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

[Posted: 9:30 AM EST] One of the key themes we have been monitoring since Trump’s election has been the uneasy alliance between the populists and the GOP establishment.  We personalized this interaction as Speaker Ryan versus Chief Strategist Bannon.  The policies that would be supported from the Ryan camp are primarily personal and corporate tax reform, which would mostly be in the form of lower marginal rates.  This group would also want to maintain globalization (including open immigration) and deregulation, with a focus on relaxing financial regulations and environmental rules.  This group is cool to the call for infrastructure spending.  The Ryan group is where the fiscal budget hawks reside.  The latter group, represented by Bannon, are economic nationalists who want to curtail globalization by restricting immigration and reducing the trade deficit through trade barriers, if necessary.  This group wants to see fiscal expansion via defense and infrastructure spending.  They are less concerned about tax cuts but are also less worried about deficits.

Although equity markets retreated in the early hours after the election, that pullback was short-lived.  After a surprisingly conciliatory acceptance speech, equities turned and have been rallying ever since.  It appears to us that this rally is predicated on the idea that the Ryan cohort will generally prevail, meaning we would mostly see an establishment GOP program of tax cuts and deregulation.

The key unknown is which group will eventually prevail.  It would make sense for Trump to swing between these two groups; in fact, if he completely favors one over the other, it may either lead to him being a one-term president or undermine his ability to work with Congress.  In reality, we expect him to give “bones” to each side over the next four years.  However, we do have to say that Bannon has won the last few days.  The executive order to ban Muslim immigrants, refugees and, for a time, U.S. green card holders from a handful of Islamic nations comes purely out of the Bannon agenda.  Although reports are somewhat conflicting, it does appear that this policy change caught much of the government by surprise.  According to reports, Bannon and his inner circle were behind the executive order.

The other important decision was to appoint Bannon as a permanent member of the National Security Council while indicating that the director of National Intelligence and the chair of the Joint Chiefs of Staff will no longer be permanent members of the council.  For background, this council was created by President Truman to offer the president advice and assistance with national security and foreign policy issues.  The statutory attendees are the president, vice president, secretary of state, secretary of defense and secretary of energy.  These members are required, by statute, to attend.  Before President Trump’s recent decision, the chair of the Joint Chiefs of Staff and the director of National Intelligence were also required by statute to attend; that is no longer the case.  The director of National Drug Control Policy is also a statutory member.  All other members, now including the chair of the Joint Chiefs of Staff and the director of National Intelligence, are invited to meetings that pertain to their responsibilities.

We suspect that the chair of the Joint Chiefs of Staff and the director of National Intelligence will end up attending most meetings.  Thus, the downgrade of their positions may be more form over substance.  However, appointing Bannon as a permanent member elevates someone whose position has traditionally been more of a political advisor rather than security advisor.  It’s a bit like putting Karl Rove on the council.  It is a clear indication of Bannon’s influence on the administration.

We are watching the impact on financial markets.  If Bannon’s influence grows, we would expect Trump’s policies to lean more toward the populists and less toward the establishment.  That would be bearish for long duration debt and likely also bearish for equities as we would look for multiples contraction over time.  Simply put, populist policies are inflationary and negative for financial markets.  The major “known/unknown” is how the FOMC will react.  Central bank independence is granted by the political system and thus can be taken away by that same system.  A Bannon-influenced Fed will have more in common with the Burns/Miller era than the Volcker/Greenspan era.

At the same time, it is important to remember that President Trump needs Congress to get major things accomplished.  Thus, some sort of accommodation to the GOP establishment is probably necessary.  We are closely watching the U.S. political situation as well.  Trump may very well represent a major rejiggering of party affiliation.  It seems hard to imagine that labor may find its home in the GOP while the Democrats become the party of business, but such shifts have occurred before.  The Democratic Party was the party of Jim Crow before the 1964 Civil Rights Act and the GOP was the party of trade protection before WWII.  Thus, we are paying close attention to party affiliation changes.

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

[Posted: 9:30 AM EST] It was a quiet night overall; the big news is Q4 GDP, which we will cover below.  Here are a few items we are watching:

The Italian Constitutional Court finally clarified the 2015 election reform law, known as the “Italicum.”  It ruled against a runoff system (similar to France’s) but did retain the proposal to offer “bonus seats” to parties winning over 40% of the vote.  The goal is to eliminate the influence of smaller parties and make Italian governments less fragile.[1]  This change probably won’t lead to that outcome as it is highly unlikely that any single party will gather 40% of the vote.  Thus, coalition governments will remain the norm.  Italy isn’t scheduled to hold elections until early next year but now that this Italicum has been clarified, the odds will increase that the current government may be dissolved early and we could see another major European election this year.

PM May is meeting with President Trump today.  There are reports that the president may offer May a bilateral free trade deal as a “reward” for Brexit.  Making such an offer, especially with TTIP virtually dead, may encourage other nations that are considering leaving the Eurozone (Italy, France) to look to bilateral deals with the U.S.  European unity is coming under strain and how this meeting goes today may lead to even more concerns in the EU.

Greece refused to extradite Turkish military officers who participated in last July’s coup.  Eight officers fled Turkey as the coup failed, seeking refuge in Greece.  Greek courts ruled that the alleged coup conspirators may face overly harsh punishment if they are returned and thus did not allow the government to extradite the soldiers.  Needless to say, this decision will infuriate Turkey and worsen already poisoned relations between the countries.  The legal decision is being hailed as a victory for “European values,” which will undermine EU relations with Turkey as well.  Will this prompt Turkey to open its borders and allow refugees to return to Europe in retaliation?  This is an issue we will be monitoring.

In our travels to the coasts we have noted a common comment that foreign money is boosting real estate values in local markets (not an issue here in St. Louis, BTW).  Similar reports are often heard from cosmopolitan cities such as London, Sydney and Melbourne.  Bloomberg is reporting that real estate agents in many cities are saying that there has been a sudden drop in interest, and transactions are not being consummated due to China’s tightening of capital controls.  One of the rules the Chinese State Administration of Foreign Exchange (SAFE) enacted late last year was a clause that forced anyone who was using their legal quota of moving $50k offshore to promise not to use the funds for offshore property investments.  Violating the promise would lead to a three-year ban on foreign currency and a money laundering investigation.  This change has apparently cooled the ardor for shifting assets out of the country.  As a general rule, regulation can’t completely halt capital flight but it can raise the cost of moving money out of the country.  Recent regulations appear to have succeeded for now, although we would expect new tactics to emerge over time which will allow Chinese citizens to invest overseas.

Finally, we note that Amazon (AMZN, $839.15) has been granted a patent for a robot that would pack shipping boxes, something that is currently being done by humans.  It’s not that humans are inefficient; CNN[2] reports that Amazon warehouse workers spend only about a minute fulfilling each order, which includes 15 seconds packing the box with bubble wrap and tape.  Automating the process suggests that the company simply wants to reduce the amount of labor involved.  It is fairly clear that the current administration wants to boost jobs in the U.S., especially the routine jobs that have traditionally been held by the middle class.  Trump and his government appear convinced that foreign trade is the primary reason these jobs have disappeared.  However, economists mostly believe that automation has probably played a larger role and so, if the goal is to increase routine jobs with good pay, regulations against automation may eventually be required.[3]

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[1] Not the word from the movie A Christmas Story which is usually associated with an Italian word describing a leg lamp.

[2] http://money.cnn.com/2016/10/06/technology/amazon-warehouse-robots/

[3] https://www.nytimes.com/2017/01/25/business/dealbook/how-efficiency-is-wiping-out-the-middle-class.html

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

[Posted: 9:30 AM EST] Global equities are holding this week’s gains on renewed optimism that tax changes and infrastructure spending will lift the economy and earnings.  We note that the GOP House leadership is pressing the idea that tax changes should be mostly revenue-neutral and there is a renewed push for border adjustments in the Ryan bill.  As a reminder, the border adjustment would tax imports but not exports.  There is also some marketing going on, with proponents suggesting the border tax is a “fee” to avoid the stigma of a tax.  According to some sources, Trump is uncomfortable with the border adjustment; he is said to believe it’s too complicated and it limits his freedom to unilaterally support friends and harm enemies.  However, these sources also claim that advisor Steve Bannon likes the border adjustment idea.  It appears to us that without the border adjustment, corporate tax cuts will reduce revenue to the Treasury significantly and will lead to a higher marginal rate.  It should also be noted that Congressional Republicans are not strongly behind infrastructure spending but the president is pressing the case for public investment.  It remains to be seen how Trump will handle this if Congressional Republicans refuse to yield.  Will the president team up with Democrats and threaten GOP unity to get infrastructure spending?  We will be watching but we do expect that some infrastructure spending will be forthcoming; the right-wing populists are counting on it.  That infrastructure spending will likely include the border wall that the president is proposing.

In Europe, we are monitoring a couple of political developments.  First, the Social Democratic Party of Germany (SPD) has a new leader, Martin Schulz, and he is apparently looking to run against Chancellor Merkel.  The CSU/CDU conservative parties, led by Merkel, are currently governing with the SPD.  It doesn’t appear to us that one could create a government by excluding either the mainstream conservatives or socialists, but the composition of power could change.  In other words, if the SPD does well in the November polling, the CSU/CDU/SPD coalition could remain but the SPD might win more positions of influence in the government.  Currently, Schulz’s popularity rivals Merkel’s.  If the SPD gains more power, it may be more willing to expand fiscally and reduce pressure on the southern tier nations by boosting imports.

We are also watching reports that French authorities have opened an investigation of embezzlement against François Fillon, the current leading presidential candidate representing the establishment-right in France.  According to reports, authorities are investigating whether Fillon’s spouse was paid €500k of public money for a “no-show” job over an eight-year period.  There were two jobs, one as Fillon’s parliamentary assistant and one as assistant to Marc Jouland, who took Fillon’s seat when he became a government minister in 2002.  It should be noted that hiring family members is not illegal in France (about 10-15% of members of Parliament practice nepotism), but it would be against the law if Penelope hadn’t actually done anything.  Fillon has been running as a right-wing candidate in the Reagan/Thatcher mode, which is unusual for France.  He is calling for sharp cuts in government spending and a reduction in government jobs; he has also been supportive of ending Russian sanctions.  French presidential elections can go two rounds if no candidate wins a majority.  In the second round, only the top two candidates participate.  There are currently three candidates, Fillon, Marine Le Pen of the National Front and Emmanuel Macron, running as an independent (although a Socialist, he is offering free market positions, almost a center-right platform).  The Socialists are still deciding on a candidate.  There has been some speculation that if the current polls are accurate and there is a runoff between Fillon and Le Pen, leftist voters may lean toward the National Front which could bring a populist who wants to leave the Eurozone.  If the charges against Fillon stick, it might reduce Le Pen’s chances, although we tend to think it will simply upend the election and make it harder to predict.  Anything that boosts Le Pen will likely be taken as bearish for the EUR.

We monitor a number of issues in our analysis, in part, to turn “black swans” (issues that are completely unexpected, called “unknown/unknowns”) into “grey swans” (“known/unknowns”).  Infectious disease is one of those factors.  The NYT is reporting that the WHO is monitoring a bird influenza circulating in China that seems to have a rather high mortality rate.  The strain, called H7N9, has been present every winter in China since 2013; more than 1,000 cases have been reported over the past four years with a 39% mortality rate.  So far this year, 225 cases have been confirmed and China is about to embark on the New Year’s migration, where millions of Chinese migrate home for the weeklong holiday.  Vacation travel can increase the likelihood of transmission as travelers mix in close quarters.  This strain has mostly affected those directly involved in poultry farming and processing (it is a bird-flu), but there are two suspected cases of human-to-human transmission; if the virus can be directly transmitted, it could indicate it has mutated into a more dangerous influenza.  Influenza pandemics have the potential to slow global growth as illness and precautions against contracting the disease affect spending and travel.  At this point, this strain remains contained but it does bear monitoring.

U.S. crude oil inventories rose 2.8 mb compared to market expectations of a 2.5 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.

Comparing the seasonal pattern to the current inventory accumulation is supportive.  Although it is early, oil inventories are rising slower than average.  To justify current prices, inventories will need to decline this year.  As the chart shows, that process should begin in earnest in Q2.

 

Based on inventories alone, oil prices are overvalued with the fair value price of $39.96.  Meanwhile, the EUR/WTI model generates a fair value of $37.71.  Together (which is a more sound methodology), fair value is $36.63, meaning that current prices are well above fair value.[1]  OPEC has managed to lift prices but maintaining these levels will be a challenge given the dollar’s strength and the continued elevated levels of inventories.

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[1] The forecast that uses both independent variables is lower than the two separate models because the €/$ exchange rate and oil inventories are highly inversely correlated at -89%.  In theory, it appears that some investors may be using oil inventories as a way to protect against dollar weakness.

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

[Posted: 9:30 AM EST] After a sluggish start to the year, equity markets have resumed their northward march.  There isn’t a whole lot of news to trigger this rise, although the reversal of the Obama policy on pipelines may have lifted hopes that deregulation is really on the agenda.  Another factor that might be behind the lift is hopes for infrastructure spending.  The Democrats in Congress have suggested a $1.0 trillion spending package; their program has no path for funding.  However, we sense that this president isn’t overly concerned about the size of the deficit.  We suspect that the Democrats are doing this, in part, as a political ploy, thinking they might break the “Ryan/Trump coalition.”  However, it isn’t clear to us that such a coalition really exists.  Trump may be sui generis and could be more than open to supporting a massive infrastructure build over the objections of his own party (and strong objections from his appointee for OMB).  The KC Star and the McClatchy Washington Bureau[1] report that the president’s team has compiled a list of 50 infrastructure projects costing around $137.5 bn.  The fact that his administration is lining up projects surely suggests that he is amenable to infrastructure spending.  Would President Trump team up with Democrats over the objections of Congressional Republicans to approve infrastructure spending?  We believe this is a distinct possibility.

Who wins?  All firms involved in construction and equipment and probably those long the dollar.  The losers?  Treasury bond investors.  A widening deficit and fiscal stimulus in an economy that is arguably near full employment could boost inflation and prompt the Fed to raise rates.  Of course, this assumes the FOMC will continue to follow the policy pattern that has been in place since Paul Volcker, which is to quell inflation by raising rates.  However, we would not be shocked to see this president try to strong-arm monetary policymakers to keep policy accommodative, similar to the Burns/Miller era of the 1970s.  If we get the latter, the dollar weakens, commodity prices rise and long-term interest rates rise as well.  This situation is one of the most significant “known/unknowns” that we are watching.

We do note that this topic of slack in the economy isn’t necessarily settled.  Yes, the unemployment rate would clearly suggest that the economy has little unused labor resources available.  However, the data is not completely clear on this issue.

This is one of our favorite charts to measure the problem of determining slack.  The blue line shows the U-3 unemployment rate, while the red line shows the employment/population ratio.  The two series were highly correlated (+84%) from 1980 until the end of the last business cycle, at which point it has become evident that the relationship between the two series has broken down.  This difference is significant; had the relationship remained the same, the economy would have added 8.3 mm more jobs.  Why has this divergence occurred?  Some of it is due to an increase in retirements.  The term “population” is defined by the BLS as the civilian non-institutional population over the age of 16.  Thus, those in the military and in prison are not counted.  However, as retirements rise, the number willing to work in the population group does fall.  Still, we have serious doubts that this alone accounts for eight million jobs.  Thus, there may be more slack available than the unemployment rate itself would suggest.

In addition, the level of involuntary part-time employment remains elevated.

This chart shows the level of involuntary part-time employment as a percentage of the labor force.  Although the number has been falling recently, it remains well above the troughs seen in the last two business cycles, which may suggest that firms could tap the part-time market for additional workers.

Finally, wages are remarkably low given the current unemployment rate.

This chart looks at the unemployment rate relative to wage growth for non-supervisory workers.  Note that on the graph, the scale for the unemployment rate is inverted and advanced nine months.  In the past, when the unemployment rate has been this low, wage growth has been running a bit higher than 3.75% per year.  It is currently around 2.5%.  The lack of wage growth could suggest that there is enough “hidden unemployment” to keep wages suppressed.

Finally, capacity utilization is consistent with available resources.  Utilization in manufacturing is less than 75%.  We do note the relationship between capacity utilization and inflation isn’t all that clear.  One reason is that the economy is constantly competing with overseas capacity, which may be cheaper to utilize.  This is where the president’s trade policy may have an impact, leading to both higher utilization here and rising price levels.  Still, at present, it appears that the economy could absorb the strain from fiscal spending on infrastructure.

Of course, the other issue is the return on infrastructure investment.  Any investment, either public or private, is measured on its return.  Unfortunately, by its very nature, public investment doesn’t have a clear return otherwise the private sector would willingly provide it.  In theory, roads could be completely privately funded and paid for by user fees.  In a world of electronic tolling, one could even engage in congestion pricing and offer “sales” during slack road use periods.  But some public investment simply can’t be priced; defense is a classic example as are some elements of public transportation.  The issue of wise public investment is complicated.  Many projects turn out to be less of a boost to the economy than planned.  Still, the argument that the economy doesn’t need public infrastructure spending now because it isn’t needed is not necessarily true, as we outlined above.

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[1] http://www.mcclatchydc.com/news/politics-government/white-house/article128492164.html

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

[Posted: 9:30 AM EST] The big news overnight came from the U.K. where the Supreme Court ruled that Parliament must move on Brexit before an Article 50 declaration can be made.  Although this decision is being portrayed as a setback for PM May, it isn’t exactly a huge shock.  A number of legal experts warned that the referendum alone would not be enough to pass constitutional muster and the court confirmed this opinion.  Interestingly enough, Scotland and Northern Ireland MPs won’t participate in this vote as decided by the court.

It doesn’t appear that the results of the referendum will be reversed by Parliament.  MPs have made it clear that they will support the outcome of the referendum.  However, taking the decision to Parliament will, to some extent, remove some of May’s power over the process of Brexit.  Those wanting a “hard Brexit,” especially favoring strict immigration restrictions, may be frustrated.  A number of MPs have indicated that they want to offer amendments to any bills granting May the power to declare Article 50.  Most of the proposed amendments would soften immigration restrictions and press for fewer trade restrictions with the EU.  In other words, the amendments will push for a “soft Brexit.”

It is suspected that May will quickly offer a short bill for Parliamentary approval.  However, it will be difficult for her to limit amendments.  The more amendments that are considered, the greater the likelihood is that the Article 50 declaration will be delayed.  It is also more probable that she will lose control of the process and be forced into a softer Brexit stance.  May has proven to be a leader that controls the process; if the Parliamentary vote forces her to lose control of how Article 50 is executed, political turmoil will likely rise.  This fear probably explains why the GBP is weaker this morning.  In general, the softer Brexit proves to be, the more bullish it is for the GBP.  Thus, news of the Supreme Court’s decision is arguably bullish for the currency but the political tensions it could raise lifts uncertainty and is consequently being taken as bearish, at least for now.

As we noted yesterday, the president formally killed TPP yesterday by pulling the U.S. out of the treaty.  Although there is much media wailing about this action, in reality, TPP was dead a long time ago.  Secretary Clinton had promised not to enact it if she won the presidency; essentially, neither candidate supported TPP or its European twin, TTIP.  Although all the evidence suggests that Trump is going to be more protectionist than previous presidents, one really can’t hang TPP on him.  After all, if President Obama had really thought it had a chance, he could have rammed it through the lame duck session of Congress.  Given the backlash against globalization, there was little chance it would have passed through the legislature anyway.

Bloomberg, citing BOJ sources, suggests that the Japanese central bank is committed to maintaining a zero percent 10-year JGB even as inflation rises.  There has been speculation that the BOJ would set a higher target for the long-dated sovereign in Japan as inflation rose.  Essentially, the BOJ has given up control of its balance sheet.  It is reasonable to assume that the higher inflation rises, the more the 10-year yield would rise in an unfettered market.  Capping the yield, in theory, will require more buying as inflation rises.  Expanding the balance sheet is a quiet method of keeping downward pressure on the Japanese currency.

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

[Posted: 9:30 AM EST] It was a rather tumultuous weekend with the incoming administration sparring with the media over a number of issues.  Those factors are being hashed out in the media so we won’t focus on them.  However, what we are paying attention to is the impact on financial markets.  The dollar is sharply lower this morning; some of this weakness is probably due to the fact that there was so little in the weekend comments from the new government on trade and tax policy.  The inaugural speech was clear that the U.S. will be adjusting its superpower role, something we discussed in the 2017 Geopolitical Outlook under the idea that the U.S. is shifting from a mostly benevolent hegemon to a malevolent superpower.  The speech puts the world on notice that U.S. foreign policy will be about boosting U.S. growth even at the potential expense of foreign growth and stability.

This, by itself, is a major shift in U.S. policy.  It essentially marks the end of how the U.S. has managed the world since 1944.  Although American policy has been successful (the primary goal was to prevent WWIII, which we did accomplish), it hasn’t been cheap.  The U.S. has been forced to increase the size of government (there is no such thing as a small government superpower), expand domestic and foreign surveillance (the U.S. had one intelligence agency at the end of WWII; now, 17), suffer through a series of status quo wars and run persistent trade deficits to ensure adequate global dollar liquidity.  These costs were significant and the burdens were not equally distributed.  Trump’s broad policy, it seems, is to lower these costs and redistribute the burden.

It’s the actual policy measures that are unknown.  We note that this morning the U.S. formally exited TPP; TTIP is also essentially dead, meaning the U.S. won’t be the global pivot for trade rules.  Greg Ip had a report in the WSJ over the weekend suggesting that Trump doesn’t want a broad-based tariff.  Instead, he wants to be able to wield the threat of trade restrictions to encourage foreign firms to build plants and equipment in the U.S. and, at the same time, discourage U.S. firms from doing the same abroad.[1]  That may mean he will reject the Ryan corporate tax reform that includes border adjustments.  These adjustments will reduce the president’s power to affect investment changes.  Instead, Trump has been calling for a large cut in corporate tax rates.  Interestingly enough, without the border tax adjustment, the tax cuts will likely lead to lower government tax revenue.  Trump seems to be signaling a general disregard for deficits.[2]

This leads us to this morning’s market action.  Is the weaker dollar a sign that investors are concluding that Trump’s policies won’t be as dollar bullish as originally thought or is this mere profit-taking (“buy on the election, sell at inauguration”)?  We suspect it is more the latter.  Trump’s policies appear to be reflationary; in other words, he wants to pump up nominal GDP growth.  Under normal circumstances, that should lead to dollar strength as rising nominal growth usually leads to higher interest rates.  For now, we are assuming that the Fed will raise rates faster if inflation rises quicker than expected.

However, that thesis assumes the FOMC will react to higher inflation by tightening monetary policy.  We would not be surprised to see President Trump try to cajole the Fed into maintaining steady rates when faced with rising inflation.  Most of us have spent our careers during a period of central bank independence and support for inflation control.  However, that hasn’t always been the conduct of policy.  Under Fed Chairs Arthur Burns and William Miller, the Nixon and Carter administrations (especially the former) pressed the Fed to maintain easy money in the face of rising inflation.  Carter did reverse that policy with the appointment of Paul Volcker; we note that Carter was a one-term president.  Simply put, we would not be completely shocked to see Trump appoint doves to the two open governor positions and press the Fed to keep rates low despite rising inflation and wages.  If that is the outcome, we are looking at a dollar bear market.  For now, we don’t think this is the most likely outcome but it is one we are watching closely.

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[1] http://www.wsj.com/articles/trump-on-trade-peace-through-strength-1485086400 (paywall)

[2] This is generally not unique; the party that holds the White House tends to be less concerned with deficits and becomes fiscally hawkish when out of power.