by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] As we bid goodbye to April, there’s a new emperor in Japan and the IS leader re-emerges.  China’s PMI data (see below) came in a bit light.[1]  On the other hand, Europe’s GDP came in better than expected.[2]  Here is what we are watching:

Spanish elections, some thoughts: The center-left has struggled in Europe recently, so the improved fortunes in Spain have raised some hopes of a recovery.  Here is what we noticed.  First, a key factor in the Socialists’ resurgence was a fracture on the right.  The center-right lost votes to Vox, the hard-right anti-immigrant party.[3]  Centrist parties have struggled with the rise of populism in recent years; for example, in Germany, the AfD has made strides against the CDU and has been pulling the CDU in a rightward direction.  The Popular Party in Spain tried to hold on by moving to the right but the gambit failed.  The Socialists were better able to maintain solidarity, mostly by suggesting that not voting for the center-left was implicit support for Vox.[4]  The problem is that this outcome was probably unique to Spain and may have been an accident of timing and may not be repeatable.  In other words, there doesn’t appear to be anything magical about what Sanchez did to win; he may have simply gotten lucky.  Second, Sanchez did offer a more leftist platform, calling for a reversal of austerity and a higher minimum wage.  So, in essence, his win was due to the right fracturing and a shift to more populist positions.  Without the first, the second probably wouldn’t have mattered.

The return of Baghdadi: The leader of Islamic State (which, in reality, no longer exists) was seen in a video released by the group yesterday.  This is the first time in five years that he has been seen in this format.  Although there have been rumors of his demise, he appears to be on this side of the earthly pale.[5]  IS has lost its caliphate, but it is rapidly becoming a global terrorist organization, similar to al Qaeda.[6]  This will require different tactics compared to attacking a specific land target; look for the same strategies that were used against al Qaeda to be applied here, such as tracking money flows and counterterrorist activities.

Infrastructure?  Senate Minority Leader Schumer and Speaker Pelosi are scheduled to meet with President Trump to discuss infrastructure.[7]  Although infrastructure spending is attractive in the abstract, we haven’t seen much action on this issue because the two parties are divided on their methods of achieving public investment.  Initially, the administration wanted public/private partnerships to fund infrastructure spending.  Unfortunately, opportunities for large projects with such mechanisms are limited because a steady stream of revenue must be generated in order for them to work.  Much of public investment does not generate direct cash flows.  President Trump is said to favor direct public investment as do Pelosi and Schumer.[8]  However, the latter want to force the president to raise taxes to fund the project, which is a non-starter as 2020 looms.  In addition, Trump’s position is at odds with GOP legislators, who want to spend less, not more, especially with the debt ceiling looming in the fall.[9]  So, we expect a lot of media coverage but see little chance of progress.

Oil bounce: Oil prices are lifting today on reports that Saudi Arabia wants to extend production cuts into year-end.[10]  Meanwhile, Iran has indicated it will ignore U.S. sanctions and continue to export oil by evading such measures.[11]

A peace accord between Kosovo and Serbia: Two decades after a conflict that led to the separation of Kosovo from Serbia, the two sides are nearing an accord in which the latter will formally recognize the existence of the former.[12]  If a deal can be reached, it would create conditions where Serbia could potentially join the EU.  It would also mean Serbia no longer blocks Kosovo from joining the UN.  Still, a deal isn’t certain.  To make it work, there may need to be a swap of land, which is fraught with risk.[13]  And, Russia would not be keen on Serbia joining the EU and perhaps being pulled from its orbit.

Equities and flows: Although equity markets continue to grind higher, flows from investors continue to move in the opposite direction.  Lipper reports that both equity ETFs and mutual funds reported outflows last week, while fixed income enjoyed new flows.[14]

Reflections on serial defaulters:There are some nations that engage in sovereign defaults on a seemingly regular basis.  Argentina is the most notable but isn’t alone.  Early in my career,[15] I worked as a country risk analyst and had a front row seat to the latter stages of the Latin American debt workout.  I was part of a massive debt/equity swap program that saw my commercial bank shed hundreds of millions of non-performing sovereign loans.  As the process wound down, I remember thinking that these defaulters would be denied access to the credit markets for decades.  Yet, in less than five years, most of them were borrowing again.  Although I had chalked up that development to P.T. Barnum’s observation that “a sucker is born every minute,” it turns out there is good reason to invest in the “borrow, default, return” cycle.  A recent paper by Josefin Meyer, Carmen Reinhart and Christoph Trebesch supports the idea that it is profitable to lend to serial defaulters.[16]  However, as one would expect, such lending carries much higher risk.[17]  The trick is to get a return commensurate with the risk, which usually means putting money in the country when it is in its most dire state.

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[1] https://www.reuters.com/article/us-china-economy-pmi-manufacturing-offic/china-april-factory-growth-unexpectedly-slows-as-economy-struggles-for-traction-idUSKCN1S602V?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosmarkets&stream=business

[2] https://www.theguardian.com/business/live/2019/apr/30/eurozone-gdp-french-economy-grows-by-03-business-live

[3] https://www.ft.com/content/237a0924-6a2b-11e9-a9a5-351eeaef6d84?wpisrc=nl_todayworld&wpmm=1

[4] https://www.theguardian.com/commentisfree/2019/apr/29/far-right-podemos-spain-socialists-vox?wpisrc=nl_todayworld&wpmm=1

[5] https://www.washingtonpost.com/world/middle_east/isis-leader-baghdadi-appears-in-a-video-for-the-first-time-in-five-years/2019/04/29/a82611d4-6a9b-11e9-bbe7-1c798fb80536_story.html?utm_term=.77707b2c1321&wpisrc=nl_todayworld&wpmm=1

[6] https://foreignpolicy.com/2019/04/29/the-post-caliphate-caliph/?wpmm=1&wpisrc=nl_todayworld

[7] https://finance.yahoo.com/news/us-chamber-fixing-infrastructure-could-turbocharge-economy-185433052.html

[8] https://www.washingtonpost.com/powerpost/amid-oversight-clash-democrats-pitch-trump-on-big-and-bold-infrastructure-bill/2019/04/29/596b6ede-6a98-11e9-8f44-e8d8bb1df986_story.html?utm_term=.61303d5a877e

[9] https://thehill.com/homenews/senate/441066-trump-on-collision-course-with-mcconnell-on-spending

[10] https://www.reuters.com/article/us-global-oil/oil-prices-firm-as-saudi-arabia-says-opec-may-extend-supply-cuts-idUSKCN1S6022

[11] https://www.reuters.com/article/us-usa-iran-oil/iran-to-keep-exporting-crude-oil-despite-u-s-pressure-iran-president-idUSKCN1S60B1

[12] https://www.nytimes.com/2019/04/29/world/europe/kosovo-serbia.html?emc=edit_MBE_p_20190430&nl=morning-briefing&nlid=5677267tion%3DtopNews&section=topNews&te=1

[13] https://www.nytimes.com/2018/09/19/world/europe/kosovo-partition-aleksandar-vucic.html?emc=edit_MBE_p_20190430&module=inline&nl=morning-briefing&nlid=5677267&section=topNews&te=1

[14] http://lipperalpha.refinitiv.com/2019/04/lipper-u-s-weekly-fundflows-insight-report-funds-take-in-net-new-money-paced-by-bond-funds/?utm_source=Eloqua&utm_medium=email&utm_campaign=00008DM_NewsletterLipperAlphaInsightFundInsightsWeekly_Other&utm_content=Newsletter_FundsWeekly_29April2019&elqTrackId=f87f2ba465fc44cfa3d39db1a68f9097&elq=bb3eb132bdcc4a4fa627db4af3d8d2f6&elqaid=46161&elqat=1&elqCampaignId=166&stream=business

[15] Obviously, this is referencing Bill, not Thomas.

[16] http://papers.nber.org/tmp/3712-w25543.pdf

[17] https://ftalphaville.ft.com/2019/04/30/1556614127000/Why-investors-keep-coming-back-to-Argentina/

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy Monday!  It was a cold weekend in the Midwest, with a late April snow for the upper parts of the nation’s midsection.  It’s going to be a busy week, with the FOMC meeting and Japan’s Emperor Akihito taking the rare step of abdication tomorrow.[1]  Here is what we are watching:

Spanish elections: Pedro Sanchez’s Socialist Party had a good election, a rarity for center-left parties in the West.  Although the Socialists will still need to build a coalition government, the party did take 123 of the 350 seats in the Spanish Parliament; that was up from 85 seats in the last government.  The center-right opposition Popular Party took 66 seats.  The centrist Ciudadanos won 57 seats, and the hard-left Podemos won 42 seats.[2]  Vox, the right-wing populist party, took a surprising 24 seats, the best performance for a hard-right party in Spain since 1982.[3]  It will still take weeks for Sanchez to form a government, but there isn’t another alternative to a return of his government.  The election is supportive for the Eurozone and the EU as it shows that a centrist party can still win elections in the region.

Fed: The FOMC meets this week.  There will be talk of an “insurance cut,” a rate reduction to “ensure” the expansion continues.  This won’t happen on Wednesday but expect the chair to be noncommittal on this issue in the press conference.  There are no dots or new forecasts at this meeting but, consistent with the Fed’s new policy, there will be a press conference.  The key issue for the FOMC is falling inflation.[4]  Chicago FRB President Evans suggested that inflation around 1.5% could trigger a rate cut.[5]  Although the insurance cut and rate reductions due to inflation will likely dominate the discussion, we would not expect a move this week.  In fact, with the early June summit on the inflation mandate, we probably won’t see a rate move before that meeting unless the economic data turns decidedly bad or a financial accident occurs.

China trade talks: Talks resume this week in Beijing as negotiators near an agreement.[6]  Still, there are difficult issues that remain to be worked out,[7] with enforcement of the agreement one of the areas that remains unresolved.[8]  It does appear President Trump and General Secretary Xi are planning a June signing ceremony in the U.S.[9]  The financial markets have mostly discounted an agreement with China, although we would not be surprised to see further gains if a deal is completed.

Japan trade talks: Although President Trump has expressed some optimism that a Japan/U.S. trade deal may be coming soon, PM Abe has refused a key component of U.S. demands, an end to agricultural tariffs.[10]  Abe faces local elections later this year and giving in on agriculture would put Abe’s party at risk.  Paradoxically, Abe did consume a significant amount of political capital to reduce agricultural tariffs as part of TPP.  Thus, the other nations in the agreement now have better access to Japan’s agricultural markets compared to the U.S., which refused to join the agreement.[11]

Growing tensions in the South China Sea: The U.S. has put China on notice that it will no longer tolerate aggressive actions at sea by China’s fishing fleet and its coast guard.[12]  China has been expanding its power in the region by using these two factors to expand its influence.  Traditionally, navies have less aggressive terms of engagement with non-military vessels.  China has used this practice to its advantage, using the coast guard and fishing fleet to project power.  By putting out this notice, the U.S. Navy is signaling to China that the U.S. will treat fishing vessels and coast guard ships with the same protocol as official Chinese naval vessels.  We also note that the U.S. sent two warships through the Taiwan Strait yesterday as a show of force.[13]

Iran oil sanctions: The Trump administration is holding fast to its position on Iranian oil waivers, indicating that a hard stop will be enforced on May 1.  In other words, there will be no grace period for winding down transactions with Iran.[14]  Meanwhile, President Trump has renewed his call for OPEC to boost production to offset the loss of Iranian crude.[15]

African Swine Fever: There are reports that the deadly African Swine Fever[16] has moved into North Korea.[17]  The virus, which does not directly affect humans, is deadly for pigs, with a very high fatality rate.  It has already adversely affected China’s massive pork industry and reports indicate it may be in Eastern Europe as well.[18]  It hasn’t been reported in the U.S. yet, but agriculture security officials are very concerned about the virus entering North America at some point.  The virus is a bearish factor for grains but has sent pork prices soaring.

Is a sacred cow on the block?  A decade ago, Germany implemented a fiscal rule that makes it nearly impossible for the country to run fiscal deficits.  This decision, coupled with high private sector net saving, has led to Germany running a massive trade surplus.  At long last, it appears there may be some cracks developing in support of the fiscal rule.[19]  The rule has curtailed public investment and Germany’s infrastructure has suffered over the 10 years it has been in place.  Germany needs to bend on this issue.  Its economy has become very dependent on exports.

On the above chart, we have put a vertical line representing the onset of the fiscal law.  Since implemented, the trade surplus has continued to increase.[20]  Germany’s current account surplus represents about 7.5% of its GDP, one of the highest in the world.  Expanding its fiscal deficit should reduce that surplus and boost growth for the rest of the Eurozone.

S&P on Italy:Standard and Poor’s left everything unchanged by maintaining the BBB rating on Italy’s sovereign debt along with the negative outlook.  So, the good news is that a crisis was averted; the bad news is that nothing has been resolved.

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[1] https://www.nbcnews.com/news/world/japan-s-revolutionary-emperor-akihito-abdicate-leaving-imposing-legacy-his-n997971?wpisrc=nl_todayworld&wpmm=1

[2] https://www.washingtonpost.com/world/europe/spain-goes-to-the-polls-in-contentious-snap-election/2019/04/28/553266c7-6e27-4ee6-b91d-2dbebe69ca9a_story.html?utm_term=.cbbeb63402b4&wpisrc=nl_todayworld&wpmm=1

[3] https://www.politico.eu/article/spains-socialists-set-to-win-election-without-majority-poll/?utm_source=POLITICO.EU&utm_campaign=f67bb6c46b-EMAIL_CAMPAIGN_2019_04_29_04_46&utm_medium=email&utm_term=0_10959edeb5-f67bb6c46b-190334489

[4] https://www.ft.com/content/9ba361de-6913-11e9-80c7-60ee53e6681d

[5] https://www.chicagofed.org/publications/speeches/2019/risk-management-and-the-credibility-of-monetary-policy

[6] https://www.nytimes.com/2019/04/28/us/politics/mnuchin-china-us-trade-negotiations.html?action=click&module=Top%20Stories&pgtype=Homepage

[7] https://finance.yahoo.com/news/u-china-talks-resume-significant-014443281.html

[8] https://www.reuters.com/article/us-usa-trade-china-analysis/as-trade-talks-reach-endgame-u-s-china-ties-could-hinge-on-enforcement-idUSKCN1S50DE

[9] https://www.scmp.com/economy/china-economy/article/3007835/chinese-president-xi-jinping-could-travel-us-sign-trade-deal

[10] https://www.ft.com/content/6ae28e80-698b-11e9-80c7-60ee53e6681d?shareType=nongift

[11] https://news.yahoo.com/abe-trudeau-extol-pacific-trade-pact-without-us-202032288.html;_ylt=A0geKVXkD8ZcQQwAcwljmolQ;_ylu=X3oDMTByMjB0aG5zBGNvbG8DYmYxBHBvcwMxBHZ0aWQDBHNlYwNzYw–?wpisrc=nl_todayworld&wpmm=1

[12] https://www.ft.com/content/ab4b1602-696a-11e9-80c7-60ee53e6681d?shareType=nongift

[13] https://www.reuters.com/article/us-usa-taiwan-china-military/two-us-navy-warships-sail-through-strategic-taiwan-strait-idUSKCN1S5003

[14] https://www.reuters.com/article/us-usa-iran-sanctions/no-wind-down-for-china-on-stopping-its-iran-oil-buys-trump-officials-idUSKCN1S2238

[15] https://www.cnbc.com/2019/04/29/oil-market-trump-opec-output-us-iran-oil-sanctions-in-focus.html

[16] https://www.wsj.com/articles/inside-chinas-battle-to-contain-deadly-swine-fever-11556193605

[17] https://www.dailynk.com/english/north-korea-appears-to-have-outbreak-of-african-swine-fever/

[18]https://www.avma.org/News/JAVMANews/Pages/190515a.aspx?mode=mobile&utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axioschina&stream=top

[19] https://www.ft.com/content/fff17750-65c8-11e9-a79d-04f350474d62?shareType=nongift

[20] For reference, gross exports represent about 12% of U.S. GDP.

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s GDP day!  We cover the numbers in detail below, but our quick take is that the data was much stronger than expected, coming in at 3.2%, well above the +2.3% forecast.  Here is what we are watching:

Disappointing Japan: Although inflation was modestly higher than expected, the decline in industrial production was unsettling.

This chart shows the yearly change in industrial production.  The gray bars indicate recessions in Japan.  Although March’s decline of -4.6% isn’t necessarily a clear signal of an impending downturn in Japan, any further weakness increases the odds that the country is entering a downturn.

S&P on Italy: Standard and Poor’s is expected to issue an update on its BBB rating on Italy’s sovereign debt.  In October, the rating agency maintained this rating, just above “junk,” but also indicated it had a negative outlook for the country.  Although we would be surprised to see S&P cut Italy below investment grade, such an action isn’t out of the question and would lead to significant market turmoil.[1]

Weaker global trade: Global trade volumes fell at their fastest pace since May 2009, when the world economy was still reeling from the global financial crisis.  The current downturn reflects weak global growth but also rising trade tensions.[2]

Spanish elections: Spain’s voters go to the polls on Sunday for what will likely be an inconclusive election.[3]  Although the current PM, Pedro Sanchez, is expected to remain in power, it may take weeks of coalition-building before a government will form.  Until recently, Spain was a stable two-party system, with a center-left and center-right party holding court.  But, this stability has fractured over separatism (Catalonia, Basque) and economic issues.[4]  All eyes will be on a newly emerged hard-right party, Vox, which has been rising in the polls.  Vox is expected to receive around 10% of the vote.[5]

China trade talks: There are numerous reports that President Trump and Chairman Xi are planning to meet soon to finalize a trade agreement.[6]  Chairman Xi is expected to travel to the U.S. for the signing ceremony.  China has been worried about last-minute changes to the agreement at the time the leaders meet, so we expect the meeting won’t take place without solid guarantees that such changes won’t occur.

OBR: Chairman Xi promised that “one belt, one road” financing will be less onerous in the future and that corruption concerns will be addressed.[7]  The plan is also looking for financing from third parties, suggesting that China may be having second thoughts about the credit risk it is undertaking.

Brexit: Talks with Labour are apparently going nowhere and PM May has pulled her exit program from a vote.[8]  It looks like the U.K. will still be part of the EU for the upcoming European Parliament elections next month, much to the chagrin of all involved.  Although we don’t expect anything to happen in the near term, it is looking increasingly as if all parties will drift into October without a deal and a hard break is becoming more likely.

Japan and monetary policy: Treasury Secretary Mnuchin has made it a point during trade negotiations to include restrictions on currency depreciation.  His concerns are well founded—one of the reasons that tariffs became less common was that in a floating currency environment countries could easily offset the impact of tariffs through currency depreciation.  Comments about a return to the gold standard by some Fed governor candidates is, in part, tied to this issue.  Therefore, we noticed with interest that Japan’s Finance Minister, Taro Aso, indicated Japan would not consider tying monetary policy to current trade discussions.

There was a seemingly unspoken arrangement among central bankers that unorthodox monetary policy, e.g., negative rates, zero rates, quantitative easing, would only be tolerated if the express purpose was for domestic economic support but not for competitive depreciation.  In reality, those practices tended to bring currency weakness.

Since 2010, the dollar was tightly correlated with the yearly change in the Fed’s balance sheet.  During QE, there was widespread criticism of the practice, especially by emerging economy central bankers, fearing the U.S. was forcing adjustment on their economies through the weaker dollar.

Taro’s comment is important; if the U.S. begins to press foreign nations to abandon unconventional monetary practices due to their effects on foreign exchange, it will severely restrict these nations’ abilities to conduct independent monetary policy.  Of course, the whole point of the gold standard was to place some degree of restriction on the actions of central bankers and governments.  That’s why we don’t expect a return to such a program, and it should be noted that returning to a gold standard would, at some point, lead to deflation.

We expect the Trump administration to eventually realize that the most important tool it has available is a weaker dollar.  Such a deliberate policy would likely need some degree of Fed cooperation but, given how aggressive the president has been with the Fed, cooperation could likely be delivered.  Like Reagan in his first term, there was a seeming problem with the idea of “weakness” in any policy; however, as we saw with the Plaza Accord in the second term, policy can change.  If the goal is reflation, a weaker dollar is a useful tool.

Crypto in trouble: The NY attorney general has made allegations against two firms, Tether and Bitfinex, alleging they participated in a cover-up to hide losses up to $850 mm.  Both firms have been under scrutiny for some time but if the legal process moves forward then it will likely undermine the entire cryptocurrency complex.[9]

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[1] https://www.ft.com/content/f4332b06-6754-11e9-9adc-98bf1d35a056

[2] https://www.bloomberg.com/news/articles/2019-04-25/world-trade-volumes-are-plunging-at-the-fastest-pace-in-a-decade?srnd=markets-vp

[3] https://www.ft.com/content/819e8bf2-60fc-11e9-a27a-fdd51850994c?emailId=5cc2732bcebaf800044b27c0&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[4] https://www.theguardian.com/world/2019/apr/23/spains-general-election-2019-all-you-need-to-know?wpisrc=nl_todayworld&wpmm=1

[5] https://www.politico.eu/article/spain-far-right-big-vox-question/?utm_source=POLITICO.EU&utm_campaign=d6791399e0-EMAIL_CAMPAIGN_2019_04_26_04_31&utm_medium=email&utm_term=0_10959edeb5-d6791399e0-190334489

[6] https://www.nytimes.com/2019/04/25/us/politics/trump-xi-jinping-trade.html https://www.scmp.com/economy/china-economy/article/3007835/chinese-president-xi-jinping-could-travel-us-sign-trade-deal

[7] https://www.wsj.com/articles/chinas-xi-vows-new-direction-for-belt-and-road-after-criticism-11556249652?mod=hp_lead_pos4

[8] https://www.ft.com/content/3bac82bc-6768-11e9-9adc-98bf1d35a056?emailId=5cc2732bcebaf800044b27c0&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[9] https://finance.yahoo.com/news/bitfinex-operator-accused-n-y-223953580.html

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s another mostly quiet morning as a plethora of earnings are released.  Here is what we are watching:

South Korea goes negative: Real GDP slipped into negative territory in Q1.

Weak investment spending led to the unexpected slowdown.  Although exports were weak, on a net basis, they were offset by soft imports as well.  The decline in South Korean growth is further evidence of a global slowdown.

Central bank news: The BOJ left policy unchanged[1] despite lowering growth and inflation forecasts for 2020.  Its primary response to the downgrade was forward guidance, indicating it would not consider raising rates until next year.  At the same time, Governor Kuroda signaled that no new stimulus measures would be considered.  The PBOC indicated that policy is on hold, responding to speculation that additional easing is coming.[2]  The BOE is beginning the process of selecting a new governor.[3]  Carney will be leaving his post next February.  Carney has been controversial, angering Brexit supporters by forecasting an economic downturn if the U.K. leaves the EU without a trade arrangement.  Although not in today’s news, ECB President Draghi will leave office in the fall and we expect that EU leaders will announce his successor in June.  From a market perspective, the key is “anyone other than Jens Weidmann” of the Bundesbank.  Weidmann is considered an extreme hawk and would be less likely to support unconventional policy if the Eurozone runs into debt issues.[4]  If he gets the nod (and Berlin is thought to be supporting him in this role) we would expect at least a temporary jump in the EUR.

OBR: The “one belt, one road” foreign investment program (or, as we like to refer to it, “the Chinese imperial project”) is holding meetings in Beijing at the Belt and Road Forum.  Dozens of nations have sent representatives to the meeting, indicating the interest in gaining access to Chinese infrastructure funding.  China is taking steps at this meeting to address criticism that the projects saddle countries with high debt.[5]  The U.S. has not moved strongly against the project yet, but it clearly has the attention of Washington.

Turkey: The central bank dropped references to further policy tightening and admitted that currency reserves fell $1.8 bn last week.  Although official foreign reserves are $26.9 bn, if drawn swap lines are removed, reserves are closer to $14.9 bn.  In February, Turkey’s goods and services imports were around $16 bn, so Turkey is in a precarious position without swaps.  At the same time, it’s important to note that Turkey sits in a geopolitically sensitive area.  It can likely “encourage” EU support by “discussing” the flow of refugees, and can play the West off Russian or Iranian influence.  We are always worried that Erdogan will overplay his leverage but that doesn’t mean the leverage doesn’t exist.

Argentina: Unlike Turkey, Argentina sits at the end of the world.  It isn’t geopolitically important and thus has to fend for itself.  Borrowing costs have jumped and credit default swaps have reached 1200 bps, making it the world’s second most risky sovereign borrower (with Venezuela in the top spot).  Remember that century bond issued in 2017?[6]  It’s trading at 70 cents to the dollar.[7]  The Macri government announced a price freeze on 60 items in a bid to bring inflation under control.  Spooking investors are the looming elections on October 27 and the increasing likelihood that the infamous Kirchners will return to power.  The latest polls indicate that Cristina Kirchner holds a four-point lead over the incumbent.  The Argentine peso has been under pressure.

Brexit: The leadership challenge against PM May failed.[8]  There is no evidence of progress on talks with Labour.  However, a major looming threat did emerge to the U.K. as Scotland’s First Minister Sturgeon indicated she will take steps to hold another referendum on leaving the U.K. if Brexit occurs.[9]  We suspect this one might pass.

Putin’s trash problem: The late congressional leader Tip O’Neill was credited with the quote that “all politics is local.”  No matter how powerful the office, basic public goods must be provided by officeholders.  Mayors in major U.S. cities have lost elections over potholes and snow removal.  In Russia, protests have broken out against the creation and expansion of open-air landfills, which are estimated to be four times the size of the island of Cyprus.[10]  Although we doubt this will bring down the government, as noted above, other politicians have fallen from power for less.

GDP: The first report of Q1 GDP will be released tomorrow.  Here is the Atlanta Fed estimate.

The current forecast is for 2.8% growth.  The Bloomberg consensus is for 2.2% growth.  Here are the Atlanta FRB’s contributions to growth estimates.  Inventory rebuilding and improved net exports have lifted their growth estimates over the quarter.

Energy update:  Crude oil inventories rose 5.5 mb last week compared to the forecast rise of 0.5 mb.

In the details, refining activity jumped 2.4%, well above the 0.9% increase that was forecast.  Estimated U.S. production rose slightly by 0.1 mbpd to 12.2 mbpd.  Crude oil imports surged 1.2 mbpd, while exports rose 0.3 mbpd.

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

Refinery activity recovered strongly this week.

Had it not been for the rise in imports, we would have likely seen a decline in inventory levels.

Based on oil inventories alone, fair value for crude oil is $53.98.  Based on the EUR, fair value is $52.22.  Using both independent variables, a more complete way of looking at the data, fair value is $51.91.  This is one of those rare circumstances when the combined model fair value does not lie between the estimates from the two single-variable models.

Current prices are running well above fair value.  Geopolitical risks, including the unrest in Libya, continued problems in Iraq and the end of Iranian oil export waivers, are lifting prices.  However, our data does suggest that the markets are getting a bit rich and evidence that any of these situations are improving will likely lead to at least a period of consolidation, if not a pullback, in prices.  We note that some Russian crude oil has been rejected by refineries due to contamination.[11]  Given tight supply conditions, such news is important and has lifted prices this morning.

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[1] https://finance.yahoo.com/news/boj-gives-first-timeframe-super-065221925.html

[2] https://www.reuters.com/article/us-china-economy-policy/china-central-bank-has-no-intent-to-tighten-or-relax-monetary-policy-vice-governor-idUSKCN1S10A6

[3] https://www.ft.com/content/f084bc74-6653-11e9-a79d-04f350474d62?emailId=5cc1298dc5f9c30004ff5d1e&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[4] https://foreignpolicy.com/2018/03/08/the-most-dangerous-man-in-europe-is-jens-weidmann/

[5] https://www.ft.com/content/f7442058-66f9-11e9-9adc-98bf1d35a056?emailId=5cc1298dc5f9c30004ff5d1e&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[6] https://www.cnbc.com/2017/06/20/argentina-sees-strong-demand-for-surprise-100-year-bond.html

[7] https://www.ft.com/content/2fcfc230-66c6-11e9-a79d-04f350474d62

[8] https://www.ft.com/content/c844299e-66ac-11e9-9adc-98bf1d35a056?emailId=5cc1298dc5f9c30004ff5d1e&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[9] https://www.nytimes.com/2019/04/24/world/europe/scotland-independence-referendum-brexit.html?emc=edit_MBE_p_20190425&nl=morning-briefing&nlid=5677267ion%3DwhatElse&section=whatElse&te=1

[10] https://www.politico.eu/article/vladimir-putin-garbage-problem-russia-landfills/?utm_source=POLITICO.EU&utm_campaign=5fe066dd05-EMAIL_CAMPAIGN_2019_04_25_04_53&utm_medium=email&utm_term=0_10959edeb5-5fe066dd05-190334489

[11] https://www.themoscowtimes.com/2019/04/25/germany-poland-halt-oil-imports-from-russia-over-quality-concerns-a65377

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