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

[Posted: 9:30 AM EST] Populist candidates in both France and the Netherlands are seeing their polling numbers deteriorate.  In France, Marine Le Pen is holding at around 26% support, which is a statistical dead heat with Emmanuel Macron.  She was leading by up to seven points last month.  Mostly her support has held around 25%, but Macron has seen his numbers improve to close the gap.  Second round polls continue to show that Le Pen will gain about 42% of the vote, not enough to win the election.  In the Netherlands, Geert Wilders’s Party of Freedom has slipped to second place at 23%, behind the center-right People’s Party for Freedom and Democracy, led by Mark Rutte, at 25%.  Wilders was polling in the mid-30s in early January.

In light of Brexit and the Trump win, there are concerns about the reliability of polling.  The last Brexit polls were 48%/46% in favor of remain; the outcome was 52%/48% in favor of leaving.  The RealClearPolitics average poll two days before the U.S. election was 46.8% for Clinton and 43.6% for Trump.  The actual outcome was 48.2% for Clinton and 46.1% for Trump.  The poor performance of the polls seems to be due to a number of factors.  The demise of land lines has made telephone polling more difficult and sampling errors appear to be higher. There is also some evidence of preference falsification, where voters may tell pollsters they are voting for a candidate they actually don’t intend to vote for.

While there is great concern about the French vote, Macron holds a 30-point margin over Le Pen in runoff polls.  Although we saw an eight-point swing with Brexit, a 30-point swing to give the vote to Le Pen would be massive.  Again, we wouldn’t necessarily count Le Pen out; after the initial vote next month, we could see conditions change in the runoff.  Macron is essentially running as a candidate without a party.  He is somewhat inexperienced and could make a political mistake.  But, from where we are now, it seems more likely that Le Pen will not win the presidency.  If she loses, we would expect a short-term rally in the EUR.

The Dutch elections are more certain.  Although Wilders could still win a plurality, none of the other parties will be willing to join him to create a government.  Still, if his party gets 30% of the vote, it will either force a “grand coalition” of center-left and center-right parties or force the center-right to cobble together a coalition of small conservative parties.  Either situation will likely be unstable and lead to ineffective governments.

All this suggests the Eurozone will continue to deal with high levels of political uncertainty going into the German elections in the fall.  We would not be shocked to see the current Italian government fall.  Given the high level of dissatisfaction in Italy with the Eurozone, an election there could lead to a serious disruption of the single currency.  So, for now, we expect the EUR to struggle due to political conditions.

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

[Posted: 9:30 AM EST] In Washington, the wheels of policy continue to move forward.  The GOP has offered its first swing at replacing the Affordable Care Act (ACA).  It keeps many of the more popular measures, such as pre-existing condition coverage and child coverage up to age 26.  It does jettison the individual coverage mandate, replacing it with a 30% penalty to renew coverage if allowed to lapse.  All the taxes surrounding the ACA would be repealed.  Two popular proposals, including a national market for insurance (allowing policies to be sold across state lines) and malpractice reform, failed to make it into the bill because these measures would require a filibuster-proof majority in the Senate.  This new version would be part of budget reconciliation, which only requires a majority in the Senate.

We place low odds that this proposal will pass in its present form.  We expect the Democrats to oppose the measure since it reverses the bill the party passed under President Obama (the ACA).  But there isn’t all that much unity in the GOP for the bill either.  This new version is strikingly similar to the ACA and that won’t be lost on most observers.  Still, some movement on health care will allow Congress to move forward on a budget and tax policy.

China’s forex reserves rose modestly in February to $3.005 trillion, up from $2.998 trillion, a $6.92 billion rise.  This is the first rise in reserves in eight months.  China has tightened rules on foreign investment, which has thwarted a number of overseas mergers and acquisitions.  The rise in reserves could be signaling that these measures have had some effect, although we note that the Chinese New Year also fell mostly in February, which may have distorted the measure.  Still, the rise in reserves does give the Xi regime some breathing room and may ease pressure on the government to add additional measures to restrict outflows.

The Reserve Bank of Australia left rates unchanged, as expected.  The AUD rose modestly on the news.  The ECB meets on Thursday; although no change in policy is expected, the markets will pay close attention to forward guidance.  The Eurozone economy is showing signs of improvement and inflation has lifted, although the latter has mostly been a function of rising oil prices.  If the ECB’s guidance remains unchanged, we could see the EUR weaken.

Peter Navarro, President Trump’s head of the National Trade Council, again called out Germany for its massive trade surplus and accused the country of using the Eurozone as a cover for policies that triggered the growing surplus.  Although Navarro’s economic nationalism lies outside mainstream economic thought, we agree with his analysis of Germany’s policy mix.  Germany has effectively colonized the Eurozone through its saving and investment policies, creating conditions where other nations in the group, especially in the southern tier of Europe, cannot compete with German productivity.  Without the ability to depreciate their currencies, these states must either depress their labor costs through unemployment to improve competitiveness or rely on Germany to expand its economy to raise wages in Germany and improve the southern tier’s competitiveness.  Germany is forcing the former condition on the southern tier, which has been negative for their economies.  However, this inter-Eurozone condition has tended to weaken the euro, making it more competitive with the rest of the world.

What does seem to be lacking from Navarro’s analysis is a recognition of the dollar’s reserve status.  As the supplier of the reserve currency, the U.S. must run trade deficits because a surplus would effectively reduce the global money supply, cutting global economic growth.  If the Trump administration makes good on its promises to reduce the trade deficit, there will be fewer dollars available for the global economy and, very likely, a slowdown in the global economy.  We note today that the OECD is warning that the upswing in financial markets and surveys, by itself, won’t necessarily guarantee a stronger global economy.  The OECD is currently forecasting global GDP growth of 3.3% for 2017 and 3.6% for next year.  This is roughly average for the past decade.  The G-20 meets next week in Germany.  We will be watching to see how the Trump administration handles its first major international meeting.

Finally, in an update to this week’s WGR, North Korea has banned Malaysians in the country from leaving in response to the ouster of the North Korean ambassador from Malaysia.  This makes Malaysians in North Korea virtual hostages of the regime.

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

[Posted: 9:30 AM EST] There were two news stories of note over the weekend.  First, President Trump accused the previous administration of wiretapping his campaign.  This is a very significant charge, akin to Nixon’s “plumbers” breaking into the Democratic National Headquarters.  The FBI and the former Director of National Intelligence have denied the charges.  James R. Clapper, the former Director of National Intelligence, was on the Sunday news shows denying that any such activity took place.  Unfortunately, Clapper’s veracity is seriously in question given that he gave false testimony to Congress in 2013 related to the NSA’s program to capture phone data on U.S. citizens.

We don’t know whether this happened or not.  There was clearly some surveillance of the campaign tied to Russia; that’s why Michael Flynn is no longer in the White House.  However, we do know that any time spent by Congress or the White House investigating this issue is a distraction from fulfilling the president’s agenda.  And, since political capital is perishable, delays increase the odds that less will get done.

We have updated our election cycle chart.  The blue line in the chart below shows the rebased S&P 500 Index behavior for a new GOP administration.  The red line shows the current situation.  So far, the pattern is holding reasonably well.  In fact, the current level has gotten a bit ahead of itself recently.  Much of the surge is based on assumptions that the president will accomplish tax reform and deregulation.  If the administration finds itself bogged down by other issues and the agenda’s momentum stalls, it will be hard to keep the market up as we head into the latter half of the year.

The other issue is North Korea, which we will discuss in the most recent WGR to be published later today.  In our report, we take a look at the recent assassination of Kim Jong Nam, the older brother of the current leader of the Democratic People’s Republic of Korea, Kim Jong Un.  North Korea launched four ballistic missiles over the weekend, three of which fell in Japan’s exclusive economic zone in waters off the island nation.  The launch coincides with annual military drills that South Korea and the U.S. are about to conduct.  According to reports, North Korea is improving its missile technology and will, in time, be able to reliably reach the U.S. with an intercontinental ballistic missile.  The U.S. is considering deploying the Terminal High Altitude Area Defense (THAAD) system, which could shoot down any North Korean missiles that are aimed at South Korea or Japan.  It probably wouldn’t be able to shoot down a North Korean missile aimed at the U.S.  We note that the weekend NYT reported that the U.S. has tried to deploy cyberweapons to disrupt the North Korean missile program; although we have seen a series of failures in recent years, it is clear that progress is being made.

North Korea has become a nearly unsolvable problem.  Although the U.S. would probably prevail in a conventional attack against the Hermit Kingdom, the costs of war would be high.  South Korea would suffer tremendous damage and China may come to the aid of its ally like it did in the first Korean War.  Simply put, as long as North Korea isn’t a direct threat to the U.S., there is little stomach for triggering a costly war.  However, if North Korea sufficiently threatens the U.S., the cost calculus will change.  We continue to closely monitor conditions in North Korea.  So far, financial markets are taking this all in stride.  After all, if North Korea were an imminent threat, the Japanese yen would be collapsing.

Finally, we note that the CPC has been meeting in Beijing in anticipation of the important autumn meetings that will “re-elect” Xi Jinping to a second term.  Today, Li Keqiang, the premier of China (equal to a U.S. VP), lowered the GDP growth target to 6.5%.  That target is still quite lofty and probably unsustainable.

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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.