by Bill O’Grady and Thomas Wash

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

by Bill O’Grady and Thomas Wash

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

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

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

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

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

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

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

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

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

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

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

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

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It was a very quiet overnight session.  Media attention is focused on the midterms.  Here is what we are watching this morning:

Midterms: We have already discussed the election at length.  Here is our simple guide.  The consensus outcome is a Democratic House and a Republican Senate.  If this outcome is the result, market action shouldn’t be significant.  If the Democrats take both houses, we would expect a pullback in equities on fears that there will be a parade of investigations and perhaps an attempt to reverse the tax bill.  This fear is overblown.  We suspect the Democratic Party establishment is cool to impeachment and thus will try to quell the more aggressive tendencies of the party’s left-wing populists.  And, never forget, the president can veto bills.  If the GOP holds both houses, expect an initial equity rally on ideas that even more tax relief may be coming.  However, some of that bullishness will be tempered by fears of further trade impediments.  Our expectation is the consensus.

Although this year’s midterm pattern in equities hasn’t exactly followed the average pattern, it should still be noted that equities tend to have strong gains after the midterms.  Such seasonal studies should always be taken as guides; Ned Davis, a well-known market analyst, used to suggest that the pattern, and not level, was the important factor to watch.

It’s notable that the real pattern break was last year, when the big rally in stocks was due to the passage of the tax bill.  The midterm year is usually rather flat.  Although we did make new highs, it has arguably been a sideways year.  If the pattern holds, we should see a strong market into the middle of next year.  Why does this pattern exist?  In general, there are two factors behind it.  First, the election fosters some degree of uncertainty and getting the results ends that uncertainty and supports sentiment.  Second, the incumbent president is interested in re-election and thus pushes for economic stimulus to avoid the worst political outcome, a recession into the election year.

Iran sanctions: Although eight nations have been granted waivers for buying Iranian crude oil, it’s not clear how they will pay for it.  S.W.I.F.T. has confirmed that it is severing ties with Iran’s banks.[1]  This will make it nearly impossible for the nations able to buy Iranian crude to easily pay for it.  European leaders are trying to create an alternative messaging network but are struggling to make progress.  One factor is that no nation is keen to house the network, fearing that nation will become a target for U.S. sanctions.[2]  It’s apparent that the EU won’t have a workaround in place as sanctions go into effect.

China and U.S. trade: There are growing hopes of a thaw developing between the U.S. and China over trade as the G-20 meeting looms on November 29.  The two parties are holding security talks which were previously delayed.[3]  American business leaders offered optimistic comments as well.[4]  Although we are not convinced that a major reduction in trade tensions is in the offing, some minor deals are possible.  The U.S./China issue is existential, the problem of a rising power threatening an established hegemon.[5]

Natural gas prices: Yesterday, natural gas prices rallied strongly as a significant cold front is expected to bring wintery weather to the central and eastern regions of the U.S.  Inventories are at their lowest levels since 2014 on a seasonally adjusted basis.  In that year, Henry Hub prices peaked at $6.55 per MMBTU.

This chart shows natural gas inventories with a seasonal adjustment factor.  The lower line on the chart shows the deviation from normal.  The growth of shale oil produces natural gas as a by-product and that extra supply has tended to keep prices low.  This year, rising exports to Mexico and LNG processing has offset production, leading to the lower inventory situation.  A key factor in yesterday’s rally was the early cold snap.  In general, inventory managers want to keep storage for later in the winter; therefore, when faced with early cold weather the supply usually comes mostly from current production, which tends to boost the price.  Overall, early cold weather has a bigger impact on natural gas prices than later cold weather, depending on the storage situation.  The combination of early cold weather and low inventory levels is bullish for natural gas.

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[1] https://www.nytimes.com/2018/11/05/business/dealbook/swift-iran-sanctions.html?emc=edit_mbe_20181106&nl=morning-briefing-europe&nlid=567726720181106&te=1

[2] https://www.ft.com/content/644d3400-e045-11e8-a6e5-792428919cee?emailId=5be16ad533bfe100045e9ead&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[3] https://www.reuters.com/article/us-usa-china/frost-thaws-in-u-s-china-ties-ahead-of-g20-meeting-idUSKCN1NB0A0

[4] https://www.reuters.com/article/us-china-airshow-boeing/boeing-optimistic-about-speedy-resolution-to-u-s-china-trade-dispute-exec-idUSKCN1NB0R9

[5] https://www.confluenceinvestment.com/research-news/reading-list/ – See our review of Destined for War (History/Geopolitics)

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