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

[Posted: 9:30 AM EST] We are seeing a modest decline in U.S. equities and a softer dollar as traders square positions in front of two key speeches today, one from Vice Chair Fischer and the other from Chair Yellen.  It is highly likely these leaders at the Fed will signal a rate hike is coming at the March 15^th meeting.  Fed funds futures put the odds of a hike at 90%; for much of this century, the Fed has not risen rates without preparing the financial markets for the move.  Expectations for a rate hike create a “freebie” for the central bank that it will almost certainly use to its advantage.

The real question is the terminal rate.  Simply put, where does the Fed achieve at least a neutral policy rate that is neither accommodative nor restrictive?  We regularly publish the Mankiw Rule variations to examine this idea, although we view these models as more of what the Fed thinks it should do, not what the Fed should do.  In other words, the Mankiw Rule (and its forefather, the Taylor Rule) works off a Phillips Curve model that suggests there is a relationship between inflation and labor markets.  Our research suggests there isn’t much of a link and thus the Fed is probably using an improper model.  A better structure, in our opinion, would be for the FOMC to merely focus on an inflation target and assume the labor markets take care of themselves.  But, we don’t expect anyone from Washington to make it to our offices in leafy Webster Groves, MO anytime soon.

So, here are a couple of our concerns.

This chart shows the past four tightening cycles along with the Chicago FRB National Activity Index.  This is the first time in nearly three decades that the Fed has started to raise rates when this index is below zero, suggesting an economy growing below trend.  This analysis would suggest the Fed believes it is so far behind the curve that it should raise rates even though economic growth remains sluggish.

Second, the Atlanta FRB GDPNow forecast is suggesting a weak Q1 GDP report.

The forecast has dropped to +1.8% after running above +2.5% into mid-February.

The latest data, which included personal income and consumption, advance trade data and construction spending, have reduced the consumption forecast and widened the trade deficit.  In addition, the drag from inventory liquidation rose as well.  The forecast suggests that the economy continues to grow at a sluggish pace and there isn’t much there to suggest the Fed should be moving aggressively to raise rates.

So, what do we expect from the vice chair and chair today?  No big surprises; they will likely confirm the market’s bias for a March hike and signal that they will continue to move rates higher based on the data flow.  If both are upbeat about the economy, we may see the dollar lift.

The shadow of Russian influence on the Trump administration continues to be a distraction.  Both parties have become masters of creating controversies that drain the party in power’s political capital by forcing them to deal with the distractions instead of policy goals.  What is interesting to us is how the persistent “smoke” (as described by Mike Allen at Axios today) on Russia is affecting that nation’s equities as well.

This chart shows the MICEX index for Russian equities in USD terms.  From the Election Day lows on November 9^th until early January, the index rose 25.0%; since then, it is down 8.9%.  Note how the index has broken the trading range and appears poised for further weakness.  The potential for a Russian scandal for this administration will, at a minimum, thwart any attempts at normalization with Russia and is being taken as bearish by Russian equity markets.

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

[Posted: 9:30 AM EST] Yesterday’s equity market rally was quite impressive; President Trump’s speech was clearly well received and the ISM data also came in strong, raising hopes of a better economy.

This chart shows the yearly change in the S&P 500 index along with the ISM manufacturing index.  Over the long run, the two series are modestly correlated.  However, since 1997, the two series have been a much closer fit, correlating at 71%.

This scatterplot shows the relationship between the two series from 1997 to date.  In general, a reading under 50 on the ISM increases the likelihood of a negative yearly return on the index.  The current level, at 57.1, is consistent with 22% annual growth in the index.  Although the ISM is something of a sentiment index, it does track the economy well and signals that economic growth may be accelerating and the FOMC is probably on the way to raising rates sooner rather than later.

At the end of this report, we have updated our P/E chart and we note that the ratio has jumped.  The history of the data comes from Standard and Poor’s but forecast earnings come from I/B/E/S (see the footnote for details), which is owned by Thomson/Reuters.  We have noted for some time that the two series have diverged; last year, Q4 earnings from the former were $106.60 (Q4 is estimated by Haver until the official number is released), while the latter is on pace for $118.95.  Although the spread over $12 per share is meaningful, we are actually seeing the difference narrow over time.

This chart shows the ratio of the two series along with the S&P 500.  The ratio has narrowed to 11.5% and is coming down from previous highs but is still elevated.  We monitor this ratio closely because in the past a widening ratio tended to coincide with recession and a weaker equity market.  We have noted that the spread also seems to track oil fairly well and thus rising oil prices have probably played a role in bringing down the ratio.  However, since we have shifted to the Standard & Poor’s estimate for Q4, earnings have fallen and the P/E has increased.

U.S. crude oil inventories rose 1.5 mb compared to market expectations of a 3.0 mb build.

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 below shows, inventories remain elevated.

As the seasonal chart below shows, inventories usually increase into April before rising refinery operations for the summer driving season lower stockpiles.  After rising quickly earlier in February, the pace of injections has slowed back to normal.  If the past two weeks are a guide, we may be on a path to more supportive storage data in the coming weeks.  Still, we are looking at six more weeks of injections.

Based on inventories alone, oil prices are overvalued with the fair value price of $30.20.  Meanwhile, the EUR/WTI model generates a fair value of $37.91.  Together (which is a more sound methodology), fair value is $34.82, meaning that current prices are well above fair value.  So far, the oil markets continue to ignore the bearish rise in oil inventories and the stronger dollar.  The market has already discounted a drop in stockpiles during Q2; assuming a €1.06, inventories of 380 mb translate into oil prices of $53.36.  Without a rapid decline in inventories in Q2, oil prices are vulnerable to a sizeable correction.

Bloomberg is reporting that the early estimates of Russian output show little change in February.  Meanwhile, OPEC compliance has dropped to 70% from 80% in January despite another 65 kbpd cut from Saudi Arabia.  Most of the drop in compliance came from Libya and Nigeria, which were not assigned quotas; their output combined rose 100 kbpd.  Although OPEC compliance remains elevated, it is likely to weaken as time passes.  In general, that is the historical pattern.  Thus, without a sharp boost in demand, it may become difficult for oil prices to hold at current levels.

Fed Governor Brainard indicated in a speech yesterday afternoon that she thinks policy rates are likely to rise.  Brainard is arguably the most dovish member of the committee; if she is now prepared to raise rates, we can expect hikes to come.  Fed funds futures now signal a 94% chance of a rise in March.

Finally, reflecting rising concerns about the threat from Russia and growing disinterest from the U.S., Sweden has brought back the draft.  Compulsory military service ended in 2010; the new law will cover men and women born in 1999 or later.  The Swedish military has been unable to encourage enough young Swedes to enter voluntary service (there are complaints about low pay noted in several articles), thus creating the need to bring back conscription.  Sweden spends about 1.1% of its GDP on defense, although it does appear that spending is due to rise.

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

[Posted: 9:30 AM EST] Although political analysts continue to dissect the president’s speech, the markets have clearly rendered a verdict—it was a winner.  The Trump trade of higher interest rates, stronger dollar and equities is back in force this morning.  Our take on the speech was that it was more polished than most of his previous remarks and less dark than the inaugural oration.  There wasn’t a lot of detail but there were some hints at the direction of policy.  On health care, elements of Speaker Ryan’s plan emerged.  The focus seemed to be on “access to coverage” rather than “coverage,” which would suggest that households could refuse to buy insurance without penalty.  One of the more popular elements of the ACA is the pre-existing condition issue; access could be met with high-risk pools, which have had a rather mixed record.  An expansion of tax credits and health savings accounts were also floated, a Ryan principle.  On the other hand, the president did suggest a goal to “bring down the artificially high price of drugs and bring them down immediately.”  That might entail allowing Medicare to directly bargain on drug prices, which would create an oligopsony and effectively allow the government a major role in setting drug prices.  On infrastructure, he called for public-private partnerships for funding, which will limit the level of spending; the private sector will only participate in spending that will directly generate revenue and there isn’t much of that coming from freeways.

Although some have noted that the lack of detail is troubling, historically, such speeches are usually light on detail.  We view the speech as little more than a mere campaign speech and thus accounts for the market’s strong reaction this morning.  The optimistic tone and the improved delivery were clearly taken as a positive.

With the speech out of the way, the focus now shifts to the FOMC.  A rising number of members of the committee are hinting at a March rate hike; the odds of a March hike, based on the fed funds futures, is at 84% this morning.  On Friday, Chair Yellen is scheduled to speak.  If she confirms the comments of the other members, a hike on the 15^th will approach certainty.

This chart shows the implied yield from the Eurodollar futures for three-month LIBOR out two years.  The implied yield is approaching its December highs; this level is consistent with fed funds of 1.84%.

In France, Conservative candidate François Fillon reiterated that he would stay in the race for president despite the decision to postpone a campaign event at a Paris farm show.  Fillon has been under investigation for hiring family members for what prosecutors are saying were make-work jobs.  He is scheduled to testify to judges on the matter on March 15^th.  Current betting sites are giving Emmanuel Macron 10-11 odds to win the second round compared to Marine Le Pen at 2-1.

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

[Posted: 9:30 AM EST] On the eve of President Trump’s first major address to Congress, financial markets are mostly steady.  As each day passes, however, the odds of passing a sweeping agenda lessen.  The temporary nature of political capital is perhaps one of an incoming president’s least appreciated elements of governing.  The master of managing the early stages was President Roosevelt; the idea of focusing on the first “100 days” came from his first term.  However, it should be noted that Roosevelt enjoyed a crushing mandate; he won 472 (out of 531) electoral votes, 42 states and gathered 57.4% of the popular vote.  In addition, Roosevelt had commanding control of Congress, with 70 Senate seats held by his party (out of 94) and 322 out of 435 House seats.  With complete control of Congress, Roosevelt was able to pass numerous new laws, including Glass-Steagall, the Securities Act and the Tennessee Valley Authority, among many.  In fact, the only real restraint on his power was the Supreme Court, which he unsuccessfully tried to “pack” by adding new judges.

President Trump’s hold on power is significantly more tenuous.  Although he won a majority in the Electoral College, he did not win a majority of the popular vote.  His party’s hold on Congress is narrow, with only a 52-48 margin in the Senate.  Thus, he cannot ensure that all filibuster-prone bills will become law unless he can woo eight Democrats to vote with his proposals.  Otherwise, a filibuster can prevent a vote.  That doesn’t mean nothing can get done.  Reconciliation bills can pass with a simple majority but, since they are part of budgets, they usually “sunset” after 10 years.  That’s what happened to parts of President Bush’s tax cuts, especially regarding the estate tax.

The real issue, as we see it, is the populist-establishment divide within the GOP (it also exists within the Democrat Party, exhibited in their recent national committee leadership vote).  The right-wing populists want infrastructure spending, trade restrictions and immigration reform.  Getting rid of the ACA without a replacement probably won’t be popular and cutting taxes isn’t high on the agenda either; many populists’ marginal income tax rates are already low.  Additionally, this group wants no changes to entitlements; Social Security and Medicare are sacrosanct.  On the other hand, the right-wing establishment want tax cuts and ACA removal.  This group is where the budget hawks live and thus entitlement reform is always a goal.  Maintaining deregulation and globalization is a key element of the establishment across party lines.

All along we have postulated that a successful Trump presidency will require him to deftly manage the goals and expectations of these two groups.  Needless to say, the goals and aspirations of the two groups don’t overlap much.  The other outcome is a left- and right-wing populist coalition,[1] which is theoretically possible but unlikely.

Financial markets have been building in expectations of fiscal spending, deregulation and tax cuts.  The longer the administration fails to move programs forward, the less patience the markets will have with future legislation.  Our expectation, based on past equity market performance during first-term new republican administrations, is that equities will remain supported into summer.  However, if disappointment sets in as the year wears on, a pullback later this year is possible.  Tighter monetary policy could exacerbate this trend.  We note that fed funds futures have now put the odds of a rate hike at the March 15^th meeting up to 50% after being well below that just a few weeks ago.  A March hike would raise the odds of three hikes this year.

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[1] Ralph Nader’s proposal in his book.  Nader, R. (2014). Unstoppable: The Emerging Left-Right Alliance to Dismantle the Corporate State. New York, NY: Nation Books.

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

[Posted: 9:30 AM EST] Over the weekend, parts of President Trump’s budget plan were released to the public. According to the New York Times, the president plans to increase defense spending and scale back non-defense spending, most notably the EPA and the State Department. The increase in defense spending should have a positive effect on equities as it should have a spill-over effect in other areas. Typically, military spending has led to increased manufacturing and investment in infrastructure as well as research and development; this will likely have a multiplier effect that trickles down to the rest of the economy. Increases in military spending have also been correlated with higher employment as more contract workers and factory workers are hired. On Sunday, Steve Mnuchin stated in an interview with Bloomberg that the current budget plan will not seek to cut entitlements “for now.” President Trump will elaborate on his budget proposal during his speech to the Joint Committee on Taxation in Congress on Tuesday. He is expected to run through a few obstacles to getting his budget plan passed, namely, the Republicans’ deficit concerns, Democrats’ almost devout opposition to the president and skepticism of the proposed border adjustment tax on both sides of the aisle.

Today, Wilbur Ross is expected to be confirmed as Commerce Secretary by the Senate. This confirmation would be a major boost to Steve Bannon’s populist camp. Ross is known for his skepticism of multilateral agreements and also shares Bannon’s affinity for bilateral agreements. He has been a vocal critic of China and has stated that his first priority once taking office will be to renegotiate NAFTA. In order to make his job easier, the Trump administration has already looked into ways to bypass the WTO dispute system. Ross’s appointment is likely to complicate relationships with some U.S. trading partners as it is unclear whether he will change the trade environment laid out by current cabinet members. Recently, Trump’s cabinet members have lessened some of their protectionist rhetoric in order to foster more hospitable trade negotiations. Currently, we are unsure if Ross is likely to continue along this path. Mexico’s Economy Minister Ildefonso Guajardo has threatened to leave the negotiating table if the U.S. puts a 20% tariff on cars.

In Europe, Theresa May has stated that she will decline a demand from Scotland for a second independence referendum. First Minister of Scotland Nicola Sturgeon was likely to demand a referendum the day Article 50 is triggered. Last year, Scottish citizens voted for the United Kingdom to remain in the EU. Although many believe that Scotland would still probably vote to remain in the UK if a referendum were to take place, May’s refusal to hold a referendum is likely to spark anti-UK sentiment. The pound fell 0.6% as a result of this controversy.

France’s 10-year bond yield fell to a one-month low as recent polls show Emmanuel Macron’s lead is expanding. Marine Le Pen is still expected to make it out of the first round of voting but markets suggest that she will have a hard time winning in the second round.  Last week, Marine Le Pen took a hit in the polls as her staff were investigated for misappropriation of government funds. Although we agree that Le Pen will likely lose the upcoming election, we believe that an upset is possible due to the rise of populism throughout Europe.

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

[Posted: 9:30 AM EST] During a panel discussion at the CPAC convention, White House Chief Strategist Steve Bannon and White House Chief of Staff Reince Priebus sought to quell rumors of a possible rift between the two. The discussion was mild-tempered, with both stating that they respect each other and are focused on helping President Trump fulfill the promises he made on the campaign trail. Even though Priebus kept the conversation light by restating the conservative platform, Bannon, on the other hand, caused a bit of a stir by claiming that he plans to “deconstruct the administrative state” and promote “economic nationalism.” We interpret these comments as essentially wanting to create an economy that looks inward for growth as opposed to outward, as well as taking the U.S. out of all multinational institutions. As we have noted before, Bannon’s goals are populist in nature and directly contradict the traditional conservative pillars such as economic self-reliance and multi-lateral free trade agreements. Although the two were able to get along on stage, we firmly believe they have fundamentally different worldviews and will continue to butt heads until one of them eventually wins out. As we see it, Priebus has the edge as the president seems to be more focused on deregulation and lowering taxes than he is on challenging current trade agreements.

In other news, it seems that President Trump’s cabinet members have decided to walk back some of his more controversial promises. Treasury Secretary Steve Mnuchin stated that he is not ready to label China a currency manipulator, but instead will regularly review foreign exchange markets to determine who is cheating. President Trump had campaigned on labeling China a currency manipulator when he took office. Meanwhile, Rex Tillerson and John Kelley sought to ease tensions with Mexico by stating that the U.S. will not seek mass deportations and the recent immigration policy change is not a “military operation,” which President Trump had described it as during a meeting with manufacturing CEOs. The opposing stances within the Trump administration are likely not a result of dissent but rather a way to set the groundwork for future negotiations. This is not the first time the Trump administration has tried to smooth over relationships with other countries. Two weeks ago, President Trump told Chinese President Xi Jinping that he would honor the “one China” policy; prior to taking office, President Trump had challenged the policy by taking a phone call from the Taiwanese president. The change in tone is likely a positive sign for equity markets as it appears that Trump will seek a more conciliatory tone when negotiating with foreign leaders. Trump’s brash style had led many foreign leaders to become more defiant so as not to appear weak to their constituents. Yesterday, Mexico’s Foreign Affairs Secretary Luis Videgaray threatened to not accept the measures of the immigration ban if the U.S. continues to make decisions without consulting them first. The change in tone should lead to a better negotiating environment going forward.

In Europe, negotiations between the United Kingdom and the Eurozone have become more complicated as Brussels stated it will seek €60 billion from the UK if it leaves the Eurozone. Although the bill has been referred to as an “exit charge,” it is likely also a result of the UK’s other commitments to the EU such as pension obligations and past pledges to the bloc’s budget and projects. Brussels also stated it will not start trade talks until it is given assurance on what will happen to EU citizens currently living in the UK. This signals that the EU may be taking a harder negotiating stance following the trigger of Article 50 of the Lisbon Treaty.

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

[Posted: 9:30 AM EST] Equity markets have remained relatively calm after the Fed minutes reaffirmed the outlook of most investors.  In the minutes, the Federal Reserve voted unanimously to maintain current rates due to the PCE remaining below its 2% target as well as “heightened uncertainty” about changes in fiscal and government policy.  However, one committee member suggested that even if economic and inflation data were consistent with expectations, the committee should consider raising rates “relatively soon” in order to maintain flexibility.  The Fed minutes reaffirmed market sentiment that a March rate hike remains relatively unlikely.  Nevertheless, they do suggest that the Fed may become more hawkish in the upcoming months.

In other news, Treasury Secretary Steve Mnuchin stated that he should have a “very significant” tax plan by the August recess.  It is believed that his tax plan will include tax cuts to middle income households and businesses alike.  The Trump administration believes the increased growth in the economy should offset any potential losses in tax revenue, and there has also been talk of a controversial border adjustment tax.  During an interview on CNBC’s “Squawk Box,” Mnuchin stated that the Trump administration’s aim is to get the U.S. growing at a rate of 3% or better.  In addition to tax reform, Mnuchin believes that rolling back some of the policies laid out by the Obama administration would also support growth.

Although we believe that Mnuchin will meet his August deadline, we are not sure if it will garner support in Congress.  Paul Ryan has struggled as of late to persuade Republicans to support the border adjustment proposal, which the president has deemed too complicated.  There has also been backlash from businesses such as Walmart, who believe that the plan will hurt them in the long run, and farmers who believe the tax will lead to a trade war.  We will continue to monitor these developments.

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