by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA

[Posted: 9:30 AM EDT] Global equity markets are trading lower this morning as worries over earnings are pressuring prices.  Japan fell on weak export data and the Bank of Korea surprised with a rate cut.  Here is what we are watching today:

Fed talk: Perhaps the most important variable in the path of equities this year is monetary policy.  The financial markets have built in at least 100 bps of easing over the coming months.  The current economy, as noted by yesterday’s Beige Book, doesn’t look weak enough to warrant such strong action.  Of course, if policymakers wait until they get unambiguous evidence of economic weakness, they will miss their opportunity to avoid recession.  If policymakers key off the financial markets, they do run the risk of the “false positive” and may cut rates when such action isn’t needed.  Our position is that the costs for cutting rates too much and too early are low; inflation probably doesn’t become a problem and the real risk is overheating asset markets.  And, even the risk there isn’t all that obvious.  The risk from financial asset bubbles is usually over-investment as firms use the rising stock market or tighter credit spreads to build capacity, which turns out to be excessive and weighs on future growth.  We don’t see that happening, either.  The investment reaction to either strong equities or tighter credit spreads has been modest this entire expansion and that factor probably won’t change.  The Fed’s leadership may be underestimating the risk of recession to bank independence.  When the GOP is pushing to undermine the central bank’s independence, imagine what a left-wing populist would do.  To some extent, MMT relies on a central bank that is compliant to the needs of the fiscal authority.  So, from where we sit, the risk of easing too much pales in comparison to the risks of reducing rates too slowly or not enough.

However, we carry no illusions that our views matter.  Instead, we watch what policymakers do.  There remains a fairly large contingent on the FOMC that still relies on some form of the Phillips Curve.  These members will have a hard time moving to ease without a rise in unemployment.  What this means in practice is if Chair Powell pushes to lower rates, he will need to manage a rising number of hawkish dissenters.  If the Fed eases, as expected, at the end of this month, we expect KC FRB President George to dissent.  There are others who won’t support the action among the presidents but they don’t vote in this cycle.  As a general rule, three dissents are considered a vote of no confidence in a Fed chair, although governors count more in this rule than presidents.  The dissents are probably not enough to thwart a move toward easing but the markets will prefer unanimous outcomes.

Stalled trade talks: China wants to know what the U.S. wants.  Although there are conversations occurring, there appears to be little progress. According to sources familiar with the U.S.-China trade talks, one reason for their recent lack of progress is that administration officials can’t agree on how to ease restrictions on Chinese telecom equipment firm Huawei (002502.SZ, 3.44).  In a major concession to Chinese President Xi at last month’s G-20 meeting, President Trump promised to allow U.S. firms to supply components to Huawei so long as they don’t endanger national security, but officials in the Trump administration are having trouble agreeing on which products meet that standard and wouldn’t give the firm a strategic edge.  At the same time, Chinese officials want Huawei off the U.S. “entity list” altogether.  The resulting logjam provides more evidence that a final trade agreement is unlikely to be achieved for some time, keeping the issue as a cloud over the markets.

Meanwhile, Larry Kudlow made critical statements about China and the WSJ reports that China’s growth model is fading even excluding the trade tensions.  The article suggests that socialism may have undermined China’s growth and prevented it from lifting per capita GDP at a level seen in other Asian nations.  Although socialism may have played a role, other factors did as well.  The one-child policy, a direct outgrowth of CPC control, gave China an initial lift by reducing its dependency ratio.  However, the cost of that policy is being witnessed now as China is aging rapidly and its working age population is beginning to slow.  China’s size alone likely played a role too.  The U.S. was willing to allow the smaller Asian nations to expand exports for longer because the impact was small in the bigger scheme of things.  China doesn’t have that benefit due to its size.  Nevertheless, it should be noted that all the Asian growth miracles were based on investment-led development.  In all cases, there is a transition that occurs when investment can no longer lead the economy; we would note that Japan was never able to fully make the transition and has been mired in three decades of sub-par growth.  In sum, China’s communist system doesn’t make this transition any easier, but no nation makes the transition without trouble.  The U.S. transition was seen in the Great Depression.

So, what do we see going forward?  We have growing doubts that a deal can be negotiated because we can’t separate out the trade issue from the technology issue.  In addition, both sides appear to be overestimating their positions and underestimating their opponents.  China may conclude it has a vested interest in stringing out talks and hoping for a new administration in 2020.  If we are correct, this issue will remain in limbo and thus be less of a market factor going forward.

In another side note, the WSJ reports that there has been a decline in foreign buyers for U.S. real estate.  The National Association of Realtors reports that buying fell by 36% in Q1 compared to the same period last year.  It is unclear what is driving the decline.  Dollar strength has probably played a role.  It is possible that fears of anti-foreign sentiment in the U.S. may be sending this capital flight elsewhere.  Or, it is also possible that the amount of capital flight is declining.  But, the outcome is a drop in coastal real estate activity.

China: New data shows that Chinese stock buybacks have surged so far this year, with the total through July 17 reaching some $13.6 billion.  That’s almost double the total for all of 2018, reflecting an easing of regulations by authorities last year.  Stock dilution from new issuance can be a detriment to per-share returns in the emerging markets; in contrast, further increases in buybacks would likely be a positive for Chinese stocks.

Hong Kong: Officials in Beijing are working on a comprehensive strategy to resolve the Hong Kong political crisis, which was sparked by Chief Executive Carrie Lam’s effort to push through a bill allowing extradition to China.  The plan, which reportedly would not include the use of military force, will soon be presented to China’s top leadership.

Instex: This is an alternative payments system created by the EU to circumvent U.S. financial sanctions and maintain JCPOA.  Russia announced its support for the system, with the clear goal of using it to avoid U.S. sanctions as well.  This news may be more than the Europeans were bargaining for as we doubt the EU was planning on the platform becoming a way for rogue nations to avoid sanctions.  So far, activity in the platform has been modest at best, but Russia’s actions show the risk of creating mechanisms that might be used for other, more nefarious, purposes.

Libra: Testimony between Congress and Facebook (FB, 201.80) grew contentious yesterday.  Rep. Maxine Waters (D-CA) called for a moratorium on the Libra project and was rebuffed.  Tech firms are moving into difficult waters; they have generally been given a pass by governments, dazzled by the products and services they offered.  However, sentiment has turned to some extent and managing domestic and foreign legislatures and regulators is going to become increasingly difficult.  For example, the EU competition commission has hit U.S. semiconductor firm Qualcomm (QCOM, 75.76) with a fine of €242 million for dumping baseband chipsets in the EU market at below-cost prices.  That’s the second major EU fine against Qualcomm in the last year, and it continues a long series of EU competition actions against U.S. technology firms.  The twist this time?  The EU says Qualcomm’s dumping aimed to secure more business with Chinese technology firms Huawei (002502.SZ, 3.44) and ZTE (ZTCOY, 5.77).  Separately, at a meeting of G-7 finance ministers in France, U.S. Treasury Secretary Mnuchin continued to complain about France’s new 3% tax on digital services.  Mnuchin complained the tax unfairly hits big, dominant U.S. technology firms, while Le Maire stressed that the tax would only be temporary until a broader, international approach to digital taxation is agreed upon by the Organization for Economic Cooperation and Development (OECD).

Debt ceiling: Speaker Pelosi (D-CA) has indicated that the deadline for a deal is Friday.  Although the White House and the Speaker have been in close contact, it is still unclear if a deal can be struck.  If not, we will likely face a debt ceiling issue.  Perhaps a bigger concern is that even if a deal is made, the president may not, in the end, accept it.  If a deal can’t be made, we will see automatic spending cuts that will tend to dampen the economy.

International Monetary Fund: The G-7 finance ministers have also been discussing who should replace Christine Lagarde as the head of the IMF.  The frontrunners appear to be Jeroen Dijsselbloem, the former finance minister of the Netherlands, and Olli Rehn, the current head of the Finnish central bank.  Portuguese Finance Minister Mário Centeno and Spanish Economy Minister Calviño are also in the running.  Reflecting Britain’s loss of status amidst its Brexit convulsions, Bank of England Governor Mark Carney didn’t make the short list.

Mexico: President López Obrador has released his plan to bolster the finances of state-owned oil company Petróleos Mexicanos (Pemex) and reverse its flagging production.  The plan would include significant tax relief in 2020 and 2021, as well as capital injections from the government.  However, private-sector firms would only be allowed to participate in the country’s oil sector through incentivized service contracts rather than the production-sharing joint ventures that had begun to be implemented under a 2014 constitutional reform.  Pemex would also push ahead with an expensive new refinery project that many observers think doesn’t make economic sense.  The plan is being taken as more evidence that López Obrador really does intend to fully implement the populist, nationalist policies that many investors fear.

Odds and ends: The EU’s alternative to GPS, Galileo, has “gone dark” now for almost a week.  Operators have not offered any reason why.  The new EU Commission president is likely to face a throng of MEPs essentially trying to leverage her narrow win into their own pet projects.  As PM May leaves, she warns against political division.

Energy update: Crude oil inventories fell 3.1 mb last week compared to the forecast drop of 2.8 mb.

In the details, refining activity fell 0.3%, modestly less than the 0.35% decline forecast.  Estimated U.S. oil production rose by 0.3 mbpd to 12.0 mbpd; Hurricane Barry probably was the reason for the decline.  Crude oil imports fell 0.5 mbpd, while exports fell by the same amount.  Stocks fell due to the decline in production.

This is the seasonal pattern chart for commercial crude oil inventories.  We are now well within the spring/summer withdrawal season.  This week’s decline is consistent with the seasonal pattern in terms of direction but was larger than normal.

Based on oil inventories alone, fair value for crude oil is $56.02.  Based on the EUR, fair value is $52.70.  Using both independent variables, a more complete way of looking at the data, fair value is $52.62.  We have seen a sharp decline in oil prices in the recent week.  There are two factors behind this drop.  First, there has been some movement on the diplomatic front with Iran.  Rand Paul (R-KY), who leans libertarian and tends to support avoiding global conflicts, may lead a U.S. negotiating team to Iran.  It would be unlikely that he would support a war so this news is taking some of the geopolitical risk premium out of the market.  However, we do note reports that say Iran’s Revolutionary Guards have seized a foreign oil tanker in the Persian Gulf on grounds that it was smuggling fuel.  The tanker appears to be a United Arab Emirates ship that disappeared from radar screens last Sunday.  The news has heightened concerns about Iran’s response to new U.S. sanctions over its nuclear program, so global oil prices have jumped.

Second, although oil inventories are declining, product inventories are building which may undercut refining activity.

This chart shows the level of inventory divided by the four-week average of consumption, showing how many days of inventory there are available relative to demand.  This time of year, the days to cover tend to decline.  The ratio rose this week, suggesting product inventories are rising.  If they continue to build, especially for gasoline, we would not be surprised to see falling refining activity and lower oil demand.

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by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA

[Posted: 9:30 AM EDT]

Global markets are trading quietly this morning, consistent with mid-summer.  Here is what we are watching today:

The EU vote:  Well, she won, but it was close.  Ursula von der Leyen received 383 votes, marginally more than the 374 she needed to win.  She will be the first German to hold this post since 1958.  Although the vote is anonymous, it does appear she had some backing of British MEPs, which means she may not have a working majority once Brexit occurs.  This outcome will likely create a weak EU Commission President which will likely be quietly preferred across the EU’s capitals.  In Germany, because Leyen resigned from her post as defense minister, the CDU leaker AKK will take over the position.  The pattern of the vote shows the dwindling power of the center-left and center-right and the rising power of single issue parties (e.g., Greens) and the extremes of the left-wing and right-wing.

In related news, The European Union’s competition commission has launched a formal investigation into whether Amazon (AMZN, 2,009.90) is competing unfairly against the third-party sellers using its website.  The investigation arises from Amazon’s dual role providing a marketplace for those sellers and also selling its own products in competition with them.  At issue is whether Amazon is unfairly using data collected from those third-party sellers in order to out-sell them.  The inquiry illustrates how data rights and data ownership have become so important to consumers and businesses alike.  It also broadens the EU’s scrutiny of big, dominant technology firms based largely in the United States, which is sure to draw the ire of President Trump and worsen U.S.-EU tensions.

Iran:  Yesterday, oil prices plunged on reports that the U.S. and Iran might be open to negotiations.  However, this news comes in the midst of increasing tensions.  Contact with a UAE oil tanker has been lost in the Strait of Hormuz and it is possible that Iran has seized the vessel.  Iran claims it “aided” the ship but that has not been confirmed by outside sources.  Meanwhile, the tone coming out of Iranian leadership remains hostile.   What we may be seeing is a recalibration by the U.S.  It is possible the Trump administration thought Iran would capitulate quickly to a return of sanctions and make a new agreement, one that would preclude ever making a nuclear weapon.  Now that Iran has shown it won’t back down, a case could be made that the U.S. and its allies are not taking the Iranian bait to escalate hostilities.  There is another possibility.  Governments around the world are “gaming” the U.S. 2020 elections.  For example, the EU is clearly stalling on trade talks, hoping for a new government to end the current trade regime.  Iran may want a new U.S. president as well but wants to achieve that by drawing the U.S. into a war that will spike oil prices and probably push the U.S. into recession.  Instead, the U.S. response is to avoid strong reactions to provocations and allow sanctions to continue to weaken the Iranian economy. In either case, Iran will likely continue to take bolder actions to eventually trigger a response.  Thus, yesterday’s decline probably overstates the degree of “thaw”.

The EU is also downplaying Iran’s behavior, going along with U.S. efforts to prevent an escalation.  And, Iran is also trying to draw Europe into a conflict.  Judicial officials confirmed that Iran has arrested a French-Iranian scholar on unspecified charges, drawing demands for information and diplomatic access by France.  Such arrests of dual citizens have sometimes led to espionage charges.  If it comes to that this time, it would be a sign that France is having little success in its efforts to keep Iran in the 2015 nuclear deal in the face of renewed U.S. sanctions.

Turkey:  President Trump has confirmed that the United States will stop any further sales of the F-35 fighter jet to Turkey, in response to Ankara’s purchase of Russia’s S-400 air defense system.  Not only does Turkey stand to lose the hefty down payment it has made for its F-35 order, but the Pentagon has also taken steps to exclude Turkish firms from supplying parts for the plane.  Since Turkey reportedly produces approximately 6% of the value of every F-35, that could be a noticeable blow to Turkish industry.

U.S.-China Trade:  In a decision that could play into the current U.S.-China trade dispute, the World Trade Organization (WTO) has issued a final ruling in a 2012 case in which China complained about U.S. import tariffs imposed in retaliation for China’s subsidizing of certain export firms.  On its face, the ruling went against the U.S. tariffs, in the sense that it said the tariffs were calculated incorrectly.  However, the ruling also confirmed that the subsidies really were giving the Chinese firms an unfair advantage, which could help harden the U.S. position in the current dispute.

Taiwan:  Han Kuo-yu, the popular mayor of Taiwan’s second-biggest city, has won the opposition Kuomintang Party’s presidential primary, beating Terry Gou, the founder of Apple (AAPL, 204.50) supplier Foxconn (2354.TW, 66.80).  The China-friendly Han, with overt and covert support from Beijing, will compete against the independence-minded incumbent, Tsai Ing-wen, next January.

A lift in GDP:  The Atlanta FRB GDPNow forecast increased to 1.6%, up 0.3%, after yesterday’s retail sales data. The 30 bps of growth came exclusively from increased consumption.

 

Here is the contribution table.

The general strength of the economy does appear to be dividing the FOMC.  Dallas FRB President Kaplan seems to be leaning to only one cut, whereas Chicago FRB President Evans seems open to more.   Although economists remain divided on the path of the economy, some prominent money managers are looking for further weakness.  In an interview with the Financial Times, celebrated hedge fund manager Kyle Bass said he believes the U.S. economy will fall into a recession by mid-2020 and the Federal Reserve will be forced to cut its benchmark fed funds interest rate all the way to zero, where it will remain for the foreseeable future.  According to Bass, “As we have all learned, once an economy falls into the tractor beam of zero rates, it’s almost impossible to escape them.”  Although Bass seems to be focusing more on a broad economic slowdown, a recent report by FTI Consulting highlighted the fact that U.S. online retail sales have slowed for four straight quarters and may continue to slow as the industry matures.

Libra:  Facebook (FB, 203.81) was on Capitol Hill yesterday to discuss its new cryptocurrency with lawmakers.  Casual observation would suggest it didn’t go well.  Democrats seemed united against the idea; the GOP was divided.  One item to consider; the unofficial motto of Silicon Valley is “move fast and break things.”  It appears that the company didn’t fully consider all the issues surrounding the impact of Libra.  The history of the financial markets show the impact of innovations that go awry and given the reach of social media, an unexpected problem could have a global impact.

A budget deal?  There are reports that House Democrats are close to an agreement with the Treasury over a two year budget deal.  Although there is still a chance that negotiations fail, this news does increase the odds that a debt ceiling crisis will be averted.

A spat between Japan and South Korea:  One of our positions is that America’s success as a hegemon was through the “freezing” of historic friction points in Europe and Asia.  Specifically, the U.S. took over the security of Europe to resolve the German problem and demilitarized Japan to eliminate the island’s fear of being cut off from natural resources.  In both cases, nations that had previously dominated their regions became docile and prevented WWIII.  Now that the U.S. is questioning the need to maintain hegemony, these previously frozen conflict zones are showing signs of thawing.  A case in point is developing between South Korea and Japan.  The Korean peninsula has been an area of contention for centuries between China and Japan.  If China controlled the area, it was only a short boat ride away from invading Japan.  If Japan controlled the peninsula, it had a foothold into further encroachment into China.

Needless to say, Koreans were never comfortable with the hegemonic designs of either China or Japan.  The U.S. forced South Korea and Japan to get along despite deep resentment of the Koreans over their treatment during Japanese occupation.  Over the years, both nations arranged to overcome latent hostility.  In 1965, both nations agreed to waive reparations.  But recently, South Korean courts have ruled that the 1965 agreement does not eliminate individual claims of reparations against Japan by individuals.  As a result, courts there have ordered the seizure of Japanese company assets.  Japan is retaliating by applying trade embargos on key technology components.  South Korea appears to be digging in for a longer fight.  The South Korean finance minister, Hong Nam-ki, said his government is working on a plan to reduce the country’s reliance on Japanese manufacturing inputs and make its own producers more independent.

A key to peace in the region has been the ability of the U.S. to force cooperation among allies.  However, as the U.S. signals withdrawal, old conflicts emerge which will divide former allies (albeit forced ones) and allow China to exploit these divisions to expand its power and undermine American influence in Asia.  An additional observation; this action adds to the growing use of protectionism and reduced globalization, which will have major implications for the global economy going forward

Odds and ends:  It appears Spain’s PM Pedro Sanchez won’t be able to form a government.  Sanchez’s Socialists won the most seats in elections last April but was 53 seats short of a majority.  He has, so far, been unable to find a coalition partner to form a majority government.  If he cannot, he will either try to govern with his current minority or call new elections.  Although Japan is known for its lack of immigration, there are signs that its rapidly aging population is leading the island nation to open up to foreigners.  The current foreign-born population in China is now 2.1% (the U.S. is around 15%).

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by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA

[Posted: 9:30 AM EDT] It’s July!  The trading deadline looms in baseball and a few deals (two involving our beloved cross-state team) have already occurred.  Markets, on the other hand, are very quiet.  Here is what we are watching today:

The EU vote: The EU Commission presidency vote happens late today and the current candidate, German Defense Minister Ursula von der Leyen, is talking to various groups trying to cobble together enough votes to take office.  She needs 374 votes to win, but anything less than 400 will tend to reduce her mandate.  The vote is expected to be very close.  In her last speech before the vote, Ms. von der Leyen pledged to push through a new EU carbon tax and achieve carbon neutrality for the EU by 2050.  She also backed EU-wide unemployment insurance and promised to punish international technology firms that “play” the EU tax system.  Ms. von der Leyen is expected to win with the support of Europe’s mainstream parties, though she has gotten significant pushback from many in the center-left, especially the German SPD.  She has shunned giving the Greens any specific role in government.  If she loses, it will plunge the EU governance into uncharted waters.  It is unclear if there is any consensus on another candidate.  If she is rejected, it may put downward pressure on the EUR

While the legislators will also soon be voting on a new leader of the European Central Bank (former International Monetary Fund Chief Christine Lagarde), it’s important to remember that none of the new leaders will have carte blanche in their roles.  As an example of that, Banque de France Governor François Villeroy de Galhau said at a conference today that monetary policy shouldn’t be dependent on market expectations.  The statement was seen as pushing back against expectations that the ECB will loosen policy at its upcoming meeting.

Libra: We have had concerns about the rise of cryptocurrencies for some time.  Although the coins might have some worth as a store of value asset and do help citizens evade capital controls, they are also useful for transactions in the black market.  Ransomware threats often require payment in cryptocurrencies.  However, what has surprised us is how governments have generally not reacted to the potential sovereignty threat that cryptocurrencies represent.  One of the important roles of government is the creation of currency; giving that up to the cryptocurrency market opens up the possibility of private money and the loss of state power.  Facebook’s (FB, 203.91) proposed foray into the cryptocurrency market appears to have caught the attention of Washington.  The SEC is considering if it should regulate Libra, essentially deciding if Libra is a security.  The Treasury is also expressing concern, with the Treasury secretary warning that Libra may be a “national security issue.”  There is even talk of banning tech firms from offering any financial services.  Regulation may not kill Libra but making it palatable to regulators will likely undermine the attractiveness of cryptocurrencies, in general, which comes from their anonymous nature.

Central bank weapons: Central bankers around the world are quietly preparing for the next downturn.  Since interest rates are already low, unconventional policies will likely be necessary to stimulate growth.  The ECB is considering adding unsecured bank debt to the assets it will buy in a downturn.  The Fed is considering the launch of a repo facility that would allow the central bank to accept Treasuries as collateral if money market rates rise a certain level above the policy rate.  The fact that such measures are under consideration suggests the developed world central banks are concerned that conventional monetary policy will not function well in the next downturn.

Brexit: Both candidates for leadership of the Tories are pushing for no backstop in Northern Ireland.  It might be possible to put a trade border inside Ireland to allow the physical border to be open between the U.K. and Ireland, but the problem is that such an action would effectively move the border of the U.K. further into what is now the Republic of Ireland.  We don’t see the EU giving that to Britain.

Meanwhile, here’s a new word to watch—proroguing—which is when the executive closes Parliament, ostensibly to implement policies favored by the executive but opposed by the legislature.  This idea has been circulating among Brexit supporters as a way to prevent Parliament from preventing the country from leaving the EU.  Proroguing outside of normal recesses is constitutionally tricky.  Essentially, it requires the Queen to shut down Parliament at the request of the PM.  We have doubts Queen Elizabeth would take this action.  After all, such a move would rekindle republicanism, which wants to end the royals altogether.  As the chances of a hard Brexit increase, the pound continues to weaken today to its lowest level since April 2017.

Greece: In a sign of improved investor sentiment toward Greece and its new center-right government, the government is planning to sell a new seven-year bond at a yield of just 2.1%, a modest 2.6% spread above comparable German debt and barely more than the U.S. Treasuries of the same maturity.  That comes as loosening monetary policy has driven yields to below-zero in a range of emerging markets.  All the same, in spite of those signs of positive sentiment, there are reasons to maintain caution regarding the emerging markets, especially considering the evolving global backdrop of trade protectionism and a reversal of globalization, policy turmoil in places like Turkey and Mexico, and the recent strength in the dollar.

Bulgaria: Interior Minister Mladen Marinov said Bulgaria is undergoing a massive hacker attack from a Russian website, including the release of millions of emails with stolen personal financial data and statements calling for Bulgarian Finance Minister Vladislav Goranov to resign.  According to Marinov, the attack suggests Russian revenge for Bulgaria’s recent decision to buy F-16 fighter jets from the United States.

China: The Chinese government pushed back against comments from President Trump, who argued that the 6.2% GDP growth in Q2 is evidence that the Chinese economy is suffering and that Beijing would be wanting to make a trade deal with the U.S.  China’s fiscal spending in H1 rose 10.7% as the government moves to bolster growth.  The government yesterday issued a new policy prohibiting both central and local agencies from providing subsidies or loans to support state-owned companies that otherwise wouldn’t be financially viable, i.e., “zombie enterprises.”  The communiqué said the policy aims to make it easier to close down such zombies and better allocate resources, but China will probably also tout it in order to diffuse U.S. criticism about unfair subsidies for state-owned exporters.  The problem is that local governments will still be the ones deciding whether or not firms are viable, and they’ll still have an incentive to keep the zombies alive.  Top-level trade negotiators from the United States and China plan to talk by phone again this week, with U.S. officials expressing optimism that the conversation will lead to new face-to-face negotiations, but China’s hardline Commerce Minister Zhong Shan warned that China will “stand firm in defending the interests of our country.”

North Korea: In spite of positive atmospherics arising from the meeting between President Trump and North Korean leader Kim Jong-un after the G-20 summit last month, North Korean state media today warned that a joint U.S.-South Korean military exercise next month would reduce the justification for it to pursue denuclearization and better international relations.  The article said North Korea might consider renewed long-range missile tests if the exercise goes forward.

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by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA

[Posted: 9:30 AM EDT] Happy Monday!  China’s GDP came in on expectations but the trend is clearly showing that growth is slowing.  The EU Commission vote is this week.  Global debt is growing.  Tropical Storm Barry is now moving into Missouri.  Here is what we are watching today:

China’s GDP: China Q2 GDP came in on expectations at 6.2%.  China’s GDP almost always comes in on forecast because the government can set the growth rate by taking on more debt.  But, the fact that the Xi regime accepted growth this low does suggest the government is trying to slowly reduce the glide path of growth.  The reading in Q2 is the slowest growth in nearly three decades.  Weaker exports were partly to blame for the slowdown.  In general, China can probably only grow at around 3.5% to avoid adding to debt.  We believe Xi has the power to reduce growth to that level but he wants to get there slowly in order to avoid an abrupt drop in output.  Given that he has the ability to stay in power indefinitely, he may be around long enough to lower China’s growth to a sustainable pace without something that looks like a recession.

Hong Kong: Knowledgeable officials in Hong Kong say the territory’s chief executive, Carrie Lam, offered to resign several times in recent weeks in the midst of massive protests against her proposed bill to allow extraditions from Hong Kong to China.  However, the officials say Beijing refused to accept the resignation, telling Lam to stay in her post “and clean up the mess she created.”  Meanwhile, protestors continue to agitate against the extradition bill and other grievances, including a near-riot in a luxury shopping mall last night.  While Lam remains in charge, the incident confirms that her days are numbered and that the political situation in Hong Kong is likely to remain unstable for the foreseeable future.

Global Monetary Policy: The acting head of the International Monetary Fund (IMF), David Lipton, offered his backing for looser monetary policy by the major central banks, such as the Federal Reserve and the European Central Bank.  In an interview with the Financial Times, Lipton said, “If the economy needs support, you provide support . . . It’s more important than it’s been in a long time to avoid a recession, to be careful about any actions that might trigger a downturn.”  We already believe more loosening is on the way – including a likely interest rate cut by the Federal Reserve at the end of the month – but Lipton’s statement will help give monetary authorities political cover to proceed with the moves in spite of skepticism among some policymakers.

United States-Turkey: Officials from the State Department, Pentagon and National Security Council have drawn up a list of proposed sanctions against Turkey for its purchase of Russia’s S-400 air defense system, the first deliveries of which began on Friday.  The proposed sanctions would have to be approved by President Trump, but officials say the United States won’t make a public reaction to the S-400 deliveries until sometime after today.  Sanctions would likely ratchet up tensions between the countries and present further headwinds for the Turkish lira and Turkish assets.  Another problem for Turkey is that there are rising tensions over natural gas drilling in waters off of Cyprus.  The island is divided between Turkey and the EU and the former is drilling off waters that it claims, which are not globally recognized.  The EU is threatening to cut funding for Turkey.

Russia-Ukraine: In a sign of at least some thawing of relations between Russia and Ukraine, an official at the Russian Ministry of Foreign Affairs said the two governments are discussing the return of two dozen Ukrainian sailors who were seized by Russia last year.  The development comes after the new Ukrainian leader last week suggested multilateral talks on Russian-Ukrainian peace, and President Putin said he would be open to the idea under certain conditions.

Mexico: On the other hand, Mexico’s economy appears to be falling into recession.  Clearly, the trade conflict with the U.S. is having an adverse effect on investor sentiment in Mexico.  However, another factor could be AMLO’s policy of cutting government spending on the bureaucracy.  One of AMLO’s campaign promises was to move spending away from the bureaucracy to the poor.  However, this has led to the reduction of some basic services, such as firefighting.  Although there is an element of AMLO’s austerity that is going to be popular, it is going to be difficult to determine what activities are wasteful and unnecessary and what are critical.  While no one would argue that police services are needed, there may be questions on whether new cruisers are necessary.  Once public investments are questioned, over time, such investments decline and eventually public workers won’t have the tools necessary to do their jobs.  It is possible that the cuts to government spending have occurred before the spending was shifted to the poor; if that’s the case, then the government sector will be a drag on the economy.

U.K. makes an offer: The U.K. has offered to release the tanker it holds if Iran doesn’t deliver the oil to Syria.  It isn’t clear what kind of guarantees Tehran can offer to satisfy the British but it does look like both sides are trying to ease tensions.

Debt: The Institute for International Finance (IIF) is a bank-owned body that conducts research on international financial matters.  One of the tasks the IIF performs is to monitor global debt levels. The IIF reports that global debt rose $3.0 trillion in Q1 to $246.5 trillion.  With global GDP estimated to be around $85 trillion, world debt/GDP is around 290%.  Emerging market debt has hit a record high.  One side effect of low interest rates is that they encourage the expansion of debt levels, making the global economy vulnerable to rising interest rates.

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by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA

[Posted: 9:30 AM EDT]

Happy Friday!  We’re almost to the weekend, but before we get there, we still have some important developments to keep track of.  We’re seeing some potentially positive developments in the trade row between Japan and South Korea, but on the other hand, we’re also noting some negative news in the tensions between Turkey and the United States.  We continue to watch monetary policy developments closely.  Here are the top stories we’re watching at the moment:

Japan-South Korea:  Working-level export control officials from Japan and South Korea met today to discuss Japan’s new restrictions on high technology chemicals shipped to South Korea.  The talks lasted longer than expected, which may point to some progress on the issue.  However, public statements on both sides suggest there’s a high hurdle for resolving the conflict.  Japan claims some of the chemicals ultimately end up in North Korean military equipment, but South Korea claims the restrictions are really to punish the country for its complaints about Japanese behavior during World War II.  One potential positive from the conflict is that the restrictions may be impeding South Korean chipmakers enough to whittle down the global oversupply of memory chips.

Turkey:  The Ministry of Defense announced today that it has started taking delivery of equipment related to its purchase of Russia’s S-400 air defense system.  The move is likely to further exacerbate tensions with the United States, probably guaranteeing that the Trump administration will prohibit any further sales of the F-35 jet fighter to Turkey and possibly spurring Congress to impose sanctions.

U.S. Monetary Policy:  Even as Federal Reserve Chairman Powell was wrapping up his dovish testimony before Congress yesterday, speeches by several other Fed officials were highlighting the disagreements among policymakers regarding the need for interest-rate cuts.  For example, Fed governor Lael Brainard pointed to growing economic risks and low inflation as a reason for “softening the expected path of monetary policy.”  New York Fed President John Williams echoed the sentiment.  In contrast, Atlanta Fed President Raphael Bostic said he sees no urgency to lower rates, and Richmond Fed President Thomas Barkin said soft inflation alone is not a reason to cut rates.  Although a rate cut at the end of the month still seems likely, those sentiments suggest there is still some possibility that the policymakers could hold rates steady.

Mexican Monetary Policy:  Fed Chairman Powell’s dovishness is in line with the increasing dovishness among many other major central banks.  However given the continued integration of the North American economy, it can be instructive to also pay close attention to developments in Canada and Mexico.  This week, for example, Banco de Mexico issued the minutes of its June 27 policy meeting, at which it held its benchmark rate steady at 8.25%.  In the minutes, the policymakers focused on many of the same issues playing into Chairman Powell’s dovishness.  The policymakers saw a risk that the Mexican economy would show increasing signs of deceleration, with “little clarity and visibility” into the future of economic policies going forward.

Cryptocurrencies:  Echoing Fed Chairman Powell’s criticism of Faceboook’s (FB, 201.23) proposed cryptocurrency, Libra, during his testimony before Congress, President Trump last night issued a series of tweets slamming Libra as “not money” and suggesting any company trying to issue such a currency should be subject to banking regulations.  In yet another attack on the cryptocurrency space, an official at Frances Finance Ministry said his country would “not allow private enterprises to give themselves the attributes of state sovereignty.”  With officials around the world piling on to protect their monopoly over money creation, the futures market currently suggests Facebook is set for a down day, even as the broader market seems set to rise.  All the same, some cryptocurrency advocates see a silver lining in the row, arguing that the pushback by officials is a sign of the industry’s growing importance.

Mankiw Rule update: The Taylor Rule is designed to calculate the neutral policy rate given core inflation and the measure of slack in the economy.  John Taylor measured slack using the difference between actual GDP and potential GDP.  The Taylor Rule assumes that the Fed should have an inflation target in its policy and should try to generate enough economic activity to maintain an economy near full utilization.  The rule will generate an estimate of the neutral policy rate; in theory, if the current fed funds target is below the calculated rate, then the central bank should raise rates.  Greg Mankiw, a former chair of the Council of Economic Advisors in the Bush White House and current Harvard professor, developed a similar measure that substitutes the unemployment rate for the difficult-to-observe potential GDP measure.

We have taken the original Mankiw rule and created three other variations.  Specifically, our model uses core CPI and either the unemployment rate, the employment/population ratio, involuntary part-time employment and yearly wage growth for non-supervisory workers.  All four compare inflation and some measure of slack.   The most recent data is shown in the chart at the top of the next page.

This month, the estimated target rates all rose.  Three of the models, the ones using the unemployment rate, wages and involuntary part-time employment all rose 20 bps to 30 bps.  Even the most dovish, the variation using the employment/population ratio, rose by 12 bps.  The combination of higher core CPI and better employment data lifted the rate model.  The leadership of the Fed has been backing away from the Phillips Curve model, thus we don’t expect the rise to slow the pace of expected hikes.  However, there are still members of the FOMC that ascribe to the Phillips Curve and as a result we could see dissents emerge to a rapid drop in rates, barring a decline in inflation or data suggesting a weaker employment situation.

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by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA

[Posted: 9:30 AM EDT]

Good Morning!  Equities continue to trend higher on Powell’s testimony yesterday.  Trade tensions are elevated.  The Persian Gulf heats up.  Here is what we are watching today:

Powell:  The chair returns to the hill today but the second day is usually a repeat of the first.  However, if the chair does think the markets got something wrong he will try to steer comments to correct that impression.  We don’t expect that to occur today.   The comments yesterday were unequivocally dovish and signal a near certainty that there will be a rate cut at the end of the month.  Normally, the Q&A session with the chair is two hours of political posturing where little new information is revealed.  There was a lot of that yesterday but we did note three interesting exchanges.

1. The Phillips Curve took a hit in an exchange with Alexandria Ocasio-Cortez (D-NY), who noted that unemployment has fallen over the past few years without any uptick in inflation. This occurred despite persistent warnings from the Fed that inflation could be around the corner because of tightening labor markets.  She got the chair to admit that the Fed’s estimates about the relationship between the labor markets and inflation were incorrect.  We will be watching for ramifications from this exchange in the future.  In our estimate, the FOMC majority continues to cling to the Phillips Curve, probably because without it they have no clear guidance for setting policy.  If the Fed isn’t careful, Congress will give it one. As an example, let’s say the Fed cannot allow the unemployment rate to move above 5%?  If inflation is dead (and we think it is, if and only if we remain globalized and deregulated) then targeting the unemployment rate is reasonable.  Otherwise, this path will take us back to higher inflation.
2. Rashida Tlaib (D-MI) noted that the Fed bought commercial paper during the financial crisis to stabilize that market. Tlaib asked if the Fed could buy municipal paper to help cities and states.  Powell suggested the Fed didn’t have the legal authority to do that but we are not sure he is correct.  Quantitative easing (QE) is something of a “Pandora’s box” to politicize central banks.  The BOJ, for example, has been buying equity products.  QE in Europe has led to such distortions that even emerging market European debt markets are now offering negative nominal yields.  If the Fed opened its balance sheet to buying municipal bonds, it would likely remove the pro-cyclical nature of state and local government borrowing, which is usually constrained by tax revenue.  Essentially, the decision of a central bank to buy one asset but not another politicizes the process of monetary policy.  Although QE may have been necessary under the strain of the Great Financial Crisis, the opportunity cost was that the Fed now finds itself mired in political decisions.  Since the structure of the Fed is isolated from the voters, such decisions may very well eventually be brought under the purview of the voting public.
3. Chair Powell took the opportunity to slam Facebook’s (FB, 202.73) proposed cryptocurrency, Libra, suggesting it could destabilize the financial system. We have been wondering how long it would take before governments begin to figure out that the ability to print money is a key element of sovereignty.  Cryptocurrencies fell on the news.

We will be watching to see if the Senate takes up any of these issues.  We doubt we will hear too much on the first two points but a return to point #3 is highly likely.

U.S.-China trade talks:  There wasn’t much positive news on the trade front.  Recent Chinese announcements indicate Commerce Minister Zhong Shan, reportedly a hardliner on trade, has been inserted into the Chinese trade team, potentially signaling that China will be taking a tougher stance in the renewed trade talks.  Along with Chinese Vice Premier Liu He, Zhong was reportedly on this week’s phone call with top U.S. trade negotiators in which the Chinese participants declined to offer any specific commitments on purchasing U.S. agricultural products.  The call also produced no firm timetable for any upcoming face-to-face meetings between the trade teams.  One of the factors that may be slowing talks are the informal but critical CPC meetings that take place at the Chinese seaside resort town of Beidaihe later this month.  This annual summer retreat of the CPC allows current and retired officials to discuss issues off the record and Xi may be cautious about taking aggressive trade steps only to face criticism from his “elders.”  Another trend complicating matters is that the Trump administration views the trade conflict as a source of political strength going into the elections and therefore may not opt for a deal unless the Chinese capitulate.  Paradoxically, Chair Powell’s testimony and expectations of easier monetary policy may support this position; if the president is less worried that a trade conflict will hurt the economy, then he may be willing to string the talks out well into next year.  The decision by the administration to meet with Hong Kong activists suggests a hardening of positions.

Iran:  Iranian speedboats harassed a British flagged oil tanker yesterday, but the Iranian vessels backed off when a Royal Navy warship intervened.  Reports say the H.M.S. Montrose positioned herself between the tanker and the Iranian vessels and forced the Iranians to disengage by training her guns on them, although Iranian Foreign Minister Zarif denied any such incident occurred.  The incident follows the British seizure of an Iranian tanker earlier this week on grounds that the vessel was carrying oil to Syria in violation of European Union sanctions.  Iran had responded to the seizure by threatening unspecified consequences, and as we reported yesterday, reports said at least one British tanker (apparently the one in today’s incident) had temporarily taken refuge in a Saudi port.  The U.S. accused Iran of “nuclear extortion” and promised more sanctions.  Iran appears to be steadily ratcheting up its nuclear enrichment but doesn’t seem to be moving rapidly to cross the threshold of a nuclear weapon.  The steady enrichment process appears to be a negotiating stance; if talks do occur, Iran can offer to pull back on enrichment in return for sanctions relief, which it clearly needs.  The risk to Iran is (a) the U.S. doesn’t really care if it goes nuclear because its missiles can’t reach the U.S. mainland,[1] so sanctions never end, and (b) the U.S. does care and bombs its nuclear sites with greater effectiveness than expected.  The potential for escalation remains and this is putting a bid under oil prices.

Broader Persian Gulf security:  Today’s U.K.-Iran incident also seems likely to accelerate the current plans for a multi-nation naval operation to monitor and protect shipping in the broader Persian Gulf.  Echoing his calls for NATO members to fund more of the alliance’s defense, President Trump has also been calling for oil-consuming countries to contribute more ships to the security effort in the Gulf.  However, as in NATO, those countries seem to be slow-walking any additional contributions.  For example, Japanese officials today said their contribution to any Gulf protection plan would probably be limited to logistical support, given the country’s pacifist constitution.  Researcher Sachi Sakanashi of the Tokyo-based Institute of Energy Economics is quoted today as saying, “(Japan) will prioritize de-escalation over creating tensions by joining the U.S.-led coalition.”

French tech tax:  The U.S. has been of two minds on tech regulation.  American regulators are concerned about the power, reach and influence of U.S. tech firms and are considering ways to regulate them, including using anti-trust measures.  However, these are American firms and the U.S. is clearly uncomfortable with other nations, especially European ones, using state power to affect these companies.  The Europeans have mostly missed out on e-commerce and social media and so they can increase the cost of tech firms doing business with little repercussions and so European states have a clear incentive to tax the activities of tech firms.  The Macron government is proposing to tax large technology companies; this has caught the attention of the U.S. which is investigating whether such a plan would be considered a hostile trade action.  The Trump administration is considering tariff retaliation if the tax is implemented.

Brazil:  The lower house of Congress yesterday preliminarily approved President Bolsonaro’s plan to reform the country’s pension plan in order to dramatically cut its cost.  The bill received 379 votes in favor and 131 against, suggesting it should also pass on its second and final vote, at which time it would be sent to the Senate for its approval.  Even though the bill has been watered down compared with its original version, it is still expected to cut the country’s pension costs sharply and help shore up government finances.  The bill has therefore been a strong positive for Brazilian assets recently.

A brewing Italian scandal?   There are reports that deputy PM Salvini may have been willing to accept money from Russia to support his political aspirations.  Russia’s attempts to affect political outcomes in the West are well known, but it isn’t clear if such a scandal would seriously harm Salvini.

Odds and ends:  Merkel’s health continues to be a concern among European leaders.  Although U.S. politicians often use European public health systems as an alternative to the private systems in the U.S. the overseas systems are not without issues.  Recently, Europe has been suffering through serious shortages of key drugs.  Although some of this problem may be due to industry structure, a truism of economics is that if one fixes prices, the risk is that one trades the problem of high prices for the problem of shortages.  Finally, one repercussion of legalized pot—a rise in candy and snack demand!  Who knew?

Energy update:  Crude oil inventories fell 9.5 mb last week compared to the forecast drop of 2.9 mb.

In the details, refining activity rose 0.5%, above the 0.1% rise forecast.   Estimated U.S. oil production rose by 0.1 mbpd to 12.3 mbpd.  Crude oil imports fell 0.3 mbpd, while exports rose 0.1 mbpd.  Stocks fell on weaker imports and rising refining demand.

This is the seasonal pattern chart for commercial crude oil inventories.  We are now well within the spring/summer withdrawal season.  This week’s decline is consistent with the seasonal pattern in terms of direction but was larger than normal.

Based on oil inventories alone, fair value for crude oil is $55.03.   Based on the EUR, fair value is $52.70.  Using both independent variables, a more complete way of looking at the data, fair value is $52.67.  Oil prices are getting a bit above fair value, likely due to tensions with Iran and tropical storm worries.  However, the market is probably also expecting further declines in inventories given the seasonal patterns; thus, prices are moving higher in anticipation.

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[1] This stance creates the same problem for Iran’s neighbors that a nuclear North Korea without ICBMs poses for Japan, China and South Korea.