by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Equities were weak around the world but we are seeing a mixed recovery in the early U.S. trade.  Technology remains under pressure.  Here is what we are watching today:

Oops: Yesterday, we bravely opined that Kim Jong-un probably didn’t go to China.  Well, today we get to issue a correction.  He did go to China, although the visit was officially “unofficial.”  In other words, it wasn’t a scheduled state visit.  We don’t know for sure why Kim chose China and Chairman Xi for his first visit with foreign leaders.  However, there are a number of possibilities.  First, China may have feared being isolated.  As North Korea prepares for summit meetings with South Korea, the U.S. and maybe Japan, China may have suddenly become quite open to meeting with the North Korean leader.  Simply put, the diplomatic situation is changing and China has been mostly on the sidelines.  China may have wanted to improve relations before the summits, fearing it was out of the loop.  Second, Kim may have wanted to remind his summit “guests” that he still has ties to China and use that knowledge for leverage.  Kim comes from a long family line of leaders who are deft at playing powers off each other.  Third, we expect China to try to host the U.S./North Korean summit to increase leverage over both nations.  From what we said yesterday, we still believe North Korea eyes China warily.  Kim Jong-un executed his uncle along with most of his family and also assassinated his brother in a spectacular attack in a Malaysian airport.  His uncle was well liked in China and had close ties with Beijing.  And, his brother, Kim Jong-nam, was being protected by China.  The North Korean leader has reasons to believe China would prefer a more accommodating leader in Pyongyang and thus fears Chairman Xi.  The fact that this meeting has taken place suggests that either (a) Kim Jong-un feels more confident now, or (b) Chairman Xi has signaled to Kim that he doesn’t have designs on his removal from power.  That probably doesn’t mean China can put itself between the U.S. and North Korea, but it has an incentive to try and Kim has an incentive to see what that insertion is worth to Beijing.

Market action: The equity markets have been struggling since their late January peak.  Although a number of factors are involved, the biggest is the sentiment turn against technology.   In our recent review of Scott Galloway’s book (see Reading List link above), The Four, we note how the major tech firms have become darlings of consumers, with two of them providing what appeared to be “free services” which are, instead, data accumulating operations that are sold to advertisers or, as we have discovered, political campaigns.  Galloway has made it clear that about the only force that can restrict these firms is government.  Until recently, government regulation looked like a long shot but that is no longer the case.  Mark Zuckerberg of Facebook (FB 152.22) is preparing to testify before Congress.  According to Axios,^[1] the president has Amazon (AMZN, 1497.05) in his sights.  Technology isn’t the whole market but it has become the largest sector in the S&P, currently at 24.8%.  The impact of technology and the effect of concentration (always an issue in a capitalization-weighted index) is best observed in the relationship between the cap-weighted and equal-weighted S&P indexes.

This is a five-year chart of the normalized spread between the equal-weighted and the cap-weighted indexes.  When the chart is red, the equal-weighted index is outperforming the cap-weighted index.  Over the long run, the equal-weighted index tends to outperform.  Why?  Because the buyer of a cap-weighted index is usually buying more of the most expensive stocks in the index.  Since about mid-2017, the cap-weighted index has outperformed; however, that performance gap is narrowing rapidly.

Although we will have more to say on this topic in the upcoming Asset Allocation Weekly Comment (which will be published on Thursday due to the market’s close for Good Friday), we suspect we are in a corrective phase.  Earnings should remain robust due to the tax changes and strong economy, and there is no recession in sight, which usually triggers major bear markets.  Although a 1987 event is possible, the fact that we call it a “1987 event” shows how long it’s been since a major bear market has occurred without a coincident recession.

How long will this go on?  The following Bloomberg chart offers some insight.

The shortest corrective, or, perhaps better said, “digestive,” phase in this bull market was 97 days, which means we have about another month.  As we will show in the upcoming AAW Comment, all three of these sideways corrections occurred with low levels of liquidity; this one is occurring with over $1.0 trillion in retail money markets.  Thus, we suspect it will be shorter.   But, we will likely see continued churn in the market for at least another few weeks.

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[1] https://www.axios.com/trump-regulation-amazon-facebook-646c642c-a2d7-454b-a9a9-cdc6e4eaef2c.html

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s risk-on around the world so far today.  Here is what we are watching:

Is Kim in Beijing?  Although a number of reports have speculated the leader of North Korea has traveled to China, this news has yet to be confirmed.  If he did travel to China, it would be his first foreign visit since becoming the leader of North Korea in 2011.  We suspect he isn’t on the train.  Instead, this is more likely a high-level delegation updating China on the path of negotiations.  Beijing has significant interest in North Korea’s ongoing thaw with the South and potential summit meetings with Japan and the U.S.  Although China is likely relieved that the prospect of war has been reduced, it is also probably concerned that it isn’t participating in any of these meetings and worried that its interests are not being represented.  As we have discussed, relations between China and North Korea are not nearly as warm as advertised.^[1]  China does not want to see a hostile power on its border and if the U.S. and North Korea normalize relations it is quite possible that North Korea could become allied with the U.S. and, at least from China’s perspective, part of America’s containment of China.  Hence, the visit by someone from North Korea.

Is Abe ok?  Over the past month, Japanese PM Abe has been under fire for a land sale scandal.  His finance minister looked in grave danger and Abe himself was facing the threat of an internal party revolt.  Abe’s approval rating plunged from 56% in February to 42%, the fifth lowest in his current round as PM.  Nobuhito Sagawa, a key figure in this scandal and Ministry of Finance official, testified that neither Abe, his wife nor Finance Minister Aso had any involvement in changing the documentation surrounding the land deal.  His testimony, at least for now, reduces the likelihood that Abe’s government will fall.  On the news, the Nikkei jumped 2.72% and the JPY weakened.  The fear has been that a fall of the Abe government would also spell the end of Abenomics, which relies mostly on a weaker JPY and has lifted the values of Japanese financial assets.

Pound down: A report from the BOE, expressing concern that Brexit will lead to loss of market share in the EU for London’s financial services industry, triggered a sharp drop in the GBP this morning.  The currency has been appreciating as PM May moves toward a soft Brexit but the BOE’s report acts as a reminder that there will be disruptions from Brexit that will adversely impact the most globalized parts of the U.K. economy.

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[1] See WGRs, North Korea and China: A Difficult History, Part 1 (10/16/17); Part II (10/23/17); and Part III (10/30/17).

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Risk assets are rising this morning after the weekend media suggests the rhetoric on trade is much more potent than the reality.  Here is what we are watching this morning:

BREAKING: President Trump to expel 60 Russian diplomats, joining 14 other EU nations taking similar actions in response to Russia’s attack on a former double agent in the U.K.

The trade walk back: In a series of Sunday interviews, Treasury Secretary Mnuchin intimated that the administration is in trade talks with Chinese officials.[1]  We suspect China is working from the position that giving President Trump some high-profile “wins” will likely placate him and persuade him to back away from blanket trade impediments.  We agree with this assessment.  As we have said repeatedly, if the president had really wanted to implement anti-import legislation, he could have simply accepted the border adjustment tax.  President Trump appreciates the power of image.  Passing a complicated tax that reduces imports won’t fire up anyone (expect a few policy wonks), whereas high-profile actions, such as promises from China to purchase more U.S. goods, have much more impact on voters but matter little to the overall flows in the end.[2]  Our position is that trade action will end up being rather modest; significant trade restrictions are more likely to come from a left-wing populist.

John Williams to the NY FRB: Reports indicate that San Francisco FRB President John Williams is the leading candidate for the NY FRB position.  Williams is a respected economist, considered strong on policy.  We rate Williams a “2” on our 1-5 “hawk-dove” ranking system, meaning he is a moderate hawk.  What makes this job important is the unique voting power of the NY FRB president.  The other 11 regional FRB presidents rotate on the voting roster; only four of the 11 regional bank presidents actually vote on policy in a given year.  However, the NY FRB is a permanent voting member due to that district’s power as the center of American finance.  Like all FRB presidents, the local FRB bank board approves its president with the approval of the Federal Reserve in Washington.  The governors of the FOMC are approved by Congress.  Thus, the NY FRB president is a rather powerful position.  If he is appointed, he will make the FOMC’s permanent voters a bit more hawkish than the current composition.

Radicals in Italy?  In a rather unexpected development, the Five-Star Movement and the Northern League are making progress toward forming a government.  If that were to occur, it would be a “Nader alignment.”  Ralph Nader[3] proposed that right- and left-wing populists should make common cause based on their economic interests and build coalitions to remove the establishment from power.  Although the economic attractiveness of such a coalition makes sense, in reality, the social differences are really difficult to overcome.  However, if this government does develop, it would offer a roadmap of sorts for other populists in the West.  Thus far, financial markets are not expecting these parties to actually form a government as the German/Italian bond spreads have not widened significantly.

Puigdemont arrested: The former leader of Catalonia was detained[4] as he crossed the border from Denmark into Germany.  Germany intends to extradite Puigdemont to Spain where he is subject to arrest for separatist activities.[5]  News of the arrest sparked protests in Barcelona.

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[1] https://www.wsj.com/articles/u-s-china-quietly-seek-trade-solutions-after-days-of-loud-threats-1522018524

[2] https://www.ft.com/content/1d56221c-30bb-11e8-b5bf-23cb17fd1498

[3] See Nadar, R. (2014). Unstoppable: The Emerging Left-Right Alliance to Dismantle the Corporate State. New York, NY: Nation Books.

[4] https://www.nytimes.com/2018/03/25/world/europe/germany-carles-puigdemont.html?emc=edit_mbe_20180326&nl=morning-briefing-europe&nlid=5677267&te=1

[5] For background on Catalan separatism, see WGRs, The Situation in Catalonia: Part 1 (11/6/17) and Part II (11/13/17).

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It was a dark and stormy night for risk assets.  However, we are seeing glimmers of light in U.S. equity futures as they have recovered their overnight losses and have turned positive.  Here’s what we are watching:

A budget deal: The budget deal passed Congress, meaning a shutdown was averted.  Along with it is a clear ending of austerity.

This chart shows the contribution of government spending to GDP, smoothed with a three-year moving average.  This chart always comes as a surprise; this only measures what the government spends on goods and services.  Much of government spending is transfer payments which are captured by the consumption or investment sectors of the economy.  As the chart shows, we have only seen two other periods when government spending detracted from growth and both occurred during periods of military demobilization.  It is remarkable to see government spending reduce growth during a period of overall weak economic activity.  Much of this weakness was due to falling state and local government revenues; these entities usually cannot deficit spend so, as revenue declined, so did their spending.  However, the federal government did not offset these declines due to the austerity policy of sequester.  That policy is clearly over.  Thus, government spending will now provide support for growth.  Of course, deficits will rise as well.  This will either lead to (a) a wider trade deficit, or (b) higher inflation.  [BREAKING: President Trump tweets he may veto the spending bill due to the lack of wall funding and the lack of resolution on DACA.  However, if there is a veto, the shutdown will likely be short and, if anything, more spending will be the result.]

John Bolton: H.R. McMaster was ousted from his position as National Security Advisor, effective April 9, and will be replaced by John Bolton.  Bolton has extensive government experience and is a well-known policy hawk.  This is the president’s third National Security Advisor.  Michael Flynn left early in the term due to scandal, while the president and McMaster never got along and reports suggest that Tillerson and Mattis were not fond of McMaster.  However, Bolton is an entirely different figure.  He is an experienced Washington hand who is well versed on how to use the apparatus of state to move policy.  He is on record calling for military action against both Iran and North Korea, and he supported the invasion of Iraq.  Although much of the media is framing this decision as the president selecting a National Security Advisor who is more aligned with his views, it should be noted that the president’s positions are fluid while Bolton’s are quite consistent.  Thus, if talks with North Korea bring a thaw, it’s hard to imagine Bolton will like this outcome and he may be vocal in his opposition.  Bolton and Trump do appear to be on the same page regarding Iran, which means the nuclear deal is clearly in danger and the Middle East could be heating up.  In response, we have seen oil and gold prices lift.

Trade:  China announced token retaliation against the administration’s announced sanctions.  Although trade policy is worrisome, we want to reiterate that, at least so far, the bark has been far worse than the bite.  We view what has transpired so far as warning shots across the bow rather than the onset of hostilities.  If everything the U.S. has announced is implemented, it will affect about 10% of China’s exports to the U.S. and 2% of its global exports.  That’s not to say what is happening isn’t important.  To some extent, targeting China probably signals the fact that the U.S. is no longer treating China as an emerging capitalist democracy but as a strategic competitor.  For the past three decades, the U.S. has allowed China to engage in openly mercantilist trade policies on the assumption that rising income would eventually force the CPC to democratize.  That assumption has mostly been proven false and now the U.S. has to fashion a new response to China.  This trade action by the administration will probably be seen by historians as the beginning of this process.

The recent action in steel equities offers a cautionary tale of how difficult it is to position investments in this trade policy environment.

This is a chart of the S&P steel sub-index.  Expectations of trade action lifted this group in February.  Since March 9, the index is down 12.1% as the administration exempted allies from the steel tariffs.  Clearly, it is hard to position for such policy uncertainty.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s a risk-off morning so far.  Equities are declining, Treasury yields are falling and the JPY is appreciating.  The factors hitting risk markets are softer than expected PMI data (see table below) and trade fears.  Here is what we are watching this morning:

China trade: Tomorrow, the administration plans to announce around $50 bn of tariffs and penalties on China, focusing on intellectual property confiscation.  We will be watching to see how the administration acts with China.  The pattern with other trade issues has been to announce dire changes then negotiate to a less aggressive position.  For example, we are seeing some moderation in the NAFTA negotiations.[1]  On the steel tariffs, we are seeing a steady parade of exemptions.  As we have noted before, the president likes flexibility in negotiations; he stakes a position then moderates from there.  Thus, the fear of trade action is reasonable but the actual policy pattern we are seeing, so far, has been less onerous than what’s been announced.  We would expect some threats of retaliation from China.  The most likely targets will be agricultural.

Other central banks: As forecast, the Bank of England didn’t change rates, but the vote was 7-2, with the dissenters calling for a rate hike.  The news led to an initial spike in the GBP and British debt but the former has given up its initial gains.  The PBOC responded to the Fed rate hike by raising its seven-day repo rate by 5 bps to 2.55%, but we suspect this was more for show; the move is small as the repo rate acts as a floor for interbank lending rates.  The actual interbank lending rate is nearly 3.15%, so the impact from the official rise is nil.  However, the optics of not following the Fed, especially with the Trump administration teeing up trade actions, would not have been favorable.

The Fed: As expected, the Fed raised rates by 25 bps.  Growth estimates were increased and the FOMC expects unemployment to fall below 4%.  In the statement, growth was described as “moderate” compared to “solid” in the last statement, likely reflecting the persistent pattern for soft Q1 GDP data.  The dots did move higher.

The red dot is yesterday’s meeting.  We don’t use the median but the average, and we note that the terminal policy rate has increased, with 2020 showing a 3.3% terminal rate.  We also note that the implied yield on the two-year deferred Eurodollar futures is near 3%, suggesting the market is building in further rate hikes in light of this report.  In general, it appears the market expects three hikes this year and three next year, but the risk of even tighter policy is possible.

How did Powell do?  We think rather well.  He answered quickly and directly and referenced the committee on economic questions.  He appeared more comfortable on questions of market liquidity or bank stability.  Financial markets were whipsawed a bit; we suspect there was concern that Powell would make a gaffe and thus there was a good bit of positioning.  But, interest rates eased and equities recovered as the press conference wound down.  What is notable is that the dollar weakened and gold continued to rally.  Although the currency trade is complicated by administration trade policy, the fact that the dollar weakened and gold rallied after the policy change suggests those markets viewed the action as dovish, or at least neutral, and shifted their focus to trade policy.

Energy recap: U.S. crude oil inventories fell 2.6 mb compared to market expectations of a 3.0 mb build.

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 last March.  We would consider the overhang closed if stocks fall under 400 mb.

As the seasonal chart below shows, inventories are usually rising this time of year.  This week’s decline is clearly supportive.  Every week that fails to show a build is a week where the seasonal factors become less bearish.  Although there is still time for stockpiles to rise, it is unlikely they will reach their seasonal norms.

Based on inventories alone, oil prices are undervalued with the fair value price of $64.75.  Meanwhile, the EUR/WTI model generates a fair value of $74.84.  Together (which is a more sound methodology), fair value is $71.56, meaning that current prices are below fair value.  Oil prices rose this week as the DOE data was bullish.  As noted above, we are not seeing the usual seasonal build, which is supportive.  At the same time, rising tensions with Iran are also adding to geopolitical concerns.

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[1] https://www.wsj.com/articles/nafta-negotiators-signal-progress-on-thorny-auto-content-rules-1521711001

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s Fed day!  Here is what we are watching this morning:

Powell speaks: The Fed meeting concludes today with virtual certainty of a 25 bps rate hike, taking the target to 1.75%.  It should be noted that the target is actually the upper target rate; in reality, the rate that banks are actually charged is the effective rate, which runs in a 25 bps range with the target as the upper end of that band.

This chart shows the upper band, lower band (target -25 bps) and the effective, or actual, fed funds rate.  After the rate increases today, we expect the effective rate, currently around 1.42%, to rise to 1.67%.

This is not the most important issue for today, however.  The two most important issues are (a) what do the dots chart project for this year, and (b) how will Powell do in his first press conference?  Powell is not an economist.  He can’t use technical terms to provide a non-answer to a question.  Our position is that transparency is not a virtue for the Fed.  A Fed chair wants to maintain optionality and clarity works against that.  Therefore, the potential for an unexpected market-moving event is elevated.  Thus, we have been seeing what looks to us as position-squaring in financial markets.  So, this afternoon we will see how Powell does.

Trade: The WSJ[1] is reporting that although the Trump administration is planning on unveiling tariffs on China this Friday, the reality is that nothing will be implemented immediately.  The president clearly wants to use tariffs as bargaining chips.  As we have mentioned before, if he simply wants to narrow the trade deficit through direct action, he should have supported the border adjustment tax.  That would have been effective but it also would have restricted his ability to negotiate because he would have had nothing to use as “carrots and sticks.”  For the financial markets, the trend in trade policy is not helpful, but the specifics are, for the most part, rather benign.  In related news, the G-20 was unable to agree on a trade consensus; most nations wanted the U.S. to commit to a multilateral trade regime which the administration rejects on principle.

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[1] https://www.wsj.com/articles/trump-to-ramp-up-trade-restraints-on-china-1521593091

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT]

Framing the Fed: The FOMC meeting begins today.  Here we lay out the basic path for monetary policy.

The chart on the left shows the implied three-month LIBOR rate, two years deferred, derived from the Eurodollar futures market.  Note that the yield has increased dramatically since mid-2017, coinciding with optimism and then the passage of the tax bill.  The chart on the right compares that rate to the fed funds target, with the spread between the two rates shown on the upper line of the chart.  In general, LIBOR rates exceed fed funds (fed funds have less credit risk), but the two rates do become a good guidepost for policy.  We have set vertical lines where the two lines cross.  Usually, this marks the end of a tightening cycle.  The Greenspan Fed seemed to closely watch this rate and stopped raising rates when the implied rate fell below fed funds.

The current spread indicates the FOMC will raise rates another 150 bps, to a terminal rate of 3.00%, in two years.  Assuming 25 bps per hike, that implies seven more increases before this time in 2020.  That could mean three hikes this year and four in the remaining 15 months, or four this year and three in the last 15 months.  The number for this year is the topic of discussion.  We expect a clear signal for three and the potential for an additional hike.  It is worth noting that it was not unusual in previous tightening cycles for the implied rate to decline to the target.  Thus, we may not make it to 3.00%.  However, for that to happen, the implied rate will need to decline at some point.

The other issue is that this meeting will be the first press conference for Chair Powell.  A number of pundits have applauded the new Fed leader for speaking plainly.  This is not actually a virtue in our estimation.  Clarity in policy dampens fear and encourages investors to take on more risk until financial markets become unstable.  Thus, a little obscurity should be welcomed.

The prince is in Washington: Saudi Crown Prince (CP) Mohammed bin Salman is visiting the U.S. capital today.  There are a number of items on his agenda, including an attempt to pull the U.S. into a harder line on Iran and likely feeling out policymakers for their reaction to the Kingdom of Saudi Arabia (KSA) acquiring nuclear power.  CP Salman would like to diversify the KSA’s energy away from hydrocarbons, but getting nuclear reactors could give the country the infrastructure to develop indigenous nuclear weapons.  The harder line on Iran should be a bit like pushing an open door—the nomination of Pompeo to the State Department puts an Iran hawk in place and the president has been consistently critical of the Iranian nuclear deal.  In May, the president has to recertify the Iran deal and there is growing speculation he won’t do so.  Finally, the KSA is considering limiting the listing of its Saudi Aramco IPO to the Saudi equity market only.  We suspect the KSA doesn’t want to tackle the intrusive reporting requirements of London or New York.  However, we would not count out Beijing as it would not be a shock to see China offer placement for the IPO and wave Western-level compliance.  Concerns surrounding Iran may be behind the rise in oil prices today.

More Facebook (FB, 172.56) fallout: Shares are lower again this morning as the company struggles to get in front of the fallout from the Cambridge Analytica scandal.  Perhaps the most interesting development is that Democrats are turning on the company.[1]  Generally speaking, industry groups line up politically and technology has tended to land with Democrats.  The extractive industries and much of manufacturing has been captured by the GOP, while the financial sector tends to be divided between both parties.  The Democrats are angry that Facebook may have assisted the GOP during the presidential election and are thinking of exacting revenge.  If this broadens to the entire sector it may affect donation flows for the upcoming mid-terms and the 2020 presidential race.

China trade issues: It appears the president is poised to impose some $60 bn in tariffs against Chinese products on Friday.[2]  So far, China appears to be following two tracks on this issue.  First, China is trying to be conciliatory; Premier Li Keqiang promised in a speech at the end of the National Party Congress to do more to protect intellectual property.[3]  Chairman Xi’s top economic advisor, Liu He, told a group of business leaders that he intends to takes steps to open up China’s economy.[4]  It appears China is trying to manage the relationship and avoid an all-out trade war; however, President Trump seems to be spoiling for a fight.  Second, if a trade war does start, look for China to attack U.S. agriculture.

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[1] https://www.politico.com/story/2018/03/19/angry-democrats-facebook-424456

[2] https://www.washingtonpost.com/business/economy/trump-prepared-to-hit-china-with-60-billion-in-annual-tariffs/2018/03/19/fd5e5874-2bb7-11e8-b0b0-f706877db618_story.html?utm_term=.33ce92d9800c

[3] https://www.bloomberg.com/news/articles/2018-03-20/china-to-open-manufacturing-cut-tariffs-and-taxes-premier-says

[4] https://www.bloomberg.com/news/articles/2018-03-02/top-xi-aide-is-said-to-promise-u-s-ceos-action-on-china-reforms, https://www.reuters.com/article/us-china-parliament/chinas-premier-hopes-trade-war-can-be-averted-pledges-more-open-economy-idUSKBN1GW0AO