Market Backlash

The Treasury market had priced in a 25-basis-point increase in the FOMC’s target range for federal funds prior to the FOMC’s December 18–19 meeting. The Committee was faced with essentially three policy options: Pause, deliver on the 25-basis-point increase and signal a pause, or deliver on the 25-basis-point increase and signal the willingness to continue raising rates.

Cumberland Advisors' Bob Eisenbeis

The decision was a 25-basis-point increase in the target range and a signal that the most likely path for 2019 included two more rate moves. Until the announcement and subsequent press conference, the Dow was up 300 points, but it plunged into negative territory when the FOMC delivered on what turned out to be a modified version of the third option. That market funk continued the next day. Markets clearly wanted a strong signal that the FOMC would pause in 2019, and traders weren’t mollified by the generally moderate tone struck by Chairman Powell in his press conference.

Different people took different messages away from the press conference. First, when asked what role recent market turmoil played in the FOMCs decision, Powell said – consistent with long-standing Fed policy – that market turmoil was not a defining consideration, a view that was received negatively by the market, despite the fact that Powell went on to elaborate that the FOMC looks at many considerations, including global issues, concerns about tariffs, the declining impact of the tax cut and financial market conditions more broadly. That clarification apparently fell on deaf ears.

Second, when questioned about the impact of the president’s recent tweets, Powell did not state that the president, like other citizens, has a right to his personal opinions. Rather, he issued the emphatic statement that the Fed was independent and would do what it felt needed to be done, free from political considerations. Clearly, the president’s tweets were not well received by the FOMC.

Third, Powell noted that the policy rate was at the low range of what the Committee viewed as neutral and that financial conditions continued to be accommodative in the context of a growing economy, strong labor markets, and an inflation outlook near the Committee’s target. He went on to try to dispel the view that two rate hikes were a given for 2019. He emphasized that the Committee would be driven totally by incoming data. Again, markets didn’t hear him.

What is the Committee expecting as far as those data are concerned? The SEP forecasts clearly showed that median growth had been marked down for both 2018 and 2019; and the central tendencies for both 2018 and 2019 were also marked down. There was virtually no change in the unemployment forecasts; and PCE headline inflation forecasts had softened somewhat, while PCE core forecasts were essentially unchanged for 2019, at the target rate of 2%.

If those forecasts are realized, there will likely be, at most, two policy moves in 2019. Moreover, the chairman’s message was clear: The Committee will not do anything stupid. Chairman Powell emphasized that the Committee could be patient and is not wedded to any particular path.

The keys to both timing and amount will be incoming data on growth and inflation. Given that, when might we expect the next rate hike, if it is deemed justified? Monthly data will be available on PCE, but only quarterly data will be available on growth. More importantly, the FOMC will not receive data on Q4 2018 until January 30, but that is likely to be stale news given what is already known about economic performance in 2018. More relevant is that Q1 2019 GDP will not be available until the Committee’s April meeting, and Q2 GDP will not be available until its July meeting. This timeline suggests that the most likely time for the first rate hike, if it is to occur, would be at the Committee’s April meeting. Having said that, a patient FOMC could reasonably wait to make its first rate move in 2019 until its July meeting, where it would have readings on several months of employment and inflation data and readings on growth for the first half of 2019. It is worth repeating, the Committee is clear that it will not do anything stupid.

Robert Eisenbeis, PH.D.
Vice Chairman & Chief Monetary Economist
Email | Bio



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Is Climate Warming Creating More Dangerous Hurricanes?

Two Hard-Hitting Hurricane Seasons

Last year was a September to remember in the US as far as hurricanes go. First, Harvey hit Texas with 130-mph winds and thundering rains totaling up to 60 inches in places, setting all-time US rainfall records. Next, Irma created havoc across the Caribbean and Florida as the strongest Atlantic hurricane on record, with 185-mph sustained winds that leveled islands and nearly created a nightmare scenario in Florida. And of course no one will forget Maria, which hit an ill-prepared Puerto Rico with catastrophic results.

Here are some recent pieces in which I describe the effects of these hurricanes:

https://www.cumber.com/key-west-bob-bunting/
http://bobsstocks.com/cuba-caribbean-hurricanes-now/
https://www.sarasotamagazine.com/slideshows/2018/7/1/how-cuba-saved-florida-from-a-category-5-hurricane

From June through August the 2018 hurricane season yielded a slightly elevated number of storms, but all were weak. Elevated wind shear, a near-record cold Atlantic Ocean, and Sahara dust clouds combined to lull us to sleep – that is, until Florence formed in September off the African coast, just as Irma had. This time the track was more northwest, across thousands of miles of open water. Finally, Florence hit a patch of warm water, found low wind shear, and fought off the dust. The result was the first major hurricane of 2018 and one that had a clear shot at the Carolina coast.

Packing 140-mph winds after a 24-hour cycle of super-rapid intensification, Florence was not a storm to discount. The Carolinas are a magnet for Atlantic hurricanes: Think Hazel, Hugo, Gloria, and Donna, among others. But what made Florence even more of a threat was both human denial and the natural slope of the continental shelf, which is shallow and thus amplifies storm surge, especially for storms coming into the coast at right angles. Usually storms approach from the south, not from the east. It makes a difference. Florence came in perpendicular to the coast and acted much like a plow pushing the water at the coast, creating a large storm surge even as the storm itself weakened, striking with top winds of 106 mph.

Like Harvey, this massive storm ground to a halt just as it was making landfall. As with Harvey, record rains pelted North and South Carolina for days, dumping trillions of gallons of water on ground already saturated from a very wet summer. With storm surge and 30+ inches of record-setting rainfall, epic flooding resulted. Many rivers crested at levels that are hit only in a 1000-year flood, inflicting widespread major flooding that continued for weeks and killed not only people but millions of animals, creating billions in losses.

Finally, it was October 2018, and many began to think we were done with hurricanes. After all, at this point, although there had been many weak tropical storms and hurricanes, there had been only one major storm, and now Florence was out of the news.

Back in June, the Sarasota magazine published a nice summary of hurricanes, and I was pleased to be part of the spread of articles. Here is an excerpt from the discussion of Sarasota and hurricanes:
“Sarasota is more vulnerable to storms – like Wilma or Charley – that form in the Caribbean and enter the Gulf of Mexico, usually early or late in hurricane season. (The most perilous time for us, Bunting says, is the first two weeks of October.) But even those storms rarely hit our stretch of the west coast. Because of the shape of Florida’s land mass and atmospheric factors related to the rotation of the earth, they tend instead to make landfall to the south, often around Naples, and travel east across Florida, or to curve north and hit the northern Gulf Coast.

“Does this mean we can breathe easy? Hardly, says Bunting, who confesses, ‘I couldn’t sleep’ during the days that Irma threatened our coast. ‘All it takes is one,’ he says. ‘Only one.’”

You can read the entire article(s) here: https://www.sarasotamagazine.com/articles/2018/6/27/major-hurricanes-rarely-hit-our-region-here-s-why

Sure enough, in the second week of October a weak tropical system emerged south of Cuba, in the area climatologically favorable for late-season hurricane formation. This worrying development was made even more scary by a very warm loop current in the Gulf of Mexico, which was moving warmer than normal sea-surface temperatures off the West Florida Centennial Shelf northward to a position near the Big Bend region of Florida. Tropical Storm Michael entered the Gulf, and as it moved almost due north, it began to strengthen.

At first a Category 1 hurricane, Michael soon sucked energy from the warm loop current and intensified with a bang! During the next 24 hours the storm churned northwest of Sarasota toward Mexico Beach in northwest Florida. The Category 1 storm exploded to a very strong Category 4 with 155-mph winds; and the eye wall, surrounding a pinpoint eye, struck Mexico Beach and surroundings like a large tornado, complete with a storm surge. Wiping the Earth’s surface clean at the impact point, Michael registered the third lowest pressure ever recorded in the eye of a US hurricane making landfall – 919 mb. Imagine the panic of people watching the radar images like the one below as the storm approached the beach.

Hurricane Michael ravaged the town of Mexico Beach, Fla

Note, too, the small eye surrounded by the red eye wall as Michael ravaged the town of Mexico Beach. As the hours passed, much of northwest Florida and parts of Georgia saw record wind speeds and mass destruction totaling billions.

Is Climate Change Responsible?

Are hurricanes getting stronger because of climate warming? Are nature’s largest storm events and the rainfall totals they bring being magnified by the climate change? Is humanity responding to the threats or simply ignoring reality in hopes that the threats will go away or that our descendants will mitigate them later? Does sea level rise play a role in what appears, to the uninitiated, to be worsening storm impacts? Are we still dealing with critics who say that what we are seeing is nothing unusual or that everything can be blamed on a warming climate?

Let’s answer these questions to the extent that they can be answered. While 2017–18 featured the strongest set of hurricanes ever recorded, there isn’t enough evidence yet to say that hurricanes are stronger now than they have been in the past. This year, including Florence and Michael, has been above normal with regard to the number of storms (15) but normal with respect to the number of major hurricanes (2). Those two storms happened to hit the Mid-Atlantic Coast and Gulf Coast. It just takes one such event to change perceptions, and we had two.

But it is accurate to say that for each degree the air warms, it can hold nearly 4% more water. It is also accurate to say that warmer ocean waters have more heat potential, thereby increasing storm intensity, all other things being equal. So while the recent record of hurricanes does not prove in a statistical sense that hurricanes are more intense because of a rapidly warming climate, there is room for legitimate concern.

Explosive storm development also seems to be different and more concerning than in the past. Harvey, Irma, Florence, and Michael all had 24-hour periods during which they exploded from Category 1 to Category 4 or 5! Warmer sea-surface temperatures are clearly one major factor. In heavily populated areas, if such explosive storm development occurs, evacuation just cannot happen in time. How to deal with this issue will be one of the most talked-about topics for years to come as we learn how to adapt to climate-warming issues.

There is also evidence that heavier rain events are being caused in some part by the warming climate. First, as noted above, warmer air can hold more moisture; but also, as the earth warms, the jet streams tend to set up further north and are weaker than was normal for most of the 20th century. These two factors mean that storms hold more rain and tend to slow down and meander rather than moving at a brisk clip with the help of jet stream winds. Harvey and Florence certainly did just that, and I agree with the IPCC conclusion that slower-moving storms with heavier precipitation are becoming more common.

What, if anything, are we doing about these trends? Certainly, an effort is occurring in the US and other countries to limit greenhouse gases, with or without the Paris Agreement, and much more is needed in both the short and long term. But with regard to hurricanes in North Carolina, there has been little action to protect the eroding shoreline. A recent news article tells the story:
https://www.huffingtonpost.com/entry/north-carolina-sea-level-rise-hurricane-florence_us_5b985a87e4b0162f4731da0e

In Florida, local communities are getting more involved in protecting themselves, but still there is still too little happening on state and regional levels.

Sea level is now rising about an inch every seven to eight years now. Along the North Carolina coast the sea level has risen about 6.5 inches since 1950. When storm surges occur on top of even a modest sea level rise and the continental shelf is shallow, the surge/flood impacts from both major and minor hurricanes are amplified. This was the case with Category 2 Florence!

An interesting point and counterpoint were recently raised in California regarding climate warming, at the Climate Action Summit (https://www.globalclimateactionsummit.org) in San Francisco, which featured many impressive and interesting presentations.

One troubling takeaway was the emphasis on attributing every bad weather event, from droughts to fires and floods, to climate warming. Fires, floods, and droughts have been around for a very long time. The key point, however, is that our climate is warming much faster now than climatic changes have unfolded in the past. Changes that used to take thousands of years are being compressed into decades. This precipitous rate of change is what is so troubling!

The counterpoint was a series of panel discussions organized by a group called the Hartland Foundation, specifically to rebut the Climate Action Summit and climate warming in general. See https://youtu.be/5_XSrrw4DDc.

This group was less impressive and seemed to focus more on PR than scientific discussion. I was struck by the dearth of IPCC members or representation from first-rate science institutions at this gathering. This group failed to identify the rate of climate warming as unusual and highly correlated to human-generated greenhouse gas emissions.

Ignoring what is and hoping for the best is not a strategy. Shooting the messenger , climate science, is costing us big-time, but perhaps the lessons from Florence will lead to a more reasoned and action-oriented approach. As many readers know, I am not in the camp that expects worst-case scenarios of sea level rise by 2100. See my article
https://www.cumber.com/guest-commentary-by-bob-bunting-its-getting-hotter/.

But there is no reason to believe that the past and current trend of sea level rise will suddenly stop and good reason to believe, on the other hand, that the rate will increase as global temperatures continue to rise.

Evidence Calls for Action

While fair debate is welcome and needed, dismissing climate warming as nonexistent is not helpful, nor is sensationally predicting the end of the world by 2100. What is helpful is concerted action to mitigate the impacts of the most likely climate-warming scenarios. Preventing further damage to the climate by limiting greenhouse emissions, pushing technological solutions, and promoting scientific understanding are key to being successful – as I know we can be!

Policy reacts to the will of society but with a time lag. That’s why it’s so important to study this issue and not be drawn in by polarizing positions. It is all too easy to jump on bandwagons, but the answers are now largely known for those who want to deal with high-probability scenarios. In North Carolina an opportunity was missed on a statewide level. During the 1990s, as I discussed in my previous article published by Cumberland, the US and the world missed an early opportunity to deal with climate warming. Now it’s time for local action that will trickle up rather than down. Perhaps North Carolina and its coastal communities will help lead the way.

Florida is one of most vulnerable areas, with $7T in real estate along the beach lying in harm’s way and with climate-enhanced red tide becoming more of a real problem. Florida has the opportunity to lead the climate adaptation movement for local and regional mitigation of the additional climate changes sure to come in the next decades.

Herein lies a series of opportunities for local and regional coordination through a new center in the Sarasota-Manatee area that can take developing climate science and tailor it for decision makers in state, regional, and local governments. Billions of dollars already being spent can be better utilized for the formation of effective, coordinated, and enduring adaptive solutions.

Also, because the adaptation to climate warming is one of the most important issues of our time, the situation is ripe for entrepreneurs who want to stop talking and start doing! I predict that new business development in this area will create an economic boom for those who can seize the opportunity!

Sarasota -Manatee is ground zero for climate impacts from rising sea levels, explosive hurricane development, and red tide. Because it is, it can be a hub that helps Florida, the region, and local levels to create a platform for academia, government, and the private sector to foster mitigation and adaptation as well as to catalyze economic opportunities that mitigation will surely spark.

Florida and the Sarasota-Manatee area have the expertise, financial resources, and leadership to help broker a more effective approach to dealing with climate-change impacts. It’s time to take the abundant resources we have available and organize them, much as Steve Jobs and company did when they reinvented the phone with the iPhone. They took the pieces that we all use in our daily lives, from music to calendars and from news to maps, and handed them back to us in the form of an “on the go” platform that integrated what already existed into a truly transformative device. That example provides the inspiration that we can do it, too; but this time we are challenged to creatively adapt to deal with an issue that will fundamentally impact all our lives. Stay tuned!

We thank Bob for allowing us to publish his work: Bob Bunting – atmospheric scientist, author, educator, and entrepreneur.


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4Q 2018 Review: Market Volatility

From the trade war to the Fed, the fourth quarter of 2018 has been full of uncertainty, which is markets’ least favorite scenario.

 

Market Commentary - Cumberland Advisors - 4Q 2018 Review Market Volatility

The US equity market posted one of the worst October numbers since the financial crisis. The NASDAQ tumbled 9% in October, marking its worst monthly drop since November 2008. Although the equity market caught some breath in November, the resumed sell-off in December has made the odds of a Santa Claus rally slim to none, especially if we take account of the possibility that some year-end tax-loss-related repositions may be exacerbating the market sell-off.

While a 10% correction in the market is not uncommon, there is one interesting aspect of the fourth-quarter market: intraday volatility. Out of 54 trading sessions so far in the current quarter, the Dow has had 16 sessions with intraday 500+ point swings since October 1.* This is roughly 2% of the current level of the Dow. We even had two sessions with 900+ point swings, October 10 and October 29. Additionally, the Dow had five consecutive sessions with 500+ point swings from December 4 to December 11. Not only does the market find it hard to establish some momentum in a rebound rally in this environment of unusually high intraday volatility, but market participants also tend to build bearish sentiment as the volatility drags on. For example, the latest AAII Investor Sentiment Survey, on December 13, showed the lowest bull-bear spread since February 11, 2016, even though the YTD 2018 S&P 500 return was basically flat then.

Our quantitative strategy started this quarter with all-cash position and went back into the market throughout the sell-off. We are currently invested and will hold a neutral position in the near future.

Have a great holiday.

Leo Chen, Ph.D.
Portfolio Manager & Quantitative Strategist
Email | Bio


*Data from Bloomberg, ending on December 17, 2018


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The Global Economy Moderation & International Equity Markets

As 2018 draws to a close, economic growth in almost all economies, including that of the US, is moderating but is still expansionary and in most cases remains above long-term trends.

Market Commentary - Cumberland Advisors - The Global Economy Moderation and International Equity Markets 

For the year 2018 as a whole, global growth looks likely to be the same as for 2017, 3.7%, with advanced economies advancing at a 2.4% pace and emerging markets at a robust 5% pace. The recent moderation in growth appears likely to continue into 2019, but with annual rates for the year remaining very close to those for the current year. This outcome would be far better than the recession some are predicting. Downside risks, however, are growing.

Global equity markets, particularly those outside the United States, have significantly undershot these relatively benign economic prospects due to heightened uncertainty about a deepening trade war, slower growth in China, the Brexit negotiations in Europe and tighter global liquidity with higher interest rates as central banks around the globe, with the exception of the Bank of Japan are normalizing monetary policy (“withdrawing the punch bowl”). These uncertainties, together with leading indicators signaling slowing economic momentum, have undermined risk appetites, driving almost all international equity markets to painful losses for the year to date. Another factor was the generally elevated valuations at the beginning of the year.

The iShares All Country ex US ETF, ACWX, is down 15.6% year to date December 17th on a total return basis. Eurozone markets, as measured by the iShares MSCI Eurozone ETF, EZU, have lost 18.1%, with the iShares MSCI Germany ETF, EWG, down 23.1%; iShares MSCI France ETF, EWQ, down 14.7%; and iShares MSCI Italy ETF, EWI, down 19.9%. Elsewhere in Europe, the iShares MSCI United Kingdom ETF, EWU, has lost 18.5%; and the iShares MSCI Sweden ETF, EWD, is down a similar 17.5%. Advanced markets in Asia fared better this year. The iShares MSCI Japan ETF, EWJ, is down just 13%, perhaps in part because Japan’s expansionary monetary policy is being maintained. Also, the iShares MSCI Hong Kong ETF, EWH, has outperformed, with a loss of just 10.3%. Similarly, the iShares Taiwan ETF, EWT, is down 13.4%.

As is the case with advanced markets, emerging markets as a group are down some 17.5% year to date, as measured by the iShares MCSI Emerging Market ETF, EEM. Here also there are significant differences among the individual national markets. The economic slowdown in China, due in part to trade difficulties vis-à-vis the US and more importantly to the ongoing domestic credit crunch, is affecting other emerging-market economies. China’s equity market, as measured by the iShares MSCI China ETF, MCHI, fell 18.8%. The iShares MSCI Korea capped ETF, EWY, has lost 22.3%, while the iShares MSCI Indonesia ETF, EIDO, has performed better, losing 13.9%. In Latin America, the iShares MSCI Mexico capped ETF, EWW, has dropped 20%, while the iShares Brazil capped ETF, EWZ, has recovered from a steep fall to end up down only 5.2%.

Looking forward, while the base case economic outlook is for only a modest further slowdown in global growth, the important uncertainties present downside risks that will continue to affect market sentiment. In particular, failure of the US and China to lower trade tensions would have significant negative market and economic effects, as would a failure in UK-EU Brexit negotiations that results in the UK exiting the EU without a deal. The eventual outcome of US negotiations with North Korea is another important unknown. And investors will likely remain concerned about the possibility of a sharper economic slowdown, in particular one coming from slower growth in China. They also are seeking a clearer view of the likely pace of further monetary policy tightening by the Federal Reserve and by the European Central Bank. A positive factor is that the year will start with equity asset valuations that are more attractive than they were last January, due to a combination of price declines and positive earnings growth. Also markets are heavily oversold. If the major downside risks do not materialize, the outlook next year is for modest positive risk-adjusted returns. Close monitoring of developments and selectivity among markets will be desirable.

William Witherell, Ph.D.
Chief Global Economist
Email | Bio


Sources: Goldman Sachs Economic Research, Barclays, Financial Times, IMF, CNBC


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Leveraged ETF Tracking Error

Cumberland Advisors Market Commentary - Leo Chen, Ph.D.We discussed the goal of leveraged ETFs previously – to provide daily returns that match the desired ratio over the underlying index (https://www.cumber.com/margin-trading-vs-leveraged-etfs/). These ETFs rebalance daily to maintain the proportional leverage through derivatives such as futures, forwards, and swaps. We will demonstrate that this daily rebalancing feature dictates the long-term returns of leveraged ETFs, deviating from the multiple of the underlying index over the same period due to compounding.

One of our earlier commentaries compared the long-term returns of a leveraged ETF and an unleveraged index that suffers from a lack of compounding (http://www.cumber.com/leveraged-etfs/). We will revisit the issue with a simple example. If an index returned 30% in one year, then the arithmetic average daily return would be 0.1190%, using 252 trading days a year (1); however, the geometric average would be 0.1042% (2):

30%/252 ≈ 0.1190%                 (1)
(1+30%)1/252 – 1 ≈ 0.1042%     (2)

Apparently, requiring both daily and long-term returns of leveraged ETFs to match the underlying index is not realistic. Hence, given that leveraged ETFs’ target is to track the daily multiple returns, we recommend focusing on the daily tracking error.* We continue with our previous choice of the ETF SPXL as our example. We use one of the largest ETFs, SPY, as our comparison. First, we notice that the correlation between SPX and SPY has been lower than the correlation between SPX and SPXL (Table 1) since their inceptions. Moreover, the average daily tracking errors of SPY and SPXL are both very small, around 0.01%. The spread between the tracking errors is only 0.0034% (Table 2), net of expenses. On the other hand, we also compare the absolute values of these daily tracking errors. Interestingly, even if both the absolute values are greater than before, the spread between the absolute averages is still relatively trivial – 0.0335%. From the daily return perspective, leveraged ETFs do not provide significantly higher tracking errors than their counterparts do.

Next, we will demonstrate that the  compounding effect accounts mathematically for most of the long-term performance discrepancy.*** The approximation below shows that the compounded return of a leveraged ETF over a long period can deviate from the underlying index even without any tracking error.
where  is the leverage ratio, n is the number of holding days,  is the index average return, S is the standard deviation of the daily returns, and  is the compounded return over the period, ignoring expenses. The main takeaway from equation (3) is that the higher the volatility S and the leverage ratio , the lower the compounded return over the holding period. The return can be very poor in a sideways environment or rather pleasing in a bull market.
We can thus conclude that the so-called tracking error of a leveraged ETF over the long run is not really the same as the traditional tracking error; instead, it reflects the compounding effect. This effect is more pronounced with high leverage ratios and volatility. Alternatively, some traders may refer to the effect as “time decay” or “volatility decay.” From the mathematical perspective, we can identify the compounding effect as the driving factor.

Leo Chen, Ph.D.
Portfolio Manager & Quantitative Strategist
Email | Bio


*We define daily tracking error as the difference between an ETF’s daily NAV return and the underlying index’s daily return.
**Data from Bloomberg.
***We adapt the derivation from the Richard Co and John Labuszewski paper “Leveraged ETFs: Where Is the Missing Performance?” (2009 ). We derive the approximation by applying Taylor series.


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TNB and the Regulatory Dialectic

Back in the 1980s Professor Edward Kane coined the term regulatory dialectic to capture the dynamics of how regulated financial institutions found innovative ways to circumvent regulations designed to restrict their behavior.
Cumberland Advisors' Bob Eisenbeis
For example, banks adopted the one-bank holding company form in the late 1960s to avoid the restrictions on permissible activities. They subsequently used that device to create non-bank banks that also enabled them to cross state lines, avoiding the restrictions on interstate banking. The process led to a new era of nationwide banking that we now take for granted. Similarly, when Regulation Q restricted the rates that depository institutions could pay retail customers, money market mutual funds came into existence to solve that problem. And when federal law capped the amount of Federal Deposit Insurance an individual could receive to $250K per account, Promontory Financial Group (now a subsidiary of IBM), formed by former Comptroller of the Currency Eugene Ludwig and former Federal Reserve Board Vice Chairman Alan Blinder, found a way to pool accounts to expand deposit insurance coverage for large depositors far beyond the $250K limit.

The most recent example of the regulatory dialectic was the subject of an American Enterprise Institute program on December 2 in Washington, devoted to what is known as The Narrow Bank (TNB). The recently retired executive vice president of the Federal Reserve Bank of New York, Dr. James McAndrews, is now chairman of a newly licensed, uninsured, special-purpose wholesale bank in the State of Connecticut that has applied to the Federal Reserve Bank of New York for a master account. TNB would only do one thing: It would accept deposits from large accredited investors, namely the GSEs, Federal Home Loan Banks, money market mutual funds and selective other large investors; deposit those funds in the master reserve account at the Federal Reserve Bank of New York; receive an interest payment (known as interest on excess reserves [IOER]) from the Bank on those funds; and transfer all that interest to the depositing institutions, less a small fee for the service. So what is the regulatory avoidance? GSEs and Federal Home Loan Banks are permitted to hold deposits at the Fed, which serves as their fiscal agent, but they are not permitted to receive interest on those accounts.

In lieu of this option, what have the GSEs and Federal Home Loan Banks been doing with their deposits held at the Fed? They have been lending those funds out in the overnight market at rates somewhat below IOER, in part frustrating the Fed’s attempt to achieve its target for the federal funds rate with IOER operating as a floor on the funds rate. Whom have the GSEs been lending to? Interestingly enough, they have been lending to foreign banks, which borrow fed funds at a rate slightly below IOER and deposit the funds with the Fed to receive the IOER, earning a risk-free arbitrage. In fact, the terms are so attractive that about 35% of the excess reserves on deposit at the Fed are owned by foreign entities with US-chartered bank subsidiaries. This is despite the fact that such entities hold less than 10% of total deposits. These foreign institutions have some advantages over US banks. First, they are not subject to the hefty Federal Deposit Insurance rate charge to US banks on their total assets. Second, the reserves count towards the Liquidity Coverage Ratio stipulated in the Basel III regulations. Finally, the positive IOER of 2.2% is a risk-free alternative to the ECB’s negative 0.4% levied on reserves.

So what problem does TNB solve for the Fed? The main benefit is to bring the effective funds rate in line with the IOER floor. Of course, the federal funds rate target is above the floor, so what we are talking about is putting a downside limit on the intraday fluctuations in the federal funds rate.

The other issue is that TNB’s existence hinges critically upon there being a large volume of excess reserves. The Fed, as the FOMC’s most recent minutes suggest, has not decided on the desired size of its balance sheet; nor has it determined to revert to the pre-crisis policy implementation strategy that targeted the federal funds rate in an environment with a very small volume of excess reserves. Its alternative is to continue with a much larger balance sheet and rely primarily upon its current reverse repo strategy for policy implementation. In the pre-crisis world, there would be only a limited opportunity for TNB, and there is the risk that its presence might serve to disintermediate funds, especially from smaller banks, and disrupt the credit process.

The threshold question the Fed faces as it decides whether to grant TNB a master account is what the size of its balance sheet should be. In the pre-crisis world, its balance sheet was determined primarily by the volume of currency outstanding; required reserves were largely met by banks’ cash holdings; and reserve balances were about $8 billion in 2006, or slightly less than 1% of the Fed’s total assets of $850 billion. As of the most recent data, from November, excess reserves were about $1.6 trillion, and assets were $4.1 trillion. If the Fed were to shrink its balance sheet to restore the old relationship between currency and GDP, it would need about $1.9 trillion and an additional $17 billion to account for excess reserves. Additionally, the Fed has other liabilities to the Treasury and to official foreign accounts, which total about $430 billion. Together, these liabilities would imply a balance sheet for the old regime of about $2.3–$2.4 trillion.[1] How big would the balance sheet have to be if the current reverse repo regime were to be followed? The answer hinges on the expected size of the reverse repo market. The market has shrunk considerably since the policy was put in place. The principal users are money market mutual funds. In 2017 the average daily transaction volume in the market was $143 billion, with a standard deviation of $60 billion. By comparison, through the first half of 2018 the average daily transaction volume was only $19 billion, with a standard deviation of $23 billion. These numbers suggest that a balance sheet of about $2.4–$2.5 trillion would enable the Fed to pursue either its historical or new policy regime with a much smaller balance sheet than is presently in place. Such a balance sheet would imply a small role for TNB (and any other copycats that might arise), since reserves would constitute only a small portion of the Fed’s liabilities.

 
Robert Eisenbeis, PH.D.
Vice Chairman & Chief Monetary Economist
Email | Bio 


[1] Data as of November 29, 2018.

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January 25th & Gary Shilling

Gary Shilling is an icon of our finance industry. His monthly missive is priceless. Fred Rossi edits and researches. The work product is extraordinary. We thank them for permission to share the December monthly in full. The trigger for our request was their thorough examination of the climate-change debate and the coincident timing, as registration is now open for the January 25th GIC-USFSM conference, Adapting to a Changing Climate: Challenges & Opportunities, to be held at the University of South Florida Sarasota-Manatee.
 
Here is a link to the conference presentations lineup: http://usfsm.edu/climate
 
The conference is fully sponsored, so the registration cost is only 50 bucks to cover lunch and direct costs. Issues such as red tide, hurricane intensity, and rising sea levels are among those to be examined. The purpose of the conference is not to find fault; instead, it is to discuss what to do now and tomorrow and next week and next month.
 
Please take a look at the excellent data assembled by Gary and Fred, starting on page 31 of Gary Shilling’s Insight for December, available here as a PDF file: https://cumber.com/pdf/A.-Gary-Shilling’s-INSIGHT-December-2018-(Climate-Change-A-Look-From-Both-Sides).pdf – page=31.
 
Also look at the latest official US report on climate change, released by the Trump administration on the day after Thanksgiving: Fourth National Climate Assessment, Volume II: Impacts, Risks, and Adaptation in the United States, https://nca2018.globalchange.gov/.  
 
Another valuable source of reliable analysis of climate change comes from the Becker Friedman Institute for Economics of the University of Chicago. Their working paper 2018-51 is entitled “Valuing the Global Mortality Consequences of Climate Change Accounting for Adaptation Costs and Benefits” (August 2018). It’s available here: https://bfi.uchicago.edu/Greenstone-WP-201851.
 
We hope that you will join us at the USFSM auditorium on January 25 for the conference. Please forward this message to anyone who might be interested in this subject.

GIC & USFSM - Adapting to a Changing Climate - Challenges & Opportunities




Cumberland Advisors Week in Review (Dec 03, 2018 – Dec 07, 2018)

The Cumberland Advisors Week in Review is a recap of news, commentary,
and opinion from our team. These are not revised assessments, and
circumstances may have changed in the market from the time of original
publication. We also include older commentaries that our editors have
determined may be of interest to our audience. Your feedback is always welcome.

MATT MCALEER’S WEEKLY RECAP

Matt McAleer gives us the Week In Review report for the week ending December 07, 2018. What was good? What was poor? How about bonds? Direct from the equities desk is Matt’s view of the market. Thanks for joining us. WATCH HERE.

C:\Temp\Cumber\Cumberland-Advisors-Matt-McAleer-Update-December-07-2018-Video-Thumbnail

MARKET COMMENTARY

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FEATURED VIDEO

Cumberland Advisors – Trump Navarro Trade War Consequences.

David Kotok of Cumberland Advisors comments on the Trump-Navarro Trade War
David Kotok of Cumberland Advisors comments on the Trump-Navarro Trade War with China and its consequences for markets.

The video is available here.


IN THE NEWS


IN CASE YOU MISSED IT

  • Winners and Losers from Global Trade David L. Blond, Ph.D. 3/17/2018

    In a grand effort to change the subject of the political discussion from Russia to something else, President Trump fired the opening shots in a new trade war. Not content to destroy the solar industry by adding costs without adding supply to solar panels, or making South Korean washing machines more expensive without making American consumers more willing to buy US made (with foreign parts) machines from the one remaining American producer, President Trump fired off the big guns to try to save what remains of the US steel and aluminum industries with new tariffs. The response was, of course, expected.Over the past twenty years or more I’ve tried to slow the steady erosion of the US industrial base against the tide of history… Continued…
  • It’s Hot and Getting Hotter – The Case for Adaptive Strategies for a Warming Planet Bob Bunting 08/29/2018

    Bob Bunting, a friend, meteorologist, and accomplished professor, has offered his insight on climate change via this guest commentary, It’s Hot and Getting Hotter – The Case for Adaptive Strategies for a Warming Planet. We appreciate his perspective and invite you to join the conversation. Continued…


UPCOMING EVENTS

  • Adapting to a Changing Climate From hurricanes to red tide and sea level rise, learn how a changing climate affects the Sarasota-Manatee region and the state of Florida. Expert speakers will discuss the challenges and impact on Florida and other coastal communities while uncovering the adaptive strategies that bring unique social and economic opportunities. The featured speaker is Bob Bunting, CEO Waterstone Strategies/Scientist/Entrepreneur – January 25, 2019 – Selby Auditorium, USFSM , 8:30 am – 3 pm. Lunch is included. Cumberland Advisors is a sponsor and Patricia Healy, CFA, from our firm will discuss “Climate, Municipal Bonds and Infrastructure” with the audience. Details Here.
  • U.S. Manufacturing in a Global Context Save the Date! GIC is returning to Sarasota, FL on Friday, February 1, 2019 to partner with the Financial Planning Associates of the Suncoast and Cumberland Advisors. Join us at the Sarasota Yacht Club as we welcome Bill Strauss, Senior Economist and Economic Adviser of the Federal Reserve Bank of Chicago, for a presentation on U.S. Manufacturing in a Global Context. Strauss is a senior economist and economic adviser in the economic research department at the Federal Reserve Bank of Chicago, which he joined in 1982. His chief responsibilities include analyzing the current performance of both the Midwest economy and the manufacturing sector for use in monetary policy. Details Here.


ADDITIONAL RESOURCES

Lessons from Thucydides

David R. Kotok has written the monograph pamphlet, “Lessons from
Thucydides” detailing information asymmetries and their implications for
investors and world affairs. The concept of a Thucydides Trap and its
rise and avoidability (or lack thereof) is often debated and David makes
a case for dealing with them weaving current and historical events into
a comprehensive narrative.

This free monograph also has lessons for President Donald Trump’s trade
policy. Can the United States avoid a Thucydides Trap with China &
Xi Jinping? Will you benefit from the Lessons of Thucydides or fall
victim to a Thucydides Trap? If information is key, you now have a
handbook at your fingertips. Download a copy of this monograph in either
PDF (free) or Kindle ($.99) format.https://www.cumber.com/thucydides/


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Thank you for engaging with us, your comments always welcome.




Today’s Employment Report

Peter Boockvar summarized a view of this Pearl Harbor Day employment report. We agree with him.

Here’s Peter: “Bottom line, the moderation in the pace of job gains coincides with the recent uptick we’ve seen in jobless claims. It’s hard not to wonder how much of this is due to a business pause on the labor front with all the cloudiness on trade and tariffs. Construction seeing only a job gain of 5k could also be reflecting the slowdown going on in real estate, both residential and commercial. Manufacturing job gains did hang in as companies front loaded inventory builds.” (Peter Boockvar, email to subscribers, Friday, December 07, 2018 8:53 AM)

Market Commentary - Cumberland Advisors - Employment Report

In our interview with the Wall Street Journal this morning we enumerated and discussed the anecdotes we see from our client base in over 40 states. There is a slowing underway because of Trump-Navarro Trade War protectionism. It is getting worse, as one would expect. We see it in New England in the lobster industry. We see it in the Western US in construction. We see it in employment composition and businesses’ deployment of assets as they build inventories in anticipation of tariffs. And we see it in delays of capital expenditures as entrepreneurs are bewildered by Trump administration inconsistencies.

Simply put: You cannot make business decisions and investment decisions based on Twitter rampages. That doesn’t work.

The Fed’s Beige Book confirms these anecdotes in reports from the twelve Federal Reserve regions. DataTrek has a compilation out this morning. We have copied and pasted it below. The key to today’s employment report is that the data from the US national report is confirming what the survey data is saying in the Fed’s reports.

Here’s Datatrek:

That’s why we look at the Beige Book when it is released eight times a year, as it offers more color on what’s happening beneath the economic surface than the national data shows. Another word we’ve been closely monitoring in these reports: ‘tariff’. It went from no mentions in the January and March reports to the following times in future editions: April (36), May (22), July (31), September (41), October (51), and December (39).

Clearly tariffs continue to worry businesses across the US, as eleven out of twelve districts mentioned them in the latest report. Also of concern: ‘Most Districts reported that firms remained positive; however, optimism has waned in some as contacts cited increased uncertainty from impacts of tariffs, rising interest rates, and labor market constraints.’ Not dissimilar to this quarter’s market worries… Here’s some key examples of what they’re saying about each topic from the period of mid-October through late November:

Tariffs

• Boston: ‘An industrial distributor said they expected tariffs to contribute 50 to 100 basis points to price increases for their products… Looking ahead to 2019, retailers expressed significant uncertainty about the impact that tariff increases will have on prices–beyond some point, they will pass the increases on to consumers.’
• Philadelphia: ‘One firm reported that it has passed along its costs from 10 percent steel tariffs but that it expects customers to push back if the tariffs increase to 25 percent.’
• Cleveland: ‘Contacts noted that tariffs were lifting prices further down the supply chain. Selling prices rose with less intensity than they did for input costs.’
• Richmond: ‘Wholesale and retail services saw higher prices for goods affected by tariffs… Tariffs were a significant concern noted by manufacturers, as they were believed to raise costs of raw materials, thereby raising prices and lowering demand… Several retailers reported narrowing profit margins as cost of goods increased as a result of tariffs.’
• St. Louis: ‘Contacts expressed concern over the ongoing tariffs leveled at U.S. agricultural products. There are reports of storage shortages as soybeans that are normally exported to China are being stored in large quantities rather than exported.’
• Dallas: ‘Manufacturing sector slowed during the reporting period, and outlooks were less optimistic than they have been all year. Output growth softened notably in November, with the tariffs, labor constraints, and trade policy uncertainty cited as damping factors.’

‘The upshot: several districts continue to express concern and uncertainty about tariffs and potential changes in trade policy. Tariffs have already increased input costs, which many indicate they will have to pass on to consumers if they haven’t already.'” (Datatrek Morning Briefing, Dec. 6, 2018, “Beige Book: Ghost(ing) of Recession Future”)

Markets are already reacting to the outlook for slowing growth. Future Fed hiking is being repriced to fewer and fewer rate rises. There is good reason, as inflation remains subdued while the economy is slowing to a 2% or lower growth rate.

For bonds this is bullish; and for tax-free municipal bonds, which have been yielding higher than taxable Treasury bonds, this is doubly bullish.

For stocks, this removes or lessens the risk that the Fed will go too far with its hiking strategy. It remains to be seen if the stock market will see a glimmer of positive news in this weaker-than-expected jobs report. News of the arrest of a Chinese firm’s executive casts a pall over any trade negotiations.

For POTUS, this is another warning that the Trump-Navarro Trade War policy is accelerating damage to the economy. One at a time, businesses and investors are becoming disillusioned. We are in the camp that the tariffs are damaging and are spreading like a financial cancer. The Trump-Navarro policy is metastasizing.

We again reiterate that we believe the Trump policy is unsustainable. And we believe that the American business community will overcome it. We continue to use the instability in the equity markets to our advantage by selectively adding to our positions. We believe the time to buy stocks is when no one wants them and when the tape is red. If the Trump-Navarro policy leads to a full-blown cold war with China, we will be proven wrong. But if the mounting evidence reaches into policy enough to alter it, we will be right and markets may soar to new all-time highs within the next two years. Time will soon tell.




Trump Trade War Tariffs & Markets

“We’ll not mince words here: The president’s characterization of himself as “Tariff Man” is juvenile and unpresidential. We cannot imagine Mr. Eisenhower, Mr. Kennedy, Mr. Johnson, Mr. Nixon, Mr. Ford, Mr. Carter, Mr. Reagan, Mr. Bush, Mr. Clinton, Mr. Bush or Mr. Obama ever… EVER… making a juvenile statement such as this to any other nation, much less to a nation as consequential as is China. But Mr. Trump has threatened China, and his base has enthusiastically endorsed his comments. We can only shake our heads in wonder and dismay.” Source: Dennis Gartman, his eponymous daily letter, December 6, 2018.

Trump Trade War Tariffs & Markets

We agree. Markets agree. The red on the tape agrees. The flattening yield curve agrees. The deterioration of business sentiment agrees.

Culprits in order of responsibility are POTUS Trump, US Trade Representative (aka Trade War negotiator) Lighthizer, and Trade War advisor Navarro. The new Senate is planning on a debate to limit presidential trade war authority and to relocate US security provisions to the defense department and not commerce. Remember that this entire trade war narrative has been based on an executive branch’s taking a narrow, half-century-old law and interpreting it loosely to permit protectionism.

The Congress can change that. Will they? We will see.

Meanwhile the Trump administration has undone more than half of the benefits derived from tax cut, deregulation, and repatriation. Navarro poorly advised POTUS, who showed poor judgment and now likes his tariff money, since he has misled Americans by creating a de facto national sales tax imposed on the American consumer.

That is correct, dear reader. You and I pay the higher costs tariffs impose. Trump blames others and says we are imposing tariffs on “them.” Nope. The payment comes from my pocket and yours.

Business doesn’t know how to plan. So it waits. Capital investment waits. And growth slows.

We asked Mike Englund of Action Economics to update his slide used last summer on the panel we did together at a Colorado conference on Trade War effects.

We are reproducing his update below. And we thank Mike for a quick reply and superb effort. We endorse and recommend Action Economics as a basic research service. Mike writes,

“Thanks for the request. I revised the slide I believe you are referencing to include an “All China” tariff by 2020, whereby we have the 90-day cease-fire now; then a 25% tariff as previously threatened for January; then tariffs of 10% on the remainder of Chinese goods at some fall deadline, perhaps in August or September; and a hike to 25% at the end of December 2019. This scenario creates multiple ‘ledges’ for a compromise to be made.”

Dear readers, the classic aphorism holds true: In a trade war the guns are pointed inward. No one wins.

To end this misguided and failing Trump-Navarro tariff policy requires an inflection in policy. Because of trade-war-driven economic deterioration and business slowing, we expect a change to come. When it does, growth will pick up, and stock markets will recover. We cannot replace the business and wealth losses already inflicted on Americans by the Trump-Navarro Trade War. But we can stop the bleeding, and it may take the new US Senate to do it.

Stocks are cheap, and American business wants to grow. Our ETF selections continue to focus on domestic US sectors we like. Healthcare is an example.