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

[Posted: 9:30 AM EST] Donald Trump has released a pair of memos that lay out a plan to cut down on illegal immigration into the United States.  The memo expanded the definition of criminal aliens from those who have committed serious crimes to those who have been convicted of any criminal offense.  The change is designed to increase the number of immigrants who are considered priorities for deportation.  The White House plans to use all of its resources to enforce immigration laws, in addition to hiring 10,000 immigration agents to assist with the process.  This new immigration order does not come as a surprise as President Trump campaigned on tackling illegal immigration.

There have been concerns that an increase in the crackdown of immigrants could have a negative impact on the U.S. economy as many industries such as hospitality services and construction rely on them for labor.  It is worth noting that this is not the first time the U.S. has taken such strong measures against immigrants.  In 1954, Dwight Eisenhower deported many undocumented immigrants through “Operation Wetback,” which sought to forcibly repatriate Mexican immigrants. At this time, we don’t believe there will be an immediate impact on the economy, but the president’s aggressive approach suggests that our relationship with Mexico may worsen.  Secretary of State Rex Tillerson and Homeland Security Secretary John Kelly will meet with Mexican officials today and tomorrow to discuss law enforcement cooperation, border security and trade.

In other news, German yields have fallen to a record low due to concerns that Marine Le Pen, the anti-establishment candidate, could win the French election.  As mentioned in our previous reports, polls suggest that she should make it out of the first round of voting.  Popular opinion suggests that she could lose in the second round, but we are a bit more optimistic about her chances.  Le Pen, insistent on Frexit, has led many to look at German bonds as a hedge against currency risk.

Despite Le Pen’s pugnacious rhetoric, her strategy to leave the European Union has been vague.  Earlier in the year, she stated that if elected she would spend her first six months creating a basket of “shadow European currencies” that would be pegged to the reinstated franc.[1]  It is unclear how she plans to structure the basket or whether she plans to maintain a relationship with the European Union after the currency is dropped.  All things considered, we believe that Frexit could lead to the breakup of the Eurozone.

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[1] https://www.wsj.com/articles/marine-le-pen-centers-presidential-run-on-getting-france-out-of-eurozone-1484735580

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

[Posted: 9:30 AM EST] Even with a three-day holiday weekend to work with, there isn’t a ton of news this morning.  The president did appoint a new National Security Director and the pick is being well received.  European and Asian PMI data (see below) generally came in above the expansion line of 50 and above forecast.  Equities remain higher; the dollar is up, gold and Treasuries are lower and oil prices are stronger.

Although Greece was facing a deadline yesterday, the Eurozone blinked and agreed to extend talks for an adjustment in bailout payments.  In return for lowering payments from Greece, the Eurozone wants legislation to enforce structural economic reforms.  The good news here is that the Eurozone has decided not to foster a crisis in a politically uncertain year.  However, this agreement is really more of “delay and pray” by creditors.  The simple truth is that Greece isn’t able or willing to pay; creditors must either negotiate the workout or consider other forms of collateral capture (in the 19^th century, invasion might have been an option).

French polls show that National Front Leader Le Pen is gaining momentum.  Polls continue to show she will win the first round and lose the second but, given how poorly the polling industry performed in the U.K. and U.S., we still think that a Le Pen win in May isn’t out of the question.  On this news, French bond yields rose relative to Germany.

Bill Gates made headlines over the weekend with a provocative interview in Quartz[1] in which he recommended that firms that automate should pay a tax for the jobs they eliminate.  Although such proposals aren’t new, this coming from one of the “godfathers” of the tech revolution is news and suggests that Silicon Valley may be realizing that the unfettered introduction of new technology into the economy may have negative effects that need to be addressed.  Essentially, a “robot tax” is a tax on capital.  It would be quite difficult to create a tax that would have a positive effect on fiscal revenue and at the same time not severely undermine investment.  Still, it isn’t hard to see that this tax would make automation more expensive and may lead some firms to simply add people.  We will be watching this idea to see if it gains any traction.  Although the stories aren’t directly related, the NYT[2] has a long read on how technology is reducing the number of workers needed in oil exploration and drilling.  The reduction of jobs in this area due to the expansion of technology could be thwarted if a tax is implemented on the jobs lost through automation.

Finally, we have been watching China’s capital flight for a while now.[3]  Due to a combination of declining investment opportunities, General Secretary Xi’s campaign against corruption, environmental degradation and the desire for political freedom, wealthy Chinese citizens have been steadily moving money out of China.  Much of it has found its way into U.S. and European real estate, although we are seeing investment broaden.  Capital flight has caused a steady decline in foreign reserves and prompted the government to tighten restrictions on foreign investment.  Reuters is reporting that Chinese conglomerate Dalian Wanda’s purchase of Dick Clark Productions is on hold because the firm can’t get permission to move $1.0 bn out of the country to consummate the deal.  This would be the largest transaction so far that has failed due to Chinese investment restrictions and may dampen other investment areas in the West, mostly real estate.

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[1] https://qz.com/911968/bill-gates-the-robot-that-takes-your-job-should-pay-taxes/?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosam

[2] https://www.nytimes.com/2017/02/19/business/energy-environment/oil-jobs-technology.html?emc=edit_ee_20170220&nl=todaysheadlines-europe&nlid=5677267

[3] See WGR, 7/16/2012, The Mystery of Chinese Capital Flight.

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

[Posted: 9:30 AM EST] Equity markets are lower this morning.  We suspect two issues are weighing on sentiment.  First, the two left-wing candidates in France, Socialist Benoit Hamon and hard-left Jean-Luc Melenchon, are holding talks that may lead one of these candidates to drop out of the race.  Hamon is the candidate from the established Socialist party, while Melenchon used to be a member of that center-left group but found it too centrist and started his own party.  Polls show that neither would make it into the second round runoff, most likely against National Front Leader Le Pen.  Latest polls show Le Pen winning 26% of the vote and winning the first round.  Emmanuel Macron, the leader of the breakaway party En Marche!, is getting 19.5% of the vote, while Republican Party François Fillon is third with 18.5%.  Fillon has been hit by a corruption investigation alleging he paid family members to work for him but they did no actual work.  Most polls suggest that Le Pen will lose against either Fillon or Macron in the second round.

However, it should be noted that, combined, Melenchon and Hamon are polling at 25%; if either drops out and can sway those supporters to stay with the remaining candidate, Le Pen will be running against a leftist candidate.  Given the deep unpopularity of the Socialists, if Hamon is the remaining candidate, Le Pen may very well win.  Melenchon may fare better against Le Pen but he is calling for a 100% marginal tax rate on incomes in excess of €360k.  That may prove to be unpopular enough to give Le Pen the presidency.

The chart below shows the spread between German and French 10-year sovereigns.  The average spread runs around 35 bps (with French rates usually exceeding German rates).  The spread has nearly doubled as elections loom.  The first round will be held on April 23; if no candidate attains a majority in the first round (and none have since the 5^th Republic was formed in 1958), a second round is held between the two top performers.  That round would be held on May 7.  The polls show that Le Pen’s support peaks at 35% to 40% against either Fillon or Macron.  However, no polls have been run against the leftist candidates so the markets are justifiably concerned about a Le Pen win if the leftists join forces.  Although negotiations do raise this possibility, we suspect that Melenchon and Hamon won’t be able to reach an agreement.  They have sharp differences and it’s difficult to see either stepping down.  If they do come to a deal, the risks of a Le Pen win in the second round probably rise.

The other issue weighing on sentiment is that it looks like the Ryan corporate tax reform is failing to gain traction; the sticking point is the border adjustment tax, which is proving to be quite unpopular.  Without this provision, it doesn’t appear that the tax change would be revenue-neutral unless the cut is inconsequential.  We suspect the White House would be more than happy to see deficits but much of the Congressional GOP won’t agree with deficit increases.  Much of the equity and dollar rally has rested on corporate tax cuts; if these can’t get passed, it will be bearish for both equities and the dollar.

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