by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy Monday!  We are seeing a bit of optimism this morning as Chinese equities rallied overnight.  There was nothing in the news that was necessarily bullish for China but a constant drumbeat of supportive statements from CPC officials has likely given investors the idea that the government will directly support the economy and perhaps the equity market.  Here are the other items we are watching this morning:

The INF Treaty: It appears the U.S. is preparing to end its participation in the Intermediate Nuclear Forces Treaty, a late-Cold War agreement that limited short- and intermediate-range nuclear weapons from the European theater.[1]  There is evidence to suggest Russia has been violating the treaty for some time; Russia makes similar accusations against the U.S.  Although the demise of this treaty is worrisome, it was really a relic of America’s unipolar movement.  The INF puts the U.S. at a significant disadvantage to China in the Far East and would have needed to be scrapped at some point.  But, what this action likely shows more than anything is that the world is again devolving into competing blocs and is additional evidence that the post-Cold War world is moving from American dominance to a more unstable geopolitical situation.  If this view is correct we will likely see more modifications in other arrangements over time.

The Khashoggi affair: The Saudi Royal family is working hard to contain the uproar over the death of Jamal Khashoggi, a prominent Saudi journalist.  The current narrative around his death, which took a while for the Kingdom of Saudi Arabia (KSA) to admit had occurred, is that it was an arrest gone awry.  Obviously, there are massive problems with this story.  First, the crown prince projects the image of being in full control.  For this incident to have been a blunder undermines this image.  Second, Turkey appears to have a significant degree of signals intelligence on what happened inside the Saudi consulate.  And, President Erdogan has played his hand deftly, leaking information on a selective basis to undermine any story coming from Washington or Riyadh.  Ankara is working to extract as much as it can with the information it has.  Erdogan’s goals would be to extend Turkey’s power projection into the Persian Gulf[2] and to reduce Kurdish influence in northern Iraq and Syria.

Our key takeaway from this event is that the U.S. isn’t going to rupture its relations with the KSA over this affair because the Saudis are simply too important to isolating Iran and maintaining some degree of order in the oil markets.  But, it is also becoming clear that the crown prince is a significant danger to regional stability.  The list of his rash actions is long.[3]  Although some members of the Trump administration are clearly fond of Mohammad bin Salman (MbS), he is proving to be a dangerous actor.  Thus, we wouldn’t be surprised to see at least some steps to curtail his power; the history of the KSA shows that kings can be removed and crown princes replaced.[4]  If MbS survives this affair with no changes in power, it would suggest he has solidified his control and will be the fount of continued turmoil.

Italian chicken: Tensions between the European Commission and Italy remain elevated.  On Friday, Moody’s downgraded Italian local and foreign currency sovereign debt to Baa3 from Baa2,[5] putting its debt near “junk” status.  Although some commentators are arguing that this morning’s equity rally is partly due to “relief” that Moody’s didn’t take Italy to junk status, this appears to us to be a stretch.  For the most part, the action taken by Moody’s was about as expected.  S&P is scheduled to review Italy’s debt on Friday.  The EC continues to express displeasure with Italy’s budget and the Italian government continues to indicate that it intends to keep its budget regardless of the EC’s protests.

The Italian position is actually rather simple.  Although there is occasional talk of Italy leaving the Eurozone, polls suggest that Italians actually favor being in the single currency.[6]  The current government has made it clear that it has no plans to exit the Eurozone.[7]  Given how high Italian interest rates were pre-Eurozone, it is understandable why being part of the single currency is popular.

The euro started in 2000, as shown by the vertical line on the chart, but note that yields between Germany and Italy converged in the late 1990s in anticipation of Italy joining the Eurozone.  Even in the worst of the Eurozone crisis in 2011-12, Italy’s yield spread with Germany didn’t reach the pre-euro peaks.  The chart also makes it obvious why a spread of 4% is psychologically important.

Italy wants to stay inside the Eurozone but to ignore the fiscal restraining rules.  Although Italy has enjoyed lower interest rates, its economic growth has been stagnant.

This chart shows Italy’s industrial production. We have placed a vertical line showing the start of the Eurozone.  Note that production growth has been nil since entering the single currency.

The populist government has a mandate to (a) boost growth, and (b) keep interest rates low, which likely means staying in the Eurozone.  The EC does not want to see a large Eurozone economy flagrantly defy the fiscal rules.  These are incompatible goals.  Thus, we have a classic game of “chicken.”  We don’t expect Italy to blink here.  The enforcer of fiscal rules in the EC is Germany and Chancellor Merkel’s political situation has deteriorated enough to likely prevent a strong response from the Merkel government.  If Italy is allowed to violate the fiscal rules, at least initially, it’s bearish for the EUR.  However, if we end up with a wider easing of fiscal rules that leads to tighter monetary policy, we could see the EUR eventually strengthen.

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[1] https://www.washingtonpost.com/world/national-security/bolton-pushes-trump-administration-to-withdraw-from-landmark-arms-treaty/2018/10/19/f0bb8531-e7ce-4a34-b7ba-558f8b068dc5_story.html?noredirect=on&utm_term=.4d4ffd595242

[2] https://www.al-monitor.com/pulse/originals/2018/10/turkey-gulf-rapprochement-with-kuwait-may-cause-tension.html

[3] For example, see: Weekly Geopolitical Reports, Moving Fast and Breaking Things: Mohammad bin Salman, Part I (11/20/17); Part II (12/4/17) and Part III (12/11/17).

[4] See Weekly Geopolitical Report, Saudi Succession (1/20/15).

[5] https://www.ft.com/content/848c8f7e-d3e1-11e8-a9f2-7574db66bcd5

[6] https://www.reuters.com/article/us-italy-euro-poll/polls-show-most-italians-want-to-stay-in-euro-idUSKCN1IW0MT

[7] https://www.ft.com/content/9b324788-d4b2-11e8-ab8e-6be0dcf18713

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Global equities are mixed this morning due to concerns about a possible stand-off between the EU and Rome along with slower than expected GDP growth in China.  Here are the stories we are following today:

Italy budget: In a rebuke to Rome, the European Commission (EC) presented the Italian government with a letter stating its budget was in breach of EU budget rules.  The EC’s comments suggest it will likely take the unprecedented step of rejecting the budget proposal.  The Italian government was given until Monday to issue an official response.  Concerns of escalating tensions between Rome and the EU are likely overblown as Italy has suggested it is unwilling to entertain discussions of an EU exit.  Following the report, 10-year Italian bond yields rose about 20 bps and then saw a slight retreat.

 

Chinese economy: Chinese officials were forced to offer reassurances to financial markets after the GDP report showed the economy has slowed more than expected.  In response to the GDP report, Vice Premier Liu He stated that the impact of the trade war with the U.S. is more psychological than actual and that the two countries plan to meet during the G20 summit.  Nevertheless, the National Bureau of Statistics of China warned that the economy could experience “greater downward pressure” in the future.  In response, Chinese regulators stated the Chinese government is willing to facilitate private equity investments, speed up merger approvals and support bond prices.  Chinese equity markets rebounded as a result of the news of additional government support.

Gibraltar agreement: In a rare win for UK Prime Minister Theresa May, the UK was able to broker a deal with Spain regarding Gibraltar.  Although the details of the arrangement have not been released, the deal is believed to alleviate worries of ongoing disputes between the two nations following Brexit.  Gibraltar, which was ceded to Britain under the 1713 Treaty of Utrecht, has been a source of tension between the two countries as both believe they have ownership over the sovereign territory.  Following the UK’s decision to exit the EU, tensions over Gibraltar escalated when the former Spanish foreign minister, Jose Manuel Garcia-Margallo, vowed to plant the Spanish flag in the territory after the Brexit vote and a former Conservative party leader, Michael Howard, claimed PM May was willing to go to war over the region.  With this agreement in hand, PM May still needs to find a reasonable solution for the North Ireland border, which has proven to be a sticking point in Brexit negotiations.

WTO dispute: The U.S. has requested the World Trade Organization’s dispute panel to review the legality of retaliatory trade tariffs imposed by China, Mexico, Canada and the EU.  Earlier in the year, China, Mexico and Canada filed a suit questioning the legality of the U.S.-imposed steel and aluminum tariffs.  Although the WTO does not have any enforcement powers, disputes regarding tariffs will likely test the agency’s ability to mediate rising trade concerns.  The U.S. has called out the organization for not doing enough to address growing trade imbalances.  If the WTO’s decision is unfavorable to the U.S., we expect it to withdraw from the organization.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Good morning!  Equities fell and Treasury yields rose due to the hawkish tone of the Fed minutes.  There was not a lot of overnight news but below are the stories we are following today:

EU trade truce on the rocks: The truce between the U.S. and the EU appears to be in jeopardy as negotiators trade barbs in the press, accusing each other of stalling the negotiation process.  At the heart of the dispute is the trade truce, also known as the Trump- Junker deal, which lacks any concrete parameters.  The EU appears unwilling to begin negotiations without assurances that there will be no retaliation in the event of a stalemate.  The U.S. seems reluctant to grant those assurances, likely due to fears that it could undermine its leverage.  It appears that the Trump administration has been using a series of bilateral agreements with its allies to apply more pressure on China in trade negotiations, in much the same way TPP was intended.  That being said, President Trump’s harsh criticism of allied nations, specifically, has created an environment of mistrust, which could explain why countries are hesitant to engage in trade negotiations.  Nevertheless, we expect the impasse between the U.S. and Europe to end somewhat soon given that recent trade agreements with Korea, Canada and Mexico were relatively non-controversial; hence, the EU agreement will likely follow suit.  We continue to monitor this situation.

FOMC minutes: The Fed minutes, released on Wednesday, support the case for future rate hikes.  Although there were some concerns regarding rising trade tensions and strain in emerging market economies, the FOMC believes the U.S. economy is moving in the right direction.  At the same time, members of the FOMC have expressed willingness to raise rates past the neutral rate, which is a rate that is neither accommodate nor constrains the economy, in order to address financial imbalances and to contain future inflation.  This point of view runs counter to the views of the president, who believes the Fed should consider the impact that higher rates will have on the economy.  The president responded to the minutes by calling Fed Chairman Jerome Powell a weak link.  At this point, it is unclear how high the Fed is willing to raise rates but current projections suggest a neutral rate around 3.0%.  The president’s pugnacious response could be a concern as it seems he is starting to view the Fed as an adversary.  Although Powell seems unbothered by the criticism, that position could change if the president releases the bully pulpit.

Energy recap: U.S. crude oil inventories rose 6.5 mb compared to market expectations of a 1.6 mb build.  Refinery utilization was unchanged at 88.8% and oil production fell by 0.3 mbpd to 10.9 mbpd.  Exports rose 0.1 mbpd, while imports fell by 0.2 mbpd.  The rise in stockpiles was mostly due to 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.

The build up in inventories led to a drop in the price of Brent and WTI crude oil.  Rising tensions between the U.S. and Saudi Arabia, as well as the impending U.S. sanctions on Iran, have led to supply pessimism.  As a result, rising shale production is becoming important in maintaining oil price stability.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Markets are mixed this morning as strong earnings led to a surge in tech stocks but weaker earnings from automakers due to rising costs are likely weighing on investors.  Here are the stories we are following today:

Mueller to release key findings: Special Counsel Robert Mueller is expected to release a report providing an update on the Russia investigation after the November midterms.  In the report, Mueller is expected to discuss whether there is evidence of collusion between Russia and President Trump during the 2016 election, as well as whether the president was guilty of obstruction of justice following the firing of former FBI Director James Comey.  President Trump has claimed the investigation to be illegitimate and has been pushing for its conclusion or, at minimum, a limit in its scope.  The president’s legal team is currently mulling over whether to provide a written response to questions provided by Mueller as the president may not be willing to sit for a face-to-face interview.  Although the consequence of this report will likely depend on the outcome of the mid-term elections, the worst-case scenario would be a report suggesting there is evidence that President Trump is guilty of either allegation mentioned.  If the Democrats were to win a majority in both houses they will be pressured to push for impeachment, which would likely weigh on U.S. equities.  That being said, we believe a Democratic win in the Senate is unlikely.

President Trump’s Middle East dilemma: The president continues to face pressure to take a tougher stance against Saudi Arabia following the suspected killing of journalist Jamal Khashoggi.  On Tuesday, President Trump came to the defense of Saudi Crown Prince Mohammad Bin Salman (MBS) after members of his party refused to accept the Saudis’ claim that rogue agents were responsible for the killing.  In an interview with the Associated Press, President Trump compared allegations that MBS had knowledge of the murder to the sexual assault allegations Brett Kavanaugh faced earlier this month.  The president’s willingness to protect the crown prince is likely related to his desire to not backtrack on Iranian sanctions.  If the president wants to follow through on his plan to implement more sanctions on Iran, he will need Saudi Arabia’s help in offsetting the loss in oil supply.

Chinese debt bubble? Rising debt levels in China have sparked concerns of a possible infrastructure bubble developing within the region.[1]  According to an S&P report, local Chinese governments may have accumulated ¥40 trillion ($6 trillion) worth of hidden debt that is not reflected in official figures.  Although China has been pushing for more credit restrictions throughout the country, it appears rising trade tensions with the U.S. have led to lax enforcement of those restrictions.  The report suggests the local governments may have turned to local government financing vehicles (LGFV) to bypass restrictions in an attempt to stimulate regional growth.  This method allows the local governments to use land rights as collateral for loans; as a result, the credit-worthiness of the bonds are backed by land sales.  Furthermore, the relationship between debt and land values has encouraged local governments to build more infrastructure within their respective regions regardless of whether there is sufficient demand to support it.  The report is concerning because it suggests that financial markets may be more fragile than previously thought and also calls into question the CPC’s ability to stimulate growth throughout China amidst rising trade tensions with the U.S.  We will continue to monitor this situation.

U.S.-UK Brexit deal: UK Prime Minister Theresa May is facing growing pressure to secure a deal with the EU in order to start negotiations with other sovereign countries.  The UK’s bid to stay in the public procurement alliance has been stalled and is expected to lose access to the group following its exit from the European Union.  Although the WTO is likely to come to a provisional agreement following Britain’s exit, the suspense will still be a burden for PM May as she struggles to seal a Brexit agreement.  Meanwhile, the Trump administration has informed Congress that it would like to negotiate a new bilateral agreement with the UK following its departure from the EU, but the UK is forbidden to negotiate bilateral agreements while it is still part of the single-market.  The longer it takes PM May to secure a deal, the harder it will be for her to create smooth transitions following departure.

Trump attacks the Fed: President Trump has gone on the offensive against the Federal Reserve, claiming it is the biggest threat to the U.S. economy.  Over the past few weeks, the president has taken to Twitter and the press to attack the Fed’s decision to tighten monetary policy.  The market currently anticipates a fourth rate hike in December following strong economic growth, rising inflation and a tightening labor market.  The Fed minutes released later today will likely provide more insight into what the Fed might do in December.  That said, any perception that the Fed is prioritizing the president’s opinion on economic data will likely hurt the Fed’s credibility, which is important to its ability to anchor inflation expectations.[2]

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[1] https://www.ft.com/content/adabd0ae-d0f3-11e8-a9f2-7574db66bcd5

[2] For further discussion on politicizing the Fed, see our most recent Asset Allocation Weekly published 10/12/18 (also found on p. 6 of this report).

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Equities have rebounded this morning due to expectations of strong earnings, and Treasury yields are also trending upward as it appears tensions are easing with Saudi Arabia and China.  Below are the stories we will be following throughout the day:

Khashoggi death: On Monday, CNN reported that Saudi Arabia was preparing to backtrack on claims that it had nothing to do with Khashoggi’s disappearance.  According to the report, the kingdom is willing to admit that Khashoggi was killed by rogue agents looking to interrogate him, echoing a claim from President Trump earlier that day.[1]  If this report were true, the statement would allow for a bit of face-saving by all three parties involved—Saudi Arabia, the U.S. and Turkey.  Saudi Arabia would avoid condemnation from the West, the U.S. would not feel pressure to punish Saudi Arabia and the Turkish government would not be perceived as weak for backing down from Saudi Arabia.  Prior to this report, Saudi Arabia faced backlash from businesses in the form of withdrawals from its flag-post convention nicknamed “Davos in the Desert.”  Meanwhile, the U.S. and Turkish economies could be strained if Saudi Arabia decides to lower its oil production in response to being reprimanded for the suspected killing.  At the moment, it is unclear whether the president will take action in the event that Saudi Arabia publicly admits Khashoggi died in its custody, although it is rumored that Treasury Secretary Mnunchin may soon withdraw from the summit.  Oil prices fell in response to a possible de-escalation of tensions with Saudi Arabia.

Chinese de-escalation: It appears the U.S. may be softening its tone with China prior to the G20 summit, where the two sides are expected to meet.  A currency report to be released by the Treasury Department is expected to contradict the president’s claim that China is a currency manipulator.  In addition, Defense Secretary Mattis contradicted claims that the U.S. is trying to contain China.  That being said, we do not believe either assertion made by the Treasury Department or the defense secretary is a genuine reflection of the beliefs of the president or members of his administration.  Secretary Mattis was reportedly on a plane to Southeast Asia when he made the comments; the trip to Southeast Asia is widely perceived as the U.S. cozying up to countries within the region to counter China’s military assertiveness in the South China Sea.  We do believe the softer rhetoric could serve as an olive branch but we would not be surprised if the tone switches days prior to or on the day of the summit.  President Trump has been known to stir up controversy prior to trade meetings to keep his opponents off balance and create a more favorable negotiating environment for his team.  We will continue to monitor the situation.

Italian budget:  The Italian government was able to submit its budget to the EU prior to Monday’s midnight deadline.  It now awaits approval from the European Commission.  If the deal is approved, which many have speculated that it won’t be, it would ease worries of a possible clash between Italian populists and the EU.  A more likely scenario would be that the budget is rejected due to Italy breaking its commitment to reduce its deficit, at which point the EU and Italy would be at a standoff.  There have been fears that a hawkish response from Brussels could embolden populists to push for a Eurozone exit, but those concerns were calmed after Italian Deputy Prime Minister Luigi Di Maio ruled out the possibility.  Yields on Italian 10-year bonds have fallen following the budget submission, suggesting the market expects a reasonable compromise between the EU and Rome.  The two sides are due to meet on Thursday.

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[1] https://www.reuters.com/article/us-saudi-politics-dissident-report/saudi-arabia-preparing-to-admit-khashoggi-was-killed-cnn-idUSKCN1MP2DD

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] The equity sell-off has returned as U.S. tensions with Saudi Arabia and China escalated over the weekend.  Growing concerns of market uncertainty have led to a rise in oil prices, gold and Treasuries, as well as a drop in the dollar.  Below are the stories we will be following throughout the day:

Saudi Arabia hits back: Saudi Arabia responded to threats from President Trump by vowing to strike back if any actions are taken against the kingdom.  Over the weekend, the president suggested there will be consequences for Saudi Arabia if it was responsible for the suspected killing of Washington Post journalist Jamal Khashoggi.  In response to the allegations, businesses have begun to distance themselves from the kingdom by withdrawing from the Saudi conference nicknamed “Davos in the Desert,” with the most notable withdrawals being Ford Motor (F, $8.64) Chairman Bill Ford and JP Morgan (JPM, $106.95) Chief Executive Jamie Dimon.  Equity markets in Saudi Arabia also took a hit.  As mentioned last week, in the event of escalating tensions between the U.S. and Saudi Arabia we expect the kingdom to reduce oil production in an attempt to raise oil prices.  Although the U.S. could use some of its strategic supplies to offset some of the reduction in production, it will likely do little to change the world price of oil.  Therefore, we expect global equities to suffer as a result of tit-for-tat responses between the U.S. and Saudi Arabia.

Pastor Brunson’s return: On Friday, Turkey released Pastor Andrew Brunson who was detained on terrorism charges following the failed coup in 2016.  Pastor Brunson’s release will likely lead to a de-escalation of tensions between Turkey and the U.S.  Earlier this year, the Trump administration imposed sanctions on Turkey to pressure the country to release Pastor Brunson with no conditions attached.  Although there have been rumors of Pastor Brunson’s release being linked to President Trump’s decision to take a tougher stance against Saudi Arabia, the Trump administration has denied any such deal.  As a result of Pastor Brunson’s release the Turkish lira strengthened against the dollar due to the possibility of a lift in U.S. sanctions.

Another round of tariffs: On Sunday, President Trump threatened to impose another round of tariffs on Chinese goods on the grounds that it has interfered with American elections.  The president appears to be alluding to a newspaper ad in Iowa designed to sway voters in the midterm elections.  Although this does seem like an unorthodox reason for implementing new tariffs, the president may have broad protections under the “Trading with the Enemy Act of 1917” if he decides to follow through on this threat.  This law is meant to be enacted during times of war, but the U.S. involvement in Syria may be enough justification.  China’s decision to aid Iran in avoiding U.S. sanctions could be interpreted as an act to aid an enemy of the state.  While there isn’t direct conflict between the U.S. and Iran within Syria, the two are strategic foes in the region.  That being said, if the president were to proceed down this route he will likely meet stiff opposition from Congress, especially from congressmen whose states will be impacted in the event of retaliation.  We do not expect there to be much criticism from members of the Republican Party until after the midterm elections as tariffs appear to be popular with their base.

Brexit deal in trouble: The prospect of an imminent Brexit deal seems to have hit a snag after UK Prime Minister Theresa May stated she is not ready to agree to the deal in its currents state. This shift comes two days after a report suggesting PM May told her inner cabinet that a potential deal was close.  It appears that backlash from members of the Tory party and coalition partners DUP could have swayed her position over the weekend.  On Friday, the DUP categorically ruled out supporting the deal in its current state after reports suggested Northern Ireland would be treated differently from other members of the United Kingdom.  It is becoming increasingly clear that the UK parliament in its current form will not be able to agree to a Brexit deal prior to the March deadline.  The possibility of a UK exit from the EU without a deal will spark more uncertainty throughout the region; therefore, we wouldn’t be surprised if there is a push for snap elections before the end of the year.  Following the report, the pound weakened against the dollar.  We will continue to monitor this situation.

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