lower rating categories. We typically maintain municipal bond exposure in our clients’ portfolios in very high quality credit ratings (on average double-A), and have minimal exposure to lower rated municipal credits. As always we continue to monitor the municipal bond market on an on-going basis, and I will alert Kee Points readers to any interesting developments.


  • "Kee Points" with Jim Kee, Ph.D.


    • Economics of Destruction
    • Harvey and Energy
    • Houston Municipal Bonds


    The Economics of Natural (and other) Disasters

     

    Hurricane Harvey impacts: In general, disasters like earthquakes, hurricanes, and tsunamis have a surprisingly limited impact on GDP, positive or negative, though you can find opinion to the contrary. The truth is that it really depends upon a lot of things, like where the economy and confidence are at the time of the disaster, the perceived competence of the response by authorities, etc. But in general, when a city like Houston - whose GDP is greater than that of 37 US states – is hit, there is the massive negative disruption of production and distribution activities (i.e. supply-chain effects). Offsetting that is the positive impact of rebuilding efforts. To assume that these latter rebuilding effects dominate; that is, that the effect of such massive destruction is a net positive, is to commit what is known in Econ 101 as “the broken window fallacy.”


    Popularized by business journalist Henry Hazlitt in the 1940s, the broken window fallacy derives from the work of 18th century French economist Frederick Bastiat. Bastiat’s tale was of a shopkeeper’s son who happens to break a piece of glass. It is believed that the “six francs” that it cost to repair the damage “brings six francs to the glazier’s (glass tradesman) trade,” implying that breaking more windows generates more work and a larger economy. But of course the six francs comes out of the shopkeeper’s pocket, and it would have been used for something else (adding to that trade). Perhaps the shopkeeper was going to buy a new suite with his six francs, so the increased work to the glazier comes at the expense of the tailor, who sees six francs less work than otherwise. So the net effect, that is, the gain to the glazier minus the loss to the tailor (and the shopkeeper, who is out a suit), is basically zero. And here’s the lesson: The total output of the economy hasn’t changed, just its composition. That’s the way to basically think about the impacts of disasters like Hurricane Harvey, 2012’s Hurricane Sandy in New Jersey, the 2011 Japanese Tsunami (that killed 18,000), or even events like September 11th.


     


    Impact on Texas


    That view represents the long view, not the short. According to Christian Ledoux, our Director of Equity Research, about 15% of the nation’s oil refining capacity is down due to Harvey. Damage is reported to be minimal, but “best case scenario” is that it will take 7-10 days for the refineries to be up and running again; beneficiaries will be refiners with operations outside of the gulf coast. Interestingly, insurers are in far better financial shape than they were prior to Katrina (New Orleans) and Sandy (east coast), and evidentially some reinsurers are expecting the damage from Harvey to be below these two prior storms. Based upon what I’m hearing from Houston I find that a little hard to believe, but we’ll see. Of course, suppliers of everything from building materials to batteries will experience a temporary surge in business, but the value of a business is based upon its expected earnings over future years, so a short-term or temporary surge will just result in a blip in these companies’ stock prices at best.



    Houston Municipal Bonds


    What about Texas municipal bonds? According to Diederik Olijslager, our Senior Fixed Income Portfolio Manager (citing research by the Baker Group), only one municipal bond default occurred following Hurricane Katrina, which was the most destructive and costliest storm in US history (NOAA). He said public infrastructure, hospitals, public housing, water and sewer systems, and electric utilities will likely see high amounts of damage and disruption in the affected areas of Texas. And municipal bond debt service payments may be vulnerable to disruptions in those areas hardest hit. But given expected Federal (FEMA- Federal Emergency Management Agency) and State relief that is likely to be provided to local bond issuers, there is little chance of widespread bond defaults (in fact, this is a reason for cities to overstate damages). The immediate impact to municipal bonds in the affected regions will be a reduction in “credit cushion,” or credit protection, so credit ratings might be under some pressure in the near future as financial reassessments are made of bond issuers. In the near-term, bond prices may be impacted negatively as market participants attempt to reprice credit risk of impacted bond issuers, but we do not expect a long-term impact. As an aside, we at STMM had already lowered our exposure to Houston-area municipal bonds in recent years because of oil price declines.


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