As the FOMC raises rates, there are increasing concerns about the credit markets. After a long period of low rates, credit spreads are starting to widen, raising fears of financial stress. In this report, we will look at these concerns.
First, here is what we are seeing with credit spreads:
This chart looks at the spread between 10-year T-notes and similar term Baa corporates. The average and standard deviation lines are calculated from 1921. Currently, the spread is about average but it has been widening recently.
Second, here is the impact of monetary policy on credit spreads:
This chart examines credit spreads with periods of policy tightening. Although policy tightening may bring conditions that trigger a widening of credit spreads, in reality, periods of tightening usually coincide with narrowing credit spreads. This is because the FOMC usually raises rates in response to positive economic conditions, which, coincidentally, are also consistent with conditions that support firms’ ability to service debt. Credit spreads tend to widen when the Fed is easing rates.
Third, the key trigger to widening credit spreads is economic conditions.
This chart shows the Chicago Federal Reserve Bank’s National Activity Index along with the T-note/Baa credit spread. The national activity index uses 85 variables to track the economy; we smooth the raw data with a six-month moving average. A reading of zero indicates an economy growing at trend. Thus, a reading below zero suggests a weakening economy. Note how credit spreads widen when the index dips below zero. The two series are correlated at -71.9%. A regression based on this relationship suggests that the recent widening of the T-note/Baa spread is mostly a rise toward fair value.
The regression suggests the spread had become too narrow given the performance of the economy. The recent widening has mostly moved the spread back to fair value. Although it is possible the spread could widen further, it would not be justified based on the performance of the economy. For this reason, we still view credit risk as manageable.
[Posted: 9:30 AM EDT] Good morning! It’s a very quiet market this morning. Equities continue to consolidate in front of this weekend’s G-20 meeting. Here is what we are watching today:
The G-20 and China talks: We expect some sort of short-term accommodation at this weekend’s meeting. We look for the U.S. to delay implementing the tariff hike on China and postpone expanding tariffs on the rest of Chinese imports. China will offer to buy some American goods in return. However, the key issues, such as technology transfers and intellectual property theft, won’t be resolved. Although we do expect some modest agreement, we note that Peter Navarro, the president’s hardline trade advisor, has now been invited to the Saturday dinner with Xi. This may be signaling a harder line on China because he was initially kept off the seating chart. In our view, China and the U.S. see each other as strategic competitors. So, we may see a truce, which the financial markets generally expect, but a long-term resolution isn’t likely because it isn’t really possible. U.S. and China hegemonic competition is now in the open and will be a major issue for the foreseeable future. At the same time, as we detail below, Chairman Xi probably needs an agreement more than President Trump does, at least in the immediate term.
China’s economy: China’s official manufacturing PMI data came in weaker than expected, coming in at 50.0 in November, down from 50.2 in October. The official data is generally considered less reliable than the Caixin PMI report, which comes out on Monday. The fact that the report is now resting on the expansion line shows that the Chinese economy is under pressure. Although American trade policy is partly to blame, deleveraging is probably playing a larger role.
This chart shows China’s annual M1 growth along with the yearly growth of outstanding credit. Up until 2011, the two measures tended to follow each other closely. However, the response to increased money supply growth in 2016 was modest at best, suggesting the PBOC’s ability to stimulate is weakening. Further evidence is seen when comparing money growth to industrial production.
Why is this happening? One potential reason is that as China’s economy matures, it can no longer rely on investment spending to boost growth. In other words, until a few years ago, China’s economy could absorb new investment even if it wasn’t necessarily needed. But, if we have reached a point of saturation then monetary policy is essentially “pushing on a string.” This is why China’s trade issues with the U.S. are so important. After the Great Financial Crisis, China offset the loss of exports with an investment boom. If that isn’t working and consumption hasn’t improved, about the only sector left to support growth is the export sector and the Trump administration is essentially closing off that avenue.
Perhaps the biggest issue is uncertainty. A group of U.S. professors[1] have created a basket of uncertainty indicators that are constructed by scanning articles about policy, economics, etc. They have created these indices for a variety of countries, including China. The index, which uses the South China Morning Post out of Hong Kong as its principal source, suggests that economic uncertainty is sharply elevated.
This data suggests the Xi government is facing a serious sentiment problem and needs to show that it can stabilize the economy. Unfortunately, it isn’t obvious what can be done if the credit impulse isn’t working; therefore, Xi may be more inclined to make a deal with President Trump, at least to support the economy in the near term.
Good morning! Equities are consolidating this morning after a strong rally yesterday. Here is what we are watching today:
Powell: After spooking the financial markets in October, Fed Chair Powell gave a much more dovish speech yesterday. There were two elements of this talk that boosted market sentiment. First, he suggested that the current fed funds target was close to neutral[1], implying that the FOMC may be close to ending its tightening cycle or at least considering a pause. In fact, a pause would be consistent with the notion of data dependence. One element that Powell has brought to the Fed is the idea that even the best economic models are approximations and thus it’s wise not to be overly reliant on such models in making policy. It is likely that only a non-economist, or perhaps a non-academic economist, could come to such a conclusion. One could argue that Alan Greenspan conducted policy in a similar fashion. Although Greenspan was a trained economist, he worked in the private sector and was never a professor. His decision in the late 1990s to not raise rates when unemployment was low turned out to be correct. However, we would argue he was right for the wrong reasons. His argument for not raising rates was expectations of a productivity boom. Although productivity did rise, it was probably due more to fully utilizing capacity and not any “miracle.” Instead, inflation stayed low because of long-running trends in globalization and deregulation. However, it is interesting that the primary proponent of raising rates was Janet Yellen, who was likely working off of Phillips Curve models. So, having Powell in this position means the risk of policy overtightening due to adhering to an academic model has lessened. The risk has been replaced with data dependence. Operating policy on data dependence means, by definition, that policy will be reactive. That’s not necessarily a bad thing but it’s important to know what risks one is taking.
The second supportive comment from Powell was that he didn’t see evidence of financial excess in the financial markets at this time. We would agree with this perspective in most markets. High yield is the one major sector where we would disagree. Spreads remain very narrow; although they can remain at such levels for a long time, the risk/reward isn’t all that attractive. Other areas, such as private equity, are frothy as well. But, the major broad markets, stocks and bonds, are, if anything, a bit cheap.
Where do we go from here? Although the financial markets appear to be holding that the Fed is now less of an issue, we do note that the official range of the potential neutral rate is between 2.50% to 3.50%. That information is simply useless, because it implies one to five more hikes. Our Mankiw Rule estimates of neutral range from 1.85% to 3.93%. These model ranges are worthless by themselves. Instead, these models all have independent variables that reflect potential measures of slack. If you think the economy is running at full employment, fed funds should be closer to 4.00%. If you think slack exists, the policy rate is probably already at neutral. Our belief is that there is slack in the economy, which accounts for the continued low level of inflation. Thus, we see little danger in at least pausing the pace of rate hikes. The key point here, however, is that the Fed is making decisions under conditions of uncertainty. When making such decisions, one must be aware that the potential for making mistakes is high and thus caution is warranted. Powell seems to understand this better than the last two Chairs, which is probably a plus.
Further gains in equities in the short run will be dependent on this weekend’s G-20 meeting. We do note that there will be a number of Fed speakers in the coming days and some dissent might be expressed. But, for the most part, the focus will now shift to trade.
The G-20 and China talks: We expect some sort of short-term accommodation at this weekend’s meeting. We look for the U.S. to delay implementing the tariff hike on China and postpone expanding tariffs on the rest of Chinese imports. China will offer to buy some American goods—look for soybeans, oil and LNG purchases to resume. But, this outcome is merely a reprieve. It has become evident that the president (a) holds that trade is a mercantilist exercise, meaning that trade surpluses are good, deficits bad, and (b) China is a strategic competitor. Simply put, the president views tariffs as a core position.[2]
Apparently, the president is returning to auto tariffs[3], specifically targeting Chinese vehicles.[4] The U.S. is warning European nations to be wary of using Chinese 5G technology for security reasons.[5] The strategic goals of the U.S. and China have diverged and are probably not reconcilable.[6] We note that elite opinion is turning on China, meaning it isn’t just the White House that is viewing China as a strategic threat.[7]We will likely see a deal this weekend, but it should only be seen as a truce; U.S. and China policy is likely to become increasingly hostile going forward.
Brexit update: Both the government and the BOE gave their economic assessments of Brexit yesterday. In all cases, leaving the EU is expected to harm the British economy, with a “hard Brexit” causing serious economic damage.[8] Market reaction to these studies was barely noticeable, suggesting the financial markets expect policymakers to avoid the worst outcomes. We tend to agree with this assessment, but worry that policymakers, seeing the lack of market turmoil, may misinterpret the reaction and think they don’t have to worry about a hard Brexit. We do expect the May Brexit plan to fail in Parliament; it may pass with a second vote after May resigns, or we could have another referendum. Hard Brexit, exiting without a deal, is still the least likely outcome, but that isn’t to say that outcome is impossible.
A sober note:U.S. life expectancy from birth fell a tenth of a year; it peaked at 78.9 years in 2014 and is now down to 78.6 years.[9] Rapidly rising suicide rates[10] and drug overdoses are the primary culprits for the stalling of life expectancy.[11] It is highly unusual for life expectancy to decline in an industrialized nation and what we are seeing in the U.S. may also reflect the economic fallout from the Great Financial Crisis.
[Posted: 9:30 AM EDT] Good morning! Equities are ticking higher in front of Chair Powell’s speech this morning. Here is what we are watching today:
The Fed: Chair Powell speaks in NY at 12:00 EST. We don’t expect anything groundbreaking but we will be watching to see if he follows the path laid out by Vice Chair Clarida yesterday. Clarida didn’t give up much on the direction of policy (he stuck to “data dependent”) but there is one change he did signal, which is that forward guidance is dead, at least in terms of FOMC comments.[1] Forward guidance became a policy tool under ZIRP; once the Fed reached 0% fed funds, Chair Bernanke shifted his comments to say, in effect, that “rates are low and going to stay that way.” That was done to enhance whatever benefit the economy would get from low rates by indicating borrowers and investors could rely on rates staying low for a long time. The policy was always controversial; Stanley Fischer didn’t care for it at all because he feared it locked the bank into a policy that it may need to adjust in case of a sudden change in conditions. We view the discontinuation of forward guidance as evidence of policy normalization. Once rates lifted off zero, the value of forward guidance as a way to enhance the value of zero rates was removed. However, policymakers did keep guidance policy as rates rose, using the informal policy of only raising rates at meetings with a press conference, for example. However, as the Fed approaches neutrality, forward guidance becomes a problem because it could lead market participants to overestimate how much tightening is in the pipeline, leading policy to be tighter than the Fed intends. Instead, the FOMC does appear to be trying to create as much flexibility as possible so it can act appropriately if the economy slumps or accelerates and not be “straightjacketed” into a policy path.
The other Fed news of note is the president’s continued bashing of the central bank.[2] The persistence of the criticism, in some sense, reduces its effectiveness. The lambasting has become so frequent that it has become part of the background and, so far, has had no obvious impact on changing FOMC behavior. However, it may someday; if policy is designed to reflate the economy, and we think that is the underlying policy trend, then curtailing central bank independence is part of that goal. When you want low inflation, you implement central bank independence. We would not expect a formal return to the pre-1951 era Fed which was forced, by regulation, to facilitate Treasury borrowing. But, the White House can accomplish the same thing by emasculating the Fed chair, as Nixon did with Arthur Burns. The undermining of Fed independence hasn’t happened yet, but we do expect that to occur at some point and President Trump has started the process by breaking the Clinton-era “Rubin truce.”
The G-20 and China talks: It is getting increasingly difficult to figure out how much of the administration’s rhetoric is posturing for negotiations and how much is the indication of actual positions. For example, Larry Kudlow suggested yesterday that a deal might occur but his tone was not as optimistic as he usually projects.[3] Kudlow did admit that pre-meeting talks have apparently stalled.[4] At the same time, the NYT[5] suggests that, despite Kudlow’s attempt to reduce expectations, the president really wants a deal. Since we view the NYT as more of a signaling channel for elite opinion and less of a news organization, this could either be an attempt from elements within the administration to nudge the president or it really does reflect the position of the White House. The financial markets have generally discounted a truce of sorts. Although the sides appear too far apart to make a significant agreement, the promises of substantial talks in return for a delay of additional tariffs might be doable. If discussions end badly, look for global equities to sell off.
Macron’s woes continue: The French president gave a speech yesterday[6] offering his long-term vision for France. The talk was widely panned with the primary criticism being that Macron seems far too focused on long-term goals and is ignoring the plight of the bottom 90%. The recent hike in gasoline taxes appears to be the trigger; middle and lower class citizens found themselves priced out of the cities due to rising rents and were forced to move to the distant suburbs. Now, with the hike in taxes, they can’t afford to drive to work in the cities. Macron appears tone deaf to the concerns of the “yellow jackets” (protestors are wearing the yellow vests that road crews wear), and the longer these protests go on the greater the odds are that a left- or right-wing populist will see increasing popularity.
Brexit update: PM May’s plan continues to take harsh criticism; there is growing support for the U.K. to instead join the European Free Trade Association (EFTA),[7] which is what Norway operates under. This alternative does take the U.K. out from under the jurisdiction of the EU courts but still requires it to allow for the free movement of peoples. EFTA is a solution for the elites; the Euroskeptics won’t like it but such a program might be able to garner enough support from all the parties to pass. However, PM May is likely a goner if this option becomes “Plan B.” PM May has been something of a political Houdini; her political obituary has been written often. However, this issue might bring her down. On the other hand, the Tories don’t want new elections and so we would not expect her resignation to trigger a successful no-confidence vote. Instead, we would expect another compromise PM that will finally bring Brexit to a close.
OPEC: Although we may not get an official cut in quotas, we do expect the cartel to informally reduce output.[8] Russia has indicated it would support Brent at $60, which implies policies to at least stabilize prices, but we expect the Saudis to try to boost prices by at least $10 per barrel.
Don’t sleep on a government shutdown: It appears the president is hardening his position on the border wall[9] and lawmakers are struggling to develop a compromise.[10] Given the relative frequency with which such events occur, under normal circumstances we would expect the market to mostly ignore a shutdown, assuming it will be resolved soon. But, with market sentiment fragile, a shutdown could be seen as a “last straw” and trigger a selloff.
One more housing chart: We received a number of comments about our charts in yesterday’s report, most expressing surprise that cash-out refinancing has returned. We want to add one more chart which highlights that, even with the surge, current conditions are different than 2005.
This chart uses the level of cash taken from cash-out refinancing and compares it to overall household saving. At the peak of the housing bubble, cash-out refinancing represented over 30% of total household saving; simply put, households were truly using their homes as a source of saving. Currently, the percentage is 1.5%. Although cash-out refinancing is rising, it is dwarfed by the overall increase in household saving. Thus, in this regard, the reliance on refinancing for cash is probably a localized issue, a factor in housing markets that have seen sharp appreciation.
[Posted: 9:30 AM EDT] Good morning! Risk markets are under pressure this morning after the president maintained a hard line on Chinese tariffs. Here is what we are watching today:
Chinese tariffs: In an interview with the WSJ,[1] President Trump indicated that he expects to lift existing tariffs on $200 bn of Chinese imports to 25% from 10%, suggesting it is “highly unlikely” he would delay their implementation. He also said that if talks with Chairman Xi don’t bear fruit, he would likely apply tariffs to the rest of China’s imports. That would be another $267 bn in goods; it is not clear if the rate on the proposed new tariffs would be 10% or 25%. One of the key points the president made offers an insight into his thinking—he had a message to companies wondering how to cope with tariffs.
“What I’d advise is for them to build factories in the United States and to make the product here,” Mr. Trump said in the interview. “And they have a lot of other alternatives.”[2]
President Trump’s vision for America is a pre-1978 version where the economy is deglobalized and most production is performed in the U.S. by highly paid American workers. Although this would be better for U.S. labor it will (a) almost certainly contract profit margins, and (b) lead to higher inflation. We have been warning our readers for some time that we are likely moving into an equality cycle and leaving an efficiency cycle. That quote adds to evidence that this shift is underway. The eventual outcome will likely be less inequality but higher inflation.
GM (36.75, +1.72): As a reminder, we don’t discuss individual companies in this report unless the news surrounding them have macro implications. Yesterday, Mary Barra, the CEO of General Motors, announced sweeping plant closures and layoffs.[3] In total, seven production plants will close and 14,000 workers will lose their jobs. The layoffs represent 4.8% of the firm’s North American workforce. The company is reacting to a weakening global auto sales market (China rescinded a tax break in January; the cut in 2016 led to a jump in car sales in that year but since then sales have been weak[4]) and excess capacity. GM, much like Ford (F, 9.40, 0.27), is abandoning the sedan market to foreign nameplates and focusing on trucks and SUVs. GM is also trying to divert revenue to future auto technology.
Extending the equality and efficiency theme, we note that both President Trump[5] and Senator Sherrod Brown (D-OH)[6] have criticized the move. The juxtaposition of a GOP president and a hard-left Democrat senator holding the same position is notable. To be fair, Ohio was a key state in the president’s capture of the Electoral College and plant closures in the state would likely trigger a response from its senators. But, the real key is that we may be entering a world in which firms will be less able to freely allocate capital where costs are most favorable. Again, we are not saying that company pursuit of profit is the highest value. But, we think it does show that worries have diminished about triggering inflation by restricting supply. We describe this process as “intergenerational forgetfulness.” Simply put, it means that the memory of the 1970s inflation is steadily aging out and this memory is being replaced by low inflation and increasing concern about inequality.
This chart shows the adult experience of inflation for Americans by age. We start adulthood at 16 years old. Although the thought of such an early start to adulthood is somewhat humorous in the present day, for the population at the right end of the chart adult responsibilities were taken on at a much earlier age. Note that the baby boom has the highest lifetime experience of inflation, an average of 3.9%. The aggressive anti-inflation policies that began in 1978 successfully lowered inflation, so successfully, in fact, that now a large contingent of Americans see no issue with inflation. For adult Americans under the age of 50, the average inflation rate is 2.1%; older than 50, it is 3.7%. Thus, it makes sense that there is less fear of causing inflation by undermining supply-favoring policies as there are simply fewer Americans that have experience of high inflation.
While we think we are early in this process, the direction appears rather clear. However, that doesn’t mean that inflation is necessarily imminent. A new study from the San Francisco FRB makes a strong case that the recent lift in core PCE was due to factors unrelated to the cyclical trends in the economy. Instead, the article indicates that the recent rise was due to one-off events and core inflation is likely to fall below target as these factors wane. This report would argue for a cautious approach to policy tightening.[7]
Trouble on the farm: Two items of note here. The Minneapolis FRB reports[8] a rise in Chapter 12 bankruptcy filings. This part of the bankruptcy code is mostly constructed for farmers and combines the corporate features of Chapter 11 with the filing simplicity of the household Chapter 13 structure. The weakness in the farm belt is mostly due to weak commodity prices which is forcing consolidation. Thus, smaller farms are facing trouble and being forced to either restructure or sell out. The report notes an increase in non-performing agriculture loans in the Ninth Fed District. The second item relates to soybeans. It is no secret that China has retaliated against U.S. tariffs by applying tariffs to U.S. soybeans. China is buying its supplies from other sources, mostly South America. Although the logistics are not seamless, U.S. farmers have been picking up sales from former customers of South America who are now focusing on China. At the same time, China has been experimenting with feed mixes for its hogs to use less protein, which would reduce demand altogether. However, a new fear has emerged—African swine fever is apparently spreading through China’s hog herds. The disease is usually fatal for hogs and the spread of the fever is starting to affect overall Chinese soybean imports.[9] This news will add increased pressure on grain prices and add to farmer woes.
Update on the Kerch Strait: As we reported yesterday, Russia used a tanker to block a bridge arch on the Kerch Strait, a narrow waterway that links the Black Sea to the Sea of Azov. Three Ukrainian naval vessels were attacked and taken by the Russians. The Ukraine parliament declared a month of martial law.[10] Although there is some concern that conditions could deteriorate, neither side likely wants an escalation. The fact that this occurred just before the G-20 meeting may be an indication that both sides want to remind the world that the Ukraine situation has not been resolved. But, we would not expect a hot war to emerge from this event.
A couple of housing charts: We are seeing a rise in household refinancing, with the majority of borrowers taking cash out of the transaction.[11]
The above chart shows that 80% of new loans are for more than 5% of the previous loan amount; since the data began in 1985, a reading over 80% occurs about 18.5% of the time. However, what is surprising is that these refinancing loans are clearly occurring with the express purpose of equity withdrawal as these borrowers are giving up lower mortgage rates.
A ratio of one would indicate a swap at the same rate. The current ratio is now the highest on record. As the referenced WSJ article suggests, homeowners are returning to cash-out refinancing because they have not been able to generate enough income to pay down other debt or make other purchases. As these charts show, however, activity at these levels has become problematic in the past. This is an area we will continue to watch closely.
Since the election of Donald Trump, there has been much discussion about the demise of the “Liberal International Order,” or LIO. Several books on the topic have been published recently[1] and the general tenor is that the U.S. is giving up global leadership and the world is in trouble. We have been making this argument as well for a rather long time. However, there is an alternative viewpoint, which is that the U.S. isn’t giving up global leadership but is ending the LIO for something different.
What we may be seeing is not a retreat from the world but a significant change in management style, hence the title of this week’s report. We have dubbed this new style “The Malevolent Hegemon,” as opposed to “The Benevolent Hegemon” or the LIO, which describe how the U.S. managed the world from 1945 until 2008. We argue that the LIO began to wane under the Obama administration but a replacement model wasn’t evident. The Trump administration does appear to be creating a new model of hegemony.
In Part I of this series, we will begin with the basics of hegemony. From there, we will describe the unique model of U.S. dominance, Pax Americana, with the U.S. as a benevolent hegemon. Part II will discuss why the U.S. has become jaded with this role, which has spawned the search for another model. Part III will analyze what appears to be the emergence of a new model, which we describe as the malevolent hegemon. We will discuss the differences between the two models. With this analysis in place, we will examine the possible outcomes from this shift. At the conclusion of the series, we will discuss potential market ramifications.
[Posted: 9:30 AM EDT] Happy Monday! Risk markets are higher this morning on hopes of a détente between China and the U.S. on trade and on hopes that the FOMC will signal some dovishness. Thanksgiving has passed and the West is gearing up for Christmas. Here is what we are watching today:
Tensions at the Kerch Strait: Russia used a tanker to block a bridge arch on the Kerch Strait, a narrow waterway that links the Black Sea to the Sea of Azov. Although both Ukraine and Russia technically share jurisdiction over the area, Russia, with control of Crimea, effectively holds power over the strait. Both nations have disputes over territorial waters, making the region a potential hotbed for conflict. According to reports, three Ukrainian naval vessels approached the bridge but were blocked by the tanker. Later, Russian warplanes and coast guard vessels fired on the Ukrainian vessels and seized the three Ukrainian ships.[1] Russia claims the Ukrainian ships illegally entered Russian waters after Russia had told the Ukrainian vessels that the strait was temporarily closed[2]; Ukraine obviously disputes this narrative. NATO is backing Ukraine on this issue and the latter has asked for an emergency U.N.S.C. meeting. Ukrainian President Poroshenko is asking parliament to impose martial law which would make it easier to mobilize.
The below map shows the strait.
(Source: BBC)
Will tensions escalate from here? Only if NATO (which means the U.S.) decides to make a strong response. We don’t expect that to occur. The White House is not likely to directly defend Ukraine over this skirmish and the Europeans don’t have enough power to do so. What is worrisome about this incident is that it could be a probing tactic by Putin to gauge the West’s resolve. If he can get away with this, he may try a similar tactic with the Baltics at some point. For now, financial markets, with the exception of Russian financial assets, are mostly ignoring this event. But, it could make the G-20 meeting later this week a bit more interesting.[3]
Italy relents? Italy’s governing coalition is hinting it may reduce its deficit target to avoid a confrontation with the EU commission.[4] Although we have our doubts that the deficit will actually be reduced, there is the potential for enough “window dressing” to allow the official numbers to improve and, at least for now, ease tensions between the EU and Italy. Financial markets rallied on the news.
Macron’s woes: French President Macron is facing continued widespread protests over his government’s decision to raise fuel taxes. The policy was designed for environmental reasons but car owners in France are not happy with the decision. Although the numbers are down from last week, the persistence of the protests are somewhat unusual. This weekend’s action was mostly in Paris, which is also a departure from last week, when they were more widespread.[5] Our take on the protests is that the participants are mostly working class and the concern is primarily financial. The West is facing widespread populism, a revolt of the bottom 90% against globalization and deregulation. Macron’s political movement was, in some regards, part of this reaction. He built a party from scratch, defeated the established center-left and center-right and prevented a populist surge from either the left or right. However, winning elections is one thing, governing is another. He is trying to govern as a center-right supporter of free markets when the bottom 90% want to be protected from the forces of globalization and deregulation. The administration’s response to the protests has been to mostly berate or ignore them. That may prove to be a mistake.
Brexit update: The EU approved the Brexit deal.[6] Now, PM May faces the difficult task of moving a reluctant parliament to accept the arrangement.[7] She has a couple of weeks to cobble together a coalition of Conservatives and Labour to pass the measure. Although there is little enthusiasm for the deal, it isn’t obvious that a better deal can be arranged. We would not be shocked to see the first vote fail, which could lead to another try—an outcome we refer to as the “TARP method.” The first TARP vote failed but market reaction concentrated the minds of legislators to pass the measure. If this deal fails, the next step would be May’s resignation followed by either hard Brexit (leaving without a deal, likely causing significant economic disruption) or another referendum. We are leaning toward the second referendum outcome, but we do think the odds that the current form passes may be higher than most think. Although a hard Brexit is still a possibility, it is probably the least likely outcome.
Taiwan swings toward China: In local elections over the weekend, the China-leaning KMT party won going away, rejecting the separatist Democratic Progressive Party (DPP).[8] Taiwan President Tsai Ing-wen resigned from DPP party leadership following the drubbing. Presidential elections are coming in a year and these local elections raise the possibility that the island will return to KMT rule. In general, the DPP tends to find support among local Taiwanese who would prefer independence, whereas the KMT finds support among the Chinese Nationalists whose ancestors fled the mainland after Mao won the civil war in 1949. Power tends to swing between the two parties. Neither has been able to maintain power but the KMT’s recent performance does ease some of the potential tensions that have been rising under President Tsai.
Trump and the Fed: Financial markets have been hinting that the FOMC should be considering at least a pause to prevent further weakness in the financial markets. Chair Powell will be giving a speech Wednesday evening on Fed policy and emerging markets and there is hope of a dovish tone. Meanwhile, the WSJ[9] reports that the president is unhappy with Powell and is blaming Treasury Secretary Mnuchin. As we stated numerous times after the election, there was a battle going on between the GOP establishment and the populists. That battle is still underway; Mnuchin, along with Kudlow, represent the former. To some extent, the president has been balancing these two forces. His stump speeches are pure populist but his governing is mixed. The tax cuts and deregulation generally favor the establishment, whereas the immigration and trade policy are populist. One issue we have been watching since Trump’s election is relations with the Fed. Presidents since Truman have, at times, been at odds with the central bank. It is powerful, independent and can wreck a president’s political position by bring a recession. Trump is not unique but appears so because since the early 1990s there has been a détente between the two forces—presidents leave the Fed alone and the Fed promises to be careful.
Our concern has been that President Trump might take a page out of President Nixon’s playbook and force the Fed to deliver easy policy. He has already undermined the truce via tweet. Nixon got his way with the Fed by creating a crisis for Chair Arthur Burns (his administration leaked that Burns wanted a doubling of his pay) and then offered to support Burns in return for easy policy. We thought we would get something similar with Trump picking easy money governors but instead the president, mostly under Mnuchin’s guidance, delivered center-right establishment picks for governors. It appears the president has finally figured out he didn’t get what he wanted and is turning on his treasury secretary. If the president can browbeat the Fed into delivering easy policy and this causes financial markets to worry that the Fed won’t stand up to inflation threats, then it could unanchor inflation expectations and lead to a much weaker dollar and higher bond yields.
Oil: Oil prices have taken a beating over the past few weeks; rising inventories are the primary culprit, although a steady series of presidential tweets are playing a role as well. There seems to be a notion floating around that the Saudi crown prince, now indebted to the White House for not pressing the Khashoggi incident, will be beholden to Washington. Recent production numbers from the kingdom support this idea.[10] Perhaps…but, at the same time, there isn’t anything coming out of the Kingdom of Saudi Arabia (KSA) to suggest it wants prices to continue to fall. At the same time, continued declines in oil prices do appear to be President Trump’s goal.
Does this make sense? There is evidence to suggest that lower gasoline prices lift consumer confidence. But, it isn’t the most important factor.
The above chart on the left shows consumer confidence and the unemployment rate (the latter with an inverted scale). The two series track each other closely and correlate at the -75% level. To measure the impact of gasoline prices, we scale gasoline prices by the hourly wages of nonsupervisory workers. This gives us a measure of how many gallons of gasoline a worker can purchase for an hour’s worth of work. The recent decline in gasoline prices has lifted the number to 8.3 gallons; however, this measure has been falling since 2016 and has not prevented consumer confidence from continuing to rise. The evidence suggests falling unemployment plays a bigger role.
At the same time, oil and gas drilling has become more important to the U.S. economy.
This chart shows the relationship between overall industrial production compared with industrial production from oil and gas drilling. From 1987 to 2000, the correlation was nil, suggesting that the impact of oil and gas drilling was minimal for overall output. However, since 2000, the correlation has risen to +45.6%. This suggests that if oil prices remain low, oil and gas production will likely decline and weaken the overall economy. In general, the impact on the U.S. economy from lower oil prices is probably still positive, on balance, but the positive benefits are less than they used to be.
Finally, oil prices have fallen to a level where they are undervalued.
Our EUR and oil inventory model suggests fair value of $55.50 and is nearly a standard error below fair value. In the past, such valuation usually leads to at least consolidation. Seasonally, we should see inventories decline into year’s end and these fundamental factors, coupled with a deeply oversold market, should lead to a bounce in crude oil in the near term.
(NB: The Daily Comment will go on hiatus beginning Wednesday, November 21st, returning on Monday, November 26th. From all of us at Confluence Investment Management, have a Happy Thanksgiving!)
Another down day for equities—stocks continue their slide. News flow was surprisingly light overnight. Here is what we are watching:
Equity markets: Stock markets around the world continue to struggle. Although there are some earnings issues, for the most part, weakness is coming from multiple contraction, suggesting investor sentiment is waning. The current weakness is specific to two factors—fears based on Fed policy and Trump administration trade policy. The first problem is not unusual. The FOMC has been steadily raising rates and we are now seeing the policy rate reach a level that, by itself, isn’t necessarily restrictive but could become so in short order if comments from Fed officials are accurate on the future path of tightening. A related concern is that policymakers appear to be abandoning, or at least questioning, the Phillip’s Curve construct without offering another framework for setting policy. One trend that does appear to be in place, however, is that investors, for the first time in years, appear to be considering cash and near cash instruments as an asset class. In simpler terms, “cash is no longer trash.”
The trade issue is much more confounding. Since the end of WWII, U.S. trade policy has been set on open and free trade. In practice, this meant the U.S. acted as importer of last resort and ran persistent trade deficits to provide the world with the dollar, the global reserve currency. Although this policy was key to winning the Cold War and boosting globalization, it has detrimental effects on equality in the U.S. It has become clear that political support for free trade is waning; in the last presidential campaign, for example, both candidates promised to jettison TTP, a trade arrangement with the Pacific Rim. Restricting trade will tend to undermine efficiency and eventually lead to higher inflation. However, in the short run, the more likely impact will be a reduction in margins.
What is generally unappreciated about the administration’s trade policy is that it appears to be a reversal of over seven decades of U.S. policy. In fact, we would argue that the last time the U.S. took broad actions to restrict imports was during the 1920s. Thus, no economist today has a working economic model that incorporates deglobalization. This creates uncertainty which the equity markets are struggling to discount.
Currently, there is hope of some sort of trade truce at the G-20. The continued weakness in equities may be enough to lead the president to “call off the dogs” for a period of time. However, our view is that the president’s core belief is anti-trade, at least in the form the U.S. has pursued since WWII.[1] We believe the person in the administration that most closely mirrors the president’s trade policy is Robert Lighthizer. His view essentially favors the deglobalization of supply chains—in other words, he wants to bring production back to the U.S.[2] The policy is also treating China as a strategic competitor,[3] in a fashion not like we treated the Soviet Union, but more like how Britain viewed Germany before WWI. Thus, any easing of trade tensions that come from the G-20 probably won’t last. Instead, the goal will be to stabilize markets. So, we would not be surprised to see the president attempt to temporarily ease market concerns but one should be cautious about expecting a retreat from trade policy.
After the holiday, we are launching a three-part series on the evolving superpower policy of the U.S.; it is titled “The Malevolent Hegemon.” Our thesis is that the narrative that the U.S. is abandoning its hegemonic role is probably not true. Instead, the U.S. is changing how it exercises that role and doing it in a manner that is much less friendly to the rest of the world, thus shifting from the previous model we dub “The Benevolent Hegemon” to the Malevolent Hegemon. On trade, a key component is to shift trade negotiations from multilateral, which tends to restrict American power in trade, to bilateral, which enhances it. In the end, it isn’t clear to us if it will work. But, we don’t think the evolution of U.S. policy should be seen as isolationist.
Overall, the economy is still doing well and earnings, while probably peaking in terms of growth, will likely remain elevated. And, seasonally, we are in what is usually a bullish environment. Thus, we would not be surprised to see a recovery in the near term. But, a lift will likely need a catalyst, either in the form of a trade truce or some indication from the Fed that a pause in tightening policy is being considered.
Rising tensions in the royal family: The Khashoggi affair adds to previous evidence that the crown prince, Mohammad bin Salman, is mercurial and his policies could contribute to regional instability. As we argued in the last WGR, we would expect other potential claimants to the throne (the grandsons of Ibn Saud) to try and unseat MbS.[4] Reuters is reporting that the royal family is considering putting off the decision of which grandson will become king by putting the last “king-eligible” son of Ibn Saud, Prince Ahmed bin Abdulaziz, into the king’s role after the death of King Salman. Our fear is that the transition will not be smooth; MbS has become quite powerful and would likely move quickly after his father’s death to secure power. We believe financial and commodity markets are underestimating the potential disruption to regional stability and the oil markets from succession.
EU sours on Iran: Although the EU clearly didn’t care for the Trump administration’s decision to exit the Iran nuclear deal, support for helping Iran break sanctions has taken a blow after Tehran was implicated in plots to assassinate Iranian dissidents in Denmark and France.[5] If Europe turns on Iran over these issues, it would be a diplomatic “own goal” for the mullahs. It would also be bullish for crude oil.
Brexit update: Not a whole lot more to report. The Tory rebels still don’t have enough letters to bring a leadership vote. There is widespread discontent with the deal May negotiated with the EU but no one has come up with a better offer. The three outcomes—the current deal, a hard Brexit with no deal or a new referendum—all remain on the table. Given that neither the current deal nor a hard Brexit appears attractive, we would not be surprised to see a new referendum. It is not out of the question that the U.K. decides that being in the EU isn’t all that bad (especially if one isn’t in the Eurozone) and if the U.K. can negotiate some degree of border control on immigration (which, by the way, is happening all over Europe), we may see a reversal of Brexit.
The Swiss consider nationalism: This Sunday, Switzerland is holding a referendum on “self-determination” which would make the Swiss constitution supreme over any international treaties the country joins. Thus, if the Swiss pass a referendum at a future date that conflicted with an international treaty, the agreement would have to be either renegotiated or cancelled.[6] If this measure passes, it will make it very difficult for any future Swiss government to negotiate treaties because the other parties will never know if the pact will be rejected at some point by a future referendum. We view this vote as another example of rising opposition to globalization.
(NB: The Daily Comment will go on hiatus beginning Wednesday, November 21st, returning on Monday, November 26th.)
Happy Monday! It’s a short week as the U.S. prepares for the Thanksgiving holiday on Thursday and a slow day on Friday. Here is what we are watching today:
BREAKING: Nissan (NSANY, 17.95) Chairman Carlos Ghosn has been fired by the company and arrested by Japanese authorities on charges of income misconduct.[1]
Pence v. Xi: VP Pence and Chairman Xi gave dueling speeches at the APEC summit over the weekend, with the U.S. and China offering differing views of each nation’s trade position. Pence, in his speech, detailed a hardened U.S. trade position[2] and suggested that China’s broader policies, including the “one belt, one road” initiative, was creating debt traps for Asian nations. It should be noted that last week President Trump deemed China’s recent offers on trade to be “unacceptable.”[3] Later, Xi defended his nation’s trade and foreign investment policies and criticized the U.S. for its recent turn on tariffs.[4] For the first time ever, APEC did not issue a joint closing statement, a clear indication of the growing dispute between the U.S. and China.[5] These sharpened positions tend to weaken the case that the U.S. and China will come up with a deal at the G-20.[6]
At the same time, it isn’t exactly clear whether Pence is actually expressing policy or taking on the “bad cop” role. Last Friday, President Trump signaled a more conciliatory stance which led to a bounce in equities. That position appeared to be undermined by Pence’s speech. However, we doubt the president would allow his VP to go independent on policy. We note that Pence played a similar role with North Korea, setting a hardline stance at the Winter Olympics that was reversed by President Trump meeting with Kim Jong-un a few months later. Pence’s speech and the apparent failure at APEC may simply be a bargaining position.
In addition, there was one rather interesting note that came from a former trade negotiator, Long Yongtu, who criticized the Xi administration’s decision to target soybeans, describing the action as “unwise.”[7] Long led China’s negotiating team when it joined the WTO. It is very unusual for former officials to criticize current government policy and may signal growing unease with Xi’s confrontational strategy with the U.S. Although Xi does appear to be clearly in power, this move by Long bears watching.
Macron’s woes:[8] French President Macron is facing widespread protests over his government’s decision to raise fuel taxes.[9] The policy is designed for environmental reasons but car owners in France are not happy with the decision. There has been at least one fatality and over 400 injured.[10] At least 2,000 separate demonstrations have occurred in France over the weekend.[11] Although we doubt they will bring down the government, it does show how Macron is struggling to govern in the face of growing unpopularity. Although Macron’s issues pale in comparison to those in Germany, Ireland, the U.K. and Italy, these events show the fragility of European politics.
Tech under fire: The technology sector has always had close ties to the Democratic Party.[12] The GOP was never all that comfortable with the tech ethos. However, both sides of the political spectrum are turning on tech.[13] Recent polls show a growing and broad dissatisfaction with social media.[14] We see this as important because one of the keys to steady disinflation has been the lack of regulation on technological innovation.
Is USMCA in trouble? There are reports that the incoming Democrats want major changes to the recently negotiated new NAFTA agreement.[15] It is doubtful that the treaty can be changed significantly without blowing up the arrangement. We suspect the administration will move to a “take it or I’ll end it” stance; at that, we expect the Democrats to back down but we may see some market worries before the deal is eventually accepted.
Brexit update: PM May is on her way to Europe[16] to continue negotiations with EU officials. However, we don’t expect any major changes, although Michel Barnier, the chief EU Brexit negotiator, indicated over the weekend that the transition could be extended to 2022 to ease pressure on businesses.[17] Such an agreement would avoid the “backstop” measures on the Ireland/Northern Ireland frontier. The hard Brexit group will see this extension as a way to stay in the EU indefinitely and thus will likely oppose the offer. Spain is using the Brexit controversy to try to increase its control over the British colony of Gibraltar.[18] One trend we are watching—the odds of a second referendum appear to be rising. Another vote might make sense given the magnitude of leaving the EU, the uncertainty over what exactly voters approved at the first referendum and the inability of Parliament to make a clear decision on Brexit.[19] We do note that there are increasing fears surrounding a hard Brexit. For example, there are reports that food warehouses are running out of space as retailers engage in “just in case” inventory stocking.[20]
Unsubstantiated rumors suggest there have been 40 leadership challenge letters submitted, eight short of enough to trigger a leadership vote among the Tories. While this group contends they can still do away with May without 48 letters, the inability to hit the number suggests this group may not have as much support as it looks. Even though the U.K. PM remains in grave political danger, she continues to hold onto power.[21]
Fed waffling? There is a growing sense in the financial markets that the FOMC may not make three hikes next year. Recent comments from Vice Chair Clarida seem to suggest that the economy may need as little as two more hikes or maybe as much as six to achieve neutrality.[22] Since 1987, when then-Chair Greenspan indicated that the Fed stood ready to supply liquidity to financial firms during the 1987 Crash, financial markets have essentially found that policy authorities generally come to their aid. Part of this action is because the U.S. shifted from a safe but inefficient financial system that was constrained by regulation to one that is efficient but fragile with much less regulation. What does concern us is that the FOMC appears to be abandoning the Phillips Curve framework (which is justifiable) without an obvious new framework, which may increase the odds of a policy mistake.
Saudis lead the cutback charge: The Kingdom of Saudi Arabia (KSA) feels like it was wrong-footed by the Trump administration, which pressed on the nation to boost output to offset Iranian oil sanctions only to see the U.S. grant extensive waivers. In response, the KSA is leading the charge within OPEC to cut production by up to 1.4 mbpd.[23] Recently, the KSA has increased its oil exports to the U.S., likely in a bid to lower WTI prices.
Note that since Q1, Saudi imports to the U.S. (on a four-week average basis) have been rising sharply. According to reports, the Saudis are retaliating to the perceived “fake-out” by the administration and are planning to slash shipments to the U.S.[24] Although oil prices have been under pressure in recent weeks, these actions by the KSA should, at a minimum, lead to market consolidation. If the usual seasonal demand increase follows, we would expect prices to mount at least a modest recovery.
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