by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Markets across the world are rather quiet this morning after U.S. equity indices made new closing highs yesterday.  Here is what we are watching:

China trade talks: Treasury Secretary Mnuchin and Trade Representative Lighthizer announced another round of meetings in Beijing next week.[1]  The next round will begin on April 30.  The leader of the Chinese talks, Vice Premier Liu, will come to Washington on May 8 as part of this round of discussions.  The continuation of talks is good news for financial markets; a hard break in negotiations would certainly trigger an adverse reaction.

Another try: PM May is attempting another swing at getting her plan approved.[2]  However, for this to occur, she will need significant Labour Party support, which is unlikely to develop.  Meanwhile, Scot political leader Nicola Sturgeon is laying out a “road map” for a second referendum.[3]  Although another vote is possible, establishing exactly what would be voted on is actually quite difficult.  But, if Sturgeon can find traction for a second vote, we could see one occur later this year.

Oil: The Saudis indicated today that they would not necessarily rush to increase oil production in light of the end of Iranian oil exports.[4]  That news is supportive; however, this chart suggests at least $10 of the current price reflects the level of geopolitical risk in the market.

The dependent variable is the average price of WTI for the month, which is currently around $63.70.  Today, prices are running around $66.00.  We are a rather long way from fair value; in the past, when prices were this extended, we would have expected some price weakness to emerge.  However, we also note that crude oil inventories tend to decline starting in early May into mid-September, so the fair value price could improve.  Still, any reduction in tensions with Iran, Libya or Venezuela could easily lead to a $5 to $10 dollar decline in oil prices in the coming weeks.

Russian and North Korea to meet: Putin and Kim are set for meetings today in Vladivostok as the Russian leader attempts to insert Russian influence into the current nuclear negotiations.[5]  We would not expect too much to emerge from this meeting.  Kim is reportedly looking for food aid from Russia and Russia would like to see a gas pipeline to South Korea built.  Of course, the meeting will burnish the status of Russia.  On the other hand, Russia has opposed North Korea’s nuclear program as destabilizing and thus won’t likely offer significant support for that effort.[6]  On a related note, North Korea announced the demotion of Kim Yong Chol, who had been leading negotiations with the U.S.[7]  No reason was given for his demotion but we suspect the failure of the Hanoi discussions is probably the reason.

FOMO: As noted above, equity indices made new closing highs yesterday as an improving earnings outlook lifted stocks.  One of the charts we have monitored is the relationship between retail money market holdings and the S&P 500.

This chart shows retail money markets and the equity index.  The gray bar shows the 2007-09 recession; the orange lines are periods when money market levels fell below $920 bn.  We note that equities tended to stall when money market holdings fell below this level.  In the early part of last year, fund levels reached $1.0 trillion and, as trade tensions rose, retail investors began accumulating cash at a pace that suggested great unease; the uptrend in equities stalled.  As equity markets fell in Q4 2018, the pace of cash accumulation accelerated.  Since the recovery, retail investors continued to accumulate cash, although the pace had clearly slowed.  However, last week, we did see a $13.1 bn decline in money market funds.  This is the largest weekly decline since the week of June 10, 2009.  If withdrawals become a trend, we could see further gains in equity markets as some of this cash will likely find its way into stocks.  We will continue to monitor this particular measure of cash, but we would consider further declines to be a supportive factor for equities.

The Fed:Now that Herman Cain has bowed out, other names are starting to surface.  Judy Shelton[8] is being recommended by some.  She is popular in libertarian right-wing circles and appears to be a strong proponent of the gold standard.  What we find interesting about all the names bubbling up is that so many are gold standard supporters and such models tend to be deflationary, which is exactly the opposite of what the president wants.

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[1] https://www.ft.com/content/11ff41ba-662e-11e9-9adc-98bf1d35a056?emailId=5cbfd794aff537000465fd39&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[2] https://www.ft.com/content/adaf81e2-65b1-11e9-9adc-98bf1d35a056?emailId=5cbfd794aff537000465fd39&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[3] https://www.ft.com/content/20b9830c-65e6-11e9-9adc-98bf1d35a056?emailId=5cbfd794aff537000465fd39&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[4] https://www.cnbc.com/2019/04/24/saudi-plans-to-keep-oil-output-within-levels-of-opec-cuts-says-falih.html

[5] https://www.ft.com/content/66a3f16c-65ba-11e9-9adc-98bf1d35a056?emailId=5cbfd794aff537000465fd39&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[6] https://www.38north.org/2019/04/sblank042219/

[7] https://www.reuters.com/article/us-northkorea-usa-envoy/north-korea-removes-leader-kims-right-hand-man-report-idUSKCN1S00YG?feedType=RSS&feedName=worldNews

[8] https://en.wikipedia.org/wiki/Judy_Shelton

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Markets across the world are rather quiet this morning.  Oil remains the focus.  Here is what we are watching:

Oil: Yesterday, the Trump administration announced that no more oil waivers will be granted on Iranian oil exports, which will tighten oil supplies.  The U.S. has asked Saudi Arabia to lift production;[1] the kingdom has responded cautiously, fearful of triggering another price collapse like we saw last autumn.  We do expect Russia to lift output later this year.

What has spooked the oil markets are reports that Iran might retaliate to U.S. moves by closing the Strait of Hormuz.[2]  If Iran loses its ability to export oil, it has no incentive to keep the strait open.  After all, its enemies in the region, primarily the Saudis, would be selling oil at higher prices at Iran’s expense.  We examined this threat in a series of WGRs last year.[3]  Our analysis concluded that Iran could, at potentially great cost, shut down the strait for up to two months and even that action would not completely eliminate oil flows from the region due to the creation of alternative pipelines.  However, the actions the U.S. would take to reopen the strait would represent a significant military escalation and might lead to a broader conflict.  Thus, oil prices will tend to be supported due to the rising degree of uncertainty.

A funny guy wins in Ukraine: In the wake of Volodymyr Zelensky’s win, the hard part begins.  It’s one thing to win an election, but it’s another to govern.  Zelensky has no parliamentary party.  He does not have a group of advisors.  He faces a hostile power on his eastern border.  Ukrainian voters are tired of ineffective government and widespread corruption, but electing someone without experience or political power probably won’t fix those problems.  Ukraine’s elections highlight a broader problem in democracies—there is widespread distaste for political skill but it’s hard to get anything done without it.  Therefore, there is immense temptation to elect new faces that make great promises but do not have the skills to make political change.  As frustration builds, the temptation to jettison democracy altogether increases.

The Fed: Herman Cain has bowed out.  We are a bit surprised that he gave up so quickly but when four GOP senators announced their opposition the White House apparently didn’t see a reason to burn political capital on his behalf.  Stephen Moore remains a candidate and, so far, no senators have announced their opposition.  So, despite widespread mainstream opposition, Moore remains in the mix.  We will be watching to see who emerges as the next candidate; we would not be surprised to see Larry Kudlow get the nod.

Chinese naval parade: China will conduct its largest naval show this week as a flotilla of vessels will sail in the Asian region to showcase China’s rapid military expansion.[4]  Although China’s naval capacity is still dwarfed by the U.S., it is closing the gap and the parade will be closely watched by U.S. officials.

Brexit: Although there aren’t any looming deadlines, we note that PM May continues to negotiate with the Labour Party opposition to cobble together a coalition for her exit plan.  It seems like a long shot.[5]  Meanwhile, Tory activists are pressing for a non-binding no-confidence vote to replace May with a more hardline Brexit supporter.  Because May survived an official no-confidence vote in Parliament last December, based on party rules, she can’t face another official vote until December of this year.  Party activists are trying to force a rule change so she can be ousted.[6]  Although we still don’t expect a hard break with the EU, the odds of the U.K. stumbling into that outcome are slowly increasing.  In the short run, such an outcome would be devastating for the British economy.  However, in the long run, the U.K. may simply “beat the rush” because, at some point, we expect the EU to unravel and being out during that event will probably be better than being in. 

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[1] https://www.reuters.com/article/oil-prices-kemp/column-oil-traders-to-saudi-arabia-show-us-the-barrels-kemp-idUSL5N22538O

[2] https://www.timesofisrael.com/iran-threatens-to-close-strait-of-hormuz-after-us-ends-sanction-waivers/

[3] See WGR series, Iran Sanctions and Potential Responses: Part I (7/30/2018); Part II (8/6/2018); and Part III (8/13/2018).

[4] https://www.ft.com/content/489d138a-627a-11e9-b285-3acd5d43599e?emailId=5cbe7985a454a90004cc5090&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[5] https://www.ft.com/content/f5c0b634-64f0-11e9-a79d-04f350474d62?emailId=5cbe7985a454a90004cc5090&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[6] https://www.ft.com/content/52c55168-651a-11e9-a79d-04f350474d62?emailId=5cbe7985a454a90004cc5090&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy Easter Monday!  Most of Europe is closed today, along with a few Asian markets (Australia, New Zealand).  It’s also Earth Day.  There was a horrific terror event Easter Sunday against Christians in Sri Lanka.[1]  Here is what we are watching:

Oil: The Trump administration is signaling that there will be no more import waivers granted on Iranian oil.[2]  This decision was something of a surprise.  Although SoS Pompeo and National Security Director Bolton supported this hardline stance, the president was reluctant to take this step for fear of higher oil prices.[3]  In response, oil prices have jumped on the news.  In other Iranian news, the Supreme Leader Khamenei announced the replacement of the commander of the Iranian Republican Guard Corps (IRCG).  Gen. Hossein Salami was elevated to the post, while Gen. Mohammad Ali Jafari was removed.[4]  Salami is considered a hardliner (in a rather hardline group), so this move does suggest Iran is preparing for a more hostile environment.

Iran is the proximate cause for today’s lift but we have noted that overall geopolitical risk is adding around $10 to $12 per barrel to the price of oil; the current price is well above what the dollar and oil inventories would suggest.  In Libya, the Trump administration shifted course with regard to political leadership, offering a full endorsement of Khalifa Hifter.[5]  Hifter, a former Libyan general under Khaddaffi who broke with the late Libyan leader, offers a secular leadership option for the country.  It isn’t clear if the endorsement will lead to overt support, such as equipment and funding.  So far, Hifter has been less than impressive on the battlefield.[6]  If the conflict escalates, the potential for further supply disruption is high.

Venezuela remains problematic.  Electricity outages, trade restrictions and sanctions continue to weigh on production.  There are reports that the Russians are helping Caracas evade sanctions.[7]  Although this action might support an increase in Venezuelan supplies, we doubt the U.S. will allow this evasion to continue indefinitely.

Although we remain bullish on oil prices, we are at the point where the primary bullish factor is geopolitical.  We are probably approaching a crux where it will be difficult for prices to sustain these levels without either (a) a continued flow of news that signals further supply disruptions, or (b) improving fundamentals (falling inventories or dollar weakness).

A funny guy wins in Ukraine: The voters in Ukraine have spoken with a landslide victory[8] for Volodymyr Zelensky, defeating incumbent president Petro Poroshenko.  Zelensky has no political experience—in fact, he played a political leader on a Ukrainian TV show.[9]  Zelensky is a comedian by trade and his victory is another indication of the anti-incumbent mood of electorates and the desire for something “different” across the West.  It is unclear how well Zelensky will govern a difficult nation in an unsettled geopolitical environment, but voters in Ukraine were apparently willing to take the chance.

China: Reports that Chinese leaders are more focused on reform and less on boosting growth led to a slump in Chinese equities today.[10]  According to reports, in a review of the Q1 economy, the 25-member Politburo congratulated themselves for navigating the trade conflict with the U.S. and signaled that Chinese policy will continue to focus on reform and show less concern toward excessive growth.[11]  The need for economic restructuring is nothing new; China is in the midst of the difficult shift from investment-led growth to consumer-led growth.  When the U.S. went through this process, we suffered the Great Depression.  Japan is still struggling to make this adjustment which began in 1990 and has led to nearly three decades of stagnation.   In practice, Chinese leaders have tended to start the process of reform, which will lead to slower growth and falling debt, but upon seeing weaker growth the leadership has panicked and boosted spending and debt.  Chinese financial markets have enjoyed a rally on expectations that Chinese leaders have “blinked” again in the face of slowing growth.  Today’s news suggests that reform remains on the agenda; our position is that the CPC is not confident enough to allow growth to decline and thus the continued pattern of “reform, panic, stimulus, reform” will continue.  But, we do acknowledge that there will be a point when China’s debt capacity will be reached and it will be impossible for them to continue this process.  We don’t think we are close yet, but the signal that the endgame is approaching will be when China taps foreign capital markets for loans.  That has started but isn’t at a huge level…yet.

The dollar: In a survey of conference calls on Q1 earnings, the largest area of company concern is dollar strength, with the second being increasing labor costs.[12]  So far, the Treasury has maintained a strong dollar policy, not supporting steps to weaken the dollar.  At some point, we do expect a reversal of this policy and industry opposition to dollar strength could be a factor that brings about this policy shift.

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[1] https://www.nytimes.com/2019/04/21/world/asia/sri-lanka-bombings.html?emc=edit_MBE_p_20190422&nl=morning-briefing&nlid=5677267tion%3DtopNews&section=topNews&te=1

[2] https://www.wsj.com/articles/u-s-to-end-iran-oil-waivers-to-drive-tehrans-exports-to-zero-11555898664?mod=hp_lead_pos2

[3] https://www.reuters.com/article/us-global-oil/oil-prices-jump-more-than-2-percent-as-u-s-set-to-end-iran-import-sanction-waivers-idUSKCN1RY00J?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosmarkets&stream=business

[4] https://www.nytimes.com/2019/04/21/world/middleeast/iran-revolutionary-guards-leader.html?emc=edit_MBE_p_20190422&nl=morning-briefing&nlid=5677267ion%3DwhatElse&section=whatElse&te=1

[5] https://www.nytimes.com/2019/04/19/world/middleeast/trump-libya-khalifa-hifter.html?searchResultPosition=12

[6] https://www.nytimes.com/reuters/2019/04/21/world/africa/21reuters-libya-security.html?searchResultPosition=2

[7] https://www.reuters.com/article/us-venezuela-politics-rosneft-exclusive/exclusive-venezuela-skirts-u-s-sanctions-by-funneling-oil-sales-via-russia-idUSKCN1RU2A4?feedType=RSS&feedName=businessNews

[8] https://www.nytimes.com/2019/04/21/world/europe/ukraine-elections-zelenskiy.html?emc=edit_MBE_p_20190422&nl=morning-briefing&nlid=5677267tion%3DtopNews&section=topNews&te=1

[9] https://www.washingtonpost.com/world/as-ukraine-votes-in-presidential-runoff-a-comedian-looks-to-unseat-the-incumbent/2019/04/21/b7d69a38-603f-11e9-bf24-db4b9fb62aa2_story.html?utm_term=.c9eb055e69cf&wpisrc=nl_todayworld&wpmm=1

[10] https://www.reuters.com/article/china-stocks-close/china-stocks-fall-most-in-nearly-4-weeks-on-worries-beijing-may-slow-policy-easing-idUSZZN2RKA00

[11] https://www.scmp.com/economy/china-economy/article/3006951/china-leaders-vow-reform-not-stimulate-economy-trade-deal-us?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosmarkets&stream=business

[12] https://insight.factset.com/fx-and-wages-cited-as-top-negative-impacts-by-sp-500-companies-on-q1-earnings-calls?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosmarkets&stream=business

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] U.S. equities are mostly flat, while we are seeing weakness abroad.  The Mueller report[1] gets released this morning, so the media will be focusing on that all day.  European PMI data was lackluster.[2]  In a fascinating development, a Democratic Party stalwart announced he isn’t running for president.[3]  Note that with the markets closed for Good Friday, we will not be publishing a Daily Comment tomorrow but will resume on Monday.  Here is what we are watching:

Turkey: A couple items of note.  It appears the opposition has taken control of the city of Istanbul[4] even though President Erdogan continues to contest the vote.[5]  There are reports that the Turkish central bank has been tapping swap lines to give the impression it has ample reserves.[6]  Although the borrowing is a concern, we would note that the TRY has already depreciated substantially[7] and the current account has shown marked improvement.

We also note that Turkish officials made an unexpected visit to Washington,[8] apparently trying to avoid sanctions tied to its decision to buy Russia’s S-400 missile system.  The U.S. had approved the sale of F-35 warplanes to Turkey but is suspicious of selling them to Ankara if it also has Russians in the country “helping” deploy the missile system.  Such an arrangement would give the Russians the ability to probe for weakness in the F-35’s defenses and make the stealth plane vulnerable to the S-400 anti-aircraft missiles.[9]  Finally, Turkey is working on new trade procedures to continue commerce with Iran but avoid U.S. sanctions.[10]

China trade talk: Although not confirmed, there are reports that the U.S. and China are planning for an early May trade deal announcement.[11]  To some extent, financial markets have already discounted a modest agreement, but a deal that would lift tariffs immediately would likely give stocks a boost.

North Korea: North Korea announced it tested a tactical system.[12]  It isn’t clear whether the test was artillery or a short-range missile, but it was clearly not a ballistic missile, which would have triggered a strong reaction from Washington.  It appears Pyongyang is attempting to get the attention of the U.S. without crossing lines that would escalate tensions.  This is not unusual behavior for North Korea; it does not want to be ignored.[13]  At the same time, this test is likely nothing more than an attempt to gain attention.  Meanwhile, North Korea has indicated it would prefer not to have SoS Pompeo involved in future discussions on its nuclear program.[14]  This request is an obvious attempt to split the U.S. foreign policy establishment; we doubt President Trump will grant that request but, if he does, a deal favorable to Pyongyang is more likely.

Conservatives rise in Canada: Albertans voted in a landslide to bring back a conservative provincial government.[15]  Center-right parties now control five of the 10 provinces and increase the chances that PM Trudeau may be in trouble in October’s national elections.[16]  Trudeau has been pushing for carbon taxes to combat climate change; Alberta is the home of Canadian tar sands and is thus vulnerable to such measures.  In addition, Alberta’s energy sector has been under pressure mostly due to the lack of pipeline capacity from the province.  Some pipeline projects have been blocked by liberal-leaning provinces.  Thus, the conservatives in Alberta were able to blame Trudeau for the economic travails and the tactic was apparently successful.  Although Trudeau was never going to poll well in Alberta anyway, the economic message could resonate outside of Alberta and hurt his chances in October.

Indonesia election: Incumbent President Joko Widodo (Jokowi) is the apparent winner in this week’s elections in Indonesia.[17]  Financial markets have reacted positively to the news.

Fed talk: Apparently, Herman Cain is undeterred, indicating he won’t withdraw his name from contention for a Fed governor spot even though Senate opposition is growing.[18]  Meanwhile, Stephen Moore is finding that professional politicians rarely forget criticism.[19]

Inflation talk: This week’s Asset Allocation Weekly looks at the inflation conundrum—why is inflation staying low despite tight labor markets?  The Dallas FRB weighed in on this issue, suggesting the growth of “gig” workers, who work on demand and don’t require a commitment from employers, is reducing wage costs, allowing firms to maintain margins and are thus less compelled to push price increases onto consumers.  In addition, the expansion of online retailing means that consumers now have a national market to tap, which helps avoid local bottlenecks and monopolies and thus keeps prices low.  Although not mentioned in the article, it also reduces price discovery costs.[20]  All these are valid points.  Another interesting item—after last year’s tax cuts, we noticed a flurry of bonuses offered to workers to “share” the benefits of the corporate tax rate reduction.  However, it appears this generosity was “one-off”; bonuses in 2018 have fallen relative to the prior year.[21]

Energy update: Crude oil inventories fell 1.4 mb last week compared to the forecast rise of 2.0 mb.

In the details, refining activity rose a mere 0.2%, below expectations.  Estimated U.S. production fell slightly by 0.1 mbpd to 12.1 mbpd.  Crude oil imports fell 0.6 mbpd, while exports were unchanged.

This is the seasonal pattern chart for commercial crude oil inventories.  We are nearing the end of the spring inventory build season and will probably not achieve average, although the gap has narrowed significantly in recent weeks.

Refinery activity is still lagging average.

Usually by this week we are seeing utilization above 90%.  With summer approaching, we would look for rising utilization in the coming weeks.

Based on oil inventories alone, fair value for crude oil is $55.77.  Based on the EUR, fair value is $52.40.  Using both independent variables, a more complete way of looking at the data, fair value is $52.71.  Current prices are running well above fair value.  Geopolitical risks are bolstering prices.  The unrest in Libya could end up reducing output to zero if the fighting continues.[22]  In Venezuela, the Spanish oil firm Repsol (MCE, EUR, 15.07) has suspended oil swaps with Caracas due to pressure from Washington.  Repsol was swapping refined product for crude oil, avoiding dollar payments that would have run afoul of U.S. sanctions.  By suspending the arrangement, Venezuela now only has similar deals with Russia and India.  The former probably won’t be lost but the latter is vulnerable.  More product losses will likely lead to further reductions in Venezuelan oil output.  Thus, the geopolitical risk is real but the wide spread to fair value does suggest that a good bit of the risk has been discounted.

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[1] https://www.washingtonpost.com/world/national-security/attorney-general-plans-news-conference-to-discuss-mueller-report/2019/04/17/f5ca1cc6-6138-11e9-9ff2-abc984dc9eec_story.html?utm_term=.2e29dadcd463

[2] https://www.markiteconomics.com/Public/Home/PressRelease/5e809b959ac94d7d90cbdb6569dae3e2

[3] https://www.nytimes.com/2019/04/17/us/politics/terry-mcauliffe-president.html

[4] https://worldview.stratfor.com/situation-report/turkey-opposition-candidate-becomes-new-mayor-istanbul?id=87179e919a&e=4d1f592612&uuid=81dc1447-4fc0-4a76-8cce-9e674e520e8e&utm_source=Daily+Brief&utm_campaign=8aa8a570f5-EMAIL_CAMPAIGN_2019_04_18_11_33&utm_medium=email&utm_term=0_87179e919a-8aa8a570f5-53536341&mc_cid=8aa8a570f5&mc_eid=%5bUNIQID%5d (paywall)

[5] https://worldview.stratfor.com/article/turkeys-opposition-wins-one-battle-long-war?id=87179e919a&e=4d1f592612&uuid=b40591cb-2311-498f-9714-7dc8cafc8d12&utm_source=Daily+Brief&utm_campaign=8aa8a570f5-EMAIL_CAMPAIGN_2019_04_18_11_33&utm_medium=email&utm_term=0_87179e919a-8aa8a570f5-53536341&mc_cid=8aa8a570f5&mc_eid=%5bUNIQID%5d

[6] https://www.ft.com/content/9718e75e-611d-11e9-b285-3acd5d43599e

[7] https://www.ft.com/content/0dd381e8-619f-11e9-a27a-fdd51850994c

[8] https://www.pulse.ng/news/world/turkish-defense-minister-makes-unannounced-visit-to-pentagon/dyjvpp3?utm_source=GPF+-+Paid+Newsletter&utm_campaign=a5572d5e4d-EMAIL_CAMPAIGN_2019_04_17_03_33&utm_medium=email&utm_term=0_72b76c0285-a5572d5e4d-240037177

[9] https://www.al-monitor.com/pulse/originals/2019/04/turkey-looks-trump-congress-ultimatum-s400-f35.html?utm_source=GPF+-+Paid+Newsletter&utm_campaign=a5572d5e4d-EMAIL_CAMPAIGN_2019_04_17_03_33&utm_medium=email&utm_term=0_72b76c0285-a5572d5e4d-240037177

[10] https://www.jpost.com/Middle-East/Turkey-looking-at-new-trade-mechanisms-with-Iran-to-avoid-US-sanctions-587149?utm_source=gpf+-+paid+newsletter&utm_term=0_72b76c0285-a5572d5e4d-240037177

[11] https://finance.yahoo.com/news/u-china-said-plan-more-184126954.html and https://www.wsj.com/articles/u-s-china-set-tentative-timeline-for-next-round-of-trade-talks-11555521885?mod=newsviewer_click

[12] https://www.washingtonpost.com/world/national-security/north-korea-announces-test-oftactical-guided-weapon/2019/04/17/1f27d682-615f-11e9-9412-daf3d2e67c6d_story.html?utm_term=.2c93fb773aa9&wpisrc=nl_todayworld&wpmm=1

[13] https://www.youtube.com/watch?v=7bLnNqY6Yyk

[14] https://www.reuters.com/article/us-northkorea-usa/north-korea-rejects-pompeo-from-nuclear-dialogue-kcna-idUSKCN1RU0NU

[15] https://www.foxnews.com/world/justin-trudeau-liberal-alberta-elections

[16] https://www.washingtonpost.com/world/2019/04/17/conservative-wave-threatens-canadas-trudeau/?utm_term=.b44899a4b509&wpisrc=nl_todayworld&wpmm=1

[17] https://www.bloomberg.com/news/articles/2019-04-17/growing-intolerance-and-clamor-for-jobs-dominate-indonesia-vote

[18] https://www.wsj.com/articles/herman-cain-says-he-wont-withdraw-from-consideration-for-fed-board-11555529563?mod=hp_lead_pos2

[19] https://www.politico.com/story/2019/04/17/moore-cain-fed-1280545

[20]https://www.dallasfed.org/research/economics/2019/0416?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosmarkets&stream=business

[21] https://www.axios.com/newsletters/axios-markets-ce8f9025-0bf5-4a2a-aa8d-6937a0d6fa44.html?chunk=2&utm_term=emshare#story2 see #3

[22] https://www.wsj.com/articles/libya-fighting-hits-plan-to-revive-oil-gas-industry-11555520941?mod=newsviewer_click

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Equities are trending higher in a quiet trade.  China’s economic data was solid.  Here is what we are watching:

Chinese data: GDP came in a bit better than expected, at 6.4%, but since GDP is mostly a manufactured number we expect it to always be around forecast.  Industrial production made a strong recovery; on a yearly basis, it was up 8.4%.

In fact, the “hockey stick” recovery raises questions as to the veracity of the report.  We will be watching future data for a cooling.  Fixed investment rose 6.3% in Q1, with infrastructure spending leading the growth.

Overall, the data suggest that stimulus is working to lift the economy which is good news.  There are always worries about sustainability given China’s debt levels but, for now, China’s bounce should support global growth.

Fed talk: Larry Kudlow admitted that the White House is looking at other candidates for Fed governor, acknowledging that Senate opposition may be too high to secure the nomination of either Stephen Moore or Herman Cain.[1]  We are a bit surprised the White House isn’t pressing harder for its two potential nominees.  At the same time, there are lots of doves out there that would be less controversial and almost anyone now would look less so compared to Cain and Moore.  An interesting thought comes from Steve Englander of Standard Charter:

“A conservative version of Modern Monetary Theory (MMT) could arguably work just as well as the standard progressive version and would probably support asset prices initially. This conservative version sounds like the Fed-accommodated tax cut regime that the Trump administration seems to be supporting.”

Although MMT is usually considered a tool of the left, in reality, the importance of MMT[2] is that it will give permission to policymakers to ignore the deficit.  And, as Englander postulates, it could be a tool of the right which could expand the deficit through tax cuts and defense spending and “encourage” the Fed to accommodate the spending by keeping interest rates low.  The U.S. managed WWII spending in this fashion and it was generally successful in funding the war effort.  The risk is inflation.

The key is whether the stimulus increased aggregate demand beyond the capacity of aggregate supply; when this occurs, inflation is the result.  And so, the issue is capacity.  This chart shows real GDP from 1901 on an annual basis.  We have log-transformed the data and regressed a time trend through the data.  The lower line is an approximation of how far GDP is below trend.  We have seen two periods in the last 118 years when GDP was well below trend—the Great Depression and now.  Although the trend line may not represent capacity, it is likely a reasonable guess.  If so, there is currently ample available capacity for stimulus.  And, at some point, we expect one of the political parties to accept MMT for its political goals and one shouldn’t necessarily assume it will be the Democrats that adopt it first.  In any case, the adoption of MMT will, eventually, be inflationary.  But, that “eventually” may be a lot longer than expected.

Autocrat news: In Egypt, President Abdel Fattah al-Sisi has solidified power by extending his term of office into 2030 and increasing the power of the military.[3]  In Brazil, it appears President Bolsonaro may have intervened to prevent Petrobras (PBR, 15.37) from raising prices on diesel fuel.  The company has denied the rumors, but such behavior is consistent with “strongmen.”[4]

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[1] https://www.ft.com/content/a511defe-6075-11e9-a27a-fdd51850994c?emailId=5cb6ab69e6257a00043b2c71&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[2] ICYMI, our WGR series on MMT: Part I (3/11/19); Part II (3/18/19); Part III (3/25/19); and Part IV (4/1/19).

[3] https://worldview.stratfor.com/article/egypt-constitutional-changes-enshrine-militarys-hold-power-sisi-term-limits?id=87179e919a&e=4d1f592612&uuid=0f0caba0-903c-450c-bfc2-b76e4983a4c3&utm_source=Daily+Brief&utm_campaign=63ca6bffd0-EMAIL_CAMPAIGN_2019_04_17_11_34&utm_medium=email&utm_term=0_87179e919a-63ca6bffd0-53536341&mc_cid=63ca6bffd0&mc_eid=%5bUNIQID%5d (paywall)

[4] https://www.investing.com/news/stock-market-news/petrobras-ceo-denies-government-interference-after-diesel-price-hike-canceled-1836881?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosmarkets&stream=business

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Equities are trending higher in a quiet trade.  Media is focused on the tragic Notre Dame fire.  Here is what we are watching:

Fed talk: Chicago FRB President Evans and Boston FRB President Rosengren (both voters this year) made essentially dovish statements on monetary policy.  Both suggested that inflation should be allowed to move above the 2% target since it has been below target for an extended period.[1]  For most of their tenures, both were considered to lean dovish on policy.  However, in recent years, both had become more hawkish, citing worries about easy policy causing distortions in the financial markets.  Governor Brainard has made similar indications.  Although there is theoretical support for such a policy stance (Hyman Minsky would be supportive), in practice, it’s pretty difficult to pull off.  Imagine a Fed chair going to Congress and admitting the Fed raised rates to trigger a correction in stocks because the central bank ascertained that the P/E was too high.  At the same time, we have showed that the Fed might consider equity volatility in setting policy.[2]

Since the early 1990s the Fed has tended to tighten when the Vix is below 20 (on a 12-week moving average basis).  The only time the Fed raised rates with an elevated Vix was in the late 1990s.  We note that Greenspan waited for the Vix to fall below 20 before raising rates and Yellen started raising rates after the Vix had been below 20 for a long period of time, only to stop when the Vix spiked.  The recent pause is consistent with the rising Vix, although we would note that the Vix has been declining and if it continues we would expect pressure from Rosengren, Evans and Brainard for a rate hike.  That’s why dovish comments from the Boston and Chicago FRB leaders are important and likely lifting the market today.

Trade talk: The EU and Japan are engaging in trade talks with the U.S.  The EU’s discussions look like a stall tactic; the Europeans want to conclude talks by year’s end.  By then, the U.S. presidential election process will be in full swing and EU officials know the White House will want to have talks wrapped up so the president can concentrate on reelection.  We also note that the EU refuses to open up negotiations on agriculture and wants to avoid specific measures on autos.  We doubt that U.S. negotiators will tolerate these limits.[3]  We also note that the EU is considering separate tariffs on U.S. exports, up to €20 bn, if the U.S. penalizes the EU over aircraft subsidies.[4]  Two takeaways—first, the EU plans to “slow walk” broader negotiations with hopes that either elections or a new government will relieve trade pressure, and second, the potential for a trade conflict may be falling with China but it may be rising with the EU.  The market impact would be the same—bad for risk assets.  Meanwhile, trade negotiations with Japan began yesterday.[5]  Japan wants to separate talks on goods and services from forex; we suspect Japan is quite pleased with the current level of the JPY and does not want it to strengthen toward parity, which is estimated to be around ¥60.

Shadow lending tightening: In the financial system, there are traditional banks and “shadow” banks.  Both do lending but the latter do not take in deposits.[6]  Essentially, lenders make money on the spread; either on a time spread, by borrowing short and lending long, or on credit, by borrowing low-risk liabilities and lending to riskier assets.  Traditional banks are regulated, whereas shadow banks are generally not.  At the same time, shadow banks don’t have access to the Fed’s discount window, where banks can tap funds in times of stress.  Thus, shadow lenders have two significant risks.  The first is that the flow of funding, essentially the short-term money markets (repo, for example), freezes up; this risk is heightened due to the lack of access to the Fed window.  The second is that loans stop performing.  With regard to the latter, some notable shadow lenders announced they are taking steps to reduce loan exposure on fears of economic weakness.[7]  Paradoxically, these actions can accelerate the trend toward a downturn because even if borrowing costs fall to the shadow banks reluctance to lend can end up weakening economic growth.

A political microcosm: One of the reasons we track U.K. politics is because it often offers insight into American politics.  The commonality of language and support for free markets (both nations are considered “Anglo-Saxon” by continental Europe) are likely the reasons for the similarities.  Brexit has been interesting to watch because it isn’t directly represented by a person.  Instead, it is an idea.  When a person represents an idea, the concept itself can get muddled; a voter may oppose the policy of a political figure but like his image and thus continue to support him (it can work the other way, too).  This notion relates to what American pundits refer to as the “beer test”—would a voter like to have a beer with this person.

Brexit relieves us of the personality factor.  Large political parties strive to be a “big tent”; they want to avoid clear ideological boundaries and instead project rather amorphous values.  Within political parties, there are ideologs that try to force the parties to pure positions.  The leadership of large parties try to avoid this development and keep the focus on personalities because they see that as the best way to gather a larger swath of votes.

With Brexit, the personality factor is reduced and in its place are two difference visions of state and the future.  Leavers want a singular U.K. that is provincial and nationalist; Remainers have a more cosmopolitan view of the world, one that has close ties to the EU.  Recent polling shows that the electorate is breaking down, about evenly, between leave and remain.  Regardless of who wins, the loser will be a significant minority, one that feels its vision for the country has been lost.  For example, among Labour supporters in the poorer parts of Britain, there has been a shift to the Conservatives, who are seen as leavers.  Meanwhile, Tories in London who support remaining are shifting allegiance to Labour.[8]

Brexit likely represents a reconfiguration of the two parties; Labour could become the party of the educated and moneyed class (of course, for this to happen Corbyn has to go) and the Tories could become the party of the lower working classes, sprinkled with old-line traditional nationalists from old money.  A similar mixing is likely occurring in the U.S., with the GOP rapidly becoming the party of the working class and the Democrats becoming the party of educated technocrats and Greens.

For this reason, we continue to monitor the path of Brexit not so much because of what the British exit or non-exit means but for the potential harbinger of political changes in the U.S.  We do expect that if the U.K. leaves, the short-run impact will be difficult, but in the long run it probably makes sense to go because we doubt the EU will last for another decade.  Thus, leaving early will probably be a benefit.  But, as noted, Brexit reflects political division that are becoming clearer in the U.S.   What is uncertain is how the political landscape will look in the future as these divisions are resolved.

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[1] https://www.reuters.com/article/us-usa-fed-evans/fed-should-communicate-comfort-with-slightly-higher-inflation-evans-idUSKCN1RR1U9 and https://www.wsj.com/articles/fed-official-is-open-to-adopting-an-inflation-target-range-11555372800?mod=hp_major_pos10

[2] See Asset Allocation Weekly (1/11/2019)

[3] https://www.reuters.com/article/us-usa-trade-eu/eu-says-it-is-ready-to-launch-u-s-trade-talks-but-without-agriculture-idUSKCN1RR0OZ

[4] https://www.ft.com/content/79691cea-5d37-11e9-9dde-7aedca0a081a?fbclid=IwAR0hkTgjsq6fnOxtJip7O-hLNnNl8Ubqf6NgkGOY-r46gTz43AUbgcrPQ58

[5] https://www.reuters.com/article/us-usa-trade-japan/japan-and-us-hold-frank-and-good-trade-talks-economy-minister-idUSKCN1RR2GC

[6] Most believe that traditional banks lend out deposits but, in reality, they are not much different than shadow banks in that they don’t really need deposits to make loans.  https://www.zerohedge.com/contributed/2014-03-20/bank-england-admits-loans-come-first-%E2%80%A6-and-deposits-follow

[7] https://www.reuters.com/article/us-usa-economy-online-lenders-focus/worried-a-recession-is-coming-u-s-online-lenders-reduce-risk-idUSKCN1RR0BB?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosmarkets&stream=business

[8] https://www.politico.eu/article/brexit-culture-war-in-numbers-exclusive-poll/?utm_source=POLITICO.EU&utm_campaign=809df01d25-EMAIL_CAMPAIGN_2019_04_16_04_58&utm_medium=email&utm_term=0_10959edeb5-809df01d25-190334489