by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy Monday!  We switched to daylight savings time on Sunday (a rather barbaric practice).  Here is what we are watching this morning:

Scrambling on Korea talks: Weekend reporting made it clear that the president agreed to talks on his own without consulting staff.  The normal protocol is for advisors to the president to meet with officials of the other nation, hammer out a deal or at least topics for leader discussion and then the leaders meet.  That way, the odds of a successful meeting are high.  This meeting is in reverse; the president agreed to a meeting but it is unclear exactly what will be discussed.  Yes, both the U.S. and North Korea have long-standing goals—North Korea wants a peace treaty and security guarantees, while the U.S. wants denuclearization—but there hasn’t been any real discussion about how to achieve these measures.  For example, North Korea probably wants a peace treaty that will include the removal of U.S. troops from the peninsula.  Denuclearization without inspections isn’t realistic.  Thus, we currently have talks promised without an agenda.  More to come, obviously…

NEC Chair: Shahira Knight has signaled she doesn’t want the job.  Chris Liddell has emerged as the front-runner.  He is a former Microsoft (MSFT, 96.54) and General Motors (GM, 37.84) executive who has close ties to Jared Kushner.  Kevin Warsh, the former Fed governor, has also been mentioned and Peter Navarro is also offering his services.  It should be noted the WSJ editorial board is critical of Liddell, suggesting he isn’t high profile enough or strong on free trade.[1]  Expect more drama on this appointment; however, financial markets probably won’t care all that much unless Navarro is selected—that decision would be taken as bearish.

Iran nuclear deal in trouble?  Axios[2] is reporting that the president indicated to Israeli PM Netanyahu that the U.S. will pull out of the Iranian nuclear deal if major changes are not made.  According to this report, the U.S. has told European negotiators they have until May 12 to fix the deal or face U.S. withdrawal.  If the deal falls apart, look for Iran to make a dash for a bomb.  At worst, this leads to a U.S. or Israeli air campaign against Iranian nuclear sites.  At best, it sets off a nuclear arms race in the Middle East.  The Iran nuclear deal is far from perfect but it does appear to have frozen Iran’s nuclear program.  Given that Iran hasn’t really seen any improvement in its economy since the agreement, Tehran may conclude it is better off without a deal.  If the deal fails, we view it as bullish for oil prices.

Saudi IPO postponed: According to the FT,[3] the Saudi Aramco IPO won’t come to market this year but in 2019 at the earliest.  Apparently, the delay is due to the fact that CP Salman wants a $2.0 trillion valuation and company executives are struggling to achieve this number.  In a related report, the WSJ[4] is reporting there is a pricing policy difference between Saudi Arabia and Iran.  The former wants oil prices in excess of $70 per barrel (Brent), while Iran wants a price closer to $60.  This is an interesting role reversal; historically, Iran has been a price hawk, wanting to maximize revenue, while Saudi Arabia has been a moderating force, worried that high prices induce demand destruction.  We believe Saudi Arabia needs that higher price to (a) balance its fiscal budget, and (b) improve the valuation for the Saudi Aramco IPO.  We remain bullish oil until the Saudi IPO prices; after that, we will need to see if Saudi Arabia’s market share policy changes.

Trade talk: The president continues to make trade threats, this time targeting German luxury automakers.[5]  Interestingly enough, both BMW (EUR 85.46) and Mercedes-Benz (EUR 68.33) have extensive U.S. production and thus may not be all that affected by the tariff.  So far, financial markets are taking the stance that the talk is more aggressive than the reality.  Still, we view trade impediments as a serious threat to the financial markets because they would raise structural inflation, which would tend to depress P/Es and raise interest rates by boosting inflation fears.

Abe scandal: In February 2017, Moritomo Gakuen, an ultra-nationalist school developer, acquired land in Osaka for ¥134 mm, about 10% of its appraised value.  Gakuen’s schools reportedly use texts from the Imperial era as part of the curriculum, a practice outlawed by the U.S. during occupation.  Although the administration has denied the reports, the principal of the school has indicated that the PM’s wife gave him a gift of ¥1.0 mm.  By itself, the donation isn’t illegal but Abe could be in trouble if he is found to have misled parliament.  Further investigations have revealed that 14 alterations were made to documents by the finance ministry surrounding the aforementioned land sales and are threatening to engulf Taro Aso, the finance minister.  The LDP is holding leadership meetings this autumn and Abe may not be able to hold his position if the scandal continues.  If Abe is ousted, Abenomics goes with him and we would expect the JPY to appreciate.

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[1] https://www.wsj.com/articles/a-not-so-liddell-problem-1520802951

[2] https://www.axios.com/trump-said-us-will-leave-iran-deal-netanyahu-d9672407-6d18-4978-a08b-3051484b1486.html

[3] https://www.ft.com/content/62fa88b0-21f4-11e8-9a70-08f715791301

[4] https://www.wsj.com/articles/opec-divided-on-the-right-price-for-oil-1520769600?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosgenerate&stream=top-stories

[5] https://www.ft.com/content/6bbd9e74-2546-11e8-b27e-cc62a39d57a0?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST] It’s employment data Friday!  We detail the data below but the quick summary is “shocking.”  Wage growth moderated and payrolls came in stronger than expected.  In the household survey, the unemployment rate remained at 4.1% but that masked massive increases in employment and the labor force.  Employment in the household survey jumped 785k, but the unemployment rate remained steady due to an even more impressive rise in the labor force of 806k.  Thus, both the participation rate and the employment/population ratio rose sharply.  The data does indicate that there is still ample slack in the labor market and thus should cool worries about inflation.  Here are the other items we are watching:

Trump to Pyongyang: Just a few months ago, we were worried about war on the Korean Peninsula.  Now, the president is going to meet with Kim Jong-un.  This will be the first time in history that a sitting U.S. president will meet directly with the leader of North Korea.  All of us are trying to sort out what this means but it is a clear high-wire act for both leaders.  There is the potential for a game-changing agreement.  One could imagine bringing peace to the Korean peninsula and pulling North Korea out of China’s orbit.  Or, Kim could snooker Trump and get aid and sanctions relief while keeping his nukes.  We can’t cover all the bases in a Daily Comment; the basis for negotiations is enough for a full Geopolitical Report.  But, while there is great risk of failure, there is also probably a better chance of success than the pundit class recognizes.  Kim Jong-un could be looking for something different than his father and grandfather.  Although the Kim dynasty is all about staying in power, the current leader may be more interested in boosting growth.  Anecdotal evidence suggests he is more tolerant of market activity compared to his predecessors, and the young leader may have concluded he has more to worry about from Beijing than Washington.  On the other side, President Trump seems to love the dramatic and he approaches negotiations with virtually a blank slate.  We will have more to say on this in the coming weeks, but a peace deal with North Korea would be historic and a boost to sentiment.

Tariffs and trade: As expected, the president announced his steel and aluminum tariffs.  Although there were serious concerns about the direction, in reality, the president preserved flexibility and we expect a surge of negotiations to establish carve-outs and exemptions.  That doesn’t mean this president isn’t leaning toward protectionism; he is, but his core principle is flexibility.  Thus, he wants to create conditions for lots of negotiations, which, he believes, play to his strengths of extracting concessions from negotiating partners.  If our assessment is correct, we will see more trade-related measures but it is uncertain whether there is a specific goal (a trade deficit target, for example).  As we noted earlier, if the president wanted a clean trade restriction, he could have accepted the border adjustment tax.  That doesn’t appear to be his aim.

Who’s next at the NEC?  The betting sites are leaning toward Shahira Knight, a former lobbyist, as the leading candidate for Cohn’s former job.   She is currently the NEC’s tax expert.  Others in the mix are Larry Kudlow, Peter Navarro and Kevin Warsh.  All three have issues.  Kudlow has been very critical of the recent tariffs, Navarro is seen as too controversial and it isn’t clear that Warsh wants the job.  Our worry about Knight is that she may not have enough gravitas to stand up to the president.  But, according to reports, it’s her job if she wants it.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST] After a torrent of news this week, it’s comparatively quiet this morning.  Here is what we are watching:

ECB: The ECB meets today and the statement contained a surprise—the central bank has dropped its pledge to expand QE if needed.  This announcement signals the beginning of tapering.  On the news, the EUR jumped, Eurozone interest rates rose and European equities weakened.  To some extent, this decision shouldn’t have been a surprise.  The bank has been saying for some time that QE would eventually be coming to a close.  The market’s reaction does suggest that even the most modest change in ECB policy accommodation is seen as hostile.  But, the reality is that dropping this pledge isn’t a big deal.  Policy remains easy and this decision merely affects forward guidance and not current policy.

During the press conference, ECB President Draghi announced the bank increased its GDP forecast for this year to 2.4% from 2.3%, and lowered CPI forecast for next year to 1.4% from 1.5%.  In the Q&A, Draghi indicated that the decision to remove the QE expansion language was unanimous.  But, the rest of the commentary was not hawkish and the EUR fell from pre-press conference highs.  The currency is off its highs but remains above the intraday lows.  Overall, as we noted above, the ECB is preparing to taper but does remain very accommodative.

Trade: According to numerous reports, the GOP establishment is working furiously to reduce the impact of the steel and aluminum tariffs.  It appears that Canada and Mexico will not be penalized due to their cooperation with the U.S. on security, and the EU is lobbying for similar carve-outs for NATO.  The situation with trade remains fluid.  We will continue to monitor how the administration deals with trade but the worst case outcome is stagflation—trade impediments that lift inflation and slow growth.  To put it in terms related to this week’s AAW (see gray section below), trade interference shifts the aggregate supply curve higher and toward the “y” axis.  In other words, inflation is higher at each intersection of supply and demand.

Beige book: The FOMC recently released its economic report by region.  The anecdotal evidence suggests that wage pressures are rising.  We have no doubt that wage pressures are rising but, so far, we have not yet seen widespread acceleration of wages.  We suspect that much of this talk is from businesses complaining about not being able to find workers at prevailing wages.  However, wage growth itself remains around 2.4% (for production and non-supervisory workers, the majority of employment).  The chart below details the issue.

This is a scatter chart with the employment/population ratio, advanced six months, and wage growth for non-supervisory workers.  We have placed a nearest neighbor fit line.  Note that wages tend to rise quickly when the employment/population ratio moves from 58% to 60%; the slope then changes to nearly vertical, meaning that the ratio can rise from roughly 60% to nearly 62% without significant wage increases.  Labor markets don’t tighten significantly until around 62%, when wage growth accelerates significantly.  With the current ratio around 60%, this analysis would suggest there are still workers available and the threat of accelerating wages is not imminent.

Russians in Britain: Former Russian spy (and double agent) Sergei Skripal and his daughter remain hospitalized in the U.K. after an apparent attack by some sort of nerve agent.  Skripal had become an agent for MI-6 and is said to have provided the names of Russian agents working in Europe.  He was detained and jailed in Russia until 2010, when he was part of a spy swap.  Skripal was pardoned a year later.  He and his daughter were found unresponsive on a park bench, and the policeman who responded first showed signs of nerve poisoning and was also treated.  Both Skripals remain in critical condition.  The British continue to investigate; although we suspect Russian involvement, the May government will need undeniable evidence before it will respond.  This isn’t the first time Russian security services have executed Russians in the U.K.  Former FSB officer Alexander Litvinenko was poisoned with polonium-210 in 2006.  If it is determined that Russian security services attacked the Skripals, it remains to be seen how Her Majesty’s government will respond—we would expect an expulsion of diplomats.

Energy recap: U.S. crude oil inventories rose 2.4 mb compared to market expectations of a 2.5 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.  What we are seeing is very bullish—the usual seasonal build in stockpiles isn’t occurring this year.  The longer this continues, the more fundamentally bullish it becomes; thus, even with the higher than expected build this week, it is important to realize that stockpiles are well below where they should be.

Based on inventories alone, oil prices are undervalued with the fair value price of $65.53.  Meanwhile, the EUR/WTI model generates a fair value of $75.20.  Together (which is a more sound methodology), fair value is $72.08, meaning that current prices are below fair value.  Oil prices sold off yesterday despite the modest rise in stockpiles due to rising domestic production.  The DOE’s weekly report indicated that production rose to 10.369 mbpd, a new record.  Still, the strong level of output isn’t going to inventory and we have doubts that this production can be maintained without an increase in rigs in the near future.  Thus, we look for tightening supplies and higher prices in the coming months.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST] There is much to discuss this morning.  Let’s get to it:

Cohn out: Gary Cohn, Director of the National Economic Council, resigned yesterday evening.  Although reports suggest he has been considering the move for a couple of months, the proximate cause was the inability to turn the president on tariffs.  The financial market reaction was swift—equity futures plunged after the announcement, although they have regained some of their initial decline.

At this point, the broader market reaction has been rather scattered.  A turn to protectionism is, over time, inflationary (using the structural/cyclical model discussed in the AAW below, this is a structural component), but Treasuries have rallied and gold has declined.  This would suggest more worries about an economic downturn and less about inflation.  Some of this reaction may be based on expectations that the Fed will maintain inflation expectations by lifting rates.  Supporting that notion were comments late yesterday from Governor Brainard who suggested that growth “tailwinds” may speed policy tightening.[1]  What makes this remarkable is that Brainard is one of the most dovish members of the FOMC, a consistent voter for accommodation.  For her to turn even modestly hawkish does indicate tighter policy is likely.

How important is Cohn’s departure?  From day one we framed the administration as made up of factions, populists and establishment.  The former support policies that harm capital and support inflation, while the latter want policies that boost capital and contain inflation.  The backdrop of the Trump presidency has been a consistent battle between these two sides.  At first, the populists were winning, with Bannon and Miller seemingly driving policy.  The ouster of Preibus and the installation of Kelly as Chief of Staff brought order and the rise of the establishment.  The tax cuts were the clearest evidence of establishment power.  Cohn’s departure suggests a populist counterinsurgency.  But, it is clear that Trump doesn’t consistently favor one side over the other.  Instead, he seems to foster an “ebb and flow” between the two sides.  This is partly a function of his management style.  He seems to like to watch conflict and use it to make decisions.  So, now that it appears that the populists are winning, it wouldn’t be a shock to see him do something that flips the script.  One signal of that would be replacing Cohn with Larry Kudlow, an avowed supply side economist who would also strongly oppose trade barriers.  And, Cohn might not be completely gone.  There have been rumors that he could replace Kelly as Chief of Staff.

So, there are two core ideas that we are using to analyze policy.  First, pundits are turning themselves inside-out trying to divine the “real” Trump and watch him develop a consistent set of policies only to see constant vacillation.  This isn’t a bug in Trump’s management, it’s a feature.  No faction ever gets complete control because that would mean Trump loses the ability to change course.  Trump does believe, at a visceral level, that trade deficits are “losses.”  That is a common belief, but the reality is much more complicated.  As a clear example, there is only one autarky in the world, which is North Korea.  No other nation is trying to emulate the Hermit Kingdom’s economy.  In other words, trade is good for an economy.  In fact, if the president really wants to affect trade, he should have signed on to the border adjustment tax idea that was floated as part of the corporate tax reform.  That would have raised import costs, likely reduced the trade deficit and made tax reform revenue neutral.  But, that would have also taken away the president’s ability to bargain by offering and taking away benefits.  In other words, the border adjustment tax would have affected trade in his favored direction efficiently at the cost of negotiating flexibility.  The president seems to prize the latter over everything.

Second, although we watch the administration, we firmly believe in trends, not people.  The rise of populism and a revolt against the establishment and capital is underway.  Election results in Italy last weekend are just another example of this phenomenon.  Trump’s election was part of this wave.  However, he isn’t a perfect “vessel” of the trend because he does want the support of the establishment at times.  So, we have tax cuts, which populists don’t necessarily favor.  But, trade impediments are clearly part of the populist package.  Although the Cohn news dominated, we also note Bloomberg is reporting that the U.S. is considering broader action against China for violating intellectual property rules.[2]  That’s a much bigger deal.  Thus, there is likely more protectionism to come.  One of our paradigms is that economies go through 30- to 50-year cycles of efficiency versus equality.  During the former, deregulation and globalization are supported, while it’s just the opposite during the latter.  We have been in an efficiency cycle since 1978.  We are moving into an equality cycle, although it may take another decade for it to become completely obvious.  But, the tipping point is being reached.  Trade impediments and reregulation are a likely outcome.

So, where does this leave us?  The economy is still doing very well.  Earnings are robust.  The path of equities really comes down to the multiple.  Based on consumer confidence, the multiple should be fine but what we saw yesterday can upend confidence and eventually lead to a falling P/E.  For now, we still think the risk for equities is to the upside.  If Cohn’s replacement is an establishment figure, equities will likely recover.  We are much more worried about 2019; a tighter Fed and a lessening of the fiscal boost have the potential to weaken the economy and earnings.  But, for now, we still think odds favor rising equity prices.

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[1] https://www.bloomberg.com/amp/news/articles/2018-03-07/brainard-suggests-growth-tailwinds-may-speed-fed-rate-hike-pace?__twitter_impression=true

[2] https://www.bloomberg.com/amp/news/articles/2018-03-06/u-s-said-to-consider-broad-curbs-on-chinese-imports-takeovers?__twitter_impression=true

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST] Risk markets are higher this morning, building on yesterday’s afternoon recovery.  Here is what we are watching this morning:

Trade wars—the establishment strikes back: They don’t call it the establishment for nothing.  The GOP establishment playbook—tax cuts, open trade, deregulation—has always been a less than perfect fit for a president with populist leanings.  This was a worry in the president’s first year but it has generally been accepted that the president mostly tweets like a populist but governs like the establishment.  That conclusion is facing a strong challenge from Trump’s anti-trade policies.  While some were working on tax cuts, parts of the administration were working on trade impediments and retaliation.  Commerce Secretary Ross was working on trade actions on metals and against China, and tough NAFTA negotiations were ongoing.  But, the president’s announcement of across-the-board tariffs on steel and aluminum were mostly unexpected, at least in terms of timing.

However, after the initial shock, the GOP establishment is pushing back.  First, Gary Cohn, Director of the National Economic Council, is assembling a summit meeting where companies adversely affected by the proposed tariffs can inform the president and the administration of the negative effects of the action.  Second, House Speaker Ryan has also openly warned against the tariffs and hinted that the House may create legislation to reduce the president’s ability to implement trade actions.  We suspect that some sort of “deal” will be cut; the president can’t lose face by not getting anything on this issue, but the across-the-board nature of the proposed tariffs can be scaled back to the point where they don’t significantly affect trade.  In other words, the goal will be to give the president enough to let him claim a win but not so much as to actually affect trade.  Hopes that this will be the outcome are probably why equities rallied yesterday and are higher this morning.

Unfortunately, this trade debacle doesn’t address the real issue, which is the management of the reserve currency.  The U.S. benefits greatly from running a trade deficit; we get a plethora of goods and services from the world that contain inflation and improve our efficiency.  In return for goods and services, we give foreigners Treasuries, which are cheap to produce!  This only works for us because there is a natural demand for dollars as foreigners use dollars to conduct trade with other nations who trust dollars over local currencies.  However, the process of providing the reserve currency, a key element in our program to win the Cold War, creates distortions in our economy that are unhealthy.  Our financial system is very large and our sales and logistics systems are overly large as well (to handle foreign investment when foreigners with dollars don’t spend them right away and need to invest in dollar assets).  And, we struggle to create enough buying power for all the imports the world wants to sell us; our answer from 1980 to 2008 was to allow a massive expansion of household debt.  Much of this was due to the fact that sectors of our economy have been severely harmed by trade and as a result these workers no longer have the wages to buy the imports the world wants to sell to us.  The Great Financial Crisis showed that our ability to lift debt has reached its natural limit.  The nation definitely needs a new course on trade and the dollar.  Widespread protectionism probably isn’t the answer but what we have now isn’t working.  One thought would be to penalize nations with high current account surpluses with automatic trade penalties.

North Korean thaw: North and South Korea have agreed to hold direct talks next month and Pyongyang indicated it would be willing to abandon its nuclear program in return for security guarantees.  At first glance, this is difficult to believe but it actually does make sense.  Since the “axis of evil” speech, North Korea has had to assume that America’s policy goal is regime change.  Thus, having weapons to prevent such an outcome is a reasonable step on its part.  However, none of this is new.  What has changed is the realization by the two Koreas that none of their allies are really looking out for the interests of either one.  The talk of war to prevent North Korea from acquiring nukes essentially showed that Washington is willing to sacrifice South Korea to protect the U.S.  In other words, a conventional war with North Korea would devastate South Korea but leave the U.S. untouched.  At the same time, cool relations between Pyongyang and Beijing suggest that China would probably not oppose regime change in North Korea if the resulting new government is generally friendly to China’s interests.  Therefore, the incentive for North and South Korea to negotiate their own peace makes sense.  If North Korea can (a) get a working deal with South Korea to improve and modernize its economy, and (b) get the U.S. to stop threatening regime change by negotiating a security deal for nukes, it’s probably worth it.  This recent progress also shows that Kim Jong-un is apparently unconcerned about shifting the nuclear policy, which probably means that any opposition to his rule has been eliminated.

Update on National People’s Congress: China’s National People’s Congress (NPC), the state legislature of China, is holding its meetings.  Although it is the most powerful body in China on paper, in practice, it’s a “rubber stamp” for the Communist Party of China (CPC).  Yesterday, the NPC agreed to a 6.5% GDP growth target.  What’s important about this decision is that it was made at all.  China can achieve any GDP number it wants; the key driver is debt.  If China is serious about deleveraging, the first step we would expect to see is a reduction or elimination of the growth target.  This number is too high to lower debt.  Although we still believe that Xi’s actions to extend his rule will eventually lead to a period of deleveraging, this decision suggests it won’t occur in 2018.  This target also suggests that the CPC is still uncomfortable with allowing growth to slow.  Marxism has been thoroughly discredited and, in its place, the CPC promises high growth.  The CPC needs a new goal other than growth for legitimacy and thus this 6.5% growth goal for 2018 suggests it hasn’t found a new one yet.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST] Happy Monday!  Here is what we are watching this morning:

Trade wars: As details emerge on how the president decided to recommend across-the-board tariffs on steel and aluminum, it has become clear it was more of a reaction than a well-thought-out plan.  There is no actual executive order for this action so the “globalists” within the administration are working furiously to soften the tariffs.  The president tweeted this morning that he would consider dropping the tariffs if a new NAFTA deal is negotiated.  It’s hard to tell whether this latest tweet suggests he is looking for a face-saving way to walk back the recent tariff recommendations, or if he’s establishing an impossible bar to remove the tariffs.  Although the NAFTA negotiators are working to adjust the current treaty, it should be remembered that the original NAFTA negotiations took about two years to complete.  So, if the president really means he will require a completely new treaty, the steel and aluminum tariffs, if implemented, will be with us for a while.

Below are a few charts to highlight some points.

Primary metal industrial production in the U.S. has been stable for some time.  There is nothing in this data that would suggest collapse.

For contrast, this next chart shows what collapse looks like.

What we are seeing is excess capacity in primary metals.  Current capacity utilization is only 70% and has been weakening in each business cycle over the past three decades.  This suggests the industry has been too slow to reduce capacity.  Excess primary metals capacity isn’t just a U.S. problem—it’s a global problem with nations trying to hold onto jobs by subsidizing production to maintain employment.  Everyone in the industry realizes there needs to be a reduction in capacity and is waiting for someone else to take the action so they can stay in business.  This issue would argue that if the White House is actually worried about the national security effects of cutting steel capacity, the correct policy would be to subsidize the industry.

Of course, the broader concern is that the president’s actions will trigger a trade war.  This is a legitimate concern.  Using trade to foster foreign and domestic policy goals is perfectly legitimate.  In fact, the U.S. unilaterally opened its economy to trade after WWII, supplying the reserve currency, to create allies that would allow us to contain communism.  It clearly worked to win the Cold War.  Unfortunately, the policy remained in place but the U.S. doesn’t have a working idea of what it wants from foreign policy.  Those who have been adversely affected by trade have increased their influence in Washington and their goal is obvious—lots of high-paying, low-skilled jobs.  However, as long as capitalists control the political system, that outcome isn’t likely (trade isn’t the only way to hold down wages).  However, much damage can be done to the global economy by protectionism that is unguided by foreign and domestic policy.  In the immediate term, our worry is that rising protectionism unanchors inflation expectations.  That scenario would lead to much tighter monetary policy and higher interest rates.  It’s still too early to adjust our positions but protectionism is a threat.

Populists win in Italy: Early results indicate the Five Star movement took 32% of the vote, while the right-wing coalition of the Northern League and Berlusconi’s Forza Italia combined with 37%.  However, the former, which was considered the junior partner in the group, actually outpolled Forza Italia, winning 18% compared to 14% for Berlusconi’s party (minor parties in the coalition took the remainder).  The center-left collapsed, falling to 19%, a trend that has become common all across Europe.  There is no clear path to government.  No single party or coalition has a majority.  In the past, Five Star has eschewed joining any other party.  In theory, the Northern League could join Five Star to form a government.  Although such a government would be unstable, together it would send an unmistakable signal to the EU—austerity is over.  The EU hopes for protracted coalition negotiations that end up with a mainstream minority government or new elections.  If the populists get power, the EU and the stability of the Eurozone will come under threat.

The spread between Italian and German sovereigns widened on the results.

Merkel wins: The SDP rank-and-file chose a slow demise over a quick exit and voted to join another grand coalition with the CDU/CSU.  Given the steady erosion of support for center-left parties (see above), there was a push within the SDP to reject the coalition and move left.  However, this would had led to new elections and, given recent performance, the SDP could have spiraled into irrelevance.  Instead, 66% of the SDP members decided that Merkel had given them a good deal of influence despite lousy polling numbers.  We suspect this will be Merkel’s last government.

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