Daily Comment (November 22, 2017)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] As a reminder, we will not publish the Daily Comment this Friday, November 24.  Although financial markets are quiet, there was a good bit of news.  Here’s what we are watching:

Yield curve flattening: Yesterday, the U.S. yield curve flattened to its lowest point since November 2007; as a result, there have been growing concerns of an impending economic slowdown. The yield curve is one of the most widely used financial indicators in determining the health of the U.S. economy. An upward sloping yield curve signals that the economy is in good shape, whereas a flattening yield curve signals a possible slowdown and a downward sloping yield curve signals a possible recession. Furthermore, a change in the yield curve does not necessarily signal a change in the economy but rather it could reflect current monetary policy. As the Fed raises short-term interest rates, the market adjusts long-term interest rates based on inflation expectations.

That being said, we believe the flattening of the yield curve is the result of a combination of the Fed raising short-term rates and falling inflation expectations. After the election, inflation fears rose, which led to a rise in long-term interest rates. Inflation expectations have fallen as post-election inflation fears proved to be unfounded.

(Source: Bloomberg)

The chart above shows the spread between the two-year and 10-year Treasuries from June 2016 to the present. After Trump won the presidency there was a spike in the spread between the two- and 10-year Treasuries, but it has seen a steady decline since. A flattening yield curve suggests the Fed should be cautious with rate hikes next year as its actions could lead to an inverted yield curve. This sentiment is mirrored by Chicago FRB President Charles Evans, who expressed his hesitancy last month for supporting rate hikes if inflation expectations do not pick up.

Mugabe out: After 37 years of rule in Zimbabwe, Robert Mugabe has formally resigned from office and will be replaced his former Vice President Emmerson Mnangagwa. Mugabe’s peaceful departure is a positive sign for the region as it paves the way for new elections next summer. The change of power was likely supported by China, which has stood by Mugabe since he came to power in 1980. It has been reported that China became increasingly skeptical of Mugabe as he grew more unpopular among members of his own party.

Tensions rising in North Korea: Yesterday, North Korea escalated tensions with South Korea and the U.S. Last week, a North Korean border guard chased and shot a defector in the demilitarized zone that separates the two Koreas; this incident was a violation of the ceasefire agreement between the two countries. In addition, North Korea has denounced the U.S. decision to re-designate the country as a state sponsor of terrorism. The increased provocation is not likely to lead to war anytime soon, but we will continue to monitor the situation.

View the complete PDF

Daily Comment (November 21, 2017)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy Thanksgiving week!  We want to pass along a heads up that the Daily Comment will not be published this Friday, November 24.  Although financial markets are quiet, there was a good bit of news.  Here’s what we are watching:

Merkel leans toward new elections: Yesterday, we laid out the four options for Germany, suggesting that new elections were the least market-friendly because this outcome raises uncertainty.  Increasingly, it looks like Merkel is leaning toward new elections, unwilling to ask the SDP to join a grand coalition or form a minority government.  Senior leaders within the CDU/CSU are giving the parties three weeks to form a government but are putting increasing pressure on the SDP to change its position.  There are two reasons the SDP is reluctant to join Merkel to form a government.  First, voters across Europe are shunning center-left parties for ignoring the needs of lower income citizens and opting for more market-friendly policies.  The SDP took a drubbing in the polls and fears that joining Merkel again could lead to the end of the SDP as a functioning political party.  Second, joining Merkel would raise the status of the AfD by making it the official opposition.  There are hints that the SDP will join the CDU/CSU on one condition—Merkel steps down from the chancellor position.  This is why Merkel is instead willing to take a shot at another round of elections.  One important issue to remember is that Merkel has had a tendency to destroy junior partners in coalitions.  The Free Democrats slipped badly after joining Merkel from 2009 to 2013.  As noted above, the SDP has had a similar experience.  If talks finally fail, the German president will hold votes in the Bundestag for chancellor; the first two rounds of votes require a majority in order to become chancellor.  A third vote is held if a majority isn’t reached, giving the chancellor post to the highest vote winner, which will almost certainly be Merkel.  At this point, either Merkel can operate a minority government, piecing together votes to pass various measures, or the president can declare the government too unstable and call for new elections.  We may be seeing the end of Merkel’s political career.  Political tumult in Europe’s largest economy will tend to weigh on EUR sentiment.  It may help PM May get a better deal on Brexit and will open up the chance for Macron to boost France’s status within the EU and the Eurozone.

North Korea a state sponsor of terrorism: President Trump officially labeled North Korea as a state sponsor of terrorism yesterday, joining Iran, Syria and Sudan with this designation.  The DPRK was initially put on the list in 1988 after its agents detonated a bomb on Korean Air Flight 858 in 1987.  President George W. Bush removed North Korea from the list in 2008 in an attempt to improve relations during nuclear negotiations.  For the most part, this won’t make a huge difference; North Korea is already heavily sanctioned and anything that comes from this change won’t be material.  It is a global shaming for the DPRK and may increase Chinese pressure on Pyongyang.  After all, a rising global power doesn’t want to be seen supporting a designated terrorist state.  The move was also welcomed in South Korea and Japan, which live in fear of North Korean terrorist behavior.  On a related note, Kim Jong-un is disciplining the leadership of the nation’s most powerful military organization.  Although there is no information suggesting a purge of the military’s leadership, they are being “punished.”  We suspect two issues here.  First, Kim wants to put his own people in place and has been steadily removing his father’s cronies; this action may be part of that.  Second, Kim’s father had increased the power of the military over the civilian structures of the government, including the party.  Kim may be deciding that he wants to reverse that program.  We watch this because unexpected outcomes are possible any time important parts of the North Korean government come under pressure.

Yellen out: Although it isn’t a huge surprise, Chair Yellen made it official, saying she would not serve out her term as Fed governor when she steps down as chair in February.  Her governor term lasts until 2024.  This move is precedent at the Fed; when chair and vice chair terms expire in this particular office, they retire.  This is done to allow the replacements to more easily conduct their policy.  Imagine if Greenspan had stayed around as a governor after Bernanke became chair.  Divisions and second-guessing, especially during the Great Financial Crisis, would have been a real problem.  Thus, the president will have three governors in place after February—Brainard, Powell and Quarles.  He can appoint four more governors and really put his stamp on the FOMC.

No to a major merger[1]: We rarely discuss company-specific issues.  This is a macro publication and thus we don’t comment on individual company issues unless they have a macro impact.  The DOJ’s decision to reject the AT&T (T, 34.64) and Time-Warner (TWX, 87.71) merger is one of those events.  Since Reagan, the DOJ has generally been merger-supportive.  Anti-trust legislation from the Progressive era of President Theodore Roosevelt to Reagan generally prohibited large combinations.  Size was a key determining factor.  The legal arguments tended to center on whether the combined firm dominated an industry.  During the Reagan administration, anti-trust regulation shifted its focus to outcomes.  If a monopolist did not abuse its pricing power, mergers were generally approved.  A theory called “contestable markets” emerged, which suggested that mergers were usually approved even if an industry was concentrated so long as there was ease of entry so the oligopolist firms could not act with pricing power.  The key determinant seemed to be how the firms in an industry treated consumers.  If consumers didn’t face higher prices after the union, the DOJ generally didn’t object.  Thus, “vertical” mergers, combining industries together, were usually approved whereas “horizontal” mergers, firms in the same industry, faced greater scrutiny.  The aforementioned merger is considered vertical because one firm is in the distribution business while the other is in content.

What we may be seeing here is a change in precedent away from the Reagan model to the pre-Reagan model.  In practice, firms have discovered that they can reach mammoth size if they don’t adversely affect customers.  Thus, labor tends to get hammered by companies.  The whole move to the “gig” economy appears to simply be a way to push down labor costs.  Mergers seem to do the same thing.  The bigger firms become in an industry, the more they become monopsonists in the labor market for that industry.  In other words, if there were only one tech firm, it could keep programmer wages low because there wouldn’t be competition from other firms bidding up wages.  If the Trump DOJ stands its ground on this merger, it could have a chilling effect on the mega-tech industry.[2]

DACA: Don’t sleep on a December 8th shutdown.  Democrat Party leaders are making DACA a key element in approving a continuing resolution to fund the government and perhaps raise the debt ceiling.  With the GOP tied up with tax issues and the president generally open to the “dreamers,” we expect Chuck and Nancy to use their leverage to try to get a win even if it leads to a government shutdown. 

View the complete PDF


[1] A potential tongue twister…similar to https://www.youtube.com/watch?v=2OBZf0QdKdE

[2] See https://www.axios.com/the-ripple-effect-of-the-att-merger-lawsuit-2511164001.html and https://www.axios.com/the-facebook-whistleblower-wave-2511168571.html?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosam&stream=top-stories

Weekly Geopolitical Report – Moving Fast and Breaking Things: Mohammad bin Salman, Part I (November 20, 2017)

by Bill O’Grady

(N.B.: Due to the Thanksgiving holiday, the next edition of this report will be published December 4.)

Last summer, King Salman surprised the Kingdom of Saudi Arabia (KSA) by demoting Crown Prince Muhammad bin Nayef and replacing him with one of the king’s sons, Mohammad bin Salman (MbS).[1]  In the months preceding the event, the king’s son had been building his power base, gaining control of key parts of the economy and the security sectors.  After being named crown prince, MbS further consolidated power and boosted his profile.  He was given responsibility for the war in Yemen and, later in the summer, MbS and the king accused Qatar of supporting Iran and the Muslim Brotherhood.  When the KSA was unable to force Qatar to acquiesce to rather stringent demands, the KSA and the rest of the Gulf Cooperation Council (GCC) nations [2] implemented a blockade on Qatar.[3]  To date, the war in Yemen continues to drag on without any obvious conclusion and Qatar is managing to prosper despite measures taken against it.

Despite these disappointments, MbS continues to charge forward.  He has unveiled his plans to restructure the economy in a program called Vision 2030.[4]  In recent weeks, he also showed plans to build a new massive mega-city on the country’s north coast that would be a hub for growth and innovation.[5]  To pay for all these changes, the KSA plans to sell at least 5% of Saudi Aramco to foreign investors.  MbS has also implemented other economic reforms and a degree of economic austerity to build savings for these aggressive economic reforms.  The crown prince is essentially in charge of all these efforts as well.

For all this to succeed, MbS has two audiences he needs to sway.  The first audience is the majority of Saudi citizens.  Due to a rapid rise in birth rates, Saudi Arabia has a very young population; 61.5% of the population is under the age of 35.[6]  The youth of Saudi Arabia are disgruntled with social restrictions, slow economic activity and the general ossified nature of the KSA’s ruling structure.  Over the years, the ruling al-Saud family has selected its kings from the sons of Ibn Saud.  These men are aging and the consensus management has led to political stagnation.[7]  Although there is little evidence of a rebellion, the rising youthful majority does have to be addressed before it becomes a rebellion.

The second audience is foreign investors.  The economic reforms being considered by MbS will need significant funding that will require outside investment.  Thus, MbS must project not only an air of progress and excitement but also stability and a clear ability to execute.  That is a fine line to navigate.

We chose the title of this series deliberately.  It is the motto often ascribed to the management of major technology firms.[8]  Primarily started by young men, their goals are to disrupt whatever industry they move into and bring change.  However, as time has passed, the negative externalities of “breaking things” as part of their behavior has becoming increasingly apparent.  It appears to us that MbS is adopting the mindset of the tech industry in remaking the KSA…for better or worse.

This discussion brings us to the tumultuous weekend of November 4.  Over that weekend, there were mass arrests, a missile attack and the resignation of Lebanon’s prime minister.  And, just before that fateful weekend, there was a crackdown on the religious establishment of the KSA.  In this series of reports, we will discuss these events in detail, the broader geopolitics of the region and American foreign policy drift.  Specifically, Part I will focus on the sweeping arrests.  Part II will examine the resignation of Saad Hariri, Lebanon’s former PM, the missile attack on Riyadh and the crackdown on the clerics.  Part III will discuss these events within a broader geopolitical context and examine the drift in U.S. foreign policy.  As always, we will conclude the series with market ramifications.

View the full report


[1] See WGR: A Coup in Riyadh, 7/31/17.

[2] The GCC consists of Bahrain, Kuwait, Oman, Qatar, the KSA and the UAE.

[3] See WGRs: The Qatar Situation: Part 1, 8/7/17; and Part 2, 8/14/17.

[4] http://vision2030.gov.sa/en

[5] https://www.bloomberg.com/news/articles/2017-10-24/saudi-arabia-to-build-new-mega-city-on-country-s-north-coast

[6] https://www.populationpyramid.net/saudi-arabia/2016/

[7] See WGR: Saudi Succession, 1/20/15.

[8] https://www.amazon.com/Move-Fast-Break-Things-Undermined/dp/0316275778

Daily Comment (November 20, 2017)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy Monday and Happy Thanksgiving week!  We want to pass along a heads up that the Daily Comment will not be published this Friday, November 24.  Here’s what’s going on this morning:

Coalition talks collapse: Chancellor Merkel has been unable to pull together a coalition consisting of her CDU/CSU party, the Free Democrats (FDP) and the Greens, announcing this morning that talks have broken down after the FDP walked out of negotiations.  Apparently, the three sides (and, perhaps, four because the CDU and CSU have differences as well) could not agree on a number of issues, the primary one being immigration.  There are four possible outcomes: (1) Merkel can’t form a government and new elections are called.  This action would be unprecedented in German postwar history and the process is remarkably clumsy.  The Bundestag would need to elect a new Chancellor (most likely Merkel), who would then need to lose a no-confidence measure, leading President Steinmeier to call a new election.  Losing the no-confidence vote would further weaken Merkel and new elections would raise the chances that the populist AfD would get even more support.  Thus, we expect the German political establishment to work furiously to avoid this outcome.  (2) The Social Democrats (SDP) join Merkel in another “grand coalition.”  The SDP remains adamant against this outcome as its coalition with the CDU/CSU in the last government undermined the party.  And, if the SDP joined the government, the AfD would become the official opposition, furthering its political fortunes.  (3) Merkel goes with a minority government with either the Greens or FDP, also unprecedented and likely unstable.  (4) The FDP walkout was a bargain ploy and they return at the 11th hour to form a government and get more power.  In rank order of most market-friendly to least, we would say #2, #4, #3, #1.  At this point, we think #4 is the most likely, although the FDP must move quickly if this is going to occur.

The EUR fell sharply on news of the failure of the talks but has recovered on hopes that the FDP is bluffing.  The chart below shows the overnight trade of the Eurozone currency.  Initially, the EUR fell sharply, then recovered and has since given up some of its gains.

(Source: Bloomberg)

Geopolitical updates: We begin a three-part WGR series on the recent purge/missile attack/ouster of Lebanon’s PM involving Saudi Arabia this week.  We note this morning that Reuters is reporting there have been backchannel discussions between Israel and the Kingdom of Saudi Arabia.  Although we have suspected as much for some time, the fact that it is being reported suggests both nations are sending signals to Iran that it faces a potentially broader front opposing the Mullah’s actions to control the region.[1]

The Straits Times is reporting that authorities in Malaysia revealed they discovered a makeshift laboratory where it is believed North Korean operatives made the VX that assassinated Kim Jong-un’s oldest brother, Kim Jong-nam.  It is widely believed that North Korea was behind the assassination, despite its denial, and this evidence bolsters that argument.[2]

Spain’s attorney general, José Manuel Maza, died suddenly on Saturday while attending a conference.[3]  He was the lead prosecutor on the case against Catalan separatist leaders.  It remains to be seen how his death will affect the prosecution.

Trade issues: Jonathan Swan of Axios[4] published what could be a blockbuster analysis of the Trump administration’s trade policy by detailing the influence of U.S. Trade Representative Robert Lighthizer.  Lighthizer has a long history in government, working as Chief of Staff for Sen. Robert Dole (R-KS) and as Deputy Trade Representative during the Reagan administration.  He has also practiced as a private attorney specializing in international trade law.  Swan reports that Lighthizer’s mercantilist positions are gaining currency within the administration.  He is recommending very aggressive trade positions against China and has been spearheading the NAFTA negotiations, which appear headed for a rupture.  According to Swan, his presentations on trade have been accepted by the free trade establishment figures in the White House (Mnuchin, Cohn), suggesting that trade conflicts may increase once the tax issue is put to rest.  This is an issue we watch very carefully because it affects markets on various fronts.  First, trade impediments that lead to a narrower trade deficit will have the same effect as a global contraction of the money supply given the dollar’s reserve currency role.  Although our position on the dollar is bearish due to valuation levels, widespread trade restrictions would lead us to reconsider that position.  Dollar scarcity would be bullish for the greenback.  Second, trade impediments, all else held equal, will reduce supply to the American economy and lead to higher inflation.  If it affects inflation expectations, it would be quite bearish for long-duration assets.  Third, higher inflation would lead to faster policy tightening, increasing the odds of a recession.  And fourth, if tax cuts are implemented along with trade restrictions, it would force up private saving and likely slow economic growth.  So far, trade actions have been more bark than bite but that may change next year if Swan’s assessment is correct.

View the complete PDF



[2] https://www.nst.com.my/news/crime-courts/2017/11/301375/condo-unit-used-process-vx-nerve-agent-which-killed-north-korean?utm_source=Sailthru&utm_medium=email&utm_campaign=New%20Campaign&utm_term=%2ASituation%20Report

[3] https://www.nytimes.com/2017/11/19/world/europe/spain-attorney-general.html?emc=edit_mbe_20171120&nl=morning-briefing-europe&nlid=5677267&te=1

[4] https://www.axios.com/lighthizer-increasingly-influential-in-white-house-2510871315.html

Asset Allocation Weekly (November 17, 2017)

by Asset Allocation Committee

[Ed note: We will not publish an Asset Allocation Weekly Comment the week of November 24. The next comment will be published December 1.]

Over the past three weeks, we have seen a rise in the yields on high-yield bonds.  The Merrill Lynch High Yield bond effective index is up 40 bps since late October.[1]  There are a number of reasons for the sudden weakness.  They are:

  1. The tax bills in Congress may limit the deductibility of interest for corporations. Since many high-yield issuers are dependent on debt to fund their operations, a tax change could have an adverse effect on these companies and their high-yield issuance.  At the same time, we remain pessimistic that major tax reform is likely and so the final version of any tax changes will likely be limited.
  2. Telecom and health care sectors have suffered some weaker earnings growth. The failed merger talks between Sprint (S, $6.21) and T-Mobile (TMUS, $56.52) also dampened sentiment in the telecom sector.  Since these sectors are important issuers of high-yield debt, their problems have raised concerns.
  3. Spreads have narrowed significantly.

This chart shows the Merrill Lynch High Yield Master effective yield and the five-year T-note yield.  The lower lines on the chart show the average spread and the standard deviation lines.  The narrowing spread, by itself, doesn’t necessarily signal an imminent problem.  As the above chart shows, spreads can remain at the lower deviation for an extended period of time.  However, a spread at the lower deviation also suggests a market that is richly valued.

  1. The relationship of high yield to monetary policy suggests that major reversals in the high-yield spread tend to occur well into a tightening cycle.

This chart shows the high-yield spread and the fed funds target.  Major spikes in the spread are more likely after policy has already been tightened.  In addition, the spread often continues to widen after policy easing has commenced.  This pattern indicates that the spread is very sensitive to financial stress; in fact, most financial stress indices include both high-yield bonds and high-yield spreads in their construction.

Although there has been much press in the financial media on the recent backup in yields, the most recent change is barely visible on the spread.  There isn’t any obvious increase in financial stress, and monetary policy, while tightening, is not at a level that indicates it is near the end of the cycle nor is it at a level that should be causing stress.  In our Asset Allocation portfolios, we have been reducing our exposure to high-yield bonds in the income-oriented programs due to high-yield spreads falling to the lower deviation.  However, we don’t expect that the recent rise in yields signifies the onset of a financial crisis.  Obviously, we will continue to monitor the situation but, for now, we are comfortable with our current allocations to this asset class.

View the PDF


[1] https://fred.stlouisfed.org/series/BAMLH0A0HYM2EY

Daily Comment (November 17, 2017)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Global equity markets are mostly steady to higher this morning.  The EuroStoxx 50 is flat from the last close.  In Asia, the MSCI Asia Apex 50 closed up 0.8% from the prior close.  Chinese markets were lower, with the Shanghai composite down 0.5% and the Shenzhen index down 2.8%.  U.S. equity index futures are signaling a mostly steady open.

It was a mixed overnight trade.  Here is what we are watching this morning:

The House passes a tax bill:  With 227 votes, the House passed its version of the tax bill.  Although this is one of the hurdles for getting a final bill done, it isn’t the most difficult.  The Senate will be far more difficult given the narrow GOP majority there.  The Senate bill did emerge from committee but only on a party line vote.  Our policy has been to avoid going into detailed analysis of the bills simply because what is eventually agreed upon won’t look anything like the current proposals.

PBOC injects cash…lots of it:  The PBOC, the central bank of China, injected $47 bn into its financial system, the biggest in nearly a year as the Chinese 10-year yield reached 4.015%, the highest level since 2014.  In the wake of the Party Congress, it appears the Xi government is applying some austerity to the Chinese economy in a bid to wrestle with China’s excessive debt.  The injection did lead the 10-year to dip just under 4%, but a move to austerity will likely pressure Chinese rates higher.  Given the isolated nature of China’s financial system, rising Chinese rates won’t have much of an effect on global financial markets, BUT if rising rates lead to significant economic weakness that would be noticed, with the most likely effect being weaker commodity prices and likely some declines in emerging equities.  China’s policy pattern has been “stop/go” for some time and the market does not expect Chairman Xi will allow a major economic slowdown to occur.  We tend to agree.

Mueller to subpoena Trump campaign for Russia documents:  Several media outlets reported that the special counsel was asking for all related documents that show contacts with Russians during the campaign.  The importance of this request is somewhat uncertain.  Some legal experts see this as routine, others argue it bodes for a wider investigation.  The market effect from this headline was worth noting.  Although U.S. equity futures did decline modestly, the biggest impact was dollar weakness.  That has been the pattern for a while; if the Mueller investigation does start to expand, the market that will likely bear the brunt of the adjustment is the greenback.

Venezuela triggers default swaps:  The International Swaps and Derivatives Association, or ISDA, declared Venezuela and the state oil company, PDVSA, in default.  That means that credit default swaps are now triggered.  The market reacted immediately.

View the complete PDF

Daily Comment (November 16, 2017)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] After a few days of risk concerns, equity markets are “in the green” this morning.  The dollar and Treasury yields are higher.  Here is what we are watching this morning:

The tax bill: The House is expected to pass its version of the tax bill today.  Although we expect a close vote, it will almost certainly pass; if Speaker Ryan brings the bill to the floor without sufficient votes, he should be relieved of his duties.  The problem is the Senate.  Ron Johnson (R-WI) has come out against the bill in its present form and the clause to end the ACA insurance mandate has brought Susan Collins (R-ME) into the possible “no” column.  Jeff Flake (R-AZ) and Bob Corker (R-TN) have misgivings about the expected deficits from the bill…and both are virtually immune to pressure from lobbyists because they aren’t running for re-election.  The margin now in the Senate is razor thin and it isn’t obvious that the House could abide by the Senate version.  Getting tax changes done at all remains a long shot in our view and getting them done by year’s end looks increasingly unlikely.

Don’t forget the continuing resolution: The debt ceiling is a gift to the political opposition in the U.S. political system.  In reality, the debt ceiling should be nothing more than a reminder to Congress about its spending.  However, not raising it means the government isn’t going to pay for things it has already spent money on.  There is a legitimate debate on spending and the deficit; shutting down the government over the debt ceiling is not a legitimate way of resolving it.  In September, when the debt ceiling issue last loomed, the series of hurricanes made cutting spending to avoid more debt politically impossible for both parties.  In addition, President Trump was making overtures to “Chuck and Nancy,” which made it easy for the Democrats to agree to an extension.  However, Washington is knee-deep in tax proposals that the Democrats really dislike (e.g., ending the state and local tax deduction, or SALT, which disproportionately harms “blue” states), and the debt ceiling will give Chuck and Nancy leverage.  History shows that equity markets don’t become overly concerned over these issues as long as there aren’t real worries about default.

Debt ceiling events are shown in gray.  The only one that was significant was in 2011, when fears arose that the U.S. may actually default and was downgraded to AA by Standard & Poor’s.  Although we don’t expect anything like 2011, we are worried that the GOP congressional leadership is so focused on the tax bills that it lacks the available “bandwidth” to deal with this issue.  Thus, a week or two of brinkmanship could weigh on sentiment.

A note about earnings: At the end of this report we include our weekly P/E chart.  This week, we add the actual Q3 S&P earnings data from Standard & Poor’s (actually, from Haver Analytics, which estimates the final number when over 90% of firms report).  As has been the case for much of this recovery, the estimates of S&P operating earnings from Thomson-Reuters are higher than those from Standard & Poor’s.  We view the latter as the official data but the former owns I/B/E/S, the premier source for future earnings estimates, and thus it is the preferred number in the media.  We use the Standard & Poor’s number for most of the index’s earnings history because it allows us to show a chart dating back to the 1870s (see the end of this report).  In our P/E calculations, we usually use two actual earnings numbers from Standard & Poor’s and two estimates from Thomson-Reuters; however, when we have sufficient reporting we then shift to three actual Standard & Poor’s numbers and one Thomson-Reuters.  When this happens, there are discrete jumps in the current reporting quarter (see footnote in the P/E section for more clarification).  After New Year’s, when we return to two actual, two estimates, there will be a discrete rise in the P/E as well.

This chart shows a history of the two series on a four-quarter rolling basis.  During the two recessions/bear markets, the ratio tended to widen significantly as the Standard & Poor’s number fell much faster than Thomson-Reuters.  But, until this bull market, the two series tended to closely match each other.  We note the divergence widened when oil prices fell in 2014 and narrowed as oil prices recovered.  Which is the better number?  We are agnostic on this issue because we can address the divergence with various statistical tools, but we wanted to offer more detail on why the P/E rose this week.

Energy recap: U.S. crude oil inventories rose 1.9 mb compared to market expectations of a 3.2 mb draw.

This chart shows current crude oil inventories, both over the long term and the last decade.  We have added the estimated level of lease stocks to maintain the consistency of the data.  The DOE has revised its data (an exercise it does periodically) and inventories are falling faster than earlier estimated.  As the chart shows, inventories remain historically high but have declined significantly this year.  We also note the SPR fell by 0.7 mb, meaning the net build was 1.2 mb.

As the seasonal chart below shows, inventories rose modestly this week.  It appears that we are “skipping” the usual autumn inventory rebuild period.  Usually, inventories would peak next week.  After that, stockpiles would decline into year’s end and then start their largest build from early January into early April.

(Source: DOE, CIM)
(Source: DOE, CIM)

Refinery operations continued to rise last week, in line with seasonal norms.  We expect them to peak very soon.

Based on inventories alone, oil prices are undervalued with the fair value price of $55.00.  Meanwhile, the EUR/WTI model generates a fair value of $60.68.  Together (which is a more sound methodology), fair value is $58.37, meaning that current prices have fallen under fair value.  OPEC meets at the end of the month and there are worries that Russia won’t extend the current output restrictions as much as the Saudis would prefer.  At the same time, recent events in the Middle East increase the odds of supply concerns.  Overall, oil prices are within normal ranges of current fundamentals but we are generally bullish toward crude oil at this time.

View the complete PDF

Daily Comment (November 15, 2017)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Here’s what we are watching today:

Another weak day: Risk markets continue to slide this morning, although the levels of decline are not all that large.  It’s been such a long time since we have seen weakness in equity prices that even modest retreats appear significant.  However, we don’t see anything beyond a modest correction because it appears that ample liquidity is available.

This chart shows retail money market holdings relative to the S&P 500.  We have highlighted periods since the expansion began when retail money market funds fell below $920 bn.  When money market fund levels fall below this level, equities have tended to stall or at least get “choppy.”  Currently, we are sitting on ample liquidity, which suggests to us that any pullbacks will likely be met with new buying.  This isn’t a perfect relationship.  As the crash period shows, during periods of fear, the “dash for cash” overwhelms other asset prices and equity prices will tend to decline until the panic stops.  If the tax bill falters or we have a global geopolitical event, fear could trigger a sharper pullback.  But, for now, there are no signals of recession and we are likely seeing a normal pause.

Vice Chair El-Erian?  Yesterday, there were reports that Mohamed El-Erian was being considered for the vice chair position at the Fed.  This would be an inspired pick; the chair-nominee, Jerome Powell, isn’t an economist, so surrounding him with a well-respected one as vice chair would give him a counterpart with a learned viewpoint.  And, he has another helpful characteristic—he has been the second around another strong personality.  He was at PIMCO when Bill Gross was the CIO and had to work in a position where he was designed to be overshadowed.  He proved able to manage the situation.  This would perhaps make him a better pick than Larry Summers or John Taylor, who tend to be more outspoken.  His recent comments have leaned hawkish but he has also supported easing regulations.  We suspect the financial markets would welcome Mohamed to the FOMC as it would show no specific ideological bent (a problem with Taylor) and he is a preeminent economist (an improvement over Warsh).

Mugabe out?  It appears that Zimbabwe’s long-standing president, Robert Mugabe, has been ousted in a coup, despite comments from the military that his placement into house arrest isn’t really a coup.  We are not going to spend too much time on this issue because it won’t affect most financial markets; however, Zimbabwe has been an inadvertent laboratory for really bad economic policy.  The country has suffered through ruinous hyperinflation due to poor policies, which has led to laughable currency denominations.[1]  His removal might improve the situation in the country, although given the degree of damage that has been inflicted, it may take a very long time to fix the economy.

Moore under pressure: As more reports come out about Roy Moore’s questionable proclivities, we are starting to see the betting signals crack.  As we noted earlier, we view the betting information as more credible than polls, which are subject to sampling and structural problems.  The news is getting bad for Judge Moore:

(Source: Predictit.org)

Moore had a commanding lead until the scandal broke but still managed to hold a majority until the last couple of days.  He now has less than a 40% chance of winning.  We note the WSJ editorial page has concluded the GOP would be better off losing the seat than for Moore to win.[2]  We would expect this sentiment to rise.

Fed policy: With the release of the CPI data we can upgrade the Mankiw models.  The Mankiw rule models attempt to determine the neutral rate for fed funds, which is a rate that is neither accommodative nor stimulative.  Mankiw’s model is a variation of the Taylor Rule.  The latter measures the neutral rate by core CPI and the difference between GDP and potential GDP, which is an estimate of slack in the economy.  Potential GDP cannot be directly observed, only estimated.  To overcome this problem, Mankiw used the unemployment rate as a proxy for economic slack.  We have created four versions of the rule, one that follows the original construction by using the unemployment rate as a measure of slack, a second that uses the employment/population ratio, a third using involuntary part-time workers as a percentage of the total labor force and a fourth using yearly wage growth for non-supervisory workers.

Using the unemployment rate, the neutral rate is now 3.20%.  Using the employment/population ratio, the neutral rate is 0.97%.  Using involuntary part-time employment, the neutral rate is 2.71%.  Using wage growth for non-supervisory workers, the neutral rate is 0.94%.  The modest uptick in core CPI has lifted the various neutral estimates higher, but as we have seen lately, two of the measures of slack suggest the FOMC has achieved rate neutrality, while two suggest the FOMC is well behind the curve.  We expect the FOMC to mostly split the difference and end up around 2.25% for the target at the end of next year.  However, if the two variations signaling lower rates turn out to be the accurate measures of slack, this degree of tightening will lead to increased risk of recession.  The fed funds futures put the odds of a December rate hike at 92.3%.

View the complete PDF


[1] https://en.wikipedia.org/wiki/Hyperinflation_in_Zimbabwe#/media/File:Zimbabwe_$100_trillion_2009_Obverse.jpg

[2] https://www.wsj.com/articles/the-roy-moore-mess-1510703218

Daily Comment (November 14, 2017)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It was a very quiet overnight session.  Better Eurozone growth has lifted the EUR, while global equity markets continue to struggle in what looks to us like profit taking.  PPI (see below) did come in higher than forecast; shorter duration Treasury yields rose.  Here is what we are watching this morning:

May will allow Parliament to have a say on Brexit: Initially, PM May was not going to allow MPs to add amendments to the Brexit bill.  However, in her politically weakened position she has bowed to pressure, primarily from pro-EU MPs, to have a full vote and allow amendments to be voted on as well.  It isn’t clear how this will play out.  Although the May government insists the vote can’t halt Brexit, it does seem possible that Parliament could scuttle Brexit.  May’s plan is to offer two separate bills, one that is an actual vote on Brexit and another that votes on the specifics of the process, with the hopes that party discipline will ensure Brexit occurs and then allow “meaningful but essentially meaningless” votes on the second bill.  If May had a strong majority government and Tories feared her, this would probably work.  However, this isn’t the case.  If Parliament votes to defeat the Brexit bill, it isn’t obvious what would happen.  The EU is committed to the U.K.’s exit from the organization and Parliament’s inability to pass a bill shouldn’t prevent the EU from expelling Britain.  The exit was officially triggered last year.  Brexit without a plan leads to a chaotic situation.  On the other hand, we would not be shocked if Parliament blocks Brexit and the EU (read: Merkel) allows the U.K. to stay in the EU fold.  In any case, this is turning into a mess; at the same time, the GBP would likely soar if the U.K. ends up staying in the EU.

Venezuela in default: S&P has confirmed that Venezuela missed two interest payments within the 30-day grace period on its sovereign debt, on issues maturing in 2019 and 2024.  This rating agency is the first to declare the nation in default.  The rating on these two particular bonds is now “D,” down from “CC,” and the long-term foreign currency sovereign credit rating is now “SD,” or selective default, down from “CC.”  Although Venezuela’s default was really just a matter of time, there isn’t an obvious path of restructuring.  We will be closely watching how Caracas handles its debt to China; we suspect it will default on that debt last, but eventually it will likely default on that debt, too.  Complicating matters for bondholders is that Venezuela does have assets outside the country that could be seized by creditors (CITGO, for example).  We do note that the International Swaps and Derivatives Association has delayed a decision on default; if this group agrees with S&P, it would likely trigger the payment of credit default swaps.

Another governor?  There are reports the president is considering nominating Michelle Bowman, a state bank commissioner from Kansas.  She was formerly a banker with Farmers and Drovers[1] Bank in Council Grove, KS, with about seven years of banking and bank regulatory experience.  She has a BA from Kansas University[2] and a JD from Washburn University in Topeka, KS.  She does have rather extensive experience in Washington.  She worked with Sen. Dole and was counsel to the House Committee on Transportation and Infrastructure and the Committee on Government Reform and Oversight.  She was also attached to FEMA and was deputy assistant to Homeland Security Secretary Tom Ridge.  One of the governor slots is reserved for a community banker; it has been difficult to fill this position because state regulators are usually not well liked by bankers and most community bankers don’t want to leave their posts for a government job.  Although her banking experience is a bit light, her Washington experience will probably allow her to be easily confirmed.  Historically, this position tends to vote with the chair and its primary contribution is to offer “ground level” information from the small banking sector to the FOMC.

IEA bullish on shale: In its most recent report, the IEA projects strong shale growth in the U.S., leading to total liquids production of 13 mbpd by 2025.  The Paris-based group projects that the U.S. will account for 80% of the increase in global oil and liquids supply over that time frame.   Interestingly enough, recent reports from the maturing oil shale fields in Texas paint a much less favorable supply story.  The EIA (the U.S. data arm of the DOE) says that December U.S. shale production will rise to 6.1 mbpd, a new high.  However, the EIA also reports that the legacy decline rate has reached 83.3%, meaning that 83.3% of gross new production is offsetting declines in older wells.  In May, this number was 70.5, indicating that production growth is slowing.  Industry reports suggest that increasing proppants and longer well laterals in the Permian basin aren’t boosting output.  The bottom line is that macro energy analysis appears to be holding that growth will continue at almost a linear pace, whereas the micro reports suggest that if such growth is going to occur it will likely require higher prices.

View the complete PDF


[1] A drover is a person who moves animals over long distances.

[2] Go Jayhawks!

Weekly Geopolitical Report – The Situation in Catalonia: Part II (November 13, 2017)

by Thomas Wash

In Part I of our report, we examined the historical background of the Catalan independence movement.  This week, we will continue our discussion by summarizing the constitutional crisis, identifying the significant players and their motives, noting the possible outcomes and concluding with market ramifications.

Constitutional Crisis: A Summary
In addition to the historical differences mentioned in Part I, the Catalan separatist movement can be partially attributed to the vagueness of the Spanish constitution.  Although the constitution states that Spain is made up of 17 autonomous communities, the term “autonomous community” is loosely defined.  According to the constitution, an autonomous community is a self-governing region in which people share “…common historic, cultural and economic characteristics.”[1]  Furthermore, the preamble of the Spanish constitution fails to group people under the same nationality.  For example, the preamble of the U.S. constitution states, “We the people of the United States,” whereas the Spanish preamble states that the constitution “protects all Spaniards and peoples of Spain.”  As a result, the constitution’s recognition of ethnic regions and its failure to establish a unified Spanish identity have bolstered ethnic pride at the expense of national identity.

The constitution’s vagueness has also led to tensions between the autonomous community governments and the central government.  Autonomous communities like Catalonia frequently ask for additional powers and greater independence from the central government.  To the Catalan separatists, Catalans are not “Spaniards” but rather a “people of Spain.”  This sentiment is expressed in the Catalan constitution, which refers to Catalans and Spaniards as separate groups, although both groups have the same rights.

View the full report


[1] Spanish Constitution, Section 143, Part 1