by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Although it was a quiet weekend, we have had a busy morning.  Here is what we are watching:

Iran: There was media sniping this morning, which appears to have started in Iran.  First, President Rouhani of Iran warned the U.S. not to escalate tensions with his country, suggesting that a confrontation would lead to the “mother of all wars.”  He also indicated that the U.S. could not stop Iran from exporting its oil.[1]  This statement is, obviously, incorrect.  Although Iran has often threatened to shut down the Strait of Hormuz, which is perhaps the most important oil shipping chokepoint in the world, the U.S. could actually close off Iranian shipping and exports through financial sanctions and the U.S. Navy’s ability to implement a blockade.  President Trump reacted through social media, sending out an all-caps response late last night.

To Iranian President Rouhani: NEVER, EVER THREATEN THE UNITED STATES AGAIN OR YOU WILL SUFFER CONSEQUENCES THE LIKES OF WHICH FEW THROUGHOUT HISTORY HAVE EVER SUFFERED BEFORE. WE ARE NO LONGER A COUNTRY THAT WILL STAND FOR YOUR DEMENTED WORDS OF VIOLENCE & DEATH. BE CAUTIOUS![2]

This escalation appears to have been prompted by comments from SoS Pompeo, who described Iran’s leaders as the “mafia” and promised to back Iranians unhappy with their government.[3]  Pompeo reiterated the U.S. goal of lowering Iran’s exports to “as close to zero as possible” by November 4.  While it is obvious this administration is taking a hostile line toward Iran, Pompeo’s comments about supporting anti-government elements in Iran are probably a mistake.   There has been rising unrest in Iran due to the deteriorating economy.  But, the elements opposing the mullahs in Iran may not necessarily be pro-U.S.  By indicating the U.S. would aid such groups, they are immediately tainted as not being loyal to Iran.  This is a mistake that is common for Western governments; regime change may not necessarily make conditions better or empower a new, Western-friendly government.

The comments appear to have lifted oil prices.  However, prices are also higher on reports that some North Sea oil platforms have been hit with a 24-hour strike.[4]

Change at the BOJ?  We did see a jump in Japan’s 10-year government yields overnight on fears of tightening monetary policy.  The Bank of Japan continues to struggle with policy.  The central bank continues to see inflation below its 2% target with little evidence it’s rising.

This chart shows Japan’s core CPI (y/y% change).  Although we did see a jump in 2014, that was due to a hike in consumption taxes.  Currently, the inflation rate is zero.   At the same time, zero interest rates are distorting the economy and undermining how the financial system functions.  What does the BOJ need to do?  The best outcome it could achieve would be to steepen the yield curve, which would help the financial system.  Currently, the BOJ pegs the 10-year rate at zero.  There is talk that it may allow the 10-year rate to become more volatile, but the risk to this policy is that it further confirms the low inflation policy and lifts the JPY.  The central bank meets next week; we suspect these “leaks” are really trial balloons, and the market’s reaction thus far (rising 10-year yields and a stronger JPY) will support the doves on the board to leave policy unchanged.

Trade: Trade issues continue unabated.  SoT Mnuchin was at the G-20 over the weekend in Argentina.  By all accounts, not much changed.  The Trump administration continues to press for bilateral trade agreements and the rest of the world doesn’t want anything to change.[5]  Mnuchin added to the president’s recent currency comments about foreign nations depreciating their currencies for trade advantage.[6]  It should be remembered that Mnuchin made weak dollar comments at Davos earlier this year.  On Wednesday, the president of the EU Commission, Jean-Claude Juncker, will meet with President Trump in a bid to forestall auto tariffs.[7]  We would not be surprised to see some sort of deal on autos; it appears President Trump is rather isolated even within his own administration on this issue.[8]  However, we do offer one note of warning: U.S. light trucks enjoy 25% tariffs which date back to the Johnson administration (the “chicken tax”[9]).  If that gets negotiated away, it would likely be a major negative factor for U.S. automakers.

Q2 GDP: The latest reading from the Atlanta FRB’s continuous forecast for GDP is suggesting a robust quarter.

The current estimate is for a 4.5% quarter.  In looking at the contributions to growth, consumption, net exports and inventories account for about 3.3% of that growth.  Government spending is adding 57 bps.  New investment is the remainder.  Such growth bolsters the Fed’s case for higher interest rates.

AMLO—let’s make a deal!  The president-elect of Mexico penned a letter[10] to President Trump indicating he is ready to “start a new stage of U.S.-Mexico relations” and wants to conclude the renegotiation of NAFTA.  Although there have been worries about deteriorating relations due to AMLO’s nationalist stance, it does appear he is trying to work with the U.S.  If the Trump administration responds positively, it could be supportive for Mexican financial markets.

Meat Mountain:[11]Although macroeconomic theory highlights the inflationary impact of trade impediments, the reality is somewhat more complicated.  Yes, the combination of higher import prices and the loss of efficiencies that come from trade is inflationary.  However, there is the short-run effect that exporters, whose markets become closed in retaliation, find themselves sitting on rising inventories.  Eventually, these inventories are worked off and production is cut to adapt to lower demand.  However, this can lead to “fire sale” prices during the adjustment process.  It appears U.S. exports of meats are facing trade impediments and inventories are rising.  This will eventually lead to lower meat prices in the U.S. (although this is dependent upon the competitive structure of the grocery and restaurant markets; some of this price decline could show up as better margins in those industries).  Declining meat prices, while not as important to consumer confidence as energy, could be a popular event as we head into the mid-term elections.

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[1] https://www.aljazeera.com/news/2018/07/play-lion-tail-rouhani-warns-trump-180722162909627.html

[2] https://www.ft.com/content/14e607ac-8e29-11e8-b639-7680cedcc421?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[3] https://uk.reuters.com/article/uk-usa-iran-pompeo/pompeo-assails-irans-leaders-compares-them-to-mafia-idUKKBN1KD04E?il=0&utm_source=POLITICO.EU&utm_campaign=5a3b984308-EMAIL_CAMPAIGN_2018_07_23_04_38&utm_medium=email&utm_term=0_10959edeb5-5a3b984308-190334489

[4] https://www.reuters.com/article/us-total-strike-north-sea/totals-north-sea-oil-platforms-hit-by-24-hour-strike-idUSKBN1KD144

[5] https://www.ft.com/content/cbe1f2e2-8dc3-11e8-bb8f-a6a2f7bca546?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[6] https://www.ft.com/content/97105928-8db4-11e8-b639-7680cedcc421?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[7] https://www.ft.com/content/7fe120f0-8d8e-11e8-b639-7680cedcc421?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[8] https://www.politico.com/story/2018/07/22/trump-foreign-car-tariffs-juncker-735555

[9] https://en.wikipedia.org/wiki/Chicken_tax

[10] https://www.wsj.com/articles/in-letter-to-trump-mexicos-president-elect-seeks-common-path-1532285296

[11] https://www.wsj.com/articles/meat-piles-up-as-production-grows-and-exports-slow-1532268000

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] There is a lot going on.  Let’s dig in:

The president speaks: For the most part, President Trump has been opposed to a weak dollar.  At Davos this year, Treasury Secretary Mnuchin suggested a weaker dollar might be in U.S. interests if the goal was a narrower trade deficit.  President Trump publicly criticized Mnuchin’s comment, suggesting the dollar should be strong.  For many Americans, currency markets are something of a mystery.  Unlike consumers of other countries, Americans are mostly insulated from dealing with exchange rates.  We note that President Reagan was supportive of a strong dollar until it reached a level that became unsustainable.  In response, at the Plaza Hotel in NYC the G-5 adopted the “Plaza Accord,” which was a multi-lateral policy shift to deliberately weaken the dollar.

We may be seeing a shift.  This morning, on social media, President Trump openly criticized the EU and China for currency manipulation.  The dollar has plunged on the news, while gold and other commodities are higher.[1]  Although it’s difficult to know for sure, this development could be quite significant.  Tariffs, by themselves, are dollar bullish as they reduce the supply of dollars on world markets (see this week’s Asset Allocation Weekly below).  But, if the president has figured out that foreign nations are allowing their currencies to depreciate in order to offset tariffs, and he begins to jawbone the dollar lower, we will likely see a declining dollar.  It should be remembered that the dollar is overvalued by most valuation metrics, so an official weak dollar position could find a path of little resistance.

But wait…there’s more!  However, this isn’t the only thing the president has said over the past 24 hours.  He also indicated he is ready to slap $505 bn of new tariffs on China.[2]  We note that the National Economic Council’s director Larry Kudlow has noted there are no talks with China.  There is a school of thought that China may be concluding that the GOP will lose the House in November.  If that’s the case, President Trump will find himself dealing with everlasting investigations and thus will be less able to prosecute a trade war.  We note that the prediction markets are projecting a change in control for the House.

If China has taken this position, then it would make sense for the Chinese to simply stall until November and then see U.S. trade policy moderate due to distractions at the White House.  Of course, the administration can do this calculation as well and may try to force an agreement.  Although it is still not clear whether this is really China’s policy, it makes sense to us and thus we would not be surprised to see mostly silence from Beijing.

Trump and the Fed: As noted above, the dollar has been strong this year.  As we noted in this week’s Asset Allocation Weekly (see below), one of the factors boosting the greenback is the potential for a trade war.  Rising tariffs, in theory, are bullish for the dollar because they act as a constraint on dollar supply.  U.S. monetary policy is another factor that has supported the dollar.  The Fed has been steadily raising rates when the rest of the world has mostly been holding to accommodative monetary policy.

One of the factors we have been monitoring is the White House’s position on monetary policy. Earlier this year, Larry Kudlow, the director of the National Economic Council, hinted that the Fed shouldn’t raise rates due to fiscal stimulus because the tax cuts would boost investment and thus add to productive capacity.  Although that point is debatable (as we noted in last week’s AAW, it appears the tax cuts may be going to stock buybacks), the bigger issue was the interference in monetary policy.  During Bill Clinton’s presidency, Robert Rubin, who became his treasury secretary, convinced the administration to avoid commenting or criticizing the conduct of monetary policy.  The idea was that if the White House allowed the Fed to run policy and bring down inflation, the decline in long-term interest rates would be the best stimulus the economy could receive.  Since then, the unwritten rule has been that administrations leave the Fed alone.  And, for the most part, they have.  Despite what you are seeing in the media,[3] prior to Rubin’s directive, administrations often commented on, or overtly tried to sway, monetary policy.[4]  In the footnote below, we cite Mallaby’s biography of Alan Greenspan.  This history shows that presidents not only tried to manipulate monetary policy, but Greenspan himself likely participated in a scheme to undermine Chair Arthur Burns to force him to conduct an inappropriately accommodative policy during the Nixon years.  Rubin’s argument was that Fed independence would yield a better outcome than giving the impression that politicians were guiding policy.  In other words, Fed independence would lead to lower inflation expectations and a better long-term economy.

In a CNBC interview[5] and in a “hailstorm” of tweets this morning,[6] President Trump has become increasingly critical of the Fed’s tightening policy.  Although this action is clearly a divergence from policy of the past two decades, as we note above, it isn’t at all unprecedented.  One of the hallmarks of President Trump is his desire to overturn precedent.

To some extent, we have been expecting the president to become critical of the Fed.  It is important to remember that the Fed wasn’t always “independent.”  Until 1951, the Fed acted as the funding arm of the Treasury.  That is partly how the government funded the war effort with almost no rise in interest rates; the Fed simply expanded its balance sheet, absorbing the government’s borrowing.  William Martin negotiated an “accord” with the White House and Congress in 1951 which gave the Fed independence from the Treasury.  However, there is nothing written on stone tablets that says a central bank must be independent.  In fact, central bank independence is really more a function of inflation policy.  If the goal is low inflation, central bank independence is a good idea.  If a nation wants to reflate, preventing the central bank from thwarting that goal is also appropriate.  If populism is really about reflation, reducing Fed independence is likely going to occur.  We may be seeing a move in that direction.

Bottom line: We have policies that are divergent.  On the one hand, tariffs are dollar bullish.  On the other, jawboning for a weaker dollar and threatening Fed independence could be significantly dollar bearish.  We note that any move to undermine Fed independence will also increase the risk of rising inflation expectations, which would play havoc on the bond market.  So, risks are rising.

Italy again:The populist coalition is threatening to oust Italy’s finance minister, Giovanni Tria, over Tria’s nominations for the state lending bank, CDP.  Tria is considered an establishment figure and his appointment led to stabilization of the Italian bond market.  We note that this news led the Italian 10-year rate to jump from 2.50% to 2.58%.

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[1] https://www.bloomberg.com/news/articles/2018-07-20/trump-says-china-eu-have-been-manipulating-their-currencies-jjtzde52?cmpid=socialflow-twitter-business&utm_campaign=socialflow-organic&utm_source=twitter&utm_content=business&utm_medium=social

[2] https://www.cnbc.com/2018/07/19/trump-says-hes-ready-to-put-tariffs-on-all-505-billion-of-chinese-.html

[3] https://www.cnbc.com/2018/07/19/trumps-fed-criticism-is-nearly-without-precedent-in-us-history.html

[4] https://twitter.com/jimtankersley/status/1020111873923043328. Also see: Mallaby, Sebastian. (2016). The Man Who Knew: The Life and Times of Alan Greenspan. New York, NY: Penguin Books. [NB: we have reviewed this book on our Reading List]

[5] https://www.cnbc.com/2018/07/19/watch-president-trump-full-interview-with-cnbc.html

[6] https://www.cnbc.com/2018/07/20/trump-hits-the-fed-again-in-tweet-tightening-now-hurts-all-that-we-h.html

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Global equity markets are lower this morning.  The EuroStoxx 50 is down 0.3% from the last close.  In Asia, the MSCI Asia Apex 50 was down 0.2% from the prior close.  Chinese markets were down, with the Shanghai composite down 0.5% and the Shenzhen index down 0.8%.  U.S. equity index futures are signaling a lower open.  With 55 companies having reported, the S&P 500 Q2 earnings are above expectations at $39.31 compared to the $39.20 forecast for the quarter.  The forecast reflects a 19.9% increase from Q2 2017 earnings.  Thus far this quarter, 92.7% of the companies reported earnings above forecast, while 3.6% reported earnings below forecast.

We are in the back half of the week!  Everything is down this morning except the dollar.  Here is what we are watching:

Brexit thoughts:  Yesterday’s vote in the House of Commons actually suggests a rather interesting informal coalition may be evolving.  As we noted yesterday, PM May avoided a no-confidence vote by gathering enough Remain supporters among the Tories and by finding a few Labor MPs to support her as well; the Labor defectors also support either a soft Brexit or staying in the EU.  The Labor MPs could have easily forced a no-confidence vote and new elections where the Labor Party would have a good chance of winning control of Parliament.  However, that is not necessarily a favored outcome if one is a “Blairite” Labor MP, which is essentially an establishment center-left politician.  In other words, pushing for elections that lead to Jeremy Corbyn becoming prime minister is probably not an attractive outcome.  Thus, we may be seeing an informal grouping of Blairite Labor MPs joining Tory Remainers to keep Theresa May in office.  If our theory is correct, May will remain as PM and there will be a soft Brexit.  That would be a bullish outcome for the GBP.

Trade talk:  The G-20 Finance Ministers meet this weekend.  Discussions are expected to focus on trade.  The Commerce Department is holding a day-long hearing today on auto tariffs.  There are 45 witnesses scheduled; only one, Jennifer Kelly of the UAW, is expected to be supportive of auto tariffs.  Companies are uniformly opposed to tariffs as automobile production has become increasingly globalized.  Later this month, EU President Jean-Claude Juncker is expected to visit Washington, and there are hopes he will bring some tariff concessions on European tariffs.[1]  Even trade hawks in the Trump administration see the auto tariffs as misguided and would like to see some modest concessions offered that would allow the president to declare victory[2].  The administration is apparently investigating the uranium market to see if U.S. miners are being unfairly affected; if so, we could see tariffs implemented on that commodity[3].  Meanwhile, NEC’s Larry Kudlow blamed Chairman Xi for the lack of movement on Chinese/U.S. trade negotiations.[4]  The Chinese suggest otherwise.[5]  The bottom line is that there are no talks occurring between the two nations.  As we note in the next segment, China appears to be using the currency as a weapon.

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[1] Actually, the history of light-truck tariffs, where the U.S. imposes a 25% tariff on imported light trucks, is fascinating.  Here is a like to the background:  https://en.wikipedia.org/wiki/Chicken_tax

[2] https://www.politico.com/newsletters/morning-money

[3] https://www.ft.com/content/f23cc632-8ac2-11e8-b18d-0181731a0340?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[4] https://www.bloomberg.com/news/articles/2018-07-18/trump-economic-aide-blames-china-s-xi-for-stalling-trade-deal

[5] https://www.reuters.com/article/us-usa-trade-china/china-says-u-s-blaming-xi-for-blocking-trade-deal-is-bogus-idUSKBN1K90UF

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Equity markets are quiet this morning; the biggest market moves are in currencies and commodities.  The dollar is up this morning in the aftermath of the Powell testimony, which is dragging commodities and emerging markets lower.  Here is what we are watching:

Google fined: Google (GOOG, 1198. 80) was hit with the largest fine ever levied by the EU, at €4.3 bn.  EU regulators accused the company of anti-competitive behavior in the distribution of its operating system.  This action is important on a macro level because government regulation may be the only threat to the market dominance of the major tech firms.  We do expect the company to appeal the decision but we would not expect the EU to reverse this verdict.

The Powell testimony: Although the testimony generally went according to script, there were two takeaways from the discussion that we see as important.  First, Powell continues to stress that the economy is robust and that economic strength justifies tighter policy.  Focusing on economic strength should inoculate the Fed from criticism from the White House.  Of course, any modest weakness might trigger a strong push from the White House for rate cuts.  Second, Powell signaled that the quarterly cycle of rate hikes will be ending at some point.  Powell appears uncomfortable with the notion of forward guidance and wants to inject some degree of uncertainty into monetary policy.  We agree with this position.  The move to holding press conferences after every meeting next year will give the Fed more flexibility to raise rates faster if necessary.  At the same time, it can introduce the potential for pauses in tightening as well.  We note that the implied three-month LIBOR rate from the two-year deferred Eurodollar futures did not change after the testimony; it still signals a terminal fed funds rate of 3% in two years.

May survives (again): U.K. PM Theresa May is becoming the Houdini of politics; this morning, she survived a vote[1] against the hard Brexit wing of the Tories by the pro-EU wing of her party.  The hard Brexit group appeared to be pushing May into a complete exit position which is opposed by a large group of her party.  The pro-EU faction forced a vote that could have brought down the government.  But, in the end, a group of Labour MPs[2] voted with the pro-EU Tories and so May lives on another day.

Putin:A Russian aircraft carrying President Putin violated Estonian airspace[3] yesterday, passing through the NATO nation without clearance.  This is a clear provocation after the recent events in Helsinki.

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[1] https://www.ft.com/content/30f3900e-89c4-11e8-b18d-0181731a0340?emailId=5b4ecafa59397d0004ab9281&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[2] https://www.ft.com/content/e8b1c98e-89df-11e8-bf9e-8771d5404543?emailId=5b4ecafa59397d0004ab9281&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[3] https://www.nytimes.com/2018/07/17/world/europe/putin-summit-plane-estonia.html?emc=edit_mbe_20180718&nl=morning-briefing-europe&nlid=567726720180718&te=1

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Tonight’s midsummer classic, the All-Star Game, is really the official midpoint of summer.  Markets are quiet this morning.  Here is what we are watching:

Did the president go too far?  Criticism of President Trump’s performance at the press conference with Russian President Vladimir Putin was widespread.  Even Fox News, which is generally supportive of the White House, was remarkably critical.[1]  Our primary concern is always the impact of actions on the financial markets.  It’s too early for any reliable polling to tell us much and there was no significant movement in the prediction markets, either.  The history of populism does show that sometimes populist leaders, mostly due to inexperience, can overshoot their support.  If Trump’s approval wanes, it might not necessarily be bearish for financial markets because it may slow the trade conflict.  For now, we are treating yesterday’s Russia event as an item to watch.  However, we must say that the breadth of condemnation was rare.

Powell to the Hill: Chair Powell goes to the Senate this morning for his semiannual testimony on monetary policy.  Below we discuss a couple of charts worth noting.

First, we have updated our Mankiw model with four variations.  The Mankiw rule models attempt to determine the neutral rate for fed funds, which is a rate that is neither accommodative nor stimulative.  Mankiw’s model is a variation of the Taylor Rule.  The latter measures the neutral rate using core CPI and the difference between GDP and potential GDP, which is an estimate of slack in the economy.  Potential GDP cannot be directly observed, only estimated.  To overcome this problem, Mankiw used the unemployment rate as a proxy for economic slack.  We have created four versions of the rule, one that follows the original construction by using the unemployment rate as a measure of slack, a second using the employment/population ratio, a third using involuntary part-time workers as a percentage of the total labor force and a fourth using yearly wage growth for non-supervisory workers.

Using the unemployment rate, the neutral rate is now 4.02%, down from 4.14%, reflecting the rise in the unemployment rate.  Using the employment/population ratio, the neutral rate is 1.84%, up modestly from May’s 1.81%.  Using involuntary part-time employment, the neutral rate is 3.68%, up from the last calculation of 3.50%.  Using wage growth for non-supervisory workers, the neutral rate is 2.42%, roughly unchanged from the last report of 2.48%.  June’s employment data was mostly in line with May’s so the neutral rate calculations didn’t change a lot.  The only variation that is policy neutral is the one using the employment/population ratio.  Thus, given that the majority of the FOMC still holds to some sort of Phillips Curve model for monetary policy, the bias should be for additional rate hikes.

The second chart is our estimate of what the financial markets have discounted in terms of tightening.  The chart below compares the fed funds target to the implied three-month LIBOR rate, two-years deferred, which comes from the Eurodollar futures market.  Historically, the FOMC tends to tighten until the implied LIBOR rate equals the fed funds target.  In fact, when the target overshoots the implied rate, the odds of recession increase.  Currently, the implied LIBOR rate is near 3.00%, suggesting the Fed has four more hikes to go.  Clearly, the financial market’s estimate of the terminal rate is well below what the dots plot or the majority of the Mankiw rule estimates suggest for the terminal rates.  If the FOMC continues on its expected path, meaning two more hikes this year and perhaps more in 2019, the odds of recession will begin to rise.

We are already hearing discordant voices from the FOMC.  Minneapolis FRB President Kashkari[2] (not a current voter) is calling for a pause, citing the rapid narrowing of the yield curve.  We don’t expect anything from Powell other than “steady as she goes,” but concerns about monetary policy will likely rise by year’s end.

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[1] https://talkingpointsmemo.com/livewire/fox-news-host-calls-trump-presser-performance-disgusting-wrong?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosam&stream=top and https://www.thedailybeast.com/several-fox-news-hosts-bash-trumps-disgusting-putin-presser/?via=twitter_page&utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosam&stream=top and https://twitter.com/IngrahamAngle/status/1018996752064634880?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosam&stream=top

[2] https://www.reuters.com/article/us-usa-fed-kashkari/feds-kashkari-citing-yield-curve-wants-rate-hike-pause-idUSKBN1K62EE

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy Monday!  The media is focused on the Trump/Putin meetings in Helsinki but financial markets are mostly ignoring the spectacle.  The biggest major market move is in oil, which we discuss below.  Here is what we are watching this morning:

China GDP: China’s Q2 GDP[1] rose 6.7% from last year, down from 6.8% in Q1.  In related news, industrial production rose 6.0% from last year compared to expectations of 6.5%.  Although China’s economy remains healthy, there is some slowing which has weighed on emerging markets.

Here’s the contribution to growth:

Although China continues to run a large trade surplus with the U.S., it is actually seeing negative net exports in the GDP data.  This would suggest that China has a bilateral issue with the U.S. but, unlike Germany, China’s overall dependence on exports has lessened over the years.

This chart shows China’s net exports as a percentage of GDP.  The data is only available on an annual basis but it would not be surprising to see this number in “the red” for 2018 given the current net exports.  China, like most successful developing nations in the postwar world, has used export promotion for development.  That explains why China’s net exports jumped above 2.5% after 1995 and reached nearly 8% in 2007.  Recent data would suggest that China is attempting to restructure its economy but the country is still dependent on the U.S. to absorb its excess output.  That’s why the trade war is a major threat to its economy.

Oil weakness: Last week’s U.S. inventory data showed a massive decline in stockpiles, putting us on a path toward high $80s for WTI by Labor Day.  But, prices are slumping this morning.  There are two reasons cited for the decline.  First, Saudi Arabia is offering additional supplies to Asia.[2]  Second, the U.S. and other Western nations are considering SPR releases if oil prices continue to rise.[3]  We suspect President Trump is worried that high gasoline prices will hurt his party’s chances in the November midterms.  Currently, gasoline prices are elevated but not yet at a level that would be considered critical.

This chart shows the average hourly wage for non-supervisory workers compared to the national average for retail gasoline prices.  Currently, the average worker needs to work an hour to buy 7.6 gallons of gasoline.  The long-term average is 8.5 gallons per hour, so the price is “hurting” but it’s not at a level where it would be considered a serious problem.  As a general rule, we pay attention when this ratio dips under 7.0 gallons for each working hour.

This news offsets two potentially bullish items.  First, there was significant unrest in the Basra region of Iraq over the weekend.  The protests appear local; anger over the lack of jobs and poor public services appear to be the driving force behind the anger.  But, this region accounts for 80% of Iraq’s oil reserves and 3.2 mbpd of exports.   Despite being local in nature, we would not be surprised to see Iranian operatives try to fan the unrest in a bid to restrict Iraqi exports and lift oil prices.  Second, the U.S. refused to grant any waivers to European firms doing business in Iran.[4]  This means that sanctions will weaken Iranian oil sales.  Iran is trying to send its oil to Asia[5] but, as we noted above, Saudi Arabia is doing the same thing.

The production shortfalls in Libya and Venezuela, the sanctions on Iran and the unrest in Iraq are all bullish factors for oil prices.  Even if Saudi Arabia responds by lifting output, the risk is that OPEC is rapidly depleting its excess reserves.  This means the world is approaching the “vertical” part of the global supply curve, which can result in large price spikes.  The SPR is designed to offset such events.  However, it’s been years since the SPR was “fired in anger”; one would have to go back to the First Gulf War and, even then, the drawdown was small (and was eventually unnecessary).  The risk to using the SPR is that it doesn’t work as planned and the oil can’t be tapped as quickly as the “specs” suggest.  If that becomes evident, there is no backstop and prices could move higher.  In reality, the SPR is probably a better threat than it is a real protector against supply disruption.

Bitcoin worries: Last week, the Mueller investigation indicted a number of Russians involved in an attempt to sway the U.S. presidential election.  One little detail caught our attention.  Apparently, some of the conspirators used bitcoin to pay for their nefarious actions.  Given the anonymous nature of cryptocurrencies, we would expect a crackdown to emerge from nation states as they discover the usefulness of cryptocurrencies for illegal activities.  

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[1] https://www.ft.com/content/f17e67e4-8646-11e8-96dd-fa565ec55929?emailId=5b4c1d124cf1530004fccd78&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[2] https://www.bloomberg.com/news/articles/2018-07-16/saudis-said-to-offer-extra-oil-in-asia-as-opec-leader-pumps-more

[3] https://www.wsj.com/articles/u-s-and-allies-consider-possible-oil-reserve-release-1531509351

[4] https://www.ft.com/content/6a16440a-8837-11e8-bf9e-8771d5404543

[5] https://www.ft.com/content/e54129b4-85cc-11e8-96dd-fa565ec55929?emailId=5b4c1d124cf1530004fccd78&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22