[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]
[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.
(Due to the Easter holiday, our next report will be published April 29.)
The dollar is the world’s reserve currency. As such, there is a constant demand for dollars from foreign countries to provide liquidity for global transactions. Because of the reserve currency status, U.S. monetary and fiscal policy affects the world economy in ways that other nations’ policies do not. The Federal Reserve is the U.S. central bank; in its mandate, it only concerns itself with the U.S. economy unless overseas events directly affect America. In general, the Federal Reserve would not be allowed to cut U.S. interest rates to boost the Canadian economy. Fiscal policymakers almost never worry about the impact of spending or taxes on foreign economies. However, U.S. monetary and fiscal policy can affect foreign economies through access to the reserve currency and trade.
Previous reports have discussed the reserve currency role. Recent policy decisions and potential Federal Reserve governor appointments could have a dramatic impact on monetary and fiscal policy. At the same time, because of America’s superpower status and its role in providing the reserve currency, these policy actions will also impact foreign economies. The key issue is the degree to which the U.S. can use hegemony to force domestic economic adjustments on foreigners.
In Part I of this report we will review the basis of the reserve currency role and the impact of the savings identity. In Part II, we will examine the power of hegemony by historical comparison, using the Nixon and Reagan administrations as analogs. In Part III, we will examine how the Trump administration is using American power to force foreign economies to absorb at least part of the economic adjustment. Our normal analysis of potential market ramifications will conclude the third installment.
[Posted: 9:30 AM EDT] Happy Tax Day! It’s a quiet start to a short week. Here is what we are watching:
A Chinese anniversary: This is the 30th anniversary of the death of Hu Yaobang, a reformist leader in the late 1980s. Deng had supported the rise of Hu, who was implementing market reforms, to the chagrin of the traditional communist party elders. Deng appointed him general secretary in 1982. In 1987, student unrest led to him being fired from his post in January 1987 and he died two years later. His death triggered the Tiananmen Square protests in 1989 that threatened the CPC and eventually led to a harsh repression. Expect the Xi government to attempt to either quash any remembrances of Hu or only allow carefully stage-managed celebrations of this anniversary.
U.S./China trade: Treasury Secretary Mnuchin indicated that the U.S. and China are nearing the final round of concluding issues.[1] Although Mnuchin avoided discussing details of the negotiations, a few items did emerge. First, negotiators are apparently considering the possibility that the U.S. could face “repercussions” from not living up to the U.S. side of the bargain. In other words, if the U.S. fails to meet the terms of the agreement, it is possible that China could implement retaliatory actions, e.g., quotas, tariffs, etc.[2] We are somewhat surprised the U.S. would accept such a deal, even though it seems fair on the surface. We note that both Lighthizer and Navarro have argued that China has no right to retaliate with tariffs because the U.S. is simply reacting to earlier Chinse trade impediments. Thus, this concession, if true, does suggest the U.S. wants an agreement. Second, there are reports that the U.S. has also given in to China’s industrial subsidies.[3] China’s subsidies allow it to produce goods at prices below those of foreign competitors, giving it the ability to gain market share.[4] Third, one of Mnuchin’s aims, reducing the ability of foreign nations to manipulate their currencies to offset the impact of tariffs, is apparently in the agreement.[5] In theory, this position makes sense; in practice, it’s hard to execute. We continue to closely watch Lighthizer; he is a trade hawk with clear ideas on how he wants to change the U.S./China trade relationship. He will not make a deal with China for political expediency. If the White House pressures him to make an agreement he dislikes, we would not be at all surprised to see him resign.[6]
Finnish elections: The Finns went to the polls this weekend[7] and, consistent with what we have seen in the rest of Europe, the outcome showed deep divisions within Finnish society. The center-left, center-right and populist right ended the vote with a near tie. The center-left Social Democrats won 17.7% of the vote (+1.2% from 2015) and claimed 40 seats out of 200. That was a six-seat improvement. The populist right Finns Party won 17.5% of the vote (-0.2% from 2015) and 39 seats, gaining one seat. The National Coalition Party, a center-right group, took 17.0% of the vote (-1.2% from 2015) and 38 seats, a one-seat improvement. The Center party, a centrist farm party, took 13.8% of the vote (-7.3% from 2015) at 31 seats. That was a loss of 18 seats from 2011. The Greens won 11.5% of the vote (+3.0% from 2015) and 20 seats, a five-seat improvement. Finally, the Left alliance won 8.2% (+1.1% from 2015) and 16 seats, a four-seat gain. Various minor parties captured 16 seats.
There is no obvious path to 101 seats because the mainstream parties are uncomfortable with forming a government with the Finns Party. Keeping the Finns Party out of government forces a “grand coalition” structure, similar to what we’ve seen in Germany. Such governments tend to be unwieldy. We expect the process of forming a government to take weeks. But, the bigger issue remains the rise of populism and the inability of the establishment parties to successfully co-opt the movements around Europe.
More on Asian Swine Fever (ASF): As ASF continues to adversely affect the Chinese pork market, analysts are beginning to calculate the impact. China is the third largest consumer, per capita, of pork. However, due to its large population, the impact of China is massive. ASF is a deadly disease to pigs; once infected, whole herds are quickly lost. Simply put, there aren’t enough pigs in the rest of the world to offset the losses in Asia.[8] And, the effects are ongoing. The current loss of herds is curtailing future supply as farmers in China are reluctant to restart herd building. The jump in prices will tend to boost production elsewhere, but there is a natural cycle that must be accommodated.
(Source: Barchart)
The ripple effects are starting to show up in the grain markets. Until herds expand elsewhere, demand for grain will decline, especially soybeans. Complicating matters is that planting for corn will likely be delayed due to this weekend’s blizzard; the longer corn planting is delayed, the greater the likelihood that acres will shift to soybeans.[9]
Venezuela: The key to the U.S. policy of ousting Maduro is getting the military to turn on the incumbent. So far, the military has stayed loyal. Why? Most likely, Cuban intelligence operatives.[10]
The Fed:There were a number of comments on the Fed over the weekend. As we noted last week, Herman Cain’s nomination is under pressure. There is clear establishment opposition to the politicization of the Fed.[11] The president hammered on the central bank over the weekend.[12] Starting later today, we will publish the first edition in a new WGR three-part series on the interaction of the Fed on American hegemony. Essentially, it’s all about the ability of the U.S. to impose at least part of the costs of domestic economic adjustment the world. Stay tuned…
The employment data is closely watched by financial markets; although the data isn’t necessarily a leading indicator for the economy, it is probably the most important from a political and social perspective. Weak employment data is a worry for political incumbents and concerning to policymakers. However, beyond the headline data, there are usually interesting trends worth noting. In this week’s report, we will examine two trends that have longer term implications.
Career paths were part of corporate culture three decades ago. Large companies often had junior executive programs, where promising young talent was brought to the firm and would follow a rotation of positions in numerous departments before finding a permanent home. In other situations, college graduates would join a company and follow a path of positions of increasing responsibility. However, over the years, outsourcing jobs overseas and increasing industry concentration[1] have probably reduced the number of entry level professional positions in the U.S. This chart shows the percentage of production and non-supervisory workers compared to total non-farm employment.
In the 1970s, this percentage declined to a low of 66%. However, since the early 1980s, the percentage has steadily increased in each business cycle. This data suggests that an increasing number of jobs are non-management positions. We suspect that college graduates are being forced to accept non-management positions as fewer of them are available for an increasing number of graduates. Such disappointment has the potential to cause social unrest. At the same time, reversing industry concentration would tend to boost the number of management jobs in the economy (every firm needs HR, finance, etc.). Thus, support for anti-trust actions could become more popular.
Second, initial claims, on a weekly basis, fell to 40-year lows recently. However, the weekly data is “noisy” and can be affected by floating holidays and weather. Another way of looking at claims is to scale to the civilian non-institutional population. This data is at historic lows.
This low level of claims is likely due, in part, to firms holding on to workers because of tight labor conditions. A rising number of retirees will lift the non-working civilian non-institutional population but fewer workers will tend to depress claims. In any case, this level of claims compared to the population is remarkably low and would argue that wages should rise.
Overall, these two charts offer insights into longer term issues in the labor market. They won’t have an immediate effect on financial markets, but both signal potential for further disruption.
[Posted: 9:30 AM EDT] We are seeing a risk-on day. Other than this sentence, there will be no discussion of Brexit today. Here is what we are watching:
Chinese data: Bank loans rose much more than expected, with CNY 1.69 trillion extended compared to expectations of CNY 1.25 trillion. Total financing rose to CNY 2.86 trillion compared to the CNY 1.85 trillion expected. Although the data does suggest that China’s announced liquidity expansion is starting to make its way into the economy, it’s important to note that recent actions pale in comparison to what we saw in 2009-10.
The yearly growth rate of bank loans in March was 13.7%., up from 13.4% in February. This is welcome growth but not enough to boost global growth.
M2 growth remains sluggish.
Meanwhile, China’s trade surplus jumped to $55.6 bn (goods only) as exports rose 5.4% but imports fell 8.1%. The decline in imports is worrisome as this sector is usually sensitive to domestic demand. Still, the rise in the trade surplus will boost China’s GDP.
We suspect the lift we are seeing this morning in risk assets is coming from expectations of better growth in China. Although the data is showing some improvement, the growth rates are far from spectacular and the drop in imports is a concern.
Sudan: After ruling (or, perhaps, misruling) Sudan for three decades, President Omar Hassan al-Bashir has been ousted in a military coup[1] after four months of nearly continuous protests. Although al-Bashir was a brutal ruler, his regime remains in place and the ouster probably won’t end the protests. Sudan produces around 100 kbpd, but the concern is that if civil order collapses in Sudan then oil from South Sudan (about 200 kbpd) could be affected. Sudan becomes another concern for oil supply, joining Libya and Algeria. Oil prices have bounced this morning.
Cain in trouble: Four Senate Republicans have indicated they won’t support Herman Cain for Fed governor.[2] Although this news doesn’t bode well for his nomination, it doesn’t necessarily kill it either. For this number to sink Cain’s chances, all Democrats would have to reject his nomination. That might not happen. Still, if Cain is pulled, we would not be shocked to see Larry Kudlow get the nod, which would put two Trump loyalists on the Fed.
[Posted: 9:30 AM EDT] Lots of news this morning. Here is what we are watching:
Assange arrested: The Ecuadorian government has removed Julian Assange’s asylum status and he has been arrested in London.[1] We expect him to eventually be extradited to the U.S.[2] Assange is a controversial figure; Wikileaks has exposed all sorts of confidential information that governments would prefer to keep secret. His leaks seemed to take a partisan direction in the 2016 election. Thus, he has lots of enemies. It will be interesting to see how he gets prosecuted.
Central banks: Yesterday, the ECB and the Fed[3] gave us essentially dovish signals. As we noted yesterday, the ECB told the markets it has other tools to support the Eurozone economy. The Fed strongly suggested that policy would be on hold for the rest of the year. In our 2019 Outlook, we named a monetary policy error as one of the four risks facing the financial markets. It appears we can assume that this risk has been eliminated.
Mankiw Rule update: The Taylor Rule is designed to calculate the neutral policy rate given core inflation and the measure of slack in the economy. John Taylor measured slack using the difference between actual GDP and potential GDP. The Taylor Rule assumes that the Fed should have an inflation target in its policy and should try to generate enough economic activity to maintain an economy near full utilization. The rule will generate an estimate of the neutral policy rate; in theory, if the current fed funds target is below the calculated rate then the central bank should raise rates. Greg Mankiw, a former chair of the Council of Economic Advisers in the Bush White House and current Harvard professor, developed a similar measure that substitutes the unemployment rate for the difficult-to-observe potential GDP measure.
We have taken the original Mankiw rule and created three other variations. Specifically, our models use core CPI and either the unemployment rate, the employment/population ratio, involuntary part-time employment or yearly wage growth for non-supervisory workers. All four compare inflation and some measure of slack. Here is the most recent data:
This month, all the models are showing a drop in the estimated target rate. Three of the models would still suggest the FOMC is behind the curve and needs to be increasing the policy rate. However, the employment /population ratio implies a rather high level of slack in the economy and would suggest the Fed has already lifted rates more than necessary. Given the uncertainty in the economy, coupled with political pressure, we expect the FOMC to remain on the sidelines.
Brexit: As has been the case during this whole event, the extension was a compromise. Macron wanted a very short extension as did PM May. Most of the EU wanted to extend the deadline up to a year. They split the difference, with the deadline being moved to October 31 (we suspect the irony was lost on the participants).[4] The U.K. will participate in European elections, although the EMPs won’t necessarily stay very long.
So, the good news is that, just maybe, we won’t have to talk about Brexit every day for a while. Still, the whole process (or lack thereof) has been painful to watch and perhaps all of it has missed the real issue. Those of us who live in democracies have become habituated to the notion that compromise is possible on every point of contention.[5] To some extent, that is what makes democracy work. The American founders created a divided government that would foster compromise. But, there are some issues for which compromise probably isn’t possible. Slavery turned out to be one; that was resolved through war. The two-state solution in Israel probably isn’t workable because both parties claim the same land as theirs. With Brexit, there really isn’t a workable middle ground. All the solutions that avoid a hard break put the U.K. in a less advantageous position than it would have been by simply remaining within the EU. So, the real decision is to either stay or leave abruptly. From an economic standpoint, it is hard to see how the U.K. will be better off with a hard break, but socially and politically it might be. It is natural for politicians to try to find a middling solution that would give most of the benefits of being in the EU, while satisfying those who want to leave. However, that natural inclination is probably not bringing us closer to a resolution. Polls suggest the U.K. public is closely divided on leaving.[6] This problem may lead to another referendum but, even if the results are reversed, the British public will remain divided. From a market perspective, in the short run, staying in the EU is the better option. In the long run, it isn’t as clear cut; if Germany doesn’t accept the role of regional hegemon and start absorbing EU domestic demand (in the form of a trade deficit), then the EU could devolve and therefore leaving early might have its advantages.
In light of this news, the financial markets are mostly unchanged. The EU does one thing really well—it delays hard decisions. It would not surprise us to see another delay around Halloween. So, the financial markets are assuming the status quo continues. It’s probably the right call.
Trade news: There are reports that the U.S. and China are planning to create enforcement offices to monitor any trade agreements.[7] Although this doesn’t eliminate all the potential sticking points, it does resolve an important one.
Cain in trouble: Although the Trump administration hasn’t completed the vetting process for Herman Cain’s nomination for the Fed, Senators Romney (R-UT), Murkowski (R-AK) and Gardner (R-CO) have announced they won’t support his nomination. Assuming all Democrats oppose his nomination, the loss of one more Republican will doom his chances. Interestingly enough, the controversy surrounding Cain has reduced opposition to Stephen Moore. If Cain fails, we would not be surprised to see Larry Kudlow get the nod.
Dalai Lama hospitalized: The Dalai Lama is in a New Delhi hospital with a chest infection.[8] Although his condition is considered good, the news does raise questions about his succession. The CPC has always considered the Dalai Lama a threat because he represents a power that the party can’t control. China has consistently indicated it wants to approve the next Dalai Lama, which means the Buddhist designation process would be subsumed under the Chinese state.[9]
Australian elections: Australia will hold elections on May 18.[10] Current polls suggest that Labor is favored 53% to 47% in a two-party race, but the Liberal-National Coalition (conservative incumbent government) holds a small lead in a multi-party race.[11]
Energy update: Crude oil inventories rose 7.0 mb last week compared to the forecast rise of 2.5 mb.
In the details, refining activity rose 1.1%, near expectations. Estimated U.S. production was unchanged at 12.2 mbpd. Crude oil imports fell 0.2 mbpd, while exports fell 0.4 mbpd.
(Sources: DOE, CIM)
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 over the next two weeks.
Refinery activity is still lagging average.
(Sources: DOE, CIM)
Usually by this week we are seeing utilization above 90%. Given the 7.2 mb decline in gasoline stocks, we would look for rising utilization in the coming weeks.
Based on oil inventories alone, fair value for crude oil is $55.33. Based on the EUR, fair value is $51.99. Using both independent variables, a more complete way of looking at the data, fair value is $52.27. Current prices are running well above fair value. Geopolitical risks, including the unrest in Libya, continued problems in Iraq, falling Venezuelan output[12] and the upcoming decision on Iranian oil export waivers, are lifting prices. However, our data does suggest the markets are getting a bit rich, so evidence that any of these situations are improving will likely lead to a pullback in prices.
[Posted: 9:30 AM EDT] It’s a very quiet morning in front of some important news today. Brexit, the ECB meeting and Fed minutes are all on tap this morning. Here is what we are watching:
ECB: The ECB has pushed the first rate hike into next year (and it will be unlikely even then). Other than that, everything else remains unchanged. The ECB is in a difficult spot. The EU economy is clearly slowing, but with its policy rate already negative it’s not clear if additional cuts will help. And, new aggressive actions might have a “whiff of panic.” In the press conference, ECB President Draghi intimated that the central bank has policy tools to ease further; the markets are taking his comments as dovish as the EUR has weakened.
Brexit: PM May has met with French President Macron and German Chancellor Merkel. The EU intends to offer a long extension, to perhaps the end of the year or the end of Q1 2020, with the option of leaving before the deadline if a deal is reached.[1] The EU wants a longer deadline because it doesn’t want another year of monthly cliffhangers. This is a nightmare outcome for the Brexit crowd; the longer the break is delayed, the more likely it is that the U.K. never leaves. At the same time, it’s hard to see how PM May can stick around with such a long deadline. However, she is nothing if not tenacious and because she has already won a leadership vote the Tories are sort of stuck with her until December.
Fed minutes: There will be great interest in seeing any comments on how policy reversed, but given the sanitized nature of this report we doubt any real insight will emerge. We will have to wait until 2024 when the actual transcripts are released to hear what really happened. The other item of interest is the FOMC’s adjustment of its inflation target policy. Vice Chair Clarida suggested in discussions yesterday that the Fed might allow inflation to run above target for a period if it had been below target previously.[2] This policy change would allow the Fed to be more dovish and signal to markets that breaking the 2% target would not necessarily mean an immediate move to tighten. In early June, the Fed will hold a conference in Chicago on the inflation targeting issue.
China/EU summit: By all accounts, China caved to EU demands.[3] The agreement[4] pretty much gave the EU everything it asked for, including meetings on human rights, reductions in industrial subsidies[5] and reduced technology transfers.[6] Although diplomats are lauding the meeting as a “win-win,” in reality, the EU was prepared to exit the meeting due to the lack of progress.[7] China could not afford a two-front war on trade and thus the EU likely benefited from the difficult U.S./China trade negotiations.
The IMF and trade: Yesterday, we noted that the IMF had lowered global growth estimates. The fund noted that one of the uncertainties surrounding the forecast was trade policy. What the world is struggling to understand is that the U.S. is fundamentally changing its trade policy. This may be the biggest change in U.S. trade policy since Nixon closed the gold window and ended the Bretton Woods system. The Nixon administration faced an external accounts problem. By closing the gold window and floating the dollar, Nixon forced the adjustment on foreign nations. However, the cost was inflation. Under Reagan and his successors, the U.S. position was shifted to open trade to weaken inflation. Thus, globalization was supported to contain prices. Trump is shifting this policy to reduce the external balance but, unlike Nixon, he is mostly using tariffs[8] instead of dollar weakness (Nixon also used tariffs but mostly relied on currency depreciation). However, we expect the current administration to eventually seek dollar weakness. A significant way to weaken the dollar is to undermine the perception of Fed independence; the proposals to add Herman Cain and Stephen Moore could be related to this goal.[9] Nixon also undermined Fed independence in a public campaign to embarrass Fed Chair Burns. Even if Cain and Moore are not appointed,[10] the die has already been cast. If the president gives up on both, he can more easily appoint conventional doves (current Fed Presidents Bullard and Kashkari would be my recommendation) to the open governor positions. This outcome would not meet Trump’s aim of loyalty, but it would give him the same outcome without the drama.
Oil news: Uncertainty surrounding Libya remains elevated as General Hifter continues to move on Tripoli.[11] While we would not be surprised to see Hifter gain control of the capital, his actions will probably not stabilize oil production as militia groups continue to operate despite Hifter’s march on the western parts of Libya. Meanwhile, Iraqi oil output unexpectedly fell[12] and Venezuelan output plunged 0.5 mbpd in March to 960 kbpd. All this news is supportive for oil prices.
Israel elections: Although the two major right-wing party groups each won 35 seats in the Knesset,[13] it appears PM Netanyahu will be able to put together a government.[14] This will make him the longest serving PM in Israel’s history.
A conflict with Italy? Italy has raised its deficit/GDP projections on forecasts of weaker economic growth.[15] The EU is apparently not taking this news well and is making noise about rejecting Rome’s spending plans.[16] We don’t expect the EU to follow through but a conflict with Italy will further boost populism in Europe. In addition, fiscal expansion is exactly what the EU needs so punishing Italy is counterproductive.
[Posted: 9:30 AM EDT] It’s a very quiet morning in front of Brexit deadlines. The only economic news of note was weak Chinese car sales (-12.7% in March). Here is what we are watching:
BREAKING NEWS: Italy reduces its GDP forecast to 0.1% from 1.0% this year. This action will increase its deficit/GDP ratio. The IMF lowered its world GDP growth forecast for 2019 to 3.3% from 3.5%, which was a bigger decline than forecast.
Brexit: PM May is on the continent to ask for an extension.[1] She wants to stay in the EU until the end of May. There are some in the EU that want to give her a flexible extension[2] for a year, but allow the U.K. to leave sooner if a deal is reached. May is reluctant to accept a long delay as it will be seen by Tory Brexit supporters as a delay with no end.[3] Meanwhile, talks between May and Corbyn[4] continue on the idea of a customs union with the EU.[5] A customs union has its own problems (it would prevent the U.K. from striking deals on tariffs with the rest of the world, for example), but, politically, it would only pass with a subset of MP votes from Labour and the Conservatives. This could split both parties and lead to a political realignment. Another complicating issue is that if the U.K. stays past mid-May it will need to participate in EU elections, which is something the hardline Brexit supporters loathe.[6]
There are probably four potential outcomes this week. The most likely is a short delay with promises of extensions. We doubt a workable deal can emerge from Parliament and we don’t expect the EU to force the U.K. out of the EU.[7] A long delay is the second most likely result. But, in any case, a hard Brexit is the least likely outcome, which is reflected in the financial markets. The GBP remains steady despite all the uncertainty.
China/EU summit: Meetings between the two sides begin tomorrow. Talks have taken on an air of urgency as the EU has become increasingly hostile toward Beijing. We suspect European leaders are seeing two major threats from China. First, China is using its Belt and Road project to divide Europe. Italy’s recent decision to sign a memo of understanding highlights this risk. Second, China is moving up the value chain and ruthlessly using state power to dominate industries and using direct purchases of European companies to favor Chinese supply chains.[8] China is framing the dispute as the EU following Washington’s lead,[9] but the reality is that Europe has discovered China is becoming a geopolitical rival to the U.S. and it has no good response.
EU tariffs? The Trump administration is considering $11 bn in tariffs on EU goods.[10] This proposal is partly in response to a WTO ruling that EU aircraft subsidies harmed U.S. interests.[11]
Oil news: India is delaying its purchases of Iranian oil, awaiting U.S. decisions on sanctions waivers.[12] Frackers are using production methods that boost production quickly but also dissipate wells rapidly. This is leading to faster depletion rates and excess output of associated natural gas.[13] The faster depletion rates mean drilling must continue at a rapid pace just to keep production steady. If investment begins to decline, oil supplies could tighten further and support oil prices.
China v. bitcoin: Chinese officials are considering banning bitcoin mining.[14] China is the world’s largest producer of technology designed to mine bitcoins but the National Development and Reform Commission (NDRC) argued that the mining itself is wasteful and should not be permitted. We have wondered for a while why China would permit such activities; bitcoin has become the vehicle of choice for criminal activity and would be a currency outside of state control. The position of the NDRC would seem to be more consistent with the degree of social and political control the Xi government supports.
Tech regulation: The U.K. is considering a measure that would penalize social media firms for allowing harmful content to be posted on their platforms.[15] Although the rules would only apply to the U.K., they could become the basis for regulation in other countries. If it becomes law, it would force the social media platforms to more systematically police its user-posted content and dramatically increase its cost of doing business. The U.K. regulation could be part of more regulatory actions in other nations.[16]
Chart du jour (plus one): Although equity values continue to trend higher, retail investors are still shying away from stocks.
This chart shows the S&P 500 with retail money market funds as measured by ICI. In 2007, money market funds rose rapidly as the real estate crisis unfolded. This area, shown in gray, coincided with market weakness. The decline in money market funds coincided with the beginning of the current bull market. We have also placed orange areas on the chart that show periods when money market fund levels fell below $920 bn. Equities tended to stall during these times. Since mid-2017, we have seen a steady rise in money market funds and levels rose above $1.0 trillion in early 2018, which also ushered in a period of broad consolidation. The pattern in retail money market funds is similar to what was seen during the panic in 2005-08.
The recent rally in equities does not appear to be supported by falling retail money market levels.[17] Company buybacks are thought to be supporting equities.[18] Still, without the return of retail investors, it is difficult to see how this rally could extend much further. We note that flows into equities in the form of mutual funds and ETFs have been mostly negative since the middle of last year.
Note that flows were negative in 2016 but reversed rapidly as the Fed delayed policy tightening. If we see a similar pattern this year, a challenge of 3000 on the S&P is quite possible.
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