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.

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

[Posted: 9:30 AM EDT] As noted below, we have a full slate of Fed officials talking today.  We expect these speakers to generally confirm the Fed’s policy stance for at least two more hikes this year, with the potential for a third.  The most interesting member, Minneapolis FRB President Kashkari, has already made the media rounds; he had a dovish dissent to the move, arguing that there is no evidence of accelerating inflation or rising expectations.  Thus, in his analysis, there was no reason to move rates.  We would not expect such talk today.

The FBI director testified yesterday that there was no evidence of wiretaps on Trump party headquarters and did suggest that there was a broad investigation of Russian interference in the U.S. election.  We doubt this investigation will rise to the level of Watergate; however, it will act as a distraction to the administration.  Our position is that presidential political capital is at its peak on inauguration day and, like time decay on an option, is eroded until nearly fully diminished 18 months after the oath of office.  Despite this obvious pattern, presidents often squander their limited and perishable political capital on superfluous policy battles.  Health care is burning a lot of the president’s capital as are all the investigations which divert attention.

The financial markets have been focused on deregulation and tax cuts, sending equities and the dollar higher and bond prices lower.  However, we are starting to see the dollar roll over despite Fed tightening, in part because there is growing skepticism that the administration will be able to get tax reform in place.  Tax reform is one of the factors that has raised market sentiment and if the administration becomes bogged down in health care reform and defense against investigations, there simply won’t be enough bandwidth to get much of anything else accomplished.  This is an issue we are watching closely.

There was a French presidential debate yesterday.  Media reports suggest that the current presidential favorite, Emmanuel Macron, managed to avoid any major mistakes.  Although Macron is currently second in the polls to Marine Le Pen (Le Pen is at 27%, Macron at 23%), the polls all signal a Macron victory in the second runoff election.  Macron is relatively inexperienced and there were fears among Le Pen opponents that he would make a mistake at the debates and boost Le Pen’s chances for the presidency.  According to reports, Macron, though not spectacular, did avoid losing.  The EUR’s rally this morning is partly due to his better performance.

SOS Tillerson announced he will skip the NATO meetings next month to be with the president when General Secretary Xi visits the U.S.  His office also announced he will visit Russia later in April.  This sends the signal that the administration is focusing on the big nations and paying less attention to the smaller allies in Europe.  There is some fear that the U.S. is also indicating a greater affinity for authoritarian governments and paying less attention to democracies.  The charge of playing to enemies and ignoring allies was leveled at the previous administration as well.[1]  It should be remembered that one of the goals of creating the EU was to give Europe a platform on the world stage.  Henry Kissinger famously destroyed this idea with his comment,   “Who do I call if I want to speak to Europe?”  Europe still hasn’t solved this problem.  Simply put, the trend of U.S. administrations paying less attention to Europe has been underway for some time.

Finally, despite strong sentiment indicators, the Atlanta FRB GDPNow forecast is currently at an anemic +0.9%.

In the contribution data, consumption has declined 108 bps from the initial forecast and inventories have reduced the growth projection by 39 bps.

We are looking at a soft Q1 number.  Consumer confidence data suggests that consumption should improve in the coming months, although the relationship is not always consistent.

This chart shows real consumption expenditures with the Conference Board’s Consumer Confidence report.  In general, they do move together, although a case could be made that consumption led confidence in the early 1990s and in 2011.  In addition, consumption softened in front of the last two recessions despite elevated confidence.  The divergence between rising confidence and sluggish spending is something we monitor.  So far, this isn’t a major problem; however, it could develop into one if this situation persists.

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[1] https://www.theatlantic.com/international/archive/2016/12/obama-israel-kerry-allies/511796/

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

[Posted: 9:30 AM EDT] Although it has been a quiet morning, there was a lot of news over the weekend.  Here’s what we saw as noteworthy:

Mnuchin won’t disavow protectionism: The G-20 communiqué usually includes language supporting free trade and opposing protectionism.  Of course, in practice, there really is no nation that has completely open trade but some have more than others.  Instead, free trade is seen as an ideal; something that one should aspire to but realize that one will always fall short.  That wasn’t the outcome among the finance ministers at this weekend’s G-20 meeting in Baden-Baden.  The new U.S. treasury secretary, Steven Mnuchin, would not support such language.  Germany’s finance minister, Wolfgang Schäuble, suggested that Mnuchin has “no mandate” to settle on what U.S. trade policy is all about.  President Trump has made it clear that his administration intends to change America’s trade policy.  Since the end of WWII, the U.S. has steadily opened its markets to foreign nations as part of its reserve currency role.  Foreign nations have obviously taken advantage of this, implementing export promotion policies to achieve developed nation status.  Trump is suggesting that trade is the key factor behind the decline of the U.S. middle class and is determined to force nations to change their policies to boost American jobs.

Why did the U.S. engage in this policy?  We believe for two reasons—to win the Cold War and promote global growth.  We wanted to build the Free World and we did so by allowing foreign nations to trade with us.  This gave other nations a steady source of demand; they created economies designed to export by suppressing domestic demand and restraining their currency’s appreciation.  The second reason is all about world growth in general, based on the idea that a world that trades with each other may be less likely to go to war.  To provide the currency of choice for trade, the U.S. must run a trade deficit; a surplus acts as a global contraction of the money supply.

In our opinion, Trump represents a clear break in this policy.  However, support for the financial side of American hegemony has been weakening for some time.  Free trade deals have become politically difficult to pass through Congress.  Even if Clinton had won the presidency, TPP and TTIP were dead.  It’s been so long since the U.S. has fought a world war that we have forgotten why these policies were put in place.  This G-20 event is further evidence that change is underway.

60 Minutes takes on HB-1 visas: Newsmagazine 60 Minutes opened last night with a story about a group of IT workers in California who were replaced with foreigners on HB-1 visas and were given incentives to train their replacements.  It’s the kind of report that gets attention and is part of middle class angst over trade.

Was Tillerson “snuck” in China?  While visiting China over the weekend, SOS Tillerson seemed to adopt language China has been supporting for some time.  These statements included terms like “mutual respect” and “win-win” cooperation.  This language issue is a classic example of strategic ambiguity.  For most American ears, terms like mutual respect are benign.  However, China interprets these as sphere of influence concepts.  In other words, mutual respect means China won’t interfere with U.S. relations in South and Central America and the U.S. will give China a free hand in the Far East.  Did Tillerson understand China’s take on this language?  It’s possible that given his newness to the job and the lack of support staff, he easily could be unaware.  Or, he may be preparing the world for a removal of U.S. power and the creation of regional hegemonies.  If we had to guess, we would go with Tillerson’s inexperience as the explanation.  The next point suggests why.

Trump is preparing to confront China on trade in early April: According to Axios,[1] Trump is planning to press Chairman Xi on trade policy with regard to autos.  U.S. automakers face a 25% tariff when they try to import into China.  In response, U.S. automakers build manufacturing in China but, to do so, they must undergo joint ventures with a Chinese firm that is, by law, the majority owner.  Chinese automakers face a 2.5% tariff when exporting to the U.S.  Why don’t we see more Chinese cars in the U.S.?  Mainly due to poor quality.  Chinese manufacturers haven’t mastered the techniques to meet Western quality standards.  However, China has been eyeing the U.S. market for some time and we would expect quality to improve.  According to Axios, Trump will make a series of demands that will include that China must build plants in the U.S.  They can be fully owned by Chinese firms but only if the U.S. firms in China are relieved from the joint venture rule.  In addition, profit repatriation will be limited.  This gives a flavor for how the president may be looking to negotiate on trade.

Greece spinning toward another crisis: Eurozone finance ministers are meeting today to reiterate that the Tsipras government needs to comply with all the terms attached to emergency loans.  Greece isn’t really prepared to meet all the demands, which include highly unpopular pension reforms.  Markets are ignoring this issue simply because Greece always seems to “blink.”  This is because there really is no solution to Greece’s debt problem other than default and Grexit.  Would a Greek exit be a big deal?  By itself, probably not, but if Greece leaves the Eurozone and thrives, it will tempt other big economies to do the same which would spell the end of the single currency as we now know it.

Article 50 on March 29: PM May has indicated she will begin the Brexit process by declaring Article 50 on March 29.  Assuming rationality, Brexit should not be a crisis; Britain will need the EU for trade and the EU needs Britain for defense and financial services.  However, the EU fears that if Britain gets too good of a deal then other nations may decide to exit as well.  Although these fears are not unfounded, it should be noted that the U.K. is a special case; it’s a big economy and it is well integrated into Europe.  Striking a deal makes sense and one should emerge if emotions are managed.

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[1] https://www.axios.com/axios-sneak-peek-2319878918.html?utm_source=The+Sinocism+China+Newsletter&utm_campaign=e55d7dcd71-EMAIL_CAMPAIGN_2017_03_20&utm_medium=email&utm_term=0_171f237867-e55d7dcd71-29661833&mc_cid=e55d7dcd71&mc_eid=e77499fecc