Equity markets have come under pressure this autumn. The weakness has gained momentum in recent weeks.
This chart shows the yearly change in the S&P 500 Index on a monthly average basis. We have added recession shading; in general, recessions tend to trigger bear market declines of 20% or more. In fact, every decline of this magnitude has been associated with a downturn in the business cycle since the 1987 Crash.
There have been two sources of recent weakness. The first is fear that the Federal Reserve will make a policy error and trigger a recession. These fears are not unfounded. Since the mid-1950s there have been 13 tightening cycles; only four have resulted in a “soft landing,” a cycle that didn’t trigger a recession.
This chart shows the path of fed funds since 1955, shortly after the central bank became independent of the Treasury. We have placed arrows where tightening cycles didn’t bring a downturn. As the chart shows, it’s rare for the Fed to avoid a downturn. It should be noted that the second arrow coincided with the Nixon price and wage freeze; Chair Burns likely lowered fed funds in response to the price freeze. Thus, we can make the case that there were only three soft landings that were independently engineered by the Fed.
The second concern is over trade policy. The administration’s trade policy threatens to disrupt supply chains tied to China which could lead to shortage and higher prices for various goods. The impact of this outcome is very difficult to estimate; we haven’t had an aggressive policy of trade impediments since the 1920s. At the same time, it should be noted that trade frictions are partly a negotiating stance. These issues can be adjusted given the economic and political climate. Since next year is the last full year before elections, we would not be surprised to see some moderation of the Trump administration’s stance on trade policy.
If the FOMC does manage to bring a fifth soft landing and we see some moderation of trade policy, the equity market may be poised for a recovery. Since the late 1990s, the ISM manufacturing index has been a reasonably good indicator of the S&P 500.
This chart compares the yearly change in the S&P 500 Index monthly average against the ISM Manufacturing Index. The equity index, relative to the perspective of U.S. manufacturing purchasing managers, should be up 22.1% from last year; that would put the index at 3259.27. Not only that, but the current reading is at levels consistent with recession. This analysis suggests that if recession is avoided in 2019 then the equity market could be poised for a strong recovery. Essentially, this model is saying there is a disconnect between the economy and equities. These disconnects occur occasionally but the current one stands out as extreme. Therefore, there may be more risk to reducing equity exposure in the current turmoil.
[Posted: 9:30 AM EDT] It’s a risk-off Friday; global equity markets are slumping, economic data from China and Europe looked weak and PM May got rebuffed by EU leaders. As noted, equities are lower, the dollar is up and Treasury yields are down. Here are the details:
Global data: In China, retail sales hit a 15-year low as car sales[1] are on track to have their first annual sales decline since the 1990s.[2]
(Source: Capital Economics)
Since the 2008 crisis, China has maintained growth by increasing infrastructure spending and increasing debt. Policymakers are suggesting that similar actions are coming but the nagging fear is that we have reached the level where additional debt isn’t leading to stronger growth.
Meanwhile, in Europe, the flash PMI data was soft as the Eurozone manufacturing index dipped to 51.4, a 31-month low. Services also came in at 51.4, well below the forecast. Much of the weakness came from France, where protests led the composite index (combination of manufacturing and services) to fall to 49.3, below the expansion line of 50.
In some respects, today’s data is simply part of a trend that has been in place for over a year.
Sentix is a German economic research group that conducts surveys of economic sentiment. As the chart above shows, sentiment has been coming under pressure since peaking in January. Governments are aware of this weakness and have been increasing fiscal spending. Although we don’t expect a recession in the U.S. next year, global growth remains soft and the disparity between the U.S. and the rest of the world has supported a stronger dollar.
Brexit: PM May went to Brussels looking for help. As expected, she received nothing.[3] The most common complaint from EU ministers is that May didn’t know what she wanted. This sentiment is probably not completely accurate—she wants the EU to give concessions to appease MPs that the EU simply isn’t prepared to offer. The lack of progress sent the GBP lower this morning, although it should be noted that the dollar is higher across the board. Thus, this issue may not be all that important to the movement of the currency.
To reiterate, the majority of MPs do not want a hard Brexit, which would be a sudden ending of relations on March 31 that would sever EU trade relations with the U.K. At the same time, the negotiated deal May has created will not pass Parliament. Absent a referendum, it isn’t clear what the path forward is, although we do note that a hard Brexit is on the calendar if nothing else happens. It is possible May simply can’t make a deal to avoid a hard Brexit but it isn’t obvious if anyone else can, either. Labour’s Corbyn would like elections but he didn’t have the courage to call for a full no-confidence vote, which would have likely brought down the government. Corbyn’s reluctance to trigger a confidence measure suggests he doesn’t have any better ideas on how to move forward.
Our working assumption is that a hard Brexit is unlikely because no party really wants that outcome. However, each day that passes without progress increases the odds of that result because it is the only outcome determined by the calendar alone. If nothing happens by the end of March, the U.K. leaves on WTO rules. We still expect another referendum but that could require May to step down since she continues to argue that it’s her deal or nothing, which isn’t quite true. However, the strong Brexiteer fantasy that a better deal can be negotiated simply isn’t going to happen. So, we are looking at either (a) a new referendum that keeps the U.K. in the EU, (b) May’s deal, or (c) a hard Brexit. The middle choice looks unlikely so it is either a new vote or hard out. And, by the way, a referendum may simply lead to the same outcome as the first. In the end, we will probably need to approach the deadline in order to focus all parties into actually doing something. However, waiting increases the chances of a “sleepwalk” into disaster.
Senate rebuffs Saudi Arabia: The Senate[4] voted to withdraw American support for the Saudi-led war in Yemen. The vote is mostly symbolic since it won’t pass in the House. But, it is a rejection of the administration’s policy and a rare legislative defeat for the White House. In our view, the U.S. can’t sever relations with Saudi Arabia without risking a wider breakdown in the Middle East. At the same time, guiding the kingdom to find a new crown prince should be supported.
Stress monitor: With concerns rising in the financial system, it should be noted that the stress indices are holding on rather well.
We mostly rely on the Chicago FRB number because it has a much longer history, but we monitor the St. Louis report as well. The latter has ticked higher recently but we usually don’t worry about stress until we see readings above zero.
Slowdown in Q4: The Atlanta FRB GDPNow reading is down to 2.4% for Q4.
Here are the estimated contributions to growth.
The data projections show that consumption is generally holding its own but combined investment is expected to add a mere 28 bps to growth in Q4 compared to 252 bps in Q3. Net exports is expected to be a drag on growth but much less than the 191 bps decline seen in Q3. Finally, government is expected to add 30 bps to growth compared to 44 bps in Q3. Overall, the sluggishness projected should support a Fed pause if the central bank is so inclined.
[Posted: 9:30 AM EDT] Risk markets are mixed this morning with the pattern of fading overnight equity futures rallies continuing. Here is what we are watching:
ECB: The ECB is meeting today and has released a statement indicating that QE is ending[1] but the balance sheet will be maintained for the foreseeable future. That means the ECB will continue to invest in new bonds as old bonds expire. Interest rates were not changed. Overall, this outcome was mostly expected. The European economy has been weakening this year despite currency weakness and policy accommodation. Thus, we don’t expect the central bank to begin raising rates anytime soon. In the press conference, ECB President Draghi noted the weakness of recent data, which suggests policy won’t really tighten anytime soon.
May wins—now what? As expected, PM May won her leadership challenge and, based on Tory party rules, cannot face another internal party leadership challenge for a year. The vote was closer than expected, 200/117, which is disappointing. May had to promise not to run for PM in the next election, which is a bit of a humiliation. [2] On the other hand, she probably has no chance anyway. So, for now, May will lead the government into Brexit.
This is what we see going forward. First, there is little chance the EU will make material changes to the current agreement. Although there is nearly universal dislike for what May has negotiated, she was in a really weak position and was mostly forced to take whatever mercies the EU was willing to grant. Second, there is no stomach for a hard Brexit. It is now common knowledge that a hard Brexit will lead to serious economic disruption. Imagine the U.S. making a sudden stop to trade with Canada and Mexico. Grocery stores would quickly run out of some products (no guacamole!) and car production would halt as parts flow hit a sudden stop. Over time, the supply chains would adjust but the change would be painful and almost certainly inflationary. Although the BOE has made brave talk about raising rates to fight stagflation, in reality, a central bank facing inflation and recession will tend to fight the latter. Only under unique circumstances, like we saw in the late 1970s, will the first be the primary policy focus. Third, if our analysis is correct, the next likely step is a second referendum. Although this outcome is fraught with risk, there is no real middle ground between impossible new negotiations and a hard Brexit. Thus, a referendum to at least delay implementation might make sense and it’s possible a second referendum could reverse the outcome of first. Although there is grumbling about the elites re-running the vote until they get the outcome they want, one could argue that a second vote would be more informed because now the parameters are clearer. It should also be noted that holding multiple votes isn’t unprecedented; separation referendums have been held on multiple occasions in Quebec and Scotland. In the end, at a minimum, we think a hard Brexit will be avoided and the deadlines will be extended. And, “calling the whole thing off” is a clear possibility.
China trade: Negotiations continue and, actually, the situation appears to be improving. The Meng issue remains; in fact, a second Canadian was arrested in China yesterday.[3] On this issue, the Xi government is pressing Canada hard but is studiously avoiding taking actions against Americans…so far. If Meng is extradited, that could change. But, for now, China appears willing to restrict aggressive steps against Canada alone.
Meanwhile, trade talks continue and China is taking steps to improve the optics for the situation,[4] making high profile announcements. For example, China announced large purchases of U.S. soybeans.[5] The timing is important, as farmers are struggling to find storage space for the recent harvest, especially with steel tariffs driving up the price of silos.[6] China is moving to cut tariffs on U.S. autos from 40% to 15%.[7] It has asked for high level trade talks.[8] It is even offering to change its “China 2025” program to increase foreign participation.[9] We suspect that Xi is betting that Trump will accept a trade truce to improve sentiment going into 2019 to raise the odds of re-election. We doubt China has any intention to actually meet U.S. demands. From China’s perspective, the Plaza Accord of 1985 (which drove up the value of the JPY) and Reagan-era “voluntary” car export restrictions on Japanese car exports (interestingly enough, negotiated by none other than Robert Lighthizer), paved the road for Japan’s 30 years of economic stagnation. That isn’t exactly true, because Japan could have taken policy measures to adjust more quickly, but U.S. policy undermined Japan’s ability to export to the U.S. and made the adjustment process more difficult. Beijing fears the U.S. has similar plans for China. At the same time, offering concessions can buy China time, especially when the Chinese economy is slowing.
The unknown is the reaction of the Trump administration. If it is taking a long-term view, it should continue to press its advantage and force China to make significant concessions. However, that path would keep financial markets under pressure. Holding the line might be the best long-term policy but will reduce the president’s chances of re-election. We suspect the administration will soften to improve market sentiment.
Italian budget news: Yesterday, there were reports the Italian government was giving in to EU demands, offering an adjusted budget with a mere 2% deficit/GDP.[10] Although the reports were initially downplayed, in fact, it appears the reports were accurate.[11] Italian bonds have rallied strongly on the news. We suspect the bond market forced the Italian government to offer concessions.
More on tech: Apple (APPL, 169.10) has announced a significant investment plan in the U.S., boosting American employment by 20k by 2023. It is unclear if any of this $1.0 bn on new investment will bring production back to the U.S. (that seems unlikely for now). The high profile investment spending will improve its political profile.[12]
[Posted: 9:30 AM EDT] Risk markets are higher again this morning after fading the strong opening yesterday. A bail decision and, interestingly enough, a no-confidence vote appear to be the catalysts. There is a lot of news this morning. Here is what we are watching:
Meng gets bail: In the end, the Canadians granted Meng Wanzhou bail.[1] The terms are stringent; a CAD 10.0 mm bail, a private security detail and a location bracelet are all part of the agreement. However, supporting market sentiment was President Trump’s suggestion that he could “intervene” in Meng’s case if it would support trade negotiations.[2] The optics of the president’s offer are potentially problematic. If he didn’t know about the arrest (and there is some evidence to suggest he might not have known it was about to occur) then he is probably in the clear. But, if he knew about the arrangement, then her arrest makes her into a bargaining chip. We note that yesterday China arrested Canada’s former ambassador to China, setting up a potential exchange to keep Meng from being extradited to the U.S.[3] We also note that the State Department is considering issuing travel warnings for business executives traveling to China, a clear expression of concern.[4]
Although President Trump’s offer is likely helping the equity markets this morning, the path of U.S./China policy remains problematic. To some extent, trade policy is probably less important than technology transfer policy and tech issues surrounding this policy remain tense. For example, the U.S. is planning to condemn China over its hacking and economic espionage.[5] Reports suggest recent hacking activity originated in China.[6] Meanwhile, on trade, the U.S. hopes that China will begin buying U.S. soybeans soon. In fact, officials are confident enough that they are delaying aid payments.[7]
However, we also expect a truce to emerge on trade and perhaps even technology as we head into 2019. Next year will be the last full year before the 2020 elections and, traditionally, presidents try to lift the economy and markets going into elections. Although the long-term path of difficult relations with China remains in place (with all the potential for surprises and accidents), we still believe that odds favor a temporary truce.
May to face no-confidence vote: Opponents of PM May were finally able to get 48 letters from the Tories, although there is speculation that she herself may have convinced some of her supporters to send letters, triggering the vote on purpose (how Machiavellian!). It appears that she has enough votes among Tory MPs to remain as PM. Thus, winning the vote will solidify her position and this expectation explains the rally that has ensued from news of the vote. The results of the vote should emerge today in early afternoon. It should be noted that if May wins this vote, Parliamentary rules mean she cannot be challenged for 12 months.[8]
That Oval Office meeting: Yesterday, Americans were shown a bit of political theater as Nancy Pelosi, Charles Schumer and President Trump engaged in an open and spirited debate before the cameras over the border wall and government shutdown threats.[9] VP Pence remained quiet in observation.[10] We mention the event because equity markets turned lower during the spectacle. The reason for the open debate can be seen in recent polling.[11] Although the majority of Americans oppose closing the government over border wall funding, Republicans support the action 65% to 29%. Democrats oppose closing the government over border wall funding 71% to 21%. Essentially, all parties involved were targeting their political bases.
We would not expect a similar reaction to either a shutdown or another tussle for the media. Financial markets have been through a series of shutdowns; each event has less of an impact. Do we expect a shutdown? No. The GOP Senate leadership has no interest in a shutdown and we expect McConnell to prevent one from occurring.
Italian budget news: There were reports that the Italian government was giving in to EU demands, offering an adjusted budget with a mere 2% deficit/GDP.[12] Italian bonds rallied strongly on the news. However, the reports have not been confirmed. Meanwhile, League leader Salvini was forced to deny rumors he was considering snap elections.[13] We suspect these rumors are due to continued tensions between the coalition partners; Salvini would probably like to rid himself of the Five-Star Movement.
More on tech: Yesterday, Google’s (GOOGL, 1061.65) CEO was grilled on Capitol Hill. As we have been commenting for some time, the tech sector has been facing increasing political and regulatory scrutiny. At the same time, tech companies are mostly U.S. entities and American leaders have an interest in boosting their power relative to foreign firms. We note a report today that shows how the USMCA is actually quite favorable to American tech firms, especially in data gathering.[14] Although we don’t doubt the sincerity of political figures attacking tech firms, it should also be remembered that the U.S. benefits from a strong tech sector (unlike the Europeans, who have nothing close to the size and scope of American tech firms). As a result, there will tend to be a desire to support such firms.
An attack on float: One of the secrets of finance is the income generated from “float,” which is money that is between payments. Whoever “owns” that money in financial limbo collects interest. In some cases, float is a key component of a firm’s earnings. The Fed is considering measures to dramatically accelerate payments. Currently, payments are processed in batches three times a day and only during business hours. If you buy a good at midnight online, the bank may be able to earn interest on the payment until the first clearing session. The Fed wants to move the banking system to a 24/7, 365-day payment clearing system.[15] Losing float would harm the banks that are primarily making float on lower income Americans who live close to zero balances in their checking accounts. The slow pace of financial clearing often means low income households inadvertently bounce checks because deposits don’t get credited as soon as payments. Large banks are working on a similar system and oppose a Fed competitor. We will be watching this battle closely to see if it attracts populist support.
The latest iteration of our Mankiw Rule models: The Mankiw Rule models attempt to determine the neutral rate for fed funds, which is a rate that is neither accommodative nor stimulative. Mankiw’s model is a variation of the Taylor Rule. The latter measures the neutral rate using core CPI and the difference between GDP and potential GDP, which is an estimate of slack in the economy. Potential GDP cannot be directly observed, only estimated. To overcome this problem with potential GDP, Mankiw used the unemployment rate as a proxy for economic slack. We have created four versions of the rule, one that follows the original construction by using the unemployment rate as a measure of slack, a second using the employment/population ratio, a third using involuntary part-time workers as a percentage of the total labor force and a fourth using yearly wage growth for non-supervisory workers.
The rising core rate lifted all the variation’s rate projections. Using the unemployment rate, the neutral rate is now 4.05%, up from 3.93% last month. Using the employment/population ratio, the neutral rate is 1.94%, up from 1.83%. Using involuntary part-time employment, the neutral rate is 3.53%, up modestly from last month’s reading of 3.50%. Using wage growth for non-supervisory workers, the neutral rate is 3.25%, up from the previous month’s 3.08% as wage growth has accelerated.
Of all the variations, the wage growth one is the most concerning. Although comments from Fed officials have turned dovish and financial market expectations have also turned in a similar direction, the rise in wages will support the hawks’ position on raising rates further.
[Posted: 9:30 AM EDT] On the second day of the week, risk markets are rising. Trade hopes seem to be part of the reason for the increase as U.S. and Chinese negotiators are planning meetings and setting timelines.[1] It looks like the Meng arrest won’t derail trade talks. There is a lot of news this morning. Here is what we are watching:
Meng doesn’t get bail: The Canadians denied Meng Wanzhou bail despite offers to wear a location bracelet.[2] The Canadian judge has not decided on extradition yet, although we expect that she will eventually end up in the U.S. Meanwhile, we are seeing some ramifications on the trade front, mostly with technology.[3]
Brexit vote postponed: The fallout from the likely defeat of PM May’s Brexit plan continues to accumulate. Since her plan was doomed to defeat, she was forced to pull the vote and is now petitioning the EU for new terms.[4] So far, her requests are facing a “non” response.[5] While the EU would face some losses from a hard Brexit, it’s nothing compared to the difficulties the U.K. would likely suffer, although there is wide disparity in the forecasts.[6] However, there is no doubt that the initial impact of a hard border between the EU and Britain would lead to serious disruptions that will take weeks, if not months, to adjust.[7] It’s important to realize that the EU has an interest in a hard Brexit being a disaster. That would curb the enthusiasm of other nations thinking of leaving the EU (e.g., Italy). If it weren’t for the return of a hard border in Ireland, the EU may not have negotiated at all. But, a hard Brexit will almost certainly bring a return of the troubles in Northern Ireland, something the British government really doesn’t want due to the costs of maintaining security and Ireland clearly doesn’t want that outcome, either.
Notably, the most likely driver of Brexit was immigration. Polls show that at the time of the Brexit vote the EU wasn’t an issue but immigration was. By framing Brexit as a way to gain control of the borders, the Leave campaign won a victory.[8] Recent behavior in the EU has shown that the free movement of peoples has become mostly aspirational as even Merkel has softened her pro-refugee stance.[9] Like everywhere in the West, immigration is becoming a critical issue, even though there is strong evidence to suggest that immigration is a net benefit to developed economies.[10] However, it should be noted that there are distributional effects to immigration; in general, the wealthy tend to benefit the most from immigration while the poorest bear the costs. If PM Cameron had simply put up restrictions to immigration before the Brexit vote, it may have failed. But, that would have undermined his personal class interests. What about a second referendum? Although there is support for a new vote, it begs the question…will the elites continue to hold referendums until they get the outcome they want? What if the majority vote to leave again? Or, if the vote reverses, have you created a permanent “opposition class” that will be an indefinite problem?
The path forward is becoming increasingly difficult. Labour is pushing for a no-confidence measure that would likely lead to new elections and quite likely a Corbyn-led Labour government. The Tories don’t want that outcome but to move forward they may need to settle on a new party leader and PM and there is no clear leader. Meanwhile, financial markets remain under pressure and the GBP has been weak. At the same time, based on purchasing power parity, the GBP is remarkably cheap.
This chart shows the GBP parity model with standard error bands. The only time the GBP has been cheaper was at the peak of the dollar strength in 1985. If a hard Brexit is avoided, the potential for a rally in the currency is significant.
Macron blinks: In a bid to placate protestors, French President Macron gave an address yesterday and promised various fiscal measures to help the middle class and working poor, including a minimum wage hike.[11] It remains to be seen if these actions will quell unrest. However, there is one serious side effect from Macron’s spending—it could boost the French deficit/GDP ratio next year to 3.5%, well above the 3% limit established by EU treaty. France has repeatedly had deficits that exceed the limit but it has never faced scrutiny due to its influence in the EU.
Italy’s deficit is only 2.4% but the EU has issues with the structural nature of the deficit, which means the deficit could reach higher levels in recessions. However, that distinction will be lost on the average Italian voter;[12] this issue will look like the famous phrase, “all animals are equal but some are more equal than others.”[13]
New leader of the CDU: Chancellor Merkel won a significant victory, with her favored candidate, Annegret Kramp-Karrenbauer (henceforth to be known as AKK), winning party leadership.[14] Although the margin was narrow (51.8/48.5), AKK’s win means Merkel will remain chancellor for the time being. AKK is considered a “mini-Merkel” by the media and promised to continue the policies of her predecessor. Still, this is a victory for EU stability and is modestly bullish for the EUR.
This week, we conclude our series by describing what we view as a new model for the superpower role, the Malevolent Hegemon. We will discuss the differences between this model and the previous one. With this analysis in place, we will examine the potential outcomes from this shift and conclude with potential market ramifications.
What is to be done?
Distortions to the U.S. economy have occurred as a result of its role as the global hegemon. U.S. policymakers must decide how to address the inequality issue without triggering high inflation. One solution to this dilemma is to exit the superpower role. This would allow the U.S. to put up trade barriers and run trade surpluses; although potentially inflationary, it would likely increase employment opportunities for the bottom 90%.
[Posted: 9:30 AM EDT] Monday, Monday…global equity markets have been coming under pressure but U.S. equity futures have recovered in the past hour. It looks like pessimism has become excessive and maybe a rebound is in the offing. Here is what we are watching:
Equities remain jittery: Friday’s equity market action was poor, to say the least. Even with hopes of a trade truce and evidence that the FOMC is easing up, equity market action has the look of selling into every rally.[1] Some degree of caution is understandable. The trade tensions with China have the potential to undermine the high margin, low inflation environment that has been in place since 1990. The tech sector is deeply dependent on Chinese supply chains and a significant disruption of those relationships will take months, if not years, to restructure. This is why technology is under pressure.
At the same time, the White House has to make a political calculation.[2] Pushing against China is going to be a long-term trend; American policy has shifted to see China as a strategic competitor, meaning the open system of building capacity in China to take advantage of low labor costs and flexibility is going to end at some point. However, there is always an element of “Augustine’s dictum”[3] in such affairs because the immediate disruption is costly, which adversely affects the current political leadership only to benefit the successors. The president has to decide if the hardline stance on China will be popular enough with voters that they will accept slower growth and higher inflation. It’s a risky bet; if he decides it isn’t worth it we could see the trade truce broadened to support the re-election effort. We have no doubt that long-term relations with China will be different and likely hostile. However, there will be an incentive to delay the “long term” for a couple of years.
Chinese tensions remain: Meng Wanzhou remains in custody in British Columbia as China has summoned the U.S. ambassador to China, Terry Brandstad, to visit officials in Beijing to receive a “solemn protest.” China has also threatened Canada with “serious consequences” for the arrest. There is fear the arrest could threaten the U.S./China trade truce, but Robert Lighthizer, the USTR, said over the weekend that the arrest “shouldn’t have much of an impact” on trade issues, suggesting the two issues will remain separate.[4] Although the Meng arrest is a serious matter, it appears there is a concerted effort to isolate trade from the arrest.[5] Meanwhile, Lighthizer did insist that the truce deadline is March 1, 2019, suggesting the talks won’t linger.[6]
Brexit vote postponed: PM May, facing an inevitable defeat tomorrow, has pulled the vote on her Brexit plan.[7] Her “this or nothing” stance was undermined by a European Court of Justice ruling that indicated the U.K. could unilaterally withdraw from Brexit,[8] meaning there are alternatives to her plan. Not only that, but the judges have ruled that the returning party after an Article 50 declaration could return under the same conditions that existed before it left. One of the arguments made by the “leavers” is that a referendum decision to stay would be impossible because the EU would require the U.K. to give up the opt-out conditions it negotiated while in the EU, such as not having to join the Eurozone. It looks to us that a second referendum is the most likely outcome; decision markets put the odds of a second referendum at 37%, up from 24% in late November.
Reserve Bank of India (RBI) governor resigns:[9] Urjit Patel quit after weeks of rising tensions between the Modi government and the central bank. The government has been working to undermine the independence of the RBI as it wants to stimulate the economy in front of elections next year. Patel vigorously defended the independence of the bank to no avail. One of the key points to remember is that all central banks, including the Federal Reserve, have their independence only because elected officials grant them that power. He who gives can take away. If the political leaders of a country are moving to reflate an economy, weakening central bank independence is a key element in accomplishing that goal. The effective ouster of Patel will allow Modi to appoint a more compliant governor and could lead to unanchored inflation expectations for India.
India’s inflation has been under control for the past five years; the move against Patel could undermine that benefit.
Fed talk: Last week, we noted that FOMC members have become increasingly cautious about the path of policy tightening and noted that financial markets have been steadily lowering expectations for future rate hikes. St. Louis FRB President Bullard, perhaps the most dovish member of the FOMC, did come out last week supporting a pause.[10] Although we still expect the Fed to raise rates next week, we also expect language that will allow them to pause after this move.
Turkey thaw? The NY prosecutor’s office has withdrawn an appeal to extend the sentence[11] of Hakan Atilla, a former executive of Halkbank. Atilla and his former employer were convicted of violating Iranian sanctions; Atilla was given a 32-month sentence, a duration the prosecution believed was too lenient. Thus, the NY prosecutor had petitioned the court to extend his sentence. The Erdogan administration has been pushing the U.S. on this case, wanting Atilla to serve the rest of his sentence in Turkey. The NY prosecutor’s withdrawal decision suggests the U.S. may be negotiating with Turkey on a whole host of issues, including Saudi Arabia. We have been expecting some sort of quid pro quo on Turkey and Saudi Arabia; although it is still too early to tell, this action might be part of a broader scheme that would end up easing pressure on Turkey.
Google (GOOGL, 1046.58) in the barrel: Google’s CEO, Sundar Pichai, will appear before Congress tomorrow.[12] The company has mostly avoided the same level of congressional scrutiny other tech companies have faced in recent months. However, there are concerns about the company’s dominance and its privacy policies. Although much of what we will hear tomorrow will be grandstanding, the fact that there is bipartisan anger with the tech companies does signal a significant change in attitude toward the sector.
Italy’s League facing pressure: As we have noted recently, Italy’s populist coalition, a rarity in government, is facing internal pressure. The coalition, which includes the left-wing populist Five-Star Movement and the right-wing populist League, is unusual because the two populist wings tend to not get along. However, a major constituency of the League, small businesses in northern Italy, is upset with higher interest rates and the budget fight, viewing it as bad for business. It is unclear if this issue will escalate, but the tensions are worth monitoring.[13]
French protests: There were protests in Paris over the weekend but an overwhelming police presence seemed to limit the damage. Still, the protests are having an impact. President Macron continues to struggle to make an effective response.[14] The Bank of France (the country’s individual central bank) has reduced its Q4 GDP forecast from 1.6% (annualized) to 0.8% due to the disruptions caused by the protests.
The election of Donald Trump has been characterized as part of a populist uprising. In the president’s inaugural address, he talked about the “forgotten” that would have a voice in his administration. At the same time, we work under John Mitchell’s dictum of “watch what we do, not what we say.”[1]
In a recent Bloomberg podcast, Edward Alden, a journalist and fellow at the Council on Foreign Relations, was asked if the Trump administration favored business or labor. He replied that they are trying to help both.[2] We think Alden is correct in his assessment which is one of the reasons why analyzing the direction of policy with this administration is so difficult. It appears that one of the goals of the president’s trade policy is to bring production back to the United States which would benefit labor. At the same time, tax policy has generally favored capital. But, the most underestimated benefit to capital may be deregulation.
George Washington University measures the pages of the Federal Register, which is the official journal of the federal government. It publishes agency rules, proposed rules and public notices. So, the number of pages in the register says something about the number of regulations. The idea is that the more pages added to the register signals an increase in regulation.
The decline seen in the first full year of the Trump administration is remarkable.
The drop from 2016 to 2017 was 35.4%, which exceeds the 21.2% decline in 1981, Ronald Reagan’s first full year in office. The only year that was larger was 1947, which saw a 39.6% slide. That drop was likely due to postwar changes.
Another measure is called the “significant rule changes,”[3] a policy measure created during President Clinton’s first term. The decline in 2017 was unprecedented.
Only 55 new rules were added in 2017. That is clearly the fewest on record by multiples.
The drop in regulatory activity is partly why small business sentiment has been so strong.
The jump in small business sentiment mostly tracks the drop in regulation. A persistent complaint from small business leaders during the Obama administration was the regulatory burden. Not only did President Trump promise to reduce regulation, he actually accomplished it.
Tax changes and deregulation have been supportive factors for equities since the November 2016 presidential election. However, as Edward Alden noted, the Trump administration has tried to placate both capital and labor. Recent market action, with equities selling off despite a civil meeting between Presidents Trump and Xi and the yield curve flirting with inversion,[4] suggests that the financial markets are pressing President Trump to choose. Will it be capital or labor that wins out in the end? If capital is going to win, a lasting trade ceasefire needs to be declared. If President Trump sticks with tariffs, and there are ample indications that he intends to for now, then the financial markets appear to be preparing for recession. A recession in 2019 will jeopardize the president’s chances at reelection in 2020. Our expectation is that, at some point, President Trump will “blink” and tone down the trade rhetoric. But, that is an open question for now.
[Posted: 9:30 AM EDT] Happy Friday! Seventy-seven years ago, Japanese Imperial forces bombed Pearl Harbor. It’s also employment day. We detail the data below but here is the quick take—the data was a bit soft, with payrolls coming in below forecast at 155k, below the forecast of 198k. The rest of the report was near forecast. The most interesting overnight price action was the recovery in European equities, while U.S. stock futures remained in the red. Here are the details and other news items we are watching:
Fed talk: Yesterday, equities rallied strongly into the close, nearly reaching “green” levels after a hard selloff. The key factor was a WSJ[1] report suggesting the FOMC is considering a “pause” in the rate hike cycle. The consideration is certainly reasonable. Inflation remains under control. Our best estimates for inflation next year suggest core CPI will probably reach around 2.5%, well within the likely range of tolerance for policymakers. Recent market volatility and especially the flattening of the yield curve suggests caution. The NYT,[2] the paper of elite opinion signaling, quoting our friend Barry Bannister, suggests President Trump may be right about the risks of raising rates too quickly.
Two-year deferred Eurodollar futures have reduced the expected fed funds rate by 25 bps and are now signaling a terminal rate between 2.75% and 3.00%.
Given the degree of uncertainty, a pause would not be unreasonable. Part of the problem for forecasters is that the Fed has moved rates in a lockstep fashion for two cycles now. This wasn’t always the path of higher rates in the past but it has become expected now. Waiting a quarter or two to hike and breaking the pattern would set a different precedent which would probably be positive. A pause would put the idea in the minds of investors that the FOMC is truly data-dependent and policymakers will adapt when the data softens. We still expect a rate hike later this month (December 19, to be precise), but the pace in 2019 would not be preset, which would be positive for financial markets.
Chinese FX reserves: China’s FX reserves for November came in at $3.062 trillion, higher than the $3.045 trillion forecast.
We watch this data for evidence of currency intervention. The fact that reserves were mostly stable suggests only modest intervention, perhaps on the order of $11 bn last month, which was down from $13 bn in October. The reserves data does suggest external account stability, which is positive for the Chinese economy.
The arrest of Meng Wanzhou—an update: Yesterday, we reported that Canadian[3] officials had announced the apprehension [4] the CFO of the Chinese telecom firm Huawei (002502, CNY 4.71). The reaction of Chinese officials, at least so far, is rather measured. Reports[5] suggest the Xi government is separating the trade talks from the fate of Meng Wanzhou. Her issues will apparently be managed by national security officials, while trade negotiators will discuss, well, trade. We have no idea if the two issues will remain separate. We do note that Chinese policymakers are taking steps to support employment,[6] which may explain why Chairman Xi wants to keep the issues separate. U.S. trade policy may be hurting the Chinese economy more than estimated. In other words, China may need relief more than we think, thus the odds of a longer lasting truce are higher than the market expects.
That still doesn’t change the issues surrounding the long-term trends in Chinese/U.S. relations. As we noted yesterday, China is in the process of adjusting from the initial industrialization phase and history shows no other nation that made this transition did so easily. When European economies reached this point, they turned to imperialism and, sadly, mass industrialization war. The U.S. dealt with this moment with the Great Depression. When Japan and Germany made a second turn at this problem after WWII, Germany addressed it by moving up the value chain and 21st century imperialism, otherwise known as the Eurozone. Japan has adjusted with three decades of economic stagnation. Chinese leaders know where they are and are trying to adjust. They are attempting to move up the value chain by “acquiring” American technology and through imperialism with the “one belt, one road” project. In the meantime, they need trade with the U.S. to maintain growth. Although trade policy is getting all the attention, the real issue is technology. If China is forced to develop indigenously it may take too long and could push China to follow the path of Japan. In addition, if the U.S. really “pivots” toward Asia, imperialism won’t work either. Much can go wrong.
At the same time, nothing described above is a secret. It has been generally acknowledged since 2010 that China needs to adjust. However, its leaders were always fearful that moving full bore into adjustment would lead to a collapse in growth and undermine the legitimacy of the Communist Party of China (CPC). So, they have been putting off the adjustment in a sort of “stop/go” cycle that financial markets have gotten used to. What is hard to know is when the adjustment can no longer be avoided. If we are at that point, then risks to the global economy are much more elevated than they have been and there is some evidence that financial markets are starting to fear this outcome. Reports from traders indicate a high level of uncertainty over market action.[7] And, there is a growing realization that the status quo of U.S./Chinese policy[8] is truly ending and what occurs going forward is unknown.[9] John Maynard Keynes had a famous line when asked about the long-run impact of deficit spending, saying, “In the long run, we are all dead.” Years later, when inflation raged in the 1970s, the quote became, “We are in the long run and Keynes is dead.” We don’t know how close China is to the “long-run,” the hard adjustment period. But, if it’s close, the impact will be significant. Our take is that Chinese officials are in no hurry to aggressively address the transition, but it is possible they may not have much of a choice.
Merkel moves on: The CDU/CSU is holding party meetings to appoint a new party leader as Chancellor Merkel steps down. If her selection, Annegret Kramp-Karrenbauer, is appointed, then Merkel will likely keep her post as chancellor. However, if Friedrich Merz or Jens Spahn get the nod, then Merkel will probably be ousted.
Brexit update: There are rumors that PM May might delay next Tuesday’s vote, given that her plan will likely go down in defeat. It’s starting to look like a second referendum is coming; we note that the leave supporters are preparing for a second vote.[10]
Energy update: Crude oil inventories fell 7.3 mb last week compared to the forecast decline of 3.1 mb.
The large build was due to high refining activity, which remains at 95%, a 0.9 mbpd decline in crude oil imports and a 0.8 mbpd jump in exports.
(Source: DOE, CIM)
The seasonal chart suggests the usual easing of inventory accumulation into year’s end has likely started.
Based on oil inventories alone, fair value for crude oil is $59.93. Based on the EUR, fair value is $54.60. Using both independent variables, a more complete way of looking at the data, fair value is $55.73. The data is rather bullish but prices failed to rally as sentiment was overshadowed by OPEC. Reports indicate that the cartel has agreed to 1.2 mbpd of production cuts, but we have no details at this time. Oil prices are rallying on the news.
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