by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Equity markets are mixed this morning on the eve of a big week.  Midterm elections are tomorrow (don’t know about you, but we won’t miss the political ads), and the FOMC ends its meeting on Thursday.  Here is what we are watching this morning:

Elections: The decision markets put the odds of a Democrat-controlled House at 68%.[1]  That will lead to divided government and likely gridlock.  Although there is some concern that a divided government could bring the reversal of policy on taxes and perhaps regulation, in reality, the president can veto laws and, with the Senate almost certain to remain in GOP hands (decision markets put the odds at 87%),[2] the ability to actually move legislation is nil.  That being said, we wouldn’t be surprised to see an infrastructure bill make it through.  We will be watching for attempts by the House to undermine the White House on trade policy.  We doubt they can do much (the executive branch has great latitude on trade), but attempts will likely be made.  At the same time, look for the Democrat party leadership (read: center-left establishment) to try to restrain the investigation and impeachment activities that the populist left is clamoring for.  The Democrat Party establishment fears that a parade of investigations could make President Trump a sympathetic figure, much like Bill Clinton during the impeachment.  We are not expecting significant disruption, in any case.

FOMC: This is a non-press conference meeting so don’t expect much.  In fact, we would be surprised by any statement change or dissents.  The meeting is a non-event except that it will lay the groundwork for a December hike.

Iran sanctions: Sanctions go into effect today.  The U.S. is implementing all the sanctions that were in place before the nuclear deal.  Initially, it appeared the U.S. was going to exempt the S.W.I.F.T. network.  News of this exemption triggered a reaction in Congress; Ted Cruz was considering sponsoring legislation to force the administration to include the bank messaging system.  However, by adding specific Iranian banks to the sanctions list, the S.W.I.F.T. network will be pulled into the sanctions regime.[3]  Because some nations were given exemptions, there had been an impression that the sanctions on Iran would not be all that stringent.[4]  This narrative, coupled with recent increases in inventories, has been bearish for oil prices.  However, even for nations that are allowed to buy Iranian oil, it isn’t obvious if they can make financial arrangements.  For example, financial sanctions may restrict the availability of insurance for cargos.  Thus, the sanctions may be more effective than currently thought.[5]

Law of the Jungle: President Xi of China lashed out at U.S. trade policy, calling it a return to the “law of the jungle.”[6]  Xi was speaking at an international business fair in Shanghai over the weekend.  The strong rhetoric may signal that the hope of a truce in the trade war with China is unlikely.  Xi did suggest he was planning to reduce import tariffs[7] but actual moves to lower trade barriers have tended to disappoint.  If there is no thaw on the trade front, financial markets will likely take this as a bearish factor.

The BOJ to tighten?  In a speech to business leaders, BOJ Governor Kuroda indicated that the massive monetary stimulus that has been in place for years is likely coming to a close.[8]  Although actual rate tightening probably isn’t imminent, once policy turns, the JPY could appreciate significantly.  On a purchasing power parity basis, the JPY is fairly valued around ¥60.  In general, an appreciating currency is a negative factor for the Japanese economy.

Troika of Tyranny: National Security Director Bolton has dubbed a new group of evil nations the “troika of tyranny.”[9]  The members are Cuba, Venezuela and Nicaragua.  All three are leftist nations.  He used his speech to outline new sanctions on Cuba and Venezuela and is threatening U.S. action against Nicaragua.[10]  Specifically, the sanctions against Venezuela restrict the gold trade; the Maduro government has been using gold reserves to skirt U.S. financial sanctions.  Although it’s hard to see how new sanctions could make things worse in Venezuela (they are already awful), we have noted a steady stream of refugees pouring out of the country.[11]  If conditions deteriorate further, the outflow could increase and a new “caravan” of Venezuelan refugees could be heading to the U.S.

Business groups side with Modi versus RBI: Recently, we have discussed a conflict that has developed between India’s central bank and the government.  The latter is trying to influence monetary policy, mostly to moderate tightening.  The RBI has pushed back and its governor has threatened to resign.  It is not a huge surprise that business groups, interested in easy money, have decided to align with the government in this spat.[12]  Of course, anything that undermines the independence of the central bank will tend to pressure the exchange rate and could hurt financial asset values.[13]

Update on the CDU: The FT carried a flattering portrait of Friedrich Merz, a candidate for head of the CDU.[14]  Last week, we touched on the candidates for Merkel’s party leadership.  Merz represents a wing of the party that is socially conservative and market friendly.  As we noted earlier, Merz was effectively bumped out of politics by Merkel 16 years ago.[15]  Merz would likely pull disgruntled former CDU voters that have drifted to the AfD; he has a hardline stance on immigration.  An ally of Wolfgang Schäuble, Merz would also likely be a stanch defender of the rules-based fiscal order, which would pit Germany against Italy.  At the same time, Merz isn’t a Euroskeptic; he supports European integration and may be closer to French President Macron.[16]  Given the history between Merkel and Merz, if he does get control of the CDU, Merkel’s position as chancellor will likely become untenable.  However, we would expect a Merz government to end Merkel’s immigration policy and not tolerate Italy’s actions on its fiscal budget.  How this unfolds in Germany will bear watching.

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[1] https://www.predictit.org/markets/detail/2704/Which-party-will-control-the-House-after-2018-midterms

[2] https://www.predictit.org/markets/detail/2703/Which-party-will-control-the-Senate-after-2018-midterms

[3] https://www.ft.com/content/644d3400-e045-11e8-a6e5-792428919cee?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[4] https://www.politico.com/story/2018/11/02/iran-sanctions-957017?utm_source=POLITICO.EU&utm_campaign=73ebdd39f9-EMAIL_CAMPAIGN_2018_11_05_05_32&utm_medium=email&utm_term=0_10959edeb5-73ebdd39f9-190334489

[5]https://www.ft.com/content/6eef944e-c6ef-11e8-ba8f-ee390057b8c9

[6] https://www.ft.com/content/34e388ee-e0af-11e8-a6e5-792428919cee?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[7] https://www.reuters.com/article/us-china-trade/chinas-xi-jinping-promises-lower-tariffs-more-imports-idUSKCN1NA053

[8] https://www.ft.com/content/1d2c8e46-e0bc-11e8-a6e5-792428919cee?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[9] https://www.axios.com/trump-bolton-bolsonaro-against-venezuela-9d05e18e-dd68-4854-a254-1f83840c86c3.html

[10]https://apnews.com/26d89514878441f58273c8d91a5deff2?utm_medium=AP&utm_source=Twitter&utm_campaign=SocialFlow&stream=top

[11] See WGRs, The Venezuelan Migration Crisis: Part I (9/17/18) and Part II (9/24/18).

[12] https://www.ft.com/content/1e933774-de39-11e8-9f04-38d397e6661c?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[13] https://www.ft.com/content/d50a1150-debe-11e8-b173-ebef6ab1374a?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[14] https://www.ft.com/content/eebed0f4-ddbf-11e8-9f04-38d397e6661c?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[15] https://www.politico.eu/article/friedrich-merz-returns-to-haunt-angela-merkel-cdu-conservative-leadership-germany/?utm_source=POLITICO.EU&utm_campaign=73ebdd39f9-EMAIL_CAMPAIGN_2018_11_05_05_32&utm_medium=email&utm_term=0_10959edeb5-73ebdd39f9-190334489

[16] https://www.ft.com/content/00db1950-deb5-11e8-9f04-38d397e6661c

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy Employment Friday!  We cover the data in detail below, but the snapshot is that the data was very strong.  Payrolls and wages rose well above forecast.  Global equities are higher this morning on optimism that the U.S. and China can come to a trade agreement.[1]  Here is what we are following this morning:

A China trade deal?  President Trump raised hopes of a thaw in U.S./Chinese trade relations after noting he had a “long conversation” with Chairman Xi.  Trump indicated he plans to meet with the Chinese leader at the G-20 summit later this month.  This positive tone was one of the bullish catalysts that lifted equities.  However, it is always difficult to determine how much substance any of these announcements have.  We note that Trump and EU Commission President Juncker met this summer to great fanfare on trade; so far, nothing has been resolved.  On the other hand, a Bloomberg report this morning indicating the president has asked his cabinet to draft a possible trade deal with China might mean that the upcoming meeting could be real.[2]  Our position is that the Trump administration is changing U.S. policy toward China, treating the latter as a long-term strategic threat.  If our position is correct, any trade agreement made later this month will likely be superficial.  But, in the short run, it’s having the desired effect.  Not only have equity prices jumped, but soybean prices have rallied strongly and the CNY has appreciated.  The positive talk has offered markets some relief, which is helpful in the short run.

Oil waivers: As we head toward Iran sanctions coming into effect, the U.S. has granted waivers to eight nations.[3]  Although American policy is designed to hurt Iran and force new talks on its nuclear program and regional power projection, the U.S. fears a big jump in oil prices will hurt global growth.  The waivers should ease some of these concerns.  In addition, the U.S. is working to clear some political bottlenecks in the Middle East.  For example, disputes between the Kurds in northern Iraq and the Iraqi government have reduced oil flows out of Iraq.  The U.S. is working to bring the parties to an agreement to lift supply.  The Trump administration is also working with Saudi Arabia and Kuwait to lift output in the so-called “neutral zone,” a disputed region claimed by both nations.  If both issues are resolved, it could boost global output by up to 1.3 mbpd.[4]  It would be quite optimistic to expect all these barrels to return to market but any additional supply, combined with waivers, will likely keep oil prices mostly stable in the near term.

Brexit update: There has been a surge of optimism on Brexit mostly coming from London, but there are reports that the EU is softening its position on the Northern Ireland frontier, which would avoid a hard border.[5]  If this were to occur, the odds would increase for a workable Brexit strategy that would have minimum disruption.  It’s still not clear if May can gather enough Tory votes to pass a Brexit plan as she envisions it.  We believe it would get enough moderate Labour votes to pass Parliament, which would mean a deal was made but May’s position as PM could be threatened.  Although Tory backbenchers would want her ousted, given the narrow coalition that is holding the government in place, any action to remove May could lead to a no-confidence vote and elections.  And, given current conditions, new elections would almost certainly lead to a Labour government.  Any Brexit deal would be very bullish for the GBP.

A Friday oddity: Yesterday, at 8 am Eastern European Standard Time, the Finnish government released taxable income data on every Finnish citizen.  Dubbed “National Jealousy Day,”[6] the data dump lets every Finnish citizen see “who makes what.”  Although the government has released the data for years, now it can put it out electronically which makes searching much easier.  This transparency appears unique to any Western nation but the Finns seem to take it in stride. 

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[1] https://www.reuters.com/article/us-global-markets/asian-shares-rise-as-trump-xi-lift-hopes-on-resolving-trade-row-idUSKCN1N7033

[2] https://www.bloomberg.com/news/articles/2018-11-02/trump-said-to-ask-cabinet-to-draft-possible-trade-deal-with-xi-jnzjeqx4?srnd=premium

[3] https://www.bloomberg.com/news/articles/2018-11-02/u-s-said-to-give-eight-nations-oil-waivers-under-iran-sanctions?srnd=markets-vp

[4] https://www.wsj.com/articles/u-s-redoubles-efforts-to-resolve-oil-field-disputes-to-boost-global-supply-1541112738

[5] https://www.ft.com/content/ee75a230-dde7-11e8-9f04-38d397e6661c?emailId=5bdbdd938c7cba0004e3a767&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[6] https://www.nytimes.com/2018/11/01/world/europe/finland-national-jealousy-day.html?emc=edit_mbe_20181102&nl=morning-briefing-europe&nlid=567726720181102&te=1

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Equities continue to rally, although we note that we have seen some weakness emerge after a rather hawkish statement from the BOE.  Here is what we are following this morning:

BOE: The Bank of England surprised the markets this morning by indicating the economy is at full utilization, suggesting tighter policy is likely.  The bank did leave policy unchanged, not wanting to raise rates before Brexit.  Governor Carney spent much of his press conference discussing how Brexit could put the bank in a very difficult spot, where it faces rising inflation and a weaker economy.  Brexit could disrupt supply chains and boost prices rapidly.  If these price hikes stick, the BOE would likely be forced to raise rates even though the economy is suffering.  The important message from Carney was that when faced with weaker growth and higher inflation, the latter problem will be addressed by the central bank.  The GBP rallied on the news[1] and Gilt yields rose.

Brexit: Surprisingly positive comments from U.K. Brexit Secretary Dominic Raab[2] led to a rally in U.K. financial assets yesterday. There were comments suggesting a financial services deal is close to conclusion.  Raab indicated that an overall tentative agreement would be done by November 21.  It isn’t exactly clear what positive trends Raab has seen to support this position.  The U.K. side seems to be much more optimistic than the EU negotiators.  We note the EU has indicated this morning that comments from the U.K. were “misleading.”[3]  We suspect that U.K. negotiators are building up hope with the idea that the EU won’t want to puncture the optimism.  That is probably a misread by the U.K.

Taiwan tensions: The U.S. Navy has been conducting “freedom of navigation operations” in the South China Sea and in the Taiwan Strait.  These operations have raised tensions with China,[4] which sees Taiwan as a province.  There is a growing independence movement in Taiwan as evidenced by recent demonstrations calling for a referendum on the issue.[5]  The show of force from the U.S. is a problem for China on several levels.  First, China fears that Taiwan voters may see U.S. actions as a signal that the U.S. would defend Taiwan if it were to declare independence.  China would prefer that the U.S. project a degree of ambiguity to temper Taiwan’s independence movement.  Second, the Xi government has bolstered its support by pushing nationalism.  It will be difficult for the government to back down if Taiwan does move to formalize itself as a separate nation.  If the U.S. backs Taiwan, we are facing a superpower conflict.  We have not reached critical mass but we could see tensions rise rapidly soon.

Pressure on MbS: The U.S. is pressing the Kingdom of Saudi Arabia (KSA) to accept a ceasefire and peace talks in Yemen.[6]  The war in Yemen has been conducted by Crown Prince Mohammad bin Salman (MbS); he has arguably made a hash of the conflict that is brutal and seemingly without end.  The U.S. may be taking advantage of the turmoil surrounding the death of Jamal Khashoggi and the subsequent weakness of MbS to push for an end to this conflict.  To some extent, we view the U.S. action as a sign that MbS is on the ropes and thus the U.S. wants to take advantage of his current weakness.

Fed eases capital rules: The Fed has proposed easing some of the Dodd-Frank rules on less than huge banks.  It would ease the liquidity ratio and make stress tests less frequent.  The bank lobby complains the deregulation doesn’t go far enough; some regulators bemoan the easing.  Usually, when both sides are less than thrilled, the change has struck a proper balance.[7]  Although we usually favor deregulation, the easing of liquidity ratios does concern us.  Maintaining liquidity is a deadweight when times are good; one can’t have enough liquidity when things go sour.  We view the stress tests as pure regulatory capture.  They give the illusion of regulatory action but are usually gamed and thus don’t really offer a real world look at how a bank holds up in a crisis.  If the changes really favor banks, we would expect bank equities to rally in the coming weeks.

Caixin PMI: The Caixin PMI came in a bit better than forecast, at 50.1 compared to 50.0 last month.  Unlike the official data reported yesterday, we did see a modest lift in the export component.  However, the overall export index does suggest that exports will decline in the coming months and the export boost we are seeing is likely from firms front-running proposed tariffs.

The politburo came out yesterday and admitted the economy was struggling and promised additional support.[8]  This has given a modest boost to equities, although the rise appears to be mostly in large caps.[9]

Energy update: Crude oil inventories rose 3.2 mb last week, below the 6.3 mb forecast.

U.S. domestic production rose to 11.2 mb last week, up 0.3 mbpd from last week.  Oil imports fell 0.3 mbpd and exports rose 0.3 mbpd.  Refinery operations rose a modest 0.2%.  Oil stocks rose on the increase in U.S. output.

 

Oil stocks have increased rapidly this autumn as refinery runs declined due to seasonal maintenance and continued elevated U.S. production.  This has been a bearish factor for oil prices.

Based on inventories alone, the fair value for oil prices is $65.62.  Using the EUR, fair value is $57.65.  Using both, a better measure of value, fair value is $59.96.  Oil prices remain elevated, likely reflecting fears of supply tightness once Iranian sanctions are implemented.  In the coming weeks, we would expect increased refining activity to reduce stockpiles and boost the fair value for oil.  But, by any measure, current crude prices are elevated.

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[1] https://www.ft.com/content/7fd527d2-ddcf-11e8-9f04-38d397e6661c

[2] https://www.ft.com/content/3962ceee-dd25-11e8-8f50-cbae5495d92b

[3] https://www.ft.com/content/6e7c291c-ddad-11e8-9f04-38d397e6661c

[4] https://www.ft.com/content/1fbbfa1c-dcab-11e8-8f50-cbae5495d92b?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[5] https://www.reuters.com/article/us-taiwan-china-protests/thousands-rally-in-taiwan-call-for-referendum-on-independence-from-china-idUSKCN1MU090

[6] https://www.nytimes.com/2018/10/31/world/middleeast/saudi-arabia-yemen-cease-fire.html?emc=edit_mbe_20181101&nl=morning-briefing-europe&nlid=567726720181101&te=1

[7] https://www.nytimes.com/2018/10/31/business/dealbook/fed-banking-regulation.html

[8] https://www.bloomberg.com/news/articles/2018-11-01/china-is-likely-to-rely-on-fiscal-stimulus-measures-for-economy

[9] https://www.ft.com/content/0784e6e6-dd6b-11e8-9f04-38d397e6661c

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy Halloween!  It’s mid-week and equity markets around the world are lifting this morning.  It looks to us like a normal bounce from a correction.  Will it have legs?  Probably.  Our position is that this drop was mostly a normal correction but not the start of a bear market.  The reason it probably won’t be a new bear is that bear markets usually coincide with recessions and the economy isn’t in trouble.  Here is what we are watching this morning:

Early orders: In the recently released Q3 GDP data, there was a notable increase in inventories.

Inventories added 2.1% to the GDP reading of 3.5%; in fact, without inventories, the contribution from investment (inventory additions are considered investment in national income accounting) would have been just below zero.  At the time, we speculated that firms may have been accumulating inventories before tariffs lift prices.  The WSJ essentially confirmed this view.[1]  The article also noted that freight rates are rising for container ships, another sign of increasing demand.  This inventory build will support GDP into Q4; however, it may be a drag on growth next year.

China’s economic growth is weakening:[2] As noted below, we got the official ISM manufacturing data this morning and it showed a drop to 50.2 in September from 50.8 in August.  A bit of caution is in order; the Caixin manufacturing PMI, which comes from a private source, is published tomorrow and generally gives a better read on the economy because it includes a broader survey of companies.  The official data tends to represent only large firms.  What does concern us in the data is that export orders have fallen significantly.

Although export orders remain elevated, the orders index from the PMI does tend to lead orders by a few months and suggests that exports will soon decline.  This fits the above narrative that inventory accumulation will likely slow in 2019.

Patel v. Modi: The head of the Reserve Bank of India, Urjit Patel, is threatening to resign after relations with the government have deteriorated.[3]  The Modi government has recently invoked powers never exercised before to issue directions to the central bank.  The government has also issued a statement suggesting it honors central bank independence.  The Modi regime needs to avoid an open conflict with the RBA.  If markets become convinced that the Indian government is dictating monetary policy, investors will likely take a dim view of such developments and avoid investment in the country.

S&P warns U.K.: S&P Global Ratings has warned the May government that the odds of a no-deal Brexit have risen and this outcome would likely trigger a significant recession and a likely downgrade in Britain’s credit rating.[4]  We would agree with this assessment but still expect the U.K. and the EU to make a last-minute deal.  However, one development that may increase the likelihood of a no-deal Brexit is the fall of Merkel.  The German chancellor has pushed a position of moderation, unlike her French counterpart, and if Merkel does leave the political scene sooner than expected the lack of EU leadership could lead to an impasse in negotiations and a disruption. 

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[1] https://www.wsj.com/articles/shippers-brace-for-orders-surge-ahead-of-potential-new-tariffs-1540919850

[2] https://www.ft.com/content/c5b13c48-dcab-11e8-9f04-38d397e6661c

[3] https://www.reuters.com/article/us-india-cenbank-govt/india-central-bank-governor-may-resign-reports-say-rupee-down-idUSKCN1N5085

[4] https://www.ft.com/content/87b7a62a-dc5b-11e8-9f04-38d397e6661c?emailId=5bd9469d4e4a1b000433b1e1&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT]

What’s wrong with the market?  Yesterday’s equity market action was quite disappointing.  After a strong opening, prices steadily declined then slumped into the close.  There appeared to be two catalysts.  First, the Commerce Department announced it was going to restrict exports to a Chinese chip company on national security grounds.[1]  Second, it appears the Trump administration is planning to implement another round of Chinese tariffs after the G-20 meeting.[2]  The president promised to put tariffs on the remaining imports from China if there is no movement from the Xi government on U.S. trade concerns.  According to reports, if nothing toward this goal emerges at the G-20, the administration will move forward in early December.  Fears of a trade war with China, especially one focused on technology, are putting this sector under pressure.

This chart shows the relative performance of the Technology Select Sector SPDR ETF (XLK, 66.94) and the S&P 500 SPDR ETF (SPY, 263.69) over the past five years.  The chart is rebased and indexed.  The technology sector has dramatically outpaced the overall equity market over this period but is falling rather rapidly now.  The problem for the technology sector is that deglobalization is a significant threat to the margins of these companies.  And so, if trade pressures continue, new leadership will need to emerge.

At the same time, we also note that long-duration Treasuries didn’t rally, despite the weakness.  We suspect this is due to fears surrounding monetary policy.  In other words, if the Fed is continuing to tighten, it will have an adverse effect on interest rates.

AMLO fears: Mexican President-Elect Andres Manuel Lopez Obrador stated that he will abandon a project to build an airport in Mexico City; construction on the airport started in 2015. The decision was made following the results of a voluntary nationwide poll in which only a few people showed up.  The project has been criticized for being costly and unfriendly to the environment.  Investors interpreted AMLO’s decision to withdraw from the project as a sign that he may not honor contracts.  As a result, the Mexican peso fell against the dollar.

More on Merkel: Although the chancellor has indicated she intends to stay for the rest of her term in office, this is probably wishful thinking.  If she goes, who would be her successor?[3]

1. Annegret Kramp-Karrenbauer: The 56-year-old former PM of Saarland and current secretary general of the CDU would be Merkel’s favored replacement.  She has been dubbed the “mini-Merkel” by the German media.  Kramp-Karrenbauer is apparently well liked by both the left and right of the CDU.  Her support for traditional family values is a plus for the right-wing constituency, while championing the minimum wage and workers’ rights makers her popular with the leftists in the party.
2. Jens Spahn: As the current health minister, the 40-year-old is considered a strong critic of the chancellor.  If Kramp-Karrenbauer is the “mini-Merkel,” then Spahn is the “anti-Merkel.”  Spahn, who is openly gay, opposes Merkel’s immigration policy, fearing that an influx of Muslims will lead to a more homophobic society.
3. Armin Laschet: The 57-year-old current PM of North Rhine-Westphalia is pro-immigrant and a supporter of the EU.  He is seen as a key ally of Merkel in the immigration fight.  The province he governs is the most populous in Germany, which might count for boosting his experience.
4. Fredrich Merz: The 62-year-old former member of Parliament is currently a private businessman and lawyer.  He is considered a social conservative and an economic liberal.  At one point, at the turn of the century, he was considered a rising star in the CDU but concluded that Merkel’s growing power would prevent him from rising further.  Thus, he decided to go into business.

What we find interesting in this entire list is that no one seems like a clear replacement.  All of these “front runners” suffer from serious flaws.  They are either too close to Merkel’s unpopular immigration policy, or, if they oppose it, are likely too young to grab power.  It should be noted that this is by design.  One of the key political faults of leaders in parliamentary systems that have no limitation on terms is that they tend to avoid creating lines of succession, fearing that it will remove them from power “prematurely.”  As a result, when the moment of exit arrives, these leaders usually leave their party in a difficult position.  The U.S. actually had this problem with President Roosevelt; his selection of Harry Truman as running mate was done in part to discourage anyone in the government from ousting him due to failing health.  He purposely prevented his vice president from knowing important policy actions and thus Truman was thrust into power without the proper background when Roosevelt died.  Fortunately for the U.S., Truman turned out to be a pretty good president despite these handicaps.  We would not be surprised to see an unknown emerge to challenge Merkel in the next few months.

Our biggest concern over Merkel stepping down is the power vacuum it will create within the EU.  If we were advising the Italian government, we would tell them to push back hard against the EU on the budget issue and threaten to leave over it.  Without Merkel’s guidance, it is quite likely the EU leaders will cave to Italian demands.

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[1] https://www.commerce.gov/news/press-releases/2018/10/addition-fujian-jinhua-integrated-circuit-company-ltd-jinhua-entity-list

[2] https://www.bloomberg.com/news/articles/2018-10-29/u-s-said-to-plan-more-china-tariffs-if-trump-xi-meeting-fails

[3] https://www.ft.com/content/65792054-db69-11e8-8f50-cbae5495d92b

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Equity markets in the U.S. are rebounding this morning as investors begin to edge back into the market after a hard decline.  Here is what we are watching this morning:

German elections and Merkel: On Sunday, the German state of Hesse held local elections.  Although local elections don’t always impact national or global politics, the election in Hesse became a referendum on Chancellor Merkel’s government.  The results were not favorable for the ruling coalition.  Merkel’s CDU fell from 38.3% to 27.0%, and the SDU dropped to 19.8% from 30.7%.[1]  Meanwhile, the Greens took 19.5% of the vote, up from 11.1%.  The populist right-wing AfD won 13.2% of the vote, tripling its 2013 share.

In response to two difficult regional elections, Hesse this weekend and Bavaria earlier this month, Chancellor Merkel announced she is giving up her post as party leader, will not seek another term as chancellor and will end her political career at the end of her term.[2]  Her term officially ends in 2021 but it is also possible that a new CDU leader will remove her from the chancellor position before her term ends.  This announcement represents a potential watershed moment for Europe.  During the Eurozone crises of 2011-12, Merkel was able to placate the hard money wing of the CDU but also give enough support to the southern European nations to prevent a collapse of the Eurozone.  If a hardline member of the CDU takes control, discussions with Brexit and the Italian situation could become rocky.  On the other hand, it’s hard to imagine any German political figure giving the impression that they support a “blank check” to nations like Italy.  So far, market reaction has been mild, probably because Merkel remains chancellor.  But, if she is replaced before her term officially ends, pressure on the EUR could rise.

Brazil election: In the other election last Sunday, Jair Bolsonaro easily won the run-off in Brazil, 55.4% to 44.6%.[3]  This result was expected.   Bolsonaro is a controversial right-wing populist who makes critical comments about women, gays, etc.  But, what supported his candidacy was somewhat less about him and more about the deep level of corruption in the left-wing coalition.  The left-wing coalition’s most promising candidate was prevented from running because he is in prison on corruption charges.  Thus, it isn’t a huge surprise why voters wanted a change.  How Bolsonaro governs will be worth watching.  He has suggested an affinity for the period of military rule, which may mean he wants to eliminate the limitations that a democratic government puts on its leaders.  His economic consultant is Paulo Guedes, a University of Chicago grad; advisors from this school tend to support free markets.[4]  So far, financial markets have favored this outcome but it remains to be seen how the new president will actually govern; it should be noted that populism from either wing isn’t necessarily friendly to capital.

S&P and Italy: Last week, Italy avoided another rating agency downgrade as S&P affirmed its credit rating at BBB, two levels above the line that demarks investment grade, but did signal a “negative” outlook.[5]  If the credit rating agencies took Italy to below investment grade, the ECB would probably not be able to purchase Italian debt either as part of QE or for open market operations.  The impact on Italian interest rates would be negative and might force Italy’s exit from the Eurozone.  In light of this news, Italian financial assets are rallying this morning.

Brexit update: Although PM May continues to defy pundits predicting her political demise, she continues to struggle to manage her divided party.  May is pushing for an exit of indefinite length, which the hard Brexit faction refuses to accept.[6]  The hard Brexit faction does not want an indefinite stay in the European Customs union because being in that union will prevent the U.K. from negotiating any new free trade deals.  It is still unclear how Brexit will work.  And, the hard Brexit supporters can’t prove why any nation would be pressed to make a free trade agreement with the U.K.  After Brexit, it will be a fairly large but mostly isolated economy.  Despite promises of wanting a free trade agreement with the U.K., the U.S. will likely be more focused on an agreement with the EC and Japan.  Simply put, it will be hard to move the U.K. higher on the trade agenda.  China might be willing to make a deal but only with onerous conditions.  A messy Brexit would be quite bearish for the GBP, which is already undervalued.  On the other hand, it’s possible that May won’t be able to stay in power, triggering new elections.  In that case, Labour would likely win and it isn’t completely obvious whether a Corbyn government would jettison Brexit.

Austria and Italy: In another interesting development, Austria is considering a plan to offer citizenship to German speakers in the South Tyrol region.  This area, which was once part of the Austro-Hungarian Empire, has been part of Italy for years.  Some parts of the region became part of Italy after WWI, while the rest has been in Italy for nearly a century.  As the map below shows, this area is well within the Italian border.

The Austrian government has offered citizenship to German and Ladin speaking Italians, which comprise about 64% of the population.  It has not made a similar offer to Italian speakers.[7]   Although this has the look of a political stunt, it has generated some support within South Tyrol among the German and Ladin speakers.  Rome, obviously, was not impressed.  Although we doubt Austria will go through with this action, the proposal does highlight that the borders of Europe do not necessarily reflect the ethnic and religious makeup within each nation.  The European Union project was, in part, designed to offset these divisions by focusing on the “European citizen.”  However, if the EU weakens, it would not be a shock to see a surge in the claims Austria is considering.

China and Japan: In the face of trade pressure from the U.S., two long-time opponents, China and Japan, are trying to improve relations.[8]  The two leaders, Chairman Xi and PM Abe, met last week for the second time since Xi took office.  The leaders agreed to a $30 credit swap line and pledged cooperation on development projects.  Although further cooperation will be difficult, the pressure being exerted by the Trump administration will tend to create an environment where some degree of collaboration is necessary.

Softening on Iran? The WSJ reports[9] there are divisions within the Trump administration over the implementation of sanctions against Iran.  Specifically, Treasury Secretary Mnuchin wants to allow Iran to have access to the S.W.I.F.T. network, while National Security Director Bolton does not.  The network, the backbone of international bank communications, is critical to global banking.  Being excluded from the network effectively isolates a country and makes it nearly impossible to conduct international trade.  Earlier sanctions against Iran did exclude the country from the network and were effective in pushing Tehran into negotiations.  However, there is a risk to deploying this sanctions option on a regular basis.  The U.S. does not directly control S.W.I.F.T.; banks join willingly.  If banks begin to believe that the U.S. will constantly use the network to enforce sanctions, there will be a growing demand for alternative networks.  The Russians and Chinese are already working to develop a payment network for their own trade, for example, with EU support.[10]  If Iran loses access to the S.W.I.F.T. network it would severely undermine its ability to sell oil and may force the mullahs to make a new deal.  However, in the longer run, disrupting S.W.I.F.T. may lead the world further down the road of deglobalization and could take away a powerful tool for U.S. sanctions.  Perhaps the U.S. should treat S.W.I.F.T. sanctions as a very powerful weapon that is rarely used.

In related news, there has been a surge in U.S. soybean exports to Iran.[11]  Sales this marketing year (which began last month) are at 335k tonnes, up from zero compared to last year.  Two trends are driving the sales.  First, China has implemented tariffs which have cut sales to that nation.  Second, as Iran faces new U.S. sanctions it is stockpiling key commodities before implementation.

Iran sanctions do have costs to the U.S.  As our oil analysis shows, based on domestic commercial crude oil inventory and the dollar, oil prices should be in the low $60s.  We suspect that fears of supply constraints once sanctions are implemented have kept prices higher than their basic fundamentals.  The president has tried to keep oil prices from rising by criticizing OPEC and the Saudis, calling for more oil production.  However, production capacity is constrained and there may simply not be a way for producers to offset the full loss of Iranian output.  And so, there may be an argument that would support lighter sanctions to keep oil prices stable.  The same case could be made for U.S. farmers.  Allowing some food imports into Iran might mitigate price pressures on grain.  Of course, less than a full crackdown on Iran will make sanctions less effective.  We may see a less draconian sanctions regime initially with future tightening.

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[1] https://www.wsj.com/articles/german-voters-deal-merkels-coalition-another-setback-1540749894

[2] https://www.ft.com/content/0feb3b7a-db5c-11e8-8f50-cbae5495d92b

[3] https://www.nytimes.com/2018/10/28/world/americas/jair-bolsonaro-brazil-election.html?emc=edit_mbe_20181029&nl=morning-briefing-europe&nlid=567726720181029&te=1&login=email&auth=login-email

[4] Pinochet in Chile used University of Chicago-trained economists in his government.

[5] https://www.ft.com/content/a8fd6508-d92d-11e8-a854-33d6f82e62f8

[6] https://www.bloomberg.com/news/articles/2018-10-25/brexit-talks-said-to-be-on-hold-as-may-s-team-can-t-agree

[7] https://www.dw.com/en/italy-and-austria-spar-over-german-speaking-south-tyrol-dual-citizenship-rumors/a-44813995

[8] https://www.ft.com/content/160b3666-d8e3-11e8-a854-33d6f82e62f8

[9] https://www.wsj.com/articles/u-s-hesitates-over-scope-of-finance-sanctions-on-iran-1540483196

[10] https://www.presstv.com/Detail/2018/10/26/578126/Russia-China-Swift-Alternative

[11] https://www.ft.com/content/2213d3fc-d89b-11e8-a854-33d6f82e62f8