by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST] It’s a rather quiet morning.  Here is what we are following:

Economic momentum is rising: The ISM manufacturing index continued to hold near the 60 mark, which is an unusually high level.

The ISM manufacturing index exceeds 59.0 only 17% of the time.  Equally impressive is the new orders index.

The current reading of 63.5 is the highest since 2004 and only happens about 16% of the time.  The ISM indices are sentiment indicators; purchasing managers indicate if conditions are “better, the same, or worse” for various subsectors, such as orders, supplier performance, etc.  In general, there is a positive relationship between the ISM manufacturing index and equity performance.

This chart shows a scatterplot of the ISM manufacturing index and the yearly change in the S&P 500.  The regression line shows that readings of 60 for the ISM index are consistent with yearly growth of 20% for the S&P 500.  Thus, the strength we are seeing in equities is consistent with economic activity.

Iran: Although protests continue in Iran, the intensity appears to be waning, as we expected.  Poor citizens don’t have the financial resources for weeks of protests.  We will be watching to see how the government responds to the recent unrest.  This issue is the topic of next week’s Weekly Geopolitical Report.

Winter storm: The Northeast is getting slammed by a winter storm that will reduce travel and boost energy demand in the short run.  So far, natural gas prices have not jumped significantly because supply capacity remains high.  There have been local price spikes but this is mostly due to the lack of pipeline capacity; adding pipeline capacity is usually unpopular but this is the cost of not overcoming NIMBY complaints.  We may see some impact on market liquidity but it will probably be much less of a factor than in the past due to continued trading automation.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST] U.S. equities appear poised to grind higher.  Here is what we are watching this morning:

Iranian update: Iran has seen six consecutive days of protests with 22 dead and over 450 people incarcerated.  These protests are fundamentally different from the 2009 event we mentioned yesterday.  First, the participants are different.  The 2009 protests were a fight between competing elites—the “reformists” and “hardliners” were vying for power.  The hardliners won.  However, these terms should be used with great care.  The hardliners are fairly obvious in their views, but the reformers were not “reformers” in the Western sense.  They were as committed to the Islamic Revolution as the hardliners.  The reformers were simply willing to give more social and market freedoms compared to the hardliners, but neither group was willing to allow for full democracy.  When Akbar Hashemi Rafsanjani[1] is considered a reformer, it is clear the differences between the two groups aren’t all that great.

The current protests are similar to political issues we are seeing in the West, where populism has become widespread.  These protestors are angry about the state of the Iranian economy.  Officially, unemployment is 20%, but economists estimate that unemployment among Iranian youth is probably closer to 40%.  Many of the protestors are from the underclass from the countryside who have moved to towns and cities in the hope of finding work only to find unemployment.  These people have traditionally supported the regime.  In 2009, they would have been opposed to the Green Movement.  But, Iranian President Rouhani raised hopes of economic improvement as a benefit of the nuclear deal that has so far failed to materialize.  Apparently, one of the catalysts for the protests was a leaked government budget that showed billions of dollars going to the clerical elite and the Iranian Republican Guard Corps (IRCG), while cutting social spending and raising subsidized fuel prices and educational tuition.

Iran’s geopolitics are key to understanding this issue.  Iran is a mountainous nation with an internal flatlands of salt.  It is a difficult environment.  History shows it is very tough to invade—imagine a land army trying to march through the Rockies.  Thus, Iran has been mostly safe from invasion and, if invaded, the invaders were usually spent due to the effort.  At the same time, it is really costly for Iran to project power.  Just running the economy is costly and funding forces to take territory further increases the costs.  Throughout history, Persian empires used proxies to project power, just as Iran does today by co-opting the Iraqi government and through Hezbollah.

A common theme heard in the protests is the call for keeping resources at home to help the lower classes instead of expending those resources to project power.  This was also a theme in the U.S. presidential elections, not only in 2016 but also in 2008 and 2000.

So, what happens next?  The regime has been remarkably restrained so far.  We believe this is because it recognizes that it really doesn’t face much of a threat from the protests.  Relative to the 2009 event, the protestors are not well organized and they lack the resources to maintain the protests indefinitely because they are poor.  The young protestors in 2009 were children of the elite who had resources and were well versed in social media.  Those protests were a threat to the hardliners but not the regime.  These protests are a threat to both the hardliners and the reformers, but not a serious one.  At the same time, the simmering anger has to be a concern for the regime.  After all, such anger can be co-opted by revolutionary leaders.  The Russian Revolution of 1917 shows how a small group of talented leaders can use mass anger to bring revolution.  The most rational response from Rouhani and Khamenei would be to sack the aforementioned budget, take resources from the clerics and the IRCG, raise subsidies and cap prices of key goods and try to improve the lot of the poor.  However, that choice will limit Iran’s ability to project power just when it is on the cusp of winning—after all, it pretty much controls Baghdad, Islamic State is essentially defeated and Assad remains in power in Syria.  A path to the Mediterranean is opening up and the budget is designed to take advantage of that.  The protests might delay or undermine Iran’s ability to become the regional hegemon in the region.  Or, the leadership can decide to stay the course and hope that an alternative leadership doesn’t emerge.

Fed minutes: The FOMC minutes will be released later this afternoon.  Like most analysts, we will comb the report for clues about future policy, although, as we have noted at length, the voting composition will be unusually hawkish this year.  These minutes will reflect the Yellen Fed which will soon pass into the ether.

War of words: Yesterday, President Trump responded to Kim Jung-un’s threat of having a nuclear button ready to strike the U.S. by stating that his “nuclear button is bigger and more powerful.”  Although the escalation of rhetoric is nothing new, it does appear that Kim Jung-un is becoming increasingly bolder while seeking a dialogue with South Korea.  Reports from the Korea Times suggest that North Korea could be preparing to launch another ICBM test in the near future.  At the same time, the New York Times reported that North Korea has reopened its border hotline with South Korea, which could be a prelude to direct dialogue between the two countries.  South Korea has been open to talks with North Korea in an attempt to prevent any possible crises during the upcoming Olympics.  North Korea appears to be trying to drive a wedge between the U.S. and South Korea; the latter fears the U.S. will start a war with the North where the costs of war will mostly fall on South Korea.  The situation remains fluid.

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[1] https://www.confluenceinvestment.com/weekly-geopolitical-report-exit-shark-february-6-2017/

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST] Welcome, 2018!  Back to the salt mines.  Here is what we are watching this morning:

Iranian unrest: Civil unrest broke out in the major urban areas of Iran.  The protests were widespread and have led to at least 22 fatalities so far.  Iranians are angry about weak economic growth; hopes were raised that the nuclear deal would lead to a general reduction in sanctions.  Although a large number of restrictions were lifted, the U.S. has maintained a significant number of unilateral sanctions and these have been enough to keep foreign investment below expectations.  Social media reports suggest that many of the protestors come from the lower economic classes and the chants indicate calls for more focus on the domestic economy and less on expanding Iran’s geopolitical footprint (populism isn’t only occurring in the West).  Another factor to consider is that the Iranian leadership was always able to blame the weak economy on international sanctions.  The goal of the nuclear deal was to end the sanctions and thus the ordinary Iranian assumed that the end of sanctions would lead to a much better economy.  As we noted above, most U.S. sanctions remain in place but that fact probably got lost in the narrative President Rouhani was selling.

We expect Iran’s security forces to maintain security; after all, the unrest after the 2009 elections was widespread but failed to bring regime change.  At the same time, the rather reserved response from the security forces thus far does add credence to the notion that the protestors are not the sophisticated children of the elite but the natural allies of the regime, the conservative lower classes.  If the protests continue, at some point, we would look for the security services to become more aggressive.  If unrest does threaten the regime, it would likely be bullish for crude oil.

Italian elections: Although we have been anticipating elections in Italy for some time, the government set a date for the actual vote of March 4, 2018.  The single currency has the lowest popularity rating in Italy among the major Eurozone countries, although most polls still show the majority favor remaining in the Eurozone.  There are parties that not only want to leave the Eurozone but also question EU membership.  Current polls suggest the election won’t yield a definitive outcome and may lead to months of wrangling to try to form a government.  Any election sentiment that appears to support an Italian exit from the Eurozone will be bearish for the single currency.

Eurozone PMIs: The final readings for December manufacturing PMIs are shown in the PMI table below, but the numbers continue to show impressive strength.  The dollar is falling this morning on the back of Eurozone economic strength.  We also saw weaker European equities due to rising interest rates.  The chart below shows 10-year yields for Italy and Germany.  Although European interest rates remain remarkably low, we have seen rates in both these nations rise rather significantly since mid-December.  The rise in German rates reflects stronger growth, while the rise in Italian rates is likely due to a combination of political uncertainty and economic expansion.  In any case, rising European yields does have a similar effect on U.S. yields.  Our 10-year T-note model suggests that for every rise in German yields of 100 bps, U.S. yields rise 15 bps (all else held equal).

North Korea: There were several news items that emerged from the Hermit Kingdom over the past few days.  Kim Jong-un claims he now has a “nuclear button” on his desk, indicating his nation is a fully nuclear power.  We have serious doubts that North Korea’s weapons can be launched immediately, but the “button” is highly symbolic.  The U.S. and South Korea released evidence of fuel oil smuggling; initially, it was first thought that Chinese vessels were involved but later it appeared that Russian ships were actually helping North Korea evade sanctions.  Kim Jong-un also made overtures to South Korea with regard to the Winter Olympics.  Finally, former Joint Chief of Staff Adm. Mike Mullen said over the weekend that nuclear war with North Korea is “closer than ever.”  He blamed President Trump’s rhetoric for increasing tensions.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST]

(Note to readers: The Daily Comment will go on hiatus next week after today; commentary will resume on January 2, 2018.  From all of us at Confluence, thanks for reading!  We wish you a Merry Christmas and Happy New Year.)

The big news was from Europe.  Here is what we are watching this morning:

Catalonia returns: Catalonia held regional elections yesterday and the results, though not completely conclusive, favored independence.  The coalition of parties that want separation won 70 seats, but Ciudadanos received the most votes and thus won the most seats, 37 out of 135.  Ciudadanos is a center-left party that opposes independence.  Of the top three parties in terms of seats in the regional parliament, the largest opposes independence while the next two support it.  Interestingly enough, the positions are becoming hardened; parties with no opinion on separation only won 9.1% of total votes compared to 13.1% in 2015.

To a great extent, this vote solved nothing.  It was a real political blow for PM Rajoy.  His center-right Popular Party only won three seats, a dismal showing.  This election suggests that a center-left government is probably the only hope for a national government that can keep Catalonia in Spain.  In addition, it isn’t clear how the separation coalition can govern.  Its leaders are in exile and face arrest if they return to Spain.  If new leaders emerge, Rajoy may simply arrest them too.

For the time being, Catalonia will be governed from Madrid until a new government is formed.  There is no obvious solution to the current impasse.  However, it appears to us that Rajoy probably won’t be the leader to resolve the problem.  The problem for the financial markets is that Ciudadanos is an unknown quantity; Rajoy has embraced austerity and can argue that it has worked to some degree.  The chart below shows Spain’s unemployment rate.  Although it remains elevated, at 15.1%, the trend is clearly going in the right direction.  The fear in the markets is that if Rajoy’s government falls on this issue, a left-wing government may reject austerity and put the Eurozone at risk again.

We will be watching to see if any of the established parties in Madrid decide to call a no-confidence vote and trigger new elections.  Currently, Rajoy is running a minority government so there is the potential for new elections, which would be bearish for the EUR and Spanish financial assets.

Government funding: As expected, Congress passed a temporary spending bill, but nothing was really resolved.  A whole host of issues will need to be addressed by January 19.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST]

(Note to readers: The Daily Comment will go on hiatus after Friday; commentary will resume on January 2, 2018.)

Happy Solstice!  Here is what we are watching this morning:

Tax bill passes: While there was some last-minute drama, the tax bill passed.  We will be watching to see how the economy reacts, although our expectation is that the impact will be rather small.  We have taken note of a few large firms that have announced increases in their minimum wage levels, a lift in investment and one-off bonuses due to the tax cut.  We view these actions as mostly done for positive publicity; as a thought experiment, it’s worth noting that equity prices usually rise when firms announce layoffs.  But, the actions will blunt some of the negative media coverage that has developed as part of the tax measure, giving pundits talking points.

Government funding: We don’t expect a shutdown (lawmakers want to get home for Christmas), but the rhetoric will get heated before a deal is completed.  Expect a short-term funding agreement that will push the next “crisis” into late January.

The bond market: We continue to see a backup in yields, especially at the long end of the curve.  Concerns about the deficit expansion may be behind this rise but, in reality, the relationship between deficits and Treasury yields isn’t very strong.  The chart below shows the fiscal deficit as a percentage of GDP and 10-year Treasury yields.  The correlation is 0.08, which is virtually uncorrelated.  The two most important variables to yields are the policy rate and inflation expectations.  The rise we are seeing in long-term yields is a combination of fears of tightening monetary policy and the chance that the tax bill could boost inflation.  After all, fiscal stimulus with a very low unemployment rate is a textbook combination designed to raise inflation.  However, we aren’t all that worried because (a) we doubt the tax bill will have much of an impact on growth, and (b) any lift in growth will probably be offset by rising imports.  At the same time, if the administration is successful in erecting trade barriers, our concern level would rise significantly.  Thus, for now, we view the rise in bond yields as probably more of a year-end position-squaring event…but we are watching it closely.

Equities remain elevated: We have seen some weakness in the past couple of days, which we would attribute to profit-taking after the tax bill passed yesterday.  Given the recent strength in the market, we want to examine a couple of indicators we monitor.  First, retail money market funds continue to rise despite the strength in equities.

The orange bars on the chart show periods when retail money market funds have fallen to $920 bn or below.  These tend to be periods when equities correct.  We suspect this is because equities run out of liquidity to bid them higher.  What is fascinating about the current rally is that it is occurring while retail money markets have increased to $1.2 trillion.  It would appear that retail investors may not be fully participating in this recent leg up in equities.  Second, flows into equity mutual funds and ETFs have slowed as well.

This chart shows the 26-week average of flows.  Although they remain positive, the pace has slowed for new flows, confirming there is some slowing in instruments used by retail investors.  This suggests to us that sentiment is not excessive (despite what the sentiment surveys suggest) and that further gains in equities are likely.

Energy recap: U.S. crude oil inventories fell 6.5 mb compared to market expectations of a 3.1 mb draw.

This chart shows current crude oil inventories, both over the long term and the last decade.  We have added the estimated level of lease stocks to maintain the consistency of the data.  As the chart shows, inventories remain historically high but have declined significantly this year.  We also note the SPR rose by 0.4 mb, meaning the net draw was 6.1 mb.

As the seasonal chart below shows, inventories fell this week.  We are now nearing the end of the late Q4 seasonal draw.  As the new year starts, stockpiles usually begin their largest seasonal build from early January into early April.

Oil prices rose on the bullish report.

Based on inventories alone, oil prices are undervalued with the fair value price of $62.27.  Meanwhile, the EUR/WTI model generates a fair value of $63.83.  Together (which is a more sound methodology), fair value is $62.98, meaning that current prices are below fair value.  Overall, oil prices are within normal ranges of current fundamentals but we are generally bullish toward crude oil at this time.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST]

(Note to readers: The Daily Comment will go on hiatus after Friday; commentary will resume on January 2, 2018.)

Markets are showing more of the same—U.S. equities are rising and bond yields are also rising.  Here is what we are watching this morning:

Tax bill update: It’s essentially a done deal.  The House will need to vote again on the tax bill due to procedural issues in the Senate that required a vote late last night.  The vote was strictly by party line, 51-48.  We expect a similar outcome in the House.  The president will have the bill no later than tomorrow; although there is some talk he might sit on it for a few days, we suspect he will sign it immediately.

Some thoughts on the tax bill: First, this bill got finished at record speed.  Kudos to the GOP congressional leadership.  Whether one likes the outcome or not, the fact that it was done so quickly is remarkable, especially given the disarray evident this fall.  Second, don’t expect durability.  In the hyper-partisan political environment in Washington now, both parties are looking for retribution when they get power.  Look how hard the GOP worked to unwind the ACA.  Universal healthcare is a totem for the Democrat Party.  And, even though a full “repeal and replace” failed, the GOP has undermined the ACA with various measures, including removing the insurance mandate as part of this tax legislation.  One should fully expect the Democrats to try to unwind this tax bill if they gain political power in 2018 and 2020.  Why?  Because tax cuts are a totem for the GOP.

Compare the current tax reform bill to the last one.  The 1986 Tax Reform Act only had 12 Democrat senators vote against it in its final form.  It passed 74-23; 11 Republicans opposed the measure.  Three decades ago, party discipline was clearly not as strong as it is today.  To get that degree of bipartisanship, legislators from both sides had to work in concert to craft the bill.  When bills have that degree of bipartisanship, they tend to remain unchallenged by future administrations.

This is a key point.  We are rapidly reaching a status where households and businesses can only rely on the current regulatory and legislative environment to endure as long as the party in power remains in place.  Once the government shifts, one should expect a wholesale reversal to occur.  This fact will make it increasingly difficult to invest and plan.  The current tax bill’s support is completely partisan, which means a new environment will develop if and when the opposition gains power.

The other issue to remember is that this tax bill has all sorts of surprises embedded in it, due in part to the haste in which it was fashioned.  The sunset provisions, which “everybody” knows will be extended, won’t be if the Democrats are in power.  An interesting sidelight is a provision that will eliminate the ability of cryptocurrency holders to transfer their holdings into another similar instrument and defer taxes.  Before this legislation, cryptocurrencies were treated as property, allowing tax deferral for like-kind exchanges.  In the media, there is lots of talk about how other, lesser known cryptocurrencies are jumping in value relative to bitcoin.  This buying may be tied to the tax legislation.

We will have more to say on the tax bill next year.  But, for now, it will boost corporate earnings, anywhere from 5% to 10%, and is clearly bullish for equities.  That fact will support stocks into Q1.

The EU rules on Uber: The EU’s top court says Uber is a transportation company, not a platform company, and thus is subject to EU regulation on livery companies.  This is a huge blow to the company, which was mostly built on regulatory avoidance.  If this ruling becomes precedent, other platform firms may find themselves subject to similar laws in their markets.

The shutdown: Although the GOP leadership in Congress is celebrating its tax win, the looming spending bill has to be passed by Friday or the government will run out of spending authority.  We expect a shutdown will be avoided but we will likely only get a short-term extension.  This issue will probably return by mid-January.

Catalan vote tomorrow: Catalonia will hold regional elections tomorrow.  Current polling shows that separatists and unionists are in a dead heat, with nearly 20% of the electorate undecided.  The most likely outcome is an indecisive election and weeks of jockeying before a regional government is formed.  However, if the separatists win decisively, a constitutional crisis could develop in Spain.

China blinks (again): The WSJ[1] is reporting that the Xi regime is dialing back its deleveraging program to support economic growth.  This has been a consistent pattern from the CPC; although the need to deleverage is obvious, the restructuring necessary will lead to a slower growth economy, something the leadership fears.  That is good news in the short run because China is an important component to global growth.  However, the debt level is clearly unsustainable and the safest way to address it is to slow growth and shift resources to the household sector.

Cryptocurrency woes: Two cryptocurrency exchanges had issues yesterday—one in South Korea was forced into bankruptcy after a cyberattack and another in the U.S. is investigating the potential of insider trading.[2]  These issues highlight the security problems of the new currencies.

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[1] https://www.wsj.com/articles/china-seeking-growth-softens-focus-on-cutting-debt-1513700557

[2] https://www.ft.com/content/aa9fdd64-e536-11e7-97e2-916d4fbac0da?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST]

(Note to readers: The Daily Comment will go on hiatus after Friday; commentary will resume on January 2, 2018.)

Markets are quiet this morning as investors begin to wind down for the holiday weekend.  Here is what we are watching this morning:

Tax bill update: The House will vote on the tax bill in the early afternoon.  Although no Democrats are expected to support the measure and a few Republicans from high SALT states are also expected to vote against the bill, it looks like it will pass with little drama.  The Senate will take up the measure as early as tomorrow.  With Sen. Collins (R-ME) now supporting the bill, it should pass easily.

Fed speakers: Minneapolis FRB President Kashkari and Dallas FRB President Kaplan were on television this morning, both striking a cautious tone about future rate hikes.  Kashkari may be the most dovish member of the FOMC at this point; his argument is that the policy rate should not be moved higher until the inflation target is achieved.  Kaplan’s concern is that the yield curve is flattening, which should slow the pace of tightening.  These two presidents were voters in 2017 but will be non-voters in 2018.  As we noted before, the composition of the voting roster next year will be profoundly more hawkish than in 2017 even without the appointment of new governors.  Currently, fed funds futures project a 70% chance of a rate hike in March of 25 bps.

Another Houthi missile: The Saudi military indicated they successfully intercepted a ballistic missile launched by Houthi rebels from Yemen.  The Houthis said it was a Brukan 2H missile, a variant of the SCUD.  The missile was fired at Riyadh as was the earlier missile in November.  The last time this situation occurred, the Saudis declared it a casus belli against Iran, which they accuse of supporting and arming the Houthis.  So far, oil markets have not reacted strongly to the news, although oil prices are higher this morning.

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