by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA
[Posted: 9:30 AM EST]
Davos continues, the ECB meets, but it’s the coronavirus dominating the news. The U.S. is setting its trade sights on the EU. Here is what we are watching this morning:
Trade: The focus on trade is now shifting to the EU. The EU’s tactics up to this point have been to offer modest proposals and avoid direct confrontations with the U.S. This action is similar to how China initially dealt with the White House, but clearly the administration was not placated. So far, Treasury Secretary Mnuchin and Commerce Secretary Ross have been the point persons in the U.S. to the EU. This was true with China for a while. But, the real “game” doesn’t start until USTR Lighthizer shows up. This trade situation could get quite messy. First, we are only nine months away from U.S. elections; the EU likely hopes it will deal with a new president. Second, the EU is, by design, a slow-moving body and it isn’t obvious it can react quickly if the U.S. starts applying tariffs. Third, the EU really wants to apply digital taxes; we suspect this will be a red line for the U.S. Fourth, the EU is considering CO2 border adjustment taxes, which would apply a tax on the EU but also to imports based on the carbon policies of their trading partners. This action would be an anathema for the U.S. Fifth, U.S. exports to the EU are much higher than China; on a rolling-four quarter basis, it is 3.7x larger. Thus, the EU will have many more targets to apply retaliatory tariffs on the U.S. compared to China.
ECB: Although the press conference was still underway at the time of this writing, policy remains unchanged. We are starting to hear pushback from Eurozone bankers on negative interest rates. We suspect they are trying to see what sort of influence they will have with Legarde; they clearly got nowhere with Draghi.
Canada: The Bank of Canada yesterday kept its benchmark short-term interest rate steady at 1.75%, right where it has been since October 2018. However, by cutting its forecast of near-term economic growth, the policymakers also laid the groundwork for a potential cut in rates sometime in the future.
Saudi Arabia: United Nations investigators have concluded that Jeff Bezos, the founder of Amazon (AMZN, 1,887.46) and owner of the Washington Post, had his cell phone hacked via a WhatsApp account linked to Saudi Crown Prince Mohammed bin Salman. Shortly after Bezos and bin Salman traded phone numbers at a meeting in April 2018, bin Salman sent Bezos a video containing secret spyware, possibly to gain information on former Post columnist Jamal Khashoggi, whom the Saudis murdered in October 2018. The hack may have also allowed the Saudis to release compromising information on Bezos’s extramarital affair last year. The UN researchers, who were hired by Bezos, have asked the U.S., Saudi Arabia and other countries to investigate the matter. The incident underlines the crown prince’s risky adventurism as he takes a more aggressive tack on Saudi national security.
United States-Iran: Brian Hook, the U.S. Special Envoy for Iran, said in an interview that if the new leader of the Islamic Revolutionary Guards’ overseas force behaves as previous leader Gen. Qassem Soleimani did, he would meet the same fate. In other words, he would be subject to possible assassination by the United States.
The U.S. election season and the more dovish composition of the Federal Reserve Board of Governors should ensure policy accommodation continues in the near-term.
The recent resolution of trade policies with China and the prospect for finalization of USMCA produces an environment where corporate capital can be deployed with less uncertainty.
Although we hold a somewhat sanguine view of the U.S. economy over our three-year cyclical forecast period, we recognize there is the increased potential for a policy mistake that could lead to economic difficulty.
Each strategy reflects a neutral posture, with all risk assets continuing to reside in the U.S. and an equity style exposure of 60% value/40% growth, with an emphasis on larger market capitalizations.
The potential for elevated volatility in global equity markets encourages an allocation to long-term U.S. Treasuries and gold.
The recently signed initial trade deal with China, as well as the expectation for enactment of the new North American Trade Pact [USMCA], have helped propel U.S. equities to all-time highs. The trade resolutions hold the potential to encourage businesses to deploy capital toward long-term projects. As evidence, the recently released Q4 2019 Duke University CFO Global Business Outlook finds 12-month capital spending expectations increasing to 4.7% from 0.6% last quarter and R&D spending increasing to 2.7% from 0.6% the prior quarter.[1] Among consumers, the University of Michigan Index of Consumer Sentiment has similarly ratcheted up from 95.5 at the beginning of last quarter to its recent level of 99.1.[2] The business outlook and consumer sentiment figures have also been influenced by the accommodative posture of the U.S. Federal Reserve. The anticipation of two dovish nominees to the Fed’s Board of Governors encourages the expectation of continued accommodation through the U.S. election season. The relationship of the fed funds rate versus the implied LIBOR rate two years out underscores the notion that the Fed has reduced rates and stretched its balance sheet to the degree necessary to accommodate favorable economic conditions.
Despite the current rosy economic backdrop, there remain several lingering concerns. The first concern regards corporate profitability. Although broad indices have been propelled higher, corporate earnings have trended lower as the effects of the Tax Cuts and Jobs Act of 2018 roll off, making year-to-year comparisons more challenging. As this chart indicates, prior to taxes, inventory valuation adjustments [IVA] and depreciation, corporate profits as a percentage of GDP have been declining.
A second concern involves the rally in equities to spur hitherto reluctant retail investors to experience the fear of missing out [FOMO] and lead to performance chasing. While investors pulled $600 billion out of U.S. equity funds and separately managed accounts in 2019, over the past month the trend has reversed and flows have turned markedly positive, according to Morningstar’s asset flow data. Should this be the first salvo in a rush to invest, a true melt-up in equity markets could occur. If history is any guide, FOMO is notorious for leading to self-destructive investor tendencies. The third concern is that the Fed, in conjunction with the U.S. Treasury, begins to use exchange rates as a policy tool. Although this would make future tariff threats more potent, adjustments in terms of trade have deleterious ramifications for corporate and investor behavior.
Although these factors of concern are present, they do not reflect our base case for continued economic health and extension of the record economic expansion. Rather, they are intended to underscore the importance of continually monitoring data to ascertain whether our asset allocations are appropriate or in need of adjustment. While diversification among asset classes is a hallmark of modern portfolio theory, allocations based upon stagnant assumptions may yield spurious results. Accordingly, expected returns, risk, and yields require regular updates to provide proper diversification among asset classes, which is the crux of our asset allocation process.
While we hold a favorable view of the equity markets near-term, we recognize that beyond the next 12 months pressures may continue to mount in terms of corporate earnings growth. In addition, should the potential for investors to yield to FOMO be realized, a market melt-up could ensue. In such an event, valuations would become extremely stretched, leading to the potential for a subsequent significant retrenchment in equity prices. Finally, a politicized Fed in conjunction with the U.S. Treasury to incorporate exchange rates as a policy tool would have serious implications for corporate and investor behavior. Although we have a neutral allocation to U.S. equities, our concentration in each of the strategies is on large capitalization, higher quality segments of U.S. stocks. Within large cap sectors, we established an overweight to Communication Services and retain the overweights to Technology and Health Care.
The concentration on higher quality also leads to a continuation of the skew to value relative to growth, as well as the retention of a quality factor geared toward companies that meet the required criteria of profitability, quality of earnings, and low leverage. The particular elements of the quality factor include return on equity, as a measure of profitability, changes to net operating assets over the past two years as a criterion for earnings quality, and the ratio of debt-to-book value of equity to determine financial leverage.
Beyond the U.S., despite attractive valuations and solid fundamentals among many non-U.S. companies, the weighting remains void until a durable catalyst for U.S. dollar weakness is recognized. As that occurs, tailwinds associated with a decline in the U.S. dollar will be extremely beneficial for U.S.-based investors.
BOND MARKET OUTLOOK
The Fed’s increasingly accommodative posture combined with the global appetite for yield will likely lead to a continuation of a normally sloped and range-bound yield curve over the course of the next several quarters. Over our three-year forecast period, we regard long-term Treasuries as relatively attractive given the global yield appetite and the potential for gravitational pull exerted by the sheer amount of global bonds outstanding with negative yields. Additionally, should we experience more volatile markets for global equities, longer term U.S. Treasuries should prove resilient. Although nearly $5 trillion of corporate debt will be maturing before 2023, according to Moody’s, our caution is directed toward speculative grade, or high yield, corporate bonds where we expect spread widening to occur.
The duration of bond holdings in the strategies remains relatively long, stemming from our forecast for an accommodative Fed, a lack of inflationary pressure, and global demand for bonds. In the strategies with income objectives we retain the laddered structure as the core beyond the short-term segment in these strategies.
OTHER MARKETS
The combination of our forecast for rates, the lack of excesses in the real estate segment, and the more diversified pool of REIT enterprises leads to our constructive view on the segment. As a result, REITs are included across the array of the strategies.
The prior elevated allocation to gold is retained given its ability to offer a hedge against geopolitical risks combined with the safe haven it can afford during an uncertain climate for both equities and the U.S. dollar.
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA
[Posted: 9:30 AM EST]
Davos continues, impeachment dominates the news (but has no discernable impact on financial markets) and we continue to monitor the coronavirus. Lebanon gets a new government, Norway’s fails and Italy’s might be close to failing. Here is what we are watching this morning:
Governments: After three months without an official government, a new one is in the process of forming in Lebanon. Designed to be technocratic in nature in order to tackle the serious financial problems facing the country, the fear is that it will come under the sway of Hezbollah as the Sunni parties have decided not to join the new coalition. Meanwhile, a spat over allowing a Norwegian IS member to return has led the Progress Party to leave the ruling coalition in Norway, ending the parliamentary majority of the current government. In Italy, Luigi Di Maio resigned as leader of the Five-Star Movement. He is currently the foreign minister. Although he is not expected to leave his position, his resignation raises fears that the Five-Star party might disintegrate, weakening the current ruling coalition. Italian bond yields and CDS prices rose.
Trade: Tensions with China are easing in the wake of the Phase One deal. Markets are now shifting to the effects of the arrangement. One potential impact is that WTI could gain on Brent due to the need for China to import energy from the U.S. Although there are expectations that China will buy a significant amount of U.S. grain, we note that China has been stockpiling domestic grain to support prices. Wheat and rice dominate their government purchases but could lead to inventory dumping to meet the demands of the new trade deal. U.S. attention is now shifting to the EU, where the first skirmish is over digital taxes. Although the U.S. and France have come to a truce, the U.K. is showing surprising tenacity in maintaining its threat to implement such taxes. We doubt Westminster will maintain this stance as the U.K., at some point, will want a trade agreement with the U.S. The EU has every reason to tax U.S. technology firms; Europe has failed to develop firms of similar scale and thus it can gain revenue and some degree of control through tax policy. Naturally, Washington will oppose such measures, mostly by threatening Europe’s auto industry.
Energy: Two news items of note. The civil war in Libya has, over time, affected oil supplies. It appears that production and exports are being curtailed again due to tensions. The most recent event is the blockade of oil exports by the leader of the eastern part of Libya, Gen. Khalifa Haftar, has blockaded oil exports. Production is falling to near zero. Interestingly enough, this news hasn’t lifted prices, a clear indication of the market’s oversupply. Another market facing oversupply is natural gas. Despite being in the dead of the northern hemisphere winter[1], U.S. prices have declined below $2.00 MCF. The root of the current problem is associated gas that is produced by frackers in the production of oil. The natural gas, that usually is also produced in this process, is a byproduct and is price insensitive. Cheap natural gas is a supportive factor for chemical makers and fertilizer companies.
Argentina: Could we be seeing yet another Argentine default? The markets are already concerned about the new Peronist government in Argentina. However, this default may come from the provincial level and the new governor of Buenos Aires province wants to delay a bond payment for three months. There is fear that the more radical wing of the Peronist party may be pushing to confront foreign creditors and lead to yet another default.
Production delays: On Tuesday, Boeing Co. (BA, $313.37) announced that it does not expect to restore production of the 737 max until midyear at the earliest. The suspension of production is expected to ripple throughout the economy, as it will likely impact many of Boeings suppliers. As a result, many of its suppliers have already begun laying off workers. Initial estimates suggested that the slow down production could cut any where from 0.3% to 0.5% from annualized GDP figure in Q1.
[1] Paradoxically, price lows often occur in January. This is due to the mechanics of storage. Most U.S. storage is in depleted wells which must be filled and drained on a regular schedule to protect well integrity. Salt domes, the other type of storage, can be flexibly filled and depleted, but old wells must inject gas at a steady pace in the summer and withdraw it in the winter. A mild January is a death knell for prices; the gas in the wells must come out and compete with current production. Without robust home heating demand, prices can collapse.
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA
[Posted: 9:30 AM EST]
It’s Davos week! World leaders in politics, business, academia and media are all gathering in Davos, Switzerland. Your Daily Comment team is skipping the event this year, remaining in picturesque downtown Webster Groves instead. It’s a risk-off market this morning as the Chinese coronavirus has clearly mutated to person-to-person transmission. With the Chinese New Year coming on Friday, massive travel is likely which could foster the spread of the virus. In other news, the IMF has lifted its growth forecast modestly. Iran changes tactics on its nuclear program. Here is what we are watching this morning:
Davos: It is the 50th anniversary of this gathering. Although it is an important event, it has taken on a sheen of tone-deafness in recent years. Last year’s theme of inequality being discussed by billionaires is a good example. Still, this is one of the few times when leaders across different areas gather simultaneously, which does mean the potential is elevated for newsworthy events. One interesting side note: local officials say they broke up a probable Russian effort to bug the venue last summer. Police were alerted when a pair of ostensibly Russian plumbers had an unusually long stay at the resort. Police and Swiss federal officials suspected the pair of posing as tradesmen to install surveillance equipment at key facilities around town to monitor the private conversations of the world leaders attending the forum.
Iran: After the EU moved to begin the process of reimplementing sanctions in light of Iran’s nuclear activity, Tehran abruptly declared it would not take any further steps to violate the 2015 agreement. However, in a change of tactics, Iran indicated it would withdraw from the nuclear Non-Proliferation Treaty if its nuclear program is referred to the U.N. In other words, if the EU brings Iran’s recent violations of the 2015 agreement to the UNSC, Iran will threaten to sell its nuclear technology. It appears that Iran has concluded that further violations of the JCPOA would be counterproductive, but it has shifted its threats to sway the Europeans.
Russia: President Putin has released a draft of the constitutional changes he floated last week to help him stay in power past the end of his term in 2024. As we reported earlier, the changes will weaken the power of the president and prime minister. The draft amendment shows that the State Council – an advisory body made up of parliamentary leaders and provincial governors that Putin already heads – will gain new responsibility to “coordinate . . . the organs of state power.”
Eurozone: The European Central Bank’s latest bank lending report showed corporate loan demand fell 8% in the fourth quarter, even though credit standards were broadly unchanged and the ECB had cut interest rates in September. Surveyed banks expected corporate loan demand to fall 9% further in the first quarter of 2020. According to the ECB, the decline in corporate demand largely reflects weak economic conditions and reduced capital investment. In contrast, high consumer optimism and low interest rates boosted demand for housing loans by 25% in the fourth quarter. As in the U.S., the question is whether soft corporate investment and manufacturing will eventually offset the strength in the consumer sector.
The December employment data showed three interesting developments that are worth discussing. They are wage growth, hours worked and the level of “out of the workforce.”
Wage growth: For most of last year, production and non-supervisory wage growth was outpacing that of overall workers. This development suggested that ordinary workers were finally benefiting from the long expansion. However, it was uncertain if the growth was due more to changes in state and local minimum wage laws or due to tight labor markets. It appears we have our answer. Many of the changes to local and state minimum wage laws occurred after the 2018 midterm elections. December’s data would be 13 months after many of these new laws came into effect, so if legislation was the primary cause of the rise in ordinary worker pay then we should have seen a drop in December’s wage growth.
In fact, that’s exactly what we saw. In November, wage growth for this class of worker rose 3.4%; it fell 40 bps to 3.0% in December. Thus, the divergence between total private wages and production and non-supervisory worker wages appears to be solely a function of minimum wage laws. Without additional measures, it seems unlikely that the divergence will continue.
Hours worked: The growth rate of hours worked by production and non-supervisory workers fell to its lowest level since June 2010.
The combination of fewer hours and falling wage growth will tend to further dampen available liquidity for the majority of households. The weekly hours data isn’t recessionary, but it is headed in that direction.
Out of the workforce: When the Bureau of Labor Statistics calculates the labor force, it includes those working and looking for work. Some citizens purposely decide to stay out of the labor force for a myriad of reasons, with age being the most likely. In other words, as the number of citizens reaching retirement age increases, the percentage of the population that can continue to work will tend to decline as will the potential labor force. Nevertheless, as the expansion continues, the potential pool of those out of the labor force tends to decrease until a point is reached where it becomes nearly impossible to draw down this group any further. At that point, wage growth is expected to rise; at the same time, the unemployment rate can’t decline any further because potential new workers become increasingly difficult to find.
The economy may be nearing that point.
The blue line shows the percentage of those not in the labor force relative to the non-institutional population over the age of 16. The red line is the percentage of the total U.S. population older than 65, with Census Bureau forecasts. The area in yellow represents the baby boom generation. The start of this area is when the last baby boomer turned 16, and the end is when the first baby boomer hit the age of 65. In the yellow area, the percentage not in the labor force fell and stabilized. As baby boomers headed into retirement age the percentage not in the labor force began to climb. However, this percentage has recently stalled, mostly due to the extended economic expansion. This trend will be difficult to sustain as the 65+ population continues to rise. Although we are seeing workers delay retirement, the recent trend should reverse over time. That factor will tend to keep the unemployment rate lower than it has been historically.
What is important about these three trends is that two of them are suggesting some softening in the labor market, whereas the last one might mask that weakness by showing a low unemployment rate. In other words, older workers, facing a weaker labor market, may simply opt for retirement and leave the labor force entirely. That will reduce the labor force and keep the unemployment rate low, suggesting the labor market is tighter than it really is. That factor could increase the potential for a policy error.
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA
[Posted: 9:30 AM EST]
Happy Friday! Equity markets continue to grind steadily higher to new record levels. The White House officially nominated the two last open governor positions on the FOMC. An update on the Iran missile attack and other Iran issues. Germany is holding a summit on Libya; it is also in an uncomfortable position with China. The 20-year Treasury is coming back (call Youshi). Here is what we are watching this morning:
The Fed: Although the names have been circulating for some time, the White House has finished its background checks on Judy Shelton and Chris Waller. The latter is non-controversial. He is the research director at the St. Louis FRB and a conventional pick. That isn’t to say there is nothing interesting about the selection. We suspect the St. Louis Fed President, Jim Bullard, has designs on the Fed Chair job. There were rumors that Bullard was being considered for the open governor’s position. He quashed that rumor quickly but offered his research director instead. This serves two purposes: if Bullard does get the nod to replace Powell, he will have an immediate ally among the governors and, in the meantime, the composition of the board will become more dovish.
Shelton is another issue. She has argued that the Fed probably shouldn’t be in the business of setting interest rates. She has shown an affinity for the gold standard, but also seems to want to manage exchange rates in a manner to boost U.S. trade competitiveness. There were elements of the supply-side movement that wanted a gold standard, apparently, in part, to provide inflation-fighting credibility to address the fiscal expansion this group supported. This idea of “weaponizing” the dollar has been circulating recently; we addressed it in a WGR (Weaponizing the Dollar: The Nuclear Option, Part I and Part II). We expect opponents to Shelton to raise a rule that a Federal Reserve District cannot be overrepresented on the FOMC. Since Shelton and Brainard are both from Richmond, this could be raised as a problem. However, this rule has been ignored in the past, so if it is raised here it would suggest senators are looking for a reason to scuttle her nomination. Overall, we expect both to be nominated, although Shelton will be controversial.
The following table shows how the FOMC will change if they are nominated.
These are our estimates of policy leanings, with 1=most hawkish to 5=most dovish. We are assuming both of the new candidates are extreme doves (otherwise they wouldn’t have been nominated), with Waller being a traditional dove while Shelton is a political one. This means that if there is a change in administration, Shelton could become less dovish. The governors now are leaning dovish (going from 3.00 to 3.57) and the overall voting changing from 2.90 last year to 3.33 this year. This means that the hurdle for rate hikes has increased markedly. We would view these nominations as bullish for risk assets.
Libya: Chancellor Merkel is holding a meeting of the two warring groups in Libya in an attempt to reduce tensions in the divided nation. The two sides appear to be abiding by a ceasefire for now. Although we have little hope that the meetings will lead to a lasting peace (division into two nations is probably the best solution), the longer a ceasefire holds the greater the chance that Libyan oil production rises.
Germany and Huawei: The U.S. is pressuring Berlin to ban equipment from Huawei (002502, CNY 3.13). Germany has been reluctant to do so, in part, because China is threatening German car sales in China. China is the largest market for German automakers. In fact, Germany is facing a similar threat from the U.S.; the Trump administration has been considering tariffs on EU auto exports to the U.S. to address the trade deficit with the region.
China’s GDP: The Chinese government said fourth-quarter GDP was up 6.0% from one year earlier, matching the annual growth in the third quarter but coming in short of expectations for a slight acceleration. GDP for all of 2019 rose 6.1% from 2018, marking the slowest full-year growth rate since 1990. On the other hand, other Chinese data today suggests the economy may have started to firm toward the end of the year. For example, December industrial production was up 6.9% year-over-year compared with a 6.2% gain in the year to November. December retail sales rose steadily by 8.0% from a year earlier. These figures suggest the economy may have gotten a bit of a boost as companies and consumers began to sense that the U.S.-China Phase One trade deal would really be signed. However, we doubt the economy is totally out of the woods. China is still struggling with longer term issues like poor demographics, high debt levels and general maturation. Moreover, implementing the new trade deal could be a challenge, and the Trump administration may well keep up its pressure for disruptive policy changes. That helps explain why the data only gave a slight boost to Chinese stocks and the renminbi today.
U.S.-India Trade: Officials in the U.S. and India are drafting a “limited” bilateral trade deal that could be unveiled during a visit by President Trump to New Delhi in the coming weeks. The deal would address some longstanding U.S. concerns about India’s market restrictions, while restoring India’s preferential trade status and ability to export to the U.S. duty-free. The news is probably bullish for Indian stocks.
U.S./China deal: Although the press has focused simply on the signing of the U.S.-China Phase One trade deal yesterday and the big import commitments China made in the agreement, our read of the text itself suggests the bigger story may be that the U.S. got the Chinese to make significant concessions in a number of important areas. The draft deal that China walked away from last May was apparently quite intrusive, with detailed changes to multiple areas of Chinese law. The text of the deal signed yesterday also includes many requirements that China change its legal and regulatory system to match U.S. standards, but without specifically enumerating each article, chapter and clause of Chinese law that has to be changed. Most of those changes relate to the protection of intellectual property, so there are many more issues in the U.S.-China relationship that still need to be addressed.
The agreement is being widely panned in the media. Although we always take the position of political neutrality, the tone is probably more negative than justified. There are two primary criticisms of the agreement. First, China’s practice of subsidizing firms that supports their export efforts wasn’t addressed. This charge is accurate. However, as we noted yesterday, USTR Lighthizer is working to use the WTO and team up with Japan and the EU to address this issue. In our view, Lighthizer is a grandmaster of trade negotiations; he appears to have decided that the subsidy issue is better dealt with in a broader context. Second, there is legitimate concern that China will not live up to its promises as it has in previous agreements. What is different this time is that the U.S. has shown it will implement tariffs if China doesn’t do what it says it will. We find it notable that the U.S. has kept the vast majority of tariffs in place even after this deal. That suggests the U.S. feels it won’t get compliance from Beijing without the persistent threat of a “stick.”
At least in our initial look, we have some worries too. There doesn’t appear to be a well-designed dispute mechanism; thus, the ultimate enforcement may come down to “I quit.” We are also concerned that China may not be able to fully meet the import targets; we note soybean prices fell yesterday on these worries.
However, overall, the trade war with China has clearly caught the attention of Chairman Xi. We suspect the USTR’s primary goal is to change the way the Chinese economy works, similar to what he helped engineer against Japan in the late 1980s. Simply put, he wants to change China’s economy from being investment and export driven, to consumption and import driven. Japan was never able to make the transition and thus has suffered 30+ years of economic stagnation. If China wants to avoid the same fate, it will need to make changes. Of course, history never repeats exactly the same way; China is big enough that it may try to create its own sphere of influence, something that Japan, who was dependent on the U.S. for its security, could never execute.
Putin: We once worked with a strategist who pretty much always had the same forecast, but the “show” was seeing how he would manage to create a path to that outcome. Vladimir Putin is similar in that respect. We know the outcome is always that Putin will remain in power. However, how he does it is interesting to watch. In his annual State of the Union address yesterday, President Putin launched a surprise constitutional revamp that could keep him in power past the end of his term in 2024. Under the proposal, which Putin said would be put to a referendum, the power to name the prime minister and his or her cabinet would be transferred from the president to the lower house of parliament (although the president would still be able to dismiss the prime minister and cabinet ministers). Parliament would also get greater power over the judiciary and the security services. Eligibility to become president would be tightened up so that anyone taking the post would need to first live 25 years in Russia and have no foreign citizenship or residency. Future presidents would also be limited to two terms in total. Meanwhile, the State Council, which Putin already heads, would be given increased power. To put the changes in motion, Putin replaced incumbent Prime Minister Medvedev with Mikhail Mishustin, the head of Russia’s tax office who is relatively unknown and has no appreciable political base. The move reflects a number of important principles: 1) Putin takes great pain to prolong the illusion of constitutional legitimacy, just as he did a decade and a half ago when he temporarily took the role of prime minister after reaching the term limit on his first presidency; 2) By neutering the presidency and installing a weak figure as prime minister, Putin is ensuring that he will maintain overwhelming control over the government from his position at the top of the State Council; and 3) Although the timing of the change seems early compared with the 2024 end of Putin’s current term, moving now may make sense given that Russia will hold parliamentary elections in 2021, and Putin could package the move to the advantage of his party in that balloting.
Turkey: Despite a recent rebound in inflation, the Turkish central bank today cut its benchmark short-term interest rate more sharply than expected, to 11.25% from 12.00% previously. The recent rate cuts, which have been driven largely by President Erdogan, appear to be spurring better economic activity even if they are spurring stronger price hikes. That may explain why the lira actually strengthened slightly after the rate cut was announced.
Iraq: Caretaker Prime Minister Adel Abdul-Mahdi suggested in a cabinet meeting that he would leave the decision of whether to expel U.S. forces from the country to his successor. In spite of parliament’s recent call for such an expulsion and the Trump administration’s threat to impose sanctions if it does so, that means the issue may not come to a head in the near term. Any U.S. sanctions could very well be targeted against Iraqi oil exports, boosting oil prices, so pushing the issue off into the future could help keep the oil markets calmer than would otherwise be the case.
Energy update: Crude oil inventories fell 2.5 mb compared to expected no change in stockpiles.
In the details, U.S. crude oil production rose 0.1 mbpd to a new record of 13.0 mbpd. Exports fell 0.4 mbpd while imports fell 0.3 mbpd. The decline in stockpiles was unexpected but offset by large increases in product.
(Sources: DOE, CIM)
This chart shows the annual seasonal pattern for crude oil inventories. This week’s decline was a bit below normal. As the chart shows, oil inventories usually rise into late spring and then decline significantly into late summer. Last year, this pattern was disrupted to some extent because of exports.
Based on our oil inventory/price model, fair value is $64.41; using the euro/price model, fair value is $51.35. The combined model, a broader analysis of the oil price, generates a fair value of $55.43. We are seeing the divergence between dollar and oil inventories narrow as dollar weakness persists. Given the level of geopolitical risk, prices have not moved significantly above the inventory fair value price, although the combined model would suggest a richly valued market. With inventories poised to rise seasonally and tensions seemingly easing, softer prices are more likely in the coming weeks.
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA
[Posted: 9:30 AM EST] Good morning! It was a very quiet overnight session as markets await the signing of the Phase One deal with China. Here is what we are watching this morning:
BREAKING:Russian PM Medvedev resigned this morning along with the entire Russian government. This follows a speech from Putin in which he called on increasing the power of the PM and cabinet ministers. It is suspected that Putin, facing term limits in 2024, may opt to repeat his earlier job swap, where he accepts a newly empowered PM position and makes the presidency a ceremonial post.
However, it should be noted that trade relations are hardening outside this agreement. In what could be an important long-term move, USTR Lighthizer is pushing Japan and the EU to target China on corporate subsidies. This is a change in tenor; up until now, the U.S. has mostly engaged in bilateral actions. Lighthizer seems to recognize that “teaming up” with the rest of the industrialized world will probably have a stronger impact on the problematic issue of subsidies. This action won’t bear fruit for a long time; WTO actions are notoriously slow, which is part of the reason the Trump administration has mostly ignored the body. Nevertheless, it does create a framework for cooperation, and if this group can eventually include India it could force China to reduce or eliminate market-distorting subsidies.
Iran: We reported yesterday that Germany, France and the U.K. were planning to start the process of protesting Iran’s recent violations of the JCPOA. The three nations made it official. Iran warned that European soldiers in the region “could be in danger” after the move.
German slowdown: Germany expanded at its slowest pace in six years in 2019, expanding only 0.6%. As an export-promoter, Germany struggled to grow its economy as rising protectionism throughout the world led to a decrease in demand for exports. Additionally, auto-manufacturing, which represents a large part of the country’s exports, has also been hurt by changing regulations and a declining market. A reduction in the trade war may contribute to a more favorable environment for Germany, but it is worth noting that the president has the European Union in his sights as well.
Data: For years, the government’s data-releasing agencies (BLS, Commerce, USDA, etc.) would release its sensitive data to news organizations up to an hour before the official release. This allowed these news feeds to prepare stories and make the data available at the release time. There has always been a problem with this system; the government had to put elaborate security systems in place to prevent a journalist from leaking the reports.[1] The USDA even took to guarding the Venetian blinds in the reporter room to prevent signaling.
The Obama administration, in a bid to reduce costs, tried to end the embargo practice and make the news organizations wait like everyone else to get the data. However, the news bodies petitioned the administration and they retracted the decision. Now the Trump administration is apparently taking another swing at this action. If they follow through with this decision, government websites will be hammered with data requests as the release point nears. It isn’t hard to imagine their sites freezing up due to the demand. The bottom line is that if this path is taken there will invariably be some reports that won’t be disseminated in an orderly fashion. The pressure on government employees will also rise; traders who would benefit from an early look at the data (cue the Dukes) would likely be willing to bribe such employees. We will continue to monitor developments.
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA
[Posted: 9:30 AM EST]
Markets are quiet this morning as earnings season begins. Trade is the biggest headline, as the U.S. and China are expected to sign a deal tomorrow. Here is what we are watching this morning:
Trade: First, the U.S. and China are expected to sign a deal tomorrow. The PRC will pledge $200 bn in new U.S. purchases; although the full details may not be released, it is generally expected that China promised to buy around $75 bn of manufactured goods, $50 bn of energy, $32 bn of agriculture and around $35 bn in services. These numbers represent purchases over two years. The U.S. won’t implement new tariffs that were signaled in September and has removed the currency manipulator label on China. Casual observation would suggest the U.S. won this round handily. It appears Beijing is sensitive to this idea; a well-connected blogger in China has taken great pains to suggest that we are early in the evolution of the trade relationship. The deal should reduce the bilateral trade deficit the U.S. has with China; however, since trade is ultimately the difference between public and private sector net saving, the deficit in these accounts invariably will lead to trade deficits with other nations. Austerity is the most effective way to reduce trade deficits; it is also the least popular.
Second, China’s trade data improved in December, with exports up 7.6% and imports up 16.3% from the prior year. However, these eye-popping numbers are mostly due to base effects. Last year, trade was hurt by the early stages of the trade conflict. The overall balance was mostly flat.
Third, as the U.S./China trade situation stabilizes, the administration is likely to shift its focus to the EU. In anticipation, the new EU trade negotiator, Phil Hogan is coming to Washington this week to attempt to get ahead of any conflict. He will have his work cut out for him. The U.S. is at odds with France’s new digital tax and President Trump has targeted Europe’s car industry as a problem.
Iran: Iranian leaders are trying to cope with protests and have announced arrests of those responsible for downing the Ukrainian airliner. EU leaders have put Tehran on notice that it will reimpose international sanctions on Iran if it doesn’t return to compliance with the JCPOA. Iran has been trying to create daylight between the U.S. and Europe, with the hope of cracking the sanctions bind that the Iranian economy faces. However, those hopes appear dashed as Europe is demanding a return to the nuclear deal and Iran will still face U.S. sanctions, which have effectively cratered the Iranian economy. We expect Iran to try and limp along and hope a new U.S. president in November might offer a way out of their current crisis. However, if President Trump is re-elected, they may have no choice but to renegotiate the nuclear deal.
Canada-Iran-United States: Responding to Iran’s airliner shootdown that killed dozens of Canadians last week, Canadian Prime Minister has laid the blame mostly on the Iranian government. However, in an interview yesterday, he obliquely blamed the U.S. as well, noting that “those Canadians would be, right now, home with their families” if not for the escalation of tensions in the region. There are some signs that other high-profile Canadians are also making that connection. Only time will tell how much the incident might damage U.S.-Canadian relations, but in any case, it does show how the administration’s “America First” strategy has the potential to isolate the U.S. even from its strongest historical allies.
Ireland: Confirming reports we noted yesterday, PM Varadkar has called a snap general election for February 8. The call scuttles a 2016 parliamentary voting deal under which the opposition Fianna Fáil Party propped up Varadkar’s center-right government to ensure political stability during the Brexit negotiations.
China economic news: A couple of Chinese economic anecdotes caught our eye. First, it is no secret that China’s corporate sector is generating a rising level of defaults. Anytime a loan is made, there is a certain chance that the borrower will default. Additionally, given that China only outlawed defaults in 2014, and restricted the use of defaults until 2018, the potential for a significant level of dodgy loans from non-financial corporations in China is very high. So, the real focus should be on workouts. If there are lots of bad loans, some sort of resolution is required. In other words, who gets “stuck” with the costs of resolution? Here is one item that got our attention. Dandong Port Group, a port operator on the border with North Korea, had its business adversely affected by sanctions on the Hermit Kingdom. However, it does appear that aggressive overexpansion is mostly to blame for its debt problems. In 2017, it defaulted on $150 mm in bonds. It continued to default on other issues, eventually stopping payment on $1.2 bn in debt. In April, the firm began formal bankruptcy proceedings. The bankruptcy court has rendered its verdict. The company will be divided into two firms, one controlled by the state and the other private. The best assets will go to the state firm, which will be controlled by a state-run company. The other firm will be controlled by the private creditors. Bondholders will get CNY 300k maximum compensation (roughly, $44k) and shares in the new company. Needless to say, private creditors are not happy. What is of concern is that if this settlement becomes the norm in China, it will become very difficult for non-state firms to borrow money and given the level of corporate debt in China, rollovers will likely be necessary to avoid bankruptcies. Of course, if the goal is to increase state control, the Dandong Port settlement might be a desirable model. Second, Chinese automakers are laying off workers as car sales continue to slump.
An economic puzzle: In theory, the world trade balance should be zero. Short of trading with Mars or the Moon, a trade deficit in one part of the world is a trade surplus in another part, and taken as a whole, there should not be a global trade surplus or deficit. In reality, due to reporting errors and other factors, the world does run a trade surplus with itself. However, a recent paper uncovered that nearly 80% of that global surplus comes from the EU. The paper makes the case that fraud related to the EU’s value added taxes (VAT) is the culprit. Exports are treated differently in the EU VAT calculations, so it appears there is a systemic fraud going on were domestic sales are being treated as exports to evade taxes. Public finance experts have suggested the U.S. could adopt a VAT to increase government revenues to improve confidence in public deficit financing. However, this paper does highlight that such a move isn’t without risks.
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