by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Although Friday’s sell-off in equities was impressive, the financial chatter over the weekend was almost non-existent.  U.S. equity markets have been extended for some time and, so far, investors took Friday in stride.  The proximate cause for the drop was a renewed fear of Fed tightening.  Boston FRB President Rosengren, previously a reliable dove, said on Friday that a rate hike is “justified” due to the growing tightness of the labor market.  We have said much over the past few years on the issue of the labor market.  This chart, which should be familiar to our readers, is probably the best way to show the uncertainty.

This chart shows the difference between the unemployment rate and the employment/population ratio.  The two series tracked each other closely from 1980 into the financial crisis.  Since then, they have diverged significantly.  Some of the weakness in the employment/population ratio is due to demographics; as the baby boom generation heads to retirement, the ratio should ease.

However, there are two problems with this explanation.  First, the millennial generation, which is also large, is entering its working years and should offset some of the retirements.  Second, the baby boomers are working longer.

The markets correctly worry that the Fed might tighten into an economy with ample slack and clearly low inflation.  Thus a hike may be a mistake.

There may be a bigger issue, however.  This most recent weakness has hit both long-duration bonds and stocks and seemed to follow after the ECB made no policy adjustments.  There is a worry that central banks may be concluding that there isn’t much more they can do to boost economic growth without participation from fiscal policy.  And, since the odds of expanding fiscal policy are remote, we may be moving to a market situation where further monetary stimulus isn’t coming.  A case can be made that monetary policy has been majorly supportive for equity markets.

The good news is that it’s doubtful the Fed will be contracting its balance sheet anytime soon.  The bad news is that we may be moving back to mid-range, which, from this point, will be a notable pullback in equity values.  The chart below shows an S&P index model, using the Fed’s balance sheet as the explanatory variable.  The last time we had a market this expensive to the model was in 2012 when the market was anticipating QE.  Fair value for this model is 2030 on the S&P.  Although a drop to that level would not be catastrophic, it would represent about an 8% decline from current levels.

Governor Brainard, a reliable dove, is expected to speak early this afternoon.  She may ease fears of policy tightening.  Currently, the fed funds futures market places only about a 15% chance of a rate hike on the 21^st of this month but the odds are around 60% for December.

There were three other news items from the weekend that caught our attention.

What is the state of Sen. Clinton’s health?  For the most part, these discussions have been only held among right-wing pundits and bloggers.  The mainstream media has either ignored the controversy or ridiculed it.  That stance may have changed after Sen. Clinton was removed from a 9/11 ceremony complaining of light-headedness.  The video of her entourage taking her away did not look good.  Later in the day, the campaign admitted the senator had pneumonia but mainstream commentators were sounding concern.  This election season has been one of the oddest in our memory.  The weekend events simply added to the controversy.  So far, financial markets have not been affected but we would not be surprised to see some volatility tied to the election as we get closer to November.

Is Kim Jong-un crazy?  The general consensus is no.  If one looks at it from the viewpoint of the dynasty, acquiring nuclear weapons is completely rational.  For most of the Cold War, North Korea was protected by the Soviet Union and its economy was mostly on par with the South.  But, its economy lost its funding from the U.S.S.R. with the fall of the Soviet Union, and South Korea’s economy was booming during the late Cold War years, clearly overtaking the North.  The Kims found themselves isolated.  They also could not help but notice that the U.S. had overturned various regimes in nations such as Libya, Iraq and Afghanistan, and President Bush had included North Korea in his “axis of evil.”  So, how does a state keep from getting invaded?  Get a nuclear weapon.  Dictators around the world believe that Muammar Gaddafi made a strategic error by ending Libya’s nuclear program.  It should be noted that getting a nuke won’t improve North Korea’s economy or allow it to take over the South.  All nuclear powers realize that the bomb is only a defensive weapon; even if North Korea attacked the U.S., it would face certain annihilation.  It doesn’t appear that is what the Kims have in mind.  Thus, we suspect North Korea will become a nuclear power that can deliver a warhead.  The U.S. won’t like it but there isn’t much we can do about it.  In fact, only one power on Earth can, and that’s China.  Until China decides North Korea is too big of a liability it will refrain from acting against the regime.  This morning, Chinese officials criticized the U.S. for “creating” the situation on the Korean peninsula.  After all, the U.S. is the global hegemon.  It has a duty to fix such things.  The only way China may conclude it has to curb the Kim regime is if South Korea and Japan decide to build their own nuclear deterrents.  The U.S. has worked to prevent that from occurring, but that doesn’t mean we can continue to prevent it.

View the complete PDF

by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] There were two big news items overnight.  First, North Korea detonated a nuclear device overnight, its fifth such test.  Early reports suggest the blast was in the 20 to 30 kiloton range, not a big bomb (by comparison, the standard American warhead, W-88, is 475 kilotons), but it does appear the North Koreans are mastering the nuclear cycle.  We know they are working on moving from devices to warheads, and if they reach that level of development then they will have a capable nuclear deterrent.  It also looks like the Kim regime believes such a deterrent is necessary.

Although there was general condemnation of the act, the nation with the greatest influence over the Kim regime, China, is less focused on North Korea and is most upset with South Korea for deploying anti-missile defense systems from the U.S.  It is highly likely that North Korea decided to detonate this device because it felt that China would allow it.

The other interesting news item is that the Fed has recommended to Congress that financial holding companies be denied the ability to invest in non-financial companies.  This rule was part of the initial Glass-Steagall Act and was clarified further in the 1956 Bank Holding Company Act.  But, when deregulation ended these restrictions in the late 1990s, bank holding companies could engage in this activity.  In addition, the Fed also recommended that banks no longer be able to directly hold physical commodities.  This may affect commodity ETFs that hold physical products instead of futures contracts.  This wouldn’t mean these products will go away, but that banks couldn’t sponsor them.

This action represents a further step in re-regulating the financial system.  Although these merchant bank activities have become less important since the financial crisis, these new rules will prevent banks from returning to them if they become lucrative again.  The action also sends a signal that regulators are steadily returning banks to a more traditional role, which will probably make them less risky but also reduce their profitability.

U.S. crude oil inventories plunged 14.5 mb compared to market expectations of a 0.6 mb build.

This chart shows current crude oil inventories, both over the long term and the last decade.  The drop this week was huge, but likely temporary.  Imports last week fell by 1.8 mbpd due to disruptions caused by tropical storms.  Usually, importers furiously rebuild stocks in the weeks following such an event.  Thus, over the next two weeks, we would expect much of this 14.5 mb draw to be replaced.

The unexpected drop in storage has put inventories below the normal seasonal trend.  Again, we would expect that drop to be reversed in the coming weeks.

Based on inventories alone, oil prices are profoundly overvalued with the fair value price of $40.87.  Meanwhile, the EUR/WTI model generates a fair value of $49.22.  Together (which is a more sound methodology), fair value is $44.55, meaning that current prices are a bit rich.  Although the market has put great hope on an OPEC deal next month, the plan looks to be more like jawboning the market higher.  Recent comments from various OPEC members suggest that they would like stable prices, which we could argue they are getting, but none of the major producers seem ready to actually cut production at this point.  In fact, there are reports that the cartel wants prices no higher than $60 per barrel, fearful that prices above that level will spur a rise in shale production in the U.S.   For most of the history of oil prices, stability has been the norm, which is common with cartel markets.  Thus, we would expect the Saudis to gravitate toward a $50 price with a range of $5 per barrel around that point.  Using the aforementioned combined model, and assuming a €/$ of 1.1300, a U.S. crude inventory level of 482 mb would put fair value just above $50 per barrel.  Current inventories are 511.4 mb, or about 29 mb above this level.

In fact, the most bullish scenario for oil may have little to do with oil stockpiles and more to do with the dollar.  Yesterday, ECB President Draghi offered no new stimulus and the EUR rallied.   Assuming no change in U.S. stockpiles, a €/$ of 1.1556 would generate a fair value of $50.  Our calculation of purchasing power parity for the exchange rate is around 1.3000; again, assuming stable inventories, the fair value for oil at that exchange rate is $73.35 per barrel.  If the ECB is finished with policy stimulus and the FOMC hits its terminal rate with only a couple of rate hikes, a weaker dollar could develop.  This probably won’t occur this year, but might be a 2017 event.  On the other hand, there are some major political concerns in Europe.  Brexit still has to be executed, Italy has a key referendum next month, Spain will likely require new elections and Portugal may need a bailout.  These worries will likely offset, at least for 2016, any hawkishness from the ECB.

View the complete PDF

by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] This morning’s big news is the ECB’s decision to leave policy unchanged.  The EUR rallied, Treasuries dipped and Eurozone yields rose as well.  We are well into Draghi’s press conference at the time of this writing and it is evident that the ECB did nothing at this meeting.  Draghi did indicate that the ECB is ready to act and has the capacity to do so if necessary, but did not believe it was necessary at this meeting.  We suspect, and think this is the market’s take as well, that Draghi could not convince the rest of the committee to take steps to add new accommodation.  With QE set to end in March 2017 (although the ECB has indicated it could extend the program), there are worries that ECB stimulus may be coming to a close.  Equity markets have turned lower in Europe and U.S. equity futures have also moved modestly lower.

One of the lesser followed indicators we monitor is the National Credit Managers Index.  The index measures the health of corporate credit—everything from the demand for borrowing to the recoveries on bad debt.  The group noted that sales fell 6.3 points, from 60.0 to 53.7, consistent with the weak data seen in the PMI data.

This chart shows the composite index.  It should be read like the PMI data; 50 is the expansion/contraction line.  The current reading is the lowest since 2009 and it has been falling since Q2.  Note that in 2008, the index hovered around 50 only to plunge under 50 as the financial crisis emerged.  Although the data does not have a long history, the trend we are seeing is a worry.

We haven’t commented on the tax situation between the EU, Ireland and Apple (AAPL, 108.36), although we are gathering information on the issue.  However, we do note that Sen. Elizabeth Warren (D-MA) has an editorial in today’s NYT in which she is critical of the tech giant and of corporate tax policy, in general.  Economists tend to believe that corporate taxes are a bad idea—the incidence of the tax tends to fall on households anyway through higher product prices.  Clearly, the more competitive the industry, the less those firms can pass the tax on to their products.  But, for unique products and concentrated industries, the tax incidence tends to fall on households.  However, that knowledge doesn’t stop Warren from calling for higher taxes on corporations.  That she would take that position isn’t really news.  What is interesting to us is the target of her wrath, Apple.  Her party has received significant support from the tech sector and most of the commentary we have seen from Washington has been critical of the EU.  This is the second time we have noted that Warren has attacked the tech sector, suggesting that the Sanders/Warren wing of the party holds significantly different positions from the current leadership of the Democratic Party.

Although Portugal has fallen from the headlines, today’s FT notes that structural adjustments have not been addressed in the 30 months since the last crisis.  There are growing worries that a second bailout may be necessary.  The current Socialist government holds a minority and remains in office only due to the tacit support of hard-left parties.  If the current government falls, and creditors become nervous, a credit crisis originating in Portugal is possible.  If it coincides with the upcoming Italian referendum next month, the potential for another Eurozone crisis will rise.

We want to update comments we made earlier this week regarding Venezuela.  We noted earlier that Citibank (C, 47.48) had resigned as pay agent for PDVSA bonds.  We speculated that if no other bank took the role, it might increase the likelihood of default.  Our report that Citibank has resigned from its role is true.  However, according to the terms of the agreement, Citibank can resign but cannot stop performing the role until another pay agent is appointed.  Thus, PDVSA will have a pay agent for the foreseeable future and it will be Citibank, because it is highly unlikely that anyone else will want the job.

Russian President Putin withdrew support for a batch of new security laws, called the “Spring Package.”  The new rules are very strict, essentially ending free speech, severely restricting foreign NGOs and curtailing social media.  With parliamentary elections on September 18^th and presidential elections in March 2018, Putin is caught between worries about unrest stemming from a weak economy, prompting the new security rules, and growing unpopularity due to the security measures themselves.

View the complete PDF

by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Financial markets are quiet again this morning, with the focus mostly on policy.  The ECB meets on Thursday.  Although there is a need for the bank to have a wider range of bonds to buy to maintain QE, the Germans are uncomfortable with easing the rules that would allow the ECB to buy lesser credits.  We suspect the ECB will need to adjust its rules at some point but probably doesn’t have the consensus for this week’s meeting.  Both the Fed and the BOJ meet on September 21.  San Francisco FRB President Williams gave a speech in Reno yesterday, offering mixed messages.  On the one hand, he suggested that rates should rise.  On the other, he called for the consideration of a higher inflation target and a slower pace of rate hikes.  The Fed seems to be leaning toward a rate hike but is also trying to keep the terminal rate, the rate where the rate hike strategy would cease, at lower levels.  We suspect some of this may be about raising rates to give the bank room to ease in a recession, a rather odd policy (raising rates increases the odds of a recession).  At the same time, calling for a lower terminal rate would probably prevent the dollar from rising sharply, which is also a policy goal.

Meanwhile, mixed messages abound from the BOJ as well.  Reuters is reporting that there is a three-way split among the BOJ board members.   According to the report, about one-third of the nine-member board wants to stand pat, one-third wants to lower rates further into negative territory and one-third wants to expand QE.  Governor Kuroda is said to support the negative rate option.  According to The Nikkei newspaper, PM Abe supports expanding QE by purchasing foreign bonds.  It seems Abe believes that it would be permissible as long as the goal of foreign bond purchasing is to support economic growth and not specifically to weaken the JPY.  We suspect Japan’s G-7 partners would disagree with this characterization.  In fact, foreign bond purchases would have the same impact as currency intervention even if the goal is something else.  Still, foreign bond buying would likely be effective in boosting Japanese asset markets and would weaken the JPY, which is, by itself, a form of monetary stimulus.

China’s foreign reserves fell $15.9 bn in August to $3.19 trillion, the lowest level since 2011.  Although China has been trying to clamp down on capital flight, there is a steady drop in reserves that mostly tracks the continued weakness in the CNY.  Chinese authorities seem to be willing to tolerate the outflow as long as it remains contained.

Finally, the WSJ is reporting that OPEC is interested in raising prices (although we haven’t seen anything yet that would suggest production cuts), but there is concern about allowing prices to rise near $70 per barrel because that might trigger a resurgence in shale oil production in the U.S.  Instead, the cartel is signaling it is more comfortable with oil holding in a $50 to $60 range.  Although we are comfortable with this range, we expect prices to test the low $40s or high $30s in the short run due to seasonal factors.  The WSJ reports that the end of the summer driving season finds the U.S. market still oversupplied, which probably means prices will remain soft until winter sets in.

View the complete PDF

by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Well, it’s time to say goodbye to the summer.  Our reflections on the long weekend’s news:

The lead article in Sunday’s NYT was all about climate change and coastal flooding.  The report documented rising sea waters affecting numerous communities along the Atlantic Seaboard, although there were references to problems developing on the Pacific side as well.  Climate change is a controversial topic.  We believe it is happening but the causal factors are complicated.  Human activity likely plays a role; so does sunspot activity.  It is clear that there have been wide swings in temperature in the history of Earth that also occurred prior to the time of mankind.  Our view on this topic is the same as our position on politics.  We don’t take positions—we react to what policymakers are likely to do and how their actions will affect financial and commodity markets.

The article makes clear that the GOP leadership in Congress is not going to bend on this issue as it views climate change as either a hoax or unrelated to human activity.  If the GOP is ever going to change on this issue, it won’t come from the leadership; it will come from the sub-Federal level.  Governors and major city mayors dealing with the effects of climate change will call on Washington for help.  Eventually, we expect legislation to have an impact on markets.

Economically, this is a straightforward fix—you simply tax carbon emissions.  Markets will adjust quickly.  The problem, of course, is the incidence of the tax (economist jargon for “who pays?”).  Many opponents of climate change legislation fear that forces outside their influence will allocate most of the costs to them while allowing others to go about their lives with little impact.  This is partly why they vehemently oppose climate change legislation.  The impact of environmental legislation on coal workers is a case in point.  One blogger we read remarked that if climate change legislation made air travel prohibitively expensive (especially private air travel), then it might be easier to get the majority of citizens on board.

The NYT also reported that the U.S. and China agreed to the Paris climate agreement while the president was in China.  However, buried in the report were details that China has only agreed to have its carbon emissions “peak or plateau” by 2030.  The U.S. has committed to reduce emissions by 25%, based on levels in 2005.  Thus, China’s agreement is far less momentous.

President Obama’s visit to China for the G-20 meeting was described as “bumpy.”  Chinese security officials did not allow the president to deplane by the side steps but forced him to exit through the underbelly of Air Force One.  Usually, this exit is only utilized when an area is insecure, such as in Afghanistan.  According to reports, there were several incidents of friction between Chinese and American officials regarding who could be in the president’s entourage.  We suspect this was designed to put the president on the defensive and help Chinese negotiators.

The WP reports that the Philippines’ Air Force noted that at least eight Chinese vessels were spotted near the Scarborough Shoal, an area of tension between the two nations.  The fact that China would take such provocative action during the G-20 and the ASEAN meetings that followed suggests the Xi regime is testing American resolve as U.S. elections loom.

We have been concerned for some time[1] that Iran, Russia and China would use Obama’s lame duck period to press their claims, assuming that the administration would be reluctant to use force in front of the elections.  Russia’s recent behavior in Syria and Ukraine along with China’s continued belligerence both suggest these fears are being realized.

Populism is a growing trend in the Western world.  Chancellor Merkel’s party, for the first time, gathered a smaller share of votes in a state election compared to the populist and anti-Eurozone AfD (Alternative for Germany) party.  The AfD won 22% of the vote in the Mecklenburg-Western Pomerania, a state on the Baltic coast, compared to 19% for Merkel’s Christian Democrats.  The Social Democrats won control with 30% of the vote; this party has held power in the state since 1998.  This is Merkel’s political homeland, so losing to the AfD is a severe rebuke to her open immigration policy.

In other European news, acting Spanish PM Rajoy lost another confidence vote, signaling that Spain will likely need to hold another round of elections.  If a government isn’t formed by Halloween, the third election in less than a year will be necessary.

The ECB meets on Thursday and the WSJ asks an important question—will the European Central Bank adopt the policy of the Bank of Japan and start buying equities?  Based on ECB rules, the bank is starting to run out of bonds to buy.  This isn’t unprecedented in Europe.  The Swiss National Bank, facing the same problem, accumulated $100 bn of equities when it was pegging the CHF/EUR exchange rate.  The BOJ has been buying equity index ETFs in Japan.  To some extent, owning stocks may be safer than owning lower rated bonds as equities won’t default.  On the other hand, companies do go bankrupt and equity holders are usually left with nothing.  Still, if the goal is to use asset markets to lift economic activity then equities are a logical extension.

Although there is a persistent anti-Trump tone in the media,[2] we note that the NYT ran two articles on Sen. Clinton over the weekend that put her in an unpleasant light.  The first discussed her email woes and new revelations that suggest she was less than truthful in her depiction of them.  The second revels in her fundraising with the super wealthy.  Although raising money from the rich is a time-honored political practice in U.S. politics, she faces persistent charges that she is beholden to the moneyed class.  This was Sen. Sanders’s argument against her candidacy.  The fact that the NYT prominently reported on this may be taken, at least in part, as a signal of disapproval.

Several sources report that Saudi Arabia and Russia are considering a plan to “stabilize” oil prices.  We suspect both are trying to talk the market up; the former wants stronger oil prices before its debt deal, the latter because that is the basis of its economy.  We doubt anything real will come from the oil meetings later this month, but oil prices will likely be underpinned in front of them.  Until the inventory overhang is reduced, it will be difficult for oil prices to rise.  Seasonally, this is a weak period for oil and prices would likely be lower without the jawboning.

However, there is one factor that could make a real difference.  The Venezuelan state oil company, PDVSA, has a $3.0 bn loan payment due in October and November.  An additional $2.0 bn of general sovereign payments are due in November.  Although the Maduro government continues to insist it will meet all its debt obligations, simple math suggests it is running out of money.  If Venezuela defaults, bondholders may try to seize Venezuelan oil in the U.S.  We note that Citibank (C, 47.53) has ended its role as payment processor for bondholders.  Citibank has apparently become concerned that it might face legal liability as the DOJ and Treasury have been investigating PDVSA’s criminal activity; money laundering was one focus of the investigation.  Venezuela will be forced to find another bank to take on that role, and it will likely default if it can’t find one.

American refineries are capable of refining the heavy, sour Venezuelan crude.  Other non-U.S. refineries would be forced to mix the oil with lighter crudes to process them.  If any of those other oils are touched by the U.S. oil industry or the American financial system, then seizure is possible.  Thus, Venezuela would be forced to sell oil to a nation outside U.S. financial jurisdiction.  China is pretty much the only nation that fits the bill.  However, Venezuela is already deeply indebted to China, with 0.5 mbpd of oil already going there for debt service.  We doubt China would want more of Venezuela’s oil, at least at market prices.  The bottom line is that if Venezuela defaults, 1.5 mbpd of global oil production may come off the market.  This would help rebalance the global oil market.  We also note that Venezuela sells about 0.7 mbpd to the U.S.  If it defaults, these oil exports will likely end; this may narrow the Brent-WTI spread in favor of the latter.

View the complete PDF

___________________________

[1] See WGR, 6/27/2016, The Mid-Year Geopolitical Outlook.

[2] For a good analysis of this, see http://www.rollingstone.com/politics/matt-taibbi-on-the-summer-of-the-media-shill-w434484.

by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Happy labor data day…just before Labor Day weekend!  We will spend much of this report going over the data but we want to make a couple of comments about yesterday’s ISM manufacturing data.  The report came in unusually weak, at 49.4 compared to expectations of 52.0.  It also contradicted the Markit number (a data provider that offers a similar survey), which came in at 52.0, near the 52.1 forecast.  New orders, a key sub-component of the report, came in at 49.1, down from 56.9 in July.

Although there are concerns about this data, it should be noted that it is one data point and a bit of an outlier.  We would need to see a couple more like this before we would get really worried.  Although a reading under 50 means that the majority of survey participants saw weakness, it is a slim majority.  Looking at the data on a six-month average basis shows nothing out of the ordinary.

A simple GDP/ISM manufacturing model suggests that a reading of 49.4 would generate a GDP for Q3 of 2.1%.  We would expect the Atlanta FRB’s Q3 forecast for GDP to dip off this report, but the data, by itself, is not signaling recession.  It is confirming continued slow growth.

View the complete PDF

by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] It’s global manufacturing PMI day (see Foreign Economic News section for full data table).  China’s official PMI came in better than expected, crossing into expansionary territory with a reading above 50.  At the same time, China’s Caixin PMI reading came in slightly below expectations but remained right at 50, indicating expectations of neutral growth (no expansion or contraction).  Below is the historical chart for the two Chinese PMIs.  In general, the official PMI tends to be more stable, while the Caixin has produced lower readings for the country’s manufacturing.  The good news is that although the Caixin reading showed a generally contracting manufacturing sector for most of last year, both gauges show a manufacturing rebound over the past two months.

The yuan advanced for the fifth day on relatively strong PMI data, but also on speculation that the PBOC has been supporting the currency ahead of the G-20 meeting.  The chart below shows the one-year move in the yuan.  Although the currency has weakened since the end of last year, speculation is that the central bank does not want the currency to weaken further from its current level ahead of the G-20 meeting.  However, the policy is likely to change later in September.

The U.K. also saw a strong rebound in its manufacturing PMI in August following a relatively weak reading in July.  The stronger than expected PMI reading helps dissipate post-Brexit worries and indicates that the country can grow even amidst the prospect of leaving the EU.  We have drawn a vertical line on the chart below at the Brexit vote date.  The subsequent PMI reading in July had plunged to a contractionary level of 48.3, but rebounded strongly to 53.3 in August.

View the complete PDF