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

[Posted: 9:30 AM EST] The reason for yesterday’s price strength is based on hopes that OPEC will cut output.  Here are some of the details from the agreement:

We have compared the quota arrangements to Bloomberg’s October estimate, the OPEC “reference” of November production and what the quota change is in relation to both.  On the table, we have highlighted three nations in yellow.  Indonesia suspended its membership (presently, it’s an oil importer and OPEC is an oil exporter club) and thus has no quota, while Nigeria and Libya were also not given quotas due to local unrest.  The cuts are not inconsequential; compared to the Bloomberg estimate, we have cuts of nearly 1.3 mbpd.  This is somewhat less than advertised, but still significant.  The deal is contingent on output cut pledges of 600 kbpd from non-OPEC members.  According to Bloomberg, about 500 kbpd has been pledged, with Russia cutting 300 kpbd, Mexico 150 kbpd and Oman about 45 kbpd.  Russia says it will cut during H1 2017, so it could be a while before its cuts occur.  It should also be noted that these cuts are not effective until January, therefore we would expect high production levels this month.

So, will oil prices remain firm?  Probably, although we have serious doubts that Russia will cut production at levels anywhere near its pledge.  We look for Iranian and Angolan production to rise from October levels.  On the other hand, we do expect the Gulf States to keep their word and these nations account for 1.011 mbpd of the cuts.  Thus, we will almost certainly see a cut of this amount even if the others fail to meet their obligations.  This means, conservatively, we can expect production of around 33.0 mbpd in January.

Will this reduce the supply overhang?  It will help, but declines of magnitude will only materialize if U.S. output doesn’t lift, which is probably an optimistic assumption.  Dan Yergin, a well-respected oil analyst, suggests that U.S. production will probably rise 0.3 to 0.5 mbpd in 2017 due to higher prices from this agreement.  That would fill about half of the Gulf States’ cuts.  Although optimism is clearly running high right now, in the end, the key unknown is whether this deal will reduce the current oil supply overhang.  We should see some progress but, as we detail below, current prices have already discounted significant inventory reduction in an environment of a strong dollar.

U.S. crude oil inventories fell 0.9 mb compared to market expectations of a 1.5 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, seasonally, we should see inventories tend to stabilize into the end of November and decline into year’s end.

Based on inventories alone, oil prices are overvalued with the fair value price of $38.80.  Meanwhile, the EUR/WTI model generates a fair value of $39.78.  Together (which is a more sound methodology), fair value is $37.50, meaning that current prices are well above fair value.  Assuming a €/$ exchange rate of 1.060, $50 WTI has discounted oil stocks at 401 mb, about 118 mb below current levels.  Although we expect the oil market to give OPEC the benefit of the doubt, some period of consolidation at these levels would make sense.

The GBP jumped today on reports that Brexit Secretary Davis is considering paying the EU for access to the single market.  Fears that firms would be prevented from accessing the single market for finance has pressured the U.K. currency; however, if the May government can maintain access to the EU, much of the negative economic impact from Brexit would be mitigated.  As we have noted before, the GBP is deeply undervalued on a parity basis so this news should be supportive for the currency.

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

[Posted: 9:30 AM EST] The big overnight news came from the OPEC meeting, where the latest is that the cartel has agreed to reduce production by a reported 1.2 mbpd.  There are also reports that OPEC expects non-OPEC producers to cut output by an additional 0.6 mbpd.  We still don’t have details on the cuts.  According to reports, it seems that the Saudis did “blink” in that they are apparently allowing Iran to operate without a quota.  If this is the case, it is a major shift by the kingdom and suggests power is shifting to the Tehran-Baghdad-Moscow axis.  Regarding the non-OPEC cuts, Russian cuts are said to be at least 0.2 mbpd to maybe 0.4 mbpd.  However, we seriously doubt Russia will actually cut anything and we really don’t expect other non-OPEC producers to do anything either.

This is a three-day tick chart for nearest oil futures.  The jump today is obvious.

So, what happens now?  Here are a few thoughts:

Financial markets, by design, discount the future.  Using our inventory/dollar oil price model, assuming a €/$ exchange rate at today’s levels of 1.0637 and oil prices of $48.20 (about where we are today), this price is discounting U.S. commercial crude stockpiles[1] of 421 mb, or a decline of about 100 mb from current levels.  So, assuming 3.0 mb draw per week, it will take about 33 weeks to reach this level…or assuming 2.0 mb draw per week, we are about a year ahead of ourselves.  This price reaction is probably overdone.  Now, it is possible that the dollar could weaken.  A euro at 1.1475 would justify current oil prices assuming constant inventory levels.  However, for the near term, we would not expect the dollar to weaken.

We may see the Brent-WTI spread widen.  Much of the OPEC supply is priced at Brent.  However, higher oil prices will start to spur U.S. production which, at current spread levels, will tend to raise U.S. inventories.  The WTI price will need to fall relative to Brent to support U.S. exports.

Rising U.S. oil production could be bearish for natural gas prices.  As oil production rises in the U.S., associated natural gas output will rise, too.  This factor will tend to boost natural gas supply and, in the absence of stronger demand, natural gas prices would be dampened.

Overall, we are somewhat surprised by the OPEC news, although the “devil remains in the details.”  In other words, until we see an actual roster of production quotas, this is all jawboning.  The fact that the Saudis appear to have caved increases the likelihood of an agreement.  As we discussed above, there is a lot of optimism already in the market that will require a significant decline in inventories.  At the same time, the very fact that OPEC is trying to support prices is positive for oil and, at least for a while, traders will probably give the cartel the benefit of the doubt.  Interestingly enough, OPEC cuts will probably give market share to non-OPEC output over time.

In yesterday’s GDP data, we note that profit margins have improved.

This chart shows corporate profits for the economy as a percentage of GDP on a before- and after-tax basis.  Note that margins have rebounded over the past two quarters, which is something of a surprise.  Since 1980, the spread between before- and after-tax profits have averaged about 2.6%.  If tax reform is successful, this spread could narrow further and lift after-tax profits.

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[1] Adding back in pipeline oil.

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

[Posted: 9:30 AM EST] On the eve of the OPEC meeting, the cartel is struggling to come to an agreement, with Iraq and Iran still insisting on a production freeze above their current levels of output.  Russia has decided not to send a delegate.  If a deal of substance is going to be made, it will require unilateral cuts from Saudi Arabia.  Because oil demand is price inelastic in the short run (which means that a 1% rise in price will lead to a <1% fall in demand), revenue would rise to all producers; however, for Saudi Arabia, any rise in revenue would be less than its rivals.  It also runs the risk that non-OPEC producers, mainly U.S. shale producers, will lift output and fill any reductions OPEC makes.  Although the odds of a substantial deal are low, we would not be shocked by some sort of face-saving agreement in which non-specific cuts are promised.  Unfortunately for the cartel, a deal lacking substance will probably fail to lift the market because the stronger dollar is working against higher oil prices.

Current oil prices are more consistent with a EUR/USD exchange rate closer to $1.100.  For the most part, oil prices have ignored the impact of Trump’s election.  It seems rather obvious that OPEC hopes have allowed oil prices to levitate in the face of a stronger dollar.  But, a disappointing OPEC outcome runs the risk that oil will fall to around $37 per barrel.

It appears that Park Geun-hye, the president of South Korea, is preparing to resign from office.  Her administration has been rocked by a scandal where a Rasputin-like figure appears to have used her relationship with the president for personal gain.  It is unclear whether the legislature will accept her resignation or press for impeachment.  Resignation would probably not be immediate, whereas impeachment would remove her from office more quickly.  Park has been facing massive protest rallies against her government as the scandal worsens.  What is concerning about this outcome is that as the South Korean government is distracted with internal strife, the geopolitical situation in the Far East is becoming increasingly unstable.  The president-elect has officially killed TPP, raising the impression that the next government is ending the “pivot” to Asia, and, as we noted in our recent WGR series, the Philippines has moved toward China.  It isn’t out of the question that the mercurial leader of North Korea, Kim Jong-un, could view this as an opportunity to “make some noise,” which could be anything from nuclear blackmail to military action against the South.  We don’t think Kim will necessarily do anything rash, but the odds have increased.  It behooves the South Korean leadership to act quickly to address the presidential question because the longer the turmoil lasts, the greater the odds are that North Korea takes the opportunity to create problems.

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

[Posted: 9:30 AM EST] The big news item over the weekend was the passing of Fidel Castro, the revolutionary leader of Cuba.  The immediate impact of his death on markets will be rather small; as Fidel’s health weakened over the past decade he turned over the day-to-day running of the government to his younger brother, Raul.  Still, Fidel was an important factor in the Cuban government.  Raul, at 85 years old, is expected to retire in 2018.  Thus, we will be seeing a change in power in Cuba.  We don’t expect a wholesale reversal of socialism in Cuba but, without Fidel, we would expect to see a softening of what were often rigid socialist policies under Fidel.

Cuba’s geopolitical importance is that it is near the key U.S. port of New Orleans.  For much of U.S. history, this city was the most critical port for the U.S. economy.  This port was the terminal point for the massive American river system that includes the Mississippi, Missouri, Ohio, Illinois and Arkansas Rivers.  If a foreign power could impinge on New Orleans, it would effectively bottle up the agricultural and material wealth of the U.S.  Controlling Cuba was key to keeping New Orleans safe; that was part of the reason for the Spanish-American War.  When Castro ousted Batista in the early 1950s, the importance of New Orleans had diminished as other forms of transportation were created.  But, when Cuba fell under Soviet influence, Fidel became a significant threat.  The 1962 Missile Crisis almost led to a nuclear exchange that may have been a disaster.  Fidel survived 11 U.S. presidents and was a pain for almost all of them.  Thus, his death will likely lead to an easing of tensions.

Of course, one of the reasons why Cuba might be more malleable is due to the economic collapse of one of its key supporters.  The Saturday NYT had a long report about the newest refugee crisis as Venezuelans are taking small watercraft to island nations in the Caribbean and flooding across the Brazilian and Colombian borders.  The Venezuelan economy is in near collapse and, according to this report, the lack of food is driving Venezuelans to leave their homeland.  Venezuela needs higher oil prices to have any chance for economic recovery, although the distortions caused by the late Hugo Chavez are also a major handicap to the economy.

There has been great hopes for an OPEC deal, but the cartel is still struggling to allocate production cuts.  The key sticking point remains between Saudi Arabia and Iran, although there is disappointment that Russia appears only willing to freeze production.  What is especially galling about Russia’s behavior is that its production is at record levels, meaning OPEC cuts will boost Russia’s market share.  At this point, an OPEC deal hinges on whether the Saudis can live with giving up market share to Iran, Iraq and Russia, which it is also essentially fighting in Syria.  If the kingdom needs higher prices more than it needs geopolitical influence in the Middle East, it will be forced to make what are effectively unilateral cuts in output.  That outcome may be more than the Saudis can stomach.

Finally, in case you missed it, one of our favorite China analysts, Michael Pettis, had an op-ed in the WSJ last week in which he discussed the key role of the U.S. in global trade.  Most importantly, he discussed how the U.S. has been willing to run persistent trade deficits by providing the reserve currency.  This has allowed the global economy to expand and has supported globalization.  Pettis makes it clear, and we agree, that the Chinese economy is in no position to take over America’s role in the global economy.  The last election has also made it clear that the U.S. citizenry is tired of the role of importer and consumer of last resort.  Although Pettis holds out hope that some sort of restructuring is possible, a more likely outcome is a reversal of globalization.

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

[Posted: 9:30 AM EST] Uncertainty continues to plague the European Union as a result of growing populist movements.  Today, Turkish President Recep Tayyip Erdogan threatened to allow refugees to enter Europe after the European Parliament voted to stop talks regarding Turkey’s admission into the EU.  Turkey has received a lot of criticism from the EU for its brutal crackdown following the failed coup earlier this year.  If Erdogan were to carry out this threat it would strengthen populist movements throughout the EU.  Populist leaders such as France’s National Front Leader Marine Le Pen, who plans to immediately withdraw France’s membership from the EU if elected, have exploited peoples’ frustrations with slow economic growth and growing immigration.  If populism were to take hold throughout Europe it could lead to the end of the European Union.

The stock market rally is continuing to rise to new highs.  President-elect Trump’s proposals to increase infrastructure spending and tax cuts along with business deregulation have been met with optimism about possible economic growth.  A lot of this growth in optimism can be attributed to beliefs that he is more flexible than most people gave him credit for during the election.  He has recently softened his stance on climate change, Obamacare and immigration.

There is still uncertainty within the oil markets as Russia has only committed to an output freeze and Iran is looking for an exemption.  As a result of this uncertainty, Saudi Arabia has pulled out of “non-OPEC” meetings.  Even though it is widely perceived that an agreement will be reached before November 30, there is growing pessimism within the market.

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

[Posted: 9:30 AM EST] U.S. stock futures moved mostly sideways after reaching a record high over the past two days.  There was little additive news to the macro and political news that have carried the U.S. reflation trade recently.  President-elect Trump gave an interview to the NYT yesterday and commentators generally agreed that his tone has softened from the harsher campaign rhetoric.  A WSJ article suggested that Romney is Trump’s top pick for Secretary of State.  Markets rallied modestly on the news as his policies are expected to be market-friendly.  Two other major personnel decisions are still undecided, although Steven Mnuchin is seen as the most likely candidate for Treasury Secretary and James Mattis for Defense Secretary.

The probability of a December Fed hike was around 85% after the election, but has crept up slowly and has now reached 100% (the likelihood is actually 100.2%).  The chart below shows the level of market expectations for a hike next month.  The market is expecting a 25 bps move, with a very small likelihood that it might move even more (represented by the 100.2% probability).  These expectations follow the strong market rally and comments from several Fed officials indicating their openness to a December hike, including Chairwoman Yellen, who acknowledged that a rate hike may be coming “relatively soon.”

Oil moved lower this morning as participation from Iraq and Iran in an OPEC production cut was left unresolved.  Although Saudi Arabia is still the largest producer in the bloc, pumping 31% of OPEC output, Iraq and Iran have gained market share following the end of sanctions and war.  Iraq is currently the second largest producer of the bloc, pumping 13.5% of the group’s output, while Iran is third with 10.8% of production.  Both countries would also like to expand production.  Their reluctance to cut production means Saudi Arabia would have to shoulder a larger portion of the quota.

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

[Posted: 9:30 AM EST] Equities continue to move higher in the post-election environment.  This rise is coming in the face of virtual certainty that the FOMC will raise rates next month.  We may be starting to see a shift in market sentiment away from the focus on monetary policy toward economic growth.

This chart shows a model of the S&P 500 using the Fed’s balance sheet as the independent variable.  Since 2009, the relationship has been quite close; the mostly sideways market seen since 2014 is consistent with tapering.  However, since the middle of the year, we have seen equities persistently exceed the upper band of the model.  Either equities are overvalued (fair value based on this model is 2029) or the relationship is starting to break down.  We are leaning toward the latter.  Both presidential candidates were calling for fiscal expansion with Trump’s admittedly vague promises expected to be larger than Clinton’s.  If we are shifting toward economic growth and away from policy, it means the FOMC may be able to raise rates and have less impact on equities than the past few years would have suggested.  On the other hand, equities may become more sensitive to economic growth and if there are delays in fiscal expansion or we fail to see growth pick up, equities could be vulnerable to weakness.  In the near term, however, hopes are high that Trump and a GOP Congress will be able to move on policy changes.

We do note that President-elect Trump gave a statement yesterday in which he indicated the U.S. would formally remove itself from the TPP group.  Japanese PM Abe indicated that TPP is “meaningless” without the U.S.  We would agree.

Meanwhile, optimism surrounding OPEC remains elevated.  Nigeria was the most recent cartel nation to comment on the proximity of a deal.  However, in the past hour, oil prices have begun to slide.  We have probably reached a price point that OPEC must now deliver.  If they fail to negotiate a credible deal, oil prices will be vulnerable to a sharp decline.  Given the EUR/WTI relationship since 2012, a 1.06 €/$ exchange rate translates into a WTI price of $35.80.

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