by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] The Year of the Pig begins!  Several Asian markets were closed and China will be closed all week.  Thus, it was a very quiet overnight session.  Here is what we are watching this morning:

Venezuela: Although the EU did not act as a group to call for Maduro’s exit, Guaido did receive endorsements from a large number of European nations.[1]  For the EU to issue anything as a group, it must have unanimity.  Hungary and Italy did not cooperate.  Protests continue in Venezuela but the key to removing Maduro rests with the military.  There have been a few notable defections, including the acting head of the Venezuelan Air Force, Gen. Francisco Yanez.[2]  Overall, though, the military still seems to cling to Maduro.  It should be noted that history shows sentiment within the military can swing quickly, so we could see the military shift to the opposition at some point.  Meanwhile, the oil markets appear to have discounted the turmoil for now as prices are stabilizing.

Brexit: There isn’t a lot of news to report.  PM May goes back to the EU this week[3] to renegotiate her Brexit plan.  We don’t expect much to change.   Hardline Brexit supporters are warning May that mere promises from the EU won’t be enough—they want an entirely new treaty.[4]  That is unlikely to occur.  May is likely betting that the hardliners will blink at the prospect of a hard Brexit; that probably isn’t true.  May might be able to get her plan through Parliament with mere promises from the EU, but only with significant Labour support.  At some point, May might be forced to choose between saving her party and saving her plan.  She probably can’t do both.  So far, May appears unwilling to go down in history as the party leader who destroyed the Tories and would rather go down in history as the PM who led to a hard Brexit.

Another blow against globalization: French industrial policy has tended to support “national champions,” which are state-supported firms that are given special favors to achieve global prominence.  In practice, this means these firms are protected from foreign competition to achieve scale.  In development theory, this is known as the “infant industry argument,” which postulates that nations trying to develop should nurture and protect small companies to allow them to grow.  It might be legitimate for a developing nation but it is mostly pure protectionism for a large economy.  Being a major global exporter, Germany has tended to avoid national champions but, in the face of rising competition from China and the U.S., Germany is about to propose new industrial policies to help create national champions.[5]  One of the other factors that has tended to prevent France from fully developing such policies is that the EU would block them due to its anti-trust rules.  However, one of the key nations that supported general market liberalization was the U.K.  Thus, Brexit may be creating conditions where France and Germany will cooperate on protecting companies.  This new policy is a reflection of the general retreat from globalization that is now underway; simply put, nations are now viewing each other as enemies and are less open to cooperation.

The growing war on capital: Populism is a direct threat to capital.  Whether it comes from the right or left, over time, populism will reduce margins and increase inflation.  The right-wing version tends to be less dependent on tax rates and direct transfers; instead, it presses for regulation that reduces the supply of labor and lifts wages, reducing margins.  Regulations usually include work rules that require a certain number of workers for a job regardless of whether or not regulation has eliminated them.  For example, until the Staggers Act of 1980, U.S. interstate commercial traffic was regulated by the Interstate Commerce Commission.  This act, along with others, led to the deregulation of the railroads, airlines and trucking.  In the aftermath, cabooses were no longer put on freight trains with the required labor inside, airlines competed on price and the Teamsters Union was deeply undermined as truckers became independent.  Right-wing populists would support bringing back such measures; in addition, they tend to support significant barriers to legal immigration to keep the supply of labor curtailed.

The left-wing variant tends to support regulation as well, although it is less strict on immigration.  However, the left-wing variant is much more supportive of new public transfers (bigger safety net) and higher taxes on upper incomes and capital.  For example, the Democrats are looking at expanding Social Security.  To maintain the fiction of the program being a retirement plan, the payroll tax rate would rise to 14.8% and incomes above $400k would be included in the payroll tax (creating a “dead zone” for the tax between $132,900 and $400,000 that would not be taxed).[6]  Senators Schumer and Sanders are calling for legislation to limit stock buybacks.[7]   Anti-trust rules appear to be turning back to an earlier period where size alone was enough to trigger action.[8]  In the mid-1980s, anti-trust rules reflected the idea that as long as consumers were not harmed by the firm, size was generally acceptable.  What legislators failed to grasp was that size could create labor monopsony, which means that businesses had enough power to restrain wages.

Overall, this issue isn’t something that will affect financial markets today; on the other hand, we have been warning for several years that we are coming to the end of an efficiency cycle that will be replaced by its opposite, an equality cycle.  Although equities can thrive in an equality cycle (as evidenced by the 1960s equity market), that only comes after equities revalue from the high margin/high multiple efficiency cycle (the revaluation that occurred during 1929-1957).  When does the equality cycle begin in earnest?  Not next week, but likely in the next decade or sooner; as we referenced above, the evidence of a turn is growing.  After all, it wasn’t so long ago, under President Bush, that reforming Social Security meant reducing benefits.  That era seems long past. 

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[1] https://www.wsj.com/articles/juan-guaido-recognized-as-venezuelas-president-by-major-eu-countries-11549275207

[2] https://www.washingtonpost.com/world/the_americas/venezuela-protests-guaido-vs-maduro/2019/02/02/ef043b00-2660-11e9-b5b4-1d18dfb7b084_story.html?utm_term=.05b98c6a4e6c&wpisrc=nl_todayworld&wpmm=1

[3] https://www.politico.eu/article/theresa-may-vows-to-battle-in-brussels/?utm_source=POLITICO.EU&utm_campaign=5f84c6d0b5-EMAIL_CAMPAIGN_2019_02_04_05_33&utm_medium=email&utm_term=0_10959edeb5-5f84c6d0b5-190334489

[4] https://www.ft.com/content/01ca3026-278f-11e9-a5ab-ff8ef2b976c7?emailId=5c57bb738d8e400004ee789f&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[5] https://www.politico.eu/article/germany-industrial-plan-signals-europes-protectionist-lurch/?utm_source=POLITICO.EU&utm_campaign=5f84c6d0b5-EMAIL_CAMPAIGN_2019_02_04_05_33&utm_medium=email&utm_term=0_10959edeb5-5f84c6d0b5-190334489

[6] https://www.nytimes.com/2019/02/03/us/politics/social-security-2100-act.html?action=click&module=Top%20Stories&pgtype=Homepage

[7] https://www.nytimes.com/2019/02/03/opinion/chuck-schumer-bernie-sanders.html

[8] https://www.ft.com/content/c27a517a-2631-11e9-8ce6-5db4543da632?emailId=5c57bb738d8e400004ee789f&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s employment day!  We cover the data in detail below but here is a quick rundown.  The payroll data came in much stronger than expected, but there was a large downward revision to December.  The unemployment rate ticked higher, but that was likely due to the government shutdown.  Overall, the data show (a) the economy is still doing well, and (b) there is still slack in the labor force.  Here is what we are watching this morning:

BREAKING NEWS: As expected, the U.S. will withdraw from the Intermediate-Range Nuclear Forces Treaty.[1]  The U.S. has accused Russia of violating the treaty; this is the reason for the withdrawal.  This treaty has been in place since 1987.

China: Although the trade talks ended with something of a whimper, more meetings are expected to follow and the president’s upbeat assessment of the talks makes it look like a deal of some kind is coming.  In particular, Chairman Xi and President Trump will meet in February, perhaps to hammer out and announce the final deal.[2]  We will likely see a partial deal by March 1 with more talks to follow.  To some extent, both leaders benefit by extending the clock.  Once the elections pass, we expect U.S. and Chinese relations to become more hostile, but neither leader is relishing the economic dislocation that comes from breaking the relationship now.  Consequently, we expect some sort of deal soon and maybe talks that stretch into next year.  The key figure to watch is Lighthizer.  If the trade negotiator figures out he is being played and won’t be allowed to construct the deal he really wants with China, then he will likely leave the government.  As long as he stays, we suspect he thinks that an agreement to fundamentally change the trade and investment relationship with China is still possible.

Brexit: This is what we know: neither side wants a hard Brexit.  The majority in the British Parliament want a different deal than what PM May negotiated.  The EU is not likely to change the agreement.  Thus, we are heading into a binary outcome where either (a) Britain accepts May’s plan, or (b) we get a hard Brexit.[3]  May seems to believe the best way to get outcome (a) is to run the clock down until the end of March and see Parliament acquiesce to her plan.[4]  We also suspect that May agreed to go back to the EU to try to change the deal knowing full well there is little likelihood of that outcome, although, perhaps, the odds aren’t zero.[5]  May might hope to get some cosmetic changes so that she can frame another vote as a “new deal.”  Meanwhile, new twists have developed.  Spain wants Gibraltar to be treated as a colony of the U.K. rather than territory.[6]  Reopening negotiations with a body that requires a unanimous vote can bring unexpected complications.

Venezuela: John Bolton hinted on Twitter that the U.S. might support safe passage for Maduro and other regime officials.

I wish Nicolas Maduro and his top advisors a long, quiet retirement, living on a nice beach somewhere far from Venezuela. They should take advantage of President Guaido’s amnesty and move on. The sooner the better.

Other than that, not much has change on the Venezuelan front.

Fed Governors: Although the administration has not formally withdrawn Marvin Goodfriend from consideration, in reality, there is little chance he will get approved and there is an even smaller likelihood that the president would want a hawk for the position.  In something of a surprise, there were reports that Herman Cain, once a GOP presidential candidate, was being considered for the post.  It should be noted that Cain does have relevant experience—he was on the board of the K.C. FRB, spending some time as chairman.  The K.C. FRB has become the most consistent hawkish member of the FOMC, so Cain’s consideration does appear at odds with the president’s desire for doves.  It would appear the establishment wing of the administration is still trying to slip centrists and hawks past the president and onto the FOMC.

An Iran sanctions workaround?  The EU has created a Special Purpose Vehicle that would allow companies in the EU to get around U.S. sanctions on Iran.[7]  The new vehicle, called the “Instrument in Support of Trade Exchanges,” or INSTEX, is designed to avoid using dollars and may simply use barter for the trade of humanitarian goods.  We doubt it finds much use; without using a currency, a seller of EU agricultural goods would need to accept Iranian oil, for example.  It isn’t obvious if that cargo could be insured due to U.S. sanctions.  Most likely, this body will represent a signal that the EU can operate independently of U.S. policy but, in reality, it can’t.  We expect the administration to be harshly critical of this action and no major EU company to participate for fear of running afoul of U.S. sanctions.[8]

Another reason for Iran to be unpopular with Americans: Tehran has banned public dog walking or riding in cars with dogs.[9]

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[1] https://en.wikipedia.org/wiki/Intermediate-Range_Nuclear_Forces_Treaty

[2] https://www.wsj.com/articles/china-trade-negotiators-proposing-trump-xi-meeting-in-china-next-month-11548940089 and https://www.ft.com/content/8cddb4d4-2565-11e9-8ce6-5db4543da632?emailId=5c53d7385117e90004fae6fc&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[3] https://www.nytimes.com/2019/01/31/business/brexit-european-union.html?emc=edit_mbe_20190201&nl=morning-briefing-europe&nlid=567726720190201&te=1

[4] https://www.ft.com/content/484b050c-2578-11e9-8ce6-5db4543da632?emailId=5c53d7385117e90004fae6fc&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[5] https://www.youtube.com/watch?v=zMRrNY0pxfM

[6] https://www.ft.com/content/ab72fb3a-2578-11e9-b329-c7e6ceb5ffdf?emailId=5c53d7385117e90004fae6fc&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[7] https://www.politico.eu/article/trump-iran-europe-sanction-powers-set-up-firm-to-thwart/?utm_source=POLITICO.EU&utm_campaign=1f45bc1d0f-EMAIL_CAMPAIGN_2019_02_01_05_45&utm_medium=email&utm_term=0_10959edeb5-1f45bc1d0f-190334489

[8] https://www.nytimes.com/2019/01/31/world/europe/europe-trade-iran-nuclear-deal.html?emc=edit_mbe_20190201&nl=morning-briefing-europe&nlid=567726720190201&te=1

[9] https://www.bbc.com/news/blogs-news-from-elsewhere-47041611

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Yesterday brought a strong rally in U.S. equities.  Here is what we are watching this morning:

Fed meeting: The Fed meeting delivered more than what was expected.[1]  First, the FOMC removed language from previous statements suggesting the path for the policy rate was on a gradual path higher.  Second, the statement suggested the balance sheet could be adjusted in either direction, although it did reiterate that the fed funds target remains the primary policy vehicle.  Essentially, policymakers moved from a path of steady tightening to signaling that further tightening may well be on hold.

What led to the change?  Chair Powell noted the events that led to what appears to be an end to the current tightening cycle.  First, slower global growth apparently entered the discussion.  Although the Fed’s mandate precludes acting as the global central bank (even though it is), the Fed will, on occasion, pay attention to world events.  However, this usually occurs when the world economy encroaches on the U.S. economy.  We are seeing a clear slowing of U.S. growth so the Fed may be thinking the slowdown is coming from abroad.  Second, trade tensions were mentioned, and third, so was the government shutdown.  We do note that the Treasury will hit the debt ceiling in March, although the real funding crunch won’t occur until summer.  Perhaps the Fed is trying to get in front of all that.

We note the financial media is carrying stories from economists and analysts with words such as “perplexed” and “puzzled,” meaning, of course, that they had forecast multiple hikes this year and now appear wrong.[2]  The doves who have been crying for the Fed to stop are now celebrating their influence.[3]

So, what do we think happened here?  It appears to us that two things may be unfolding.  First, Chair Powell may be finally killing the Philips Curve.  The theory, which has guided Fed policy for decades, states that inflation is caused by the degree of slack in the economy.  When slack is removed, the chances for inflation increase.  One of the best measures of slack is the labor market.  Essentially, the Phillips Curve argues there is a trade-off between unemployment and inflation; if you want less of the latter, you have to accept more of the former.  Fed policymakers have clung to the theory even when evidence supporting it has become increasingly thin.

This chart shows the relationship between core CPI and the unemployment rate.  Visually, the unemployment rate tends to lead inflation by a bit more than five quarters.  During the 1960s into the early 1980s, one can observe a pattern that supports the Phillips Curve.  However, in the 1990s, inflation and the unemployment rate fell simultaneously and the level of unemployment seen around the turn of the century supported a peak in core CPI of 2.5%.  During the 1970s, the same level of unemployment triggered inflation near 12%.  So, something clearly changed.  We believe globalization and deregulation flattened the aggregate supply curve, meaning there is lower inflation at each intersection of aggregate demand.

Although FOMC members were aware of these changes, a theory one was raised on is hard to shake.  Accordingly, members of the FOMC continued to use the language of the Phillips Curve even though they tended to ignore it in terms of policy.  Thus, we would often see deviations from the Taylor Rule or the Mankiw Rule, both of which are tied to the Phillips Curve.  Over time, policy seemed to pay an increasing amount of attention to financial markets (hence the idea of the “Fed put”).

Powell appears to be finally ditching the Phillips Curve once and for all.  Why now?  Age probably plays a role.  The idea that scientific progress occurs “one funeral at a time” is part of it.  The economists who came of age in the 1970s are aging out and the newer economists live in a world of lower inflation.  Of course, if policy shifts to deglobalization and reregulation, both very likely given the rise of populism, then the Fed may by ending its use of the Phillips Curve just when it becomes useful again.  But, for now, it appears the Phillips Curve is dead.

This leads us to the second change; if the Phillips Curve is out, what has replaced it?  For now, nothing is official.  But, we suspect the Fed is focusing on inflation and the financial markets.  In a recent Asset Allocation Weekly, we discussed the relationship of policy to the VIX.[4]  The recent jump in the VIX would have been enough to signal a pause to the FOMC.  Another item the FOMC seems to track is the implied LIBOR rate from the Eurodollar futures contract, two-years deferred.

This chart shows the fed funds target and the implied LIBOR rate, with the spread on the upper line of the graph.  We have placed vertical lines at points of inversion.  In general, the Fed tends to stop raising rates at the point of inversion.  The rapid drop in the implied LIBOR rate is a clear signal that the Fed should stop raising rates and, right on cue, that’s what Powell indicated yesterday.

We should note one of the dangers the FOMC has now created for itself with this reversal is that financial markets will struggle to cope if conditions improve and it decides it needs to tighten further.  At the same time, the slowing we are seeing in the U.S. economy and abroad, along with controlled inflation, will likely allow the Fed to stop raising rates here without serious problems.

In terms of market impact, the most obvious was yesterday’s rally in the front end of the yield curve and in equities.  However, we also saw the dollar fall sharply.  As we noted in the 2019 Outlook and elsewhere, we have been expecting the dollar to weaken this year.  The reaction to the FOMC statement supports that idea.

Gold: Dollar weakness supported a strong rally in gold yesterday.  Another factor helping gold is that nations that have run afoul of the U.S. and face financial sanctions are turning to gold in their foreign reserves.  Although gold doesn’t offer a yield, it is transferable and is mostly protected from the U.S. Treasury.  Last year, gold-buying by central banks reached its highest level in nearly 50 years.  The highest year was when President Nixon ended Bretton Woods by closing the gold window.[5]  A weaker dollar combined with central bank buying should support further strength in gold.

China: In this week’s WGR, we opened a two-part report on U.S. relations with China. [6]  Overall, it looks like relations will become more hostile over time.  That doesn’t mean we won’t get a trade deal, but it likely won’t be anything more than a “can-kicking” exercise to help the U.S. and Chinese economies for the next 18 months.  There are reports that Foxconn (TPE: 2354, TWD, 59.20) is considering a significant reduction in its announced direct investment into the U.S.[7]  Although the company is based in Taiwan, it has large facilities in China and may be signaling that it is going to side with China if relations cool between the two countries.

Venezuela: There’s not much new to report as the standoff continues.  However, the WSJ reports that the effort to oust Maduro is part of a broader policy to extend U.S. influence in South and Central America and curb Russia’s and China’s forays into the region.[8]  Succeeding in that goal would also undermine Cuba.  In a historical sense, the policy is consistent with the Monroe Doctrine.  The U.S. has historically worked to thwart leftist regimes in the region that could have, or did, offer alliances with the communist bloc.  Undermining Chinese influence would also make sense.  However, we do wonder how much of this policy change is coming from the president himself and how much is coming from John Bolton.  Given Trump’s Jacksonian leanings, it would make sense for him to push back against Maduro, especially when he was going to oust U.S. diplomats.  At the same time, Jacksonians tend to avoid such open-ended foreign entanglements that intervening directly in Venezuela would entail.  In other Venezuelan news, Maduro is cracking down hard in the poor neighborhoods that used to be the backbone of regime support.[9]  Chavez built his coalition on the military and the poor, isolating the merchant and middle classes.  He paid for this policy by raiding PDVSA’s oil coffers.  The drop in oil output, due in part to the lack of investment, has forced Maduro to choose between the brass and the poor.  The latter have lost out.

Energy update: Crude oil inventories rose 0.9 mb last week compared to the forecast rise of 3.0 mb.

In the details, estimated U.S. production was unchanged at 11.9 mbpd.  Crude oil imports dropped 1.1 mbpd, while exports were unchanged.  The drop in imports may reflect the impact of Venezuelan sanctions.  Refinery runs declined 2.8% and should continue to fall in Q1.  Product stocks fell.

This is the seasonal pattern chart for commercial crude oil inventories.  We would expect to see a steady increase in inventory levels that will peak in early May.  This week’s increase was well below expectations and a bit below seasonal norms.

Based on oil inventories alone, fair value for crude oil is $58.76.  Based on the EUR, fair value is $55.61.  Using both independent variables, a more complete way of looking at the data, fair value is $55.99.  By all these measures, current oil prices are generally in the neighborhood of fair value.  We still expect prices to move toward $60 in the coming weeks, although rising oil inventories will tend to be a bearish factor for the market.

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[1] https://www.ft.com/content/2565e154-24b7-11e9-b329-c7e6ceb5ffdf?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56 and https://www.nytimes.com/2019/01/30/us/politics/fed-interest-rate.html?emc=edit_mbe_20190131&nl=morning-briefing-europe&nlid=567726720190131&te=1

[2] https://www.ft.com/content/36cb58ba-24ef-11e9-8ce6-5db4543da632?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56 and https://www.wsj.com/articles/the-feds-mysterious-pause-11548893175

[3] https://www.wsj.com/articles/the-fed-apologizes-11548894046

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

[5] https://www.ft.com/content/8148a8f0-2479-11e9-8ce6-5db4543da632?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[6] See WGR, What to do with China: Part I (1/28/2019).

[7] https://www.politico.com/story/2019/01/30/foxconn-manufacturing-jobs-1136919

[8] https://www.wsj.com/articles/u-s-push-to-oust-venezuelas-maduro-marks-first-shot-in-plan-to-reshape-latin-america-11548888252

[9] https://www.nytimes.com/2019/01/30/world/americas/venezuela-maduro-protests-faes.html?emc=edit_mbe_20190131&nl=morning-briefing-europe&nlid=567726720190131&te=1

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy Fed Day!  U.S. equity futures are higher this morning in light of some solid earnings reports.  Here is what we are watching this morning:

Fed meeting: The FOMC ends its two-day meeting today.  Although we won’t get new dots or forecasts, Chair Powell begins his new policy of press conferences after each meeting.  No action on rates is expected, but we will be watching for any hints on future policy (are risks “balanced” and will rate hikes be removed from the statement or contain the usual “gradual” language?).  In addition, the markets will be looking for any flexibility on the balance sheet.  We expect a mostly neutral statement; it would be a surprise to see them turn hawkish but it would also be a surprise to see them move toward a clear dovish stance.

Trade talks: Talks with China begin today and, so far, trade is being kept separate from the Huawei (002502, Shenzhen, CNY 3.32) issue.  China is offering protection for foreign investors[1] and is also preparing a timeline of reforms to address structural trade concerns.[2]  Although we doubt this will satisfy USTR Lighthizer, it will likely be enough for the president.  While we think U.S./China relations are on a deteriorating path, as we noted yesterday, both Chairman Xi and President Trump need peace this year.[3]  Thus, we remain optimistic that some sort of deal will be negotiated.

Venezuela: Conditions are deteriorating further in Venezuela.  The courts, firmly under the control of Maduro, have frozen opposition leader Guaido’s banks accounts and have prevented him from leaving the country.[4]  Maduro did indicate he was willing to “negotiate” but it is unclear who would mediate.  In response to the freezing of Guaido’s assets, the U.S. is giving Guaido control of some Venezuelan government accounts held by the U.S. at the NY FRB.[5]  The situation is a mess and oil prices are rising on fears that oil production from Venezuela will fall further.  Saudi Arabia has indicated it has no plans to offset any decline in output from Venezuela; in fact, the Saudi oil minister indicated the U.S. should use the SPR if shortfalls develop.[6]  The Saudis believe they were wrong-footed on the Iran sanctions issue and are making it clear it won’t happen again.[7]

Brexit: Things got rather weird yesterday.  Parliament rejected a series of proposals but did approve a non-binding measure to avoid a hard Brexit.  And, they approved an amendment that sends PM May back to Brussels to negotiate a different border agreement in Ireland.[8]  However, May was not given any specific instructions as to what the border agreement should look like.  It isn’t that there was no direction; May was told that Parliament doesn’t want a hard Brexit and the Euroskeptics don’t want an Irish border solution that effectively keeps the U.K. in the EU with few of the benefits.  This outcome isn’t really possible.[9]  The EU has made it clear that it won’t renegotiate the current agreement.[10]  With such uncertainty, it would seem the most logical outcome would be to delay Article 50; however, that solution is a problem for the EU because it holds EU Parliamentary elections in May.  If the U.K. is still in the EU, Britain would seemingly participate in these elections even though it wants to leave.  Although there is universal desire to avoid a hard Brexit, the chances of stumbling into one remain elevated and not fully discounted by the market.

Our parity model suggests fair value for the GBP/USD exchange rate is 1.65, which means we would have a much stronger pound in the absence of Brexit.  We assume a hard Brexit would lead to a rapid drop in economic output and yield an exchange rate of 1.10.  Thus, if a deal ends up with the U.K. leaving but maintaining most of the benefits of the EU (or not leaving at all), then we get 1.65.  The current exchange rate should indicate the market’s estimate of the odds of either outcome.  So, if P = good Brexit and 1-P = bad Brexit, then (P*1.65) + ((1-P)*1.10) = current exchange rate.  Solving for P at current exchange rates would indicate the market thinks there is about a 40% chance of a good Brexit and a 60% chance of a hard Brexit.

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[1] https://www.scmp.com/economy/china-economy/article/2184138/china-rushing-through-overseas-investment-reform-unprecedented

[2] https://asia.nikkei.com/Economy/Trade-War/China-to-kick-off-trade-talks-with-timeline-for-structural-reforms

[3] https://www.wsj.com/articles/as-china-trade-talks-begin-trump-faces-pressure-to-make-a-deal-11548808477

[4] https://www.washingtonpost.com/world/the_americas/venezuelan-officials-seek-to-block-us-supported-opposition-leader-juan-guaido-from-leaving-the-country-freeze-his-assets/2019/01/29/1a4791a0-232c-11e9-b5b4-1d18dfb7b084_story.html?utm_term=.453c43ca259c&wpisrc=nl_todayworld&wpmm=1

[5] https://www.nytimes.com/2019/01/29/us/politics/venezuela-bank-accounts-guaido-pompeo.html?emc=edit_mbe_20190130&nl=morning-briefing-europe&nlid=567726720190130&te=1

[6] https://www.wsj.com/articles/saudis-not-rushing-to-respond-to-venezuela-oil-ban-11548794233

[7] https://www.youtube.com/watch?v=gqzA1VOiC-M

[8] https://www.washingtonpost.com/world/europe/brexit-theresa-may-tells-a-divided-parliament-she-wants-to-reopen-talks-with-eu/2019/01/29/66ebca3a-1fe9-11e9-a759-2b8541bbbe20_story.html?utm_term=.4dc5921db939&wpisrc=nl_todayworld&wpmm=1

[9] https://www.ft.com/content/8ecf0b4c-2328-11e9-8ce6-5db4543da632?emailId=5c512e3432bcbc000472fcc1&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[10] https://www.nytimes.com/2019/01/29/world/europe/brexit-theresa-may-eu-irish-border.html?emc=edit_mbe_20190130&nl=morning-briefing-europe&nlid=567726720190130&te=1 ; https://www.ft.com/content/75f24764-23c9-11e9-8ce6-5db4543da632 ; and https://www.ft.com/content/390709e2-23de-11e9-8ce6-5db4543da632

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] U.S. equity futures are modestly higher this morning after a drop yesterday.  It’s the last week of the Year of the Dog—my two are sad about its end.  The Year of the Pig starts next week.  Here is what we are watching this morning:

Trade talks and Huawei (Shenzhen, 002502, CNY 3.68): The U.S. DOJ has issued indictments against Huawei.[1]  This action was not a huge surprise.  The U.S. has also requested formal extradition of Meng Wanzhou, the CFO of the company (and daughter of the founder).[2]  The worry is that the indictment and potential extradition could scuttle U.S./China trade talks.  Although it could, we think odds favor the two issues remaining separate.  That doesn’t mean the trade talks will be much easier.  China is likely to offer to buy lots of commodities from the U.S. in a bid to narrow the trade surplus with the U.S.  Robert Lighthizer will insist on structural changes that will undermine China’s ability to move up the value chain.[3]  If both leaders didn’t need a deal, these talks would be pointless.  But, both Trump and Xi need some sort of face-saving win; Trump needs a better economy to help his reelection odds and Xi wants to avoid a bigger slowdown.[4]  We expect a deal but not the deal, which will delay the evolving break between the Chinese and U.S. economies.  Eventually, though, the U.S. seems to be heading toward the recognition that China is a strategic competitor and will work to reduce the ties between the two economies.[5]  Interestingly enough, we are starting to hear reports that Chinese capital flight is leaving the U.S.[6]  However, this likely reflects the Xi regime’s extending grip on flows and less of a lack of desire from Chinese citizens to find a safe place for their money.

Venezuela: The U.S. announced new sanctions on Venezuela, targeting the state oil company, PDVSA.[7]  With this action, the U.S. has effectively outlawed American businesses from transacting with PDVSA.  The U.S. imports around 0.5 mbpd from the country; that loss should be manageable, although it does affect the grade mix.  U.S. refineries are configured to utilize heavy/sour crude which is more difficult to refine.  The loss of Venezuela could complicate some refiners’ production.  In the short run, the U.S. refining industry is in maintenance season so the negative impact will likely be less than normal.  The U.S. has indicated that sanctions will end if Guaido is installed as president.  Companies can apply for waivers and oil at sea can still land.  Thus, it will be a couple of weeks before this action starts to bite.  However, the sanctions will soon reduce Caracas’s cash flows, which depend on refining dollars from Citgo, the PDVSA-owned U.S. subsidiary.[8]  These cash flows are important.  We note the stances taken by governments on Venezuela tend to neatly follow the interests of bondholders.[9]  Most U.S. and European bondholders, who are holding defaulted bonds, would benefit from a new government and an IMF deal, while China and Russia would not benefit from a change in government.

Fed meeting: The FOMC starts its two-day meeting.  While we won’t get new dots or forecasts, Chair Powell begins his (ill-advised, in our opinion) new policy of press conferences after each meeting.  No action on rates is expected; the markets are watching for comments on the balance sheet, although the committee’s comments on the economy will be interesting in light of the government shutdown (see below).  Our take on the balance sheet is that the impact was mostly psychological,[10] a position held by many policymakers and economists.[11]  The financial markets would love an endpoint, for Powell to indicate that the reduction will end at a certain level.  They won’t get that; most likely, Powell will indicate “flexibility” on both rates and the balance sheet, offering hope that policy tightening will be on hold if the economy continues to slow.

Brexit: It’s a big day for Brexit.  With 60 days to exit, Parliament is debating a number of measures to address the Irish backstop and proposals to prevent a hard Brexit and maybe allow for another referendum.  PM May addressed the body today and indicated that now is the time to tell the EU what it wants, not just what it rejects.  This article gives a rundown of the current amendments;[12]  it should be noted that the one given the best odds is designed to extend Article 50.  We suspect the outcome of all this will be to delay the exit and try to avoid a hard break.  That outcome would be mildly bullish for the GBP.

Shutdown’s over—when does the data return? Because the shutdown lasted so long, government statisticians will be forced in many cases to calculate two data sets, one for the lost month and one for the current month.  Other data will simply be delayed.  For example, the first release of Q4 GDP will be postponed due to the loss of work.[13]  In some cases, such as the retail sales report, the data is a survey; this may require canvassers to ask questions such as, “How were things six weeks ago?” that might be hard to answer.  Although economic data may not seem like a big deal compared to the world’s problems, it will affect the continuity of some series and may result in significant revisions over time.  In other words, the view of the economy may change in a period of uncertainty.

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[1] https://www.ft.com/content/c8e6d5b0-2375-11e9-8ce6-5db4543da632?emailId=5c4fe8dc1930b50004fbcc61&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22 and https://www.nytimes.com/2019/01/28/us/politics/meng-wanzhou-huawei-iran.html?emc=edit_mbe_20190129&nl=morning-briefing-europe&nlid=567726720190129&te=1

[2] https://www.washingtonpost.com/world/national-security/justice-dept-charges-huawei-with-fraud-ratcheting-up-us-china-tensions/2019/01/28/70a7f550-2320-11e9-81fd-b7b05d5bed90_story.html?noredirect=on&utm_term=.3e706d8d0ad4&wpisrc=nl_todayworld&wpmm=1

[3] https://www.wsj.com/articles/big-divides-remain-as-u-s-china-trade-talks-resume-11548717555

[4] https://www.cnbc.com/2019/01/28/reuters-america-update-2-china-to-offer-some-subsidies-on-cars-appliances-to-lift-weak-demand.html

[5] The topic of this week’s and next week’s Weekly Geopolitical Reports.  See WGR, What to do with China: Part I (1/28/2019).

[6] https://www.wsj.com/articles/chinese-exiting-u-s-real-estate-as-beijing-directs-money-back-to-shore-up-economy-11548757800

[7] https://www.nytimes.com/2019/01/28/us/politics/venezuela-sanctions-trump-oil.html?emc=edit_mbe_20190129&nl=morning-briefing-europe&nlid=567726720190129&te=1

[8] https://www.washingtonpost.com/national/health-science/trump-administration-announces-sanctions-targeting-venezuelas-oil-industry/2019/01/28/4f4470c2-233a-11e9-90cd-dedb0c92dc17_story.html?utm_term=.d54b378da587&wpisrc=nl_todayworld&wpmm=1

[9] https://www.axios.com/following-money-venezuela-nicolas-maduro-bonds-3022bbb1-42cd-4825-a27d-e81307510be3.html

[10] See Asset Allocation Weekly (1/4/2019).

[11] https://www.wsj.com/articles/a-4-trillion-scapegoat-for-market-volatility-the-feds-shrinking-portfolio-11548671432

[12] https://www.politico.eu/article/commons-brexit-showdown-watch-like-a-pro/?utm_source=POLITICO.EU&utm_campaign=58c6c0d451-EMAIL_CAMPAIGN_2019_01_29_05_43&utm_medium=email&utm_term=0_10959edeb5-58c6c0d451-190334489

[13] https://www.nytimes.com/2019/01/28/business/economy/economy-government-shutdown.html

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Welcome back; we are sure the Pro Bowl captured your attention over the weekend.  There is a lot going on this week, including unemployment data, Chinese/U.S. trade meetings and Brexit votes in Parliament.  The U.S. government has reopened, at least temporarily, and it’s going to get real cold in the Midwest to the Northeast this week.[1]  Here is what we are watching this morning:

Venezuela:  There are still two presidents in Venezuela with no clear end in sight.  Some European nations indicated they would no longer recognize Maduro if he does not call for new elections in 10 days.[2]  Maduro rejected the EU ultimatum.[3]  We do note that Maduro is avoiding a showdown with the U.S. by not ousting American diplomats.[4]  Oil markets have been rallying on tensions in the face of bearish inventory data but, this morning, we are seeing a slump as the crisis continues.

An interesting insight into the differences between the foreign policy of left-wing versus right-wing populists has emerged from Italy.  That nation is the only one currently being governed by a “Nader coalition,”[5] a government made up of populists from both wings.  The left-wing populists, led by the Five-Star Movement, oppose foreign intervention in Caracas.  The right-wing populists, led by the League, support the EU and the stance of the major European governments noted above.[6]  Politically, this experiment in Italy is very important because, in most states, neither the right- nor left-wing populists hold a majority but if they were united they would usually command a large majority.  Since they are usually unable to unite, both populist groups are susceptible to being co-opted by establishment groups.  Nader’s argument is that to truly gain power, populists must work together.  So far, in Italy, the government has functioned but tensions have been mounting.

In a related observation, we note Howard Schultz’s consideration of a third-party run; essentially, Schultz could become a magnet for establishment votes from both the Democrats and the GOP (combined are probably 20% to 30% of the electorate).  The Democrats are unhappy with his potential run, fearing it will split the left-wing populists and left-wing establishment.  However, that would only happen if the Democrats nominate an establishment figure.  If Warren were to get the nomination, her voters would not likely support Schultz.  In other words, a Schultz presidential run could upset both parties by taking the establishment vote away.  Previous third-party candidates tended to split one party but Schultz could split both.  It’s hard to see Schultz winning but it is also hard to see either party gaining a majority if he has a successful run.  That might move the presidential vote out of the Electoral College and into the House of Representatives.

Brexit: We are now in the amendment phase of Brexit negotiations.  There are currently nine different proposals offered, most of which are designed to exclude a hard Brexit and a few call for another referendum.  Many include extending the deadline.[7]  May is supporting a couple of efforts by MPs to limit the time frame of the Irish backstop,[8] hoping to bring the hardline Brexit supporters to her original position.  Ireland has indicated it will not support any plan to limit the time of the backstop[9] and has further indicated that Ireland may be required to return physical barriers to the frontier, including troops.[10]  Financial markets continue to hold that a hard Brexit will be avoided which is why the GBP has been rising recently.  However, there is still a chance that Britain and the EU stumble into a hard Brexit despite efforts to avoid that outcome.

One other interesting development on Brexit.  There is some speculation that the crown may get involved in the Brexit talks.  Queen Elizabeth usually avoids the political fray; in her role as constitutional monarch, her powers are sweeping on paper but rarely used.  However, she made reference to the negotiations in a recent speech, calling on parties to “seek common ground.”  She has the power of “prorogue,” which allows her to adjourn a rebellious Parliament.  She also has the power to withhold “royal assent” from legislation which could end Brexit altogether.  Neither of these actions has been deployed by a British monarch in centuries and it goes to show the seriousness of Britain’s current constitutional crisis.[11]

EU and Iran: The EU has created a Special Purpose Vehicle to avoid U.S. sanctions on Iran.[12]  If the EU follows through on this plan and allows Iran to increase oil exports, it would be bearish for oil prices.  However, the EU is running the risk of souring relations with Washington and we will see if it has the resolve to see this through.

China/U.S. trade talks: Talks restart in the U.S. this week.  The key issue is whether President Trump will accept a short-term deal that boosts U.S. exports to China and leaves the technology issue unresolved.  We suspect he will take such an arrangement because the technology issue probably can’t be resolved[13] soon and very likely cannot be resolved at all.  It appears that we may not have a global standard for 5G, the next generation of technology that will, if it meets expectations, create the backbone for the “internet of things” and driverless cars.[14]  Our expectation is that both Xi and Trump need a short-term deal to bolster confidence.  But, the long-run positions are hardening into a superpower confrontation.

Chinese industrial profits fall:Chinese profits fell for the second straight month, falling 1.9%.[15]  Weak demand was cited for the decline.

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[1] https://www.axios.com/life-threatening-cold-polar-vortex-midwest-weather-dad70dfb-fb02-4cbb-8818-f6e84d364813.html

[2] https://www.thelocal.fr/20190127/eu-nations-put-venezuelas-maduro-on-notice

[3] https://www.politico.eu/article/venezuela-nicolas-maduro-rejects-eu-call-for-new-election-juan-gaido/

[4] https://www.nytimes.com/2019/01/26/world/americas/nicolas-maduro-juan-guaido-venezuela-diplomats.html?emc=edit_mbe_20190128&nl=morning-briefing-europe&nlid=567726720190128&te=1

[5] Nader, R. (2014). Unstoppable:  The Emerging Left-Right Alliance to Dismantle the Corporate State. New York, NY: Nation Books.

[6] https://www.politico.eu/article/5star-league-italian-government-split-over-venezuela-crisis-alessandro-di-battista/?utm_source=POLITICO.EU&utm_campaign=06bdd12864-EMAIL_CAMPAIGN_2019_01_28_05_09&utm_medium=email&utm_term=0_10959edeb5-06bdd12864-190334489  It isn’t the only issue dividing the two.  https://www.politico.eu/article/salvini-di-maio-the-green-clash-tearing-apart-italys-coalition-government/?utm_source=POLITICO.EU&utm_campaign=06bdd12864-EMAIL_CAMPAIGN_2019_01_28_05_09&utm_medium=email&utm_term=0_10959edeb5-06bdd12864-190334489

[7] https://www.nytimes.com/reuters/2019/01/23/world/europe/23reuters-britain-eu-planb-factbox.html?module=inline

[8] https://www.ft.com/content/da21a8aa-22da-11e9-8ce6-5db4543da632 and https://www.politico.eu/article/mays-brexit-assault-will-target-backstops-threat-to-peace-dup-theresa-may-good-friday-agreement/?utm_source=POLITICO.EU&utm_campaign=06bdd12864-EMAIL_CAMPAIGN_2019_01_28_05_09&utm_medium=email&utm_term=0_10959edeb5-06bdd12864-190334489

[9] https://www.ft.com/content/3cecf28e-222a-11e9-8ce6-5db4543da632

[10] https://www.ft.com/content/6e9c5762-20c1-11e9-b126-46fc3ad87c65

[11] https://www.nytimes.com/2019/01/25/world/europe/queen-elizabeth-brexit-britain.html

[12] http://time.com/5514136/european-union-iran-sanctions/

[13] https://www.nytimes.com/2019/01/21/us/politics/china-trade-pessimism.html?module=inline

[14] https://www.nytimes.com/2019/01/26/us/politics/huawei-china-us-5g-technology.html

[15] https://finance.yahoo.com/news/chinas-december-industrial-profits-shrink-again-weak-demand-041845449–business.html