Daily Comment (July 25, 2017)

Posted on July 25, 2017December 13, 2017 by Rebekah Stovall

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s another quiet summer trading day. Here are the items making news:

The FOMC meeting begins later today: The Fed has created a problem for itself. The U.S. central bank meets every six weeks (or eight times per year), but because it makes four meetings out of each year more important by issuing dots, economic forecasts and holding a press conference, the markets mostly ignore the meetings that don’t have those events. This is one of those meetings. Although the Chair and other FOMC members continue to warn us that all meetings are “live,” that perception isn’t going to change until they actually take significant policy action outside of the meetings with press conferences. So, the Fed finds itself in a situation where it really only meets four times a year. That probably isn’t enough for a major central bank. The solution? Either end the dots and press conferences altogether, add them to all meetings, or make a major policy change at a meeting without a press conference. How does this affect markets? The financial markets are mostly ignoring this week’s meeting and so we could see some volatility if the FOMC actually does something. However, we view the likelihood that anything happens as very low.

German business—I’m so happy! The German IFO index (see below) unexpectedly hit a new record high, with the July number reaching 116.0. The monthly survey of some 7k firms operating in Germany is reaching “euphoria,” according to IFO Chief Clemens Fuest. According to interviews with German firms, the recent rise in the EUR is being managed successfully which probably means further gains in the exchange rate are possible. European equities lifted on the news.

Is shale drilling starting to slow? One feature of the oil market has been the relentless rise in U.S. production. Bloomberg[1] is reporting that Halliburton (HAL, 42.51) warned that exploration companies are “tapping the brakes.”[2] Anadarko (APC, 44.21) fell sharply overnight after reporting a larger Q2 loss than expected. The company announced a cut in its capital budget and its production forecast for next year. If this becomes a trend among other companies, the price pressure coming from shale could ease. This would be good for oil prices in the short run, even though it may not be helpful for oil equities, at least initially.

These charts show U.S. oil production with a long-term view on the left chart and production over the past 32 years on the right. Note the lift in production since November 2016. If that production begins to stall, we could see oil prices move higher. We note that oil prices are higher this morning.

China prepares for war? The WSJ[3] is reporting that China is increasing its military presence along its border with North Korea. In some respects, this is merely an update to reports we have been hearing for some time about troop movement on the North Korean frontier. However, the article did note some policy signals from Beijing. China wants to avoid a flood of refugees and doesn’t want a hostile power aligned with the U.S. directly on its border. Thus, the article hints that the People’s Liberation Army (PLA) is likely drawing up plans to invade North Korea to set up a safe zone so that refugees will move there instead of into China, and it also may be taking steps to secure the nuclear facilities. Essentially, if the U.S. attacks, China wants to remove the Kim regime and establish another buffer government, one that can more easily be controlled by the U.S. and China. The danger is that China is making it clear that if the U.S. intervenes militarily in North Korea, the Chinese will as well. This could lead to a bigger war if both sides are not careful in their actions.

China and Russia hold joint naval exercises: The FT reports[4] that Russian and Chinese warships are holding exercises in Baltiysk, the home port of Russia’s Baltic fleet in the Russian enclave of Kaliningrad. China is slowly expanding its naval “footprint” and joining up with Russia clearly gets the attention of the West. The NATO frontier nations, especially the Baltic States, will be watching these exercises closely.

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[1] https://www.bloombergquint.com/business/2017/07/24/anadarko-cuts-drilling-plan-as-oil-explorers-bow-to-price-slump

[2] https://www.bloomberg.com/news/articles/2017-07-24/frack-giant-halliburton-adds-1-billion-in-sales-during-recovery

[3] https://www.wsj.com/article_email/china-prepares-for-a-crisis-along-north-korea-border-1500928838-lMyQjAxMTE3ODI4NDkyMDQ0Wj/ (paywall)

[4] https://www.ft.com/content/1dfabf08-7076-11e7-93ff-99f383b09ff9?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56 (paywall)

Weekly Geopolitical Report – A Productivity Boom: A Response to Robert Gordon, Part II (July 24, 2017)

Posted on July 24, 2017December 13, 2017 by Rebekah Stovall

by Bill O’Grady

Last week, we began an analysis of Michael Mandel and Bret Swanson’s paper[1] which is a response to Robert Gordon’s argument that the West is doomed to a prolonged period of slow productivity growth.

In Part I of this report, we examined the productivity issue and discussed Mandel and Swanson’s analysis of the situation, focusing on their specific division of industries. This week, we will look at six sectors of the economy that appear poised to digitize and how that could change the economy. We will also discuss the conditions necessary for Mandel and Swanson’s position to be correct. As always, we will conclude with market ramifications.

The Six Sectors
Mandel and Swanson’s six sectors are transportation, energy, education and training, retail and wholesale distribution, manufacturing and health care. We will discuss them in that order.

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[1] http://www.techceocouncil.org/clientuploads/reports/TCC%20Productivity%20Boom%20FINAL.pdf

Daily Comment (July 24, 2017)

Posted on July 24, 2017 by Rebekah Stovall

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s another quiet, summertime session. Here are the items we are watching this morning:

OPEC meeting: The OPEC meeting is wrapping up with no new production cuts. However, Saudi Arabia has promised to reduce its oil exports which is modestly positive. As we noted last week, Saudi oil exports tend to fall in the northern hemisphere summer due to rising electricity demand in the kingdom. Thus, the decision to “reduce” exports has more to do with the need for domestic energy. It is a bullish move in the short run but we doubt exports will remain at summer levels once autumn comes. In addition, Kuwait noted that the cartel may extend production cuts past Q1 2018, taking a page out of the central bank’s playbook of managing expectations. Over the past decade, central banks have used the concept of “forward guidance” to steer policy expectations. Kuwait’s comment hints that the cartel may be planning something similar. Overall, the meeting was neutral to negative for oil prices; the market was hopeful that OPEC would announce further production cuts, but didn’t expect them. If Saudi oil export cuts allow for a drop in U.S. oil inventories, it would be bullish for oil prices.

Venezuelan sanction threats get serious: The Trump administration is considering financial sanctions on Venezuela that would prohibit the Venezuelan state oil company, PDVSA, from making dollar transactions. This would mean the country would be isolated from the U.S. financial system and the global reserve currency. Since oil is priced in dollars, this would be a major blow to the country. Although PDVSA could accept another currency, say, the EUR, the European banks would not want to risk U.S. sanctions and probably would not participate in PDVSA transactions. This would leave Venezuela to the “tender mercies” of Russia and China, both major creditors of the Maduro government. The U.S. has threatened the sanctions if the Maduro government goes ahead with making a new constitution.

The importance of “Mooch”: Last week, President Trump shook up his White House by appointing Anthony Scaramucci as communications director. Known as “Mooch,” his appointment was vehemently opposed by Chief of Staff Priebus and Advisor Bannon. On the face of it, this appointment shouldn’t affect markets directly so, normally, we wouldn’t comment. However, this one may change the shape of things and thus requires some examination. It appears that Priebus’s objection is mostly personal; he doesn’t seem to like Scaramucci and the appointment undermines Priebus’s authority since Scaramucci will directly report to the president. The resignation of Priebus’s ally, Sean Spicer, further undermines the Chief of Staff. Bannon’s distrust of Scaramucci is more due to his Wall Street ties. Bannon fears that Trump has another establishment figure who will fall in line with Mnuchin and Cohn. Here are some reasons we are watching this appointment with interest. First, if Priebus resigns, and odds are high that he will, Cohn is the most likely replacement. This might mean he won’t become Fed Chair and would reopen this position. Kevin Warsh would be the likely leading candidate for Fed Chair (Warsh is probably a hawk). Second, if Bannon decides he is isolated and the establishment has won, he too may resign and the populist cause is probably lost. Thus, the Mooch appointment could be a big deal.

The sanctions bill: A bill putting new sanctions on Russia, Iran and North Korea is headed for the president’s desk. Although there is much controversy surrounding Russia, most presidents don’t like foreign policy from Congress. As with every bill, the president will have two choices; he can sign the bill and limit his ability to operate in foreign policy. Or, he can veto the bill and raise concerns that he is unwilling to punish Russia and cause more headaches for the White House. We suspect he will reluctantly sign the bill, especially because it also includes actions against Iran and North Korea. At the same time, we want to reiterate that no administration wants foreign policy meddling from Congress.

Infrastructure looks dead: The NYT reported over the weekend that a move to boost infrastructure spending has mostly fallen by the wayside. The establishment GOP was never much in favor of spending on fears it mostly bolsters Democrat Party supporters; in addition, they didn’t want to raise the deficit or increase taxes to fund spending. There has been some interest in public/private partnerships but those are limited to projects that generate a stream of income. In a world with very low interest rates, if such projects were easily feasible, one would think they would have already been funded. Allowing infrastructure spending to stagnate will potentially hurt the president in 2020 as his support of such a program was popular with the right-wing populists.

Capital flight discussed: Emily Badger had a column in yesterday’s NYT discussing the impact of foreign capital flight into local real estate markets. The influx of foreign money has tended to raise prices in these select areas, boosting the wealth of existing homeowners but making it difficult for new buyers to afford housing in these areas. The article mentions that China alone invested $153 bn in U.S. real estate last year (03/16 – 03/17), up 49% from the previous year. We suspect the money coming in is price insensitive as it represents an “escape pod” for wealthy foreigners looking to secure a space in the U.S. in case of future unrest at home. For the U.S., these inflows are a mixed bag. The investment should be welcome but the concentration of buying does affect American buyers and can force U.S. citizens to live in regions that are not their first choice.

Manafort, Kushner, Trump (Donald, Jr.) testify today: The session before the Senate Intelligence Committee is closed and not under oath. We don’t expect anything initially out of the testimony, although we do look for leaks to emerge in the coming days. If there is anything to this Russian situation, this meeting will be the preliminary one.

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Daily Comment (July 21, 2017)

Posted on July 21, 2017July 21, 2017 by Rebekah Stovall

by Bill O’Grady and Thomas Wash

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

Pardon me: Numerous media reports indicate that the Trump administration is exploring pardoning options and ways to ring fence Special Counsel Mueller’s investigation. There are overtones of Nixon in these comments. First, seeking pardons when no one has reportedly done anything wrong suggests that there is fear that something illegal will be found. Second, Special Investigators have wide latitude once an investigation gets underway. Trying to restrict an investigation (or for that matter, pardoning protocol) gets into legal gray areas over the boundaries of presidential powers. Of course, our concern remains focused on financial markets. One of the patterns we have seen recently is that equities tend to maintain strength while other financial areas seem to be reacting to these issues. For example, we have seen Treasuries strengthen in recent sessions after yields had backed up earlier in the month. Our position on the dollar is that the greenback is overvalued because the forex markets rapidly discounted tightening Fed policy (see the Asset Allocation Weekly below for details). However, it is possible that recent dollar weakness is also a reaction to the growing turmoil in Washington. The fact that the dollar appreciated yesterday despite a rather dovish press conference and statement from ECB’s Draghi suggests that factors other than monetary policy are underpinning dollar weakness. Simply put, the political issues in Washington are not adversely affecting equities yet, but that doesn’t mean that other financial markets are not reacting to these events.

Brexit concerns: The May government appears deeply divided over how to execute Brexit, reflecting Tory divisions that are similar to issues within the GOP here. The populists want a “hard” Brexit that will restrict the ability of foreigners to work in the U.K. and loath to pay the EU “exit fee” for leaving. The business wing of the Tories wants a “soft” Brexit that will maintain London’s financial pre-eminence which means that Brexit really isn’t much of a break with the EU. Unfortunately for Britain, there are elements within the EU that see opportunity from Brexit and are goading the Tory negotiators toward a hard Brexit so as to bring much of London’s financial business to the continent. Given PM May’s poor election performance, we suspect that her government is likely to face a no confidence vote at some point; the confusion we are seeing in negotiations may simply reflect the lack of an electoral mandate.

China v. India: China and India fought over disputed parts of their border in the Himalayas in 1962. Currently, the two states are facing off in the Doklam plateau, which is at the trisection of India, China and Bhutan. China is building a road in an area claimed by Bhutan and the latter is asking for Indian assistance in enforcing its claim. This border dispute is part of rising tensions between the two countries. India has quietly opposed China’s “one belt, one road” initiative and has recently joined naval exercises with Japan and the U.S. As the U.S. profile declines in the region, tensions between India and China are likely to increase as both powers jockey for regional influence.

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Asset Allocation Weekly (July 21, 2017)

Posted on July 21, 2017July 27, 2017 by Rebekah Stovall

by Asset Allocation Committee

In the past few years, we have generally avoided allocations to non-U.S. markets for our asset allocation portfolios due to two primary concerns. First, the dollar was rising as a result of an improving U.S. economy and policy divergences between the U.S. and the rest of the world. The Federal Reserve was raising rates and tapering its balance sheet while the majority of the other nations were still adding monetary stimulus. Second, we have had secular concerns about the stability and attractiveness of foreign investing in a world where the U.S. is seemingly reducing its hegemonic role.

This quarter we have added foreign allocations into our portfolios. The primary reason is that we believe the dollar’s bull market is probably coming to a close. On a relative valuation basis, the dollar has become rather expensive.

This chart shows four purchasing power parity models for the euro, yen, British pound and Canadian dollar. In all four cases, the dollar is trading “rich” by more than one standard error, and in two cases, nearly two standard errors from parity. Purchasing power parity uses relative inflation to value currencies. As the models show, currencies are rarely at parity. Although purchasing power parity is the oldest way to value currencies, it isn’t the most accurate. However, it tends to be useful at extremes, and exchange rates tend to move around the parity measure. In other words, parity is something of an anchor around which the actual exchange rate vacillates.

History also suggests that exchange rates can diverge from parity for long periods of time, which usually means that a catalyst is required to move currencies from extremes of under-and over-valuation. For example, in the above euro and pound models, the deep undervaluation in the mid-1980s ended with the Plaza Accord. Yen overvaluation in the early 1990s was ended by the Halifax Accord. Changes in policy or governments can trigger an end to valuation extremes as well.

This leads us to two additional reasons for this repositioning. We believe there are two catalysts which will pressure the dollar in the coming quarters. First, the Federal Reserve appears to be hedging on future tightening. Although the dots charts still indicate rising rates, a number of FOMC members have raised worries about raising rates while inflation remains depressed. Chair Yellen appears to be offering a trade to the hawks on the committee; instead of raising rates, balance sheet reductions can act as policy tightening. It is possible reducing the balance sheet will be dollar bullish. However, that isn’t supported by the data.

Although economic theory would suggest that boosting the size of the balance sheet should depreciate a currency, all else held equal, the pattern on the above chart developed likely because QE raised hopes of stronger growth. Our expectation is that reducing the balance sheet probably won’t matter, but if the pattern is consistent, balance sheet reduction may actually be dollar-bearish. So, we expect the anticipated monetary policy trade of fewer rate hikes for balance sheet shrinkage to be bearish for the dollar.

The second catalyst is policy disappointment from the Trump administration. Earlier this year, we were worried about the dollar’s overvaluation. And, proposed tax cuts and fiscal expansion from the Trump administration would have been dollar bullish, even at lofty valuations. However, the likelihood of major policy actions have declined and each month that passes without a policy adjustment means that political capital is being lost and it becomes less likely anything will pass. As disappointment grows, we would expect the dollar to retreat.

Although we retain our secular concerns about the stability and attractiveness of foreign investing in a world where the U.S. is seemingly reducing its hegemonic role, these concerns are overshadowed by the changing dynamics of monetary stimulus. Essentially, the near-term effects of policy and the exchange rate outweigh our secular concerns.

Finally, the issue of recent performance needs to be addressed. Both emerging and foreign developed equity markets have performed very well this year and there is a concern that we may be shifting too late into these asset classes. Although possible, if our expectations of a weaker dollar are accurate, history would suggest a longer period of foreign outperformance.

The red line on both charts shows the JP Morgan real dollar index. The blue line on the left chart is the ratio of dollar-denominated EAFE and the S&P; on the right chart, it’s the dollar-denominated ratio of emerging markets and the S&P. Both have been rebased to their respective start periods. On both charts, a lower ratio indicates U.S. equity outperformance relative to foreign markets; a rising ratio shows the opposite. In both cases, periods of dollar strength coincide with domestic outperformance. Thus, even with good foreign performance this year, a weaker dollar may result in a longer period of foreign outperformance.

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Asset Allocation Quarterly (Third Quarter 2017)

Posted on July 20, 2017July 27, 2017 by Rebekah Stovall

Economic data remain supportive and the inflation outlook is currently benign.
Though the economic expansion is elongated, we do not anticipate a near-term recession.
Fed policy is expected to tighten in terms of rising short-term rates and the reduction in the size of the Fed’s balance sheet.
We expect the Fed to commence the reduction of its $4.5 trillion balance sheet with a $10 billion monthly run-off by the end of this year.
Expectations for a softer U.S. dollar combined with attractive valuations overseas have encouraged us to include non-U.S developed and emerging market equity exposure, the former with a tilt toward Europe.
Overall allocations to bonds are intact, though with a heavier presence in intermediate-term bonds. Speculative grade bonds remain supportive for income objectives.
Our growth/value even weight of 50/50 remains unchanged from last quarter.

ECONOMIC VIEWPOINTS

The themes present at the start of the year continue unabated, with inflation and unemployment at low levels and both consumer and business sentiment remaining elevated. Although the U.S. is now 97 months into an expansion, closing in on the second longest on record, there are pockets of softness. For example, consumption is slower than historical experience as measured by PCE, investment is muted and capacity utilization is running at 75%, as evidenced in the accompanying chart. In addition, government spending, inclusive of the contributions of states and municipalities, is very low as a percentage of real (inflation-adjusted) GDP. These measures all factor into our belief that a recession is not on the near-term horizon and the economy holds solid potential for continued expansion despite its current length.

Although members of the FOMC are signaling further monetary tightening through an increase in the fed funds rate as well as a reduction in the reinvestment of balance sheet proceeds, markets anticipate that the Fed won’t be as hawkish as the current trajectory implies. For example, the Fed’s much-publicized dot plots indicate a fed funds rate of 2.25% by this time next year, while the markets, as measured by LIBOR, provide an implied rate of 1.61%, as exhibited in the below chart.

The Fed appears mollified by the improvement in unemployment figures and the lack of deflationary pressure, providing the latitude to move rates higher and commence some withdrawal of stimulus by reducing the reinvestment of proceeds from its $4.5 trillion balance sheet. However, uncertainties abound regarding not only the path of balance sheet reduction and its concomitant effect on the U.S. banking system and the availability of credit, but also the complexion of the Fed’s Board of Governors with its three vacancies and the prospect of a new Fed Chair. As mentioned in our last quarter’s report, it remains unclear as to whether the Trump administration will be appointing members who are hawkish or populist. While the issues surrounding the complexion of the Fed and its amount of monetary accommodation remain unresolved, the pace of tightening thus far has been appropriate and there are no indications that they have raised the prospect of thrusting the economy into a recession

Our view is that the issues that create headlines, such as current Congressional activity surrounding healthcare and the potential modifications to the tax code, are more distracting than influential at this juncture. Until, or unless, legislation is advanced or the Fed missteps, we retain the perspective that equity markets carry fair value on the traditional metric of Price/Earnings with a benign level of inflation. In addition, the intermediate and long portions of the bond market provide positive inflation-adjusted returns. The greater near-term investment significance for U.S.-based investors include expectations that nascent U.S. dollar weakness relative to foreign currencies will continue, particularly versus the euro and the basket of emerging market currencies. The Trump administration’s encouragement of a weaker dollar is a marked departure from the policies of prior administrations and consistent with our belief that U.S. economic hegemony is waning.

STOCK MARKET OUTLOOK

The economic landscape has proven favorable for U.S. equities and we find that the current economic environment remains healthy. However, signals of policy tightening from the Fed advise a degree of caution and bear continued scrutiny. In addition, recent readings of small business optimism exhibit softness compared to earlier in the year. Nevertheless, factors that are typical of elevated downside risk are noticeably absent, as shown on the accompanying chart. This graph depicts the monthly average for the S&P 500 Index versus our conflation of initial jobless claims, the Conference Board’s Consumer Confidence data and the CRB commodity index using adjusted standardized data.1 Though this shows that the U.S. economy is well advanced in the economic cycle, near-term concerns are not evident. Valuations have certainly advanced over the past year, but we believe that they can be persistent and are not untenable at this stage. Large cap, mid-cap and small cap equities have all enjoyed solid returns and traditional valuation metrics of Price/Earnings, Price/Book, and Price/Cash Flow have advanced accordingly. In contrast, non-U.S. equities, while enjoying positive returns this year, are generally priced below U.S. counterparts on traditional valuation metrics. Furthermore, given our views of a softer U.S. dollar environment, we are shifting some U.S. exposure to foreign equities. Much of this shift is being pulled from U.S. mid-cap exposure as pricing is more elevated and therefore expected returns are more muted. Among foreign domiciles, we tilt toward Europe in developed countries and also introduce exposure to emerging markets for more growth-oriented strategies.

1 For a full description of the standardization of data, please refer to our **Asset Allocation Weekly**, 6/30/17.

Among U.S. large cap sectors, we favor healthcare and industrials and continue to underweight telecom and consumer staples. We reduce our previous overweight of financials and utilities to even-weight. REITs continue to be positioned in two strategies for their diversification benefits and potential for modest appreciation. Our growth/value style bias remains evenly balanced at 50/50, reflecting our views toward sectors and industries.

BOND MARKET OUTLOOK

The Treasury yield curve has flattened over the course of this year, reflecting tighter monetary conditions at the Fed. Though the duration of the bond exposure in the more income-oriented strategies remains consistent with our prior exposures, it is now attained through a greater allocation to the intermediate segment as opposed to the former bar-belled overweights to short- and long-term bonds.

The exposure to long-term bonds has proven beneficial, but the current outlook has encouraged a more cautious positioning for the months ahead, especially as the Fed begins to engage in some normalization of its balance sheet. We maintain our favor to investment grade corporate bonds over Treasuries and mortgage-backed securities as the spreads continue to be attractive and supported. We also retain exposure to speculative grade bonds given our outlook for contained default and recovery rates.

OTHER MARKETS

Despite a more favorable outlook for commodities, we have concluded that introducing exposure at this time may be premature. In an environment of faster economic growth and/or a surge in inflation expectations, commodities would prove helpful to a diversified portfolio. However, we harbor no expectations of either environment over the near term. Accordingly, there remain no allocations to commodities in the strategies.

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Daily Comment (July 20, 2017)

Posted on July 20, 2017December 13, 2017 by Rebekah Stovall

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Equity markets continue their quiet rise to new records. Here are the items we are watching this morning.

ECB, BOJ lean dovish: The BOJ came out overnight with nothing that wasn’t unexpected. It is clear the bank won’t reach its inflation targets anytime soon, so it extended its deadline, making it the sixth time this has occurred under Abe. The JPY weakened a bit on the news but since it was mostly anticipated, the forex move was modest. The ECB has released its statement, which is almost identical to its last one. The statement was taken as dovish by the markets. In the press conference, Draghi remained dovish, suggesting that the ECB hasn’t laid out any plans for QE tapering. Even though his opening comments and answers to questions were clearly dovish, the EUR rallied, European stocks fell and European sovereign yields rose. However, we have seen a reversal in these prices after Draghi reiterated that tapering hasn’t been discussed. Market behavior suggests that traders are focused on ECB balance sheet management. Draghi is clearly keeping his “cards close to the vest” on revealing when tapering will begin. Our view on market action suggests that it might be impossible for the ECB to avoid a “taper tantrum” once ECB QE ends. Perhaps the most interesting market action is the EUR; the currency weakened after the statement then rallied during the presser. It appears to us that the currency markets have concluded the dollar is going down, most likely because the ECB will eventually act to reduce stimulus.

U.S./China trade talks stall: Negotiators for both nations quickly reached an impasse at trade talks. The Trump administration is taking the position that the bilateral trade deficit with China is a serious problem that can only occur due to unfair Chinese policies. Commerce Secretary Ross said, “If this were just the natural product of free-market forces, we could understand it, but it’s not. So, it’s time to rebalance in our trade…” Evidence of the differences between the two parties emerged when the U.S. canceled a scheduled news conference which was set for the two parties to reveal concrete proposals on trade. It appears to us that China has no intention of changing its trade policies and its plan to deal with this trade spat is endless negotiations. That would have worked before; although previous administrations clearly didn’t like the bilateral trade deficit, they understood that the superpower role necessitated a U.S. trade deficit. The Trump administration, in our analysis, is preparing to withdraw from that role which ends the need for persistent U.S. trade deficits. Thus, implementing trade barriers and ignoring the WTO are consistent with this position. America’s more isolationist trade policy is a significant threat to the Chinese economy.

Poland’s judicial crisis: The Polish government has already increased control over the media, restricted public meetings and taken other steps. Now, it is taking direct aim against the independent judiciary. The populist Law and Justice Party has introduced bills that would force all the judges to resign, save those appointed by the aforementioned party. Other bills would give the government greater control in appointing judges. The EU has indicated that the actions against the judiciary, coupled with other moves, may mean Poland would no longer be considered a “democracy” by Brussels. If this determination were to be made, it could lead to Poland losing its vote in the EU Parliament. In one sense, this isn’t a big deal; it isn’t clear how much sovereign impact the EU Parliament has anyway. However, calling Poland a non-democracy might trigger the decision to leave the EU, leading to Polexit. Although there isn’t much discussion of Poland leaving the EU, the party in power will strongly oppose outside pressures and may conclude that being outside the EU will strengthen Poland’s sovereignty. Another nation leaving the EU would seriously undermine the union.

The naming of a new Saudi Crown Prince looks like a coup: Major U.S. media[1] are publishing reports that detail how the former Crown Prince Nayef resigned from the post and was replaced by his cousin, the former Deputy Crown Prince Salman. We will have much more to say on this in future WGRs but we mention it here because it shows that the potential for leadership instability is rising in Saudi Arabia. If instability rises, we would expect oil prices to rise.

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[1] https://www.nytimes.com/2017/07/18/world/middleeast/saudi-arabia-mohammed-bin-nayef-mohammed-bin-salman.html?hp&action=click&pgtype=Homepage&clickSource=story-heading&module=first-column-region&region=top-news&WT.nav=top-news&_r=1

Daily Comment (July 19, 2017)

Posted on July 19, 2017December 13, 2017 by Rebekah Stovall

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT]The summer doldrums are upon us. Financial markets are very quiet this morning in front of tomorrow’s ECB meeting and press conference. Here is what we are watching this morning:

The ECB: The EUR has been rising recently, in part due to expectations the ECB will begin the process of withdrawing stimulus. We expect Draghi to offer a very slow path of tapering with lots of comments suggesting that the Eurozone recovery remains fragile and that policymakers must be careful to avoid tightening too quickly. We do expect signaling that a plan for tapering QE and the eventual path of ending balance sheet expansion will be detailed in September. Overall, the EUR has been strengthening and the risk is that traders have overestimated the pace of stimulus withdrawal. However, if our read for tomorrow’s meeting is accurate, the EUR should maintain recent gains. Anything that signals faster withdrawal of stimulus will lead to further currency strength.

Sanctions on Venezuela: The Trump administration is reportedly considering sanctions on Venezuela if the Maduro regime decides to rewrite the country’s constitution. The fear is that a new constitution would move Venezuela to a Cuban-style government, dispensing of contested elections and ensuring that Maduro and the Chavistas will be permanently in power. The key threat is the U.S. will ban Venezuelan oil exports to the U.S. Venezuela generally provides around 0.6 mbpd, or about 8% of U.S. gross oil imports. Although we expect the U.S. oil market to be able to handle the loss of this oil, it may cause some short-term disruptions. Venezuela mostly sells heavy, sour oil to the U.S. because American refineries have the ability to refine such crude oil. If Venezuelan imports are disrupted, some refineries may scramble to find heavy, sour oil and we may see a temporary decline in refinery operations. The sanctions will hurt Venezuela more than the U.S. but our oil infrastructure won’t be completely unscathed if sanctions are introduced.

GCC backs off: The WSJ[1] is reporting that the GCC has revised its demands that Qatar must meet to see the current blockade lifted. Specifically, it looks like Al Jazeera will not be forced to close and some clerics sympathetic to the Muslim Brotherhood will be allowed to remain in Qatar. Although Qatar has not reacted warmly to this overture so far, we suspect that pressure from Turkey and the U.S. led the GCC to ease its demands. We would not expect the same parties to lean on Qatar to accept the new “principles” as opposed to demands, from the GCC. The U.S. does need the GCC to work together to combat Iranian designs for the region and this recent dispute between the GCC and Qatar doesn’t support U.S. policy.

Off to taxes: After the legislative failure to deal with the ACA, the party is mostly moving on to taxes, primarily corporate taxes. The first issue will be whether we simply see cuts in rates or if broader reform is enacted. We suspect the president, who would like to see some major legislation signed before year’s end, will opt for simple cuts which could be done faster. However, it’s likely such cuts, which will probably increase the deficit, won’t be given permanent status. The House GOP would prefer broader reform which could then yield permanent tax cuts. However, broader reform will require spending cuts or reduction in tax expenditures to make the tax rate declines revenue neutral and negotiating such changes will slow the process down. We are leaning toward reductions in the tax rate and higher deficits.

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[1] https://www.wsj.com/articles/qatars-critics-scale-back-demands-in-diplomatic-bid-1500441047

Quarterly Energy Comment (July 18, 2017)

Posted on July 18, 2017July 26, 2017 by Rebekah Stovall

by Bill O’Grady

The Market
Oil prices peaked in March around $55 per barrel. There have been a series of lower highs and lower lows, as shown by the lines on the chart.

This obvious downtrend has led to a general bearish tone to the market. We don’t necessarily share that level of pessimism; as we will show below, dollar weakness and falling inventories are supportive for oil prices. On the other hand, there are legitimate concerns that Saudis may reverse production restrictions after next year’s initial public offering for Saudi Aramco.

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