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

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s Friday and equities are taking on water again this morning.  Today’s weakness is due to disappointing earnings from two tech giants, Amazon[1] (AMZN, 1782.17), which is down 7.7% in pre-market trading, and Alphabet[2] (GOOGL, 1103.59), down 4.2% in the pre-market.  We cover Q3 GDP in detail below but it did come in a bit better than forecast.  Here is the news we are watching today:

Establishment versus populist redux: After the election, we offered extensive comments about the differences within the parties, noting that the policies favored by the establishment (low taxes, deregulation, free trade, immigration) are not the policy goals of the populists (regulation to protect jobs, trade impediments, reduced immigration).  For much of the first year of President Trump’s term, he talked like a populist but governed like an establishment member.  Taxes were cut and regulation was reduced.  Equity markets clearly favored his policies.  Like his GOP predecessors, he seemed to give lip service to populist goals; he didn’t aggressively condemn alt-right groups, for example.  But, if one ignored the commentary, Trump governed mostly as an establishment GOP president.

That scenario began to change this year.  The administration became increasingly aggressive against immigration.  This has led to scattered complaints from some agriculture sectors.[3]  In late January, it became clear that the president was serious about implementing sanctions and changing trade.  Attacks on the Federal Reserve have become more frequent and pointed.  As policy turned populist, the president’s approval ratings have improved.[4]  The establishment may be starting to push back.  We note this morning the WSJ editorial board[5] has criticized the president’s handling of the Fed.  GOP lawmakers have been quietly unhappy with the president’s trade policy.[6]  For Republican politicians, openly opposing the president appears, at this point, to be a political suicide mission.  And so, as long as the president maintains his popularity with the base, the rest of the GOP will be forced to go along, occasionally implementing establishment goals when the president is not paying attention (e.g., the establishment FOMC appointments).

What investors need to consider is that a GOP president might not be good for equities.[7]  Although earnings are still strong, we have been seeing a steady drop in the multiple; rising interest rates do affect the P/E but ultimately it’s a measure of market sentiment.  Investors are becoming worried and thus stocks are under pressure even with good earnings.

We have worried for some time that a policy shift toward equality and populism was inevitable regardless of who is in power.  After all, capital has been gaining on labor since 1990 and is one of the reasons populism has been surging.  Although it’s still too early to tell, the policy mix of globalization and deregulation, supported by both the left- and right-wing establishment, is under threat.  It would be reasonable to expect that this pressure is expressed in the P/E.

CNY under pressure:  The CNY fell to nearly 7.0 this morning, the weakest in 10 years.[8]  China has vowed to prevent a move above 7.0 by spending its foreign reserves.[9]   Chinese officials could use a weaker CNY to offset tariffs but fears of currency weakness will lead to capital flight.

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[1] https://www.wsj.com/articles/amazon-reports-another-profit-but-sales-underwhelm-1540498816

[2] https://www.wsj.com/articles/google-parent-alphabet-delivers-surging-profit-but-slowing-sales-growth-1540498892

[3] http://www.latimes.com/projects/la-fi-farm-labor-guestworkers/

[4] https://www.realclearpolitics.com/epolls/other/president_trump_job_approval-6179.html NB: the president’s approval rating bottomed in January, just after the tax cut.  After turning populist, his approval ratings have improved.

[5] https://www.wsj.com/articles/trump-flunks-fed-politics-1540423551

[6] https://www.cnbc.com/2018/07/06/republicans-criticize-trump-tariff-trade-war-with-china.html

[7] https://www.bloomberg.com/opinion/articles/2018-10-26/trump-is-bad-for-the-stock-market

[8] https://www.ft.com/content/4fa1fbc0-d8d5-11e8-a854-33d6f82e62f8

[9] https://www.cnbc.com/2018/10/26/reuters-america-exclusive-guarding-stability-china-likely-to-slow-yuans-slide-to-7-per-dlr-sources.html

 

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s the fourth day of what has been a tough week.  Yesterday’s equity market sell-off was clearly a shocker.  Although there is other news this morning, including the ECB meeting, we start today with thoughts about equities:

Equity thoughts: Two weeks ago, in the Asset Allocation Weekly, we touched on this issue of politics, focusing on the potential impact of political polarization on Fed policy.[1]  In that report, we noted a chart on political polarization that we show again below.

This data reads as follows—the higher the level, the greater the degree of polarization.  Our position has been that deep political divisions are the norm and the decline in polarization that began at the turn of the last century that accelerated into WWII is the outlier.  The pressures of the Cold War and the outside enemy of communism functioned as a unifier.  Soon after the fall of the U.S.S.R., polarization returned with a vengeance.

For financial markets, political polarization isn’t necessarily bad.  If it results in gridlock, legislative and regulatory policy tends to remain stable and leads to conditions that are supportive for investment.  But, in a nearly equally divided society, there is a certain attractiveness to jettisoning the restraints of the constitution and democracy.  We have seen this tendency before.  In the two decades before the Civil War, Congress more resembled an open brawl.  Are we there yet?  Although members are not openly fighting, the crowds around them certainly are.

It is rare that a market decline not tied to a clear financial event (major financial firm failure) or geopolitical event (war, major terrorist act) can be pinned to a single reason.  Given that caveat, what happened yesterday was, we think, due to a combination of events:

1. Fed tightening: The trading pattern in equities since 2009 has all the look of a secular bull market. However, previous secular bulls have occurred, in part, due to the perceived resolution of serious economic or societal problems.

Each one of these previous secular bulls coincided with a new consensus.  With regard to the last two, for example, the 1952-69 bull was due to the idea that policymakers had resolved the conditions that caused the Great Depression and equities rose with that fear resolved.  The 1982-99 bull was due to the resolution of the 1970s inflation crisis.  We haven’t added shading but if we did it would be around 2013, when new highs were made.  However, we doubt that any societal issues have been resolved.  The big issues, resolving the superpower role and addressing inequality, have not been fixed.  Instead, the bullish impetus was mostly due to very accommodative monetary policy coupled with fiscal and regulatory policy that favored capital.  If that is the case, the removal of monetary policy accommodation may be a much bigger negative factor than it normally would.

2. Political polarization has become bad for business: As noted above, if polarization leads to gridlock, it isn’t necessarily negative. But, if polarization leads to violence and divisions make the nation ungovernable, this makes investing very difficult because the path of policy becomes impossible to determine.  Large demonstrations from both the right and left, the shooting of Majority Whip Scalise and the most recent bomb mailings are not conducive to a high P/E.
3. Trade policy: The uncertainty surrounding trade policy is a concern. A key factor supporting corporate efficiency has been global supply chains.  It appears to us that one of the goals of the administration’s trade policy is to bring investment back to the U.S., which will boost employment but likely undermine margins or boost inflation.
4. At the same time, it’s important not to overlook what is going well: Earnings remain very elevated. Yes, the growth may slow but the level is historically high.  The economy overall is still doing quite well.  There are areas of concern; housing is losing momentum rapidly.  But, even slowing to 2.5% growth isn’t bad.  Inflation, though somewhat higher, is still low especially given the length of the expansion and the low level of unemployment.  In the absence of political and trade uncertainty, we would likely have an S&P 500 around 3200 and we would be talking about a bubble. 
5. The bottom line: History shows that market declines that don’t coincide with recessions tend to be short-lived and are usually buying opportunities. We suspect we are coming close to a bottom and would expect a recovery from here.  In addition, the post-mid-term election period tends to be quite bullish.

Odds and ends: The ECB meeting was mostly a non-event.  Policy may start tightening next year if conditions continue to improve.  China is cutting rare earth production, something it has done before when unhappy with foreign behavior.[2]  China appears to also be reducing its buying of Iranian oil in front of the November sanctions.[3]

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[1] https://www.confluenceinvestment.com/wp-content/uploads/AAW_Oct_12_2018.pdf

[2] https://www.reuters.com/article/us-china-rareearths/china-cutting-rare-earth-output-unnerving-global-manufacturers-idUSKCN1MY2GZ

[3] https://www.reuters.com/article/us-china-iran-oil-exclusive/exclusive-sinopec-cnpc-to-skip-iran-oil-bookings-for-november-as-us-sanctions-near-idUSKCN1MY1C9

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s mid-week and equity markets are trying to find their footing.  Yesterday’s action almost qualified for what a former boss of mine would call a “Hollywood finish.”  That’s one where the market takes a beating in the early part of the day only to recover to positive territory by the close.  We didn’t get out of the red yesterday but we did see a solid recovery.  Here is what we are watching this morning:

Earnings: Although there is much hand-wringing about earnings, the fact is that, overall, S&P 500 earnings appear to be coming in about as forecast.  This is positive; however, the usual pattern is to somewhat understate earnings in the estimates and then celebrate beating the forecast.  That may not happen this quarter.  At the same time, S&P 500 earnings are running above 6% of GDP, which is a record.  Earnings themselves look fine but sequential momentum is clearly fading.

Given where we are in the business cycle, this development shouldn’t be a shock.  Wage pressures are rising.  Interest costs are increasing, too.  Although it’s difficult to see the impact of trade restrictions in the macro data, individual companies are reporting adverse effects.[1]  Our margin model suggests that margins will remain elevated but growth will be flat; that would mean earnings growth may be limited to the growth of nominal GDP next year.  That’s not bad, but significant market appreciation will require multiple expansion.  Given how elevated confidence readings are now, it would take a major decline in interest rates to boost P/Es.

Fed bashing: In an interview with the WSJ,[2] President Trump lambasted the FOMC and Chair Powell.  In a telling quote from the article, the president said, “He was supposed to be a low-interest-rate buy.  It’s turned out he’s not.”  We wondered at the time Powell was selected (to replace Chair Yellen, who was perceived as dovish) whether Powell got the job because he was seen as an easy money person.  It should be noted that Treasury Secretary Mnuchin supported Powell’s nomination; Mnuchin is an establishment figure in the administration.  In fact, all the appointees for Fed governor so far have been remarkably mainstream.  It’s becoming obvious that Powell will be blamed for equity market volatility and any economic weakness.  Interestingly enough, criticism from the White House will tend to make it more difficult for FOMC policymakers to pause the pace of hikes.  There may be legitimate reasons for the Fed to pause—equity market turmoil is one.[3]  However, FOMC members may feel the need to maintain hikes simply to enforce Fed independence.

Our position is that we are on a slow pace to reflate the economy as part of reversing four decades of rising inequality.  Central bank independence was a key policy tool to bring down inflation.  Although the actual impact of monetary policy on inflation isn’t all that strong, policy does clearly affect inflation expectations.  But, when policymakers want to reflate, they can’t have the central bank undermining their policy actions.  President Trump’s statements to undermine Fed independence, though a reversal of the early 1990s détente, does fit a reflation narrative.

GDP: We get Q3 GDP tomorrow.  Here is the most recent GDPNow estimate from the Atlanta FRB.

The current forecast is 3.9%.  Here is the contribution table:

The two largest positive contributors to growth are consumption and inventory rebuilding.  The largest offset is net exports.  We would not expect as strong of a contribution from inventory in Q4, so there is a chance we will see GDP closer to 3% in Q4.

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[1] https://www.reuters.com/article/us-usa-stocks-earnings-analysis/tariffs-begin-to-take-bite-out-of-us-corporate-earnings-growth-idUSKCN1MX2W0

[2] https://www.wsj.com/articles/trump-steps-up-attacks-on-fed-chairman-jerome-powell-1540338090

[3] https://www.reuters.com/article/us-usa-fed-selloff-analysis/for-fed-sell-off-could-point-to-fading-trump-stimulus-idUSKCN1MX32L

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Global equities are under pressure this morning.  Note that China’s big rally yesterday was unable to hold.  Earnings disappointments are being cited as the reason.  However, as our earnings figures show, earnings are coming in a bit higher than expected.  What is starting to affect equities is the idea that sequential earnings growth is clearly slowing.  That notion, coupled with a declining multiple, is putting pressure on stocks.  Here are the items we are watching this morning:

Day of decision: The EC has rejected Italy’s budget.  We now begin a three-week negotiation period during which Italy will be required to submit an amended budget.  If an agreement isn’t reached, the EC could implement the “Excessive Deficit Procedure.”  This process would probably continue until the end of November.  Ultimately, fines could be imposed.[1]  Although EC rules create lots of temporary deadlines that help facilitate agreements, Italy appears ready to defy the Eurozone.  In the end, we expect the EC to blink which will undermine Germany’s hold on the Eurozone and pressure the EUR lower.

Brexit grinds on: PM May has offered a four-point plan to address the Brexit issue.[2]  The most important element is that she proposes to extend the transition period to the end of 2021.  In addition, the troublesome Northern Ireland issue would be addressed by a temporary joint border control body that would prevent a hard border.  During this period of “limbo” negotiations would continue on a free trade deal.  May’s political position within the Tories remains dicey; however, she continues to survive against all odds,[3] mostly because there is no good alternative within the party.[4]  At the same time, if the government falls and elections are necessary, the Tories may find themselves out of office.  That fear has been enough to keep May in power.

Khashoggi: Turkish President Erdogan continues to pressure the Saudis, indicating today that the Saudi journalist was killed in a “savage” manner, laying out a case that comes just short of accusing the KSA of a pre-meditated murder.[5]  Although we and others have speculated that Erdogan wants financial support for his beleaguered economy and a withdrawal of funding and support for the Kurds, there is nothing in the Turkish president’s tone to suggest that he has achieved satisfactory compensation for this act that occurred within the Turkish state.  If Erdogan changes his tone, we will take it as evidence that an agreement has been reached.

Other items:Oil prices fell today after the Saudis promised to offset any loss of Iranian oil.[6]  Although we are not surprised by the announcement, “saying is one thing, but doing is another.”  Chancellor Merkel has agreed to open up Germany to U.S. LNG imports.[7]  This is an important concession by Germany, which has mostly supported piped natural gas from Russia, even supporting projects that would avoid land pipes through Ukraine.  Finally, Canada has allowed China to install underwater monitoring devices near a U.S. nuclear submarine base.[8]  We view this as a stunning and disturbing development, perhaps done by the Trudeau government in retaliation over trade tensions.  The Canadians seem to miss that their defense relies deeply on U.S. power projection.  Participating in a Chinese project that could undermine U.S. power projection is dangerous for them as well.

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[1] https://www.cnbc.com/2018/10/22/european-commission-on-italys-2019-budget—what-could-happen-next.html

[2] https://www.ft.com/content/de915670-d60d-11e8-a854-33d6f82e62f8?emailId=5bcea6664ab701000494c62b&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[3] https://www.politico.eu/article/theresa-may-only-four-steps-left-to-reach-irish-backstop-brexit-deal/?utm_source=POLITICO.EU&utm_campaign=378803a464-EMAIL_CAMPAIGN_2018_10_23_04_38&utm_medium=email&utm_term=0_10959edeb5-378803a464-190334489

[4] https://www.ft.com/content/c4f357dc-d5fd-11e8-a854-33d6f82e62f8?emailId=5bcea6664ab701000494c62b&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[5] https://www.ft.com/content/76a34b70-d6a5-11e8-ab8e-6be0dcf18713

[6] https://www.bloomberg.com/news/articles/2018-10-23/saudi-oil-chief-says-opec-s-in-produce-as-much-as-you-can-mode and https://www.reuters.com/article/us-global-oil/oil-falls-as-saudi-arabia-says-it-will-play-responsible-role-idUSKCN1MX046

[7] https://www.wsj.com/articles/in-win-for-trump-merkel-changes-course-on-u-s-gas-imports-1540209647

[8] https://www.scmp.com/news/china/society/article/2169474/canada-installs-chinese-underwater-monitoring-devices-next-us