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

[Posted: 9:30 AM EST] BREAKING NEWS:  The ECB has rejected a request by the troubled Italian bank Monte dei Paschi (BMDPY, $0.18) for an extension of the deadline for the bank to raise more capital.  Italian banking authorities had requested more time to complete a €5 bn rescue package but the ECB has indicated that it doesn’t believe an extension will change the likelihood of a successful bailout.  This action by the ECB all but insures the Italian government will need to bail out the bank, but according to EU rules, equity and bond holders must absorb the first losses.  The sticking point is that there are €2.1 bn of subordinated bonds that were sold to retail investors; if these investors suffer losses, the political fallout will be massive.  We suspect that Italy will allow institutional bond and equity holders to suffer losses but attempt to reimburse the retail bondholders.  However, sparing the small bondholder may not be possible.   We have seen the EUR weaken on the news.

The other major political news emerged from South Korea where President Park was impeached by the legislature.  The motion needed 200 votes in the legislature, a two-thirds majority; it passed with 256.  Park is now suspended and her duties will be assumed by PM Hwang Kyo-ahn.   If all goes according to plan, new elections will be held 60 days after she officially leaves office.  Park has offered to resign, and so in the wake of her impeachment, if she does quit, the clock starts.  On the other hand, without Park’s resignation, the impeachment isn’t official until the Constitutional Court ratifies the measure within the next 180 days.  Thus, in theory, South Korea could be without an official president for 240 days. We suspect this won’t be the case and new elections will occur soon.

OPEC holds meetings with non-OPEC members over the weekend.  Although there are residual concerns that the deal could still fail (the Saudis have indicated they won’t cut if non-OPEC members fail to cut output by 0.6 mbpd), we suspect a deal will get done and promises will be made even if no actual reductions occur.  Reuters is reporting that Saudi Arabia has already announced cuts to U.S. and European buyers, although no reductions are planned for Asia, the new area where OPEC and Russia are vying for market share.  In reality, we don’t expect material cuts from non-OPEC members and cartel compliance will lag.  However, it will take a while for that reality to set in which means oil prices will likely remain richly valued.

Yesterday, the Federal Reserve released the Financial Accounts of the United States report for Q3, which more senior readers will remember as the “Flow of Funds” data.  This is a remarkably rich report, full of insights as to the health of the economy.  The following charts are some of the ones we found most interesting.

Net worth as a percentage of after-tax income rose to 638.8% from 633.9% in Q2.  This number remains elevated and does reflect higher values for homes and financial assets.

Owners’ equity in their homes rose to 57.3%, up from 56.8% in Q2.  History would suggest that the average homeowner will consider equity of 60% as normal and once this is achieved, we would expect to see greater confidence in real estate.

Household deleveraging has clearly slowed but releveraging has not started.

Household debt as a percentage of after-tax income fell to 100.1% from 100.4% over the quarter.  As a percentage of GDP, household debt declined to 78.4% from 78.7%.  Household liabilities are rising at a slow pace.

Prior to the Great Financial Crisis (GFC), four percent growth was rarely seen at the trough of recessions.  Negative growth has not been part of the postwar experience until the GFC and although households are adding to debt, it is clearly at a slow pace.

Finally, net saving is showing a rather interesting trend; business dissaving fell but foreign saving declined as well.

This chart shows net saving as a percentage of GDP.  Business dissaving usually translates into investment, although this quarter most of the dissaving has gone to share buybacks and dividends.  The decline in foreign saving reflects a narrowing trade deficit.  If President-Elect Trump is trying to recreate the pre-1980 America, household saving will need to rise dramatically and the trade deficit will also need to drop.

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

[Posted: 9:30 AM EST] The ECB gave us a modest surprise this morning by announcing a tapering of QE.  Expectations called for an extension of the current program through September.  Now, through March 2017, the bank will purchase €80 bn of bonds; from April to December, the bank will purchase €60 bn per month.  So, we are getting a smaller amount of bonds purchased but for a longer period of time.  The total purchases actually rise (the new program buys €540 bn compared to expectations of €480 bn).  Rates were left unchanged.  The EUR rallied briefly but has since reversed.  The German Bund rose 8 bps to 43 bps.

At the time of this writing, ECB President Draghi has completed his formal comments and is in the Q&A session.  His formal comments were quite dovish.  He suggested that QE could be extended and expanded if necessary, and he has refused to describe today’s ECB decision as “tapering.”  His definition of tapering, in response to a question, is a gradual reduction of purchases with the goal of ending QE.  Thus, by this definition, the ECB is probably a long way from ending QE.

Here are a few charts to show market reaction.

The EUR did spike but rapidly reversed.

Longer duration yields rose, although we have seen some reversal.

First, German bonds:

Second, U.S. 10-year T-notes:

Overall, we view ECB policy as dollar bullish, EUR bearish and equity bullish.  The markets are taking the move as bond bearish, but we think that markets will conclude as the day wears on that the bank’s move isn’t all that bearish for bonds, either.

There was a large oil industry transaction overnight.  Russia announced that it has sold a 19.5% stake in the state-controlled Rosneft (RUB 375.80) to Glencore (GLEN, 305.60 GBX) and to the Qatar Investment Authority.  We won’t go into the details of the transaction (see footnote),[1] but our interest lies in whether or not this transaction violates sanctions that are currently in place.  Since there are no U.S. firms involved, it is possible that the deal will skirt sanctions.  On the other hand, both buyers probably touch the U.S. financial system and could face an American reaction.  This will be an interesting test for both the Obama administration and the incoming Trump administration.  We would not be surprised to see a protest from the Obama government and perhaps an attempt to interfere with the deal.  We have no idea what Trump will do.

The other interesting issue with this sale is that it explains why Russia was so supportive of an oil output deal.  Driving up oil prices makes the sale more attractive.  Now that the deal is done, it will be interesting to see if Russia is as supportive of production cuts.

U.S. crude oil inventories fell 2.3 mb compared to market expectations of a 1.5 mb draw.

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.

The annual seasonal pattern suggests inventories should decline into year’s end.

Based on inventories alone, oil prices are overvalued with the fair value price of $40.31.  Meanwhile, the EUR/WTI model generates a fair value of $38.78.  Together (which is a more sound methodology), fair value is $37.41, meaning that current prices are well above fair value.[2]  Although we expect the oil market to give OPEC the benefit of the doubt, some period of consolidation at these levels would make sense.

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[1] http://www.wsj.com/articles/glencore-qatar-buy-stake-in-russian-oil-producer-rosneft-1481143830?mod=wsj_nview_latest

[2] The reason the combined model is calculating a fair value price below the individual models for the euro and oil stocks is due to the fact that the euro and oil stocks are collinear.  In other words, the euro and oil stocks are correlated at -88.8%, meaning a weaker euro usually means higher oil stocks.  The fact that oil inventories are falling into a weakening euro is unusual.

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

[Posted: 9:30 AM EST] Today is the 75^th anniversary of the bombing of Pearl Harbor, a monumental event that led to U.S. involvement in WWII and eventually acceptance of the superpower role at Bretton Woods in 1945.

It was another quiet market overnight.  Perhaps the most important overnight news came out of China, which continues to see a drain of foreign reserves.

For the month of November, foreign reserves fell $69.1 bn, putting them at levels last seen in 2011.  We believe much of the drain is due to capital flight.  Reports of Chinese buyers of West Coast real estate have been increasing.[1]  Today’s FT reports that European companies are facing restrictions on repatriating earnings from China.  President-elect Trump has been pressing to declare China a currency manipulator, a status that would trigger an official investigation and consultations with the manipulating nation.  If anything, China is trying to prop up the value of the CNY.  If the currency were allowed to float, given the degree of capital flight, the CNY would likely plummet.  So, there is no doubt that China manipulates its currency; it isn’t alone in this regard.  But, the way China is manipulating the currency is by raising its value, which would discourage its exports.  Trump isn’t incorrect that China has used its currency to increase exports in the past, but that isn’t the case now.

In fact, the CNY has lifted a bit recently, probably on fears that the likelihood of a reaction from Trump would increase if the CNY/USD level breaches 7.0.  However, it appears the primary fear of Chinese officials is that the CNY will weaken further due to money desperately seeking a home outside of China.

As a side note, the primary reserve currency nation needs to have a deep, liquid and open financial system.  China’s financial markets have none of these characteristics.  For those worried about the CNY becoming a reserve currency and replacing the dollar, China’s recent behavior of manipulating its currency and trying to prevent money from leaving the country are simply inconsistent with being the primary reserve currency nation.

Tomorrow, Mario Draghi will hold his regularly scheduled ECB policy meeting along with his press conference.  It is expected that the ECB will extend its QE program beyond March 2017, when it is scheduled to end, but there is the potential he will signal a reduction in the pace of buying during that extension period.  We are seeing some short-covering in the EUR in front of the meeting.

Finally, we want to take note of a recent comment by Stephen Schwarzman at a Goldman Sachs (GS, 231.38) conference yesterday.  Schwarzman, the head of Blackstone (BX, 26.55), says the Trump administration will usher in the most profound regulatory/tax changes he’s seen in his 45 years in finance.

“The changes as a result [of the election] are going to be very substantial in many areas, but particularly in the business community and the financial area. You’re going to have a very substantial reversal in regulations of all types…if you look at the architecture of the financial world, it’s going to change very substantially…this is as big a change happening all at once – I’ve been in finance for, I don’t know, 45 years? This will be the biggest…When you have changes like this that are so profound, it’s going to drive higher GDP. It’s going to make the U.S. a more friendly place for foreign capital. And it’s going to have significantly accelerated growth not just for financial institutions but for the country as a whole…So, this is, like, very important. It’s very important. And it’s not just about some stocks for financial companies, although that would be a nice thing. It’s much bigger and more impactful over a much longer period of time.”

Is Schwarzman right?  We are not sure.  There have been some pretty substantial changes over the past 45 years.  These changes include the end of restrictions on interstate banking, the end of Glass-Steagall, massive industry concentration, Dodd-Frank and a series of massive tax reforms, two under Reagan, one each under Clinton and G.H.W. Bush, etc.  So, Schwarzman is guilty of a bit of hyperbole here.  We think he is saying that, under President Obama and in the wake of the Great Financial Crisis, the financial services industry has been facing a myriad of new regulations that have hurt the profitability of the industry.  Is it reasonable to assume some degree of regulatory relief?  Yes; the cabinet appointments alone would lead to that outcome.  But, will President Trump deliver regulatory changes on the scale of interstate banking or the removal of Glass-Steagall?  It seems hard to believe that anything of that magnitude is on the horizon.

And, it’s important to remember that bringing back Glass-Steagall was part of the GOP platform.  One of the key unknowns for next year and thereafter is who will best represent Trump’s policies—Speaker Paul Ryan or Senior White House Counselor Steve Bannon?  If it’s Ryan, and Trump turns out to be a typical GOP establishment supply-sider, then Schwarzman will be more correct than not (still guilty of hyperbole but not wrong about regulatory relief).  This outcome probably also means that a left-wing populist will win the White House in 2020.  If Trump is a Bannon-style populist, banks will face continued regulatory pressure.  At this point, we don’t know who Trump will actually be; at present, both Ryan and Bannon supporters are projecting their hopes and dreams on the upcoming presidency.  That’s why right-wing populists and supply siders are finding common cause.[2]  However, their policy goals are not consistent.  Bannon’s Trump punishes firms for offshoring and puts up trade barriers.  He badgers firms into increasing employment and wages.  Ryan’s Trump cuts taxes on the upper income brackets and embraces globalization and deregulation.  The visions are not in unison.  If Trump is successful, he will convince the two sides that he is their supporter and weave a policy mix that gives enough to each side to placate both.  That will take a bit of political mastery.

What’s important here is that the financial market, especially the financial sector, is discounting lots of good news.  It remains to be seen how much good news will actually be forthcoming.  Schwarzman’s quote demonstrates that hopes are high.

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[1] https://www.bloomberg.com/news/articles/2016-12-04/vancouver-housing-tax-pushes-chinese-to-1-million-seattle-homes;

http://www.seattletimes.com/business/real-estate/seattle-becomes-no-1-us-market-for-chinese-homebuyers/.

[2] In the spirit of Advent, it’s a bit like Isaiah 65:25.  The wolf and the lamb shall feed together, and the lion shall eat straw like the bullock: and dust shall be the serpent’s meat. They shall not hurt nor destroy in all my holy mountain, saith the LORD.

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

[Posted: 9:30 AM EST] It was mostly quiet overnight with the market’s focus on the aftermath of the Italian referendum.  The most relevant concern is the Italian banking system.  The lead headline in today’s FT is “Monte dei Paschi Warned to Brace for State Bailout after Renzi Defeat.”  Former PM Renzi had cobbled together a bailout plan worth €5.0 bn, contingent on winning the referendum.  With the vote’s failure, this bailout is probably not going to occur.

Under normal circumstances, a banking system crisis is usually addressed by the central bank providing liquidity to prevent a bank run, followed up by some sort of public recapitalization.  In the U.S., the Federal Reserve offered a series of packages (shown on the chart below) that allowed banks to sell assets (loans) to the government in return for liquidity.

In the case of the U.S., the acute problem was liquidity, not solvency.  Thus, the $500+ bn injected into the banking system allowed the U.S. to get through the crisis.  As loan values recovered, the money was returned.  In Italy’s case, the loans are probably bad and so a recapitalization and workout is in order.  However, EU rules require that shareholders and bondholders get “wiped out” first before governments can supply funds.  Monte dei Paschi has €2.0 bn of retail bondholders who, based on EU rules, should suffer losses before taxpayer support.  However, these bondholders should be better thought of as depositors and hitting this class of creditors will be very unpopular politically.  Overall, the Italian banking system is holding €360 bn of bad loans.  If the lira were still around and the Bank of Italy had real power, the banking system would simply be recapitalized by the central bank; the central bank would be backstopped either by taxpayers or by printing money.  The most likely outcome would be the latter, which would lead to higher interest rates and a weaker currency.

However, by joining the Eurozone, this option is no longer available to the Italian banking system.  In fact, EU rules severely constrain the Italian government’s ability to deal with this banking problem in a politically acceptable manner.  One of the key goals of the Five Star Movement, a left-wing populist movement in Italy, is to hold a referendum on exiting the Eurozone.  If EU rules trigger a banking crisis (in other words, if the perception is that rigid German rules force small Italian bondholders to lose money), then the odds of a populist reaction to leave the Eurozone will increase.  We expect the EU to bend the rules to allow the Italian government some leeway in providing support because an Italian exit from the Eurozone would probably be the death knell for the single currency.

In other news, OPEC meets with non-OPEC members over the weekend.  Saudi Arabia has insisted on pledges of a 0.6 mbpd production cut from outside the cartel.  We expect some sort of agreement will be reached but would not expect any real cuts in output.  Already, Russia’s promised cuts of 0.3 mbpd will be “gradual” in the coming months and, since the OPEC deal only runs through June, it is quite possible that Russian production won’t fall at all in H1 2017.  Kazakhstan just opened the Kashagan field and will be reluctant to reduce output; in fact, its production is set to rise by 0.2 mbpd.  On the other hand, Oman, Bahrain and Mexico will all likely see falling output due to falling investment.  Overall, we expect the promised cuts to be made but no material reductions in output are likely.  However, if negotiations fail, the OPEC deal is probably off and oil prices would be vulnerable to a drop to pre-OPEC meeting levels.

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

[Posted: 9:30 AM EST] Italians rejected former PM Renzi’s plans for government restructuring.  This outcome was actually expected by pollsters, although the level of the rejection, at 60%, was at the highest end of expectations.  As he promised, Renzi resigned.  The president of Italy will now give time for the parties in parliament to form a government.  If one cannot be formed, new elections will be held.  The new elections are the wild card in this situation.

Market reaction was swift but short-lived.  The EUR fell initially, but has since recovered.

This is a three day, three-minute chart of the EUR/USD exchange rate.  The currency plunged when the results were announced, but has recovered all of its losses.  The pattern that has been emerging is that markets react negatively to political news then recover.  What has changed is that the recovery is occurring at a faster pace.  Markets recovered fairly quickly to Brexit, with equities returning to previous values within a few weeks.  With the Trump election, recovery came in about a day.  With Renzi, it was a few hours.  The underlying themes of equity bullishness and bond bearishness remain.

Economic growth is improving.  Q3 GDP was strong; Q4 is running near 3%.

The Atlanta FRB’s GDPNow forecast has fallen a bit but is still running above consensus.  In looking at the components, we are seeing some easing of consumption and a worsening trade situation bringing the forecast down from its recent peak of 3.6%.  On the other hand, equipment investment and homebuilding are adding to growth.  The bottom line is that the economy looks like it is putting in two solid quarters of growth.  The FOMC will likely take a more hawkish view toward policy given the improving economic situation.

The other big weekend news was President-elect Trump’s call with the leader of Taiwan, Tsai Ing-wen.  Trump tore up a delicate balance with this call.  Here is a quick historical background.  In the early 1970s, the U.S. was losing the war in Vietnam.  The U.S.S.R. was threatening both Europe and China.  American intelligence concluded that the Soviets could not fight a two-front war, one in Europe and another against China.  If the U.S. wanted to cheaply keep the Soviets from acting in Europe, it needed to force the U.S.S.R. to keep defending the Sino-Russian border.  To do this, Nixon went to China and “sold off” Taiwan.  Up until that point, the official policy of the U.S. was that the Nationalist government on the island of Taiwan was the official government of China, including the mainland.  This was obviously fiction.  Nixon decided trading that fiction to keep the Soviets occupied was a good policy.  In fact, it probably was.

Many policies and procedures can become hardened into practice even though the initial reason for the change wasn’t necessarily thought to be long-term in nature.[1]  For China, getting recognition as the legitimate government of China in return for keeping up hostilities against the U.S.S.R. was a good deal.  It meant a lot to China, which didn’t have the military power to take the island (it probably still doesn’t).  Not only did Nixon end the threat to Europe, but the U.S. got listening posts in China to help spy on the Soviet Union.

However, the relationship between China and the U.S. has changed.  China has been freeriding the U.S. hegemonic role for decades (China isn’t alone in this practice, either).  Trump’s decision to take the call, which was apparently calculated,[2] is sending a signal to China that the outlines of the China/U.S. relationship are going to be renegotiated.  China won’t be happy about that.  That’s too bad.  The point here is don’t focus on Taiwan; it’s not all that important.  The key point is that the relationship between China and the U.S. is going to be reworked.  We don’t know exactly how, but a nation dependent on foreign trade and facing a crisis of capital flight isn’t in a real strong bargaining position.[3]

That doesn’t mean we won’t have more volatility in our future.  It’s important to remember that Trump ran on a campaign to change the way the economy and political and geopolitical systems work.  The warning to China, along with the warning to U.S. firms on outsourcing, should be seen in the same framework.  The most obvious outcome to all of this is probably higher inflation.

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[1] The Guru and the Cat story is a famous allegorical example.  See: https://seekingtheessence.wordpress.com/2006/09/09/the-guru-the-cat/.

[2] See: https://www.washingtonpost.com/politics/trumps-taiwan-phone-call-was-weeks-in-the-planning-say-people-who-were-involved/2016/12/04/f8be4b0c-ba4e-11e6-94ac-3d324840106c_story.html?hpid=hp_hp-top-table-main_trump-taiwan-835pm:homepage/story&utm_term=.a42045bde6cb.

[3] And, those Treasuries that China holds?  Couldn’t it “dump” them?  Yes, into a falling market and the Fed could simply return to QE temporarily to absorb the shock.  Also, where does China put that $1.19 trillion of liquidity after it sells the Treasuries?  There is no other market in the world that could absorb that cash.  It’s important to remember that China bought those bonds as a form of vendor financing to maintain employment in China.  Thus, dumping them isn’t really a threat.  In fact, the rise of capital flight represents a much bigger risk to China.

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

[Posted: 9:30 AM EST] Happy employment data day!  We cover the report in more detail below but, in a nutshell, the big surprise was a drop in the unemployment rate to 4.6%, the lowest since August 2007.  The unemployment rate fell due to a 266k drop in the labor force, meaning the employment/ population ratio remained steady at 59.7%.  Despite the apparent tightening of the labor market, wage growth remains stagnant, with the growth rate of hourly earnings for non-supervisory workers holding steady at 2.4%.  Over the past three business cycles, an unemployment rate this low has coincided with wage growth near 4%.  Market reaction has been modest; the data won’t change the likelihood of a Fed rate hike later this month.

Two major political events will occur this weekend in Europe.  First, the Italians are holding a referendum on streamlining government.  PM Renzi has staked his political future on securing a “yes” outcome.  At present, that looks like a bad move on his part.  Although Italian law makes it illegal to poll two weeks before an election, polling has suggested that the referendum will probably be defeated.  However, polling firms have not enjoyed much success lately and it would be consistent for them to be wrong here.  We do note that polls have indicated strong opposition in southern Italy, which tends to have low turnout.  We are expecting a rejection of the referendum and Renzi’s resignation, but we do caution that 2016 has been nothing but surprises so an unexpected outcome is still possible.

If the referendum fails and Renzi resigns, the odds of early elections will rise.  Both the Five Star Movement party and the Northern League are calling for a referendum on EMU membership.  Italian support for the Eurozone and the EU isn’t very strong and there is good evidence to suggest that the Italian economy needs a steadily weakening currency to function.  For example, using the leading indicators (LEI) as a proxy for growth, the average yearly change in Italy’s LEI prior to 1999 (the onset of the EMU) was 3.2% per year.  Since joining the Eurozone, LEI growth is a mere 0.2%.  The chart below shows the lira/DM exchange rate.

The Italian lira steadily weakened against the D-mark until the rate was fixed in the single currency.  Since Italy lost its ability to depreciate its currency against the D-mark, its economy has stagnated.  Thus, pressure to exit the single currency makes sense; on the other hand the chaos that action would bring would be immense.  If the referendum on Sunday fails and Italy moves toward exiting the Eurozone, Germany will face a difficult choice.  The Merkel government will either need to accommodate Italy’s needs by expanding consumption and running current account deficits within the Eurozone or watch the single currency break apart.  Although Sunday, by itself, won’t determine this outcome, it isn’t a far stretch to see this scenario developing.

The other vote is for a mostly ceremonial position of president of Austria.  Norbert Hofer, a right-wing populist who narrowly lost a similar election earlier this year that was thrown out due to voting irregularities, is trying for a second time to win this post.  Current polling has the race too close to call.  If Hofer wins, it would be the first right-wing government in Austria since 1945.  It would also claim yet another nation for the populists.

Finally, the French will vote for a new leader next spring.  The current president, François Hollande, will not run for another term.  This is the first time in postwar history that a French president has not run for another term.  It is likely that Manuel Valls, the current PM, will represent the Socialists against François Fillon from the conservative parties and Marine Le Pen from the National Front.  The final round will be held in May of next year.  Hollande’s approval ratings have been abysmal and he probably would not have survived the primary.  Current polls suggest that Fillon will face Le Pen for the presidency after the first round (in France, the first round eliminates all but the top two vote gatherers who then run in the final election).  Fillon is running as a right-wing supply side candidate, while Le Pen is a right-wing populist.

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