by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT]

(NB: The Daily Comment will go on hiatus beginning Wednesday, November 21^st, returning on Monday, November 26^th.)

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.

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[1] https://www.ft.com/content/b969db24-e8aa-11e8-8a85-04b8afea6ea3

[2] https://www.ft.com/content/7f8bfc96-e820-11e8-8a85-04b8afea6ea3 and https://www.ft.com/content/6b6f8a98-e811-11e8-8a85-04b8afea6ea3?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[3] https://www.reuters.com/article/us-italy-budget-conte-eu/italy-pm-conte-looking-to-work-with-eu-to-avert-massive-fines-reports-idUSKCN1NK0V4?feedType=RSS&feedName=worldNews

[4] https://www.wsj.com/articles/the-best-bad-brexit-deal-1542239961

[5] https://www.theneweuropean.co.uk/top-stories/three-point-three-million-leave-voters-support-peoples-vote-says-new-poll-1-5719471?wpisrc=nl_todayworld&wpmm=1

[6] https://www.ft.com/content/c6eef948-e80d-11e8-8a85-04b8afea6ea3?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[7] https://www.reuters.com/article/us-usa-trade-china-commerce-ministry/china-commerce-ministry-says-u-s-china-have-resumed-high-level-trade-talks-idUSKCN1NK0RK

[8] https://www.reuters.com/article/us-usa-trade-china-exclusive/exclusive-china-sends-written-response-to-u-s-trade-reform-demands-u-s-government-sources-idUSKCN1NJ336

[9] https://www.cnbc.com/2018/11/14/white-house-limits-peter-navarros-role-amid-china-trade-clash-with-larry-kudlow.html

[10] https://www.nytimes.com/2018/11/14/technology/facebook-crisis-mark-zuckerberg-sheryl-sandberg.html?emc=edit_mbe_20181115&nl=morning-briefing-europe&nlid=567726720181115&te=1 and https://www.nytimes.com/2018/11/14/technology/facebook-data-russia-election-racism.html?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosam&stream=top

[11] https://www.nbcnews.com/tech/tech-news/helipads-airport-lounges-perks-cities-offered-amazon-s-hq2-n936446

[12] https://www.reuters.com/article/us-saudi-khashoggi-prosecutor/saudi-public-prosecutor-seeks-death-penalty-in-khashoggi-murder-case-idUSKCN1NK1AX?il=0

[13] https://www.reuters.com/article/us-saudi-khashoggi-prosecutor/saudi-public-prosecutor-seeks-death-penalty-in-khashoggi-murder-case-idUSKCN1NK1AX?il=0 and https://www.cnbc.com/2018/11/14/powell-credits-fed-policy-for-the-us-economy-being-in-a-good-place.html and https://www.wsj.com/articles/fed-tracking-world-growth-worries-chairman-powell-says-1542242914

[14] https://www.reuters.com/article/usa-fed-powell/feds-powell-says-press-conference-at-every-meeting-means-all-sessions-are-live-idUSL2N1XP28L

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT]

(NB: The Daily Comment will go on hiatus beginning Wednesday, November 21^st, returning on Monday, November 26^th.)

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]

1. 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.
2. 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.
3. 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.
4. Northern Ireland will remain in the customs union indefinitely. This condition will only change by a new agreement.
5. 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]
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.

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[1] https://www.nytimes.com/2018/11/13/world/europe/britain-eu-brexit-deal.html?emc=edit_mbe_20181114&nl=morning-briefing-europe&nlid=567726720181114&te=1

[2] https://www.ft.com/content/cfe7c108-e7e3-11e8-8a85-04b8afea6ea3

[3] https://www.ft.com/content/40380478-e766-11e8-8a85-04b8afea6ea3

[4] https://www.ft.com/content/693b88b0-e804-11e8-8a85-04b8afea6ea3

[5] https://www.politico.eu/pro/brussels-wants-permanent-post-brexit-customs-union/?utm_source=POLITICO.EU&utm_campaign=1bbbacff3e-EMAIL_CAMPAIGN_2018_11_14_05_27&utm_medium=email&utm_term=0_10959edeb5-1bbbacff3e-190334489

[6] https://www.ft.com/content/c97af42a-e761-11e8-8a85-04b8afea6ea3?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[7] https://www.ft.com/content/c4847aca-e7f9-11e8-8a85-04b8afea6ea3

[8] https://www.ft.com/content/a6be46ba-e768-11e8-8a85-04b8afea6ea3 and https://www.bloomberg.com/news/articles/2018-11-14/u-s-said-to-hold-off-on-trump-s-car-tariffs-after-trade-meeting

[9] Mnuchin and Kudlow

[10] https://www.ft.com/content/e41de7c4-e793-11e8-8a85-04b8afea6ea3?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56  and https://www.politico.eu/article/italy-refuses-to-bow-to-brussels-budget-demands/?utm_source=POLITICO.EU&utm_campaign=1bbbacff3e-EMAIL_CAMPAIGN_2018_11_14_05_27&utm_medium=email&utm_term=0_10959edeb5-1bbbacff3e-190334489

[11] https://www.ft.com/content/5e7b5e9c-e312-11e8-8e70-5e22a430c1ad

[12] https://www.ft.com/content/319b334a-e28e-11e8-8e70-5e22a430c1ad?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[13] https://wolfstreet.com/2018/05/27/which-banks-are-most-exposed-to-italys-sovereign-debt-other-than-the-horribly-exposed-italian-banks/

[14] https://www.reuters.com/article/italy-debt-foreign-holdings/update-1-foreign-holdings-of-italian-bonds-hit-15-month-low-in-june-idUSL5N1W03O8

[15] https://www.marketwatch.com/story/heres-why-investors-remain-uneasy-about-italys-banks-and-the-doom-loop-2018-10-08

[16] https://www.nytimes.com/2018/11/13/world/europe/merkel-macron-european-army.html?emc=edit_mbe_20181114&nl=morning-briefing-europe&nlid=567726720181114&te=1

[17] https://www.politico.eu/article/europe-army-angela-merkel-emmanuel-macron-donald-trump-getting-what-he-wanted/?utm_source=POLITICO.EU&utm_campaign=1bbbacff3e-EMAIL_CAMPAIGN_2018_11_14_05_27&utm_medium=email&utm_term=0_10959edeb5-1bbbacff3e-190334489

[18] See WGR, The Mid-Year Geopolitical Outlook (6/25/18).

[19] https://www.reuters.com/article/us-oil-opec/opec-partners-discuss-oil-supply-cut-of-up-to-1-4-million-bpd-sources-idUSKCN1NJ15W

[20] https://www.ft.com/content/ecff5f86-e7c4-11e8-8a85-04b8afea6ea3?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

by Bill O’Grady and Thomas Wash

[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.

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.

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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[1] https://www.politico.eu/article/commission-sees-italy-surpassing-budget-deficit-limit-in-2020/?utm_source=POLITICO.EU&utm_campaign=a6acca9c80-EMAIL_CAMPAIGN_2018_11_13_05_42&utm_medium=email&utm_term=0_10959edeb5-a6acca9c80-190334489

[2] https://www.nytimes.com/2018/11/12/world/europe/italy-budget-european-union.html?emc=edit_mbe_20181113&nl=morning-briefing-europe&nlid=567726720181113&te=1

[3] https://www.ft.com/content/f7e26d32-e71d-11e8-8a85-04b8afea6ea3

[4] https://www.ft.com/content/6dfaf06e-e685-11e8-8a85-04b8afea6ea3

[5] https://www.ft.com/content/22dfd306-e667-11e8-8a85-04b8afea6ea3

[6] https://www.ft.com/content/1e3639a6-e5e7-11e8-8a85-04b8afea6ea3

[7] https://www.investors.com/news/oil-prices-jump-saudi-arabia-signals-opec-production-cuts/

[8] https://www.axios.com/donald-trump-automobile-tariffs-trade-war-b4f472c8-7e52-4748-b216-fd1c49794c3c.html

[9] https://www.wsj.com/articles/u-s-china-resume-talks-to-cool-trade-tensions-1542064355

[10] https://www.wsj.com/articles/u-s-china-trade-tensions-on-display-at-shanghai-expo-1541590039

[11] https://www.wsj.com/articles/u-s-deploys-new-tactics-to-curb-chinas-intellectual-property-theft-1542027624

[12] https://www.nytimes.com/2018/11/12/business/europe-trade-usa.html

[13] https://www.nytimes.com/2018/11/12/us/politics/trump-nato-trade.html?emc=edit_mbe_20181113&nl=morning-briefing-europe&nlid=567726720181113&te=1

[14] https://www.wsj.com/articles/peter-navarros-politburo-playbook-1542068623

[15] https://www.bloombergquint.com/uselections/tax-overhaul-might-be-imperiled-as-democrats-eye-corporate-hike#gs.R3==Gno

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s Monday and a bank holiday.  Since Veteran’s Day fell on a weekend, the banking system is partially closed today, which means the cash Treasury market is closed.  This is what we are watching this morning:

OPEC and oil: President Trump has been critical of OPEC and high oil prices, and the Saudis have been sensitive to his complaints.  However, now that the midterms are over, it appears the kingdom is pressing for higher prices.  The Saudi energy minister, Khalid al-Falih, suggested yesterday that the oil markets have overcorrected and prices should move higher.[1]  In addition, the kingdom is officially pushing for a 1.0 mbpd cut by December.[2]  Although Russia isn’t necessarily warm to the idea, it hasn’t shot it down either.[3]  Oil prices have suffered a significant decline recently, mostly due to seasonal factors and rising U.S. output.  The OPEC news may arrest the decline, but a reversal will need inventory reduction; a bit of dollar weakness would be helpful, too.

MbS: This week’s Weekly Geopolitical Report concludes our two-part series on the Saudi crown prince.  We note a couple of articles today.  First, the NYT reports that the crown prince was considering an assassination campaign against his and the kingdom’s enemies.[4]  Second, as we note in our report, it is likely the other princes will try to rein in MbS.[5]  His unstable decision-making is becoming a problem and could bring instability to a nation that strives for stability.

Brexit: Earlier this month, there was optimism that PM May would be able to strike a deal with the EU on Brexit.  Although the substance of an agreement appeared to be lacking, hopes were high.  It appears these hopes are fading rapidly.  The EU has rejected a key compromise point[6] on the Ireland/Northern Ireland border.  Negotiations have been intense but both sides can’t seem to come up with an agreement that will work for both parties.[7]  The British prime minister is facing political broadsides from both Remainers and Leavers; May has been trying to weave a path that would give each side enough to accept a Brexit deal that would not leave the U.K. economy completely outside the EU.  However, she has not been able to craft a compromise; in fact, such an arrangement may not be possible.  The GBP has declined on the lack of progress.  It should be noted that most EU deals don’t occur until the deadlines, mostly because there are so many parties involved that getting to an early answer is impossible.  Thus, one should not conclude that a deal isn’t coming.  However, if a plan isn’t in place by the end of November, it will be virtually impossible for the remaining members of the EU to agree in time for the March 29^th deadline.  A “hard” Brexit, which simply pushes the U.K. out of the EU and forces trade to WTO rules, would be a hard shock to the U.K. economy.  Already, there are calls for government bailouts if such an event occurs.[8]

Chinese tensions rise: Chinese authorities have been cracking down against labor protests that have been springing up recently.  These follow student activism at Peking University, where students, acting as good Marxists, supported a unionization movement for workers at the school.[9] Another issue facing the leadership is growing financial problems.  China has been using financial repression against households for years; it is how it creates saving for investment.  Households were generally only allowed to put their savings in banks that offered low interest rates, usually below the rate of inflation.  Financial firms have sprung up over the years offering higher interest rates; however, these firms are loosely regulated and, occasionally, default, causing localized unrest.  Peer-to-peer lending has been one of these industries.  Now, it appears a major one, Ezubao, has failed and depositors are demanding the government bail them out.[10]  We saw similar issues with wealth management products.  There is a solution—allow banks to raise interest rates to market levels which would undermine these unregulated financial products.  But, that would undermine the development model China has used since the late 1970s and, more importantly, reduce the wealth of powerful figures in the CPC.  Finally, the PBOC is signaling that it will act to prevent the CNY from depreciating significantly.[11]  Although the central bank may be successful in its goals, it should be noted that if the Trump administration does follow through on additional tariffs then CNY weakness is a nearly inevitable response.

Navarro reacts: Senior trade advisor Peter Navarro accused major Wall Street firms of being “unpaid foreign agents”[12] for meeting with Chinese officials earlier this month.  These strong words should be seen in the context of the divisions within not only the administration but the political system as well.  Populist wings have emerged on both the left and the right and Navarro, along with Robert Lighthizer, represent the right-wing version, at least on trade.  Populists of both stripes oppose globalization.  However, it is a bit jarring for a GOP administration to label Wall Street as unpaid foreign agents.

North Korea lurks: Although the Hermit Kingdom has been off the front pages for a while, we note that the Kim government has been continuing to work on its weapons of mass destruction.  According to the Washington Post,[13] the regime is working on its ballistic missile program at new “secret” bases.  Kim Jong-un, like his father and grandfather, won’t be ignored indefinitely and the lack of progress on improving relations could mean new tensions in 2019.

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[1] https://www.cnbc.com/2018/11/11/oil-prices-saudi-arabia-says-markets-are-getting-it-wrong-again.html

[2] https://www.ft.com/content/1e3639a6-e5e7-11e8-8a85-04b8afea6ea3?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[3] https://www.wsj.com/articles/opec-edges-closer-to-production-cut-as-saudis-russia-signal-intent-1541956957

[4] https://www.nytimes.com/2018/11/11/world/middleeast/saudi-iran-assassinations-mohammed-bin-salman.html?emc=edit_mbe_20181112&nl=morning-briefing-europe&nlid=567726720181112&te=1

[5] https://www.ft.com/content/2f853996-e5d3-11e8-8a85-04b8afea6ea3?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[6] https://www.thetimes.co.uk/edition/news/may-s-brexit-deal-crashes-as-eu-turns-off-life-support-fg02wktsp

[7] https://www.theguardian.com/politics/2018/nov/12/may-has-little-room-for-manoeuvre-brexit-german-minister-warns

[8] https://www.politico.eu/article/business-will-need-state-bail-outs-in-no-deal-brexit/?utm_source=POLITICO.EU&utm_campaign=f80619b654-EMAIL_CAMPAIGN_2018_11_12_05_40&utm_medium=email&utm_term=0_10959edeb5-f80619b654-190334489

[9] https://www.ft.com/content/cbecd5d8-e627-11e8-8a85-04b8afea6ea3?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[10] https://www.ft.com/content/c71eea4a-c198-11e8-84cd-9e601db069b8?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[11] https://www.bloomberg.com/news/articles/2018-11-12/china-signals-tougher-yuan-management-at-expense-of-market-role

[12] https://www.wsj.com/articles/peter-navarro-blasts-china-and-wall-street-globalists-1541787254

[13] https://www.nytimes.com/2018/11/12/us/politics/north-korea-missile-bases.html

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s Friday, just not a very happy one.  The market tone is definitely risk-off.  Today’s weakness is mostly made in China but there are other concerns as well.  Here is what we are watching:

China: The inflation data (see below) was mostly in line with expectations.  There was some welcome easing of inflation at the producer level.  We may see a pickup in import prices in the coming months due to recent CNY weakness.  Easing price pressures could give the PBOC room for further stimulus.  However, other media reports are raising concerns.  For example, over the past year, companies were trying to maintain borrowing when the PBOC was cracking down on shadow banking.  The response was to circumvent these restrictions by borrowing from banks using shares that were pledged as collateral.  As any financial advisor in the U.S. knows, this is a form of margin lending and the risk of such borrowing is that the value of the collateral declines, leading to the dreaded margin call.  In China, the pledged shares were not used for additional share-buying but for business needs.  The bear market in Chinese stocks has now raised concerns about the collateral of these loans, which are said to be about $620 bn, or about 10% of market capitalization.[1]  So far, lenders have not forced borrowers to sell shares and pay back the loans; we suspect financial regulators are pressing banks not to take this action.[2]  However, by not forcing the sale of shares, banks are now reserving against these loans, which will further crimp lending.

This isn’t the only area of concern in China.  For the fourth straight month, car sales have shown negative yearly growth, falling 12% in October.  For the year through October, sales are down 0.1% compared to the same period last year.  It appears a confluence[3] of events, including worries over trade, falling equity values and tightening credit standards, is undermining car sales.[4]  Sentiment weakness has also led to falling Chinese tourism.[5]

The geopolitical situation is deteriorating as well.  The Trump administration is accusing China of violating an Obama-era cyber-theft agreement.[6]  In fact, it appears cyber-theft jumped after Obama left office.  The U.S. has already responded with the DOJ starting a “Chinese initiative” to counter China’s activity.[7]  In the meantime, the U.S. Navy and the People’s Liberation Army Navy continue their dangerous encounters in the South China Sea.[8]  Defense Secretary Mattis has been working hard to maintain open lines of communication to reduce the chances of a spiraling conflict.[9]  Although President Trump has made no secret of his dislike for his SoD,[10] for now, his position appears safe.[11]

In summary, China’s financial situation is becoming increasingly perilous.  Although a sudden debt crisis is possible, we don’t think it is the most likely outcome.  Instead, we suspect China is going the route of Japan, post-1990, where growth slows to a level where additional debt isn’t necessary to support growth.  The key unknown is whether the CPC can change its political legitimacy from delivering high growth to something else.  Chairman Xi has amassed enough power to make changes that will address this issue; what we don’t know is whether he can come up with a new form of legitimacy that allows China to remain a single-party state.  The most likely outcome is a long period of slowing growth.  But, that doesn’t mean that a sudden stop isn’t possible—it’s just not as likely.

The Fed: There were no surprises in the FOMC action or statement.[12]  The Fed did acknowledge that unemployment is really low but also noted that business investment has been disappointing.  There is no doubt the Fed will raise rates in December.[13]  It should also be noted that every meeting going forward will have a press conference.  In theory, this could make every meeting live but we note that forecasts and dots will still only occur quarterly.  We will be watching to see if the FOMC will take action on rates when there are no new dots.

Oil prices continue to decline: Oil prices remain under pressure this morning, with WTI dropping below $60 per barrel.  The catalyst today was a report that the Keystone Pipeline project was halted by a federal judge, arguing that the administration didn’t take environmental concerns into account.[14]  To some extent, the market reaction doesn’t make a lot of sense.  If the Keystone project was functioning, it would be bringing Canadian tar sands oil to the Gulf Coast, adding to supplies there.  The bigger reason for the weakness is rising domestic inventories that are partly due to seasonal factors and partly due to rising U.S. production.  In addition, Iraq may be close to a deal with the Kurds that would restart exports from Kirkuk.[15]  Oil remains oversold but clearly hasn’t found a bottom yet.

Cabinet changes: Although the Sessions resignation has been the focus of the media, there are rumors that Wilbur Ross may be out at Commerce.[16]  A potential replacement could be Linda McMahon; she is considered a free trader and may signal a shift toward trade deals and away from punitive tariffs.  Although we doubt China will get much relief, a McMahon Commerce Department may be more open to deals with the EU and Japan. 

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[1] https://www.reuters.com/article/us-china-markets-pledgedshares-insight/in-china-response-to-pledged-share-meltdown-stirs-concern-idUSKCN1NE0PD?feedType=RSS&feedName=businessNews&utm_source=Twitter&utm_medium=Social&utm_campaign=Feed%3A+reuters%2FbusinessNews+%28Business+News%29

[2] https://www.apnews.com/c14fed9f16594f1d9df6baf9b656de66

[3] See what we did there?

[4] https://www.wsj.com/articles/china-auto-sales-on-track-for-a-down-year-1541750936

[5] https://www.wsj.com/articles/chinese-travel-giant-trips-up-investors-1541743516

[6] https://www.wsj.com/articles/china-violated-obama-era-cybertheft-pact-u-s-official-says-1541716952

[7] https://www.wsj.com/articles/u-s-accuses-two-firms-of-stealing-trade-secrets-from-micron-technology-1541093537

[8] https://www.nytimes.com/2018/11/08/world/asia/south-china-sea-risks.html

[9] https://www.reuters.com/article/us-usa-china-mattis-insight/how-mattis-is-trying-to-keep-u-s-china-tensions-from-boiling-over-idUSKCN1NE0FF

[10] https://www.nytimes.com/2018/10/14/us/politics/trump-mattis-democrat.html

[11] https://www.bloomberg.com/news/articles/2018-11-05/trump-says-he-plans-to-keep-mattis-as-defense-chief-after-vote

[12] https://www.wsj.com/articles/fed-doesnt-budge-1541710988

[13] https://www.ft.com/content/8989b08c-e387-11e8-8e70-5e22a430c1ad?emailId=5be51a6f4c00e900045a33a8&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22&kbc=undefined

[14] https://www.washingtonpost.com/nation/2018/11/09/keystone-xl-pipeline-blocked-by-federal-judge-major-blow-trump-administration/?utm_term=.9e32c5ce427a

[15] https://www.ft.com/content/4c7d6e66-e370-11e8-a6e5-792428919cee

[16] https://www.politico.com/story/2018/11/08/russia-probe-trumps-attorney-general-hunt-978771

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s Fed day!  The FOMC meets today but it is one of those meetings without new forecasts (“dots”) or a press conference.  Thus, we are expecting no change in rates or in the statement.  We are seeing some consolidation in equities this morning after a strong rally yesterday.  Here is what we are watching this morning:

More on the midterms: We have some additional observations about the impact of the midterm elections:

Waiting didn’t help foreign nations—China and the EU were stalling on trade talks, perhaps hoping for a Democratic Party sweep of Congress that would reduce the power of the White House.  Although this was a long shot, the costs of waiting weren’t all that high.  But, given the result, we would look for more serious negotiations to begin.  The U.S. will likely meet with China at the G-20 and we would expect EU negotiators to move faster now.[1]  The EU will be particularly concerned with the potential for auto tariffs.

The bond market is worried about GOP fiscal management, or worse—Yesterday, we noted the market volatility surrounding shifts in election forecasts that led to some violent moves in the Treasury market.  To reiterate, 528, Nate Silver’s site, shifted the odds of a GOP hold on the House that led to a spike in Treasury yields.  The forecast was being driven by partial results and, in retrospect, was probably too sensitive to this data.  The jump in yields was either due to fears of further fiscal expansion or rising inflation expectations.  Comparing the TIPS yield to the nominal leads one to conclude that financial markets are starting to view the GOP as the party of reflation.[2]  We note that in yesterday’s trade the two-year yield rose while longer duration yields fell, despite a sloppy 30-year T-bond auction.  The flattening of the curve in the aftermath of the election suggests that fixed income investors view divided government as a check on spending and further tax cuts, and thus were willing to buy the long end of the curve.

How to think about investigations—The president wasted no time ridding his administration of AG Sessions.  There is much media frenzy over the appointment of a temporary head of the Justice Department and the Mueller investigation.  For now, we don’t expect these events to have much impact on financial markets.  The firing of Mueller won’t stop the House from investigating the White House.  The news on this front will be the focus of cable news but financial markets will still focus on the economy; turmoil means there will be less chance of tax law changes.  If the investigations begin to undermine confidence, then it will be time to worry.  But, there is no evidence to suggest that is in the offing.

Red states are supporting populism—Arkansas and Missouri both passed minimum wage hikes.[3]  Earlier this year, the latter state repealed right to work.  Although both are generally reliable GOP states, their voters are openly rejecting the free market ideology of the libertarian wing of the Republican Party.  We should also note the president hinted yesterday that he might be willing to claw back some of the recent tax cuts on higher income households to give the middle class more tax relief.[4]  In other words, investors should note that the GOP may not be a reliable partner in supporting the interests of capital as time passes.

The regulatory world is becoming less tech friendly—The incoming Congress will be populated with Democrats skeptical of the tech companies on privacy and the GOP is opposing the monopoly power of the platforms.  As time passes, the perception of the tech firms has steadily moved from their leaders being seen as folk heroes to being seen as predatory.  The risk of increasing regulation is rising.[5]

China’s trade data: China’s trade data for September did not show any significant effects from recent tariffs.  Import growth was robust, up 21.4% from last year, well above the consensus growth of 14.5%.  With import volumes up 15.4%, there may be some anticipatory buying underway.  China’s surplus with the U.S. hit a new record; more interestingly, China is running nearly balanced trade with the rest of the world.

These numbers will tend to trigger tough rhetoric from the Trump administration and raise worries about further tariff measures.

Italian budget negotiations: The EU has raised its forecast for the Italian budget deficit, mostly by assuming a lower growth rate than Italy did in its budget calculations.[6]  Both parties appear to be in a standoff.  We still expect the EU to offer some concessions to Italy but the rhetoric makes it hard for the EU to compromise.  Meanwhile, Italy is using Brexit for leverage, suggesting it will support the British in their negotiations over leaving the EU.  Since the EU side needs unanimous approval, Italy’s threat may require the EU to offer concessions on the budget to secure its Brexit position.[7]

Energy update: Crude oil inventories rose more than expected, coming in at 5.8 mb compared to forecasts of 2.0 mb.

U.S. crude oil production continues to surge, rising 0.4 mbpd this week to 11.6 mbpd.  Although refinery runs did rise to 90.0% of capacity, it was only a 0.6% increase from last week.  Oil imports rose 0.2 mbpd, while exports fell 0.5 mbpd.  Needless to say, it was a bearish report.

We are approaching the end of the inventory build season.  Refinery operations should rise in about two weeks, which should reverse some of the recent inventory gains.

Based on inventories alone, the fair value for crude oil is $63.71.  Using the EUR as the independent variable, oil prices are fairly valued at $55.21 per barrel.  Using both, fair value is $57.61.  Simply put, the most bearish factor for oil now is dollar strength.  We do expect oil inventories to begin their seasonal decline into year’s end soon, which may offer bullish support in a deeply oversold market.  But, the dollar needs to weaken in order to stage a major rally.

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[1] https://www.bloomberg.com/news/articles/2018-11-08/merkel-envoy-expects-more-intense-trump-talks-after-midterms

[2] https://ftalphaville.ft.com/2018/11/07/1541617447000/Debt-markets-let-us-know-what-they-think-about-Republicans-last-night/

[3] https://ftalphaville.ft.com/2018/11/07/1541602755000/Yes-that-s-all-very-interesting–but-now-give-us-more-money/

[4] https://www.politico.com/story/2018/11/07/trump-taxes-middle-class-972638

[5] https://www.axios.com/newsletters/axios-am-23111b35-cdb5-4c7c-a377-8399bcd85faf.html?chunk=6#story6

[6] https://www.fxstreet.com/analysis/eu-raises-forecasts-for-italian-budget-deficit-thru-2020-awaiting-the-fomc-201811081038

[7] https://www.express.co.uk/news/uk/1042098/Brexit-news-Guglielmo-Picchi-UK-EU-deal-Michel-Barnier-pressure-Theresa-May-latest

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy Wednesday!  No more political ads on TV!  Here is what we are watching this morning:

Election takeaways: The midterms came out about as expected, with the House going to the Democrats and the GOP expanding its hold on the Senate.  Although, in the end, things turned out roughly as forecast, there was a lot of drama throughout the night.  Some of the closely watched political pollsters and pundits caused all sorts of swings in the overnight markets.  Here is what we are seeing:

Hardening bases—The president’s plan of creating voter interest by focusing on immigration worked with voters that are his key constituency, which would be rural and suburban older white voters, especially men, with less than a college degree.  The GOP dominated the less populated areas of the country.  The Democratic Party plan of focusing on women in the suburbs worked.  Democrats not only did well in cities but also in more affluent suburbs.  Democrats continue to make gains with those holding college degrees.[1]  Progressive candidates in red states didn’t fare well.  Moderate Democratic candidates for Midwestern governors did quite well.  One of the hardest issues of leadership is understanding the correct lessons to learn from victory or defeat.  GOP leaders will note that moderate Republican candidates lost in suburban districts.  They could decide that moderates can’t win.  Democrats may decide that the countryside is lost for good.  It is highly likely that the lesson both parties will take from this election is to keep pounding on the same themes to the same voters.  Although this may lead to narrow victories, it won’t create any sort of national unity.  In summary, the likely lesson learned by both parties will increase national divisions.

The race for the White House begins today—Although we expect the president to take a breather after a punishing campaigning schedule, the rallies he held recently will likely continue, although the pace probably won’t be as frenetic.  But, expect Democratic presidential hopefuls to emerge.  Who are we watching?  Sherrod Brown (D-OH) was easily re-elected to his Senate seat even as the GOP won the governor’s race.  Brown is a true blue collar populist; he was anti-trade before it was cool.  The national media is focused on a lot of other candidates but Brown would pose a real alternative for the Trump constituency.

Markets are good with gridlock—Perhaps the most interesting market response to the election has been a drop in the dollar.  It is possible traders are thinking that the House will now run a parade of investigations against Trump and distract him from his trade agenda.  Although possible, we haven’t seen much evidence to suggest the Democrats have become ardent free trade supporters.  In addition, gridlock likely reduces the chances of further fiscal spending, which is supportive for Treasuries.  Equities have bounced this morning and Treasuries are rallying.

Overall—The results were as expected.  We would look for equities to follow their usual pattern after midterm elections and rally.  If dollar weakness holds, it will be bullish for commodities.

Chinese foreign reserves: China’s foreign reserves fell $34.0 bn, a bit more than forecast.  We suspect the decline was due to the PBOC’s support for the CNY, although the pace of declines would suggest that Chinese authorities are trying to guide the currency lower, not prevent it from falling.

Oil supply cuts?  Now that the elections are out of the way, OPEC appears to be shifting gears and returning to price supports.  OPEC ministers are meeting in Abu Dhabi this weekend and are planning to discuss production cuts for next year.[2]  Oil prices are up today despite a large jump in oil inventories reported by the API.  We get the DOE data later this morning.

BOJ again: Another member of Japan’s central bank board, Yukitoshi Funo, said today that the BOJ may need to raise rates soon to support the banking system.[3]  This is the second time in a week that members of the BOJ have hinted at reversing accommodative policy.

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[1] https://www.politico.eu/article/7-takeaways-from-a-wild-us-midterm-election-house-senate-donald-trump/

[2] https://www.bnnbloomberg.ca/opec-said-to-consider-2019-oil-output-cuts-in-yet-another-u-turn-1.1164366

[3] https://in.reuters.com/article/japan-economy-boj/boj-policymaker-signals-chance-of-future-rate-hike-to-ease-bank-strains-idINKCN1NC0NP