by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It was a busy weekend of news.  Our thoughts and prayers go out to our friends in Texas.  Here’s what we are watching:

Harvey: TS Harvey made landfall going into the weekend as a category 4 hurricane.  Usually, hurricanes make landfall, move inland and dissipate within a couple of days.  Harvey isn’t that kind of storm.  First, instead of moving inland, the storm stalled over the Houston-Corpus Christi area and sat there, dumping prodigious levels of rainfall.  Complicating matters is that Harvey is expected to return to the GOM later today to gather more moisture.  Rainfall totals in excess of 40” are expected over parts of the Houston area, with the rain spreading into Louisiana.  Here we discuss some of the key effects on energy and the economy.

Energy: The Houston Ship Channel is perhaps the energy center of the U.S.  The area is loaded with refiners, pipelines, import and export facilities and offshore production.

Current estimates indicate that about 3.0 mbpd of refining capacity have been taken offline.  Some of these facilities will be back within a few days (on the above map, each box is a refinery), but the ones in Houston could be down for weeks.  A rough calculation of the Houston refineries[1] indicates that 2.3 mbpd, or about 13% of total U.S. capacity, will be idle for weeks.  This loss of refining capacity has several effects on oil prices.  On the one hand, the loss of refining capacity will reduce demand.  On the other, the Eagle Ford production area is relatively close to the rain bands and there are reports that some areas have been shut in.  This production area represents about 1.3 mbpd.

In addition, the Houston Ship Channel and the Louisiana Offshore Oil Port are the key oil import facilities and thus we would expect a decline in oil imports.

The market reaction thus far is declining crude oil prices, while gasoline prices are higher.  This has widened the crack spreads (the spreads between product and crude oil).

The chart above shows the spread between a barrel of gasoline versus a barrel of WTI.  The spread has jumped over $2 per barrel.  The spread between Brent and WTI has also widened over $2.00 per barrel (see below).  The widening of Brent-WTI will tend to discourage imports to the U.S. and, if the oil can be shipped, U.S. exports.  Unfortunately, the port outages in Texas will tend to dampen oil exports (and imports).

Overall, so far, we believe the impact on oil prices is probably a bit overdone; in the end, there are crosscurrents that will probably end up being more of a wash.  For refiners outside the Houston/Louisiana area, this event should be bullish.  That is the highest probability outcome.

The Economy: The economy will also be affected by this disaster.  Initially, the impact is negative.  Houstonians will be out of work for a while, which will boost initial claims for unemployment.

This chart shows initial claims around Hurricane Katrina.  There was a spike in claims of about 100k during that event.  Harvey may actually be larger.  The impact isn’t permanent; within about a month it dissipates.  As time goes on, the impact of rebuilding will be positive for GDP.  Although the impact on the nation’s wealth, in terms of lost infrastructure, means the U.S. balance sheet takes a hit, the “income statement,” or GDP, actually rises to rebuild what has been lost.

The rise in claims may lead the FOMC to hold off on rate hikes until the situation improves.  This factor, coupled with the potential for a government shutdown/potential default by the end of September, will almost certainly leave rates unchanged.  We will likely still see a reduction in the balance sheet.

Bring me tariffs!  Axios is reporting that President Trump is angry at the globalists surrounding him and wants tariffs.[2]  There is movement on trade; NAFTA renegotiations are underway and the U.S. is investigating Chinese IT trade practices.  However, the president has promised tariffs to the populists and he wants to provide them.  Tariffs have been falling since WWII, replaced mostly by non-tariff barriers, e.g., regulations, trade inspections, etc.  The president actually has a good bit of freedom in setting tariff policy and can move without much influence from Congress (although we do note Mike Lee (R-UT) has proposed legislation to curb the president’s tariff powers).  The problem with tariffs is that they are transparent and invite retaliation.  For example, if China sees its steel or solar panels affected by tariffs, one can fully expect retaliation against U.S. agriculture.  Perhaps the most effective tool has already been locked away—the Border Adjustment Tax would have likely been effective in reducing the trade deficit, although at the cost of higher inflation and a stronger dollar.  On the other hand, if the president is seeking lots of signing ceremonies, tariffs have that characteristic.

Jackson Hole: Perhaps the most important item from the meeting is what wasn’t said; ECB President Draghi didn’t directly come out and call for a weaker EUR and the Eurozone currency jumped to new highs.  In current central bank practice, it is considered improper to directly discuss the exchange rate.  And, with a U.S. president inclined to trade barriers (see above), talking down the currency would have likely triggered a reaction from the White House.  Still, the expectation is that the ECB is slowly moving to tighten and the FOMC probably won’t move as much as expected.  This is leading to a weaker dollar. 

View the complete PDF

---

[1] https://www.eia.gov/special/disruptions/?src=home-b1

[2] https://www.axios.com/axios-sneak-peek-2477874318.html?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiossneakpeek&stream=top-stories

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] South Korean war games: Pyongyang has repeated its threats of retaliation in response to the South Korean war games, contending that the drills act as a precursor to the imminent invasion of North Korea.  Pyongyang reportedly threatened that the U.K. would face a “miserable end” if it participates in military drills alongside the U.S. and South Korea.  The Kim regime has always disliked these annual exercises and belligerent comments are common when the drills are being conducted.  On Thursday, Reuters reported that the North Korean state media released photos of designs for a new intercontinental ballistic missile, which they believe will be able to strike anywhere in the U.S.  The increased belligerence of the North Korean regime will likely bolster the U.S. claim that the world should take more actions against the regime to deter its nuclear ambitions.

Cohn next?  In an interview with the Financial Times, Gary Cohn expressed dismay with President Trump’s response to the events in Charlottesville.  Cohn, who is Jewish, told the FT that he felt enormous pressure to resign after the president blamed “both sides” for the violence that erupted.  It was rumored that Cohn had briefly considered stepping down from his position as economic advisor following the president’s remarks, but decided against it due to speculation that he will replace Janet Yellen as chair of the Federal Reserve.  It is unclear how the president will react to this interview.  On the one hand, he tends to react poorly to public criticism; on the other hand, he seems to like Cohn and probably won’t oust him over the interview.  Regarding the Fed chair position, the interview could affect it either way.  If Trump wanted him out, he could move him to the Fed.  However, he could also use it as punishment.  We still favor Cohn for the Fed chair job but we view it as 60/40; in other words, odds favor Cohn but there is a chance that Yellen may remain as well.

Tax reform: President Trump is expected to release information about tax reform next week. Following the failure to repeal Obamacare, the focus has turned to tax reform as the president tries to get his legislative agenda back on track.  Thus far, the president has failed to deliver a detailed tax plan.  According to the FT, the president will begin campaigning on a simpler tax code in order to spur economic growth.  Axios reports that the president will let the GOP handle the details of the plan and have it come out of the House Ways and Means committee.  At this point, it is unclear how much Trump will look to cut taxes.

Jackson Hole: Today, Mario Draghi will speak about the developments from Jackson Hole; the topic of discussion is thought to be monetary policy’s impact on inflation.  Market participants are hoping Draghi will give clues as to whether or not the ECB will continue its bond buying program.  However, we expect the ECB president to remain coy.  The Federal Reserve and the ECB have been receiving pressure for their respective monetary policies.  In the U.S., the Federal Reserve’s hawkish approach is seen as undermining future GDP growth; in Europe, the ECB’s dovish policy has been accused of causing market bubbles.

View the complete PDF

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Iran strikes back: Saudi Arabia’s plan to isolate Iran may have backfired.  The WSJ reports that Qatar has decided to restore diplomatic and bilateral trade ties with Iran despite pressure from the Gulf Cooperation Council (GCC), a coalition of Arab countries that also includes the United Arab Emirates, Bahrain and Egypt.  Earlier this year, Saudi Arabia and the other members of the GCC decided to cut off all diplomatic ties and impose trade and travel bans on Qatar due to its supposed ties with terrorist organizations.  The demands imposed by the coalition not only included curbing ties with Iran, but also shutting down Al Jazeera and expelling extremists from its territory.  Although the blockade has had a negative impact on Qatar, it did little to force the government into submission but rather into the arms of Turkey and Iran.  This outcome will likely strengthen Iran’s reach throughout the Middle East as it attempts to expand its influence in the region.  For decades, Saudi Arabia and Iran have been battling to become the sole regional hegemon in the Middle East.

South Korean war games: Pyongyang has expressed displeasure with the ongoing war games taking place between the United States and South Korea.  North Korean officials have complained that the exercises are just “rehearsals for an invasion” and have threatened to provide a relevant response.  War games between the U.S. and South Korea occur annually and are designed to test war readiness.  In June, Beijing proposed a “double freeze” scenario in which North Korea would cease its nuclear and ballistic missile tests in exchange for the U.S. halting its war games; the deal was promptly rejected by Washington.  Tensions have simmered between Pyongyang and Washington as the U.S. has been successful in applying sanctions on North Korea to curb its nuclear and ballistic missile program.  The war games are scheduled to continue until next Thursday.

Energy recap: U.S. crude oil inventories unexpectedly rose 3.2 mb compared to market expectations of a 3.5 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 been declining.  In fact, inventories are now at their lowest level since mid-2015.

As the seasonal chart below shows, inventories are usually approaching the end of the inventory withdrawal season.  The usual decline is about 10% from April to September; this year is about the same but on a lower level.  Overall, this has been a good withdrawal season and does suggest that the supply situation is tightening.

Based on inventories alone, oil prices are overvalued with the fair value price of $53.30.  Meanwhile, the EUR/WTI model generates a fair value of $64.03.  Together (which is a more sound methodology), fair value is $60.51, meaning that current prices are below fair value.  Fears of continued excess supplies are weighing on market sentiment, but it appears to us that oil prices are rather undervalued.

View the complete PDF

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Trump attacks Washington and the media: President Trump made his first major speech on immigration yesterday in Phoenix, Arizona, during which he placated his base by threatening to shut down the government if the border wall isn’t funded, alluding to a withdrawal from NAFTA and attacking the media.  His speech will likely heighten tensions within the GOP as it appears the president is willing to protect his base at all costs even if it means challenging members of his own party.  In recent weeks, Republicans have become increasingly concerned with the president’s handling of domestic events and many have expressed reservations about funding a border wall due to the impact it may have on the national debt.  His threat to shut down the government appears to be a rebuke of Mitch McConnell, who stated earlier this month that there was a zero percent chance of that happening.  Trump’s speech will likely increase the rift in his relationship with McConnell, which reports suggest was caused by the failure to repeal Obamacare.

Soft power diplomacy: Trump’s foreign policy shift seems to have taken root with increased actions against China, Russia and Egypt.  Yesterday, the WSJ reported that the U.S. Treasury has expanded its sanctions to firms in Russia and China due to their involvement in Pyongyang’s nuclear and ballistic missile program.  The escalation of sanctions is aimed at forcing North Korea to the negotiating table.  Additionally, the Washington Post reported that the State Department is going to withhold $195 million in military aid from Egypt and has also withdrawn $96 million in other aid due to human rights violations in the country.  The shift in diplomacy reinforces speculation that the military establishment’s influence has grown in the Trump administration; as a result, we expect the president’s foreign policy to resemble those of his predecessors, President Obama and President Bush.

Yesterday’s market action: The dollar rallied as did equities.  For the past several months, the dollar has tended to weaken during periods of U.S. political dissention and strengthen on evidence of policy stability.  Dollar sensitivity to political uncertainty is rather unusual.

This chart shows the economic policy uncertainty index compared to the EUR.  The two series are essentially uncorrelated.  The behavior we saw yesterday has been something we have noted recently.  Investors have generally not been willing to sell equities in the face of turmoil but have sold the dollar instead.  Both the dollar and equities rallied strongly after President Trump’s disciplined and well delivered speech on Monday regarding the war in Afghanistan.  However, we noted lots commentary suggesting that the president has moved on from populism, citing the speech and Steve Bannon’s exit from the White House.  However, the president seems to have a “soft spot” for populist ideas.  Simply put, although it is possible that the president has moved to become an establishment Republican, it’s unlikely that he has changed.  Thus, the potential for more market uncertainty remains.

The Navy puzzle: The U.S. Navy has been hit with a series of mishaps this year. In January, the U.S.S. Antietam ran aground near Yokosuka, Japan.  In May, the U.S.S. Lake Champlain hit a South Korean fishing vessel.  In June, the U.S.S. Fitzgerald hit a container ship, and this week, the U.S.S. John S. McCain struck an oil tanker.  The Navy is reviewing the situation.  Bloomberg[1] notes that one possibility is that the Navy is trying to do too much without enough resources.  From 1998 to 2015, the Navy shrunk by 20% to 271 vessels.  The demand for the Navy’s services may simply exceed the number of ships available to perform the work safely.  However, there is another theory circulating that is much more ominous.  On June 22^nd, the Global Positioning Satellite system was manipulated; 20 vessels on the Black Sea reported a location 20 miles inland, near an airport.  This was the first confirmed instance of GPS “spoofing.”  Although the Navy uses encrypted GPS and should be protected, commercial vessels are not and thus could be vulnerable to manipulation.  There is some evidence that Russia may be behind this GPS spoofing; it would be consistent with Russia’s “hybrid war” concept and shows how a nation with much less economic power can “punch above its weight.”[2]

View the complete PDF

---

[1] https://www.bloomberg.com/news/articles/2017-08-22/why-do-u-s-navy-ships-keep-crashing

[2] https://www.newscientist.com/article/2143499-ships-fooled-in-gps-spoofing-attack-suggest-russian-cyberweapon/ and http://www.mcclatchydc.com/news/nation-world/national/national-security/article168470432.html

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] The president’s address: Last night, President Trump announced that he would expand the U.S. role in Afghanistan but did not give any specifics of the plan.  Additionally, the president stated that the U.S. will begin to pressure Pakistan to assist in the fight against terrorism as it is widely perceived that militant groups in Pakistan, most notably Haqqani, have been responsible for attacks in Afghanistan.  Trump’s apparent pivot in foreign policy allowed the GOP establishment to breathe a sigh of relief as he takes a more definitive leadership role abroad versus focusing on recent domestic issues.  News outlets have speculated for weeks that he would send 4,000 additional troops to the region, but the plan appeared to have stalled, most likely due to resistance from his former chief strategist, Steve Bannon.  Bannon’s exit from the cabinet seems to have paved the way for the decision as the military establishment faction of the president’s cabinet fills the ideological void that resulted from Bannon’s departure.  It is worth noting that Trump campaigned on a complete withdrawal from the war in Afghanistan; therefore, a reversal of this policy could lead to some backlash from his base.

Friend to foe: Breitbart News, an online publication headed by former chief strategist Steve Bannon, immediately condemned the president’s speech last night.  The news site labeled the president’s change in policy as a “flip-flop” and a “reversal of course.”  As noted in our previous report, we believe that Bannon was unable to disrupt the Washington establishment while working inside it and will now try to disrupt it from the outside.  A large faction of Trump supporters either read or are at least sympathetic to the views reported on Breitbart and, as a result, Bannon will likely use the publication to rally Trump supporters against the “globalist” factions within the president’s cabinet.  If the president continues to listen to the globalists in his cabinet, then we expect Breitbart to become increasingly more critical.

A parallel Italian currency?  Silvio Berlusconi, who is making something of a political comeback, raised the idea of creating a parallel currency in Italy.  The “new lire” could only be used within Italy (although, like bitcoin, if it became popular other nations could conceivably use it, too).  Clearly, euro-denominated bank debt would still need to be paid in euros but it might become popular if the Italian government is willing to accept the new lire for tax payments.  Of course, the other issue is in what currency would Italy denominate future government debt?  If it were denominated in the new lire, one would expect the yield to rise significantly.  Berlusconi has seen an improvement in his political standing and the euro is becoming less popular in Italy.  On the other hand, part of the reason nations in southern Europe adopted the euro was to enjoy the currency stability and low inflation that was common in northern Europe.  We suspect that the introduction of a parallel currency will end up with one of two outcomes: either it is successful and Italy leaves the Eurozone, or it fails and the Eurozone becomes even stronger.  If introduced, we suspect the odds favor the first outcome.

The election cycle: We have created an election cycle database for the S&P 500 beginning in 1928.  Taking the weekly data, we index the equity market to the first weekly close of the election year and show the behavior of the market over the subsequent four years.  This allows us to segregate the market by party in power, incumbent versus new party in power, etc.  The chart below shows how new GOP presidents fare.

Equity markets tend to like new GOP administrations; so far, the Trump administration is following the average pattern fairly well.  We are reaching the point in time where disappointment usually sets in; we suspect that by August investors’ hopes for policy changes are confronted with the difficult reality of passing legislation.  Do we expect the large drop projected by the average for a new GOP administration?  Not necessarily.  A drop of this magnitude would almost certainly require a catalyst, such as a recession (not likely), a war (improbable, but not zero probability) or a political event (a debt ceiling crisis might do the trick).  In the absence of a catalyst, the most likely outcome is a sideways to weaker market.  In general, studies like this should be used for general direction, not forecasting.  This study could mean that we may have seen the equity market high for the year.  At the same time, there is still ample liquidity available (retail MMK funds are near $970 bn, well above the $900 bn that signals a lack of buying power).  Thus, we wouldn’t be surprised if we have seen the high for this year, but the more likely outcome is a modest correction and churning for the rest of the year.

View the complete PDF

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy Eclipse Day!  Here are the news items we are following this morning:

Afghanistan policy: Tonight, President Trump will present his policy on Afghanistan.  Already we are seeing the impact of Chief of Staff (CoS) Kelly; so far, there have been no leaks of his plans.  We are expecting a modest increase in troop strength with a focus on planning.  There probably isn’t a workable solution to Afghanistan.  The NYT reported over the weekend that the country is again splitting up and being dominated by warlords.  There was never a unifying figure in Afghanistan and the naïve idea that merely holding elections will lead to democracy has been proven untrue.  American leadership is loath to walk away from a war and leave chaos but that is probably the more likely outcome here.  Still, we will watch tonight to see what the administration wants to do.

Post-Bannon: After rumors of his departure for the past month, Steve Bannon formally left the White House on Friday.  According to numerous reports, CoS Kelly told him he had to go shortly after Kelly took on his new role.  Bannon did accept and planned to leave in the middle of August; Kelly was prepared to grant him a graceful exit.  However, after his comments to the American Prospect last week, it appears he was pushed out.  There are several ramifications from his departure:

Bannon has the potential to be a major disruptive force to the president.  That isn’t his current plan but if the “globalists” in the White House control policy, we expect Bannon to become very critical of the administration.  Bannon has returned to Breitbart and there is talk of building a “right of Fox” media company complete with television, and there are rumors he may try to poach some of the more rightist personalities at Fox (FOX, 26.79) to build a new brand.  A famous line from The Godfather comes to mind here, “Keep your friends close but your enemies closer.”

The globalists dominate the White House now.  Bannon had a nationalist agenda, which included a travel ban for Muslims, trade impediments and infrastructure.  Nothing really got accomplished.  Some of this wasn’t necessarily his fault.  The nationalists’ agenda is a major shift in policy.  The lessons of history suggest that major shifts do occur but they need specific conditions in order to work.  First, you need conditions so bad that the majority of people are behind the new leadership that wants to make the change.  The last two major shifts, Franklin Roosevelt and Ronald Reagan, took office when the consensus was that the current path was unstainable.  Roosevelt’s Democrat Party held over 70% of the House and 60% of the Senate; by the next term, party control increased to nearly 80%.  Thus, he was able to make major shifts in policy.  Reagan’s party only controlled the Senate and by a narrow majority.  He was able to make policy work by building bipartisan coalitions.  Trump’s position is closer to Reagan’s but, so far, he has been unable to build a bridge with the Democrat Party.  Some of this is due to the current level of hyper-partisanship.  Second, major changes require organization and unity.  Bannon’s expertise appears to be disruption, not creation.  We do expect the nationalist agenda to eventually win out, it just may not be from this president.  For now, the globalists have won the battle but the war rages on.

Cohn is likely our next Federal Reserve Chair.  By all accounts, Cohn was quite angry with the Tuesday press conference during which the president assigned blame to both the right and left in Charlottesville.  There were rumors he was about to walk.  We suspect he is making a trade—he will stay if he gets the FOMC Chair job.

War may be more likely.  Although we don’t ascribe to the idea that military leaders pine for war, there is evidence to suggest that NSC Chief McMasters is leaning toward “preventative war” in North Korea.[1]  Bannon’s comments to the American Prospect last week suggested that there was no chance of war on the peninsula and that Kim had outplayed Trump.  According to the NYT article in the footnote below, McMaster has concluded that the usual deterrent policies that have prevented nuclear war in the past won’t work with North Korea.  We are not convinced that’s true, but McMaster’s position on this matter is far more important than ours.

The debt ceiling: Although the administration wants a clean raising of the debt ceiling, the Freedom Caucus continues to make noise about getting some adjustment.  If spending isn’t cut, then they want some sort of automatic measures to curb the growth of the deficit in future years, something that might require a sequester-type agreement.  Meanwhile, Bannon is already indicating that the president should veto any debt ceiling increase that doesn’t include money for the Mexican border wall.  This issue has been a sleeper but will become a greater focus for investors after Labor Day.

Jackson Hole: The KC FRB begins its annual gathering on Thursday.  The most closely watched figure will be ECB President Mario Draghi.  We doubt he will signal anything concrete about tapering but all eyes will be watching.

View the complete PDF

---

[1] https://www.nytimes.com/2017/08/20/world/asia/north-korea-war-trump.html?_r=0