by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST]

Looking for something to read?  In our travels we are often asked about books we recommend.  As a result, we have created The Reading List.  The list is a group of books, separated by category, that we believe are interesting and insightful.  Each book on the list has an associated review to help you decide if you want to read it.  We will be adding to the list over time.  Books marked with a “*” are ones we consider classics and come highly recommended.

Equity markets are attempting to stabilize this morning.  As noted above, Asia was mostly lower while Europe is in the green.  Here is what we are looking at this morning:

Is this it?  By our calculation, the current decline from the recent high (basis the S&P 500) was just under 10%, but would round up to that level, which is generally considered a full correction.  Despite the sudden drop after months of calm, investors have been relatively sanguine.  We do note the Ned Davis Crowd Sentiment Poll fell from around 75 to just under 67.  Usually, this index would need to decline to around 61 to signal that excessive optimism has “washed out.”  We note some of the major wirehouses have given “all clear” signals and are suggesting we should move higher from here.  We don’t necessarily disagree, but would note that in our personal experience equity corrections don’t usually end without a greater degree of fear.  It is possible that some of the usual panic has been transferred to other markets, perhaps cryptocurrencies or the volatility products, but we would not be surprised to see at least a retest of recent lows before a recovery develops.  In other words, this probably isn’t a “V” bottom in equities.

At the same time, there is no strong evidence of recession, which is the usual trigger for a major bear market.  Recent market action is rather normal behavior; in recent years, persistently supportive monetary policy has dampened market volatility and thus made corrections less common.  As monetary policy normalizes, choppy equity markets are a likely outcome.

No change in policy expectations: Fed funds futures are still indicating about an 83% chance of tightening at the March 21^st FOMC meeting.

This chart shows the probability of a rate hike for the March meeting.  At the end of January, the fed funds futures indicated near certainty of a rate hike.  Recent equity market action did add a degree of doubt but odds still strongly favor a rate hike.

The budget process: The House has passed a stopgap measure while Senate leaders are indicating they are nearing a two-year budget deal that would not only address the upcoming spending limit issue but also address the debt ceiling that is looming next month.  The keys to the emerging Senate deal are (a) immigration is to be dealt with outside the budget process, and (b) spending will rise to bring enough members on board for passage.  The Senate version will not be popular with the Freedom Caucus in the House, which means passage will rely mostly on Democrats and enough moderate Republicans to vote for the measure.  We may see another shutdown later this week, but would not expect much market impact.

Merkel has a deal: Chancellor Merkel will give the SPD the finance and foreign ministries in a new grand coalition government, which was apparently enough to get the SDP leadership to agree to form a government.  Although the SDP rank and file still need to vote on the measure, getting these two key ministries should be enough to sway most members.  Merkel’s CDU/CSU party is not pleased, according to reports.  The general expectation was that the SDP would get one of these two ministries, but not both.  Assuming the SDP approves the deal (and they would be making a huge mistake if they didn’t), Germany’s stance on the EU could soften dramatically, which could mean a more French vision is in the offing.  A more French vision would include more fiscal unity and relaxed rules of fiscal spending by individual states.  Although a new government is likely, it may not last very long; most Germans are fearful of providing a “credit card” to the rest of Europe and the SDP’s version of the EU won’t be popular with the CDU/CSU or the AfD.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST] Equities remain under pressure around the world.  We are seeing lots of swings in other markets, with Treasuries flipping from higher to lower prices and the dollar is volatile as well.  Here is what we are watching:

Algos and risk parity: Innovation is always a factor in markets, including financial ones.  Most of the time, new things are an improvement.  Sometimes this isn’t the case and, even with good things, overdoing it or becoming overly reliant upon a new, untested product can cause problems.  Early in my career, portfolio insurance was the rage; buying equities and offsetting part of the risk by being short futures (or having stops under the market in futures) gave investors the impression they were protected from market declines.  In 1987, that proved to be a false assumption.  In our times, risk parity has the potential to be the new version of portfolio insurance.  At its most basic level, both portfolio insurance and risk parity are nothing more than portfolio diversification.  In other words, holding an asset in a portfolio that moves in the opposite direction to other parts of the portfolio is basic modern portfolio theory.  Finding that diversification asset is the trick; it must (a) not be overly costly, and (b) work consistently.  Finding instruments that always move opposite to stocks is easy; finding ones that don’t offset most of one’s equity gains is hard.

Simple risk parity models usually use bonds to offset portfolio risk.  Although that hasn’t always worked, it has been effective in this century.

This chart shows the rolling five-year correlation between returns for 10-year T-notes and the S&P 500.  Until around 2000, returns for these two asset classes were positively, or directly, correlated.  They are now negatively, or inversely, correlated.  There are probably a myriad of reasons for this flip, including confidence that inflation would remain controlled.  Declines in long-term interest rates seem to have an impact as well (when the 10-year yield fell under 6%, the correlation switched), and consistent and transparent Fed policy also likely played a role.  Recently, we have seen both Treasuries and equities come under pressure.  Heightened inflation fears seem to be behind this market action.  This is an issue we are monitoring closely because asset allocation would become much more challenging if this relationship between bonds and stocks were to change to the pre-2000 relationship.

Risk parity can be much more than the simple addition of bonds to a portfolio.  One of the more popular strategies in recent years has been to use volatility instruments to diversify portfolios.  And, for every buyer of insurance, someone has to be a provider.  Selling volatility has been a very profitable strategy in recent years.  With every popular strategy, the financial services industry will create a product to facilitate demand.  Inverse volatility ETPs, which are usually ETNs,^[1] have done quite well in recent years.  Volatility has steadily declined, in part due to easy and transparent monetary policy, slow economic growth and low inflation.

This is a two-year chart of the XIV (CS VELOCITYSHRS DLY INV VIX SHRT ETN, 99.00).  Two years ago, this ETN was trading at 20; it peaked last month at 140.  The current after-hours indication is 15.43 (see below for more on this issue).

To some extent, what we are seeing in the financial markets is a normal late-cycle environment where the economy expands to capacity constraints, inflation begins to rise, interest rates move up and monetary policy tightens.  There is nothing too unusual in what we are seeing.  Now, we can quibble about all of these elements.  First, we are not convinced that hitting capacity constraints is relevant in a globalized world.  As long as excess capacity exists in the global economy, inflation can be contained by a wider trade deficit.  Second, the rise in inflation we are contemplating, to maybe 2.5% for core CPI in the coming 12 to 18 months, isn’t so earth-shattering as to force the Fed to slam on the money brakes.  Third, we are not convinced that the recent rise in wages is material; although overall wages rose by 2.9%, wages for the majority of workers, shown by non-supervisory and production workers, remain stagnant at 2.4%.  Still, there is little doubt the FOMC will continue to lift rates unless the recent break in equity markets destroys enough wealth that it affects the economy.  That isn’t likely, simply because significant equity ownership isn’t broad enough to have that effect.

What is causing the market turmoil is a repricing of the outlook coupled with vulnerabilities caused by volatility products and algorithms.  As holders of short volatility products take losses and try to exit products, they are likely selling other parts of their portfolio to gain liquidity.  It should be noted that trading was halted yesterday on several of these ETNs and they remain halted at the time of this writing.  As the chart below shows, the NAV on XIV has plunged to 4.22.

According to reports, some of these ETNs may be liquidated due to their price action.^[2]  If that occurs, it may end this product’s availability to average investors.

Algorithms are the other innovation that affects the financial markets.  These pre-programmed trading strategies are designed to use speed to succeed.  Thus, when various conditions are met, these programs begin rapid trading.  The sharp drop seen in the last hours of trading yesterday were likely triggered by such programs.^[3]  These programs can make financial markets temporarily unstable but really don’t affect long-term investors…as long as they don’t pay close attention to such swings.  To some extent, algorithms are not doing anything humans don’t usually do, but they do them faster and they seem impossible to stop once triggered.  That feature is what makes them a bit worrisome.

So, where does all this leave us?  We view this pullback as a buying opportunity.  The real worry is a recession that brings a broader bear market, and the economy is doing ok.  Insofar as this correction rids the market of some of these activities that rely on conditions that are probably unsustainable, it will make equities less vulnerable to shocks.  The bigger picture is the repricing of stocks that we are seeing; in other words, are we going to see a broader downward shift in market multiples that will lead to lower prices this year?  It’s possible, but if inflation doesn’t begin to accelerate significantly and the FOMC remains on a steady path, a dramatic repricing isn’t likely.  At the same time, we think there is probably more market turmoil in the short run.  We haven’t seen a real panic yet and usually these sort of events don’t end without fear returning to the markets.

Bitcoin hit again: While bitcoin continues to come under pressure, another voice calling for regulation has emerged.  The Bank of International Settlements (BIS), the “central banker’s central banker,” is calling on central banks to “clamp down” on these instruments, calling them a “threat to financial stability.”^[4]

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[1] Exchange Traded Products (ETPs) is the broad definition; Exchange Traded Notes (ETNs) are subsets of ETPs (the broader cousins of ETFs, or Exchange Traded Funds) which are bank notes issued to replicate an index.

[2] https://www.bloomberg.com/news/articles/2018-02-06/volatility-jump-has-traders-asking-about-poison-pill-in-vix-note

[3] https://www.bloomberg.com/news/articles/2018-02-05/machines-had-their-fingerprints-all-over-a-dow-rout-for-the-ages

[4] https://www.ft.com/content/78bf5612-0b1a-11e8-839d-41ca06376bf2

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST] It’s another down day for the broad swath of financial markets.  We are seeing weakness in equities; bonds have started to stabilize but we are seeing a rapid steepening of the yield curve.  Market action has been mostly controlled with little evidence of panic…so far.  Here is what we are watching today:

Equity issues: One of the key characteristics of this bull market has been the lack of volatility.  We have experienced long stretches with no corrections.  We see a couple reasons for this pattern.  First, the FOMC has been transparent about monetary policy; in addition, policy has been accommodative.  Second, inflation and fears of inflation have been low.  The combination of clear policy and low inflation has reduced the fears of owning equities.  There is evidence the combination of these factors is starting to change.  First, although monetary policy remains transparent, it is becoming less accommodative as the market looks for at least three, if not four, rate hikes this year.  Second, inflation fears are rising.  The wage data from last week’s employment report showed a 2.9% increase in overall wages, although we did note that the gain was a much more modest 2.4% for non-supervisory workers.  Until the latter accelerates notably, we think inflation fears may be overdone.

Inflation is the key issue.  When inflation rises, the correlation between stocks and bonds tends to turn positive, undermining diversification.  Under these conditions, bond and stock prices fall simultaneously.  That is the situation we are seeing now.  Whether or not it continues depends on the actual process of inflation.  In the short run, we look for a modest rise in price levels, with the core rate of CPI moving to around 2.5% by early 2019.  That rate is obviously higher than what we are seeing but such a move should be manageable.  The concern is, of course, whether the FOMC overreacts to this rise in price levels and tightens policy to the point where a recession is triggered.  At this juncture, there isn’t much evidence to suggest a recession is in the cards over the next couple of quarters.  Thus, the elements of a major sell-off in equities aren’t likely.

Instead, it appears what we are witnessing is a fairly normal decline in stocks.  Since 1928, a 5% drop in equities occurs about 3.4 times per year.  Corrections (10% declines) occur 1.1 times per year.  The last 10% drop occurred in late 2015.  We are clearly due for a pullback.

This chart shows the nearest futures contract for the S&P 500.  Technically, we are approaching the 50-day moving average, which may be a support area.  The lower segments on the chart show the Relative Strength Index and the Moving Average Convergence/Divergence indicator.  The RSI has moved from overvalued to the balanced area.  It has not achieved an oversold level, which would be below the lower green line.  The MACD has rolled over but hasn’t shown signs of consolidation.  The charts suggest a good bit of the excess has been worked off but we are still facing further downside.

No German coalition yet: The SDP and CDU/CSU missed their weekend deadline but talks are continuing today.  We still expect a deal to be struck, but the longer this goes on, the more pressure will develop on the EUR.

Sanctions on Venezuela?  SOS Tillerson indicated that the U.S. is considering restricting imports of Venezuelan oil and cutting off exports of product to Caracas.  If this step is taken, it will roil the U.S. and foreign oil markets.  Although Venezuela will try to sell its oil to other buyers, the characteristics of its oil (heavy and sour) are best for the U.S. refining industry.  We suspect further sanctions will cut global oil supplies and boost prices.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST] Happy employment day!  We cover the data in detail below but the initial read is that it’s a blowout.  Payrolls rose sharply, better than forecast, and wage growth accelerated (although not for all workers).  Financial markets are not taking it well; it’s another “red day” where interest rates are rising, equities are weaker and the dollar is up.  Here is what we are watching:

Is Goldilocks stuck with a porridge that is too hot?  Economic growth in the U.S. and around the world is solid.  Of the 38 countries that report manufacturing PMI, 35 are above 50.  As we note below, the employment data was quite good.  Although it is early in the forecasting process, the Atlanta FRB’s GDPNow report is rather shocking.

We expect this number to come down but, even at this early stage, it reflects an expanding economy.

So, why isn’t this good news?  A key factor to the strength in both bond and stock markets over the past nine years has been slow and steady growth, which has produced rising earnings with low inflation.  Growth acceleration raises fears of inflation and will likely prompt the Fed to raise rates steadily.  The three hikes expected for this year could turn into four and, eventually, rising rates will adversely affect the economy.

Equity prices are a function of earnings and investors are willing to pay for those earnings.  Rising inflation will tend to undermine the willingness of investors to pay up for earnings.  So, even though rising economic growth could bring even stronger earnings, equities could be constrained by a moderating P/E.  At the same time, it’s important not to become overly pessimistic here.  Bear markets are usually tied to recessions and there isn’t any evidence that a recession is approaching.  A more likely outcome is a stronger equity market with increased volatility.  The steady rising market we have seen in the past couple of years probably won’t be the path in 2018 even though the trend is higher.

Bitcoin tumbles: Bitcoin continues to spiral lower as governments boost regulatory scrutiny.^[1]  India is now joining China, South Korea and the U.S. in either taking full regulatory steps or at least examining such measures.  Axios reports that foreign governments are using cryptocurrencies to evade sanctions.^[2]  All this suggests that the movement is facing headwinds.

As the chart shows, bitcoin is down over 53% from its closing peak in mid-December.

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[1] https://www.wsj.com/articles/rise-of-bitcoin-futures-prompts-regulator-to-revisit-hands-off-approach-1517394600

[2] https://www.axios.com/how-cryptocurrencies-used-to-evade-sanctions-b752de25-0c2e-42f1-a04c-33aad930c6ed.html?utm_source=newsletter&utm_medium=email&utm_campaign=&stream=top-stories

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST]

The FOMC: The FOMC did what we expected; it held rates steady but prepared the market for new rate hikes.  We currently expect three hikes this year but, given the overall hawkishness of the 2018 voters, we cannot rule out four hikes, especially if the economy continues on its current course.  Financial markets are preparing for additional hikes.

The chart on the left shows the implied three-month LIBOR rate from the Eurodollar futures market, two years deferred.  In other words, it is the market’s projection of three-month LIBOR rates in Q1 2020.  Since September 2017, this rate has moved higher at a solid pace and now has reached its highest level in nearly eight years.  The Eurodollars are now projecting a fed funds rate of nearly 2.50% in two years.  The chart on the right shows the aforementioned implied LIBOR rate with the fed funds target. The upper line on the chart shows the spread between the two rates.  During tightening cycles, the FOMC tends to raise rates until the spread becomes negative (shown by vertical lines on the chart).  The fact that the spread is widening despite tighter policy suggests we are likely moving into an accelerating phase of tightening.

T-notes approach 2.75%: The 10-year T-note yield has moved toward 2.75% this morning as the prospect of tighter monetary policy, rising European yields and higher oil prices have boosted yields.  Although the rise in Treasury yields is a potential threat to the equity markets, in reality, we would need to see much higher yields for it to become a significant risk for stocks.

This chart shows the 10-year T-note yield and the S&P 500 earnings yield, the inverse of the P/E.  For the P/E, we use the four-quarter trailing methodology, described in our weekly P/E chart.  Although the so-called “Fed Model” has been around for a long time, in its raw form, it isn’t all that good of a predictor.  During much of the 1980s, the earnings yield was below the 10-year yield, which is odd.  Still, for most of this century, the earnings yield has been higher than the T-note yield.  Regressing the two suggests that the current level is about at fair value; to get to where equites are expensive, the 10-year would need to reach around 4.25%.  Of course, given the relative “looseness” of this relationship, we would expect a negative reaction from equities before then but this chart does suggest that it will take a larger move in rates to adversely impact equities.

Energy recap: U.S. crude oil inventories rose 6.8 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 fell under 400 mb.

As the seasonal chart below shows, inventories are usually rising this time of year.  This week, we finally saw an increase as refinery operations declined.

The rise is more normal and we would expect steady increases in stockpiles in the coming weeks until the refinery maintenance season comes to a close.

Based on inventories alone, oil prices are undervalued with the fair value price of $68.12.  Meanwhile, the EUR/WTI model generates a fair value of $72.21.  Together (which is a more sound methodology), fair value is $70.95, meaning that current prices, while elevated, are below fair value.  The weak dollar and falling oil inventories are bullish for oil prices and suggest there is more upside, especially if inventories fail to rise in their normal seasonal fashion.

Yesterday, the DOE announced that official November U.S. oil production reached 10.0 mbpd for the first time since the early 1970s.

Although this news wasn’t an enormous surprise, it is still remarkable.  It is interesting to note that the U.S. was producing just over 5.0 mbpd at the turn of the decade.  Essentially, U.S. oil output has doubled in eight years.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST] Equities are back in the green this morning.  The dollar is also in retreat.  Here is what we are watching today:

The FOMC: The last FOMC meeting chaired by Janet Yellen concludes today.  We don’t expect a rate change or anything in the statement that will raise concerns.  At the same time, market action suggests we are preparing for a series of rate hikes that could become problematic at some point.

The lower lines on the chart show the fed funds target with the implied LIBOR rate from the two-year deferred Eurodollar futures market.  The latter is projecting the three-month LIBOR rate two years from now.  The futures tend to anticipate tightening policy actions.  Recently, we have seen the implied rate rise rather strongly; that rate, at 2.665%, is the highest in seven years.  Last September, the implied rate was 1.65%, meaning that we have seen the implied rate jump 100 bps.  The rise signals to the FOMC that higher rates are now being discounted and tells policymakers it’s safe to raise rates.  The current implied LIBOR rate has discounted fed funds at 2.40%, meaning that we will almost certainly see higher rates this year.  Thus, this meeting won’t be a big deal, but a four-hike year is being discounted by the fixed income markets.

The NY FRB moves forward: The NY Federal Reserve is moving forward to replace Bill Dudley, who is expected to step down in June.  The president of the NY FRB is especially important because he votes at every meeting, just like a governor.  Once the board of directors of the NY FRB selects its nominee, final approval from the Fed’s board of governors is required for this position.

The BOJ fights back: BOJ Governor Kuroda moved to scotch reports that the Japanese central bank is beginning to withdraw stimulus by boosting bond buying.  The JPY has been strengthening recently but it did weaken this morning on these comments.  We will be watching closely to see if the market believes Kuroda or thinks that stimulus is coming to a close. If the JPY resumes its appreciation, it suggests Kuroda hasn’t convinced traders.

Cha is out: Victor Cha, an academic who served in the George W. Bush administration, was the White House’s first choice for Ambassador to South Korea.  However, Cha recently said that the idea of limited military action against North Korea (the “bloody nose” strategy) would be a mistake and could lead to a wider war.  This action against Cha suggests the administration may be leaning toward limited military strikes.  Although such strikes may work (previous examples would be the bombing of Libya by Reagan and various missile strikes in the 1990s), they tend to work best when the adversary doesn’t have the means to retaliate.  North Korea could easily misinterpret limited strikes as preparation for invasion and deploy its nuclear weapons.  The administration may simply want an ambassador that is at least open to the idea of military action even if it isn’t going to occur, but it could also mean the president is leaning toward a military engagement.  By the way, it appears there is only one carrier group in theater, the USS Carl Vinson CSG.  The USS John C. Stennis CSG could be added on short notice but, in order to conduct major operations, the U.S. military usually prefers three groups that can conduct 24/7 air operations.

Catalan surrender?  This morning Telecinco, a Spanish broadcasting network, aired a text message sent by former Catalan President Carles Puigdemont to his aide, exclaiming that the Catalan independence movement is dead and the Spanish government has won.  This comes a day after the Catalan parliament postponed holding a vote for president.[1]  In response to the report, Puigdemont stated on Twitter that he does have his doubts but he still remains supportive of the independence movement.  At this moment, it is unclear what to make of the text, but it is becoming increasingly apparent that the separatists do not have the support or leverage needed to force the Spanish government to accept Catalonia as an independent state.  That being said, we do not expect the separatists to go away completely as their supporters are very loyal.

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[1] See our discussion on this topic in yesterday’s Daily Comment, 1/30/18.

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST] It’s another red day.  Treasury prices have turned lower, equity futures are falling for the second straight day and oil is also lower.  Gold and foreign currencies are higher.  Here is what we are watching:

A medical shakeup: Amazon (AMZN, 1417.68), Berkshire Hathaway (BRK, 323,500) and JPMorgan (JPM, 116.20) announced they are forming a company designed to explore lowering health care costs by starting with their own employees.  Warren Buffett, the legendary investor, was quoted as saying, “The ballooning costs of health care act as a hungry tapeworm on the American economy,” a rather graphic description.  The three companies employ over one million workers (although not all are in the U.S.) and they have indicated the new venture will not have a profit incentive.  The inclusion of Amazon is very interesting.  As NYU Professor Scott Galloway noted in his recent book, The Four,^[1] Amazon has capital costs of zero due to its loyal investing base.  If the company moves into the high capital cost sector of health care, it will have a significant impact.  Health care stocks tumbled on the news.

SOTU: The major media is consumed with anticipation of tonight’s State of the Union address.  As we noted yesterday, we expect a teleprompter speech with the usual “common man in the crowd” asides.  We doubt we will hear too much on new programs; tax cuts were the major policy goal of the GOP and anything beyond that is too internally divisive for the party to support.  Thus, we don’t expect anything market-moving from the speech.

However, that doesn’t mean there won’t be anything interesting.  In modern times, the opposition party offers a response to the SOTU.  To highlight the divisions within the Democrat Party, there will be five responses.  Rep. Joe Kennedy (D-MA) will deliver the “formal” response.  There will be a Spanish-language response by Elizabeth Guzman, a state legislator who recently won a seat in the Virginia state legislature.  Sen. Sanders (I-VT) will offer a direct retort to the SOTU (most of these speeches are made before the president talks and thus are not really “responses” to the SOTU).  Maxine Waters (D-CA) and former Maryland Congresswoman Donna Edwards will also give responses.  Perhaps nothing highlights the internal divisions within the Democrat Party more than the fact that the party can’t coalesce around one person to offer an official response to the president’s address.

So far, none of the political divisions have had much effect on financial markets.  There have been long periods of gridlock in Congress, which have reduced the chances of significant policy changes and, for the most part, policy has mostly favored capital over labor.  Anti-trust regulation has mostly been benign and taxes are steadily being cut.  We don’t see that changing anytime soon.  At the same time, there are problems facing the country, such as entitlements, the lack of educational effectiveness, spiraling health care costs, inequality, etc., that require a measured political response and those issues are not being addressed.  A NYT op-ed asks if a third party may emerge from this morass.  It’s worth a read.^[2]

Brexit trouble: A leaked government report suggests that Brexit will make the U.K. economically worse off, regardless of the structure of the exit.^[3]  There is growing pressure for PM May to leave; however, given the state of Brexit negotiations, no strong candidate has emerged to take the position.  Simply put, she is probably still in power because no one else has any better ideas of how to structure Britain’s exit from the EU.  Given all this uncertainty, the GBP has been appreciating recently against the USD.  This is because the former had become deeply undervalued after the Brexit vote sell-off and it remains well below fair value as calculated by relative inflation rates (our fair value is around $1.64).  Still, it will be hard for the GBP to achieve fair value given the lack of clarity on Britain’s exit.

The Czech vote: Czech Republic voters reelected Milos Zeman last week to the presidency.  An anti-EU, anti-NATO, pro-Russia and pro-China politician, Zeman won by a narrow margin, only 175k votes.  He represents a growing trend of populism that is dominating central Europe and could easily include Italy after the March elections.  The financial markets are mostly ignoring these political risks because, thus far, they haven’t affected trade or foreign investment.  In other words, right-wing populism has mostly been co-opted by business interests.  As long as that remains true, populism should not adversely impact financial markets.

Cape Town concerns: Our firm, Confluence Investment Management, resides in Webster Groves, MO, a leafy older suburb of St. Louis, a city that sits on the “confluence” of three major rivers—the Mississippi, the Missouri and the Illinois.  Although it’s an older city that has suffered some of the problems of the “rust belt,” it is blessed with one very critical resource—lots of fresh water.  Thus, from our perspective, the travails of Cape Town, South Africa are jarring.  This major city is running out of fresh water.  The area has suffered through three consecutive years of drought; conditions are so dry that they usually only occur every three centuries.  Authorities in Cape Town are limiting citizens to about 13 gallons of water per person (an 8-minute shower consumes about 15.8 gallons).  Of course, in the face of restrictions, households have been hoarding water before they take effect.  Lack of water is causing rising security issues in the city and may pressure the national government to funnel resources to Cape Town, which will strain government finances.

Catalan crisis II: After another standoff with the Spanish government, Catalonia has decided to indefinitely postpone the election of a new regional president after the Spanish High Court ruled that Carles Puigdemont, the sole presidential candidate, is ineligible to participate.  In October, Puigdemont fled to Belgium to evade charges of sedition and misuse of public funds after his party staged an illegal election and declared independence.[4]  After his departure, Catalonia was forced to form a new regional government at the behest of the Spanish government, which now rules Catalonia directly.  Despite having the support of the majority of seat-holders in the Catalan parliament, Puigdemont is restricted by parliamentary regulations which state that the president needs to be present in order to formally accept the role; Puigdemont could be arrested if he tries to fulfill this obligation.  The speaker of the house, Roger Torrent, has reassured the public that he does not plan on nominating another candidate for the position and the new election will eventually take place.

The Catalan parliament’s reluctance to hold elections may be partially due to desires to regain autonomous rule from the Spanish government.  Electing Puigdemont would be a hard sell as it not only violates Catalan parliamentary regulations but would likely lack legitimacy.  It has been rumored that Puidgemont, if elected, would seek to rule Catalonia while remaining in Belgium.  As a result, we expect the formation of a regional government to be stretched out as long as possible while the Spanish government tries to do everything in its power to undermine the separatists.  This will not likely have an effect on the euro in the short run, but it will lead to more uncertainty in Spain if problems persist.

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[1] Galloway, S. (2017). The Four: The Hidden DNA of Amazon, Apple, Facebook and Google. New York, NY: Penguin Random House.

[2] https://www.nytimes.com/2018/01/29/opinion/republicans-third-party-.html

[3] https://www.buzzfeed.com/albertonardelli/the-governments-own-brexit-analysis-says-the-uk-will-be?utm_term=.mheLwVVGP5&wpisrc=nl_todayworld&wpmm=1#.jsP2e00wxB

[4] They have since stated the declaration of independence was not a formal declaration but a symbolic declaration.