In Part I of this report, we began with a brief background of Mohammad bin Salman (MbS) and discussed the surprise arrests of many leading figures in Saudi society, including several members of the royal family, that occurred the weekend of November 4. In Part II, we examined the forced resignation of Saad Hariri, the missile attack on Riyadh and the crackdown on the clerics, which all took place the same weekend as the events discussed in Part I. This week, we will analyze how these events fit into the broader geopolitics, discuss the drift in American foreign policy and conclude with market ramifications.
The Broader Geopolitics
It is important to view the actions being taken by MbS within a specific context that partially explains some of his behavior. After WWII, the U.S. took on the superpower role; for most of the period, it shared that role with the Soviet Union.
President Truman, using the theoretical construct from George Kennan’s “long telegram,”[1] made containing communism the key element of American foreign policy. The American public generally accepted this position and supported it. However, there were four other elements of foreign policy that were not acknowledged and were, in fact, hidden within the rubric of containing communism. These involved “freezing” potential conflict areas and providing the reserve currency.
[Posted: 9:30 AM EST] It was a quiet weekend in front of an active week. Here is what we are watching this morning:
NYC bombing: This is a developing incident but early reports suggest a pipe bomb or similar device was detonated near Times Square. According to early reports, there are four non-life threatening injuries and a man is in custody. At least three subway lines have been shut down. We saw the typical market reaction—equities suffered a mild selloff and Treasuries rallied. This doesn’t appear to be a major situation, at present, and if there are no follow-on incidents we would expect the flight to safety buying to reverse in the later hours of the morning.
Central bank week: The ECB, Fed and BOE all meet this week. The FOMC is expected to raise rates 25 bps on Wednesday. We will get new economic forecasts and dots plots; it will also be Chair Yellen’s last scheduled press conference. No action is expected from the ECB or the BOE, although the latter may set the stage for another rate hike.
Alabama special election: Although polling suggests Democrat Party candidate Jones is gaining ground, the prediction markets are solidly indicating that GOP candidate Moore will win easily.
(Source: Predictit.org)
If the prediction markets are correct, in the short run, it’s a bonus for the GOP as it holds the Republicans’ narrow majority. The long-run implications may be less sanguine as one would expect the Democrats to use the controversy surrounding Moore as a way to boost their chances at the mid-terms.
Tax bill: Conference committee negotiations continue this week. The president will offer his “closing arguments” on Wednesday. Passage of something is likely but the final package could be rather muddled. The haste to put the bill together will almost certainly yield some unexpected outcomes, both positive and negative. But, until the final bill emerges, projections of what it will do are highly susceptible to error.
Negative nominal interest rates remain: The FT[1] reports there are $11.2 trillion of financial instruments with negative nominal yields, the highest reading since August. Although the FOMC is clearly tightening U.S. monetary policy, this data shows the effect of accommodative policy in Japan and Europe. These negative rates are keeping U.S. long-duration interest rates lower than they would be otherwise; therefore, we should see the negative nominal rate number ease when the ECB begins to reduce accommodation. This outcome may have a modestly bearish impact on long-duration U.S. debt.
We have received a number of requests to update our S&P 500/Fed balance sheet model.
This chart shows the results from our S&P 500/Fed balance sheet model. We have projected the model’s forecast using the expected path of balance sheet reduction. It shows that the equity index tended to follow monetary policy from the end of the recession in mid-2009 until the election of President Trump. Since the election, the index has far outperformed what the balance sheet model projects for fair value.
This model was always problematic, potentially a classic example of data mining. The problem of data mining and the current discussion of “big data” get at the philosophical problem of “how do we know?”[1] Our basic procedure when looking at correlations is to try to formulate a theoretical reason for why the correlation should exist. Simply finding correlations, otherwise called data mining, is fraught with risk. Some correlations are spurious—they develop almost by accident and fade over time. Others are true as far as they go but can lead one to draw inappropriate conclusions.
(Source: Dummies.com)
This chart shows the relationship between ice cream consumption and drowning in 2006. The relationship of these two variables is a common pedagogical tool when teaching statistics. It is clear that a relationship exists between these two variables. However, they share a common factor that is the likely cause of the correlation—summer! If a policymaker neglected to take the seasonal factor into account, a case could be made for a tax on ice cream in a bid to reduce drownings. It is almost certain such a policy would fail.
We have concluded that the most likely reason the Fed’s balance sheet was related to the S&P 500 was because it showed that the U.S. central bank still had effective tools to stimulate economic growth. In other words, QE was mostly a confidence builder. It appears that Trump’s promises of deregulation and tax cuts have replaced QE in supporting investor confidence and thus, the relationship has broken down between the Federal Reserve’s balance sheet and the S&P 500.
However, we would be remiss if we didn’t examine another element of the balance sheet relationship. With globalized financial markets, it is also possible that the behavior of foreign central banks affects U.S. equities as well. Combining the exchange rate-adjusted balance sheets of the European Central Bank (ECB), the Bank of Japan (BOJ) and the Federal Reserve, with projections based on policy guidance, yields the following model.
The BOJ’s balance sheet path is more difficult to project because Japan is now fixing the 10-year JGB interest rate and adjusting the balance sheet accordingly. We have developed a projection but with less confidence than our estimates for the Fed and the ECB. We are also assuming mostly steady exchange rates. This model shows that the rise in the S&P 500 can be explained by the combined effects of balance sheet expansion from the Federal Reserve, the BOJ and the ECB. It also suggests the upside is likely limited because the ECB will begin tapering next year and is projected to stop expanding its balance sheet by the end of Q3 2018.
Thus, one possibility is that continued balance sheet expansion by the BOJ and ECB has supported equities, offsetting the lack of Federal Reserve expansion. If this is the case, then ECB tapering and the end of its expansion and the uncertainty surrounding BOJ expansion may become significant headwinds next year. However, as noted above, we believe QE was mostly a confidence booster; there is little evidence it had much of an impact on the economy. At present, tax cuts and deregulation have lifted investor sentiment and supported higher equity prices. However, we will be watching to see whether the slow end of unconventional monetary policy abroad has an impact on equities next year.
[Posted: 9:30 AM EST] It’s employment data day! We detail the data below but the short answer is that the numbers are good for capital—employment rose faster than forecast while wage growth came in weaker than expected. The lack of wage growth should bring some degree of pause on the part of the FOMC. Here are other items we are watching this morning:
Brexit goes forward: Britain and the EU reached a deal on exit terms, giving special rights to the four million EU expats in the U.K. and an exit fee of €40 bn to €60 bn. The sticky problem of the border in Ireland was resolved; although the DUP did go along, in reality, it appears that Northern Ireland will, in terms of regulation, be a de facto member of the EU. The U.K. did get some relief over EU jurisdiction. Overall, it looks like PM May got a deal because she acquiesced at every level with the EU. From here, negotiations will move on to trade. Although this is a significant development, it appears the markets fully anticipated this outcome as the GBP is essentially flat.
Basel bank accords: Although the deal took almost two years longer than planned, the Basel III accords have been approved. These rules apply to bank capital in 27 nations plus the entire EU. The goal is to create uniform bank capital rules across the developed world to prevent financial contagion. The disagreement was mostly U.S. versus EU; the former wanted stricter regulations because America’s financial structure makes businesses less dependent on banks and more on capital markets. If the EU were forced to follow U.S. rules, the EU financial markets would need massive restructuring. EU bank equities are up 3% on the news.
Continuing resolution: It looks like a short-term deal was struck to keep the government functioning but it will only last until around Christmas. The sticking points are familiar—Democrats want an immigration break for dreamers and social spending equal to defense spending. The GOP wants no immigration deal and only spending on defense. This impasse looks difficult to resolve but the most likely outcome is higher spending and deficits.
A questionable invitation: Greece and Turkey are historical enemies. For the first time in 65 years, the Turkish president visited Greece. It may be an equal period of time before such an event happens again. Turkish President Erdogan opened discussions by calling for a reworking of the 1923 Treaty of Lausanne, the treaty that established the border between the two nations. Greece has no interest in adjusting the deal. Erdogan also accused his hosts of discriminating against Muslim Turks who live in Greece. Criticism of the aforementioned treaty and support of the Muslim Turkish minority are a page out of the authoritarians’ playbook; see Hitler’s absorption of the Sudetenland in 1939. Erdogan also indicated that the division in Cyprus is due to Greek intransigence. Needless to say, hopes for some sort of improvement in relations looks like a long shot.
German coalition negotiations: Martin Schulz, the leader of the SDP in Germany, is in talks with the CDU/CSU to create a new grand coalition in Germany. If these talks fail, Germany will likely need new elections, which would be unprecedented in the postwar experience. Schulz gave a rousing speech that called for a “United States of Europe” by 2025;[1] this would signal a dramatic reversal in the CDU/CSU’s platform, which is cautious over further European integration. German conservatives are worried that further integration would entail Eurobonds (an EU bond backed by the full faith and credit of all EU members, meaning Germans would guarantee the debt of the other 26 members’ spending) and a unified fiscal budget. Schulz is laying down his markers for forming a government with Merkel. If he holds to this position, it seems highly unlikely that Merkel can form a government.
[Posted: 9:30 AM EST] It’s another quiet morning, the day before the payroll report. This is what we are watching:
Tax update: There’s not too much new to report other than there are rumblings of allowing the corporate rate to drift up by 200 bps. Unfortunately, if negotiators accept a higher rate, Congress members are lining up to use the extra revenue for pet projects. Negotiations remain difficult. Equity market action suggests that investors are now taking a “wait and see” position, not willing to bid stocks higher until a deal is actually signed.
Continuing resolution: The government’s spending authorization will be hit tomorrow and it isn’t clear if there is a clear path to avoiding a shutdown. The president is expected to meet with “Chuck and Nancy” at 3:00 EST today. House Republicans want a spending package that will not raise any new spending on anything other than defense; needless to say, Democrats have other priorities, perhaps most importantly DACA. Would a shutdown be an adverse outcome? Only in the very short run. As long as the continuing resolution process doesn’t hamper progress on taxes, we doubt the equity markets will mind. However, it could be bullish for Treasuries and bearish for the dollar.
Putin’s running: No real shocker—Russian President Putin is running for a fourth term. However, according to the Russian constitution, he cannot run for a 5th term (and, despite his attempts to project virility, in four years he will be 69 years old). After the elections, we expect the beginning of a “feeding frenzy” on who will replace him after the next term ends.
BOJ tightening? BOJ Governor Haruhiko Kuroda indicated today that the Japanese central bank is beginning the process of creating procedures to end the unconventional monetary policies designed to support the economy and end deflation. Kuroda acknowledged that low rates are distorting the financial system and policy will need to tighten at some point. We don’t expect this is a signal of imminent policy change but financial markets will tend to anticipate any adjustments. The most likely outcome would be a stronger JPY.
Employment data: For tomorrow’s employment report, non-farm payrolls for November are forecast to rise 195k. The U-3 unemployment rate is expected to remain unchanged at 4.1%. Hourly earnings are expected to rise 2.7%.
Energy recap: U.S. crude oil inventories fell 5.6 mb compared to market expectations of a 2.5 mb draw.
This chart shows current crude oil inventories, both over the long term and the last decade. We have added the estimated level of lease stocks to maintain the consistency of the data. As the chart shows, inventories remain historically high but have declined significantly this year. We also note the SPR fell by 2.4 mb, meaning the net draw was 8.0 mb.
As the seasonal chart below shows, inventories fell this week. We are now well within the year-end seasonal draw. As the new year starts, stockpiles begin their largest seasonal build from early January into early April.
(Source: DOE, CIM)
Oil prices fell yesterday due to rising gasoline stockpiles. Although the rise in stocks was large, up 6.8 mb, this is the period during the year when gasoline stocks rise.
As the chart shows, gasoline inventories will likely rise into early February. We are tracking last year closely.
Based on inventories alone, oil prices are undervalued with the fair value price of $58.52. Meanwhile, the EUR/WTI model generates a fair value of $64.68. Together (which is a more sound methodology), fair value is $62.37, meaning that current prices have fallen under fair value. Overall, oil prices are within normal ranges of current fundamentals but we are generally bullish toward crude oil at this time.
[Posted: 9:30 AM EST] Global equities continue to struggle this morning. Here is what we are watching:
Why the struggle in equities? There is a plethora of reasons why equities have started to tread water. The tax bill may fail. If it does pass, we could easily see a bout of profit-taking (buy rumor, sell fact). The next policy action from the Trump administration may be on trade. The combination of tax cuts (which raise the fiscal deficit) and trade restrictions (which would limit foreign saving from offsetting the fiscal deficit) would force domestic saving higher by either (a) cutting investment, or (b) forcing higher household and business saving, probably by boosting unemployment. That would weaken the economy and likely hurt earnings. The Fed may have too much credibility and the tax cuts may lead to faster monetary policy tightening and a stronger dollar. The fact that small caps seem to be holding up better than their larger brethren suggests the Fed concern may be playing a role; at the same time, small caps will probably benefit more from corporate tax cuts since they have not enjoyed the benefit of lobbying action to reduce their effective tax rates. The government may shut down. Chinese growth may slow next year. The bottom line is that we have seen a very strong equity market this year and a period of consolidation would make sense. And, the fact that there are so many “reasons” why equities are stalling suggests this is probably more of a consolidation than anything else. Why? Because the primary reason to worry about a bear market is either (a) recession, or (b) geopolitical event. Recession still appears to be a ways off. Geopolitical worries are a concern but we haven’t had one, so far, that would put the economy at risk.
The Jerusalem issue: The Trump administration is moving to recognize Jerusalem as the capital of Israel. We don’t have any strong feelings either way on the basis for this decision. However, it will complicate diplomacy in the region as the Arab states generally oppose the action. In other words, if the U.S. decides it wants to build an anti-Iranian coalition, this decision will make that harder. On the other hand, in the end, if the fear of Iran is great enough, it probably won’t matter. At this point, our take is that it will foster lots of punditry but probably doesn’t change much on the ground.
Bitcoin: We have been getting lots of questions on the cryptocurrency and it has been on a tear.
(Source: Bloomberg)
As the chart shows, the XBT/USD exchange rate is going parabolic. The debate around bitcoin, in particular, and cryptocurrencies, in general, is intense (Is it a real currency? Is it all a scam?). An issue we are monitoring related to bitcoin and cryptocurrencies is another cryptocurrency called “Tether” that uses the symbol “USDT.” What does Tether do? Unlike other cryptocurrencies, it is pegged 1:1 to the USD. So, why does this exist? Tether is designed to allow a holder of a cryptocurrency to shift it to Tether which, according to reports, is easier than converting bitcoin to USD. The operators of Tether say that there is one USD backing each USDT. Currently, there is 814 mm USDT circulating, meaning that there should be $814 mm sitting in a bank somewhere—except that the managers of Tether have not allowed audits and Wells Fargo (WFC, 58.55) has ended its correspondent relationship with the manager. The manager of Tether has also decided to no longer do business in the U.S., although that might be hard to do given the proto-anonymous nature of cryptocurrencies. There is growing speculation that USDT is being created without a reserve backing (in other words, USDT is simply being “printed”) and the manager is buying bitcoin with the inflows, further boosting the price of bitcoin.
So, what’s the problem? Tether’s contracts clearly indicate it is under no obligation to redeem USDT on demand (which, in theory, could eliminate the bank run problem). However, if the price of bitcoin were to fall rapidly for some reason (maybe because of the opening of futures contracts), then the backing of USDT, which may be bitcoin, would collapse. For most investors, this won’t be a big deal. But, it should be a cautionary note for investors who are considering participating in the cryptocurrency space.[1]
[Posted: 9:30 AM EST] Equity markets failed to hold yesterday’s tax adjustment gains. We are mostly marking time this morning. Here is what we are watching:
Brexit problems: As we noted yesterday, it appeared PM May had resolved the Northern Ireland/Ireland border problem. Her plan was to keep Northern Ireland in the EU Customs Union, thus creating a situation where there would be no hard border between Ireland and Northern Ireland. Under normal circumstances, that decision would have held. However, because of the Tories’ poor performance in the spring elections, the government needed support from the Democratic Unionist Party (DUP), a Northern Ireland-based Unionist (Protestant) political party. The DUP opposes the action because it fears any legislation that makes it a special zone different from the rest of the United Kingdom will eventually lead to unification with Ireland. At the same time, there is great concern that a hard border between Northern Ireland and Ireland will lead to an increase in sectarian activity and put the Good Friday agreement that brought peace to Northern Ireland into question. If the DUP left the government, it is possible that the May government would fall and bring new elections. If so, a Corbyn-led Labour Party could win which would roil the U.K. economy. The other “can of worms” that has been opened is that Scotland and the City of London are suggesting that if Northern Ireland can stay in the Customs Union, they should be able to as well. Our basic position has been that the U.K. would come up with an agreement that would generally allow it to function outside the EU with close relations. This position is mostly based upon the idea that Germany wants as little disruption as possible. However, if the U.K. faces devolution pressure due to the differences between the “remain” and “leave” camps, then there is a question as to what the U.K. will look like when Brexit occurs.
Tax drama: In what should have been a procedural vote, the House, by a 222-192 margin, approved a motion to go to conference with the Senate. The drama came from the Freedom Caucus who were withholding support to gain control over spending that will be part of this week’s expected continuing resolution to fund the government. At one point, the vote was tied. Although Speaker Ryan was eventually able to get his way and appoint conference negotiators, this event shows how fragile the political consensus is at this point and how subgroups and factions gain leverage under such conditions.
More tax drama: Part of the reason equity gains fizzled yesterday was the realization that the Senate version of the tax bill, the one most likely to be the actual finished product, included a corporate version of the Alternative Minimum Tax (AMT) that was not included in the House version. The corporate AMT wasn’t much of an issue before; under a statutory rate of 35%, very few companies were caught by the AMT. However, with a statutory rate cut to 20%, suddenly a whole host of companies would find themselves subject to the AMT. Technology firms are most vulnerable to this change, which led to a selloff in that sector yesterday. Needless to say, the lobbyists are in full force to press against this measure but the revenue would need to be found somewhere else if the House version is adopted. We expect that it will, probably by a modest increase in the corporate rate. This sort of turmoil is inevitable as the “sausage is being made.”[1]
Yemen: The ex-president of Yemen, Ali Abdullah Saleh, has been killed by Houthi forces in Yemen. Saleh was allied with the Houthis against the current (or what remains of the current) leadership in Yemen. But, Saleh turned against the Houthis, relying on various tribes to protect him; that was apparently a poor decision.[2] Saleh governed Yemen for nearly four decades, deftly managing tribal and sectarian differences to keep the country intact. However, his reaction to the Arab Spring led to his ouster. Instead of going quietly into exile, he formed an alliance with the Houthis to retake power. It is unclear if it was a faction of the Houthis that executed Saleh but it is probable that coalitions of tribes and sectarian groups are now in flux which will certainly lead to increased bloodshed but also may allow the GCC countries to make gains during this period of disunity among the opposition.
Alabama election: The GOP has decided to endorse Roy Moore for the Senate after President Trump made his support a formal endorsement as well. This chart probably explains why:
(Source: Predictit.org)
After seeing the bettors turn against Moore when the allegations surrounding his dating activity surfaced, his losses failed to hold. Current betting activity shows nearly 80% likelihood that Moore will prevail later this month.
[1] Bismarck is usually attributed with the quote, “Laws are like sausages. It is better not to see them being made.” However, it appears to have been originally coined by an American poet named John Godfrey Saxe.
Two weeks ago, we introduced this report and covered the mass arrests that took place in Saudi Arabia over the weekend of November 4, when several princes and notable figures were detained. The official reason given for the arrests was corruption, but many have speculated that the move was a cover for Mohammad bin Salman (MbS) to consolidate power and purge elements of a potential coup. And, just before that weekend, there was a crackdown on the religious establishment of the Kingdom of Saudi Arabia (KSA). This week, we will discuss the other three events that occurred that weekend: the resignation of Saad Hariri, the missile attack on Riyadh and the crackdown on the clerics.
The Long Weekend: The Resignation
The arrests discussed in Part I would have been enough for a full weekend, but that was not all that occurred. Saad Hariri, the prime minister of Lebanon and the son of the late Lebanese political leader Rafic, was summoned to Riyadh by King Salman on Thursday night, November 2. He was asked to meet with MbS on Saturday. The Hariri family has close ties to the KSA so the request was not unusual. However, when he arrived at the palace on Saturday morning, he was made to wait four hours and then presented with a resignation speech to read on television. In the speech, he cited an assassination attempt by Hezbollah and Iranian interference for his decision to resign. It appears Hariri was under house arrest in Saudi Arabia, although there are conflicting reports on this allegation.[1] It seems that MbS has concluded that Hariri was too accommodating to Hezbollah and Iran, and wanted a new prime minister who would more strongly oppose Iran’s actions in Lebanon.
[Posted: 9:30 AM EST] The big news is the tax reform bill passed by the Senate early Saturday morning. Market response has been as one would expect—equities are higher, Treasury yields are rising and the dollar is up. Here are the items we are watching this morning:
Tax bill: Our stance has been to avoid deep analysis of the bill until something is actually signed by the president. This is because the bill is being written on the fly and what emerges in the final version will be much different from what is currently being discussed. However, there is one factor common to both bills, which is that the fiscal deficit will rise. We are not deeply concerned about this outcome and, in fact, would argue that the public sector should borrow more during private sector deleveraging. When the government doesn’t borrow during private sector deleveraging, you get a 1930s outcome.
This chart shows non-financial corporate, household and non-profit debt scaled to GDP. Debt peaked during the Great Financial Crisis and fell into 2014. It has been rising modestly but a more fair reading is that debt levels are consolidating. The real issue is deciding which fiscal stimulus is most effective for boosting growth—tax cuts or public investment? Our position is that it depends on where the economy is at a given time. If inflation is high with low growth, tax cuts are probably the best action because tax cuts should boost private investment. If inflation is low along with low growth, public investment makes more sense. Why? High inflation suggests a lack of productive capacity and the best way to boost capacity is to foster private investment. Low inflation indicates an excess of productive capacity so tax cuts probably won’t trigger new investment. Thus, the tax cuts may simply be transfers to businesses and households that become spending or purchases of existing assets.
The ultimate problem with deficits is inflation. As long as a nation services its debt in its own currency, default isn’t a problem. There is an acknowledgement among the GOP that deficits may be a problem. The answer appears to be to cut entitlement spending.[1] President Reagan attempted this during the 1980s with little success. It remains to be seen if it will work this time. It should be noted that President Trump promised during his campaign that Social Security and Medicare would not be the targets of cuts.
Brexit talks: The EU and U.K. are engaged in Brexit talks today and there is evidence of progress. Ireland and the U.K. have agreed on a border deal,[2] which was a major sticking point. Last week’s “alimony” agreement also addressed a key problem. The issue of EU courts in Britain remains unresolved, as does the fate of Europeans living in the U.K. But, there is progress; we note the GBP is higher this morning, bucking the overall stronger dollar trend.
December 8th: The continuing resolution funding the government will expire on Friday. Although we don’t expect a shutdown, we do expect the Democrats to only support a very short-term extension to keep the issue in the news and extract more of their legislative goals. However, President Trump has indicated he thinks a shutdown would be blamed on his opposition and thus may be open to closing the government for a while. A shutdown would likely ease some of the current bullish sentiment.
Bitcoin: The CFTC has approved cash settled futures contracts for the CME and CBOE for bitcoin. This is an important development for cryptocurrencies mainly because now there will be an easy forum for taking short positions. It should be noted that having the ability to short doesn’t necessarily mean that shorting will be successful. The chart below shows the Nikkei 225 Index. The vertical line shows when the joint Singapore/CME contract on the Nikkei 225 futures began trading. The Nikkei peaked three years after the contract began trading. Until then, shorting the Nikkei was a futile activity. However, having a futures contract will allow participants to hedge their long positions and develop option strategies. Although it may, over time, end the strength, it will also help stabilize the market and improve its legitimacy.
Richmond Fed: The Richmond FRB announced it has nominated Thomas Barkin as its new president. Barkin is not a professional economist, although he does have an undergrad degree in the discipline. He was with McKinsey as a consultant. We expect Barkin will be confirmed (he would be confirmed by the Board of Governors, not the Senate). For now, we would expect him to be a level “3” on policy; we have not been able to find anything on his monetary policy views, so he will likely develop them over time.
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