by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST] After a few days of risk concerns, equity markets are “in the green” this morning.  The dollar and Treasury yields are higher.  Here is what we are watching this morning:

The tax bill: The House is expected to pass its version of the tax bill today.  Although we expect a close vote, it will almost certainly pass; if Speaker Ryan brings the bill to the floor without sufficient votes, he should be relieved of his duties.  The problem is the Senate.  Ron Johnson (R-WI) has come out against the bill in its present form and the clause to end the ACA insurance mandate has brought Susan Collins (R-ME) into the possible “no” column.  Jeff Flake (R-AZ) and Bob Corker (R-TN) have misgivings about the expected deficits from the bill…and both are virtually immune to pressure from lobbyists because they aren’t running for re-election.  The margin now in the Senate is razor thin and it isn’t obvious that the House could abide by the Senate version.  Getting tax changes done at all remains a long shot in our view and getting them done by year’s end looks increasingly unlikely.

Don’t forget the continuing resolution: The debt ceiling is a gift to the political opposition in the U.S. political system.  In reality, the debt ceiling should be nothing more than a reminder to Congress about its spending.  However, not raising it means the government isn’t going to pay for things it has already spent money on.  There is a legitimate debate on spending and the deficit; shutting down the government over the debt ceiling is not a legitimate way of resolving it.  In September, when the debt ceiling issue last loomed, the series of hurricanes made cutting spending to avoid more debt politically impossible for both parties.  In addition, President Trump was making overtures to “Chuck and Nancy,” which made it easy for the Democrats to agree to an extension.  However, Washington is knee-deep in tax proposals that the Democrats really dislike (e.g., ending the state and local tax deduction, or SALT, which disproportionately harms “blue” states), and the debt ceiling will give Chuck and Nancy leverage.  History shows that equity markets don’t become overly concerned over these issues as long as there aren’t real worries about default.

Debt ceiling events are shown in gray.  The only one that was significant was in 2011, when fears arose that the U.S. may actually default and was downgraded to AA by Standard & Poor’s.  Although we don’t expect anything like 2011, we are worried that the GOP congressional leadership is so focused on the tax bills that it lacks the available “bandwidth” to deal with this issue.  Thus, a week or two of brinkmanship could weigh on sentiment.

A note about earnings: At the end of this report we include our weekly P/E chart.  This week, we add the actual Q3 S&P earnings data from Standard & Poor’s (actually, from Haver Analytics, which estimates the final number when over 90% of firms report).  As has been the case for much of this recovery, the estimates of S&P operating earnings from Thomson-Reuters are higher than those from Standard & Poor’s.  We view the latter as the official data but the former owns I/B/E/S, the premier source for future earnings estimates, and thus it is the preferred number in the media.  We use the Standard & Poor’s number for most of the index’s earnings history because it allows us to show a chart dating back to the 1870s (see the end of this report).  In our P/E calculations, we usually use two actual earnings numbers from Standard & Poor’s and two estimates from Thomson-Reuters; however, when we have sufficient reporting we then shift to three actual Standard & Poor’s numbers and one Thomson-Reuters.  When this happens, there are discrete jumps in the current reporting quarter (see footnote in the P/E section for more clarification).  After New Year’s, when we return to two actual, two estimates, there will be a discrete rise in the P/E as well.

This chart shows a history of the two series on a four-quarter rolling basis.  During the two recessions/bear markets, the ratio tended to widen significantly as the Standard & Poor’s number fell much faster than Thomson-Reuters.  But, until this bull market, the two series tended to closely match each other.  We note the divergence widened when oil prices fell in 2014 and narrowed as oil prices recovered.  Which is the better number?  We are agnostic on this issue because we can address the divergence with various statistical tools, but we wanted to offer more detail on why the P/E rose this week.

Energy recap: U.S. crude oil inventories rose 1.9 mb compared to market expectations of a 3.2 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.  The DOE has revised its data (an exercise it does periodically) and inventories are falling faster than earlier estimated.  As the chart shows, inventories remain historically high but have declined significantly this year.  We also note the SPR fell by 0.7 mb, meaning the net build was 1.2 mb.

As the seasonal chart below shows, inventories rose modestly this week.  It appears that we are “skipping” the usual autumn inventory rebuild period.  Usually, inventories would peak next week.  After that, stockpiles would decline into year’s end and then start their largest build from early January into early April.

Refinery operations continued to rise last week, in line with seasonal norms.  We expect them to peak very soon.

Based on inventories alone, oil prices are undervalued with the fair value price of $55.00.  Meanwhile, the EUR/WTI model generates a fair value of $60.68.  Together (which is a more sound methodology), fair value is $58.37, meaning that current prices have fallen under fair value.  OPEC meets at the end of the month and there are worries that Russia won’t extend the current output restrictions as much as the Saudis would prefer.  At the same time, recent events in the Middle East increase the odds of supply concerns.  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] Here’s what we are watching today:

Another weak day: Risk markets continue to slide this morning, although the levels of decline are not all that large.  It’s been such a long time since we have seen weakness in equity prices that even modest retreats appear significant.  However, we don’t see anything beyond a modest correction because it appears that ample liquidity is available.

This chart shows retail money market holdings relative to the S&P 500.  We have highlighted periods since the expansion began when retail money market funds fell below $920 bn.  When money market fund levels fall below this level, equities have tended to stall or at least get “choppy.”  Currently, we are sitting on ample liquidity, which suggests to us that any pullbacks will likely be met with new buying.  This isn’t a perfect relationship.  As the crash period shows, during periods of fear, the “dash for cash” overwhelms other asset prices and equity prices will tend to decline until the panic stops.  If the tax bill falters or we have a global geopolitical event, fear could trigger a sharper pullback.  But, for now, there are no signals of recession and we are likely seeing a normal pause.

Vice Chair El-Erian?  Yesterday, there were reports that Mohamed El-Erian was being considered for the vice chair position at the Fed.  This would be an inspired pick; the chair-nominee, Jerome Powell, isn’t an economist, so surrounding him with a well-respected one as vice chair would give him a counterpart with a learned viewpoint.  And, he has another helpful characteristic—he has been the second around another strong personality.  He was at PIMCO when Bill Gross was the CIO and had to work in a position where he was designed to be overshadowed.  He proved able to manage the situation.  This would perhaps make him a better pick than Larry Summers or John Taylor, who tend to be more outspoken.  His recent comments have leaned hawkish but he has also supported easing regulations.  We suspect the financial markets would welcome Mohamed to the FOMC as it would show no specific ideological bent (a problem with Taylor) and he is a preeminent economist (an improvement over Warsh).

Mugabe out?  It appears that Zimbabwe’s long-standing president, Robert Mugabe, has been ousted in a coup, despite comments from the military that his placement into house arrest isn’t really a coup.  We are not going to spend too much time on this issue because it won’t affect most financial markets; however, Zimbabwe has been an inadvertent laboratory for really bad economic policy.  The country has suffered through ruinous hyperinflation due to poor policies, which has led to laughable currency denominations.^[1]  His removal might improve the situation in the country, although given the degree of damage that has been inflicted, it may take a very long time to fix the economy.

Moore under pressure: As more reports come out about Roy Moore’s questionable proclivities, we are starting to see the betting signals crack.  As we noted earlier, we view the betting information as more credible than polls, which are subject to sampling and structural problems.  The news is getting bad for Judge Moore:

Moore had a commanding lead until the scandal broke but still managed to hold a majority until the last couple of days.  He now has less than a 40% chance of winning.  We note the WSJ editorial page has concluded the GOP would be better off losing the seat than for Moore to win.^[2]  We would expect this sentiment to rise.

Fed policy: With the release of the CPI data we can upgrade the Mankiw models.  The Mankiw rule models attempt to determine the neutral rate for fed funds, which is a rate that is neither accommodative nor stimulative.  Mankiw’s model is a variation of the Taylor Rule.  The latter measures the neutral rate by core CPI and the difference between GDP and potential GDP, which is an estimate of slack in the economy.  Potential GDP cannot be directly observed, only estimated.  To overcome this problem, Mankiw used the unemployment rate as a proxy for economic slack.  We have created four versions of the rule, one that follows the original construction by using the unemployment rate as a measure of slack, a second that uses the employment/population ratio, a third using involuntary part-time workers as a percentage of the total labor force and a fourth using yearly wage growth for non-supervisory workers.

Using the unemployment rate, the neutral rate is now 3.20%.  Using the employment/population ratio, the neutral rate is 0.97%.  Using involuntary part-time employment, the neutral rate is 2.71%.  Using wage growth for non-supervisory workers, the neutral rate is 0.94%.  The modest uptick in core CPI has lifted the various neutral estimates higher, but as we have seen lately, two of the measures of slack suggest the FOMC has achieved rate neutrality, while two suggest the FOMC is well behind the curve.  We expect the FOMC to mostly split the difference and end up around 2.25% for the target at the end of next year.  However, if the two variations signaling lower rates turn out to be the accurate measures of slack, this degree of tightening will lead to increased risk of recession.  The fed funds futures put the odds of a December rate hike at 92.3%.

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[1] https://en.wikipedia.org/wiki/Hyperinflation_in_Zimbabwe#/media/File:Zimbabwe_$100_trillion_2009_Obverse.jpg

[2] https://www.wsj.com/articles/the-roy-moore-mess-1510703218

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST] It was a very quiet overnight session.  Better Eurozone growth has lifted the EUR, while global equity markets continue to struggle in what looks to us like profit taking.  PPI (see below) did come in higher than forecast; shorter duration Treasury yields rose.  Here is what we are watching this morning:

May will allow Parliament to have a say on Brexit: Initially, PM May was not going to allow MPs to add amendments to the Brexit bill.  However, in her politically weakened position she has bowed to pressure, primarily from pro-EU MPs, to have a full vote and allow amendments to be voted on as well.  It isn’t clear how this will play out.  Although the May government insists the vote can’t halt Brexit, it does seem possible that Parliament could scuttle Brexit.  May’s plan is to offer two separate bills, one that is an actual vote on Brexit and another that votes on the specifics of the process, with the hopes that party discipline will ensure Brexit occurs and then allow “meaningful but essentially meaningless” votes on the second bill.  If May had a strong majority government and Tories feared her, this would probably work.  However, this isn’t the case.  If Parliament votes to defeat the Brexit bill, it isn’t obvious what would happen.  The EU is committed to the U.K.’s exit from the organization and Parliament’s inability to pass a bill shouldn’t prevent the EU from expelling Britain.  The exit was officially triggered last year.  Brexit without a plan leads to a chaotic situation.  On the other hand, we would not be shocked if Parliament blocks Brexit and the EU (read: Merkel) allows the U.K. to stay in the EU fold.  In any case, this is turning into a mess; at the same time, the GBP would likely soar if the U.K. ends up staying in the EU.

Venezuela in default: S&P has confirmed that Venezuela missed two interest payments within the 30-day grace period on its sovereign debt, on issues maturing in 2019 and 2024.  This rating agency is the first to declare the nation in default.  The rating on these two particular bonds is now “D,” down from “CC,” and the long-term foreign currency sovereign credit rating is now “SD,” or selective default, down from “CC.”  Although Venezuela’s default was really just a matter of time, there isn’t an obvious path of restructuring.  We will be closely watching how Caracas handles its debt to China; we suspect it will default on that debt last, but eventually it will likely default on that debt, too.  Complicating matters for bondholders is that Venezuela does have assets outside the country that could be seized by creditors (CITGO, for example).  We do note that the International Swaps and Derivatives Association has delayed a decision on default; if this group agrees with S&P, it would likely trigger the payment of credit default swaps.

Another governor?  There are reports the president is considering nominating Michelle Bowman, a state bank commissioner from Kansas.  She was formerly a banker with Farmers and Drovers[1] Bank in Council Grove, KS, with about seven years of banking and bank regulatory experience.  She has a BA from Kansas University[2] and a JD from Washburn University in Topeka, KS.  She does have rather extensive experience in Washington.  She worked with Sen. Dole and was counsel to the House Committee on Transportation and Infrastructure and the Committee on Government Reform and Oversight.  She was also attached to FEMA and was deputy assistant to Homeland Security Secretary Tom Ridge.  One of the governor slots is reserved for a community banker; it has been difficult to fill this position because state regulators are usually not well liked by bankers and most community bankers don’t want to leave their posts for a government job.  Although her banking experience is a bit light, her Washington experience will probably allow her to be easily confirmed.  Historically, this position tends to vote with the chair and its primary contribution is to offer “ground level” information from the small banking sector to the FOMC.

IEA bullish on shale: In its most recent report, the IEA projects strong shale growth in the U.S., leading to total liquids production of 13 mbpd by 2025.  The Paris-based group projects that the U.S. will account for 80% of the increase in global oil and liquids supply over that time frame.   Interestingly enough, recent reports from the maturing oil shale fields in Texas paint a much less favorable supply story.  The EIA (the U.S. data arm of the DOE) says that December U.S. shale production will rise to 6.1 mbpd, a new high.  However, the EIA also reports that the legacy decline rate has reached 83.3%, meaning that 83.3% of gross new production is offsetting declines in older wells.  In May, this number was 70.5, indicating that production growth is slowing.  Industry reports suggest that increasing proppants and longer well laterals in the Permian basin aren’t boosting output.  The bottom line is that macro energy analysis appears to be holding that growth will continue at almost a linear pace, whereas the micro reports suggest that if such growth is going to occur it will likely require higher prices.

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[1] A drover is a person who moves animals over long distances.

[2] Go Jayhawks!

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST] Happy Monday!  Here are the news items we are watching this morning:

The president’s trip to Asia comes to a close: The president stayed mostly on script for the early part of his trip but began to stray toward the end.  We suspect historians will look at his APEC speech as one of the clearest signals that the U.S. is ending its superpower role.  Although there is much being made over the 11 remaining TPP nations putting together the treaty, in reality, there isn’t much to make the group work without the U.S. and China.  Among the remaining nations there isn’t an obvious importer of last resort, a key element of multilateral trade deals.  Essentially, multilateral trade deals are geopolitical entities, not trade agreements.  If the U.S. would have passed TPP and TTIP, the U.S. would have been the effective “center of the trading world,” straddling both the Asia-Pacific and the Atlantic.  Instead, the U.S. is promising a series of bilateral agreements.  It is interesting to note that Chairman Xi’s speech promoted globalization and got a standing ovation from the delegates.  Trump’s speech didn’t.  Perhaps the quote of the weekend came during the president’s visit to Vietnam.

“Xi Jinping’s ambitions are dangerous for the whole world,” General Cuong said. “China uses its money to buy off many leaders, but none of the countries that are its close allies, like North Korea, Pakistan or Cambodia, have done well. Countries that are close to America have done much better. We must ask: Why is this?”[1]

-Maj. Gen. Le Van Cuong

Another, perhaps more unsettling, quote:

“Everybody thinks that the U.S.-Japan alliance will last forever,” said former defense minister Shigeru Ishiba, a member of Abe’s Liberal Democratic Party and supporter of rewriting the constitution, said in an interview last month. “I don’t think so.”[2]

Was the trip a success?  If the goal of the trip was to clearly state Trump’s Jacksonian foreign policy, then yes it was.  Is that outcome good for financial markets?  As with every major event, it’s mixed and will take a long time to sort out.  But, in the end, we are in the steady process of seeing the U.S. abdicate its hegemonic role which will most likely lead to rising global insecurity.

Taxes: The House tax bill may get a vote before Thanksgiving and we expect it to narrowly pass.  However, the Senate is facing much tougher sledding.  Perhaps the biggest problem will be reconciliation.  The two bills are not close in construction.  At best, we will likely see a modest package of tax cuts without significant restructuring.  At worst, this effort will fail.  The odds of failure are rather elevated.

May’s troubles: Forty Tory MPs are apparently prepared to sign a letter of no-confidence on PM May.  The important number is 48, which would trigger a no-confidence vote within the Conservative Party and bring a leadership contest.  The strong Brexit supporters, mainly Michael Gove and Boris Johnson, are pressing for a “hard Brexit” which will limit May’s negotiating position and put the London financial industry at risk.  In addition, a hard Brexit would almost certainly lead to a hard border in Northern Ireland and put the Good Friday Agreement at risk.  The GBP slipped on the news.

Bitcoin slips: As the popularity of bitcoin has increased, the ability of the “plumbing” to handle transactions has been adversely affected.  The founders have tried to come up with a compromise that would maintain the cryptocurrency’s structure but allow for larger transactions to occur.  That compromise has failed and there is concern that traders will gravitate to other competing instruments.

Note the recent decline in bitcoin.  Although the correlation between bitcoin and gold isn’t all that close, both instruments play a similar role—a safe, anonymous store of value.  We note that gold is doing better today as bitcoin prices fall.

The Alabama Senate race: Although the polls are tightening, we note the betting sites are still putting their money on Roy Moore.

In general, we have more confidence in betting sites than polls.  The latter face problems of sampling and participant lying.  On the other hand, one can hold an opinion in a betting pool but stand to lose money if they are wrong.  Perhaps the most interesting part of this election is that the GOP establishment would probably prefer Jones, the Democrat; although he would be a member of the opposition, a Democrat in Alabama is probably conservative and may be a more reliable voter than Moore.  We will likely see more of this in the coming years as the party coalitions reform.  In other words, membership of class (establishment v. populist) will matter more than party affiliation.

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[1] https://www.nytimes.com/2017/11/11/world/asia/vietnam-china-us.html

[2] Washington Post, Worldview.

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST] We are seeing further equity weakness this morning; interestingly, too, Treasury yields are rising.  The asset market weakness doesn’t appear to have a single cause, but rather a mix of factors has weakened investor sentiment.  Here is what we are watching:

Who knew tax reform would be so hard?  Although analysts persistently warned that tax reform would be difficult, investors seemed to be quite sanguine about the potential for change.  The House and Senate have issued their bills and it’s hard to see a path to compromise.  The Senate wants to delay implementing the corporate tax changes for a year, which will infuriate the White House.  After all, no president has an interest in boosting future growth which may only benefit a successor.  In addition to that major discrepancy, the marginal rate structure is vastly different.  And, the Senate bill does less to “broaden the base” by reducing tax expenditures.  Given the political situation, the Senate bill will tend to be the blueprint because it will be much more difficult to move the bill through that body than the House.  We have had strong doubts that a tax reform bill would get passed during this administration.  Our position remains the same.  It should also be noted that there will be winners and losers if a bill does get passed.  Those hurt may be exactly the kind of households that would usually support Republicans.[1]

The populist president: President Trump gave an anti-trade speech in Asia overnight, bookended by President Xi offering a robust defense of globalization.  The cover of this week’s Economist is all about the U.S. stepping back from the world.  This is a situation we have been discussing (and warning about) for the past eight years.  Although there are lots of brave voices suggesting globalization can continue without the U.S., if it does, it won’t look like the last century’s globalization with the U.S. providing global security and the reserve currency for “free” to the world.  Instead, we expect either an 18^th century sort of colonization (the Eurozone as Germany’s commonwealth, the “one belt, one road” as China’s colonial drive) or a regionalization of power with no global power in place.  At some point, financial markets will realize that a deglobalized world will not be good for business.  Although we doubt this is the precise moment, the financial markets have mostly been ignoring the anti-trade, anti-immigrant policies of this administration.  Perhaps some of that is being priced in.

The Roy Moore situation: Although we doubt the travails of Mr. Moore are significant to today’s weakness, we see one important takeaway.  The scandal and the reaction show, in bright lines, the split within the GOP.  When the Senate majority leader calls on a candidate to withdraw from a race in a solid Republican state, it begs the question…what kind of relationship will the party leadership have with him if he wins the special election?  The election will be held on December 12.  Given the polarized nature of the electorate, unless further evidence emerges, we expect Moore to win.  Predictit still gives him a 55% chance of winning; that is down from 60% but still looks rather safe.  But, for McConnell, how reliable of a vote will Moore be going forward?  Our position is that the underlying coalitions of both parties are in flux but they become much more apparent for the party in power because it has to govern.  The ACA debacle and now the issue with tax reform are laying bare these divisions with the GOP.  The Roy Moore situation does, too.

Junk takes a hit: High yield bonds have come under pressure in the past few days, mostly on disappointing earnings from firms that issue these instruments.  Spreads have been narrowing for some time.

This chart shows the spread of high yield to the five-year Treasury.  Note that the spread is in the lower range of history.

The rise in yields is seen at the right side of the graph.  Will this continue?  A move toward 6% would not be a shock, but to sustain rates higher than that level would require a rise in financial stress.  So far, there isn’t much evidence that stress is rising.

Don’t forget December 8!  On December 8, the borrowing capacity of the Treasury will be exhausted and a new debt limit will be required.  Given that tax legislation is dominating the debate, Congress will scramble to make a deal to lift the debt ceiling; look for Democrat Party leaders to leverage this moment for their goals.

And, on other items:

China opens: In a surprise move, China announced today it will allow foreigners to purchase a majority stake in Chinese financial firms.  This is a shocker, although in reality it will have less impact than it should.  While there may be some interest from foreign firms in directly accessing the Chinese financial system, there is no consistent rule of law in China.  A foreign firm could find itself the majority owner of a bank that the government forces to do things it doesn’t want to do.  So, optically, this is a big deal, but it won’t have much effect if it isn’t accompanied by a consistent regulatory environment.

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[1] https://www.washingtonpost.com/business/economy/i-dont-feel-wealthy-the-upper-middle-class-is-worried-about-paying-for-the-tax-overhaul/2017/11/09/a5cf1acc-c55e-11e7-aae0-cb18a8c29c65_story.html?utm_term=.dfb78c5a42bd&wpisrc=nl_todayworld&wpmm=1

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST] We are seeing some equity weakness this morning.  There isn’t anything specific weighing on the market other than what looks like profit taking.  Here’s the news we are watching this morning:

President Trump in China: The president received $250 bn in trade deals and promised investments.  He will call this a win.  China, on the other hand, made no promises of structural change in the trade relationship that would be necessary for a sustained decline in the trade account.  China has created a situation of persistent oversaving; this was done to build China’s investment base.  Although this investment-led development was successful (and has been used at some point by every nation that has achieved developed status), a point is reached where the investment infrastructure is adequate and restructuring the economy away from suppressing consumption is necessary.  We actually think that process is already underway.  The aggressive consolidation of power in China by Chairman Xi will give him the wherewithal to restructure the economy.  How will that look?  One way, and, in our opinion, the best way, would be to sell off part of the state-owned enterprises to households at discount prices.  This would boost household wealth and lift spending.  Another way would be to put in social safety nets, like social security and deposit insurance.  But, doing this will directly harm the wealthy and powerful in China; that’s why Xi had to implement the purges he did in his first term.  If Xi makes these moves, the Chinese external accounts will move from surplus to at least balanced, if not deficit.  However, Xi cannot be seen as doing this because of demands by the U.S.  And so, in place of real reform, which may be coming, Xi gave “baubles” to President Trump so Xi can reform at his own pace.

China and North Korea: There’s not much new here.  U.S. policy continues to hold that North Korea is China’s problem to solve when China has no interest in solving it.  China would be more worried if the U.S. engaged in direct negotiations with Pyongyang.  As we noted recently,[1] China and North Korea are not really allies.  A North Korea aligned with the U.S. would give Beijing its worst nightmare—a hostile power on its border.

More trouble for May: PM May has lost her second minister in a week.  Priti Patel, May’s international development secretary, resigned after it was revealed she held up to a dozen unauthorized meetings with Israeli officials during a summer vacation.  This follows on the heels of the resignation of May’s defense minister, Michael Fallon, on charges of “inappropriate conduct.”  The GBP has been struggling on fears that May’s government will fall and new elections will be held.  The weakness of May’s position has undermined her ability to negotiate Brexit, which has also pressured the currency.

Saudi crackdown continues: Bloomberg[2] is reporting that the wealthy in Saudi Arabia are fearful of additional asset freezes and are trying to move money out of the country.  Although bitcoin reportedly jumped yesterday after a plan was shelved that would have created an offshoot of the popular cryptocurrency,[3] we suspect Saudi capital flight might be behind the rally and may support further upside to bitcoin.  Cryptocurrencies have proven effective in evading capital controls and bitcoin could have another leg up if Saudi subjects begin to use the tool to move money away from the kingdom.

This is a year-to-date chart on the XBT/USD exchange rate.

Venezuela may avoid default…for now: Russia has apparently agreed to restructure $3.0 bn of Venezuelan debt it holds.  This isn’t anything new; over the past three years, Moscow has given the country $10 bn of assistance.  In return, Rosneft (MCX: ROSN 334.10) was given 49% of CITGO, which is PDVSA’s refining arm in the U.S.  Russia is using Caracas’s woes to gain further control of Venezuela and will likely try to use this foothold in the Western Hemisphere to weaken U.S. influence in the region.  Still, it appears highly unlikely that Venezuela will avoid restructuring its debt.

Merkel is struggling: Chancellor Merkel has been trying to cobble together a coalition after her party’s weak showing in the September elections.  She has attempted a “Jamaica” coalition, consisting of her conservative CDU/CSU party, the Free Democrats, a libertarian-leaning party, and the Greens, the environmental party (the party colors are green for the Greens, yellow for the Free Democrats and black for the CDU/CSU, the Jamaican flag colors).  These parties are not natural allies, but political leaders fear that another election may lead to further gains for the AfD.  This weakness in Germany comes at a time of a growing global power vacuum and raises the dangers for further drift in Europe.  At the same time, distraction in Germany may lead Merkel to be soft on Brexit negotiations, which would benefit the U.K.

Energy recap: U.S. crude oil inventories rose 2.2 mb compared to market expectations of a 2.5 mb rise.

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 0.7 mb, meaning the net build was 1.5 mb.

As the seasonal chart below shows, inventories rose modestly this week.  It appears that we are “skipping” the usual autumn inventory rebuild period.  Usually, inventories would peak in two weeks.  After that, stockpiles would decline into year’s end and then start their largest build from early January into early April.

Refinery operations continued to rise last week, in line with seasonal norms.  If this continues, and we expect it will, it should be bullish for oil prices.

Based on inventories alone, oil prices are undervalued with the fair value price of $53.22.  Meanwhile, the EUR/WTI model generates a fair value of $59.70.  Together (which is a more sound methodology), fair value is $56.99, meaning that current prices are very close to fair value.  Dollar strength and the rise in oil prices have mostly addressed the recent undervaluation.  Oil prices should continue to benefit from turmoil in the Middle East, but we would look for a period of consolidation in prices unless geopolitical conditions deteriorate significantly.

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[1] See WGRs: North Korea and China: A Difficult History, Part I (10/16/17); Part 2 (10/23/17); and Part III (10/30/17).

[2] https://www.bloomberg.com/news/articles/2017-11-09/saudi-billionaires-are-said-to-move-funds-to-escape-asset-freeze

[3] https://www.bloomberg.com/news/articles/2017-11-08/bitcoin-surges-to-record-on-speculation-possible-split-avoided

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST] There was a good bit of news overnight.  Here is what we are watching:

The message from the voters: Governor and downstate elections were held in Virginia and New Jersey yesterday.  Although small sample size projections are the lifeblood of political punditry, we see three legitimate takeaways.  First, polarizing figures seem to boost voter participation.  In 2016, an element of voters opted for Donald Trump simply because he wasn’t Hillary Clinton.  Sec. Clinton was a polarizing figure, which led Republicans and disaffected Democrats (Berniecrats and others) to vote for Trump.  Now, the president has become a polarizing figure and that seemed to boost Democrat Party turnout yesterday.  It should be noted that polls were favoring the governor winners, although they did outperform the polling.  Second, the establishment/populist divide remains in place.  There is a tendency to simply look at the winners and losers but neither party has really embraced the populist mantel.  The president claims he has but if that were true his order of execution of his legislative agenda would have been infrastructure, trade restrictions and immigration restrictions.  Only immigration has been implemented and that’s because it doesn’t need legislative action.  Trade action has been limited to killing TPP but that may have been dead already.  NAFTA remains in place and actual targeted tariffs against China and other large deficit nations haven’t occurred.  Tax changes and ACA adjustments would have been far down the list.  The order of execution suggests that he isn’t fully committed to a populist agenda.  However, we are not seeing anything coming out of the Democrat Party that suggests an embrace of populism either.  Thus, the continued realignment of the underlying coalitions of the two parties will continue.  Third, the midterms very well could put the GOP majority at risk next year.  This highlights a point we have been making for over a year—political capital is limited and perishable.  Much of it was burned over the ACA repeal and now it’s being torched on tax changes.  By next spring, the president’s political capital will mostly be exhausted and he will be in the maintenance period for the rest of his presidency.

The president moves on to China: The president ended his visit to South Korea with a rather straightforward speech, avoiding bombastic threats but making it clear the U.S. would defend its allies.  China, so far, is using the Abe playbook, flattering President Trump and showing him a good time.  However, back in Washington, China is facing a significant sanctions threat.  The Senate banking committee approved the Otto Warmbier Banking Restrictions Involving North Korea Act, or BRINK Act; the bill would increase sanctions on firms doing business with North Korea, specifically targeting major Chinese banks.  Up until now, sanctions have only affected small Chinese firms and banks and therefore haven’t had a significant effect on curtailing China’s economic support of North Korea.  We note that President Trump did soften his rhetoric against North Korea earlier in this trip, calling on Kim to make a deal.  This bill may represent the “stick” and talks are the “carrot.”

The Street and Brexit: The FT[1] reports today that large U.S. financial firms have informed the Trump administration that if progress on Brexit doesn’t improve soon they will be forced to begin moving operations out of London.  Interestingly enough, it was also mentioned that the U.K. run by a Corbyn-led Labour Party would be viewed as very negative.  Initial job losses are pegged at 10k but could eventually rise to over 70k if the U.K. government is unable to execute Brexit and maintain trade relations with the EU.  The GBP fell on this report.

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[1] https://www.ft.com/content/2dec32be-c3e3-11e7-b2bb-322b2cb39656?emailId=5a021eb88a3fa4000439a9cb&segmentId=ce31c7f5-c2de-09db-abdc-f2fd624da608 (paywall)