by Bill O’Grady, Kaisa Stucke, and Thomas Wash

[Posted: 9:30 AM EDT] The big news today is no surprise but is still important—PM May formally declared Article 50, beginning the process of the U.K.’s exit from the EU.  The law gives both parties two years to work out the exit details.  Article 50 has never been used before so the U.K. and the EU are creating the framework for any future nations to leave the EU.  The law does allow for extensions, so we may not be finished in two years and a trade deal will probably take much longer to execute.  We note that there has been a good bit of speculation on what will occur; most analysts expect this to be a negative event for the U.K., although Brexit supporters suggest the opposite.  Because this action is unprecedented, we believe there will be lots of surprises that develop.  Here are a few ideas we have been thinking about:

The U.K. government is about to expand.  The EU provides regulations for a myriad of industries across Europe.  Although members grumble about being restrained by “Brussels,” the fact is that the individual nations reduce governance costs by consolidating regulation.  The U.K. will now have to take over this governance.  While this will give the U.K. government more control over its economy and society, it will need to build the bureaucracy to actually regulate these activities.  Sadly, we expect the EU to require similar regulations for tradeable goods and services, so the new U.K. regulations will likely look much like the ones it had before Brexit.  This expansion of government will be expensive and likely lead to higher deficits.

Devolution may follow.  Scotland has already started the process for an independence referendum.  Northern Ireland is making similar noise.  If former nations that were once independent decide they would like to return to the EU, or simply want independence, nations within Europe could split.  Given that most nations in Europe have regions that would like more autonomy, other nations may face pressure to either follow the U.K. out of the EU in a bid for more independence or these regions will need to be placated in order to avoid this threat.

A broader rethink of the EU may be developing.  Next week’s WGR will look at the EU at 60; on March 25, the EU officially celebrated its 60^th birthday.  Interestingly enough, there is growing sentiment that the current structure isn’t working and a looser confederation might be more effective.  Brexit may turn out to be the turning point that the EU needed to adjust and historians may decide that it was this event that led to a new arrangement for the EU.  The tensions within the EU have always been about sovereignty.  Simply put, Brexit is a signal that sovereignty is important to nation states and the pseudo-consolidation offered by the EU is no substitute for the nation state.

The role of financial markets is to discount the future—Brexit will be hard to discount and thus market volatility for European assets will probably rise.  The current consensus is that Brexit will be negative for the U.K. economy.  The weakness in the GBP is part of that expectation.

This chart shows the purchasing power parity for the GBP/USD; this model uses relative inflation to establish the valuation of the exchange rate.  The current exchange rate, around $1.25, is well below the calculated parity of $1.6439.  In fact, this is the second weakest level for the GBP since currencies floated in the early 1970s.  The weakness is mostly due to Brexit and fears that it will lead to a much weaker economy.  If the U.K. economy manages to avoid a downturn, the currency is quite cheap and could rebound.

One of the more interesting market actions this morning has been the drop in the EUR.

Note that the EUR/USD rate dropped sharply around the time the letter from May to Donald Tusk, the current EU president, was acknowledged.  It has recovered a bit but the market really doesn’t expect Brexit to be bearish for the EUR.  In fact, it might be because other nations may leave and the actual membership of the Eurozone could be more fluid than the market expects.  Again, this drop may only be temporary, but the fact that the currency sold off was unexpected.

In other news, the GOP is starting to consider its options on tax reform.  It will be daunting to execute.  Rules require that any use of budget reconciliation, which would allow tax reform to pass through the Senate without 60 votes, needs to be part of a broader budget bill.  Since the White House budget was mostly panned it would mean that a new budget would have to be built.  Congressional GOP budget plans assumed the repeal of ACA which didn’t happen (perhaps that is why we are hearing members talk about taking another swing at repeal).  Another problem is that any tax change created by this process requires a 10-year sunset, which will dampen the effectiveness.

The other way to go about this process is to try to make it bipartisan by appealing to Democrats.  Getting to 60 votes in the Senate requires eight Democrats to join with all Republicans.  The good part about that course of action is that the tax changes would be permanent unless changed by Congress in the future; the sunset would not occur.  The bad news is that this is not a bipartisan environment.  We did note yesterday that the president is considering linking tax reform and infrastructure spending together, perhaps to encourage Democrats to go along with tax reform in order to get the infrastructure spending they want.  However, if the president insists on not signing one without the other, he risks getting neither.

Tax reform is probably easier than health care reform.  However, that doesn’t mean it’s easy.  Consequently, the idea that this can be done quickly is probably incorrect.

Yesterday, the Conference Board reported that March consumer confidence jumped to a 16-year high.  The rise is significant as it should also be supportive for equities.

This chart shows the consumer confidence index along with the Shiller P/E.  Since the early 1990s, the two series are highly correlated, around 87%.  Although the Shiller P/E is complicated, the rise in consumer confidence suggests that it would be reasonable to expect multiple expansion.  A simple model of the Shiller P/E and consumer confidence suggests a P/E of 33.1x relative to the current 29.0x.

Finally, Vice Chair Fischer suggested two more rate hikes this year.  We suspect this is the baseline for the FOMC, putting the upper limit of fed funds at 1.50% by December.

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by Bill O’Grady, Kaisa Stucke, and Thomas Wash

[Posted: 9:30 AM EDT] As we mentioned yesterday, we want to expand our thoughts on equities.  Although growing disappointment is a worry regarding the president’s ability to execute his agenda, we do note that cash levels remain elevated.

This chart shows the level of retail money market funds and the S&P 500.  The three amber blocks on the chart indicate periods when retail money market levels dipped toward $900 bn.  At those levels, the rising trend in equities tends to stall.  If investors are so inclined to boost their holdings of equities, it appears that there is ample cash to do so.  As we saw in yesterday’s trade, equities opened lower but gradually edged higher during the day; this pattern is usually seen when there are investors waiting for a pullback with liquidity available.

Of course, this indicator does have another side to it; rapidly rising cash levels tend to coincide with declines in equities.  Again, this makes sense.  If investors are raising cash, they are probably doing so by selling assets, including stocks.  We aren’t seeing that now and, barring some sort of panic, we suspect that the downside in equities is probably limited.

In the wake of the health care defeat, President Trump is now signaling that he wants to implement tax reform and infrastructure spending simultaneously.  Although we don’t think he means to include them in the same bill, he is attempting to link the two and will probably indicate that he won’t sign one without the other.  His thinking seems to be that the Democrats would really like infrastructure spending and the GOP really want lower taxes.  If he links the two, he might be able to accomplish both.  Although this is a novel idea, and it makes sense as a bargaining position, the problem is that it doesn’t appear that either policy change has been fully developed.  Regarding infrastructure, although lists of projects have been drawn up, there isn’t much on funding mechanisms.  Meanwhile, the only tax proposal is from Speaker Ryan and it includes the border adjustment tax (BAT), which has little support.  There is growing talk that without the revenue from AHCA and BAT, the highest corporate marginal tax rate may only be cut to 28%, which is what President Obama proposed.  That is well below the 15% to 20% that had been promised during the campaign.  The idea of linkage has merit; however, there is the need for details, which this administration didn’t master with health care.

Yesterday, South African President Jacob Zuma called Finance Minister Pravin Gordhan back from a “road show” for foreign investors.  Gordhan was on his first day of a seven-day tour of the U.K. and U.S.  There are reports that Zuma wants to fire Gordhan, who has repeatedly prevented Zuma from implementing policies that the former sees as illegal patronage.  Zuma has previously tried to fire his finance minister only to back down due to financial system stress.  In the wake of this news, we have seen the ZAR weaken.

Bloomberg reported over the weekend that Chinese nationals are in a “race to apply for U.S. golden visas,” the EB-5 class.  This visa allows any foreign investor to receive a green card who invests $1.0 mm in the U.S. (or $500k in targeted employment areas of high unemployment) that creates 10 jobs.  What has spurred interest is that Congress is considering increasing the minimum on targeted employment areas to $1.35 mm (and $1.8 mm for investments outside the targeted employment areas).  Chinese citizens can only legally move $50k per year outside of China but that restriction is apparently not all that tight, as this chart can attest.  China is clearly the leading source nation for EB-5 visas.

Although this program is a small part of the estimated $728 bn that exited China last year, it is popular with Chinese nationals because it offers an “escape pod.”  It is worth noting that Chinese investment in this program tripled in 2012 compared to 2011 when President Xi took office.  We don’t know for sure all of the factors driving Chinese capital flight, although we suspect the crackdown on corruption may be part of that desire to move funds abroad.  This program of giving a green card is likely an attractive option.

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by Bill O’Grady, Kaisa Stucke, and Thomas Wash

[Posted: 9:30 AM EDT] Global equity markets are in retreat this morning as bond yields fall and the dollar declines.  What we are seeing is the reversal of the “Trump trade” that came out of the election.  The Trump trade was to buy equities (especially financials), sell bonds and buy the dollar.  Thus, concerns about the future path of policy are leading to a retreat on these positions.

As it become obvious on Friday that the AHCA was not going to pass, Speaker Ryan decided not to hold a vote on the bill.  We did see some weakness in equities; overall, the decline looked to be well contained.  However, over the weekend, sentiment deteriorated and concerns rose that the whole Trump agenda may be imperiled.  This is how that current analysis stands:

The GOP faces major divisions that Trump will struggle to manage.  As we have documented over the past two years, populists on both the left and right wings have become increasingly unhappy with how the center-left and center-right establishment have been managing the country.  The insurgent campaigns of Sen. Sanders and the victory of Donald Trump revealed those divisions, and the AHCA revealed the divisions within the GOP.  We found it notable how the president initially blamed the Democrats after the AHCA failed but shifted his focus to the right wing of the GOP later in the weekend, including the Club for Growth, Heritage, etc.  It’s worth remembering that Trump is a populist; the GOP establishment and much of the hard right are not.

Those divisions exist for tax reform as well.  The Freedom Caucus usually want policy to be revenue neutral and tend to be deficit hawks.  We note that Rep. Mark Meadows (R-NC) did suggest over the weekend that tax cuts don’t have to be “fully offset,” suggesting there may be some room to maneuver.  However, it’s unclear how much room exists.  A simple cut in rates may get through Congress on just GOP votes but only in the reconciliation process, meaning the cuts will sunset in 10 years.  Such cuts won’t have as much effect because businesses won’t know if the reductions will stand and thus will be reluctant to make long-term investments based on them.  Expansive tax reform may be more difficult than the health care bill, so it could mean a very simple tax cut and little else.  And, the border adjustment tax is probably dead as well.

Trump is reaching out to Democrats.  If that was the plan, he should have led with infrastructure.  That would have created goodwill in a policy area where Democrats are inclined to help.  Trump could have used that goodwill to gain support for other policies.  Trump is facing a similar problem that Speaker Boehner faced; some legislation may require isolating the Freedom Caucus and joining with moderate Democrats to pass things.  Unfortunately, in the current partisan political environment, those moderates may be terrified to vote for anything GOP-led for fear of being hit with a primary challenge from the left.  Thus, by leading with the AHCA and trying to bring down what the Democrats see as one of their major achievements, it will be difficult to get any bipartisan cooperation.

The AHCA’s failure will make tax reform harder in other ways.  Speaker Ryan wanted to lead with health care because the AHCA would have would have eliminated the taxes that the ACA levied.  By reducing the amount of revenue coming into the government from the ACA, the baseline would have been reduced, making the impact of tax cuts appear less onerous.  In addition, the spending cuts shown by the CBO would have freed up revenue for tax reductions.  Thus, the scope of tax reform may be reduced.

The debt ceiling may become a crisis.  The continuing resolution funding the government expires on April 28.  We have been expecting it to be extended, with the real “crunch” coming in autumn.  However, the failure of the AHCA suddenly complicates this issue.  The Freedom Caucus will likely insist that any new resolution end funding for Planned Parenthood.  There is no way the Senate will vote for such a resolution even if the House goes along with the Freedom Caucus on this issue.  The other way this moves forward is the “Boehner option” of pulling Democrats into a coalition to fund the government.  However, they will have their own demands and will undermine the speaker.  The president will be unsympathetic; his argument will be that the Freedom Caucus had the chance to defund Planned Parenthood with the AHCA and their failure to pass that bill means that Planned Parenthood will continue to receive money from the government.

The big picture is that political coalitions are shifting.  A two-party system is really one of enforced coalitions.  In other words, political parties tend to have groups within them that are not necessarily compatible but grudgingly work together for political purposes.  Every so often, however, these coalitions can’t hold and new ones are formed.  For example, we noted last week that the head of the AFL-CIO was worried that the anti-trade group within the Trump administration is losing influence.  It’s a bit shocking when “anti-trade” and “GOP” are united; however, it should be noted that the GOP was the party of tariffs before WWII.  We are not sure how various groups will realign in the coming years but we feel confident that it will occur.  Investors should be careful in that the GOP may evolve into the party of the working class and the enemy of capital.  It’s worth remembering that Andrew Jackson was a Democrat; Trump recently laid a wreath at his tomb.

In other news, there were widespread protests in Russia over the weekend and Russian security forces arrested Alexei Navalny, an opposition figure.  The protests rose over reports that PM Medvedev took over $1.0 bn in bribes but also seemed to reflect opposition to Putin’s reign.  The protests occurred despite official bans.  Unlike earlier protests, they occurred across the country, along the Black Sea coast and as far east as Vladivostok.  Putin is usually able to quash these uprisings but the fact that this one came out of nowhere will likely rattle the Kremlin.

OPEC is talking about extending its production cuts and Saudi Arabia is clearly wanting to boost prices by cutting its own output.  The Kingdom noted its output cuts are nearly double what it had promised.  However, non-OPEC cuts have been disappointing as Russia has mostly failed to reduce output.  Anyone surprised by Russia’s lack of compliance has no sense of history; Russia is notorious for not meeting such promises.  Saudi Arabia should have known these promises were unlikely to be fulfilled, which has likely led it to reduce output beyond its quota cuts.  We believe the Saudis are engaging in “window dressing” in front of its Saudi Aramco IPO next year and thus will take aggressive steps to keep prices supported.  However, there are limits to how much the kingdom can cut output and maintain revenue in a falling price environment.

So, where does all this lead us?  After the election, all the groups supporting President Trump were projecting their best outcomes on his presidency.  Reality is starting to set in.  It’s fair to say he won’t get everything done; no president ever does.  However, worries on even the most basic legislation (like tax reform) are bearish for equities.  How bearish?  We note that the economy is still doing ok and there appears to be ample cash on the sidelines.  Thus, the worst case scenario is probably a pullback toward the 2200 area for the S&P 500.  We will have more on this tomorrow.

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by Bill O’Grady, Kaisa Stucke, and Thomas Wash

[Posted: 9:30 AM EDT] The focus of attention remains on the AHCA, which is due for a vote this afternoon.  The president has already pivoted on this issue; he has warned that if the vote fails, the GOP is stuck with the ACA for good and he is moving on to tax reform.  It is becoming increasingly apparent that moving on health care so soon in his term was a mistake.  We suspect the White House was expecting a quick win and didn’t fully comprehend the splits that exist within the House GOP.  The Freedom Caucus wants nothing less than full ACA repeal with really no replacement other than interstate insurance.  We note that a few states do allow interstate sales.  Georgia, Maine, Kentucky, Rhode Island and Wyoming passed laws allowing out of state insurers to sell in their states; to date, none have taken up the offer.  It’s hard to crack a local monopoly.  Meanwhile, more moderate Republicans are facing a backlash against losing some of the more popular parts of the ACA, like no lifetime caps and the pre-existing conditions clause.

Twitter is abuzz with talks of backroom deals to bring House members on board.  In the end, it may pass, although if forced to bet we would fade the trade.  However, even if it passes the House, it won’t pass the Senate in its current form.  So, once the Senate gets the bill, it will make changes that the Freedom Caucus won’t accept.  It should also be remembered that when Americans say they want health care reform, it’s different than when economists talk about it.  The latter want to bring some semblance of a market to health care, with insurance only covering catastrophic health events and all other care coming out of pocket.  To lower costs, there is talk of price transparency (imagine websites that list prices and customer feedback on medical procedures, much like what we have with cars, restaurants and credit cards) and maybe loosening the regulations on health care to boost the number of providers.  When the public says health care reform, it mostly means the ability to consume all the health care desired at little to no cost.  Given these parameters, reform that health care economists craft will be disliked by the public; thus, a politician who puts his name on such reform will inevitably face some degree of disappointment.

The White House has correctly assessed this situation and is calling for a vote; if the AHCA goes down, the president will move on to tax reform and hang the loss on Speaker Ryan.  If this is the outcome, we expect the damage to equities will be slight and the financial markets will turn their attention to tax changes.  It should be noted that the reason for working on health care first was to create revenue to allow for tax cuts to be partly funded by health care reform.  The president seems unconcerned about the deficit and so we are setting up for another tussle between the White House and deficit hawks.

However, there is a sleeper to watch; on March 16^th, the Treasury reached the debt ceiling borrowing limit.  For the time being, the Treasury has work-arounds that should keep the government running until autumn.  But, at some point, Congress will need to vote to raise the debt ceiling.  Fiscal hawks in the GOP will be loath to support more borrowing and will want Trump’s tax and spending policies to be offset by reductions elsewhere.  Given the tensions witnessed within the GOP on the AHCA, the debt ceiling could be another point of contention.

Senate Minority Leader Schumer (D-NY) is indicating his party will filibuster Judge Gorsuch and essentially force the leadership to either find a new candidate or invoke the so-called “nuclear option,” which would allow Supreme Court candidates to be voted on by a simple majority, ending the filibuster on judge approvals.  Going nuclear would be a further step toward turning the Senate from a moderating influence into simply a second House.  Although this outcome won’t necessarily affect financial markets immediately, as we move toward reducing the Senate’s traditional role, the more volatile policy will become.  In a sense, we could see wholesale shifts in policy every time we have unified government (when a single party controls Congress and the White House).  It would make elections even more critical and create market conditions where the fate of companies and industries rests on who controls the government.

Finally, AFL-CIO President Richard Trumka is rooting for the populists in the White House.  Although unions traditionally support Democrats, Trump won the largest share of the union vote since Reagan, mostly due to his stance on trade.  In a WSJ article,[1] Trumka is worried that the Wall Street wing will moderate the president’s anti-trade stance.  The juxtaposition is a bit jarring, but an interesting read.

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[1] https://www.wsj.com/articles/trumps-trade-vows-succumbing-to-moderate-advisers-trumka-says-1490283529 (paywall)

by Bill O’Grady, Kaisa Stucke, and Thomas Wash

[Posted: 9:30 AM EDT] Yesterday saw the first 1% decline in the S&P since October.  We have seen a strong rise in equities since the Trump election, with much of it coming from expectations of stronger economic growth due to fiscal spending, tax cuts and deregulation.  It does appear that expectations have become elevated; as we noted yesterday, Q1 GDP is now forecast by the Atlanta FRB to come in less than 1%.  Of course, we should see economic growth pick up later in the year but, so far, we have mostly just seen improving surveys.  The actual data has been modest at best.

However, the bigger reason why we saw the selloff yesterday was due to a growing realization that it’s going to be a lot tougher to get legislation passed than election comments suggested.  History shows that passing meaningful legislation is always hard.  As the process has become more transparent and earmarks have fallen out of favor, it’s getting even more difficult to pass bills.  The dispersed media means that any action taken by a member of Congress can now be scrutinized; in fact, it can be framed by the blogosphere and the punditocracy in the harshest terms.  The inability to offer “goodies” in the form of district or state spending makes it even more difficult to cobble together majorities.[1]  There was a reason Otto von Bismarck has been attributed with the quote, “laws and sausages are two things one must not watch being made.”[2]

The American Health Care Act (AHCA) is expected to come up for a vote tomorrow.  The president was on Capitol Hill yesterday lobbying for its passage.  Media reports suggest the bill doesn’t have enough votes to pass in the House.  The Freedom Caucus is generally opposed; it mostly just wants to see the ACA repealed and sees the new bill as “Obamacare lite.”  Others among the GOP worry that the new bill will lead to fewer Americans being able to acquire affordable insurance.  If it fails, it will be characterized as a loss for the president.  However, even if it passes, it has no chance in the Senate.

We will be watching how the president deals with defeat.  Will he simply accept the loss and move on to tax reform?  One reason the GOP leadership in Congress wanted to work on health care first is that they anticipated it would reduce spending, which will make it easier to make tax cuts revenue neutral.  That will be harder with the ACA in place, but it won’t necessarily stop tax reform from proceeding.  Although the deficit hawks will be concerned about revenue-neutral tax cuts, we doubt the president will share those concerns.  If he simply pivots to tax reform and infrastructure spending, losing on health care isn’t a big deal.  The financial markets were always more concerned about taxes and fiscal spending; health care was mostly a side issue.

Another issue probably weighing on market sentiment is the president’s conduct thus far.  Today’s WSJ has a critical editorial on his behavior.  We expect the other major national newspapers to be critical; however, when the WSJ turns on a GOP president, it signals a problem.  The personal conduct issues, especially the loose regard for facts, undermines the credibility of the president.  We view this as the unnecessary consumption of political capital, the most precious of assets for a new president.  If it turns out that tax reform and infrastructure spending fail to materialize because of ill-timed legislative efforts and conspiracies, it will be difficult for equities to hold their gains.

This charts shows the S&P 500, indexed to the beginning of the election year.  The blue line shows the average index behavior for a new GOP president.  So far, Trump’s presidency has mostly been following the average pattern, which would suggest that disappointment will set in in the fall.  It should be noted that this is simply an average and deviations are possible.  But, we believe this mostly reflects the normal cycle of sentiment as there is great hope that a new Republican president will be market-supportive until reality sets in about nine to 10 months into the first year in office and the market pulls back.  If the administration fails to move forward on taxes and infrastructure, disappointment may set in.

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[1] A classic example was the so-called “Cornhusker Kickback,” where Sen. Ben Nelson (D-NE) was offered $100 mm in Medicaid funding for Nebraska for his support of the ACA.  To be fair, the funds were eventually withdrawn due to public outcry.

[2] Actually, this was probably misattributed to him.