by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] The U.S./North Korea summit ended abruptly as the leaders reached an impasse.  We are seeing some modest flight to safety market action.  Here is what we are watching this morning:

The summit abruptly ends: The two sides reached an impasse.  North Korea was willing to shut down its Yongbyon nuclear complex but wanted a full sanctions lift.  The U.S. was willing to lift sanctions but only if North Korea ended its nuclear production, gave up all its existing warheads and closed other nuclear sites the U.S. has discovered.[1]

We admit to being surprised at how the meeting ended.  It seems that continuing to talk and go through the motions of ceremony, even with the same result, would have helped maintain relations.  At the same time, once it becomes clear there is no room for further discussion it does make sense to simply back away.  Market reaction was mostly centered in Asia, with South Korean markets[2] taking a dive and the KRW depreciating.  Other Asian markets weakened as well.

One other takeaway of note is that it seemed President Trump really wanted a deal.  In fact, there were worries he would cave to a weak agreement just to make an agreement.  The fact that he walked away from talks does indicate he won’t be taken.  This had to be noticed in Beijing.  If the president was willing to turn away from these discussions, perhaps he might do the same thing with Chinese negotiations.  Was this a deliberate plan?  We doubt it.  The president’s style is to improvise, so we think it’s more likely he figured out a deal wasn’t forthcoming and determined leaving made more sense.  But, if he discovers this move affects China’s viewpoint, expect him to play it up.  On this note, USTR Lighthizer outlined a deal in testimony yesterday where the U.S. will place tariff “triggers” on China to force compliance.  Although the histories of such arrangements are spotty (a good example is the exercise the Treasury performs twice a year to determine if nations are manipulating their currencies—although such manipulation is common, it is rarely enforced), it remains to be seen whether Chairman Xi would agree to such a regime.[3]

India v. Pakistan: There are actions being taken to reduce tensions.  Pakistan has indicated it will return the captured pilot.[4]  However, there are persistent reports of sporadic clashes along the frontier.  As we noted yesterday, Pakistan has been isolated after the attack in Kashmir and thus has an interest in de-escalation.

Brexit: It is looking increasingly likely that Brexit will be delayed.  On March 12, Parliament will vote again on PM May’s deal.  Given that it lost in historic fashion earlier this month it will likely fail again.  The next day, Parliament will vote on whether it supports a hard Brexit.  That is unlikely as well.  On the 14^th, a third vote supporting an extension of the deadline will be before legislators.  That will almost certainly pass (if the two earlier votes are rejected, it is the only logical conclusion).[5]

Here is the latest data from PredictIt on exit.

The question is whether the U.K. will leave the EU on March 29.  Note that this decision market hasn’t been above 50 cents since late last year.  Essentially, the markets have been expecting a delay, which explains why the GBP hasn’t fallen.

European news: The ECB looks poised to move its stance toward easier policy as Eurozone growth slows.[6]  Spain’s former PM Rajoy testified against Catalan separatists yesterday, indicating the separatists bear responsibility for the violence and deaths that occurred in last year’s protests.[7]  Greece’s creditors, displeased with the pace of reforms in Greece, may not participate in the country’s first private post-crisis funding.[8]

Energy update: Crude oil inventories fell 8.6 mb last week compared to the forecast rise of 3.0 mb.

In the details, estimated U.S. production rose 0.1 mbpd, reaching a new record of 12.1 mbpd.  Crude oil imports plunged by 1.6 mbpd, while exports fell 0.2 mbpd.  Refinery runs rose 1.2% compared to the forecast of unchanged.

This is the seasonal pattern chart for commercial crude oil inventories.  We would expect to see a steady increase in inventories that will peak in early May; the pattern coincides with refinery maintenance.  Last week’s large decline is an anomaly and is very bullish for oil prices.  The unexpected drop in inventories was partially due to an early rise in refinery operations, although the increase isn’t far out of seasonal norms.  But, the slide in imports was a shocker.

The above chart is the four-week average of crude oil imports.  The data shows a sudden decline in crude oil imports even with the data being smoothed.

This chart shows the top five foreign suppliers of U.S. crude oil since early 2017.  The data is on a four-week average basis.  Note that we saw a sharp drop in Canadian crude oil imports, which will probably be reversed at some point.  However, there has also been a profound decline in imports from Saudi Arabia.  Since Q4, imports have declined by half.  That drop reflects Saudi oil policy and will not be reversed anytime soon.  We also point out that Venezuelan imports have also declined but the level isn’t all that large.  Overall, the drop in Saudi imports “moved the needle.”

Based on oil inventories alone, fair value for crude oil is $58.71.  Based on the EUR, fair value is $54.03.  Using both independent variables, a more complete way of looking at the data, fair value is $54.90.  By all these measures, current oil prices are roughly in the area of fair value.  This week’s drop in crude oil inventories was a shocker and probably won’t be repeated, but it also likely means that we won’t see the usual seasonal build in crude oil stocks, either.  Thus, it improves the odds that prices hold their current levels into spring.

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[1] https://www.washingtonpost.com/politics/trump-and-kim-downplay-expectations-as-key-summit-talks-begin/2019/02/28/d77d752c-3ac5-11e9-aaae-69364b2ed137_story.html?utm_term=.206117d9e980&wpisrc=nl_politics&wpmm=1 and https://www.ft.com/content/752d339c-3af4-11e9-b72b-2c7f526ca5d0

[2] https://www.ft.com/content/7c75cda0-3b15-11e9-b72b-2c7f526ca5d0

[3] https://www.politico.com/story/2019/02/27/china-trade-deal-lighthizer-1222220

[4] https://www.reuters.com/article/us-india-kashmir/trump-hints-at-de-escalation-between-india-and-pakistan-as-u-s-mediates-idUSKCN1QG0IR and https://www.scmp.com/news/asia/south-asia/article/2188087/kashmir-conflict-pakistan-willing-return-captured-indian-pilot

[5] https://www.ft.com/content/7d973c06-39c5-11e9-b72b-2c7f526ca5d0 and https://www.washingtonpost.com/business/economy/trump-trade-official-says-a-us-china-deal-wont-fix-all-of-beijings-anti-trade-policies/2019/02/27/aeb569b0-3a11-11e9-aaae-69364b2ed137_story.html?utm_term=.102b4b94f888

[6] https://www.ft.com/content/ca008578-35f8-11e9-bd3a-8b2a211d90d5

[7] https://www.nytimes.com/2019/02/27/world/europe/spain-rajoy-testimony-catalan-separatists.html?emc=edit_mbe_20190228&nl=morning-briefing-europe&nlid=567726720190228&te=1

[8] https://www.wsj.com/articles/greeces-creditors-threaten-to-withhold-first-post-bailout-funding-11551289224

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] There is an escalation between India and Pakistan, and a summit in Hanoi.  Futures markets suffered a technical glitch and stopped trading for several hours overnight.[1]  Here is what we are watching this morning:

India v. Pakistan: There has been an escalation of tensions between India and Pakistan.  During the past week, over 40 Indian paramilitary operatives were killed by militants in the disputed Kashmir region.  The militants are thought to be supported by Pakistan.  India responded with an aerial attack into Pakistani territory; it isn’t clear how effective the attack was, but it showed that the India Air Force could penetrate Pakistani air space without much trouble.  However, this morning, Pakistan claims it shot down two Indian fighters and apparently has one of the pilots in custody.[2]  Tensions between the two countries are nothing new.  Periodic clashes occur with great frequency.  There is always a concern about these clashes because both nations possess nuclear weapons and can likely deliver them.

We don’t think this current situation will escalate;[3] neither do the markets, otherwise we would be seeing flight to safety buying in gold, the dollar and Treasuries.  But, that doesn’t mean this situation isn’t instructive.  One interesting trend is that Islamabad isn’t getting support from anyone.  The U.S. has offered support to India[4] as has the EU.[5]  Even China, perhaps Pakistan’s closest ally, instructed both sides to restrain themselves.[6]  Simply put, the developed world is against the use of stateless proxies for policy goals; they can’t be completely controlled and offer the sponsoring nation a degree of deniability that makes them dangerous.

We wonder if these attacks were not tied to the upcoming Indian elections.  The brass in Pakistan likely prefer PM Modi as a foil.  He has been struggling against an insurgent Congress Party and the military in Islamabad could fear that a Modi loss would deescalate tensions between the two nations and undermine the support for defense spending.  By giving Modi a crisis, he gets to look like a leader and it may boost his reelection chances.

The summit meeting: President Trump and Dear Respected Comrade Kim are meeting in Hanoi today.  We do not expect any breakthroughs, although the outlines of a deal are emerging.  We suspect Trump would allow North Korea to keep its nuclear program in return for giving up its ICBMs.  This would make North Korea a nuclear threat to its near neighbors but not to the lower 48 (however, the range of North Korea’s intermediate-range missiles would include Alaska and Guam).[7]  Although one can see the logic in Trump’s position if this does become U.S. policy, it could trigger a regional nuclear arms race by prompting Japan, which is a threshold nuclear state, to develop its own deterrent.  At the same time, moving to normalize relations with North Korea will unsettle Beijing, which has used the Hermit Kingdom as a buffer state.  If the U.S. and North Korea develop better relations, China will be displeased.

Brexit: There isn’t a whole lot new to report, but there is some background on why PM May has reversed her position.  The government has ascertained that both the public and private sectors are woefully underprepared to sever relations with the EU and the economy would almost certainly suffer a nasty disruption if a break were to occur at the end of March.[8]  Votes on her plan or an extension will ensue next month and the odds that her plan gets more support are increasing as Brexiteers are beginning to realize that a hard Brexit isn’t going to be allowed to transpire.  Instead, the vote on March 12 is becoming a choice between May’s deal and indefinite delay.  Faced with that prospect, Brexit supporters may grudgingly decide that May’s plan is better than no exit.

Another interesting bit of information has emerged on the EU/U.K. post-agreement talks.  Apparently, EU bureaucrats sit in on the meetings and write confidential minutes to distribute to member nations.  As often happens, these summaries have leaked and confirm what we have long suspected—nothing happens in these meetings.[9]  The EU isn’t going to change anything and thus the U.K. will need to act if an adjustment is going to occur.

Powell to Capitol Hill: Chair Powell went to Capitol Hill.  There were no real surprises.  He gave ample reasons why policy will remain on pause, which was clearly telegraphed by other statements and speeches.[10]  He did warn of the fiscal deficit, but this has been a nearly constant theme of Fed chairs for decades.  After all, fiscal expansion can complicate monetary policy; if the former leads to an overheated economy then the Fed has to play the role of spoiler and tighten monetary policy.  Nevertheless, there is no inflationary evidence that current deficits are a problem.

Nigerian elections: Incumbent President Buhari has apparently won reelection in a poll that was marred with violence and a low turnout.[11]  We recently profiled these elections in a WGR.[12]  As we noted in our report, it is unlikely the opposition will accept the results peacefully, which may support oil prices.

Zarif resigns, Rouhani rejects: Iran’s foreign minister, Javad Zarif, offered to resign earlier this week.[13]  President Rouhani refused to accept the resignation.[14]  So, for now, Zarif will remain at his post.

League wins again: As we noted yesterday, the Five-Star Movement took a drubbing in local elections in Abruzzo over the weekend.  The votes are now in from local elections in Sardinia with the same result.  Right-wing populism is on the rise in Italy.  The leadership of the Five-Star Movement put on a brave face[15] regarding these losses, but if this trend continues the party will be doomed, at best, to junior partnership within the coalition.

A cyber counterattack: The U.S. military confirmed that it disrupted the internet access of a Russian troll farm[16] as a signal to Russia that the U.S. is not without the capacity to retaliate against cyberattacks.  We would not view this as a major disruption but more of a warning to Moscow.

A threat to tech: The Federal Trade Commission has created a task force to examine competition in the online platform industry.[17]  There has been growing concern about the acquisitive nature of some of these firms and this body could build a case for anti-trust action.[18]

Confirming our suspicions:A recent study[19] shows that only Germany and the Netherlands benefited significantly from joining the Eurozone.  Italy has fared the worst.  We have concluded that the Eurozone has essentially allowed Germany to treat the rest of the Eurozone as colonies, creating conditions that forced other nations to absorb its imports by expanding their debt burden.  This study mostly confirms that notion, although we were surprised that the Netherlands also prospered.  This is why we believe that, at some point, either the Eurozone will break up or Germany will have to play the role of benevolent hegemon and become a net importer (we think the first is the more likely outcome).

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[1] https://www.ft.com/content/73279334-3a32-11e9-b72b-2c7f526ca5d0?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[2] https://www.ndtv.com/india-news/air-force-pilot-missing-pakistan-claims-hes-in-their-custody-we-are-ascertaining-claims-government-2000101

[3] https://www.nytimes.com/2019/02/26/world/asia/india-pakistan-kashmir-airstrikes.html?wpisrc=nl_todayworld&wpmm=1

[4] https://www.hindustantimes.com/world-news/we-support-india-s-right-to-self-defense-us-nsa-john-bolton-to-ajit-doval/story-uuvWwXJLRm51B4Px4xU0gK.html?wpisrc=nl_todayworld&wpmm=1 and https://www.ft.com/content/329e95fe-3a39-11e9-b72b-2c7f526ca5d0?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[5] https://twitter.com/tanvi_madan/status/1100431568441614337?wpisrc=nl_todayworld&wpmm=1

[6] https://theprint.in/opinion/the-factivist/india-has-called-pakistans-nuclear-bluff-again-but-modi-cannot-become-complacent/198346/amp/?__twitter_impression=true&wpisrc=nl_todayworld&wpmm=1

[7] https://thediplomat.com/2018/05/we-need-to-talk-about-north-koreas-intermediate-range-ballistic-missiles/

[8] https://www.ft.com/content/7d973c06-39c5-11e9-b72b-2c7f526ca5d0?emailId=5c76210b18880800041f4764&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22 and https://www.ft.com/content/fe7faba2-39e1-11e9-b856-5404d3811663?emailId=5c76210b18880800041f4764&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[9] https://www.nytimes.com/2019/02/26/world/europe/brexit-theresa-may-brussels.html?emc=edit_mbe_20190227&nl=morning-briefing-europe&nlid=567726720190227&te=1

[10] https://www.ft.com/content/9fb7ffc2-39d0-11e9-b856-5404d3811663?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[11] https://www.bbc.com/news/world-africa-47380663

[12] See WGR, The Nigerian Election (2/11/2019).

[13] https://www.nytimes.com/2019/02/25/world/middleeast/javid-zarif-resigns.html?emc=edit_mbe_20190226&nl=morning-briefing-europe&nlid=567726720190226&te=1 ; https://www.apnews.com/08cb7394544947f5aa0459a2fb99fcd7?utm_source=POLITICO.EU&utm_campaign=6c8db1e66d-EMAIL_CAMPAIGN_2019_02_26_05_51&utm_medium=email&utm_term=0_10959edeb5-6c8db1e66d-190334489 ; https://www.wsj.com/articles/irans-foreign-minister-resigns-in-an-instagram-post-11551128482

[14] https://www.aljazeera.com/news/2019/02/iran-rouhani-rejects-top-diplomat-zarif-resignation-190226152426950.html?utm_source=Eurasia+Group+Signal&utm_campaign=80438cd2d4-EMAIL_CAMPAIGN_2019_02_27_12_23&utm_medium=email&utm_term=0_e605619869-80438cd2d4-134308033

[15] https://www.ft.com/content/2dc730be-39d9-11e9-b856-5404d3811663?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[16] https://www.washingtonpost.com/world/national-security/us-cyber-command-operation-disrupted-internet-access-of-russian-troll-factory-on-day-of-2018-midterms/2019/02/26/1827fc9e-36d6-11e9-af5b-b51b7ff322e9_story.html?utm_term=.70944d2e0996&wpisrc=nl_todayworld&wpmm=1

[17] https://www.ft.com/content/2801ced2-39f7-11e9-b856-5404d3811663?emailId=5c76210b18880800041f4764&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[18] https://www.ftc.gov/tips-advice/competition-guidance/guide-antitrust-laws

[19] https://www.cep.eu/fileadmin/user_upload/cep.eu/Studien/20_Jahre_Euro_-_Gewinner_und_Verlierer/cepStudy_20_years_Euro_-_Winners_and_Losers.pdf

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Equities are taking a breather this morning in a news heavy environment.  Here is what we are watching this morning:

Brexit: The drama continues.  PM May met with her cabinet this morning and will support a vote on delaying Brexit past the March 29 deadline[1] and another vote that would not allow a hard (no deal) Brexit.[2]  Meanwhile, opposition leader Corbyn has reversed his earlier positon and will back a second referendum.[3]  In fact, a number of Labour leaders have indicated they will support a Remain position (Labour, like the Tories, are divided on Brexit).  May opposes extending the deadline; we suspect her support for these measures is designed to push Brexit supporters into adopting her plan as the best alternative to no Brexit.  The votes are seen by the market as lessening the odds of a hard Brexit; the GBP rallied on the news.  We will likely have votes on these issues in the next day or so.

Powell to Capitol Hill: Chair Powell will visit the capitol for his semi-annual congressional testimony.[4]  We doubt new ground on monetary policy will be established; the FOMC is on pause and will likely remain so as the economy goes through a soft patch.  We would expect regulation to be a topic of interest, with left-wing political figures pressing the chair on macro prudential issues.  Expect lots of coverage but nothing market moving.

Here is an interesting chart that might help explain why the FOMC decided to pause:

This chart shows U.S. core CPI along with China’s PPI, both on a yearly change basis, starting with China’s entrance into the WTO.  Although not a perfect correlation, it does suggest that, with a bit more than a five-quarter lead, China’s producer prices affect U.S. core CPI.  The recent drop in China’s PPI would signal that price pressure in the U.S. should dissipate in the coming months and give the FOMC room to keep policy steady.

The administration’s decision to delay additional tariffs on China may have also affected monetary policy.[5]  A paper by the San Francisco FRB suggests that the second round of tariffs could have boosted personal consumption prices by 0.4% and business investment costs by 1.4%.[6]  So, the delay gives Powell additional reasons to be patient.

Zarif turns in his resignation: Iran’s foreign minister, Javad Zarif, has offered to resign from his position.[7]  It isn’t clear why he resigned or if President Rouhani will accept the resignation.  Zarif was the lead negotiator of the Iran nuclear deal and has come under pressure from Iranian hardliners for negotiating the deal in the first place.  At the same time, he is schooled in Western diplomacy and if Iran’s plan is to hope President Trump is defeated in 2020 (and assuming a Democratic president would want to revive the nuclear agreement) then keeping Zarif in government would make more sense.  If Rouhani accepts the resignation it would be a signal that Iran has given up hope that the nuclear deal will return even with a change in government in Washington.  We expect Rouhani to turn down the offer; by resigning and having his offer refused, one would expect the pressure from hardliners to dissipate.  In other words, Zarif may be bluffing.

Trade: We have been expecting the administration to accept a lesser trade deal with China to avoid the economic dislocation that broader trade conflict might bring.  After all, the 2020 elections are not all that far away.  We have noted that hardliners in the administration, Navarro and Lighthizer, might balk at a lesser deal and could resign.  However, this isn’t the only area of political pressure.  Democrats are also pressing the administration to push back on China.  It isn’t clear if this is an ideological position or simply supporting the “right” policy that would also harm the president’s reelection chances.[8]

Venezuela: VP Pence met with South American leaders yesterday to shore up support to isolate the Maduro regime.[9]  Pence also announced additional sanctions on Venezuela and promised additional measures would be coming soon from the Treasury Department.[10]  So far, the military remains aligned with Maduro; we suspect U.S. sanctions will be designed to reduce cash flows to the military in hopes that fears of pauperism might lead the brass to change sides.

Trump on oil: Yesterday, we noted that the president called for OPEC to increase production and reduce oil prices; futures prices dropped on the news.  OPEC has responded by saying it will maintain and likely extend current production cuts.[11]

League wins:We are watching Italian politics closely because its current coalition is the rare mix of both left- and right-wing populists, a “Nader coalition.”  We have noted recently that the alliance is fraying as the Five-Star Movement, the left-wing of the coalition, has been losing favor.  Regional elections held yesterday are continuing that trend.  In the election in Abruzzo, the League doubled its share compared to the region’s vote in the last general election, while the Five-Star Movement saw its share drop in half.[12]  If current trends continue, we expect the League, the right-wing side of the current arrangement, to eventually end its pairing with the Five-Star Movement and join with the center-right to form a new coalition.  Although the Nader coalition remains theoretically possible, in nature it is difficult to manage given the wide divisions between left- and right-wing populists on social issues.  What remains to be seen is whether the center-right would control policy in a right-wing coalition or if the League would gain the upper hand.

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[1] https://www.ft.com/content/3875b900-3901-11e9-b72b-2c7f526ca5d0

[2] https://www.reuters.com/article/us-britain-eu/theresa-may-buckles-british-pm-to-rule-out-no-deal-brexit-the-sun-idUSKCN1QF0LZ

[3] https://www.ft.com/content/028b90ca-3925-11e9-b856-5404d3811663 and https://www.nytimes.com/2019/02/25/world/europe/Jeremy-Corbyn-brexit-referendum.html

[4] https://finance.yahoo.com/news/fed-chair-powell-senate-testimony-184449926.html

[5] https://www.wsj.com/articles/trumps-retreat-on-tariffs-may-help-keep-inflation-pressure-at-bay-report-says-11551130832

[6] https://www.frbsf.org/economic-research/publications/economic-letter/2019/february/inflationary-effects-of-trade-disputes-with-china/?mod=article_inline

[7] https://www.nytimes.com/2019/02/25/world/middleeast/javid-zarif-resigns.html?emc=edit_mbe_20190226&nl=morning-briefing-europe&nlid=567726720190226&te=1 ; https://www.apnews.com/08cb7394544947f5aa0459a2fb99fcd7?utm_source=POLITICO.EU&utm_campaign=6c8db1e66d-EMAIL_CAMPAIGN_2019_02_26_05_51&utm_medium=email&utm_term=0_10959edeb5-6c8db1e66d-190334489 ; https://www.wsj.com/articles/irans-foreign-minister-resigns-in-an-instagram-post-11551128482

[8] https://www.nytimes.com/2019/02/25/us/politics/china-trump-trade-deal-democrats.html

[9] https://www.ft.com/content/3722d028-393e-11e9-b72b-2c7f526ca5d0?emailId=5c74b26254742a0004f1e257&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[10] https://www.nytimes.com/2019/02/25/world/americas/pence-guaido-venezuela-colombia.html?emc=edit_mbe_20190226&nl=morning-briefing-europe&nlid=567726720190226&te=1

[11] https://www.wsj.com/articles/saudis-likely-to-push-to-maintain-opec-output-cuts-despite-u-s-pressure-11551117577

[12] https://www.politico.eu/article/right-wing-parties-set-to-win-regional-italian-election-projections/?utm_source=POLITICO.EU&utm_campaign=6c8db1e66d-EMAIL_CAMPAIGN_2019_02_26_05_51&utm_medium=email&utm_term=0_10959edeb5-6c8db1e66d-190334489

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s a risk-on day with China’s equities on a tear.  Here is what we are watching this morning:

It’s official—tariffs are delayed: Although anyone paying attention would not be surprised by this outcome, President Trump confirmed that the next round of tariffs on China will be delayed.[1]  Citing “substantial progress” on intellectual property and technology transfer, the president tweeted that a delay would be implemented.  The delay means that $200 bn of Chinese goods will not, for the time being, see a tariff hike from 10% to 25%.  Before this announcement, there was some concern about what appeared to be an open conflict between USTR Lighthizer and the president over the issue of the memorandums of understanding (MOU).  The president seemed to be indicating that the MOUs didn’t matter whereas Lighthizer views them as the structure of the trade agreement.  Since the administration isn’t planning a formal trade agreement (which would require congressional approval), the MOUs are the deal.[2]  The tiff between the president and the USTR is probably more about form than substance; the White House is arguing that the president was merely indicating he wanted a longer term agreement and seemed to misunderstand what an MOU meant.  The reason we highlight this discussion is because we view Lighthizer’s tenure at the administration as critical.  If he concludes that he is being impeded by the president from getting a substantive agreement because the White House needs a pre-election “win,” then we believe the USTR will resign.  Thus, the friction may be a sign of underlying tensions on this potential division.

So, despite what appeared to be an obvious direction in these talks, financial markets liked the delay in tariffs.  We note that although U.S. markets are stronger this morning, Chinese equities jumped,[3] suggesting less optimism outside the U.S.  Our positon remains unchanged—we will get a deal with China on trade but not the deal.[4]

Venezuela: The weekend ended in a stalemate.  The aid massed at the Venezuelan frontier mostly stayed out of the country.  There was significant violence and growing talks about outside intervention.[5]  We are not sure what outside intervention would look like; if an invasion is decided, we suspect the U.S. would want to lead a multilateral force that would unseat Maduro.  Getting Maduro out is probably doable; stabilizing the country is another matter.  The best way out would be for the military to turn on Maduro but, so far, that hasn’t happened.

Brexit: The drama continues.  PM May is delaying her final vote on her program until March 12[6] in a clear bid to push close to the deadline and bring Brexit supporters to her plan.  Meanwhile, later this week, Parliament will vote on a new plan that would preclude a hard Brexit.  An earlier plan failed but given how May is using the deadline to improve the odds of her arrangement, it might just pass this time.  At the same time, the EU has countered with a proposal to delay Britain’s exit by up to 21 months if a deal isn’t done.[7]  We suspect the EU is putting this long delay out there as a way to scare Brexiteers that if they don’t take May’s deal then it won’t mean hard Brexit but an eternal limbo of delay.  A long delay would be bullish for the GBP and would increase the odds of avoiding a hard Brexit.

Trump on oil: The president is calling for lower oil prices; futures prices dropped on the news.

The president has been sensitive to the impact of oil prices on political popularity, although the impact of energy prices on consumer confidence is modest at best.  He is pressing OPEC to boost output.  We suspect, unlike what we saw last autumn, the cartel won’t help him this time.  In the fall, the White House pressed OPEC to increase production to offset Iranian sanctions.  However, the U.S. granted numerous countries waivers on Iranian purchases, leading to oversupply and a sharp drop in prices.  We doubt OPEC will heed the call of Washington this time around.  Thus, the drop today probably won’t hold.  In addition, we note that Mexico’s oil production has fallen to a three-decade low, which is reducing supply.[8]

The economy: The Chicago FRB released its National Activity Index today.  It’s one of our favorite indices, giving us a broad monthly look at the economy.  As the report below shows, the data isn’t pretty.  We smooth the data in the chart below to account for monthly volatility, but the report is a concern.  We note the Atlanta FRB’s GDPNow report is projecting a 1.4% increase in GDP for Q4.

Here is the contribution table:

The mid-month data on retail sales, industrial production and durable goods lowered personal consumption expenditures by about 75 bps.  Falling inventories reduced it earlier by another nearly 30 bps.  We would expect Q1 to be soft as well; the FOMC’s pause appears to be well timed.

The Fed: We are in the midst of a generational change in policy management.  The 1970s were a period when the Fed accommodated inflation impulses to support full employment.  The Volcker reformation led to a focus on inflation reduction and the management of inflation expectations.  Now, there is a rethink going on at the central bank in light of the breakdown of the Phillips Curve model.[9]  New ideas include moving to an inflation target that is less fixated on short-term increases above target to targeting inflation over a longer period, which would allow for inflation “overshoots.”[10]

And, it’s not just the Fed.  We are seeing an inflation rethink across the economy.  The emergence of Modern Monetary Theory, which explicitly uses inflation to guide fiscal policy, is a sign that policymakers are thinking more broadly on deficits.  An op-ed in the NYT over the weekend suggests that deficits may not matter much anymore.[11]  Even Warren Buffet has backed down on deficits.[12]  This looks to us like the early stirrings of reflation.  In the short run, this turn won’t matter all that much but the past four decades of steadily falling inflation, falling interest rates and rising equity multiples may not be duplicated over the next four decades if this trend continues.

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[1] https://www.wsj.com/articles/trump-to-delay-tariff-increases-on-chinese-imports-11551050187

[2] https://www.wsj.com/articles/officials-play-down-appearance-of-rift-between-trump-and-lighthizer-on-trade-11550974778

[3] https://www.ft.com/content/981da9c0-38ad-11e9-b72b-2c7f526ca5d0?emailId=5c737d6f8dee5d00047bf15c&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[4] https://www.scmp.com/news/china/diplomacy/article/2187578/cautious-optimism-beijing-us-china-trade-deal and https://www.ft.com/content/8abe631c-389b-11e9-b72b-2c7f526ca5d0?emailId=5c737d6f8dee5d00047bf15c&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[5] https://www.ft.com/content/e11a3f30-383f-11e9-b856-5404d3811663?emailId=5c737d6f8dee5d00047bf15c&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22 and https://www.wsj.com/articles/venezuela-opposition-calls-for-consideration-of-force-against-regime-11551040222

[6] https://www.ft.com/content/ac3aedc8-382b-11e9-b72b-2c7f526ca5d0?emailId=5c737d6f8dee5d00047bf15c&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[7] https://www.bloomberg.com/news/articles/2019-02-24/eu-is-said-to-mull-idea-of-proposing-brexit-extension-to-2021

[8] https://www.reuters.com/article/us-mexico-oil-pemex/mexicos-pemex-crude-output-lowest-since-records-began-idUSKCN1QC00E

[9] https://www.stlouisfed.org/from-the-president/video-appearances/2019/bullard-cnbc-inflation-monetary-policy?utm_source=twitter&utm_medium=SM&utm_content=stlouisfed&utm_campaign=faf2b8b8-21c3-41a8-aded-4ac0fcea8dba&stream=business

[10] https://www.wsj.com/articles/fed-embarks-on-a-rethink-of-its-inflation-target-11551016801

[11] https://www.nytimes.com/2019/02/23/upshot/how-america-learned-to-stop-worrying-and-love-deficits-and-debt.html?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosedge&stream=business

[12]http://www.berkshirehathaway.com/letters/2018ltr.pdf?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosmarkets&stream=business, see page 14

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s a modest risk on day today in front of “mega Fed”—seven FOMC members will talk today.[1] Here is what we are watching this morning:

Fed minutes follow-up:  Yesterday, we noted two quotes lifted from the Fed minutes.

…several of the participants argued that rate increases might prove necessary only if inflation outcomes were higher than in their baseline outlook.

Several others indicated that if the economy evolved as they expected, they would view it as appropriate to raise the target range for the fed funds target later this year.

We argued that there appears to be a split on the board related to the relationship between inflation and growth.  Essentially, the two variables have become much less sensitive to each other.  Our take is that, due to globalization and deregulation, the aggregate supply curve has “flattened” or, technically speaking, has become more elastic, meaning that higher levels of output have only modest effects on price levels.  This change has made the conduct of monetary policy more difficult because the Fed no longer has a working model for the economy.  If supply constraints are less relevant, then the Fed has some difficult policy choices.  If faster growth doesn’t affect inflation significantly, then it would appear the Fed should only focus on inflation.  In fact, there are other important central banks in the world that operate with a single inflation mandate; the ECB is the most prominent.  However, there is a risk to this plan.  Because inflation is low, the Fed could provide too much liquidity to the economy that, instead of finding its way into the goods markets, ends up in the financial markets, creating asset bubbles.  The FOMC doesn’t have the mandate to target equity markets, although we can make a case that policy has become increasingly sensitive to volatility.[2]  But, so far, policymakers have been reluctant to aggressively use financial asset prices to set monetary policy (imagine a Fed chair testifying before Congress that “we raised rates because the P/E was too high”; although a defensible proposition, it would likely cause a political backlash).

At this juncture, we think there are three schools of thought developing at the Fed.  The first includes the diehard Phillips Curve advocates; they view the current low unemployment as a threat to price stability and argue for continued rate hikes.  They are only being pacified now due to recent economic weakness but would argue that the fed funds target should be around 3.5% to 4.0%.  The second are actually Phillips Curve advocates as well but ones who suggest the relationship has changed and we should be “patient”until we know what the new one is and allow inflation to actually develop.  We think Chair Powell is in this camp.  The third group argues that the Phillips Curve relationship was spurious, an accident of history, and therefore the Fed should target inflation alone with an eye on financial markets, either making excuses to raise rates when financial markets are frothy or pressing for macroprudential actions (e.g., raising margin debt requirements) when necessary.  What is important for our analysis is that there is no real consensus on policy right now and thus predicting the path of the fed funds target has become much more difficult.  Two articles today on this topic are worth a read.[3]

Venezuela: As noted yesterday, this weekend, the opposition is planning to move tons of donated aid across the Venezuelan borders.  Maduro has closed the border with Brazil[4] along with the sea lanes from three Caribbean islands.[5]  There could be violence.[6]  If there is, we will be watching to see how the Trump administration reacts.[7]  In other news, Hugo Carvajal, the former head of intelligence, has turned against the Maduro regime.[8]

Trade talks: President Trump will meet with China’s trade envoy, Liu He,[9] this afternoon.[10]  As we noted yesterday, there are hopes that the Memorandum of Understanding (MOU) will come at the culmination of talks.[11]

Brexit: PM May is trying to prevent other soft Brexit Conservatives from leaving her party to join the new centrist group.[12]  The departure of three MPs has complicated May’s ability to hold her coalition together; in some respects, the Tory Party is a bit more hard Brexit-leaning, especially since the DUP is critical to her majority.  As we have argued all along, May will likely have to decide if she either wants a soft Brexit and a generationally damaging split in the Conservative Party or a hard Brexit and party unity.  However, we may be wrong on this argument; May could end up losing both, ending up with a hard Brexit and the end of the Conservatives. [13]  There are rumors the EU will give May a 90-day extension; we don’t see how that will make conditions better but it does suggest the EU is equally worried about a hard Brexit.

Trouble down under: Yesterday, we discussed how China is putting pressure on both New Zealand and Australia.  There were reports that China’s Dalian port has banned Australian coal imports.[14]  China has indicated today that the ban news isn’t true.[15]  So, we will continue to watch this issue to see how it progresses.

Elections in Spain: PM Pedro Sanchez[16] has called for snap elections on April 28 after the Spanish Congress rejected his budget.[17]  However, the budget isn’t really the issue of this election—it’s Catalonia.  Sanchez tried a different tactic with Catalonian separatists compared to the previous conservative administration.  The latter used imprisonment to try to stop the movement; Sanchez tried negotiating.  Neither one worked.  This is the third election in Spain in three and a half years.  Spanish politics reflects what we are seeing across the West—parties and political alliances are fraying and new configurations are forming.  We doubt the upcoming elections will resolve these underlying tensions.

Energy update: Crude oil inventories rose 3.7 mb last week compared to the forecast rise of 3.1 mb.

In the details, estimated U.S. production rose 0.1 mbpd, reaching a new record of 12.0 mbpd.  Crude oil imports rose by 0.7 mbpd, while exports jumped 1.3 mbpd.  Refinery runs were unchanged, as forecast.

This is the seasonal pattern chart for commercial crude oil inventories.  We would expect to see a steady increase in inventories that will peak in early May; the pattern coincides with refinery maintenance.  Note that inventories are rising at a slower pace than normal.  This is mostly due to crude oil exports.  If this slow pace continues, it would be a bullish factor for oil prices.

Based on oil inventories alone, fair value for crude oil is $57.10.   Based on the EUR, fair value is $53.97.  Using both independent variables, a more complete way of looking at the data, fair value is $54.22.  By all these measures, current oil prices are roughly in the area of fair value.  If inventories continue to rise, as the seasonal pattern would suggest, we might see oil prices correct modestly in the coming weeks.  But, we still look for $60 prices through the summer.

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[1] https://finance.yahoo.com/news/fedspeak-frenzy-what-to-know-in-markets-friday-231055151.html

[2] See Asset Allocation Weekly, 1/11/2019.

[3] https://www.ft.com/content/66087f76-35f3-11e9-bd3a-8b2a211d90d5 and https://www.reuters.com/article/us-usa-fed-pivot-insight/a-fed-pivot-born-of-volatility-missteps-and-new-economic-reality-idUSKCN1QB0IK

[4] https://www.nytimes.com/2019/02/21/world/americas/venezuela-aid-block-brazil.html

[5] https://www.nytimes.com/2019/02/20/world/americas/venezuela-borders-aid.html?module=inline

[6] https://www.axios.com/newsletters/axios-am-bc3c4888-ea2b-4248-9e96-63848bdf9912.html?chunk=6#story6 and https://www.ft.com/content/8149fad0-34c2-11e9-bd3a-8b2a211d90d5 and https://www.crisisgroup.org/latin-america-caribbean/andes/venezuela/high-noon-over-humanitarian-aid-venezuelas-border?utm_source=Sign+Up+to+Crisis+Group%27s+Email+Updates&utm_campaign=6f7a3251b7-EMAIL_CAMPAIGN_2019_01_18_03_54_COPY_01&utm_medium=email&utm_term=0_1dab8c11ea-6f7a3251b7-359779305

[7] https://www.nytimes.com/2019/02/18/world/americas/venezuela-guaido-maduro-trump.html?module=inline

[8] https://www.nytimes.com/2019/02/21/world/americas/hugo-carvajal-maduro-venezuela.html

[9] https://www.wsj.com/articles/u-s-bets-on-chinas-special-envoy-in-trade-talks-11550795104

[10] https://www.bloomberg.com/news/articles/2019-02-21/trump-is-said-to-plan-meeting-with-china-s-trade-chief-on-friday

[11] https://www.scmp.com/news/china/diplomacy/article/2187195/new-round-us-china-trade-talks-begin-washington-eye-toward

[12] https://www.ft.com/content/51712a20-35b9-11e9-bb0c-42459962a812?emailId=5c6f6b5a71c75900040856cf&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[13] https://www.ft.com/content/b662b452-35e7-11e9-bd3a-8b2a211d90d5

[14] https://www.reuters.com/article/us-china-australia-coal-exclusive/exclusive-chinas-dalian-port-bans-australian-coal-imports-sets-2019-quota-source-idUSKCN1QA0F1

[15] https://www.reuters.com/article/us-china-australia-coal/china-says-australian-coal-imports-remain-normal-canberra-seeks-to-calm-investors-idUSKCN1QA2US

[16] Not this Pedro Sanchez https://www.youtube.com/watch?v=BD5F7KFhZfA

[17] https://www.politico.eu/article/spains-sanchez-calls-snap-election-on-april-28/

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] U.S. equity futures are steady this morning in quiet trading. There is some optimism, however, on the China/U.S. trade talks and on the Fed’s balance sheet.  European and Japanese PMIs were disappointing, suggesting weaker global growth, and the Philly Fed was very weak (see below).  Here is what we are watching this morning:

Fed minutes: Although the bulk of the market chatter seemed to be around the balance sheet, we view that discussion as mostly sterile—there isn’t much evidence to show that QE helped the real economy and there isn’t much to suggest that QT has impeded it either.  Here are the two items we find interesting, shown by these quotes:

…several of the participants argued that rate increases might prove necessary only if inflation outcomes were higher than in their baseline outlook.

Several others indicated that if the economy evolved as they expected, they would view it as appropriate to raise the target range for the fed funds target later this year.

Chair Powell now has a committee divided over a basic issue.  The first entry suggests that the FOMC should only pay attention to inflation and ignore the growth path.  These members probably hold the position that the Phillips Curve is no longer relevant and the central bank should only focus on inflation.  The members mentioned in the second entry likely still hold to a Phillips Curve model and thus stronger growth should trigger tighter policy even in the absence of rising inflation.  That’s because the Phillips Curve, at its core, maintains that the loss of slack in the economy will eventually lead to higher prices.  Although it makes intuitive sense, globalization and deregulation seem to have flattened supply curves to the point where even if the Phillips Curve relationship holds it isn’t very powerful.

We suspect Powell is in the former camp.  If so, he will likely press to keep policy steady until actual evidence of inflation occurs.  Usually, the chair has some sway with the committee and may be able to keep the number of dissents manageable, but divisions will be something to watch in the coming months.  As long as growth is lackluster and inflation tame, the divisions probably won’t be evident.  Still, they might develop at some point and then we may see a spate of dissents that could undermine Powell.

Venezuela: This weekend, the opposition is planning to move tons of donated aid on Saturday.  Maduro has closed the borders.  There could be violence.[1]  If there is, we will be watching to see how the Trump administration reacts.

On the issue of Venezuelan debt, according to a report from the FT,[2] the opposition leader in Venezuela, Juan Guaido, has approached Lee Buchheit, a sovereign workout specialist who recently retired from a major law firm that specializes in this area.  Buchheit proposed that the best way for Venezuela to work out of its debt situation is for the government to “ring fence” its petroleum-related assets in the U.S.  Venezuelan debt lacks collective action clauses so a small group of creditors could seize Venezuelan assets in the U.S. and effectively prevent any significant restructuring.  The U.S. and the U.N. did something similar with Iraqi debt after the fall of Saddam Hussein, with the UNSC issuing a directive forbidding all U.N. members from attaching or seizing any Iraqi assets.  President Bush also issued an Executive Order doing the same thing in 2004, and did so every year of his presidency.  President Obama followed Bush’s lead by extending the ban through 2014.

These orders were devastating for bondholders.  Essentially, bondholders received about 10 cents on the dollar for the Hussein-era debt they held.  Needless to say, Venezuelan creditors are cool to this plan, claiming that it will deny the new government access to capital.  Although it will do so for a while, in our experience,[3] new lenders always appear even after default and workout.  At first blush, if the U.S. were to implement such a plan, it would not get support in the UNSC because China and Russia can veto any proposals.  However, if the president were to sign an Executive Order preventing creditors from attaching Venezuelan assets in the U.S. and use the threat of military force to prevent foreign creditors from being physically able to control collateral assets in Venezuela, then it could force China and Russia to accept sharply reduced settlements on their debt.

Trade talks: There is evidence of progress on the U.S./China front.  This morning, there are reports that China will boost agricultural imports.  The two sides are putting together an outline of commitments on various issues in a Memorandum of Understanding (MOU).[4]  We suspect the outline and MOU will be out before the March 1 deadline, but we doubt this will be the culmination of talks.  Instead, the MOU will be a roadmap to further negotiations that will likely stretch into next year.  In the end, we doubt the substantial issues will ever be decided.[5]  At the same time, both sides need an immediate deal[6] even if it falls short of a comprehensive agreement.

On the EU front, it appears the Trump administration is turning up the pressure, threatening auto tariffs.[7]  Getting a deal with Europe will be difficult; the Europeans want to avoid auto restrictions, which would deeply hurt German automakers,[8] and the U.S. wants open trade on agriculture, which would disrupt the EU’s carefully negotiated Common Agricultural Policy.  At the same time, U.S. auto nameplates are protected by a 25% tariff on light trucks[9] that would go away under conditions of free trade.

Financial markets have mostly discounted a trade deal with China, but a resumption of trade hostilities with the EU isn’t currently in prices.  Thus, if this conflict heats up, it could put pressure on the current equity rally.

Brexit: Although there is nothing concrete, we may be seeing some movement on both sides of the Channel.[10]  The EU appears sensitive to U.K. concerns about the Irish backstop being temporary in name but eternal in practice.  It appears the goal is to show enough movement for Brexit supporters to go along with May’s original agreement but without so much change to force the EU to hold another vote.  Meanwhile, the splinter group has added another member, a Labour Party defector.[11]

Trouble down under: China is putting pressure on both New Zealand and Australia over the Huawei (002502, Shenzhen, CNY, 4.01) issue and other concerns.  China’s Dalian port has banned Australian coal imports,[12] and China has also threatened New Zealand.[13]  China is a key customer for both countries and it appears Beijing is using that position to influence policy in both nations.  Australia has been a favored destination for Chinese capital flight and the Xi government would probably like to press Canberra to extradite Chinese citizens trying to flee the clutches of the Communist Party of China.  It is important to note that Australia and New Zealand are members of the “five eyes” network, an alliance of English-speaking nations (U.S., U.K., Australia, New Zealand and Canada) that share intelligence.  The U.S. is particularly worried that any of these nations using Huawei equipment could be subject to hacking by the Chinese government, allowing it to gain access to the shared intelligence of the five eyes group.

The Mueller investigation: For the most part, we have not commented on the investigation because financial markets have mostly ignored it.  That doesn’t mean we haven’t been monitoring developments, but we didn’t believe it made sense to weigh in on a controversial topic that wasn’t affecting “our lane.”  However, there are reports that the investigation may be wrapping up soon[14] and a report could be issued to the DOJ in a few weeks.  We won’t speculate on what it may contain but it could have information that might affect market sentiment.  If so, we will address this issue once it becomes a market factor.

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[1] https://www.axios.com/newsletters/axios-am-bc3c4888-ea2b-4248-9e96-63848bdf9912.html?chunk=6#story6 and https://www.ft.com/content/8149fad0-34c2-11e9-bd3a-8b2a211d90d5

[2] https://ftalphaville.ft.com/2019/02/19/1550575804000/A–nuclear-option–to-resolve-Venezuela-s-debt-woes/

[3] Bill was a country risk analyst at a bank that did international lending and was involved in the Brady bonds and debt/equity swaps in the late 1980s.  Most of the affected nations were able to access the credit markets within five years or less.

[4] https://finance.yahoo.com/news/exclusive-u-china-sketch-outlines-024419838.html

[5] https://www.ft.com/content/79d8e466-342f-11e9-bd3a-8b2a211d90d5?emailId=5c6e34726220f700040cf3c1&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[6] https://www.wsj.com/articles/warriors-on-trade-trump-and-xi-face-a-similar-challenge-at-home-11550709127

[7] https://www.wsj.com/articles/trump-continues-to-weigh-eu-auto-tariffs-11550693479

[8] https://www.ft.com/content/9aea1f38-352b-11e9-bd3a-8b2a211d90d5?emailId=5c6e34726220f700040cf3c1&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[9] https://en.wikipedia.org/wiki/Chicken_tax

[10] https://www.ft.com/content/5c0c3c70-3548-11e9-bb0c-42459962a812

[11] https://www.ft.com/content/c71397c0-352f-11e9-bd3a-8b2a211d90d5

[12] https://www.reuters.com/article/us-china-australia-coal-exclusive/exclusive-chinas-dalian-port-bans-australian-coal-imports-sets-2019-quota-source-idUSKCN1QA0F1

[13] https://www.nytimes.com/2019/02/14/world/asia/new-zealand-china-huawei-tensions.html

[14] https://www.washingtonpost.com/world/national-security/justice-department-preparing-for-mueller-report-in-coming-days/2019/02/20/c472691c-354b-11e9-af5b-b51b7ff322e9_story.html?utm_term=.c53d26a2710a

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s mid-week (already!).  Global equities are stronger this morning and U.S. equity futures are flat.  Here is what we are watching this morning:

More U.K. defections: Yesterday, we reported that seven Labour MPs left their party to form a new centrist party, called the Independent Group.  Today, three Tory MPs left their party to join them.[1]  May’s coalition of Tories and the DUP gives her a narrow majority of two seats; her party holds 317 seats and the DUP 10.  The loss of three MPs actually puts her now in the minority and thus makes her vulnerable to a no-confidence vote.  However, given that she has survived one no-confidence vote already,[2] we doubt another one will come anytime soon.  But, for now, it does appear she is operating a minority government.

Brexit: May is on her way to Brussels for more negotiations.[3]  This looks to us as a “going through the motions” exercise but May is probably hoping for language on the Irish backstop that might mollify her coalition.  It isn’t likely.  On the backstop issue, May officially scotched a rather odd plan from Brexit Conservatives to create a high tech border control mechanism on the Ireland frontier that would act as an invisible customs monitor.[4]  Since the technology doesn’t currently exist, it was rather easy to put it to rest.  Brexit is steadily progressing toward next month’s deadline.  May’s tactics appear to be to run out the clock and leave MPs with one of two options, either her plan or a catastrophic hard Brexit.  The MPs are trying hard to avoid that difficult choice but they don’t have an alternative plan.  However, there is one increasingly obvious downside—businesses are quitting the U.K. on fears of a hard Brexit.[5]

Fed: The FOMC releases the minutes of its most recent meeting today.  We will pore over the report for any clues about policy but we don’t expect too much new information.  Although we expect some caution that the markets may have become too sanguine on rate expectations,[6] what we are hearing from Fed officials suggests the committee is rather comfortable with leaving rates about where they are now.[7]  In fact, most of the focus has now, for better or worse, shifted to the balance sheet.  Our position is that the balance sheet’s effect has mostly been psychological.

This chart overlays the CAPE with the Fed’s balance sheet.  Since the last recession, the two tended to track each other, although expectations of tax reform did lead to a large rise in the multiple in late 2016 through 2017.  Note that the P/E has declined as the balance sheet has contracted.  There are obviously other factors that contributed to the multiple contraction.  Fears of a trade war are part of the contraction and the CAPE, which uses the 10-year average of earnings, is rolling off the 2008 earnings drop, thus lifting the “E.”  But, we would argue that the balance sheet did contribute to weakening investor sentiment.  Thus, if the FOMC signals an end to QT, it would be reasonable to expect a rise in P/E.

Trade: According to reports, China’s lead negotiator, Vice Premier Liu He, is planning to discuss a memorandum of understanding (MOU) with U.S. negotiators.  Such a document would be a clear signal that an agreement was reached.  The fact that Liu was given the authority to make a MOU would suggest that China is serious about a deal.[8]  President Trump has signaled some flexibility by making the March 1 deadline somewhat optional.[9]  The U.S. is pressing China to promise to not use its exchange rate as a tool to manage its trade issues.[10]  However, former Fed Chair Yellen cautions that such promises may not be possible to keep.[11]

Huawei (002502, CNY 4.09) and the Europeans: The U.S. is working to prevent Huawei from selling its products to allies.  However, Europe is cool to cooperating with Washington.  The U.K. has indicated that it views the risks to using the Chinese company’s products for 5G as “manageable”[12] and Germany has indicated it may buy the company’s products.[13]  We expect this issue to become increasingly complicated.  The U.S. will likely threaten not to do a free trade deal with the U.K. after Brexit if London goes down this path and may use the car tariff threat against Germany to accomplish its goal with Huawei.

A curious report out of China: A Chinese blogger reports that local governments in China are banning price cuts on housing.  Price cuts on unsold inventory have been a source of unrest in China; households that bought at a higher price face an immediate decline in wealth if the prices on new homes fall.  Thus, local governments appear to be signaling to developers that they cannot engage in price cuts to clear inventory.[14]

Purges in the Hermit Kingdom: Reports indicate that Kim Jong-un has purged between 50 and 70 wealthy and high-ranking officials.  Some of this action appears to be a simple shakedown.  North Korea has been gradually and quietly using markets to boost the economy but the regime likely fears that if some people get too wealthy they may opt to gain political power.  In addition, the regime may need money and therefore the crackdown is a rather harsh form of taxation.  Some of the crackdown does appear to be aimed at critics who oppose talks with the U.S.  To some extent, the purges probably indicate that the regime does want to improve relations with the U.S. and Kim wants to ensure that he can make changes without opposition.[15]

And, finally:There are some pundits who don’t really offer any penetrating insights but are important for their signaling.  We tend to view Tom Friedman at the NYT in this light.  His insights are rarely penetrating but he says them well and we use them as signals of elite consensus.  In other words, he is almost never in front of anything, but when he says something it officially becomes common knowledge.  In today’s NYT, he has an op-ed suggesting that the U.S. now has four political parties.[16]  Friedman, a spokesman for the center-left elite, hammers the populist left in his article.  Of course, he hits at the populist right and the center-right as well.  The analysis in the article doesn’t break any new ground, but the fact that he wrote it is important—it is now common knowledge that the political system is split and the fragile populist/elite coalitions of the past four decades are no longer holding (and, for what it’s worth, in our opinion the divide began in 2008).

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[1] https://www.ft.com/content/4bd129da-3500-11e9-bd3a-8b2a211d90d5

[2] https://www.nytimes.com/2019/01/16/world/europe/brexit-theresa-may-no-confidence-vote.html

[3] https://www.bloomberg.com/news/articles/2019-02-19/britain-targets-brexit-deal-within-days-as-may-heads-to-brussels

[4] https://www.ft.com/content/93745dd2-3476-11e9-bb0c-42459962a812

[5] https://www.politico.eu/article/the-day-project-fear-got-real/?utm_source=POLITICO.EU&utm_campaign=9cb3b43de9-EMAIL_CAMPAIGN_2019_02_20_05_44&utm_medium=email&utm_term=0_10959edeb5-9cb3b43de9-190334489

[6] https://www.wsj.com/articles/investors-sound-warning-about-markets-complacency-on-interest-rates-11550588400

[7] https://www.reuters.com/article/us-usa-fed-williams-exclusive/exclusive-feds-williams-says-new-economic-outlook-necessary-for-rate-hikes-idUSKCN1Q82KL

[8] https://www.scmp.com/news/china/diplomacy/article/2186735/chinese-vice-premier-liu-he-set-washington-talks-week-latest?li_source=LI&li_medium=home-top-picks-for-you

[9] https://www.reuters.com/article/us-usa-trade-china-deadline/trump-says-march-1-deadline-for-china-trade-talks-not-magical-date-idUSKCN1Q82HD

[10] https://www.bloomberg.com/news/articles/2019-02-19/u-s-said-to-press-china-for-stable-yuan-as-trade-talks-progress

[11] https://www.bloomberg.com/news/articles/2019-02-19/yellen-offers-caution-as-u-s-pushes-china-to-keep-yuan-stable?srnd=markets-vp

[12] https://www.ft.com/content/619f9df4-32c2-11e9-bd3a-8b2a211d90d5

[13] https://www.wsj.com/articles/in-rebuke-to-u-s-germany-considers-letting-huawei-in-11550577810

[14] http://investinginchinesestocks.blogspot.com/2019/02/big-trouble-in-china-housing-govt-bans.html

[15] https://www.wsj.com/articles/kim-jong-un-purges-north-korean-elite-in-violent-crackdown-11550593810

[16] We discussed the issues of identity and class in the WGR series, Reflections on Politics and Populism: Part I (7/16/2018) and Part II (7/23/2018).