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

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