by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s employment day!  We cover the data in detail below but the quick read is bullish.  The key data point was a huge jump in the labor force, which increased 601k after falling 382k over the past three months.  Thus, even with a rise in payrolls, the unemployment rate rose due to the increase in the labor force.  The data is bullish for financial assets because it suggests there is remaining slack in the economy.  Perhaps today is the day historians will mark as the beginning of the Great Trade War as the U.S. and China implemented tariffs against each other.

A note on our comment—we update the U.S. petroleum weekly data on Thursday but, this week, the numbers were delayed until yesterday due to the Independence Day holiday.  Because of the length of the recap and our coverage of the employment report, we will delay our energy recap until Monday’s comment.  Here is what we are watching:

Trade wars: The $34 bn[1] of tariffs on China were implemented at midnight EDT.[2]  China has undertaken similar measures.  In 10 days, another $16 bn of tariffs will be added.  And, President Trump upped the ante by suggesting he could apply tariffs to more than $500 bn in flow, essentially everything China exports to the U.S.[3]  China is blaming the U.S. for the “war,”[4] which will only infuriate Trump, who holds the position that the U.S. is merely correcting what has been an unfair situation.  We have talked about the trade conflict at length in recent weeks but one thing we want to reiterate is that winning a trade war is not about how much pain a nation can inflict on another but how much pain a nation can absorb.  Note the difference between Europe and China.  As we noted yesterday, the EU, at German urging, is considering ending tariffs on imported automobiles, something they would not have done without U.S. pressure.  This suggests to us that the EU is simply not prepared to take the pain associated with a drop in car production.  Consequently, they are suing for peace.  On the other hand, China appears to be digging in for a long, protracted trade war.[5]  The Chinese media is framing the trade war as the West’s attempt to contain China’s rise.  In other words, Chairman Xi is planning on using nationalism to “steel”[6] his citizens for absorbing the pain by making the trade war more like a real war.  Xi has often referred to the “century of humiliation” that began with the First Opium War in 1842.  The Opium War narrative is that the Chinese failed to rally behind the emperor in 1842 and foreigners defeated and “carved up” the country and it could happen again if China fails to rally behind Chairman Xi.

In some respects, the timing of this trade war is unfortunate for China.  The country is trying to deleverage while maintaining growth and the usual way to do this is to export one’s way out.  The trade war will likely close that avenue of maintaining growth.  At the same time, now Xi can blame any slowdown on Trump and can therefore use a slowdown to take the necessary steps to contain debt growth.  In any case, China isn’t planning on backing down and our take is that the White House doesn’t think it can lose.  Strictly speaking, we can’t.  China has much more to lose because it runs a trade surplus with the U.S.  However, a trade war will inflict pain and Americans will be less likely to rally around Trump when the economy begins to stumble because of trade disruptions.  Thus, if winning a trade war is dependent upon the willingness to accept pain, China may be in a better position than generally expected.

The Fed: The Fed minutes were released yesterday and they had a little something for everyone.  The Fed intends to stay on its tightening path, although it did acknowledge the risk coming from the aforementioned trade war.  Interestingly enough, Fed economists didn’t view the uncertainty surrounding GDP, unemployment and inflation to be different than the past two decades.  We view this position as strikingly naïve.  Market reaction to the employment data suggests a dovish response from the FOMC.  This reaction is probably not warranted; after all, it’s only one month’s data in a notoriously volatile series.  But, the key takeaway from the minutes is that the Fed is not altering its course.[7]

Brexit: PM May is meeting with her cabinet today[8] with the goal of establishing a unified vision of the economic and trading relationship the U.K. will have with the EU after Brexit.  There is the potential for a breakup; watch for resignations.  If some of her cabinet members quit, a leadership challenge is likely and there is a chance the government will fall.  May has remained in office by weaving a perilous path between a hard and soft Brexit but, in the end, she leans toward the latter.[9]  Elections could bring a Corbyn-led Labour government which would likely be profoundly bearish for U.K. financial assets.

Trump to Europe: The president travels to Europe next week and he blasted the Europeans at a rally in Helena, MT last night, which may be a forewarning of what his talks will be like.[10]  The president is also meeting with President Putin,[11] which has raised fears not only with the U.S. establishment but also with European leaders.  If the U.S. abandons NATO, the Europeans will be forced to defend themselves against the Russians.

Oil: A couple of quick notes and a reminder that we will recap the weekly data on Monday.  First, there are growing doubts that the Saudis will ever introduce the Saudi Aramco IPO.[12]  The key sticking point appears to be the scrutiny that going public would bring to the Kingdom of Saudi Arabia (KSA).  Saudi Aramco is essentially the funding arm of the KSA.  When outside investors see how much profit is taken by the royal family, it would not only tell the Saudis where the money is going, but it would undermine the valuation of the stock.  If the IPO isn’t going to happen, the Saudis will have less incentive to keep prices high and may decide to boost production and capacity to (a) take advantage of high prices, and (b) eventually undermine the shale revolution.  Second, South Korea has suspended Iranian oil loading for this month, the first time since 2012, suggesting that U.S. sanctions are beginning to affect Iranian oil sales.[13]

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[1] https://www.ft.com/content/5c5b66a8-80a6-11e8-bc55-50daf11b720d?emailId=5b3ef34663ab2e00040aceba&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22 and https://www.nytimes.com/2018/07/05/business/china-us-trade-war-trump-tariffs.html?emc=edit_mbe_20180706&nl=morning-briefing-europe&nlid=567726720180706&te=1

[2] https://www.ft.com/content/bd99c39c-8024-11e8-bc55-50daf11b720d?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[3] https://www.cnbc.com/2018/07/05/trump-says-us-will-impose-16-billion-in-additional-tariffs-on-china-i.html

[4] https://www.reuters.com/article/us-usa-trade-china/china-state-media-slams-trumps-gang-of-hoodlums-as-tariffs-loom-idUSKBN1JW07L?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosam&stream=top

[5] https://www.wsj.com/articles/u-s-china-prepare-for-trade-battle-1530824054?mod=hp_lead_pos1

[6] See what I did there?

[7] https://www.wsj.com/articles/fed-expects-to-keep-raising-rates-ending-years-of-stimulus-1530813720

[8] https://www.ft.com/content/4e844a06-7f96-11e8-bc55-50daf11b720d?desktop=true&segmentId=7c8f09b9-9b61-4fbb-9430-9208a9e233c8#myft:notification:daily-email:content

[9] https://www.ft.com/content/36eafa08-804e-11e8-8e67-1e1a0846c475?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56 and https://www.ft.com/content/44fbf0e6-8041-11e8-8e67-1e1a0846c475?emailId=5b3ef34663ab2e00040aceba&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[10] https://www.axios.com/trump-nato-nightmare-defense-spending-europe-germany-74d2d010-e32a-40b2-8e71-920601f0e9a0.html

[11] https://www.nytimes.com/2018/07/05/world/europe/trump-putin-summit-election-meddling.html?emc=edit_mbe_20180706&nl=morning-briefing-europe&nlid=567726720180706&te=1

[12] https://www.wsj.com/articles/doubts-grow-aramco-ipo-will-ever-happen-1530813982

[13] https://af.reuters.com/article/energyOilNews/idAFS6N1R4016

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Welcome back!  Here is what we are watching this morning:

On trade, it’s good news and bad news:  The good news first…German automakers met with Richard Grenell, the U.S. Ambassador to Germany, and reaffirmed their support for zero tariffs on EU/U.S. auto trade.[1]  The German automakers also indicated they would maintain their investments in the U.S. if tariff increases were averted.   The EU, as expected, is following Germany’s lead.[2]  This change in Europe’s stance does suggest that U.S. pressure might lead to policy changes, which is the political establishment’s hope.  In light of U.S. trade pressure, China is wooing Europe to join an anti-U.S. alliance on trade.  Thankfully, so far, the EU sees the folly of China’s offer and has demurred.[3]  The news on auto trade has lifted risk assets this morning. Now, the bad news…at midnight, the U.S. is planning to implement tariffs on $34 bn of Chinese goods.  China is expected to retaliate in kind.[4]  At worst, the Chinese tariffs could be the opening salvo in a significant trade war.

Oil talk:  Over the holiday, President Trump reiterated his call for OPEC (read:  Saudi Arabia) to increase oil production in an effort to lower oil prices.  In fact, the tweet was blunt—we are paying for your defense so bring down gasoline prices.[5]  In reality, there isn’t a whole lot more OPEC can do to lower oil prices.  Falling production in Libya, Venezuela and Nigeria are curtailing supply.  The U.S. sanctions on Iran will simply exacerbate the problem.  The U.S. might be expected to fill the global gap and is working to do so.  But, pipeline constraints in west Texas are limiting the supply that can be made available for export.  That pipeline problem won’t be resolved for about a year.  The president correctly understands that rising gasoline prices will be unpopular with his populist base.  The key unknown is this—are the tweets simply jawboning, so even if prices stay high, voters will still credit him for trying to bring down prices?  Or, do voters really want lower prices or else?  If it’s the latter, the president may have only one tool left, which is an SPR release.  However, the risk is that if the SPR release fails to lower prices, there are no other policies available to lower prices in the short run.  In other words, the threat of an SPR release might be more powerful than the actual announcement.  After all, if the market believes that shortages do exist, adding oil from the SPR could very likely trigger hoarding, leading to a condition where inventories rise at the commercial level but prices rise as well.  For the most part, the greatest threat for higher oil prices is in the summer.  When demand falls after Labor Day, price pressures will likely ease.

Iran:  Iran has threatened to reduce its cooperation with the IAEA, the body that determines if Iran is meeting its obligations with the nuclear deal.[6]  Reducing cooperation would likely end the treaty because without inspections, the fear that Iran is secretly enriching uranium would undermine trust.  The commander of the al Quds Force of the Iranian Revolutionary Guard Corps, the infamous Qassem Solaimani, indicated that his nation would block the Strait of Hormuz if the U.S. stops Iranian oil sales.[7]   This is a serious threat; casual calculation suggests that about 30% of world oil exports pass through this chokepoint.  Most of the oil goes to the Far East.  The U.S. can prevent Iran from blocking the strait permanently, but it would involve military action.  It should be noted that Gulf producers, cognizant of this threat, have increased pipeline capacity to avoid the strait.  Still, a blockade, or a serious threat of one, will lead to oil hoarding and drive prices higher.

ECB:  Hawks on the ECB indicated today that interest rates may rise sooner than President Draghi suggested in the bank’s last meeting.  Although we doubt that the ECB will move rates higher anytime soon, the report has boosted the EUR this morning.

Novichok returns:  Two British citizens, Charlie Rowley and Dawn Sturgess, have reportedly been stricken by Novichok, the nerve agent used against a former Russia spy four months ago.[8]  It is possible that this poisoning was accidental; the couple had visited a botanical garden that the Russian spy and his daughter had visited during the previous attack.  It doesn’t appear that Rowley and Strugess are spies, so what this event may prove is that it is difficult to decontaminate an area after Novichok is used.

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[1] https://www.ft.com/content/77d1671c-7fa6-11e8-bc55-50daf11b720d

[2] https://www.ft.com/content/87bf0aa0-7ed2-11e8-8e67-1e1a0846c475

[3] https://www.reuters.com/article/us-usa-trade-china-eu-exclusive/exclusive-china-presses-europe-for-anti-us-alliance-on-trade-idUSKBN1JT1KT

[4] https://www.wsj.com/articles/u-s-will-shoot-itself-in-the-foot-if-it-pulls-the-tariff-trigger-china-says-1530767200

[5] https://www.ft.com/content/6168aae0-7fd2-11e8-8e67-1e1a0846c475

[6] https://www.reuters.com/article/us-iran-oil-sanctions/iran-threatens-to-cut-cooperation-with-nuclear-body-after-trump-move-idUSKBN1JU1E9

[7] https://gulfnews.com/news/mena/iran/iran-threatens-to-block-strait-of-hormuz-1.2246857

[8] https://www.nytimes.com/2018/07/04/world/europe/salisbury-poison-skripal-amesbury.html?emc=edit_mbe_20180705&nl=morning-briefing-europe&nlid=567726720180705&te=1

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] From all of us at Confluence Investment Management, have a safe and happy Independence Day!

The “dog days” of summer officially begin today.[1]  It looks like a risk-on day so far.  U.S. financial markets close early for the mid-week Independence Day holiday.  Equity markets close at 1:00 EDT and bond markets close one hour later.

A German deal: Chancellor Merkel and Interior Minister Seehofer reached a deal[2] on immigration yesterday, preventing a potential government collapse.  Germany will create transit centers on the German/Austrian frontier to collect asylum seekers from across the EU.  The plan is to give Germany the right to send those immigrants back to the nation where they first arrived.   Seehofer wanted to see asylum seekers immediately turned away from the border.  Merkel refused to endorse that plan, fearing it would end the Schengen rules which have created passport-free travel within the EU.  An end to Schengen would certainly undermine EU unity, which is already under stress.

Although this compromise was seen as a loss for Seehofer, Merkel has clearly backed away from her 2015 position of nearly open borders for refugees.  And, the reaction of other EU nations toward the German plan appears hostile.[3]  Austria announced it is considering measures to protect its southern border from immigrants.  Austria is arguing that Germany is taking “national measures” instead of EU measures to deal with asylum seekers.  If this policy becomes the norm, it would represent a major retreat from EU rules of free movement.

Perhaps the most important takeaway from this row is that the mainstream parties are being steadily pulled toward populism.  This event is just another example of the retreat from globalization.  Obviously, this is not just a European issue but is roiling the U.S. political landscape as well.  One comment we hear often is that politicians will back away from populist policies when they adversely affect equity markets.  To some extent, Wilbur Ross indicated that the administration isn’t moving policy based on equity market performance.[4]

CNY jawboning: Chinese authorities eased concerns that the PBOC is using a weaker CNY to offset the impact of tariffs against Chinese goods.[5]  PBOC Governor Yi Gang tried to calm markets by suggesting the dollar’s recent strength against the CNY is due to “pro-cyclical behavior.”  There were reports that state banks were buying CNY, a form of quasi-public currency intervention.  Without tightening monetary policy, such moves will have a limited impact on stemming CNY weakness.  The rally in the CNY has lifted global equity markets.

NATO warning: The White House has sent a stern warning to NATO members indicating that they need to boost their defense spending.[6]  The problem of NATO “freeriding” on the U.S. security guarantees has been a constant complaint by American presidents.  However, the concern was somewhat half-hearted; the success of NATO was based on resolving the “German problem.”  Due to the lack of natural geographic defenses (no mountains or impassable rivers), Germany was vulnerable to invasions from east and west since its unification in 1870.  The inability of Europe to resolve German insecurity was the primary cause of two world wars.  The U.S. solved the problem by essentially taking over Germany’s defense.  Not only did this resolve German militarism, but it forced Germany to follow U.S. foreign policy.  This was true of most of the rest of Europe as well (France did try to hew its own foreign policy, with some success).  If Germany rearms, it will almost certainly, at some point, want to manage its own foreign policy.  History suggests the outcome won’t be favorable.  It is not unreasonable for the U.S. to prompt NATO to pay more for its defense but the U.S. must be ready for Europe to break away from America’s orbit in terms of foreign policy.

Oil prices: Oil prices continue to move higher this morning on growing skepticism that Saudi Arabia and Russia have enough spare capacity to offset production shortfalls in Venezuela and Libya and the impact of sanctions on Iran.  In addition, U.S. production is hitting pipeline bottlenecks, a legacy problem based on an American oil supply system that was built for importing oil as opposed to supplying oil domestically.  President Trump is clearly aware of the potential negative effects of higher gasoline prices; we would not be shocked to see an SPR withdrawal announcement to try to cap recent price increases.

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[1] https://www.almanac.com/content/what-are-dog-days-summer

[2] https://www.ft.com/content/126ab2d6-7e0f-11e8-bc55-50daf11b720d

[3] https://www.ft.com/content/767e8bc6-7e96-11e8-bc55-50daf11b720d

[4] https://www.cnbc.com/2018/07/02/cnbc-transcript-us-commerce-secretary-wilbur-ross-on-cnbcs-squawk.html

[5] https://www.ft.com/content/1e49cc2c-7e73-11e8-bc55-50daf11b720d

[6] https://www.nytimes.com/2018/07/02/world/europe/trump-nato.html?emc=edit_mbe_20180703&nl=morning-briefing-europe&nlid=567726720180703&te=1

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s the first day of Q3!  So far, it’s not an auspicious start.  We did celebrate “Bobby Bonilla Day” yesterday, one of our favorite holidays.[1]  There is lots of news this morning.  Let’s dig in:

Mexican elections: As expected, Lopez Obrador, otherwise known as AMLO, easily won Sunday’s election, taking an estimated 53% of the vote.  All of his competitors have conceded defeat.  In addition, it appears he will have a majority in the legislature.  There is great fear among the business class in Mexico.  AMLO ran on an anti-corruption platform with a clear bias for the poor of Mexico.  In some respects, AMLO is a bit like President Obama; many in Mexico are pinning their hopes and dreams on the new president with expectations that are sure to disappoint.  We do expect him to negotiate a hardline with the Trump administration over NAFTA, but AMLO has not indicated he wants to end the free trade agreement.  The peso has weakened on the news.

Trade: First, on Friday, $34 bn of sanctions on Chinese goods are set to be implemented with expected retaliation.  Second, the president is expressing his disappointment with firms that have announced job shifts in response to the foreign retaliation.[2]  This is additional evidence that Trump’s trade policy is nationalist in design.  It’s all about jobs and economic activity here rather than elsewhere.  While that’s good for American jobs, it almost certainly won’t be good for American earnings.  Axios[3] is reporting the administration has drafted a bill that would essentially give complete trade authority to the White House.  In some respects, this leaked report is how this administration negotiates.  It starts with an outrageous position and retreats back to what it wanted all along.  By all accounts, the chance that this bill would get passed is nil.  However, given current conditions in Congress, it isn’t clear whether the leadership is up for taking on the social media attacks the president can make.

There are three takeaways from this report.  First, although this bill is unlikely to become law, the “dead on arrival” statements are probably incorrect.  Second, this bill is further evidence of the anti-globalist core of this administration.  Third, even if the bill fails, the president can run on it in 2020; there isn’t really much difference between the left- and right-wing populists regarding trade and this trade position could cause even broader splits within the Democrat Party.  So, even if the bill fails to gain traction, it may have political value.

As we noted last week, the president is already weakening the WTO by refusing to approve appellate judges who handle trade dispute appeals.  In September, an appellate judge is expected to retire and once he does so the body won’t have a quorum, therefore disputes cannot be appealed.[4]  So, by continuing to veto judges, the administration is effectively rendering the WTO into irrelevance.

Central bank notes: A couple of items here.  First, the Fed is finding that managing reserves while paying interest on them and removing them at the same time is causing some degree of turmoil in the short-term interest rate markets.[5]  This may lead the Fed to keep the balance sheet higher than expected and end the reduction of the balance sheet sooner than expected.  Second, the administration’s director of the National Economic Council, Larry Kudlow, made a statement[6] late last week suggesting the Fed shouldn’t raise rates too quickly because growth doesn’t cause inflation.  This positon is classic supply-side economics; this school assumes that supply will always expand to meet demand if conditions are right.  In other words, in a deregulated and globalized economy with low tax rates, supply will always increase to meet demand and therefore monetary policy should only tighten on clear evidence of overheating (which should be addressed with more supply expansion).  The important takeaway from his comment is that the administration is skirting close to breaking the “Rubin consensus” that administrations should not comment on monetary policy.  We believe a major risk factor is that the Trump administration could adopt the Nixon playbook of managing the Fed, which set the stage for the inflation of the 1970s.

Oil: President Trump has asked the Saudis to boost output to lower oil prices.  Over the weekend, we heard from relatives and neighbors asking us, “Why are gasoline prices so high?”  We indicated that the combination of strong demand, falling supply in Iran, Libya and Venezuela and the lack of adequate pipeline capacity in Texas are all conspiring to raise prices.  The response was that no one cared…they just want gasoline prices to decline.  So, the president is leaning on the kingdom to help.  Although there are some doubts as to whether the president really did ask,[7] we have no doubt that Trump, like nearly all American presidents (G.W. Bush was perhaps an exception), wants lower gasoline prices.

German drama:The head of the CSU and the government’s interior minister, Horst Seehofer, is threatening to resign.  He is expected to meet with the chancellor today to see if a compromise can be met.  If he does resign and the CSU pulls out of the government, it could fall, bringing new elections and probably the end of Merkel’s political career.  It is possible that Merkel could simply replace Seehofer, but a CSU exit will almost certainly trigger a crisis.  A fall of the Merkel government would be a bearish event for the EUR.

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[1] In 1999, after the Mets released Bonilla, they owed him $5.9 mm.  Rather than pay him the money, they negotiated a deal where he would be paid $1,193,248.20 per year, starting on July 1, 2011, with continuing payments each July 1^st until 2035 (when Bonilla will be 72 years old).  That amount assumed an 8% return on investment on the original $5.9 mm.  However, the reason the Mets negotiated the deal was that the Wilpon family, the owners of the Mets, were investors with Bernie Madoff, who, at the time, was returning 12% to 15% per year with an eerie lack of volatility.  The owners figured they could put the money with Madoff and earn the spread over the 8%.  Of course, things didn’t work out that way but Bonilla still gets his money each year. http://www.espn.com/mlb/story/_/id/16650867/why-mets-pay-bobby-bonilla-119-million-today-every-july-1-2035

[2]  https://www.politico.com/story/2018/07/01/trump-harley-davidson-689614

[3] https://www.axios.com/trump-trade-war-leaked-bill-world-trade-organization-united-states-d51278d2-0516-4def-a4d3-ed676f4e0f83.html

[4] https://www.politico.eu/article/wto-donald-trump-protectionism-brussels-fears-trump-wants-the-wto-to-fail/

[5] https://www.wsj.com/articles/fed-faces-decisions-on-shrinking-its-huge-bond-portfolio-1530466910

[6] http://thehill.com/policy/finance/394810-kudlow-fed-should-move-very-slowly-on-rate-hikes

[7] http://fortune.com/2018/07/01/white-house-trump-tweet-saudi-arabia-oil/

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy Friday and good riddance to Q2!  It’s looking like a risk-on day.  Lots of news today.  Let’s dig in:

EU summit: A deal was struck on immigration and refugees in a nearly all-night session.[1]  The agreement says that seaborne migrants will be placed into processing centers in the EU itself.  These centers will sort out who are legitimate asylum seekers from those who are just migrating.  Nations will voluntarily establish these centers with support from the broader EU (read: Germany).  There are promises that enough money will be allocated to encourage border nations (read: Italy) to set up these centers.  Although the deal is being hailed (the EUR jumped on the news), in reality, no nation has yet agreed to actually establish such “controlled centers” and it also isn’t clear which nations will take the immigrants once they are accepted.  Merkel was able to get language put in place that requires the initial nation to keep tabs on the new immigrants to ensure they don’t move across borders.  It isn’t at all obvious how this can be executed under Schengen rules, which allow EU member citizens to freely move about the continent.  Merkel needed this element to quell the internal political threat from Bavaria.

Although Italy, Poland, Hungary and the Czech Republic are governed by populists, the agendas differ.  Italy wants refugees dispersed around the EU to relieve the burden on Italy, a frontline state.  Under EU rules, Italy is responsible for the migrants if they land on Italian soil.  Poland, Hungary and the Czech Republic resisted any plans that would force them to take refugees.  Essentially, no deal was reached other than to establish the processing centers.  The bottom line: it wasn’t the worst outcome but, in reality, little was accomplished.  The EU remains in trouble on this issue.

U.S. ditching the WTO?  Axios[2] is reporting that President Trump is indicating a desire to leave the WTO.  So far, no one in his administration, as best we can tell, is supportive of this action.  In reality, the U.S. is crippling the WTO by refusing to approve appellate judges that handle trade dispute appeals.  In September, an appellate judge is expected to retire and once he does so the body won’t have a quorum, therefore disputes cannot be appealed.[3]  So, by continuing to veto judges, the administration is effectively rendering the WTO into irrelevance.  However, the optics of the U.S. actually leaving the WTO would send an unmistakable sign that the postwar order, built on U.S. hegemony, is over.  One of the president’s strengths is “political theater.”  He knows how important visual symbolism is; the summit with North Korea is a good example.  Leaving the WTO would be part of that as well.  If the U.S exits the WTO, look for the dollar to rise and pressure on foreign equities to escalate as well.

Mexican elections: Mexico will hold elections on Sunday.  Barring an epic political surprise, Lopez Obrador, otherwise known as AMLO, will be the next president of the country.  Mexican voters are angry.  Corruption is rife, security is lacking due to narco-terrorism and the economy is struggling due to concerns around NAFTA and the weak peso.  AMLO is making broad promises to clean up corruption and improve the economy.  In addition, Mexicans want a leader who will stand up to the verbal assaults coming from Washington.  We view him as a populist in the model of Lula in Brazil, not Chavez in Venezuela.  Although his election is well anticipated and should have already been discounted by the financial markets, his actual election could put further pressure on Mexican financial assets.

Central bank notes: A couple of items.  Chair Powell will testify before Congress on July 17.[4]  Boston FRB President Rosengren, who for most of his career has been a dove, is signaling support for two more rate hikes this year.[5]  Today’s core PCE number, hitting 2%, supports higher rates.  The ECB is considering some form of “operation twist” to keep long rates low,[6]  which would be supportive for lower rates here.

Iran: Japan and India[7] are indicating they will reduce oil imports from Iran, which is boosting oil prices (mostly Brent) this morning.  The administration finds itself at cross-purposes.  It wants lower oil prices (thus the tweet storms against OPEC), but it is also sanctioning Iran, which is bullish for oil.

Banning cryptocurrencies:The U.S. government has apparently realized that cryptocurrencies could be a way for excessive and perhaps illegal campaign contributions.[8]  Mostly untraceable, cryptocurrencies could come into a campaign and be spent without a traceable record.  The Secret Service has apparently warned Congress to this threat.

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[1] https://www.ft.com/content/4831b0c8-7b52-11e8-bc55-50daf11b720d

[2] https://www.axios.com/trump-threat-withdraw-wto-world-trade-organization-f6ca180e-47d6-42aa-a3a3-f3228e97d715.html

[3] https://www.politico.eu/article/wto-donald-trump-protectionism-brussels-fears-trump-wants-the-wto-to-fail/

[4] https://www.wsj.com/articles/powell-to-testify-before-senate-on-july-17-1530237985?mod=hp_listb_pos1

[5] https://www.wsj.com/articles/boston-feds-rosengren-says-its-time-to-take-away-monetary-policy-punch-bowl-1530192388

[6] https://www.reuters.com/article/us-ecb-policy/ecb-mulls-small-twist-to-keep-borrowing-costs-low-sources-idUSKBN1JP0XX

[7] https://www.reuters.com/article/us-india-iran-oil-exclusive/exclusive-india-preparing-for-cut-in-oil-imports-from-iran-sources-idUSKBN1JO18L

[8] https://www.ccn.com/congress-should-take-action-against-privacy-coins-secret-service-official/

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] As the second quarter winds down, this morning’s news flow is fairly quiet.  GDP came in a bit soft (see below).  Here is what we are watching this morning:

The EU summit: EU leaders are meeting today through the weekend.  The primary topic will be immigration and refugees.  There are two issues at hand—what to do with incoming refugees and what to do with them once they are in Europe.  Italy and Greece want to change the current rule, called the Dublin Agreement, which says the country that registers an immigrant is responsible for him/her and an EU nation can return the immigrant to the registering nation.  Italy and Greece tend to be the landing point for refugees coming from North Africa, so those countries would be required to keep them under the Dublin Agreement.  Both nations view this as unfair; however, Greece does appear open to a deal with Germany on this issue.[1]  It is unclear what Greece wants in return.  Perhaps this is the quid pro quo for the recent debt relief agreement.  Italy remains staunchly opposed to maintaining the Dublin Agreement and has been turning refugee vessels away.  Merkel is facing tensions within her ruling coalition and having the option of sending migrants back to the south where they landed, even if not exercised, might solidify her government.

One idea being floated is to create disembarking zones outside the EU,[2] perhaps in North Africa, to prevent EU migration rules from being triggered.  At these disembarkation points, potential asylum seekers could wait for asylum decisions.  If accepted, they could then, in theory, enter any EU nation.  Australia uses a similar model where asylum candidates are held on South Pacific islands.  The problem that arises is if asylum is rejected.  Sometimes rejected asylum seekers live in a form of legal limbo, unwilling to return but unable to enter.

The second problem for Merkel is that she wants migrant sharing among all members of the EU.  That position is strongly opposed by several members of the EU.  The leader of Austria, Sebastian Kurz, has been in talks with the leader of Bavaria, Horst Seehofer[3]; Kurz has indicated that Italy, Hungary, Austria and Bavaria would form an anti-immigration bloc and refuse to accept EU-mandated immigrant quotas.  The alliance with Kurz may give Seehofer enough standing to refuse to cooperate with Chancellor Merkel and potentially bring down her government.

There are other items on the agenda as well.  Agricultural interests are pressing for an EU response to trade threats from the U.S.  The Common Agricultural Policy (CAP) has come under scrutiny by the Trump administration; recently, tariffs on Spanish olives were implemented.  If the U.S. expands its attack on agriculture, the demise of CAP would likely lead to further pressure on the EU and may cause some states to follow the U.K. out of the EU.  Anything that threatens the solidity of the EU is probably bearish for the EUR.  There will also be discussions about EU reforms proposed by France and Germany.

U.S./Russia Summit: The two nations have agreed to meet on July 16^th in Helsinki.  Europeans are decidedly nervous.[4]  They fear the U.S. will attempt to improve relations with Russia at the expense of European defense, something the U.S. has underwritten since 1947.  We believe the Europeans have a right to be worried, although the fears should have predated the current president.  The U.S. has become jaded by the costs of hegemony and is probably willing to let Germany rearm to pay for its own defense.

Trade: Although there isn’t anything new today on this topic, we do want to point out a good article by Greg Ip of the WSJ.[5]  Companies are restructuring supply chains to deal with rising trade impediments.  Although the broad effect will be to raise costs and reduce efficiency, the beneficiaries will likely be those who have been left behind by globalization and deregulation.  The overall gains may just be relative; on an absolute basis, the “left behinds” might not be better off, but those who have benefited greatly from globalization and deregulation may suffer more.

Energy recap: U.S. crude oil inventories fell 9.9 mb compared to market expectations of a 2.5 mb draw.

This chart shows current crude oil inventories, both over the long term and the last decade.  We have added the estimated level of lease stocks to maintain the consistency of the data.  As the chart shows, inventories remain historically high but have declined significantly since March 2017.  We would consider the overhang closed if stocks fall under 400 mb.

As the seasonal chart below shows, inventories are well into the seasonal withdrawal period.  This week’s rather large decline, the second in a row, is consistent with that pattern.  If the usual seasonal pattern plays out, mid-September inventories will be 410 mb.

Based on inventories alone, oil prices are near the fair value price of $68.73.  Meanwhile, the EUR/WTI model generates a fair value of $60.63.  Together (which is a more sound methodology), fair value is $62.94, 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.  The action to suppress Iranian oil exports has boosted oil prices but the rapid decline in oil inventories over the past week is very supportive for prices.  It should be noted that a 410 mb number by September would put the oil inventory/WTI model in the high $70s per barrel.  Although dollar strength could dampen that price action, oil prices should remain elevated.  At the same time, refinery utilization is now 97.5%.  We will be reaching a point in the near future where domestic oil consumption growth will peak for the summer season, although we do expect the level to remain elevated.  

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[1] https://www.ft.com/content/5a5f1e8a-7a11-11e8-bc55-50daf11b720d?emailId=5b34612130d92200049bdb3c&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[2] https://www.ft.com/content/1e53958a-7a23-11e8-bc55-50daf11b720d?emailId=5b34612130d92200049bdb3c&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[3] https://www.washingtonpost.com/world/europe/as-merkel-teeters-austrias-kurz-seizes-the-moment-as-europes-rock-star-of-the-new-right/2018/06/26/b2560c2c-732f-11e8-bda1-18e53a448a14_story.html?utm_term=.262ef8a19c1e&wpisrc=nl_todayworld&wpmm=1

[4] https://www.washingtonpost.com/news/global-opinions/wp/2018/06/27/why-europe-is-very-nervous-about-a-trump-putin-summit/?utm_term=.9ef624550dd1&wpisrc=nl_todayworld&wpmm=1

[5] https://www.wsj.com/articles/as-trade-barriers-go-up-global-supply-chains-unravel-1530100987?mod=ITP_us_0&tesla=y

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Here we are at mid-week.  Financial markets are recovering this morning after a difficult overnight session.  Here is what we are watching:

Softening on trade?  Around 7:35 AM EDT, the White House[1] announced it would not create a new regime to scrutinize Chinese investments and instead will use the current foreign investment apparatus, the Committee on Foreign Investment in the U.S. (CFIUS) to analyze Chinese investments.  Risk markets have recovered on this news, likely for a couple of reasons.  First, going this route means China isn’t necessarily being targeted specifically, which does tone down tensions.  Second, using CFIUS appears to confirm Treasury Secretary Mnuchin’s position that all nations are being watched for intellectual property theft, not just China.  This notion refutes comments from Peter Navarro, which followed Mnuchin’s aforementioned comments by saying that no nations other than China were being investigated.

There is other evidence of softening.  Chairman Xi has instructed the Chinese media[2] to stop talking about “China 2025,” the controversial program to essentially move China up the value chain.  Using CFIUS and China backing away from at least talking about China 2025 are positive developments.  On the other hand, CFIUS can still effectively block Chinese investment.  And, we doubt Xi will give up on China 2025.  Given the nearly constant shifting positions of the White House, investors are clearly looking for some kind of sign that will accurately predict the future path of policy.  However, that clear path isn’t likely to emerge anytime soon.  Instead, financial markets are starting to look like the shoe scene from the Monty Python movie Life of Brian,[3] desperately searching for some indication in a cacophony of policy actions.

Meanwhile, China is clearly taking steps to protect itself from rising trade tensions.  As we noted yesterday, the PBOC cut reserve requirements.  There is talk of China subsidizing firms targeted for tariffs.[4]  We are also seeing financial authorities accepting a weaker CNY.[5]  As the chart below shows, the CNY had been appreciating from early 2017 until recently but the depreciation has accelerated over the past few days.  As we have noted before, the Trump administration appears to tolerate currency manipulation, unwilling to purposely jawbone the dollar lower to improve the U.S. trade situation.  We expect other nations to follow similar currency policies as a way to offset the impact of tariffs.  But, the bottom line is that policy-induced volatility is here to stay; from the president’s perspective, uncertainty is a feature of his administration, not a bug.

Iran sanctions: Oil prices surged yesterday after the White House warned allies that they should be prepared to cut oil imports from Iran to zero by November.[6]  Although this action was anticipated, the deadline was much quicker than expected.  Iran exports around 2.2 mbpd; we don’t expect all imports to end (China will likely continue to buy Iranian oil, roughly 0.7 mbpd), but a reasonable expectation is that Iran’s oil exports will fall to around 1.0 mbpd.  Saudi Arabia can absorb this lost oil but its spare capacity would fall to around 1.0 mbpd, leaving the world dangerously close to no slack in the oil markets.  Current oil prices are elevated relative to inventories and the dollar, and this geopolitical threat is keeping oil prices elevated.  The rial remains weak.[7]

About last night: There were a series of primaries last night and the net takeaway is that the political situation is becoming increasingly populist.  The headline shocker was from New York’s 14^th district, where Alexandria Ocasio-Cortez defeated Joe Crowley, a representative with nearly two decades of experience.  Crowley hadn’t faced a primary challenge since 2004.  There was talk that Crowley could mount a leadership challenge to Nancy Pelosi (D-CA).  His money advantage was 10-1.  Ocasio-Cortez ran on a progressive platform, calling for a federal jobs guarantee and the abolition of ICE.  We view this outcome as similar to David Brat’s win over Eric Cantor in 2014.  The populists on both sides (right- and left-wing) are gathering strength and establishment voters are increasingly being faced with candidates who want equality policies that will, at some point, lead to lower returns to capital and rising inflation.

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[1] https://www.ft.com/content/a819ec8a-79f4-11e8-8e67-1e1a0846c475

[2] https://www.politico.com/story/2018/06/26/beijing-made-in-china-2025-trump-trade-651852

[3] https://www.youtube.com/watch?v=Ka9mfZbTFbk

[4] https://www.reuters.com/article/us-china-trade-usa/china-should-take-self-defense-measures-in-trade-war-global-times-idUSKBN1JN01G

[5] http://www.scmp.com/business/banking-finance/article/2152669/yuan-drops-through-660-level-beijing-signals-it-favours

[6] https://www.washingtonpost.com/world/national-security/us-pushes-allies-to-cut-oil-imports-from-iran-as-sanctions-loom/2018/06/26/c1d20e78-794f-11e8-aeee-4d04c8ac6158_story.html?utm_term=.4e682cb86412&wpisrc=nl_todayworld&wpmm=1

[7] https://www.reuters.com/article/us-iran-economy-rial/iran-rial-plunges-to-new-lows-as-us-sanctions-loom-idUSKBN1JK0HZ?wpisrc=nl_todayworld&wpmm=1

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] After a rough day yesterday, financial markets are attempting to stabilize this morning.  Here is what we are watching:

Trouble in Iran: Protests are escalating in Iran.  Comments on Twitter suggest there is widespread dissatisfaction with the government.  Unconfirmed reports of crowds chanting “Leave Syria, think of us” and “Death to Palestine” suggest that Iranians are getting tired of their country’s foreign adventures while the economy languishes.  Adding to trouble, the unofficial Iranian rial rate has dropped to 90k/USD, down from 43k/USD at the beginning of the year.  The return of sanctions is undermining the economy but there is also growing discontent with the current government.  We haven’t seen much of a crackdown yet, which makes us wonder if the hardliners are allowing the protests to expand in order to remove President Rouhani from office and put a hardliner into power.  This is a risky strategy because without elections any new president will struggle with legitimacy and simply being appointed by the Grand Ayatollah may not be enough to quell unrest.  It is always difficult for outsiders to discern what is going on in Iran; it should be noted there was genuine surprise by the Shah’s fall in 1978.  Since the theocracy was established in the late 1970s, it has been very effective in containing unrest.  However, that doesn’t mean it will always be true.

Although regime change has been a goal of the U.S. since the revolution in 1978, it is unclear who would govern Iran if the government falls.  Nevertheless, any new government would likely sue for peace with the Trump administration in a bid for sanctions relief.  And, we suspect they would get it.  So, it could be bullish for oil in the short run but long-term bearish if a new government leads to increased exports.

Trade: The EU applied tariffs on items it views as politically sensitive.  Harley-Davidson (HOG, 41.57), the maker of iconic American motorcycles, was an obvious target for the EU.  In response, the company announced it would move production outside the U.S. to prevent the tariffs from being applied to U.S. exports.[1]  The president accused the company of “waving the white flag”[2] on this issue.  Here is an important point.  The president and his followers[3] are economic nationalists; they view trade through the viewpoint of nation against nation.  Major companies, for the most part, are run by members of the establishment who view the world from a global perspective.  Thus, in light of trade actions, they tend to think in terms of supply chains,[4] not national employment.

There charts show what we think is the president’s worldview:

 

The upper line on both charts is the level of U.S. manufacturing payrolls.  We have regressed a trend through the data from 1945 to 1978 and extended that trend past 1978.  Note that actual manufacturing employment began to fall below trend in the late 1970s and has continued on that path into the present.  The lower line on the left-hand chart shows the yearly change in CPI.  When manufacturing employment began to fall below trend, so did inflation and inflation volatility.  The lower line on the right-hand chart shows net exports along with the aforementioned trend data on manufacturing employment.  The impact of globalization is abundantly clear—the widening trade deficit has pushed manufacturing employment well below trend but has also been instrumental in reducing inflation.  We believe one of President Trump’s core beliefs is that manufacturing employment is the key to middle class prosperity and he wants to move the red line on the above charts back to trend.  To do so, he needs to reduce globalization by ending the trade deficit.  If he does that, we anticipate a return of inflation.  Harley-Davidson’s reaction to tariffs is perfectly rational if a company is a profit-maximizing firm as it is trying to keep its costs under control and its products competitive, thus moving production makes sense.  But, if one’s goal is to bolster nationalism through an increase in manufacturing employment, Harley-Davidson’s behavior is inappropriate.  Instead, the company should keep production in the U.S. and assume (hope?) that Europeans will be willing to pay more for the brand.

This divergence of goals is a key element in the current debate between the political establishment and insurgent populism, not just in the U.S. but in Europe as well.  What makes this issue tricky is that each side of the debate sees its own position as a self-evident truth and accordingly perceives the other side’s viewpoint as untenable.

Is China blinking?  Bloomberg[5] is reporting there is growing opposition to a trade war in China.  Important voices in China appear to be arguing that Chairman Xi doesn’t really have the country ready for a trade war and therefore making peace with the U.S. is a better course of action.  We have our doubts that Chairman Xi can back down as the leader of China has also stoked nationalism to solidify his political power, so caving to the U.S. will look like a surrender.  We may be too pessimistic, but our read on Xi is that he won’t give in to President Trump on China 2025 or any other Chinese policy goal.

Is Trump’s political capital exhausted?One of our positions is that new presidents have about 18 months of political capital; from inauguration into the summer of the second year, a president sees a steady diminishment of power.  Usually, when presidents realize they cannot pass any major legislation as Congress’s attention shifts to the midterms, they focus their attention on foreign policy, where they are less reliant on Congress to accomplish their goals.  This may also explain why the president is focusing on trade.[6]

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[1] https://www.ft.com/content/54a6cc82-7867-11e8-8e67-1e1a0846c475

[2]https://twitter.com/realDonaldTrump/status/1011360410648416258?utm_source=POLITICO.EU&utm_campaign=90fa10452d-EMAIL_CAMPAIGN_2018_06_25_08_13&utm_medium=email&utm_term=0_10959edeb5-90fa10452d-190334489 ; https://www.reuters.com/article/us-harley-davidson-tariffs/trump-blasts-harley-plan-to-shift-u-s-production-to-avoid-eu-tariffs-idUSKBN1JL185

[3] https://www.ft.com/content/29f24644-78f1-11e8-bc55-50daf11b720d

[4] https://www.reuters.com/article/us-usa-trade-supplychains/trump-tariffs-force-companies-to-rework-supply-chains-idUSKBN1JL2LR ; https://www.wsj.com/articles/trump-rides-a-harleyto-europe-1529968178

[5] https://www.bloomberg.com/news/articles/2018-06-25/as-trade-war-looms-china-wonders-whether-it-s-up-for-the-fight

[6] https://www.axios.com/donald-trump-administration-gridlock-congress-legislation-house-midterms-14ee0143-6f8e-4228-b7b5-653e6e6ea027.html