Last year, we introduced an indicator of the basic health of the economy and added it to the many charts we monitor to gauge market conditions. The indicator is constructed with commodity prices, initial claims and consumer confidence. The thesis behind this indicator is that these three components should offer a simple and clear picture of the economy; in other words, rising initial claims coupled with falling commodity prices and consumer confidence is a warning that a downturn may be imminent. The opposite condition should support further economic recovery. In this report, we will update the indicator with the July data.
This chart shows the results of the indicator and the S&P 500 since 1995. The updated chart shows that the economy is doing quite well. We have placed vertical lines at certain points when the indicator falls below zero. Although it works fairly well as a signal that equities are turning lower, there is a lag. In other words, by the time this indicator suggests the economy is in trouble, the recession is likely near or underway and the equity markets have already begun their decline.
To make the indicator more sensitive, we took the 18-month change and put the signal threshold at -1.0. This provides an earlier bearish signal and also eliminates the false positives that the zero threshold generates. Notwithstanding, we will pay close attention when the 18-month change approaches zero.
What does the indicator say now? The economy is healthy and currently supportive for equity markets, although the second chart does show that momentum is starting to slow, albeit from a very high level of activity. The second chart shows that the indicator is still comfortably above the point of concern. Thus, for now, there is no economic evidence to support a major correction; if one is to occur, it will mostly likely be generated by a geopolitical event.
[Posted: 9:30 AM EDT] Markets are down as investors are concerned that a possible collapse of the Turkish lira could spill over to the Eurozone. Here is what we are watching:
Economic warfare? Proposed U.S. sanctions on Turkey and Russia have caused the currencies in the respective countries to fall precipitously (see charts below). The sanctions are in response to a pastor being held on terrorist charges in Turkey and a Russian-sponsored nerve-agent attack earlier this year on a former Russian spy in Britain. Representatives of both governments have accused the U.S. of waging economic warfare against their countries and have vowed to respond. Although it is unclear how these countries will respond to the sanctions, it does appear their constituents support a strong response, therefore anything less would look like a sign of weakness.
(Source: Bloomberg)(Source: Bloomberg)
Both countries appear to be vulnerable to these sanctions. A bill dubbed as “the sanctions bill from hell” by one of its backers is currently making its way through Congress. If the bill passes it will limit Russian state-owned bank operations in the U.S. and limit the banks’ access to U.S. dollars; this action could suppress GDP growth. Turkey’s situation is much worse as its economy was already being hurt by inflation and a weakening Turkish lira prior to the sanctions. Due to Turkish President Recep Tayyip Erdogan’s unwillingness to impose austerity in order to combat inflationary pressures, his government has been dependent on short-term, dollar-denominated loans. As a result, sanctions that limit his government’s access to U.S. dollars could possibly lead to a collapse of its banking system. The next few days will be critical as neither country can afford to back down without receiving blowback from its citizens. Both leaders run authoritative democracies so their legitimacies are rooted in nationalism and therefore their popularity hinges on their ability to demonstrate strength domestically and abroad.
Space Force 2020: Yesterday, Vice President Mike Pence announced that the Pentagon will begin the process of establishing a Space Force as the sixth branch of the U.S. military by 2020. In order to establish Space Force, Pence has asked Congress to allocate $8 billion dollars over five years for the project. Despite Pence’s announcement, there is a bit of ambiguity as to what this space force will actually entail. Last month, U.S. Secretary of Defense James Mattis stated that Space Force will not attempt to weaponize space, but his comment runs counter to claims that Space Force would be established in order to counter Chinese and Russian technological advancement in anti-missile technology.
Economic capacity: This morning, the WSJ reported that suppliers are beginning to run out of parts to fill orders and deliveries have slowed as a result. This isn’t necessarily a bad sign in the economy as it suggests demand is still very strong, but it could also mean the U.S. is currently running at or above its economic potential. In order to make shipments, companies have been digesting higher costs. In the long run, this could be inflationary as companies will try to push some of those costs onto consumers. That being said, this development is consistent with the late-cycle boom and we have expected demand to settle as the stimulative effects of the tax cuts wane. We will continue to monitor this situation.
[Posted: 9:30 AM EDT] Markets are quiet this morning. Here is what we are watching:
Trade update: Russia is facing another round of sanctions,[1] these tied to the chemical weapons poisoning in April of British citizen and former Russian spy Sergei Skripal and his daughter. The sanctions are part of a specific U.S. law, the Chemical and Biological Weapons Control and Warfare Elimination Act. The act is designed to punish nations that use chemical and biological weapons; it essentially denies export licenses for dual-use technologies.[2] An interesting aspect of this law is that a second set of “draconian” sanctions will follow if Russia does not supply evidence that it is no longer using such weapons and does not allow on-site UN chemical weapons inspections within 90 days.[3]
Needless to say, Russia is furious about these new sanctions, although some of their effectiveness will be reduced if the EU doesn’t go along. Attaining unity among the EU nations for sanctions will be hard as the new Italian government has been quite friendly to Moscow and may not support action. Russian financial assets, especially the RUB, weakened on the news.
(Source: Bloomberg)
China announced it is retaliating[4] against the recent tariffs from the Trump administration on $16 bn of Chinese goods. Yesterday, we noted that Chinese officials were meeting for their annual meetings at the Beidaihe resort. We have been hearing increased rumblings of discontent with Chairman Xi. Although we don’t think his position is in doubt, it does appear the chairman is getting some criticism, with the focus being that he may have overplayed his hand with the U.S.[5]
Last month’s acclaimed meeting between President Trump and EC President Juncker did avert a trade war but the Europeans have indicated the promised trade talks won’t happen anytime soon. According to reports, EU negotiators need another six weeks to prepare. We suspect this is a stall tactic. The Europeans are likely hoping that the GOP will lose legislative power in the mid-term elections which will distract the president and lead to a reduction in trade pressure.
A comment on Tuesday’s election: Missouri voters overwhelming rejected a “right-to-work” proposal that was on the ballot. Right-to-work laws make “closed shops” illegal; in a closed shop, a worker doesn’t have to join the union but he must pay dues to the union as a condition of employment. In an open shop, a worker can choose to accept or reject union representation and he is not required to pay dues if he rejects joining. Unions argue that open shops encourage workers to “free ride” the union, getting the negotiated benefits without paying dues for representation. Open shop advocates argue that no one should be forced to join a group they may not agree with.
Initially, the Missouri legislature, dominated by the GOP, passed a right-to-work measure but labor groups were able to gather enough petition signatures to bring the issue to the voters. This lopsided win for labor in a deep red state is something of a surprise. But, to use our “identity and class” paradigm we discussed in a recent WGR,[6] it is quite likely that voters who would usually support Republicans were able to vote for their class interests on this specific issue, separate from their identity interests. It is likely these union GOP voters would probably still support a Republican candidate, even if that candidate espoused a right-to-work position, because they would perceive their identity interests are being met even if their class interests are not. Although this vote has raised some speculation that the labor rank and file might be moving back to the Democrats,[7] we doubt this is the case. Identity interests are very strong. What will be interesting to watch in the coming years is if the GOP begins to support labor-friendly policies to adapt to this part of the electorate and reject the business-friendly element of its constituency (the recent blow-up with the Kochs comes to mind).
Turkey and China: Turkey’s energy minister announced that China will build a nuclear power plant northwest of Istanbul.[8] This news comes on the heels of comments from China’s ambassador to Syria, along with its military attaché, that China is open to the possibility of Chinese military operations in Syria to support the government.[9] It appears that China’s interest is in preventing the Turkistan Islamic Party from training Uighur militants that operate in China’s far west Uighur province. Although there has been no confirmation of China sending any military personnel, the comment itself is striking and further evidence that other nations are looking to fill the power vacuum created by the slow withdrawal of American influence.
Meanwhile, the U.S. and Turkey have been unable to resolve their differences on U.S. citizens being held in detention. The TRY continues to probe new lows on the lack of progress.
(Source: Bloomberg)
Is a key support for Treasuries on the way out? As part of the recent tax law, corporations have been granted a temporary tax break. Companies can deduct their payments to pensions but the cut in the highest marginal rate, from 35% to 21%, reduces the value of those payments on a post-tax basis. However, the tax law allows payments to pensions to be deducted at the old 35% rate until September 15. Reports suggest firms have been aggressively taking advantage of this measure and buying long-dated Treasuries for their pension funds. That may be part of the reason why longer dated Treasuries have performed well in recent months and could rally further as firms rush to take advantage of this loophole. However, there is the potential for a rate back-up after mid-September when the measure expires.[10] We would argue that the impact of this measure may be overstated, that continued low inflation and low inflation expectations are still more important to yields, but a back-up in yields next month might occur simply based on sentiment.
Energy recap: U.S. crude oil inventories fell 1.4 mb compared to market expectations of a 3.0 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. This week’s decrease in inventories was a bit less than expected as oil exports did not rise as much as anticipated. We do note that U.S. production declined 0.1 mbpd to 10.5 mbpd.
As the seasonal chart below shows, inventories are well into the seasonal withdrawal period. This week’s decline in stocks was consistent with seasonal patterns. If the usual seasonal pattern plays out, mid-September inventories will be 401 mb.
(Source: DOE, CIM)
Based on inventories alone, oil prices are near the fair value price of $71.14. Meanwhile, the EUR/WTI model generates a fair value of $59.18. Together (which is a more sound methodology), fair value is $63.14, meaning that current prices are above fair value. Currently, the oil market is dealing with divergent fundamental factors. Falling oil inventories are fundamentally bullish but the stronger dollar is a bearish factor. It should be noted that a 401 mb number by September would put the oil inventory/WTI model in the low $80s per barrel. Although dollar strength could dampen that price action, oil prices should remain elevated.
[Posted: 9:30 AM EDT] Today’s trade is becalmed—there is nothing major happening in any markets thus far. This sort of activity is very typical for August. Here is what we are watching today.
Trade news: The U.S. announced that $16 bn of Chinese imports will face an additional 25% tariff.[1] The tariffs are scheduled to take effect on August 23. There was no direct reaction from China.
China: The reason there was no direct response from China may be due to the fact that the leadership of the CPC is holding its annual meetings at the Beidaihe resort.[2] The meetings are usually held annually under strict secrecy. Dubbed an “unofficial retreat,” the attendees, which often include former general secretaries, have an opportunity to meet informally and discuss policy. It has been noted that Chairman Xi hasn’t been seen on the news for a few days, suggesting he may have gone to the resort in the first couple days of August. Xi is expected to meet with Malaysian President Mahathir in mid-August, so the leadership may be on holiday for another week or so.
The KSA vs. Canada: The recent spat between Canada and Saudi Arabia has raised one interesting issue. Western colleges and universities have enjoyed an influx of foreign students. Often, these students are wealthy and are thus a rare breed on many campuses—a student paying the full advertised tuition.[3] Although the data is less than complete, the latest data available shows 900k+ foreign students are in the U.S. out of around 20 mm total. Here is what the top 10 destinations look like:
Saudi Arabia has told its students in Canada that they should plan on leaving and going to school elsewhere.
There are three issues to consider with regard to the KSA’s action. First, universities are designed to permit free and full expression of ideas. That characteristic has been coming under fire from numerous fronts and brought a rather famous response from the University of Chicago.[4] However, if universities, fearful of losing the lucrative foreign student “inflows,” begin to temper their criticism of foreign policy actions by non-democratic nations, the concept of the university itself comes into question. Second, for some colleges and universities, the foreign flows may be the difference between continuing operations and insolvency. The number of colleges and universities in the U.S. is already in decline.[5] Losing foreign students would exacerbate this trend. Finally, foreign students have been a “stealth” way to foster capital flight. Sending “junior” to study in the U.S. and buying a house or condo for him to live in while at school has become a convenient way to build an escape pod in the West. A drop in foreign students could be a negative factor in college town real estate.
Will the concerns of higher education affect foreign policy? It likely depends on the country but it wouldn’t be surprising, especially for smaller nations lacking other levers of influence. The KSA would probably not take these steps with the U.S. as the risks would be too great, but Canada is a different story.
[Posted: 9:30 AM EDT] We are seeing some risk-on behavior this morning; global equities are moving higher, the dollar is a bit weaker, precious metals are stronger and Treasury rates are rising. Here is what we are watching today.
Primaries today: The media will be mostly focused on primaries being held in numerous states. There will be lots of commentary on who wins. The prediction markets are currently putting the odds of Democratic Party control of the House at 65%.[1] The same market puts the odds of the Senate remaining with the GOP at 74%,[2] meaning a divided government is the most likely outcome in November. That outcome would indicate no meaningful legislation will be passed in the second half of the president’s term.
The twilight of Abenomics? There is growing evidence that the BOJ is giving up on pushing inflation higher, concluding that the costs of policy to the financial system are outweighing the benefits.[3] In fact, according to Reuters,[4] the BOJ considered raising rates twice over the past year. On a parity basis, the JPY is deeply undervalued; fair value, based on relative inflation rates, is around ¥58/$. Japan’s ultimate problem is oversaving in the corporate sector. There is little investment opportunity in Japan but the political system is holding onto the same policies that led to the Japanese miracle—suppressing household consumption, building domestic saving in the corporate sector and using that saving for investment. When the investment isn’t there, the country has to either (a) run offsetting fiscal deficits, or (b) run current account surpluses. Of course, ending the policy would make the most sense as giving more money to the household sector to lift consumption would do wonders for Japan…as it would for China.
Iranian sanctions: The first round of sanctions is now in place. The EU is making brave sounds about refusing to cooperate but the trade-off between having access to the U.S. financial system or doing business with Iran will clearly favor the U.S. China, on the other hand, will likely not cooperate. We expect China to continue to do business with Iran and buy its oil even when the next round of sanctions, which specifically affects oil exports, goes into effect in November. We are starting to see countries trading with Iran to conduct business in countertrade, which is an international economics concept similar to bartering.[5] Instead of paying for goods in dollars, nations trade goods for goods. During the Cold War, firms in Europe and the U.S. would sometimes trade with Eastern Bloc nations using countertrade. Although possible, bartering is a less efficient way of doing business for two reasons. First, it isn’t always possible to find goods that meet reciprocal needs. Second, it is harder to make intertemporal decisions, something that money makes easier. We would also expect China to offer to buy Iranian oil with CNY; this, of course, will limit Iran’s choices for reserve purposes. There are fewer Chinese financial assets to purchase and Iran will be mostly forced to buy Chinese goods. The other major problem is insurance. Most of the marine insurance is provided by Western firms who will probably abide by sanctions. Thus, buyers of Iranian crude oil may not be able to insure the cargos, which will almost certainly curtail sales.
There are reports that Iranians are hoarding gold, a normal response given the recent weakness in the Iranian rial.[6] As is often the case, the poor in Iran are being hurt the most. The less fortunate tend to spend more of their income on necessities, which are rising in price.[7] For now, although we are seeing increasing unrest, the regime appears in control. But, pressures are rising.
Turkey: Turkish 10-year sovereigns rose over 20% overnight, although yields did ease later in the day. Here is a chart of yields for this debt over the past five years.
(Source: Bloomberg)
The Turkish lira remains under pressure as well.
(Source: Bloomberg)
It is possible that if the U.S. and Turkey come to some sort of agreement to ease tensions, Turkish assets may enjoy a short recovery. However, underlying problems of high inflation and the lack of political will to adopt austerity will prevent a sustainable lift in Turkish assets.
Sweden buys Patriots: Sweden announced last week that it will buy a $1.0 bn Patriot missile system from the U.S.[8] Sweden is not an official member of NATO but does have close ties to the alliance. Growing concerns about Russian aggression have prompted the country to consider the anti-ballistic missile system as its current systems cannot stop a ballistic missile attack. As the U.S. pulls back from defending Europe and Russian aggression increases, European nations face the need to defend themselves. This is an example of that situation.
The U.K.:Trade Secretary Liam Fox warned over the weekend that the likelihood of a no-deal Brexit is increasing, mostly due to the “intransigence” of EU negotiators.[9] Fox puts the odds at 60/40 favoring a no-deal severing of ties. A no-deal Brexit would likely be quite bearish for the GBP.
Last week, we introduced the topic of the Trump administration’s decision to implement sanctions on Iran and covered two potential responses from Iran, which were restarting its nuclear program and projecting power. This week, we will discuss the threat to the Strait of Hormuz.
Response #3: Closing the Strait of Hormuz
On its face, it seems somewhat illogical for Iran to close the Strait of Hormuz to oil traffic because it would not only prevent the Gulf States and Iraq from exporting oil, but it would prevent Iran from doing so as well. As a result, we believe that Iran would only take this step if sanctions were so effective as to nearly end Iranian oil exports. Thus, Iran would have to be in dire “straits” before taking this step.
The world has several recognized oil flow “chokepoints” where there is the potential for a disruption of oil flows.
(Source: EIA)
As the global superpower, one responsibility of the U.S. is to secure the world’s sea lanes to support global trade. As this map shows, there are numerous points where oil trade could be affected by blockades. In terms of volume, the two most critical are the Strait of Hormuz, through which about 18.5 mbpd and products pass, and the Strait of Malacca, which sees about 16.0 mbpd of energy traffic. Much of the oil, refined product and LNG produced in the Middle East passes through the Strait of Hormuz. Energy destined for the Far East moves through the Strait of Malacca, while flows to the Western Hemisphere and Europe either pass through the Suez Canal and the SUMED pipeline or the Cape of Good Hope.[1] Disruptions to the latter group would tend to have more severe regional effects, whereas disruption to the Strait of Hormuz would affect global energy supplies.
[1] We note that Houthi rebels apparently recently threatened a Saudi oil tanker in the Red Sea at the Bab el-Mandab chokepoint: https://www.ft.com/content/f0858962-9005-11e8-b639-7680cedcc421; we don’t view this threat to be as significant as actions in the Strait of Hormuz, but if Iran were able to threaten both chokepoints it would have a much more substantial impact on prices. For now, we are assuming this attack was a “one-off” and not part of a campaign to stop Red Sea shipping.
[Posted: 9:30 AM EDT] Markets are rather quiet this morning, a reflection of the “dog days” of summer. However, there was a lot of news over the weekend. Let’s dig in:
Trade talks: China indicated it is preparing for a protracted trade war.[1] In a new turn, Chinese state media pointedly blamed President Trump for the trade war and indicated it won’t back down.[2] This comes after the president tweeted a thread where he suggested that tariffs are working.[3] As we have noted before, there are really no winners in a trade war but prevailing in a trade war is more about how much pain one can accept. China appears to be betting that an authoritarian system can bear a greater burden than a democracy. This belief is common among authoritarian supporters because democracies can be so divided. However, those divisions have historically melted away when an external threat refocuses the electorate. In addition, it might be a mistake to overestimate the CPC’s ability to rally the population to suffer through a trade war. Although authoritarian regimes appear to outsiders as monoliths of stability, history shows they can collapse with frightening speed.[4] We note a recent report in the FT[5] suggesting that Xi may be cracking under the strain as evidence that China may not be able to resist U.S. pressure to the degree as expected. The PBOC reinstated a 20% reserve requirement on yuan forwards,[6] effectively boosting the price of shorting the currency. Although this action did stabilize the currency, the act itself shows a growing degree of concern. China knows that depreciation will reduce the impact of U.S. tariffs. However, a rapid decline in the CNY will also trigger capital flight and increase financial market risk. After all, when a nation engages in policies to prevent a currency from weakening, it is a clear signal that it believes the currency will weaken further in the absence of such measures. Such moves are perhaps justifiable if one believes the pressures are short-term in nature. But, if the pressures are structural, the actions won’t work.
A drone attack: Over the weekend there was an assassination attempt against Venezuelan President Maduro via drone strike.[7] The optics of the attack were not favorable.[8] As the drone flew over a military parade where Maduro was reviewing the troops and making a speech, the soldiers on parade scattered and the generals surrounding Maduro looked to be protecting themselves first. Although Venezuela blamed foreigners, it appears the attack came from dissident elements in the Venezuelan military.
Saudi Arabia: The dominating news report is a diplomatic spat between Canada and the Kingdom of Saudi Arabia (KSA). The Canadian foreign minister called for the release of dissident women’s rights activists who are being detained. The KSA reacted strongly, expelling Canada’s ambassador and freezing trade.[9] This appears to be a rather strong reaction to a normal complaint and perhaps is a reflection of the inexperience of the crown prince. Oil prices jumped on reports that Saudi oil output unexpectedly declined.[10] It is unclear what caused the shortfall but it does raise questions about the KSA’s ability to boost oil production and is bullish for oil prices. Additionally, there are reports that the KSA, with U.S. support, paid elements of al Qaeda to vacate areas[11] in Yemen. This looks to us like the Houthis are the focus of the war in Yemen. Al Qaeda has generally supported the Houthis even though they are regarded as Shiite; the Saudis likely believe that this support isn’t deep and are therefore trying to exploit the division. Of course, history shows that making deals with al Qaeda is fraught with risk. After all, al Qaeda was an element of the jihadist resistance to the Soviets in Afghanistan. Although the jihadists were instrumental in defeating the communists there, al Qaeda was behind the attacks on 9/11. There are reports that the KSA was considering an invasion of Qatar in 2017. According to these reports, then SoS Tillerson opposed the invasion and the KSA and the UAE joined efforts to get Tillerson removed.[12]
Iran: The first phase of sanctions against Iran go into effect today,[13] although there does appear to be less unity compared to earlier sanctions efforts.[14] We note that Iran held war games last week in the Persian Gulf and simulated a “swarming” attack.[15] However, we are hearing reports suggesting there are backchannel talks going on between Iran and the U.S.[16] It would not shock us if President Trump wants another summit meeting similar to the North Korean event. It has been well documented that North Korea is still working on missiles and nuclear weapons so even a summit meeting might not change conditions very much. But, Iran should be willing to engage in talks if for nothing more than to delay further sanctions until the November mid-terms with the hope that the GOP loses its grip on Congress and the president is subjected to constant investigations by the House. In reality, the U.S. doesn’t want a hot war in Iran. It’s not clear what the objectives would be and there is no guarantee that regime change would actually improve anything.
Germany:We are noting two developments. First, Germany is considering bringing back what is effectively a draft, although it would allow for some to perform national service instead of a stint in the military.[17] However, of greater concern is that Germany is also pondering whether it needs its own nuclear deterrent.[18] One of the key elements of American foreign policy has been increasingly forgotten—NATO was more about the U.S. providing security for Western Europe because the Europeans couldn’t get along and had triggered two world wars. Although American presidents have consistently asked for more defense spending from Europe, in reality, they never wanted too much because the Europeans may not listen to U.S. policy directives if they had formidable militaries. However, due to intergenerational forgetfulness,[19] the U.S. appears to be promoting the rearming of Europe. That just doesn’t seem like a good idea.
At the end of June, we published a study of how the equity and bond markets reacted to the inversion of the yield curve. This week’s report takes that inversion data and compares it to how the 10 sectors of the S&P 500 perform.[1] For this report, we will use the two-year/10-year Treasury spread as our yield curve variation; although this alternative has a shorter history than the fed funds/10-year Treasury spread, data on the 10 sectors we will analyze begins in 1988. Thus, the two-year/10-year Treasury spread will offer enough history to analyze the behavior of the sectors.
For reference, this is the two-year/10-year Treasury spread.
The gray bars show recession and the red vertical lines are placed where the yield curve inverts. On average, it takes 15-months from inversion to recession, with the range being 10 to 18 months.
The sector data only covers the last three recessions. We have taken each inversion and index the 10 sectors to the inversion, tracking the data one year before the inversion and two years after. The chart below averages the three events.
We have placed vertical lines at the point of inversion at one year and two years from inversion. As we noted earlier, the overall S&P 500 tends to avoid an outright decline until the recession starts. The best sectors are Health Care, Consumer Staples and Energy. Materials and Industrials tend to hold up. The worst performing sectors are Technology, Telecom and Financials, although Financials performed rather well in the 2000 inversion. Thus, there are no huge surprises here. Health Care and Consumer Staples are defensive sectors. In all three cases, oil prices were rising into the inversions and thus supported energy equities. The 2000 inversion and subsequent recession also ushered in a major decline in Technology and Telecom and these sectors were generally weak during the other two events. Finance fell hard in the 1989 and 2006 inversions.
This tells us that when the next inversion occurs, investors should consider positions in Health Care, Consumer Staples and Energy, with underweights in Technology and Telecom. Obviously, each cycle has its own unique characteristics, but history does offer some insight into potential market behavior.
[Posted: 9:30 AM EDT] Happy Beer Day![1] Also, it’s employment data day. We detail the data below but the quick take is that the data is a bit better than expected but not so strong as to change policy. Financial markets are treating the report with some caution, mostly due to the weaker headline data on payrolls; initially, equities fell modestly on the news, the dollar retreated and bonds held mostly steady. Here is what we are watching today.
Trade update: China has announced a series of retaliation acts against the U.S., a $60 bn list of goods for tariffs. We have seen some pullback in equity markets on the news, although the impact was rather modest. Meanwhile, talks with Mexico are showing signs of improvement and Canada appears poised to join the negotiations. For now, trade hostilities are focused on China.[2]
Mileage standards: The Trump administration took action yesterday to roll back Obama-era mileage standards for autos.[3] The new standard will be held at 2020 levels, which is around 37 mpg for fleets. Obama’s original plan was for fleet standards to reach 54.5 mpg by 2025. Perhaps even more important is the goal of ending California’s dominance in setting environmental rules by ending the state’s authority to establish its own auto emissions standards. That will allow the auto industry to focus on a 50-state regulatory environment and no longer be forced to adjust to the actions of a single, but very important, state in terms of auto demand.
On its face, this is a major win for the automakers and oil companies. For automakers, it will free them from difficult to achieve standards and allow them to sell cars Americans seem to prefer, which are larger SUVs and light trucks. For the oil industry, the Obama mileage standards were part of a two-part nightmare. Not only did the standards mean that gasoline consumption per vehicle was poised to decline but, in addition, the industry is dealing with a major trend change in miles driven.
The chart on the left shows total annual miles driven by autos and light trucks. We have put gray bars during periods when that month is below the previous peak. As the chart shows, most of the time, until 2008, we made new highs each month. The chart on the right shows the level of miles driven per year relative to trend. As the lower line shows, we fell below trend during the financial crisis and have not returned to trend.
The reason for the continued stagnation in miles driven is complicated. The slow development of household formation among the 19-35 age cohort likely plays a role. The advent of social media likely affects the trend as well (one no longer has to “cruise” the local burger joint or go to the mall to meet up with friends). We may have reached “peak sprawl,” ending the ever-expanding commutes that bolstered the upward trend. There is little evidence that we are returning to trend anytime soon, so the oil industry is being forced to cope with a loss of demand that will be hard to offset. Consequently, the change in mileage standards has to be welcome news for the oil industry because the miles driven trend coupled with increased efficiency is a clear path to weaker consumption.
Losers with this news are the electric car sector, copper and lithium and public transportation projects. There will be a tendency for households to lean toward gasoline powered vehicles, which are usually less expensive.
However, there is an important underlying issue that this event highlights. Put oneself into the position of a vehicle manufacturer. If the Obama-era rules were to remain in place, about the only way to reach those standards would be through increased hybridization. Building hybrid cars and introducing new generations of larger, battery powered electric motors, along with a plug-in capability, was the likely path forward. And, doing research to expand and improve hybridization would be reasonable as well. Now that the standards have changed, does the industry now stop that process?
There is a risk to doing so and it has to do with how government works now. The Cold War consensus led to mostly steady policies in regulation. That isn’t to say policies never changed, but change was usually legislated, making it “sticky,” and was maintained by the subsequent administrations with modest tweaks. But, in our current age of discord, policy is often made by executive order. Even when legislation passes, much of the actual rule-making is still done by regulatory bodies. Thus, the next executive can simply reverse the previous policy by either changing it or not enforcing earlier rules. If a populist left-wing government takes power in 2020 or 2024, these mileage rules could revert back to the Obama-era rules or perhaps become even stricter. If an auto company abandons hybridization research, it could find itself at a horrible disadvantage of not being able to meet the new standards.
This age of discord means that the potential for policy “whipsaw” increases and forces companies to gamble on where future regulation will go. In addition, it increases the stakes in elections, making them more “life and death,” and thus encourages not only more lobbying efforts but also election interference.
Although the media will focus on what just passed, investors and companies have to look beyond the present and estimate how likely it is that policy will change in the future. That means forecasting political outcomes as well as the path of development and future consumer demand. It will be interesting to see how automakers react to this change.
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