by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT]

[BREAKING: President Trump agreed to a meeting with Chinese leader Xi Jinping to discuss ongoing trade tensions during the G20 Summit.  Earlier this week, U.S. officials had warned China that trade discussions would only take place if it provided a detailed list of trade concessions.  This meeting signals a slight de-escalation of tensions between the two nations.  The story is still developing.]

Good morning all!  There was a sharp sell-off in equities worldwide after a higher than expected core PPI report sparked concerns about ongoing trade tensions; at this time, bonds and currencies remain relatively stable.  Here are the news events we are following today:

Market jitters: The equity sell-off that started in U.S. markets yesterday spread into European and Asian markets overnight.  The sharp sell-off prompted the president to initially conclude that the Federal Reserve had “gone crazy” with monetary tightening, and then later attributed the sell-off to market correction.  Although there were likely multiple causes that contributed to the stock market sell-off, the prospect of a fourth rate hike being one of them, the most prominent cause appears to be fears of escalating trade tensions between the U.S. and China.  Yesterday’s PPI report looks to have sparked the sell-off.  The chart below shows the VIX index, most commonly known as the fear gauge.

As you can see, the rise in the VIX coincided with the release of the report.  Higher than expected core PPI has sparked concerns that profit margins might suffer due to either rising costs or inflation.  Although there have been whispers that this event is possibly a signal of the economy losing steam, at this moment, we remain optimistic as there is no clear sign of a downturn happening in the foreseeable future, but we continue to monitor the situation.

Adjusted sanctions: China, Russia and North Korea have called on the U.N. Security Council to adjust current sanctions against Pyongyang.[1]  South Korea is also rumored to be considering a reduction in unilateral sanctions against the regime.[2]  The push for a reduction in sanctions is in stark contrast to the Trump administration’s position of maintaining sanctions until North Korea is completely denuclearized.  Although South Korea’s interest in reducing sanctions is likely due to its goal of creating a more stable Korean peninsula, China and Russia’s interests appear to be more strategic.  Although it is unclear, it seems that sanctions and trade tensions have forced Russia and China into a strategic partnership to undermine the U.S.  We see their united push to adjust sanctions as a way of demonstrating their importance to the U.S. in achieving its diplomatic agenda.

New reserves in the Gulf: On Wednesday, Mexican state-owned oil company, Pemex, stated it has discovered new oil reserves in the southeast basin of the Gulf of Mexico.  The discovery provided a sigh of relief to oil market skeptics that feared the Iranian sanctions – which are due to be put in place on November 4 – will force up oil prices.  It is unclear whether this will impact the U.S. decision to provide sanction waivers to countries that would like to keep importing Iranian oil, but we will continue to monitor this situation.

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[1] https://www.politico.com/story/2018/10/10/china-russia-north-korea-sanctions-891640

[2] https://www.aljazeera.com/news/2018/10/south-korea-eyes-lifting-sanctions-north-korea-181010194334831.html

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] U.S. equity futures have weakened on an unexpected jump in core PPI (see below).  Here is what we are following:

China: There were a few items of interest this morning.  First, Treasury Secretary Mnuchin warned China not to use a weaker currency to offset U.S. trade tariffs.[1]  So far, China has denied that it is considering a forced depreciation of the CNY.  However, the dollar/yuan exchange rate has weakened toward the CNY 7.0 level, which would be psychologically important.  For China, the exchange rate is a dual-edged sword.  An obvious retaliation against tariffs would be a weaker currency, which would offset higher costs on Chinese goods.  However, currency weakness in the past has triggered capital flight and any hint that the Xi regime is going to use a weaker currency could lead to outflows that would be hard to control.  We would expect a slow depreciation of the currency but most of the offset to tariffs is probably going to come from increased domestic investment, which will exacerbate China’s debt problem.  Second, during the just completed “Golden Week” in China, holiday purchases were said to be “soft.”[2]  Consumer spending during the holiday rose about 6.7% over the week, the first single-digit growth rate in post-reform history.  As the Chinese economy slows, we would expect the government to increase stimulus to avoid a slump.  Finally, Andrew Ross Sorkin has a report in the NYT[3] raising the age-old concern about China deploying the “nuclear option” and dumping Treasuries.  We discussed this issue from the Chinese side in a recent series of Weekly Geopolitical Reports.[4]  This is really not an issue.  As we noted in our reports, China has no real alternative to Treasuries.  If it decides to dump its holdings, not only would it suffer significant losses, but it would lose an outlet for its exports (which is how the reserves are generated in the first place).  However, there is another issue we didn’t delve into in the aforementioned reports—the Fed could simply execute a form of QE and purchase all the Treasuries the Chinese wanted to sell.

Trump and the Fed: President Trump criticized the Federal Reserve again yesterday.[5]  This Friday’s Asset Allocation Weekly will discuss the dangers of politicizing monetary policy.  There is a potential danger with White House criticism of the FOMC; the Fed really doesn’t control inflation (that’s a function of the intersection of aggregate supply and aggregate demand, meaning there are many factors affecting inflation with monetary policy being a minor one), but it does control inflation expectations.  If financial markets conclude that policymakers are “pulling their punches” to avoid disapproval, it would raise fears that policy won’t tighten enough in the face of inflationary pressures and un-anchor expectations.  We note that NY FRB President Williams suggested the Fed will likely reach a neutral policy level in “a year or so.”[6]

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[1] https://www.ft.com/content/cd325c24-cc32-11e8-b276-b9069bde0956

[2] https://www.scmp.com/economy/china-economy/article/2167700/are-chinese-consumers-losing-power-soft-spending-golden-week

[3] https://www.nytimes.com/2018/10/09/business/dealbook/china-trade-war-nuclear-option.html

[4] See WGRs, China’s Foreign Reserves: Part I (6/4/18); Part II (6/11/18); and Part III (6/18/18).

[5] https://www.reuters.com/article/us-usa-fed-trump/trump-renews-fed-criticism-says-raising-rates-too-fast-idUSKCN1MJ2JW

[6] https://www.wsj.com/articles/feds-williams-more-gradual-rate-increases-will-keep-expansion-moving-1539133800

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s another risk-off day; we did see U.S. equities recover yesterday into the close but the futures are indicating a lower opening.  Here is what we are following:

China: There has been speculation that President Trump and Chairman Xi would meet at next month’s G-20 summit, but the White House has indicated the U.S. won’t engage with China unless it brings a detailed list of concessions.[1]  China has responded by saying it does have a list but won’t present it without assurance of a “stable political climate in Washington,”[2] which we take to mean as a single voice on Chinese trade policy.  There have been multiple voices on trade policy, from the relatively dovish positions of Treasury Secretary Mnuchin to the more hardline positions of Lighthizer and Navarro.  But, what has likely spawned the condition for a single point person was a recent speech by VP Pence which seemed to signal a break point in relations.  Up until now, American presidents tolerated unhelpful behavior from China (e.g., forced technology transfers, large current account surpluses, informal trade impediments) with the belief that, eventually, China would follow the path of other Asian authoritarian regimes and democratize.  The Pence speech seems to suggest that this isn’t going to happen and the U.S. is prepared to treat China as a hostile power.[3]

We are rapidly breaking new ground here at a time when MSCI is considering boosting China’s weighting in the emerging market indices.[4]  If tensions continue to rise, index investing could become a problem.  We do note that China is taking steps to offset these tensions.  Yesterday, we noted the reduction in bank reserve requirements.  There are reports in China’s media today calling for strong stimulus measures to boost growth.[5]  Overall, we have two significant cross-currents—U.S. pressure and domestic stimulus.  In the short run, the latter is probably more important.  Increased Chinese stimulus could boost commodity demand but only if the CNY doesn’t markedly weaken.

IMF downgrade: The IMF, in its biannual update on the world economy, lowered its global GDP growth projections by 0.2% to 3.7% for this year and next.[6]  The body cites tariff concerns and emerging market weakness as reasons for the downgrade.[7]  The IMF did say it would boost its forecast if the trade dispute between the U.S. and China is resolved.

Oil prices:Oil prices have lifted as Hurricane Michael has evolved into a rather significant storm.  Energy companies have been evacuating staff from offshore oil platforms, which will reduce U.S. production by 0.3 mbpd (out of 11.1 mbpd).  Perhaps more importantly, although the key energy region between Houston and the Mississippi Delta will be mostly spared, the storm will disrupt oil imports.  The Louisiana Offshore Oil Port (LOOP) should not be directly affected by the storm but tankers will probably not be able to access the LOOP for a couple of days simply due to the presence of the storm.

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[1] https://www.ft.com/content/6f1bd226-cb67-11e8-b276-b9069bde0956

[2] ibid

[3] https://www.wsj.com/articles/the-deeper-meaning-of-pences-china-broadside-1539010010

[4] https://www.bloomberg.com/news/articles/2018-09-25/msci-considers-boosting-china-a-share-weighting-adding-chinext

[5] https://www.reuters.com/article/us-china-economy-policies/china-must-take-strong-stimulus-measures-to-support-growth-state-media-idUSKCN1MJ07H

[6] https://www.ft.com/content/9d03bef0-cb0e-11e8-b276-b9069bde0956?emailId=5bbc31cd953e44000494e4a2&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[7] https://www.reuters.com/article/us-imf-worldbank-outlook/imf-cuts-world-economic-growth-forecasts-as-import-tariffs-emerging-market-issues-bite-idUSKCN1MJ025

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s Monday—financial markets are in clear risk-off mode amid lots of news.  It is Columbus Day, a bank holiday, so commercial banks and the Treasury market are closed today.  Here is what we are following:

China: Chinese markets reopened after a week-long holiday to a significant drop in equity values and a drop in the CNY.

The exchange rate is testing recent lows as trade tensions rise with the U.S.  There was an exchange between Chinese Foreign Minister Wang Yi and Secretary of State Mike Pompeo that has been described as “frosty”[1] during a five-hour visit by Pompeo to Beijing.  China indicated that U.S. policy was “misguided.”[2]  Tensions between the two countries are clearly rising.  There was a near collision between Chinese and U.S. destroyers recently and the U.S. is considering increasing the number of Freedom of Navigation operations near outcroppings that China has been fortifying in recent years.  Meanwhile, on trade, the U.S. doesn’t seem to be anywhere close to easing pressure on China; in fact, the long-term goal of the Trump administration appears to be shortening the supply chains,[3] with a focus on pulling productive capacity out of China.  Part of China’s retaliation will be a weaker currency; we note that China lowered its reserve requirements in a bid to boost the economy.[4]  We believe the CPC will do all it can to maintain high levels of economic growth as it views growth as legitimizing the rule of the party.  Although the Chinese government tends to keep a lid on dissent, we do note there were riots over the holiday when a real estate developer cut prices in a bid to sell remaining units.  The current property owners were furious and attacked the sales office, smashing windows.[5]  Falling real estate values may be a more significant threat to the CPC than trade.

Brazilian elections: As expected, Jair Bolsonaro won a plurality on Sunday,[6] taking 46% of the vote, nearly winning a majority.  There will be a runoff on the 28^th which will likely make Bolsonaro the new president of Brazil.  Bolsonaro is a right-wing populist whose platform is law and order and has shown an affinity for the military dictatorships of the early 1980s.  Equity markets in Brazil have welcomed the outcome.

Italy: After agreeing on a budget last week, the EU criticized Italy’s rising deficits.  This criticism prompted a strong reaction from the League’s deputy PM, Matteo Salvini, who suggested that “the enemies of Europe are those sealed in the bunker in Brussels.”[7]  The exchange triggered another sell-off in Italian bonds and a drop in the EUR.  As the chart below shows, the spread between German bunds and Italian 10-year sovereigns widened out over 300 bps, with Italian paper hitting a yield of 3.60% and German yields easing lower.  Italy is a mortal threat to the Eurozone; if Italy leaves, it will severely damage the single currency to the point where it would probably not survive in its current form.  We would expect other southern tier nations to exit the single currency if Italy leaves.  If Germany wants to keep the Eurozone in place, it will be forced to ease its restrictions on fiscal spending and probably accept a Eurobond, a sovereign backed by the full faith and credit of all members in the Eurozone.  Germany will see this as giving the Italians a credit card, leaving Germans to service the debt.  Simply put, it is unlikely that Germany will accept this change.  Thus, tensions will likely remain elevated.

The long arm of the authoritarians: Last week, we noted that Jamal Khashoggi, a Saudi journalist who had been critical of the Salman reign in Saudi Arabia, had gone missing after entering the Saudi embassy in Istanbul.  He was recently living outside the kingdom on apparent fears of arrest and writing for the Washington Post.[8]  Turkey claims that a Saudi unit tortured and killed Khashoggi last week.[9]  The Saudis have denied the report.  Separately, the head of Interpol, a Chinese national named Meng Hongwei, has resigned after he was arrested while visiting China last week.[10]  Although two unrelated events, both indicate that authoritarian regimes, which generally won’t tolerate dissent, are signaling to their citizens that (a) you can’t run away, and (b) the West won’t protect you.  If this message is true, it may stem capital flight which has boosted coastal real estate markets in the U.S. and Britain.

Oil prices: Oil prices have dipped on reports that the Trump administration is considering granting some waivers to nations wanting to import Iranian oil.  That action may be necessary to contain the recent jump in oil prices.  We will be watching to see if these waivers are permanent or if they need to be renewed after the midterm elections.  If it’s the latter, we view this as a bid to lower oil prices in front of the midterms. 

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[1] https://www.ft.com/content/bb666e06-cad2-11e8-b276-b9069bde0956

[2] https://www.washingtonpost.com/world/china-tells-trump-administration-to-stop-its-misguided-actions-and-allegations/2018/10/08/cd17c926-cac1-11e8-a85c-0bbe30c19e8f_story.html?utm_term=.946be1214f51

[3] https://www.wsj.com/articles/u-s-tariffs-on-china-arent-a-short-term-strategy-1538841600

[4] https://www.marketwatch.com/discover?url=https%3A%2F%2Fwww.marketwatch.com%2Famp%2Fstory%2Fguid%2F8187f748-ca70-11e8-9cdc-8834b4cd15bb&link=sfmw_tw#https://www.marketwatch.com/amp/story/guid/8187f748-ca70-11e8-9cdc-8834b4cd15bb?mod=dist_amp_social

[5] https://twitter.com/polarmcbear/status/1048473629015465984?s=11

[6] https://www.ft.com/content/86a29826-cad1-11e8-9fe5-24ad351828ab

[7] https://www.ft.com/content/36abf528-cac3-11e8-b276-b9069bde0956

[8] https://www.washingtonpost.com/news/global-opinions/wp/2018/10/06/read-jamal-khashoggis-columns-for-the-washington-post/?utm_term=.ba113d6a41ef

[9] https://www.ft.com/content/d62a06ec-c9b7-11e8-b276-b9069bde0956?emailId=5bbae01f8faec70004dff956&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[10] https://www.ft.com/content/52edca9e-ca56-11e8-b276-b9069bde0956

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s employment Friday!  We cover the data in detail below, but the short recap is that the payroll data came in well below forecast at 134k vs. estimates of 185k.  However, revisions added 87k, so the overall increase in payrolls did exceed estimates.  The unemployment rate dipped to 3.7%, below the 3.8% expected.  Wages were on forecast at 2.8%.  Overall, it’s a solid report and should support further increases in the policy rate.  We are seeing further weakness in bond prices and a stronger dollar.  Equities are mostly steady.  Here are other items we are watching today:

Brazil to the polls: Brazilian voters go to the polls Sunday in what has been a rather wild pre-election season.  For much of the run-up to the election, former president Luiz Inacio Lula da Silva was the front-runner, although he had been convicted of corruption.  The courts barred him from running.  With Lula out of the way, Jair Bolsonaro is leading in the polls.[1]  Bolsonaro, a former member of the military, is a controversial figure[2] running on a right-wing populist platform.  He was recently stabbed during a campaign rally, but has recovered.[3]  The electorate’s shift from favoring Lula, a hard-left candidate, to Bolsonaro, a hard-right candidate, is a pattern we have seen across the democracies of the world.  The center-left and center-right are losing support, seen as the vanguard of globalization and deregulation.  Voters want something different even if that “difference” is not ideologically consistent.  We would not expect a final result from Sunday’s election; Brazil requires a majority to take the presidency and if no candidate exceeds 50% (polls don’t suggest any candidate will) then a runoff between the two largest vote winners will be held on October 28.  Brazilian equities (in dollar terms) have been under pressure this year.

A Bolsonaro victory may be a catalyst for an equity rally as he would be seen, at least initially, as friendly to capital.

The disappearing journalist:Jamal Khashoggi is a Saudi journalist who has been living outside the kingdom recently on apparent fears of arrest.  Earlier in the week, he entered the Saudi consulate in Istanbul.[4]  He hasn’t been seen since.  The Saudis say they don’t have him but it is generally believed that the kingdom has detained him.  Khashoggi has been critical of Saudi Crown Prince Salman,[5] a leader who has shown he will not tolerate dissent.  We would not look for the U.S. to get deeply involved in this issue, but Khashoggi is well known and if he has been arrested it could be a public relations issue for Saudi Arabia.

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[1] https://en.wikipedia.org/wiki/Opinion_polling_for_the_Brazilian_general_election,_2018

[2] https://www.voanews.com/a/brazil-presidential-candidate-let-police-kill-criminals/4550275.html?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosam&stream=top

[3] https://www.theguardian.com/world/2018/sep/06/brazil-jair-bolsonaro-far-right-presidential-candidate-stabbed

[4] https://www.washingtonpost.com/news/global-opinions/wp/2018/10/02/post-contributor-and-prominent-saudi-critic-jamal-khashoggi-feared-missing-in-turkey/?noredirect=on&utm_term=.f2897ec3a42a

[5] https://www.washingtonpost.com/news/global-opinions/wp/2018/09/11/saudi-arabias-crown-prince-must-restore-dignity-to-his-country-by-ending-yemens-cruel-war/?noredirect=on&utm_term=.a2d2b3321ca5

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s a global down day for equities.  Rising long-duration interest rates are the most cited culprit.  Here is what we are watching today:

Rising long-duration yields: Long-duration yields are mostly a function of the policy rate and inflation expectations.  Determining the policy rate is a snap.  Determining inflation expectations is another matter.  History tends to show that inflation expectations change slowly, although some factors, like oil, can cause short-term shifts in anticipated inflation.

The chart on the left shows oil prices and 10-year yields.  From the mid-1970s into 1990, the two series were positively correlated at the level of +83.9%.  Since then, the two series are negatively correlated at the level of -69.0%.  During the 1980s into the 1990s, anyone building a yield model incorporated oil prices because yields were very sensitive to oil prices.  However, as investors began to believe that the central banks would prevent oil prices from triggering wider inflation, the correlation flipped.  Simply put, until the early 1990s, investors believed that high oil prices lifted inflation.  After the early 1990s, investors believed that high oil prices depressed economic activity and thus was bullish for Treasury prices (leading to lower yields).

However, the chart on the right shows that there are short periods when there is a positive correlation between oil prices and yields.  We use a five-year rolling correlation which shows that even in the post-1990 period, when the general correlation was lower, there are episodes when the correlation turns positive for short periods of time.  It would seem that these phases tend to occur when economic growth is strong, such as the one we are in now.  Thus, part of the rout we are seeing in the long end is due to high oil prices, which, as we note below, are mostly due to fears of Iranian sanctions.

At the same time, there are growing worries about the policy rate.  Recent speeches by Chair Powell and other FOMC members mostly lean hawkish.[1]  Although the Phillips Curve seems to be rapidly falling out of favor (as it probably should), we are entering a period where there is no dominant model for inflation and its effect on policy.  Instead, we are increasingly left with anecdotes.  For example, here is one from Chair Powell’s recent speech which measures reported bottlenecks or shortages in the Beige Book.

Pretty scary, huh kids?[2]  Well, in the 1998 period, when bottlenecks were being widely reported, core CPI topped out at 2.5%.  In 2001, when reported bottlenecks nearly disappeared, core CPI peaked at 2.8%.  Simply put, reported bottlenecks seem to have little relationship to actual inflation.

So, what’s driving bond yields higher?  Fears of continued policy tightening and oil prices.  The two-year deferred Eurodollar futures have ticked up to an implied yield of 3.27%, suggesting a terminal fed funds target of at least 3.25%.  And, oil prices are raising short-term inflation worries.  But, the recent move is excessive and smacks of short-covering and we suspect it won’t be maintained.

China: The news flow on China overnight was quite negative.  First. Bloomberg broke an important story alleging that Chinese spies used a hardware hack to essentially use our smart phones to monitor our behavior.[3]  The U.S. Navy is proposing a major show of force in the South China Sea.[4]  VP Pence is said to be preparing a speech outlining Chinese aggression.[5]  Overall, relations are looking increasingly strained.  The breakdown in relations will tend to pressure Chinese financial assets with residual effects on other EM markets.

Energy recap: U.S. crude oil inventories rose 8.0 mb compared to market expectations of a 1.5 mb draw.

This chart shows current crude oil inventories, both over the long term and the last decade.  We have added the estimated level of lease stocks to maintain the consistency of the data.  As the chart shows, inventories remain historically high but have declined significantly since March 2017.  We would consider the overhang closed if stocks fall under 400 mb.  Refinery utilization was unchanged at 90.4% as was oil production at 11.1 mbpd.  Exports declined 0.4 mbpd, while imports rose 0.2 mbpd.  The rise in stockpiles was mostly due to falling exports and slower refining activity.

As the seasonal chart below shows, inventories have begun their seasonal build period.  We should see inventories continue to rise in the coming weeks as refinery operations decline for autumn maintenance.

Based on inventories alone, oil prices are below fair value price at $70.20.  Meanwhile, the EUR/WTI model generates a fair value of $60.88.  Together (which is a more sound methodology), fair value is $64.77, meaning that current prices are well above fair value.  Oil prices have been in a strong bull market for the past several weeks, mostly on fears of supply constraints from sanctions on Iranian oil exports.  In fact, Russian President Putin suggested to President Trump today that he should stop blaming OPEC and foreign oil suppliers for high oil prices and instead “look in the mirror.”[6]  Although this week’s data is bearish for oil prices, news that the U.S. was pulling out of a 63-year oil treaty with Iran after the Iranians won a verdict at the International Court of Justice boosted prices.[7]  Relations with Iran continue to deteriorate and the increase in tensions is supporting higher prices in the face of rising stockpiles.[8]  It is possible that, at least in the short run, oil prices are getting a bit ahead of themselves.  But, fear of supply losses in the coming weeks is keeping a bid under the price of oil.

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[1] https://apnews.com/cf5305d356fd49309543d711ea5ef6e9/Fed-chairman-defends-gradual-pace-of-rate-hikes

[2] https://www.youtube.com/watch?v=t9iIf4tFoyE

[3] https://www.bloomberg.com/news/features/2018-10-04/the-big-hack-how-china-used-a-tiny-chip-to-infiltrate-america-s-top-companies?srnd=businessweek-v2&utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosam&stream=top

[4] https://www.cnn.com/2018/10/03/politics/us-navy-show-of-force-china/index.html?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosam&stream=top

[5] https://www.nytimes.com/2018/10/03/us/politics/china-pence-trade-military-elections.html?action=click&module=Top%20Stories&pgtype=Homepage

[6] https://www.bloomberg.com/news/articles/2018-10-03/putin-tells-trump-to-blame-guy-in-the-mirror-for-high-oil-prices

[7] https://www.cnn.com/2018/10/03/politics/pompeo-icj-iran-ruling/index.html

[8] https://www.bloomberg.com/news/articles/2018-10-03/iran-oil-buyers-craving-obama-s-waivers-get-trump-shock-instead

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Risk-on is in the air this morning.  Here is what we are watching:

Italy: Financial markets are showing some signs of relief this morning following the populist government’s promise to lower fiscal deficits after 2019.[1]  This has the look of a common promise made around the holidays, when one says that dieting will commence right after New Year’s.  Promises are easy to make, austerity isn’t.  We strongly doubt there will be any change in policy but the mere promise suggests that the EU and Italy can avoid a direct confrontation in the short run.

Powell speaks: The Fed chair’s remarks were no surprise.[2]  Policy is largely laid out into next year, with another 100 bps of tightening expected.  Given the flux over policy structure we expect the FOMC to raise rates slowly until we see fed funds around 3.25%.  At that point, if the 10-year yield doesn’t rise significantly, the yield curve will likely curb any desire to raise rates further.

Yesterday, we described the Powell Fed’s communication policy as “less is more.”  We have media confirmation today.[3]

More on USMCA: In the new treaty, there is a clause that will further isolate China.  There is a provision that requires any nation in the agreement to give three months’ notice to the other parties if it enters trade negotiations with a non-market economy[4] (read: China).  If any of the three nations make a deal with a non-market economy, that nation can be driven out of USMCA.  Again, this isn’t much different than the goals of TPP but the enforcement is much different.  TPP attempted to isolate China by creating “carrots” for joining the free trade group.  USMCA uses a “stick” approach, penalizing nations in the pact for making trade deals with China.  We would not be surprised to see future trade arrangements (Japan and the U.S. are in negotiations now) contain similar clauses.

How close was it?[5]  Last week, there was an incident where the U.S.S. Decatur, an Arleigh Burke-class destroyer, and a Luyang-class Chinese destroyer came within 45 yards of each other as the Chinese vessel challenged the U.S. Navy ship in the South China Sea.  The U.S. and China are becoming increasingly confrontational on multiple fronts (as noted in the above comment) and the odds of escalation are rising.  At this point, we are not putting a high probability on open conflict, but the chances are rising and neither side appears willing to back down.

$15 per hour: Amazon (AMZN, 1971.31) made headlines earlier this week by announcing it would boost its base wage to $15 per hour.[6]  We suspect there are multiple reasons why the company made this move.  There is no doubt that labor market conditions have been tightening.  Companies tend to avoid moving salaries higher because it is hard to reduce them when economic conditions deteriorate.  When labor costs need to be cut, wage rigidity tends to lead to layoffs rather than wage cuts.  Thus, companies have been increasing pay in the form of bonuses and benefits which can be adjusted more easily.  Thus, Amazon’s move does press against that trend.  To some extent, this action may give Amazon a competitive edge; its distribution network isn’t all that labor intensive relative to its competition, so this move will tend to force its “brick and mortar” competition to raise wages too,[7] which will pressure their margins more than Amazon’s.  The policy and political optics are favorable.  Sen. Sanders (I-VT) was pressing the company with legislation designed to force it to pay for transfer payment support to its workers.  The hike was lauded by Sanders and will likely force other retailers to go along.

Retailing represents about 10.7% of total non-farm payrolls.

As the chart shows, the uptrend line was broken around the turn of the century, most likely due to the rise of online retailing.  We note that transportation and warehouse worker counts have been rising rapidly since 2010.

Assuming much of the rest of retailing is forced to match Amazon, we will see a sharp rise in wages for about 10.7 mm workers.  And, restaurants, which likely use the same labor pool that supports retailing, may face increased worker shortages.  This could boost wages at the low end and is something we will be watching closely in the coming months.

Trump and the king:President Trump noted, at a campaign rally last night, that the U.S. protects Saudi Arabia and it “wouldn’t last two weeks” if the U.S. were to withdraw that support.[8]  Although they would likely make it longer than a fortnight, over time, there is no doubt that the Saudis would be in trouble without U.S. security support.  Of course, the kingdom could seek help from others.  Russia would be a natural partner.  A more overt alliance with Israel is possible, too.  The onset of fracking has made the U.S. commitment to Middle East security obsolete and we have seen a steady decline in American interest in maintaining borders and organizing security.  The president isn’t happy with OPEC actions and current oil prices, albeit the recent rally is mostly due to the announcement of sanctions on Iran.  Still, higher oil prices are something of a mixed bag for the U.S.  Rising gasoline prices undermine consumer confidence (but not spending—this is the “pundit’s canard” because the GDP consumption data doesn’t care if you spend $5 on a slurpee and burrito or on gasoline…it’s still spending), but higher oil prices also boost investment activity in the oil patch and thus, unlike what we used to see, higher oil prices do act to support parts of the American economy.  The key takeaway here is that if Saudi Arabia can’t rely on the U.S. it will find other partners for security.  They may not be as effective or generous, but alternatives do exist.

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[1] https://www.theguardian.com/business/live/2018/oct/03/italy-budget-row-markets-eurozone-services-imf-growth-business-live

[2] https://www.reuters.com/article/us-usa-fed-powell/feds-powell-says-u-s-outlook-remarkably-positive-idUSKCN1MC2A7

[3] https://www.wsj.com/articles/fed-looks-to-pare-language-describing-future-of-rates-policy-1538472600

[4] https://www.politico.com/story/2018/10/02/trump-trade-canada-china-warning-825358

[5] https://twitter.com/jljzen/status/1047296954814750725

[6] https://apnews.com/cdbab66e07d64b4b9b9f0246be806339/Ripple-effect?-Amazon%27s-$15-wage-may-help-lift-pay-elsewhere

[7] https://www.wsj.com/articles/amazons-wage-increase-adds-pressure-for-employers-to-boost-pay-1538518368

[8] https://www.reuters.com/article/us-usa-trump-saudi/trump-i-told-saudi-king-he-wouldnt-last-without-u-s-support-idUSKCN1MD066