Since the election of Donald Trump, there has been much discussion about the demise of the “Liberal International Order,” or LIO. Several books on the topic have been published recently[1] and the general tenor is that the U.S. is giving up global leadership and the world is in trouble. We have been making this argument as well for a rather long time. However, there is an alternative viewpoint, which is that the U.S. isn’t giving up global leadership but is ending the LIO for something different.
What we may be seeing is not a retreat from the world but a significant change in management style, hence the title of this week’s report. We have dubbed this new style “The Malevolent Hegemon,” as opposed to “The Benevolent Hegemon” or the LIO, which describe how the U.S. managed the world from 1945 until 2008. We argue that the LIO began to wane under the Obama administration but a replacement model wasn’t evident. The Trump administration does appear to be creating a new model of hegemony.
In Part I of this series, we will begin with the basics of hegemony. From there, we will describe the unique model of U.S. dominance, Pax Americana, with the U.S. as a benevolent hegemon. Part II will discuss why the U.S. has become jaded with this role, which has spawned the search for another model. Part III will analyze what appears to be the emergence of a new model, which we describe as the malevolent hegemon. We will discuss the differences between the two models. With this analysis in place, we will examine the possible outcomes from this shift. At the conclusion of the series, we will discuss potential market ramifications.
[Posted: 9:30 AM EDT] Happy Monday! Risk markets are higher this morning on hopes of a détente between China and the U.S. on trade and on hopes that the FOMC will signal some dovishness. Thanksgiving has passed and the West is gearing up for Christmas. Here is what we are watching today:
Tensions at the Kerch Strait: Russia used a tanker to block a bridge arch on the Kerch Strait, a narrow waterway that links the Black Sea to the Sea of Azov. Although both Ukraine and Russia technically share jurisdiction over the area, Russia, with control of Crimea, effectively holds power over the strait. Both nations have disputes over territorial waters, making the region a potential hotbed for conflict. According to reports, three Ukrainian naval vessels approached the bridge but were blocked by the tanker. Later, Russian warplanes and coast guard vessels fired on the Ukrainian vessels and seized the three Ukrainian ships.[1] Russia claims the Ukrainian ships illegally entered Russian waters after Russia had told the Ukrainian vessels that the strait was temporarily closed[2]; Ukraine obviously disputes this narrative. NATO is backing Ukraine on this issue and the latter has asked for an emergency U.N.S.C. meeting. Ukrainian President Poroshenko is asking parliament to impose martial law which would make it easier to mobilize.
The below map shows the strait.
(Source: BBC)
Will tensions escalate from here? Only if NATO (which means the U.S.) decides to make a strong response. We don’t expect that to occur. The White House is not likely to directly defend Ukraine over this skirmish and the Europeans don’t have enough power to do so. What is worrisome about this incident is that it could be a probing tactic by Putin to gauge the West’s resolve. If he can get away with this, he may try a similar tactic with the Baltics at some point. For now, financial markets, with the exception of Russian financial assets, are mostly ignoring this event. But, it could make the G-20 meeting later this week a bit more interesting.[3]
Italy relents? Italy’s governing coalition is hinting it may reduce its deficit target to avoid a confrontation with the EU commission.[4] Although we have our doubts that the deficit will actually be reduced, there is the potential for enough “window dressing” to allow the official numbers to improve and, at least for now, ease tensions between the EU and Italy. Financial markets rallied on the news.
Macron’s woes: French President Macron is facing continued widespread protests over his government’s decision to raise fuel taxes. The policy was designed for environmental reasons but car owners in France are not happy with the decision. Although the numbers are down from last week, the persistence of the protests are somewhat unusual. This weekend’s action was mostly in Paris, which is also a departure from last week, when they were more widespread.[5] Our take on the protests is that the participants are mostly working class and the concern is primarily financial. The West is facing widespread populism, a revolt of the bottom 90% against globalization and deregulation. Macron’s political movement was, in some regards, part of this reaction. He built a party from scratch, defeated the established center-left and center-right and prevented a populist surge from either the left or right. However, winning elections is one thing, governing is another. He is trying to govern as a center-right supporter of free markets when the bottom 90% want to be protected from the forces of globalization and deregulation. The administration’s response to the protests has been to mostly berate or ignore them. That may prove to be a mistake.
Brexit update: The EU approved the Brexit deal.[6] Now, PM May faces the difficult task of moving a reluctant parliament to accept the arrangement.[7] She has a couple of weeks to cobble together a coalition of Conservatives and Labour to pass the measure. Although there is little enthusiasm for the deal, it isn’t obvious that a better deal can be arranged. We would not be shocked to see the first vote fail, which could lead to another try—an outcome we refer to as the “TARP method.” The first TARP vote failed but market reaction concentrated the minds of legislators to pass the measure. If this deal fails, the next step would be May’s resignation followed by either hard Brexit (leaving without a deal, likely causing significant economic disruption) or another referendum. We are leaning toward the second referendum outcome, but we do think the odds that the current form passes may be higher than most think. Although a hard Brexit is still a possibility, it is probably the least likely outcome.
Taiwan swings toward China: In local elections over the weekend, the China-leaning KMT party won going away, rejecting the separatist Democratic Progressive Party (DPP).[8] Taiwan President Tsai Ing-wen resigned from DPP party leadership following the drubbing. Presidential elections are coming in a year and these local elections raise the possibility that the island will return to KMT rule. In general, the DPP tends to find support among local Taiwanese who would prefer independence, whereas the KMT finds support among the Chinese Nationalists whose ancestors fled the mainland after Mao won the civil war in 1949. Power tends to swing between the two parties. Neither has been able to maintain power but the KMT’s recent performance does ease some of the potential tensions that have been rising under President Tsai.
Trump and the Fed: Financial markets have been hinting that the FOMC should be considering at least a pause to prevent further weakness in the financial markets. Chair Powell will be giving a speech Wednesday evening on Fed policy and emerging markets and there is hope of a dovish tone. Meanwhile, the WSJ[9] reports that the president is unhappy with Powell and is blaming Treasury Secretary Mnuchin. As we stated numerous times after the election, there was a battle going on between the GOP establishment and the populists. That battle is still underway; Mnuchin, along with Kudlow, represent the former. To some extent, the president has been balancing these two forces. His stump speeches are pure populist but his governing is mixed. The tax cuts and deregulation generally favor the establishment, whereas the immigration and trade policy are populist. One issue we have been watching since Trump’s election is relations with the Fed. Presidents since Truman have, at times, been at odds with the central bank. It is powerful, independent and can wreck a president’s political position by bring a recession. Trump is not unique but appears so because since the early 1990s there has been a détente between the two forces—presidents leave the Fed alone and the Fed promises to be careful.
Our concern has been that President Trump might take a page out of President Nixon’s playbook and force the Fed to deliver easy policy. He has already undermined the truce via tweet. Nixon got his way with the Fed by creating a crisis for Chair Arthur Burns (his administration leaked that Burns wanted a doubling of his pay) and then offered to support Burns in return for easy policy. We thought we would get something similar with Trump picking easy money governors but instead the president, mostly under Mnuchin’s guidance, delivered center-right establishment picks for governors. It appears the president has finally figured out he didn’t get what he wanted and is turning on his treasury secretary. If the president can browbeat the Fed into delivering easy policy and this causes financial markets to worry that the Fed won’t stand up to inflation threats, then it could unanchor inflation expectations and lead to a much weaker dollar and higher bond yields.
Oil: Oil prices have taken a beating over the past few weeks; rising inventories are the primary culprit, although a steady series of presidential tweets are playing a role as well. There seems to be a notion floating around that the Saudi crown prince, now indebted to the White House for not pressing the Khashoggi incident, will be beholden to Washington. Recent production numbers from the kingdom support this idea.[10] Perhaps…but, at the same time, there isn’t anything coming out of the Kingdom of Saudi Arabia (KSA) to suggest it wants prices to continue to fall. At the same time, continued declines in oil prices do appear to be President Trump’s goal.
Does this make sense? There is evidence to suggest that lower gasoline prices lift consumer confidence. But, it isn’t the most important factor.
The above chart on the left shows consumer confidence and the unemployment rate (the latter with an inverted scale). The two series track each other closely and correlate at the -75% level. To measure the impact of gasoline prices, we scale gasoline prices by the hourly wages of nonsupervisory workers. This gives us a measure of how many gallons of gasoline a worker can purchase for an hour’s worth of work. The recent decline in gasoline prices has lifted the number to 8.3 gallons; however, this measure has been falling since 2016 and has not prevented consumer confidence from continuing to rise. The evidence suggests falling unemployment plays a bigger role.
At the same time, oil and gas drilling has become more important to the U.S. economy.
This chart shows the relationship between overall industrial production compared with industrial production from oil and gas drilling. From 1987 to 2000, the correlation was nil, suggesting that the impact of oil and gas drilling was minimal for overall output. However, since 2000, the correlation has risen to +45.6%. This suggests that if oil prices remain low, oil and gas production will likely decline and weaken the overall economy. In general, the impact on the U.S. economy from lower oil prices is probably still positive, on balance, but the positive benefits are less than they used to be.
Finally, oil prices have fallen to a level where they are undervalued.
Our EUR and oil inventory model suggests fair value of $55.50 and is nearly a standard error below fair value. In the past, such valuation usually leads to at least consolidation. Seasonally, we should see inventories decline into year’s end and these fundamental factors, coupled with a deeply oversold market, should lead to a bounce in crude oil in the near term.
(NB: The Daily Comment will go on hiatus beginning Wednesday, November 21st, returning on Monday, November 26th. From all of us at Confluence Investment Management, have a Happy Thanksgiving!)
Another down day for equities—stocks continue their slide. News flow was surprisingly light overnight. Here is what we are watching:
Equity markets: Stock markets around the world continue to struggle. Although there are some earnings issues, for the most part, weakness is coming from multiple contraction, suggesting investor sentiment is waning. The current weakness is specific to two factors—fears based on Fed policy and Trump administration trade policy. The first problem is not unusual. The FOMC has been steadily raising rates and we are now seeing the policy rate reach a level that, by itself, isn’t necessarily restrictive but could become so in short order if comments from Fed officials are accurate on the future path of tightening. A related concern is that policymakers appear to be abandoning, or at least questioning, the Phillip’s Curve construct without offering another framework for setting policy. One trend that does appear to be in place, however, is that investors, for the first time in years, appear to be considering cash and near cash instruments as an asset class. In simpler terms, “cash is no longer trash.”
The trade issue is much more confounding. Since the end of WWII, U.S. trade policy has been set on open and free trade. In practice, this meant the U.S. acted as importer of last resort and ran persistent trade deficits to provide the world with the dollar, the global reserve currency. Although this policy was key to winning the Cold War and boosting globalization, it has detrimental effects on equality in the U.S. It has become clear that political support for free trade is waning; in the last presidential campaign, for example, both candidates promised to jettison TTP, a trade arrangement with the Pacific Rim. Restricting trade will tend to undermine efficiency and eventually lead to higher inflation. However, in the short run, the more likely impact will be a reduction in margins.
What is generally unappreciated about the administration’s trade policy is that it appears to be a reversal of over seven decades of U.S. policy. In fact, we would argue that the last time the U.S. took broad actions to restrict imports was during the 1920s. Thus, no economist today has a working economic model that incorporates deglobalization. This creates uncertainty which the equity markets are struggling to discount.
Currently, there is hope of some sort of trade truce at the G-20. The continued weakness in equities may be enough to lead the president to “call off the dogs” for a period of time. However, our view is that the president’s core belief is anti-trade, at least in the form the U.S. has pursued since WWII.[1] We believe the person in the administration that most closely mirrors the president’s trade policy is Robert Lighthizer. His view essentially favors the deglobalization of supply chains—in other words, he wants to bring production back to the U.S.[2] The policy is also treating China as a strategic competitor,[3] in a fashion not like we treated the Soviet Union, but more like how Britain viewed Germany before WWI. Thus, any easing of trade tensions that come from the G-20 probably won’t last. Instead, the goal will be to stabilize markets. So, we would not be surprised to see the president attempt to temporarily ease market concerns but one should be cautious about expecting a retreat from trade policy.
After the holiday, we are launching a three-part series on the evolving superpower policy of the U.S.; it is titled “The Malevolent Hegemon.” Our thesis is that the narrative that the U.S. is abandoning its hegemonic role is probably not true. Instead, the U.S. is changing how it exercises that role and doing it in a manner that is much less friendly to the rest of the world, thus shifting from the previous model we dub “The Benevolent Hegemon” to the Malevolent Hegemon. On trade, a key component is to shift trade negotiations from multilateral, which tends to restrict American power in trade, to bilateral, which enhances it. In the end, it isn’t clear to us if it will work. But, we don’t think the evolution of U.S. policy should be seen as isolationist.
Overall, the economy is still doing well and earnings, while probably peaking in terms of growth, will likely remain elevated. And, seasonally, we are in what is usually a bullish environment. Thus, we would not be surprised to see a recovery in the near term. But, a lift will likely need a catalyst, either in the form of a trade truce or some indication from the Fed that a pause in tightening policy is being considered.
Rising tensions in the royal family: The Khashoggi affair adds to previous evidence that the crown prince, Mohammad bin Salman, is mercurial and his policies could contribute to regional instability. As we argued in the last WGR, we would expect other potential claimants to the throne (the grandsons of Ibn Saud) to try and unseat MbS.[4] Reuters is reporting that the royal family is considering putting off the decision of which grandson will become king by putting the last “king-eligible” son of Ibn Saud, Prince Ahmed bin Abdulaziz, into the king’s role after the death of King Salman. Our fear is that the transition will not be smooth; MbS has become quite powerful and would likely move quickly after his father’s death to secure power. We believe financial and commodity markets are underestimating the potential disruption to regional stability and the oil markets from succession.
EU sours on Iran: Although the EU clearly didn’t care for the Trump administration’s decision to exit the Iran nuclear deal, support for helping Iran break sanctions has taken a blow after Tehran was implicated in plots to assassinate Iranian dissidents in Denmark and France.[5] If Europe turns on Iran over these issues, it would be a diplomatic “own goal” for the mullahs. It would also be bullish for crude oil.
Brexit update: Not a whole lot more to report. The Tory rebels still don’t have enough letters to bring a leadership vote. There is widespread discontent with the deal May negotiated with the EU but no one has come up with a better offer. The three outcomes—the current deal, a hard Brexit with no deal or a new referendum—all remain on the table. Given that neither the current deal nor a hard Brexit appears attractive, we would not be surprised to see a new referendum. It is not out of the question that the U.K. decides that being in the EU isn’t all that bad (especially if one isn’t in the Eurozone) and if the U.K. can negotiate some degree of border control on immigration (which, by the way, is happening all over Europe), we may see a reversal of Brexit.
The Swiss consider nationalism: This Sunday, Switzerland is holding a referendum on “self-determination” which would make the Swiss constitution supreme over any international treaties the country joins. Thus, if the Swiss pass a referendum at a future date that conflicted with an international treaty, the agreement would have to be either renegotiated or cancelled.[6] If this measure passes, it will make it very difficult for any future Swiss government to negotiate treaties because the other parties will never know if the pact will be rejected at some point by a future referendum. We view this vote as another example of rising opposition to globalization.
(NB: The Daily Comment will go on hiatus beginning Wednesday, November 21st, returning on Monday, November 26th.)
Happy Monday! It’s a short week as the U.S. prepares for the Thanksgiving holiday on Thursday and a slow day on Friday. Here is what we are watching today:
BREAKING: Nissan (NSANY, 17.95) Chairman Carlos Ghosn has been fired by the company and arrested by Japanese authorities on charges of income misconduct.[1]
Pence v. Xi: VP Pence and Chairman Xi gave dueling speeches at the APEC summit over the weekend, with the U.S. and China offering differing views of each nation’s trade position. Pence, in his speech, detailed a hardened U.S. trade position[2] and suggested that China’s broader policies, including the “one belt, one road” initiative, was creating debt traps for Asian nations. It should be noted that last week President Trump deemed China’s recent offers on trade to be “unacceptable.”[3] Later, Xi defended his nation’s trade and foreign investment policies and criticized the U.S. for its recent turn on tariffs.[4] For the first time ever, APEC did not issue a joint closing statement, a clear indication of the growing dispute between the U.S. and China.[5] These sharpened positions tend to weaken the case that the U.S. and China will come up with a deal at the G-20.[6]
At the same time, it isn’t exactly clear whether Pence is actually expressing policy or taking on the “bad cop” role. Last Friday, President Trump signaled a more conciliatory stance which led to a bounce in equities. That position appeared to be undermined by Pence’s speech. However, we doubt the president would allow his VP to go independent on policy. We note that Pence played a similar role with North Korea, setting a hardline stance at the Winter Olympics that was reversed by President Trump meeting with Kim Jong-un a few months later. Pence’s speech and the apparent failure at APEC may simply be a bargaining position.
In addition, there was one rather interesting note that came from a former trade negotiator, Long Yongtu, who criticized the Xi administration’s decision to target soybeans, describing the action as “unwise.”[7] Long led China’s negotiating team when it joined the WTO. It is very unusual for former officials to criticize current government policy and may signal growing unease with Xi’s confrontational strategy with the U.S. Although Xi does appear to be clearly in power, this move by Long bears watching.
Macron’s woes:[8] French President Macron is facing widespread protests over his government’s decision to raise fuel taxes.[9] The policy is designed for environmental reasons but car owners in France are not happy with the decision. There has been at least one fatality and over 400 injured.[10] At least 2,000 separate demonstrations have occurred in France over the weekend.[11] Although we doubt they will bring down the government, it does show how Macron is struggling to govern in the face of growing unpopularity. Although Macron’s issues pale in comparison to those in Germany, Ireland, the U.K. and Italy, these events show the fragility of European politics.
Tech under fire: The technology sector has always had close ties to the Democratic Party.[12] The GOP was never all that comfortable with the tech ethos. However, both sides of the political spectrum are turning on tech.[13] Recent polls show a growing and broad dissatisfaction with social media.[14] We see this as important because one of the keys to steady disinflation has been the lack of regulation on technological innovation.
Is USMCA in trouble? There are reports that the incoming Democrats want major changes to the recently negotiated new NAFTA agreement.[15] It is doubtful that the treaty can be changed significantly without blowing up the arrangement. We suspect the administration will move to a “take it or I’ll end it” stance; at that, we expect the Democrats to back down but we may see some market worries before the deal is eventually accepted.
Brexit update: PM May is on her way to Europe[16] to continue negotiations with EU officials. However, we don’t expect any major changes, although Michel Barnier, the chief EU Brexit negotiator, indicated over the weekend that the transition could be extended to 2022 to ease pressure on businesses.[17] Such an agreement would avoid the “backstop” measures on the Ireland/Northern Ireland frontier. The hard Brexit group will see this extension as a way to stay in the EU indefinitely and thus will likely oppose the offer. Spain is using the Brexit controversy to try to increase its control over the British colony of Gibraltar.[18] One trend we are watching—the odds of a second referendum appear to be rising. Another vote might make sense given the magnitude of leaving the EU, the uncertainty over what exactly voters approved at the first referendum and the inability of Parliament to make a clear decision on Brexit.[19] We do note that there are increasing fears surrounding a hard Brexit. For example, there are reports that food warehouses are running out of space as retailers engage in “just in case” inventory stocking.[20]
Unsubstantiated rumors suggest there have been 40 leadership challenge letters submitted, eight short of enough to trigger a leadership vote among the Tories. While this group contends they can still do away with May without 48 letters, the inability to hit the number suggests this group may not have as much support as it looks. Even though the U.K. PM remains in grave political danger, she continues to hold onto power.[21]
Fed waffling? There is a growing sense in the financial markets that the FOMC may not make three hikes next year. Recent comments from Vice Chair Clarida seem to suggest that the economy may need as little as two more hikes or maybe as much as six to achieve neutrality.[22] Since 1987, when then-Chair Greenspan indicated that the Fed stood ready to supply liquidity to financial firms during the 1987 Crash, financial markets have essentially found that policy authorities generally come to their aid. Part of this action is because the U.S. shifted from a safe but inefficient financial system that was constrained by regulation to one that is efficient but fragile with much less regulation. What does concern us is that the FOMC appears to be abandoning the Phillips Curve framework (which is justifiable) without an obvious new framework, which may increase the odds of a policy mistake.
Saudis lead the cutback charge: The Kingdom of Saudi Arabia (KSA) feels like it was wrong-footed by the Trump administration, which pressed on the nation to boost output to offset Iranian oil sanctions only to see the U.S. grant extensive waivers. In response, the KSA is leading the charge within OPEC to cut production by up to 1.4 mbpd.[23] Recently, the KSA has increased its oil exports to the U.S., likely in a bid to lower WTI prices.
Note that since Q1, Saudi imports to the U.S. (on a four-week average basis) have been rising sharply. According to reports, the Saudis are retaliating to the perceived “fake-out” by the administration and are planning to slash shipments to the U.S.[24] Although oil prices have been under pressure in recent weeks, these actions by the KSA should, at a minimum, lead to market consolidation. If the usual seasonal demand increase follows, we would expect prices to mount at least a modest recovery.
(NB: Due to the Thanksgiving holiday, the next report will be published on November 30.)
Last year, we introduced an indicator of the basic health of the economy and added it to the many charts we monitor to gauge market conditions. The indicator is constructed with commodity prices, initial claims and consumer confidence. The thesis behind this indicator is that these three components should offer a simple and clear picture of the economy; in other words, rising initial claims coupled with falling commodity prices and consumer confidence is a warning that a downturn may be imminent. The opposite condition should support further economic recovery. In this report, we will update the indicator with October data.
This chart shows the results of the indicator and the S&P 500 since 1995. The updated chart shows that the economy is doing quite well. We have placed vertical lines at certain points when the indicator falls below zero. Although it works fairly well as a signal that equities are turning lower, there is a lag. In other words, by the time this indicator suggests the economy is in trouble, the recession is likely near or underway and the equity markets have already begun their decline.
To make the indicator more sensitive, we took the 18-month change and put the signal threshold at -1.0. This provides an earlier bearish signal and also eliminates the false positives that the zero threshold generates. Notwithstanding, we will pay close attention when the 18-month change approaches zero.
What does the indicator say now? The economy is healthy and currently supportive for equity markets. Thus, the recent weakness in equities is not due to the economy but other factors, including monetary and trade policy. The good news is that if there is any reduction in concern over these issues then the economic data would likely support stronger equity prices. The negative news is that there isn’t much evidence yet to expect a pause in Fed tightening or a systemic easing of trade tensions. Thus, for the time being, equities will struggle to challenge recent highs.
(NB: The Daily Comment will go on hiatus beginning Wednesday, November 21st, returning on Monday, November 26th.)
Happy Friday! After a strong close in equities yesterday, we are giving some of the gains back this morning. Trade worries continue to dominate. This is what we are watching this morning:
Brexit: After yesterday’s high drama, things are remarkably calm this morning. Hard Brexit Tories submitted no-confidence letters, the first step to trigger a leadership challenge to PM May. So far, their efforts are falling well short of what is required; a total of 48 formal letters are needed to bring a leadership challenge but the group only has 20 and can’t seem to generate further interest. After a flurry of cabinet resignations, the rest of May’s cabinet seems to be sticking. PM May’s political obituary has been written dozens of times in recent months,[1] but she remains standing and, due to her ability to maintain composure and press on, she continues to survive. Of course, part of her success is due to the fact that there isn’t an obvious replacement. The hard Brexit group is a set of difficult personalities that don’t seem to like each other much and all assume they are the natural leader of the group. Although they are loud and get lots of press coverage, they don’t seem to be all that powerful. Another factor helping May is that it isn’t clear if a better deal is possible. As we have noted over the past two days, Britain’s bargaining position is weak and the prospect of sending the economy into a deep recession, even if it is short in duration, isn’t an attractive position.
Still, there is no doubt that May doesn’t have the votes from her coalition to pass this measure. She has been calling for a “free vote”[2] in Parliament. Corbyn, hoping to bring down the government and become the next PM, won’t likely agree. But, he may not be able to discipline his backbenchers who may vote with May on the measure.
What happens if the vote fails?[3] There are five possible outcomes:
Hard Brexit: The U.K. leaves the EU without a deal and becomes severed from the continent. We would expect a deep recession, a dramatic decline in British financial equities, a weaker GBP and higher Gilt yields. However, we would not be surprised, in the midst of financial and economic turmoil, to see negotiators attempt to make specific agreements on immigration, border security, etc.
Renegotiate: Although the EU has indicated it isn’t open to new talks, faced with hard Brexit, it may be open to new negotiations. If this option is taken, look for the U.K. to join the European Free Trade Association in order to remain in the common market. This isn’t a permanent solution (if one goes this direction, why leave?) but it could buy time.
New general elections: This is the outcome that Corbyn is pressing for. Labour has been pushing for a soft Brexit, similar to what we would see with option #2. However, financial markets would take a dim view of a Corbyn government and we would likely see a massive selloff in the GBP and much higher interest rates.
Second referendum: Although there would be political obstacles, this outcome makes some sense. The first vote was a decision between the EU with all its flaws and a “glorious” future outside the EU. Now that it’s evident that there will be no glorious future, another vote would be a choice between more realistic alternatives.
Accept the current deal: In the end, MPs may finally conclude that, after threats of failure, the May deal is the best they will get. This is the TARP outcome; initially, the House voted against TARP but reconsidered when financial markets collapsed.
In the end, we think the U.K. will avoid a hard Brexit and maintain ties to the EU. It should be noted that there is widespread dissatisfaction with the EU across Europe and, at some point, we would not be shocked to see other nations expand their sovereignty at the expense of the broader union. But, a hard Brexit would almost certainly lead to an immediate negative outcome that all involved would likely try to avoid.
Trade truce: Equities rallied yesterday on hopes of a trade truce with China.[4] Although we could see some sort of delay in tariff implementation, the anti-globalists within the administration do continue to have influence.[5] We would not be surprised to see the president try to calm concerns over trade at the G-20, but we would not expect a major reversal.[6] The WSJ has a good article about how President Trump’s views on trade have developed from his early years; his perception of trade as a “zero-sum” game are deep-rooted and we would not expect him to ever fully abandon them.[7]
Port facilities are reporting a surge in imports,[8] suggesting that firms are trying to beat the onset of tariffs by building critical inventories. The chart below shows the contribution to GDP from goods imports and inventories. Rising imports are a negative number in this calculation. Note that in Q3 there was a surge in imports and a sharp rise in inventories. We would expect a negative impact from inventory destocking, likely showing up in Q1 2019 GDP, but that would be partly offset by lower import numbers.
Gulen extradited? NBC is reporting that the White House is considering extraditing Fethullah Gulen to Turkey in a bid to placate Turkish President Erdogan and get him to stop pressing on MbS and the Saudis.[9] This would be a significant move if the U.S. follows through, although it should be noted that career officials at the DOJ oppose the move. Giving up Gulen would be significant, a signal to other high-profile foreign refugees that they might not be safe in the U.S.[10]
Fed news: The Senate has confirmed Michelle Bowman as FOMC governor, taking the position reserved for community bankers. This position tends to be a reliable voter with the chair as the position doesn’t usually attract candidates with strong monetary policy views. Meanwhile, Nellie Liang and Marvin Goodfriend remain candidates for governorship. Liang has been criticized for not being a strong enough supporter of deregulation, while Goodfriend has pretty much disappeared even though the administration hasn’t removed his name from consideration. Goodfriend is something of a hawk on policy and thus we would not be surprised to see him replaced at some point. President Trump has two vacancies remaining on the committee.
Chair Powell is launching a broad review of monetary policy and communication at the Federal Reserve. It isn’t exactly clear what he intends to accomplish but we fear it means greater transparency.[11]
Foreign central bank news: The BOJ is sending persistent signals that it is concluding the costs of its unconventional monetary policy actions are outweighing the benefits.[12] If the BOJ begins to reverse policy, the JPY could appreciate sharply. In a speech yesterday, ECB President Draghi acknowledged that the Eurozone economy has been sluggish. This may delay policy tightening further into the future.[13] Finally, the PBOC is said to be considering its first rate cut in three years.[14] Although the Chinese central bank has cut reserve requirements, it has avoided an actual rate cut, most likely to avoid currency weakness. The fact that the PBOC is considering such measures suggests economic conditions are deteriorating.
(NB: The Daily Comment will go on hiatus beginning Wednesday, November 21st, returning on Monday, November 26th.)
It’s Thursday morning. Today’s headlines are being dominated by Brexit. Here is what we are watching:
Brexit: PM May suffered a significant blow overnight as two cabinet ministers resigned,[1] including her Brexit minister Dominic Raab and pensions secretary Esther McVey. Losing Raab was particularly bad because he was supervising the negotiations over Brexit. Over the past two and a half hours, May has been faced with withering criticism in Parliament. It is hard to see how she survives the criticism. A leadership contest has been called; if 48 Tory MPs agree, then a vote to remove her from power will follow. However, if she survives (and she might, simply because there is no obvious alternative), she cannot face another similar challenge for a year.
Nevertheless, the stark reality this deal shows is that the EU held all the negotiating leverage all along. There isn’t much of a compelling reason for the EU to quickly make a free trade agreement with Britain. Both Frankfurt and Paris welcomed undermining London’s global financial role and the EU is big enough to restructure supply lines to exclude the U.K. Although the Unionists in Northern Ireland are not necessarily comfortable with a hard border, they fear this outcome less than if the customs border becomes the Irish Sea, which would mean steady economic integration into Ireland and could mean eventual unification. However, the rest of the U.K. would not relish a return to the Protestant/Catholic tensions that led to British troops being stationed in Northern Ireland for years to separate the two groups.
As we noted yesterday, a hard Brexit would be a clean break but would also lead to a deep recession with supply disruptions that could have potentially tragic outcomes. May has tried to avoid this outcome by effectively joining the EU Customs Union (similar to Norway) as a “temporary” solution with no obvious deadline for actually leaving the customs union. This outcome avoids the deep recession outcome but doesn’t really leave the EU. In fact, it’s worse than staying in the EU because by staying in the customs union the U.K. would live by the same rules but get little say in creating those rules.[2]
The hard Brexit supporters are, to some extent, wildly overstating Britain’s leverage. EU leaders have an incentive to make things difficult for the U.K. to act as a warning to nations like Italy (which, we note, is now looking to avoid fines[3] in its fiscal dispute with the EU). It is difficult for a nation with the expansive history of Britain to discover that its status has fallen to the degree that it has little power. Britain has much more power within the EU than it does outside of it. There has always been a bit of separation between the British Isles and the continent as the British have always been sort of “half in, half out” of Europe. The harsh reality is that the U.K. can either (a) have a decent economy while influencing the EU but not dominating it, or (b) risk irrelevance and a weaker economy but have much more independence.
So, where do we go from here? The deal May negotiated is far from ideal for the U.K. The deal, sadly, reflects less on May’s negotiating skills and more on the U.K.’s weak bargaining position. We expect much opposition; there is nothing easier than criticizing an unfavorable agreement. But, the other alternatives are (a) a hard break and serious economic disruption, (b) accept the deal May has negotiated,[4] or (c) hold a new referendum to better determine what the citizens of the U.K. really want.[5] When the first referendum was held, it was a vote against the EU rules that the British knew compared to the idea of a “gauzy” glorious independence.[6] Now that the latter outcome has been dispelled, another vote might make sense.
For now, the markets are taking today’s news as leaning toward a hard Brexit. The GBP is down and Gilt yields are higher. But, there is much more to come before the Brexit situation is resolved.
Chinese trade: There is some evidence of a thaw. First, high level talks have resumed.[7] Second, the Xi government has sent a formal response to U.S. reform demands, which may bring further talks.[8] But, perhaps most importantly, the globalists suddenly seem to be on the ascendency. On Tuesday, Larry Kudlow slammed trade advisor Peter Navarro, suggesting he had done the president a disservice by trying to restrict Trump’s ability to negotiate. We surmise that Kudlow would not have made such strong statements without the president’s approval. And, the lack of response from the White House following Kudlow’s comments suggests this is the case. New reports suggest that Navarro is being muzzled.[9] We view what is happening with White House trade policy is a microcosm of the “establishment v. populist” fight that has been part of the administration from day one. President Trump tends to straddle the two groups, favoring one side or the other to achieve his goals. When he wanted the tax bill, he favored the establishment. His approval ratings didn’t rise with the tax bill, so he turned to trade, which did boost his ratings. However, equity markets have suffered and perhaps this is leading to some moderation on trade, which would favor the establishment. We would not expect a consistent policy direction in this area but look for vacillation depending on the short-term goals of the White House.
Facebook (FB, 144.22) and Amazon (AMZN, 1599.01): In this report, we only comment on specific companies when they have macro effects. The NYT[10] has published an investigative report that reflects badly on Facebook, suggesting the company was less than forthright in its handling of the Russian election interference scandal. And, Amazon is facing harsh criticism over its selection process for its second headquarters as regional governments offered all sorts of incentives to woo the facility[11] to a trillion dollar company (at least at one time). The broader issue is that the perception of the tech sector has deteriorated over the past few years. The fact that Nancy Pelosi, who is seen as a representative for the Bay Area technology industry, is facing what appears to be growing opposition to her winning the House Speaker role reflects this trend. Overall, technology has been one of the key factors in disinflation; if the industry’s popularity weakens, it could face increased regulation. If the goal is reflation, restraining and regulating the introduction of new technology is a necessary component.
Khashoggi update: The public prosecutor is seeking the death penalty for five of the 11 suspects involved in Khashoggi’s murder.[12] As expected, the prosecutor did not implicate the crown prince. This outcome is no surprise. However, there is potential fallout from this action. If the indicted participants face penalty, it will be difficult to convince other security operatives to participate in similar events. After all, who would want to follow orders only to face the death penalty? So, in one sense, this action protects MbS. On the other, it undermines his power.
Powell: Powell’s speech yesterday was more of the same. On the one hand, the Fed chair believes the Fed should be given credit for the strong performance of the U.S. economy. At the same time, he acknowledges that there will be headwinds next year.[13] Powell also confirmed that all meetings going forward, which will have press conferences, will be “live,” meaning rate changes can occur at any one of them.[14]
Mankiw rules: Here is 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.
Using the unemployment rate, the neutral rate is now 3.93%, steady from last month. Using the employment/population ratio, the neutral rate is 1.83%, up 15 bps from last month due to the rise in the ratio. Using involuntary part-time employment, the neutral rate is 3.50%, down from 3.79%. Using wage growth for non-supervisory workers, the neutral rate is 3.08%, up sharply from the previous month’s 2.47% as wage growth has accelerated.
Of all the variations, the wage growth one is the most concerning, although it is still within the range of the market’s expected terminal rate, which is around 3.25%. Having three of the four variations suggesting further tightening does support the idea that the Fed will lean toward tighter policy.
(NB: The Daily Comment will go on hiatus beginning Wednesday, November 21st, returning on Monday, November 26th.)
There is a lot going on this morning. Let’s dig in:
Brexit—the end of the beginning: Yesterday afternoon (EST), the EU and the U.K. announced that a tentative deal over Brexit had been reached.[1] Currently, we don’t know all the details as the 400+ page document is being kept from the public until the cabinet gets a chance to read it.[2] Once the cabinet has completed its review, we expect it will be distributed to the press and public. So far, PM May is acting as if she has the support of her cabinet; we would not be shocked to see a resignation or two but, for the most part, we think she has the majority of the cabinet on board.[3] As we noted yesterday, she won’t have the support of her entire coalition. There is an element that simply wants a hard Brexit (essentially, an exit without any provisions) with the hope that other nations will come flocking to make trade deals with the U.K. Although this might happen, it could take years and, in the meantime, the U.K. would not have favored status with anyone. Plus, a hard Brexit will lead to a hard border at the Northern Ireland/ Ireland frontier which could lead to a return of the unrest that plagued the area for decades. To pass the agreement through Parliament, May will need around 20 to 25 Labour defectors. Labour head Corbyn sees this vote as an opportunity to bring down the government, force elections and perhaps take power. However, we are not sure he has the broad support of the Labour Party (center-left Blairites don’t care much for him) and they may vote for the deal simply to deny Corbyn this goal.
Here is a summary of the general outline of the agreement:[4]
The U.K. will pay an exit fee of €40 bn to €45 bn to ensure that the rest of the EU won’t be forced to pay additional funds because of Brexit. Essentially, the U.K. will contribute to EU budgets for 2019 and 2020. Some payments, especially for pensions, may continue as long as 2064.
EU citizens living in Britain and U.K. citizens in the EU will live under existing EU residency and security laws. Future EU rulings on non-residents won’t be binding but the U.K. agreed to give “due regard” to any changes.
The transition period will last through December 31, 2020, and can be extended once by mutual agreement. This will allow time for the EU and U.K. to negotiate a free trade agreement.
Northern Ireland will remain in the customs union indefinitely. This condition will only change by a new agreement.
The U.K. will also remain in the customs union,[5] which will allow for the free movement of goods from Northern Ireland to the rest of the U.K. While in the customs union, the U.K. will be forced to abide by EU rules on competition.[6]
Governance will be conducted through independent arbitration, which means that neither the U.K. nor the EU is bound by the court decisions of the other.
One note to remember: there are no real surprises here.[7] MPs may not like what is in this deal but the outline has been evolving for some time. This agreement does not offer the U.K. full independence from the EU. As long as the U.K. is in the customs union, it can’t make its own free trade agreements. But, a hard Brexit—a full break with the EU—would shut down trade and financial arrangements between the two entities and make EU citizens living in the U.K. essentially refugees living under U.K. law. The disruption would be massive; we would expect Gilt yields to soar and U.K. equities to plunge along with the GBP if this agreement isn’t accepted. In the long run, the U.K. may be better off, but in the short run, the cost may be an economic dislocation that would be historic. The EU got the deal it wanted because it is betting that, faced with the customs union or catastrophe, Parliament will vote for the former. As we noted yesterday, we would not be shocked by a “TARP-like” event, where Parliament votes the deal down only to face an immediate market crisis, which prompts another vote in Parliament or maybe another referendum. Our bottom line is that the odds of a hard Brexit are not trivial but it’s also not the most likely outcome. It makes much more sense to make this deal and then adjust the arrangement over time. However, that doesn’t mean that reason will prevail.
So, what does this mean for U.S. markets? A hard Brexit would likely bring a knee-jerk flight to safety trade—Treasuries rally, equities fall, gold rallies, dollar rallies and GBP drops. If May wins the day, look for U.K. assets, especially the GBP, to rally strongly.
Car tariffs on hold for now: The Trump administration has decided to hold off on car tariffs for the time being.[8] We find that equities tend to rally anytime the “globalists”[9] in the administration win, although we note that equities failed to hold gains after positive trade comments from Kudlow yesterday. In fact, market action has been disconcerting; rallies tend to fade, which suggests that investors are using rallies to reduce equity exposure. We would not expect this pattern to remain but, until it shifts, rallies may struggle to hold.
Italy dares the EU: Italy has made it clear to the EU that it doesn’t intend to make any changes to its budget, effectively daring the EU to apply sanctions.[10] The sanctions would come from the EU’s “excessive deficit procedure.”[11] Bottom line, it would mean that the EU would fine Italy 0.2% of its GDP for violating the fiscal rules. The EU has never actually implemented such sanctions, even when Germany violated these levels in the early aughts. Italy’s real risk isn’t from EU sanctions—it’s from the financial markets pushing up borrowing costs and triggering a financial crisis. Italy, realizing this risk, has called on its citizens to buy bonds.[12] Such appeals to patriotism generally fail; in fact, it often leads well-informed domestic investors to flee domestic paper. The broader risk comes from the so-called “doom loop.” Bank regulations force banks to allocate capital to the assets it holds based on how regulators perceive risk. Regulators, captured by governments, treat sovereign debt as risk-free (as long as rating agencies deem it investment grade) and thus banks tend to hold higher yielding sovereign paper. If a sovereign runs into trouble, the contagion vector is the banking system. This is why the Greek crisis was such a problem; French and German banks held Greek bonds and thus Greece was forced to accept austerity to bail out these banks. Italy could bring similar problems on a much larger scale.[13] Of course, Italy’s issues are well known, and investors have been dumping Italian bonds, which is why their yields have been rising.[14] Unfortunately, this has led Italian banks to hold more of their nation’s bonds, which is pressuring the Italian banking system.[15] Our view is that if Italy stays in the Eurozone, the populist fiscal expansion will end in tears. However, the real threat from Italy to the Eurozone is if Italy concludes it would be better off outside the currency bloc. We doubt the EUR survives Italy’s exit.
The European Army: Although we would not expect a European Army to emerge in the short run,[16] French President Macron’s proposal is a natural outgrowth of changes in U.S. policy.[17] The U.S., as part of its Cold War policy, deliberately froze three conflict zones in Europe, the Far East and the Middle East.[18] American taxpayers mostly funded the maintenance of these areas because U.S. policymakers were convinced that if the nations in the region tried to create their own security arrangements it would lead to conditions that brought about two world wars. Although the costs to the U.S. were substantial, the U.S. has not fought another mass mobilization world war. Although President Trump has been explicit in his goal of not funding the security of these conflict zones any further, we would argue that this sentiment predated his administration. President Bush’s foreign policy before 9/11 was to reduce America’s security footprint. VP Gore ran on the opposite side of that argument. President Obama wanted to “lead from behind.” This was all about trying to figure out how to adjust U.S. foreign policy to the post-Cold War world. To date, no administration has solved that riddle. But, if you tell the Europeans they are going to foot the bill for their security, it should come as no surprise that the EU will decide its own security arrangements. Now, we have serious doubts that the EU can create a functioning army as the nations rarely agree on anything. But, a more likely outcome is that the “European army” is really the “Wehrmacht.” We suspect this is why Macron is trying to lead this effort to make it a joint French/German-led army.
Energy: It’s the tale of two markets. Natural gas prices remain on a tear due to cold weather. Meanwhile, oil prices fell sharply yesterday. The decline in oil prices has caught the attention of OPEC, which is now pressing for a much larger cut in production, perhaps as much as 1.4 mbpd.[19] The DOE reports its data later this morning. The API reported a large inventory build and we would expect something similar from the government data. At the same time, seasonally, we are coming to a period where inventories tend to decline. Thus, we would not be shocked to see oil start to find support at these levels.
Chinese data:China’s economic data remains soft, especially in property and real estate.[20] Although monetary policy has eased to some extent, so far, it hasn’t been able to arrest the slowdown. We would expect the Xi regime to try to boost growth further. Of course, all eyes remain on the upcoming G-20 meeting at the end of the month, where Chairman Xi and President Trump are expected to meet to discuss trade.
[Posted: 9:30 AM EDT] Good morning! We are seeing a recovery in equities this morning after a rough day yesterday. The dollar’s a bit weaker this morning. Energy is mixed—oil prices are continuing their slump but natural gas is on a tear due to early winter weather east of the Rockies. Here is what we are watching today:
Italian deadline day: It appears Italy is only making cosmetic changes to its recent budget, daring the EU[1] to sanction the country. Italian yields are ticking higher, with the 10-year sovereign hitting a yield of 3.45%. Although we are sympathetic to Italy’s plight, this budget will do nothing more than give the economy a short-term boost. What Italy really needs is debt restructuring, something the creditor nations in the EU are loath to offer. Thus, we are getting a short-term confrontation over something that won’t really fix the problem. The other solution is for Italy to exit the Eurozone and service its debt in a new local currency (another form of debt restructuring) but that process would likely trigger a crisis. We will be watching to see if the EU rejects the budget but offers Italy an “out” by requiring modest changes.[2]
Brexit: David Lidington, an official in the May government, suggests that a Brexit deal is “almost within touching distance” and a final agreement could emerge in the next 48 hours.[3] Although negotiators may reach an agreement (the biggest sticking point remains the Irish frontier), getting any agreement through Parliament will be the most difficult part. First, it isn’t evident that May has enough support in her narrow coalition to win a majority on any agreement. There are enough hard leavers among the Tories that anything less than a total abandonment of the EU is unacceptable. Second, the government coalition partner, the DUP, will reject anything that sniffs of a plan that makes Northern Ireland not quite the same as the rest of the U.K. It appears that some basic vote counting leaves May 37 votes short of approval, assuming any deal that emerges isn’t egregiously biased against the U.K.[4] Thus, May will need that many Labour MPs to support the plan. Labour’s Corbyn has ordered his party to reject any deal,[5] which means any Labour MP voting for the plan will have to reject the orders of the party leadership, always risky for the future career of an elected official. On the other hand, there is the risk of something similar to what we saw in the TARP situation in the U.S. in 2008. Congress initially rejected the arrangement only to trigger a financial crisis, which led Congress to reconvene, make a few cosmetic changes to the bill and pass it. Corbyn’s goal is to bring down the government and force elections, which could bring a Labour government into power. The question is, “will Corbyn be willing to create financial calamity to become PM?”
Merkel speaks: In what may likely be her last major speech, Chancellor Merkel will address the European MPs today in Strasbourg about the “future of Europe.” Although there is hope among Europhiles that Merkel will offer a striking vision to further the cause of European integration, such an outcome would be quite out of character. We expect a speech without much substance.
Oil woes: After staging an early morning rally yesterday, oil prices failed to hold gains and are lower this morning. President Trump tweeted against the cartel this morning, calling for lower prices.[6] Meanwhile, OPEC feels it was “duped” by Trump into raising output only to see the U.S. grant waivers to eight nations on Iranian crude exports.[7] Oil prices won’t bottom until oil inventories stop rising. Meanwhile, an early cold snap has led to sharply higher natural gas prices.
(Source: Barchart.com)
Early winter cold weather tends to be very bullish for natural gas prices because utilities prefer to hold inventory in November to avoid an inventory shortage in February. This practice will tend to cause price spikes if winter arrives early. At the same time, once temperatures moderate, prices will tend to reverse rather quickly.
Trade: The White House is returning to trade policy now that the midterms are over. According to reports, President Trump really wants tariffs against foreign automakers.[8] Frankly, if President Carter would have rolled out such trade impediments the U.S. automakers would have cheered. However, it is worth noting that U.S. nameplates haven’t been all that supportive of such measures today. This is because the industry is thoroughly globalized. If the president does push in this direction, we would expect a sharp increase in U.S. car prices but it could be years before jobs shift to the U.S. – assuming that these jobs aren’t automated away. Some of today’s lift comes from headlines that Treasury Secretary Mnuchin and Vice Premier Liu have resumed discussions, raising hopes that some cooling of trade tensions between the U.S. and China are in the offing.[9] However, we doubt that much will come of these talks; American companies were something of a no-show at China’s recent import expo[10] and the administration is rolling out a new strategy to prevent China from obtaining American technological secrets.[11] Meanwhile, negotiations between the EU and the U.S. have restarted; the EU was stalling talks before the midterms, perhaps hoping the GOP would take a drubbing and give European negotiators an edge. Instead, the vote was more of a draw and so talks are accelerating[12] in an atmosphere where President Trump continues to criticize NATO members for running trade surpluses with the U.S.[13] Finally, we note the WSJ opinion writers have taken notice of Peter Navarro’s recent accusation of American business leaders being “unregistered foreign agents” for China. The editorial board clearly sees that Navarro’s policies are deglobalizing and a threat to profit margins. It is trying to separate Navarro from the president, perhaps hoping that Trump, at heart, supports trade. However, it is quite possible that Navarro is in government because Trump is more in the anti-trade camp than the WSJ would care to admit.[14]
Tax threat: For now, the tax cuts enacted late last year are safe. However, there is growing evidence that the Democrats are considering enacting bills in the House that would raise the marginal rate.[15] Again, these would have no chance getting through the Senate or surviving a veto. However, the mere threat of changing the rate will affect corporate behavior. After all, the Democrats might return to power at some point and make a play to raise the marginal rate. If businesses begin to fear this outcome, they will be inclined to use the tax code for short-term benefits rather than for long-term investment.
China data: China released data on its credit markets and the bottom line is that the pace of borrowing is slowing. Bank loans increased in October by CNY 697 billion, down from CNY 1.38 trillion in September. Some of that decline is seasonal as the first week of October is a holiday week, but growth was +13.1% from last year, down from +13.2% a year ago. Shadow bank financing is falling rapidly, too.
(Source: Capital Economics)
According to Capital Economics, Chinese economic growth continues to slow.
So far, the Xi government’s push to boost the economy doesn’t seem to be working.
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