by Bill O’Grady and Thomas Wash

[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.

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[1] https://www.wsj.com/articles/u-s-china-trade-talks-get-under-way-11544498812

[2] https://www.ft.com/content/585c0506-fcdb-11e8-aebf-99e208d3e521

[3] https://www.ft.com/content/4d9f48a4-fc85-11e8-ac00-57a2a826423e?emailId=5c0f40831a95f60004f1fc7a&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[4] https://www.ft.com/content/9c59a204-fc6d-11e8-aebf-99e208d3e521?emailId=5c0f40831a95f60004f1fc7a&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[5] https://www.ft.com/content/32849728-fd1a-11e8-aebf-99e208d3e521

[6] https://www.ft.com/video/88be2a8e-8ff8-4d03-8e11-805676432825?emailId=5c0f40831a95f60004f1fc7a&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22&playlist-name=editors-picks&playlist-offset=0 and https://www.independent.co.uk/news/business/news/brexit-no-deal-news-imf-forecast-gdp-world-trade-organisation-economy-a8633681.html?wpisrc=nl_todayworld&wpmm=1

[7] https://www.washingtonpost.com/world/europe/theresa-may-just-warned-of-a-no-deal-brexit-here-are-some-of-the-doomsday-scenarios/2018/09/17/3507ab2c-943b-11e8-818b-e9b7348cd87d_story.html?wpisrc=nl_todayworld&wpmm=1

[8] https://ftalphaville.ft.com/2018/12/11/1544504400000/The-only-Brexit-chart-you-need-to-see/

[9] https://www.ft.com/content/18b9b194-fb98-11e8-aebf-99e208d3e521

[10] https://www.ft.com/content/797f7b42-bb44-11e8-94b2-17176fbf93f5

[11] https://www.nytimes.com/2018/12/10/world/europe/macron-france-yellow-vests.html?emc=edit_mbe_20181211&nl=morning-briefing-europe&nlid=567726720181211&te=1 and https://www.ft.com/content/0ebf9df0-fcb7-11e8-aebf-99e208d3e521?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[12] https://www.bloomberg.com/news/articles/2018-12-11/macron-hands-eu-a-new-headache-in-fight-over-italian-budget

[13] Orwell, George. (2016, ebook edition; first published 1944). Animal Farm. South Australia: The University of Adelaide. (Chapter 10).  https://ebooks.adelaide.edu.au/o/orwell/george/o79a/complete.html#chapter10

[14] http://www.spiegel.de/international/germany/kramp-karrenbauer-succeeds-merkel-as-cdu-leader-a-1242904.html

by Bill O’Grady and Thomas Wash

[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.

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[1] https://www.wsj.com/articles/the-markets-latest-problem-hesitation-to-buy-the-dip-1544360400

[2] https://www.wsj.com/articles/trump-is-gripped-by-market-volatilityand-his-role-in-it-1544199996

[3] “Lord, make me chaste, but not yet.”  See: https://lexloiz.wordpress.com/2008/10/15/%E2%80%98lord-make-me-pure-but-not-yet%E2%80%99-%E2%80%93-augustine%E2%80%99s-naughty-prayer/

[4] https://www.ft.com/content/7ba065a0-fb6b-11e8-aebf-99e208d3e521

[5] https://www.bloomberg.com/news/articles/2018-12-09/trump-trade-rep-tries-to-insulate-china-talks-from-huawei-case

[6] https://www.reuters.com/article/us-usa-trade-china/u-s-says-march-1-hard-deadline-for-trade-deal-with-china-idUSKBN1O80LX

[7] https://www.ft.com/content/9c59a204-fc6d-11e8-aebf-99e208d3e521

[8] https://www.ft.com/content/cda4913c-fc51-11e8-aebf-99e208d3e521

[9] https://www.ft.com/content/dd01d6f6-fc71-11e8-ac00-57a2a826423e; for background, see: https://www.ft.com/content/be7dc478-ecbe-11e8-8180-9cf212677a57

[10] https://www.cnbc.com/2018/12/07/feds-bullard-says-central-bank-could-delay-december-rate-increase-then-raise-in-january.html

[11] https://www.courthousenews.com/us-drops-bid-to-toughen-sentence-for-turkish-banker-hakan-atilla/

[12] https://www.axios.com/google-braces-for-bipartisan-backlash-on-capitol-hill-1544385095-51ffa65c-94d2-4de2-ac72-d24831a022ef.html

[13] https://www.reuters.com/article/us-italy-league/italys-league-leader-faces-friendly-fire-over-budget-idUSKBN1O80AQ?feedType=RSS&feedName=worldNews

[14] https://www.ft.com/content/a1b90a98-fbbc-11e8-aebf-99e208d3e521

by Bill O’Grady and Thomas Wash

[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 21^st 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.

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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[1] https://www.wsj.com/articles/restrained-inflation-reduces-urgency-for-quarterly-rate-increase-pattern-1544127856

[2] https://www.nytimes.com/2018/12/06/business/dealbook/trump-federal-reserve-interest-rates.html

[3] https://www.theglobeandmail.com/canada/article-canada-has-arrested-huaweis-global-chief-financial-officer-in/

[4] https://www.ft.com/content/10065056-f8e2-11e8-af46-2022a0b02a6c

[5] https://www.scmp.com/economy/china-economy/article/2176878/beijing-declines-link-huawei-executive-sabrina-meng-wanzhous

[6] https://www.scmp.com/economy/china-economy/article/2176511/china-takes-steps-support-jobs-trade-war-starts-hit-employment

[7] https://www.bloomberg.com/news/articles/2018-12-06/biggest-worry-for-traders-they-don-t-know-why-stocks-are-moving?srnd=premium

[8] https://www.ft.com/content/d425ee0a-f9bf-11e8-8b7c-6fa24bd5409c

[9] https://www.washingtonpost.com/opinions/global-opinions/the-economic-confrontation-with-china-is-just-beginning/2018/12/06/87bfffd2-f99d-11e8-863c-9e2f864d47e7_story.html?utm_term=.e11cd0c0415a

[10] https://www.ft.com/content/080d418a-f887-11e8-8b7c-6fa24bd5409c?emailId=5c09f6e7418e5e0004acd645&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s a major risk-off day so far.  The key issues are an arrest and its impact on trade and a difficult OPEC meeting.  Here are the details and other items we are watching:

The arrest of Meng Wanzhou: Yesterday evening, Canadian[1] officials announced they had apprehended[2] the CFO of the Chinese telecom firm Huawei (002502, CNY 4.71), Meng Wanzhou, in Vancouver.  She is the daughter of Ren Zhengfei, the founder of the company, and one of the four chairpersons of the company.  The arrest is tied to an investigation that her company attempted to sell U.S.-made equipment to Iran, a violation of American sanctions on the Iranian regime.  There is suspicion that the company has violated U.S. trade controls on Cuba, Sudan and Syria as well.[3]  The U.S. is seeking and will likely get extradition of Meng.   Western intelligence agencies have viewed Huawei as a security risk, fearing the company is a tool of the PRC to penetrate Western telecommunications networks.  U.S. telecom networks are banned from using Huawei equipment; Canada, the U.K., Australia and New Zealand have also placed restrictions on Huawei equipment.[4]

This arrest is certainly justifiable.  Huawei appears to be a “bad actor,” acquiring U.S. technology and allegedly selling it to nations unfriendly to the U.S. after agreeing it wouldn’t do such things.[5]  However, as any law enforcement official will tell you, the decision to arrest is never automatic.  Just because someone is breaking the law doesn’t necessarily mean an arrest automatically follows.  Instead, the decision to arrest is just that—a decision.  We suspect the decision to arrest Meng was made at the highest levels of the U.S. government.  Although the arrest was certainly legitimate, the timing must also be seen as deliberate.

Since Buenos Aires, both China and the U.S. have sent mixed messages on what was decided.  Given that a joint statement wasn’t released, each side has issued its own statement and, as we noted on Monday, they don’t line up all that closely.  The president added to confusion with a series of tweets where he called himself “tariff man,”[6] suggesting the truce he negotiated with Xi wasn’t going to change things all that much.  The president has attempted to walk back some of those comments[7] but financial markets are in “Missouri mode” and are saying “show me.”

So, how will the arrest of such a high-profile Chinese executive affect trade negotiations?  It is possible that the White House thinks it can use Meng for leverage, promising to release her for concessions.  That is a very dangerous precedent; every Western executive in China would be put at risk.[8]  The most likely outcome is that the arrest will make negotiations difficult, if not impossible.  This outcome is clearly being reflected in the financial markets.

A key issue we are wrestling with is the nature of the U.S./China relationship going forward.  The two nations have had something of a symbiotic relationship for nearly three decades.  China has been willing to provide cheap goods produced by compliant labor, while America has provided investment, intellectual property and a steady source of consumption.  This has led to a flood of cheap goods into the U.S., which has kept prices low and contained labor costs.  The relationship allowed the Chinese economy to grow rapidly and has led to widening income inequality in the U.S.  We have been noting, for some time, that strains in this relationship have been developing.  For China, it has reached the economic moment where it has created too much industrial capacity and needs to reduce that excess capacity; if growth is going to continue, it needs to make major adjustments.

Every nation that has reached this point struggles with it.  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 21^st 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 follow the path of Japan, which will put the Communist Party of China (CPC) at risk.  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 CPC’s legitimacy.  So, leaders been putting off the adjustment in a sort of “stop/go” cycle that financial markets have gotten used to.  It is hard to know 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.  There is some evidence that financial markets are starting to fear this outcome.

Will trade negotiators be able to overcome Meng’s arrest and stabilize the situation?  Perhaps, but the long-run path for the U.S. and China appears to be headed toward persistent confrontation.  What we don’t know is how close we are to this long-run outcome.

OPEC: Oil prices are plunging this morning as the cartel continues to struggle with the mechanics of production cuts.  The group has agreed, in principle, to reduce output.  But, how much and the allocation of reductions remain unresolved.[9]  OPEC probably needs a cut of 1.3 mbpd to bring prices back toward $55 per barrel (WTI) and the Saudis will likely need to represent 1.0 mbpd of that cut for the proposal to have any credibility.  In addition, Russia has to make promises to reduce output as well.  And, it will take a while before the recent decline in oil prices reduces American output, which has been surging.

Complicating matters is the Khashoggi affair.  Congressional leaders heard the CIA’s take on events yesterday and were scathing in their criticism of the White House over this issue.  There is concern that the Trump administration is using this event as leverage over MbS to keep Saudi output high and lower oil prices further.  Although this is possible, as we have noted, lower oil prices aren’t as much of an unalloyed benefit for the American economy as they used to be.  While it will make consumers happy, it will harm oil and gas activity and reduce investment.  In addition, lower oil prices will do nothing good for the Saudi economy.  At some point, the Saudi royal family may conclude that MbS is bad for business and sack him; we doubt he goes quietly.  If so, the geopolitical risk for oil is probably being underestimated.

Brexit: With everything else going on, this issue has sort of slid to the backburner.  As it stands now, PM May’s plan looks DOA; it will almost certainly be voted down next Tuesday and then we will see if (a) the vote is close enough to try to renegotiate with the EU, or (b) the vote is an overwhelming rejection which would lead to either the fall of May’s government and new elections or a new referendum.  The fact that the GBP is holding up suggests the financial markets believe a hard Brexit will be avoided.

Facebook (FB, 137.93): The company continues to marinate in hot water and its woes are raising questions for all of social media.  In Scott Galloway’s book, The Four, he notes that the only real business risks to the large tech companies come from government.  And, when he wrote his book, he suggested that the threat wasn’t all that strong because the companies had mostly co-opted regulators.  That condition has changed.  European regulators are leading the charge against Facebook directly but other tech firms as well.[10]  The Europeans are accusing Facebook and others of anti-competitive behavior and the companies have few allies on the continent since the industry is mostly centered in the U.S.  The fear of regulation is clearly hurting equity performance of these companies.  Interestingly enough, relations between the White House and the tech firms have been improving; they may realize they need friends.[11]

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[1] https://www.theglobeandmail.com/canada/article-canada-has-arrested-huaweis-global-chief-financial-officer-in/

[2] https://www.ft.com/content/10065056-f8e2-11e8-af46-2022a0b02a6c

[3] https://www.nytimes.com/2018/12/05/business/huawei-cfo-arrest-canada-extradition.html?emc=edit_mbe_20181206&nl=morning-briefing-europe&nlid=567726720181206&te=1

[4] These nations comprise the “Five-Eyes” network of Western intelligence agencies.

[5] Op. cit., NYT article above

[6] https://www.nytimes.com/2018/12/04/business/yield-curve-recession-stock-market.html

[7] https://www.politico.com/story/2018/12/05/trump-china-trade-deal-1045367

[8] Although, realistically, they are already at risk.  But, this action likely means the risks are elevated.  https://www.axios.com/huawei-arrest-china-retaliation-73f847b7-4dbb-4987-926a-d9ac915b2285.html

[9] https://www.wsj.com/articles/a-weakened-opec-convenes-with-market-dominance-in-doubt-1544087560

[10] https://www.axios.com/zuckerberg-at-war-with-european-regulators-fa6e0376-4894-42f7-a0a3-c130882e2471.html  and https://www.bloomberg.com/news/articles/2018-05-23/facebook-loses-eu-friends-as-bloc-s-lawmakers-weigh-break-up?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosam&stream=top

[11] https://www.axios.com/white-house-tech-meeting-silicon-valley-trump-stabilized-6403b20f-5376-46cc-9a3e-71063d72c391.html

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT]

(NB: Due to tomorrow’s National Day of Mourning and the closure of financial markets and the government, we will not publish the Daily Comment tomorrow.  We will return to our regular schedule on Thursday.)

Good morning!  The euphoria of yesterday has dissipated to some degree.  Here is what we are watching today:

Trade skepticism: As we noted yesterday, the lack of a unified communique after the Trump-Xi meeting led to both sides reporting different results.  President Trump has added to uncertainty with a tweet indicating that China has agreed to eliminate tariffs on U.S. autos.[1]  There isn’t any evidence (at least, not yet) that such a deal was made.  In addition, the White House has appointed Robert Lighthizer to lead upcoming talks with China.[2]  He is a hardliner on trade and his appointment to lead the talks, instead of Kudlow or Mnuchin, is a sign that the president intends to keep pressure on China.

As mentioned yesterday, the clock is working against President Trump, assuming he does want to be reelected.  If a recession is triggered next year, it will deeply weaken his chances of winning reelection in 2020.  It is obvious that trade worries are dampening the financial markets; the effects on the economy are still at the anecdotal level, but even this evidence suggests that the sluggish level of investment may be tied to trade uncertainty.[3]  The political calculation that the president might be making is whether the value of being hard on China is enough to offset a much weaker economy.  History suggests that a recession would be a death knell for reelection, but the situation with China is somewhat unique.  Our position is that the president should avoid recession at all costs, thus tamping down the trade issue for the next year or so would be prudent.  Appointing Lighthizer suggests that probably isn’t the president’s thinking.[4]

The chart below shows the election cycle with the current government.  To build this data, we take weekly data for the S&P 500 beginning in 1928 and index each four-year period to 100.  The blue line shows the average market performance.  The midterms occur near the end of the second full year.  Note that, on average, the market rises nearly 20% from late October of the midterm year into summer of the year before the election year.  This pattern isn’t an accident; presidents tend to “pump prime” the economy going into that year to help the reelection process.  President Trump has actually done the pump priming early, but that doesn’t mean he won’t continue the process.  We would not be at all surprised to see an infrastructure deal made to boost growth.  However, if the trade situation becomes a depressant on the economy, it could hurt his election chances.  That’s why it would be logical to ease up on trade, but just because it’s logical doesn’t mean it will happen.

The yield curve: There have been some ominous developments in the interest rate markets in the past 72 hours.  First, the two-year/10-year T-note spread has dipped under 15 bps, nearing inversion.

Note that the two-year yield has been rising much faster than the 10-year yield.  This is consistent with policy tightening.  Second, the three-year/five-year T-note spread, which is much less monitored, has actually inverted.  The chart below shows a history of that data.

Although this spread gave a couple of false positives (e.g., 1965, 1998), it is generally reliable.  The FOMC is treading into difficult waters.

Given the reliability of the yield curve in predicting the business cycle, the financial media will enter a “hair on fire” moment with every pundit suggesting trouble ahead.  That isn’t to say that we won’t be concerned as well.  But, we offer a couple of caveats.  First, as we discussed in the June 29^th Asset Allocation Weekly,[5] yield curve inversion doesn’t mean the equity markets immediately go negative.  In fact, using the 2/10 spread from the late 1960s, equities rise for about nine months on average after inversion and, in some cases, equities remain above the level at inversion for at least two years.  Thus, inversion is a real concern but may not be immediately negative.  Second, the general public’s increased focus on the yield curve may lead policymakers afoul of Goodhart’s Law, which states, “Any observed statistical regularity will tend to collapse once pressure is placed on it for control purposes.”[6]  We could very easily see the FOMC use the yield curve to guide policy and thus take the necessary steps to avoid inversion, upending the predictive value of the relationship.

Still, the near inversion is a worry.  The FOMC should pay attention to this and tread carefully.[7]

Brexit: In exactly one week, Parliament will vote on PM May’s Brexit deal.  The odds of passage appear slim; in fact, most observers now say the key is the level of defeat.  If the loss is close (< 30 votes), she may be able to go to the EU for adjustments to her deal to improve its odds in a second vote.  On the other hand, if the loss is overwhelming (>50 votes), then her plan is doomed as is her government.  We then enter a world of binary outcomes—we either get a hard Brexit with catastrophic losses for the GBP and British financial assets or a second referendum that may lead to no Brexit at all, which would trigger a large rally in the aforementioned assets.  Interestingly, the European Court of Justice ruled yesterday that the U.K. could unilaterally end Brexit, which increased the attractiveness of another referendum.[8]  We are leaning toward another vote; between a hard Brexit and a new vote the odds are probably leaning a bit toward the latter.

Macron backs down: The French government has suspended its fuel tax increase in the face of rising unrest.[9]  The FT has an interesting report on the incidence of Macron’s taxes.[10]  The report shows that the bulk of Macron’s tax benefits has gone to the richest segment of the income distribution, while the poorest have suffered significantly.  This outcome should not have been a shock; this is the essence of neoliberalism, the policies of Thatcher and Reagan.  The goal of such policies is to expand the supply side of the economy by rewarding entrepreneurship; it is implemented to contain inflation, not necessarily to spur growth.  Why Macron would seek to implement such changes now, nearly four decades after the inflation crisis has passed, is inexplicable.

At the same time, it should come as no surprise that unrest has developed.

OPEC: The Saudi oil minister indicated this morning that a deal is not in place yet.[11]  That news has taken oil off its highs.  We still expect a deal to be made but talks continue.

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[1] https://www.bloomberg.com/news/articles/2018-12-03/trump-s-advisers-struggle-to-explain-deal-he-says-he-cut-with-xi

[2] https://www.politico.com/story/2018/12/03/trump-china-relations-trade-pact-1037425

[3] https://www.nytimes.com/2018/11/28/magazine/trade-war-tariffs-small-business.html

[4] https://www.wsj.com/articles/lighthizerhas-long-seen-chinese-trade-policy-as-unfair-to-u-s-1543860249

[5] See Asset Allocation Weekly (6/29/18)

[6] https://en.wikipedia.org/wiki/Goodhart’s_law

[7] https://www.reuters.com/article/us-usa-fed/as-fed-says-on-track-narrowing-yield-curve-could-complicate-debate-idUSKBN1O22MK

[8] https://www.ft.com/content/a17f134a-f79f-11e8-af46-2022a0b02a6c

[9] https://www.ft.com/content/b7ee911c-f79c-11e8-8b7c-6fa24bd5409c

[10] https://www.ft.com/content/b6297b3a-f4bd-11e8-9623-d7f9881e729f

[11] https://uk.reuters.com/article/us-oil-opec/opec-works-on-deal-to-cut-output-still-needs-russia-on-board-idUKKBN1O30Y6

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Good morning!  There is great joy in the financial and commodity markets this morning.  Here is what we are watching today:

The G-20 and China talks: To some extent, we got the deal we were expecting.  Presidents Trump and Xi essentially agreed to a 90-day truce.[1]  The U.S. will delay applying an additional 15% to the existing 10% tariffs on $200 bn of Chinese exports to the U.S.  China vaguely agreed to buy more U.S. goods.  Talks are said to be forthcoming.  However, they failed to issue a joint communique on the agreement.  The indications from either side were quite different:

Our take on this deal is that both Xi and Trump needed a win.  As we noted last week, the Chinese economy is slowing and a weakening equity market in the U.S. was becoming a daily signal of trouble.  At the same time, the underlying issues have not been resolved.

Here is a quick sketch of the underlying problems.  China is rapidly entering the period in its development where it is facing industrial overcapacity.  There are essentially four ways that this issue gets addressed.  The first is a massive revaluation of the excess capacity through a debt crisis.  That is how the U.S. addressed this issue; we refer to it as the Great Depression.  Japan addressed the same problem by slowly adjusting debt (and the underlying asset values) and has endured over three decades of stagnation.  The second method is mass war; this either utilizes the excess capacity or sees it destroyed.  The third is value chain improvement.  In this method, the economy shifts to higher value products, which allows the higher value new capacity to keep the economy intact while the lower value capacity is either closed or rebuilt.  Germany did this from the mid-1960s into the mid-1980s (think Volkswagens to Mercedes).  The fourth way is through imperialism, where the nation acquires colonies which allows it to force its excess production on a conquered client state.  This was the preferred method in the 19^th century; examples today include the Eurozone (Germany colonizing the rest of Europe) or China’s “one belt, one road” project.

China, under no shape or form, wants to use the first method, and likely wants to avoid the second.  It is trying to move up the value chain (the “China 2025” project), thus deploying the third method, and is clearly also trying to use the fourth approach.  The U.S. is attempting to thwart both efforts by preventing China from acquiring U.S. technology (likely necessary to move up the value chain) and by offering alternatives to the “one belt, one road” program.  China needs the U.S. to allow it to move up the value chain, which would, of course, put the U.S. and China at trade competition in areas the U.S. currently dominates, such as high tech, aerospace, etc.  China also needs the U.S. to allow it to dominate its region so it can utilize its excess industrial capacity through forced exports to the weaker nations in the Far East and Middle East, forcing America to cede its influence in the Pacific.  The U.S. isn’t going to allow this to happen willingly.  If China isn’t allowed to implement options three and four, it will be forced into option one or two, neither of which looks attractive.

But, the deal does buy time for both sides.[2]  For China, this gives its negotiators breathing room to try to cobble together some sort of deal.  For the U.S., promises from China to buy soybeans will ease pressure on that sector and, at the same time, the rally in equities will appease the establishment wing of the Trump administration.  But, we would not expect the issues mentioned above to be resolved anytime soon.[3]

However, it is premature to suggest this agreement is inconsequential.  China may be hoping that a divided U.S. legislature and perhaps the Mueller investigation will become enough of a distraction to the White House that the trade issue might fade next year.  In addition, we are already seeing the early stages of the 2020 presidential campaign and thus the White House won’t want to take trade actions that could trigger a recession.  Thus, we may have already seen the most aggressive trade actions; from here, the president will likely be leery of doing anything to upset the financial markets and, as we have seen this year, trade wars can do that.  In addition, we are watching the establishment wing of the GOP to see if they use the aforementioned distractions to curtail the president’s power on trade.[4]  After all, the GOP establishment doesn’t want to see free trade curtailed.

The deal was clearly welcomed by financial markets.  Equities and commodities are higher, although the dollar, curiously, is holding on rather well.  On the commodity front, soybeans are up on expected Chinese buying and oil is higher as well (see below).  U.S. interest rates jumped despite recent Fed dovishness.  Although we have doubts that the long-term issues are any closer to resolution, the pause could very well be longer than 90 days; in fact, it could stretch into the November 2020 elections.  If so, Chairman Xi may have done just enough to improve China’s situation.

OPEC+: OPEC has determined that the cartel needs to cut production by 1.3 mbpd.[5]  After a rousing greeting between President Putin and Crown Prince Salman, Russia has indicated its cooperation with OPEC will continue, raising hopes of Russian cooperation with price support.[6]  But, the real shocker came from Canada, where the provincial government of Alberta has imposed production cuts of 8.7%.[7]  We rarely see G-7 nations agree to production restrictions.  Although the Canadian action is in response to logistical bottlenecks, the announcement is supportive for oil prices.  In related news, Qatar will exit the cartel in January; its production is now centered on natural gas and it is in conflict with Saudi Arabia and thus likely wants to avoid cooperating with the kingdom.[8]  Although other nations have left before (and, for that matter, rejoined…see Ecuador), this is the first nation from the Gulf region to leave OPEC.

Shutdown averted?  Over the weekend, President Bush (#41) passed away.  President Trump has ordered a national day of mourning on Wednesday, which will close the government (and the NYSE).  The day of respect for the former president will delay a potential government shutdown and may end up precluding any such action.[9]

Caixin PMI: The November Caixin PMI, the one believed to be more reliable than the official index (it has a broader survey, including smaller firms), came in modestly better than forecast at 50.2, up from 50.1 in October.  New orders ticked higher; export orders fell but may lift due to the aforementioned truce.

Macron in trouble: Civil unrest in France continued over the weekend and the scope and persistence is becoming a crisis for President Macron.  We are seeing two developments.  First, elements of French society, probably best described as anarchists, appear to be participating in the protests as well, increasing their violence.  Second, political opponents of Macron are sensing weakness and are mobilizing to use the protests to undermine the government.[10]  Macron held emergency meetings with his advisors after he arrived in Paris from Argentina and is considering a crackdown on the protests.[11]  The current unrest is being called the worst in a decade.[12]  Macron’s election was something of a protest vote; his party was new and he promised to make major changes.  However, his policies were akin to the reforms of the 1980s, the supply side revolution of Reagan and Thatcher.  These protests suggest that this outcome wasn’t what these voters were looking for.  Thus, France avoided a populist outcome in the last election that may not be true in the next election.

Watching Italy: We found the Italian elections to be the most interesting because it brought a government formed almost entirely of left- and right-wing populists.  One of the failures of populism has been the inability of both variants to form a coalition based on economic interests.  This coalition we dub the “Nader coalition,” who proposed such an arrangement in his book Unstoppable.[13]  In practice, in most circumstances, the identity differences have been simply too wide to overcome.  Thus, what happened in Italy was notable.  However, pro-business elements of the League, the right-wing side of the coalition, are starting to rebel against the party leadership.[14]  This development bears watching because it may undermine the right-wing side of the coalition, which, to date, has dominated the government.

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[1] https://www.wsj.com/articles/meeting-between-trump-and-xi-went-very-well-adviser-says-1543711542 and https://www.economist.com/finance-and-economics/2018/12/02/the-us-china-trade-war-is-on-hold

[2] https://www.ft.com/content/4c60cec2-f60e-11e8-af46-2022a0b02a6c?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[3] https://www.wsj.com/articles/u-s-china-face-thorny-obstacles-to-lasting-trade-peace-1543785395

[4] https://www.axios.com/chuck-grassley-trump-tariffs-section-232-national-security-613bb759-acac-4a36-9703-9a2ee1958f28.html

[5] https://www.wsj.com/articles/opec-economic-panel-recommends-output-cut-from-october-levels-1543603319

[6] https://www.ft.com/content/7c6d6fa0-f69d-11e8-af46-2022a0b02a6c

[7] https://www.washingtonpost.com/world/the_americas/alberta-government-imposes-oil-production-cuts-for-province/2018/12/02/40acd566-f69b-11e8-8642-c9718a256cbd_story.html?utm_term=.4bce34a6bf12

[8] https://www.ft.com/content/66cc3bee-f6c6-11e8-af46-2022a0b02a6c

[9] https://www.politico.com/story/2018/12/02/trump-assents-to-shutdown-delay-1037152 and https://www.ft.com/content/e58fd762-f660-11e8-8b7c-6fa24bd5409c?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[10] https://www.ft.com/content/222bdc0a-f631-11e8-af46-2022a0b02a6c?emailId=5c04b7e19b0ba30004415a75&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[11] https://www.ft.com/content/3c448d04-f61c-11e8-8b7c-6fa24bd5409c

[12] https://www.washingtonpost.com/world/europe/protest-riot-shocks-paris-leaves-133-injured-412-arrested/2018/12/02/b131eb88-f60e-11e8-99c2-cfca6fcf610c_story.html?utm_term=.901773d5d341&wpisrc=nl_todayworld&wpmm=1

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

[14] https://www.ft.com/content/eda609a6-f2f2-11e8-ae55-df4bf40f9d0d?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56