(Due to the Martin Luther King Jr. Day holiday, our next report will be published on January 27.)
On January 3rd, the U.S. launched a missile strike that killed Major General Qassem Soleimani, the leader of the Quds Force of the Islamic Revolutionary Guard Corps (IRGC). As a high-profile commander, his death rocked the region and raised fears of a broader confrontation.
Although the situation remains fluid, Iran and the U.S. appear to have come to a point of stasis; in other words, the odds of further immediate escalation have declined. In this report, we will discuss recent events and examine the context surrounding these events. As always, we will conclude with market ramifications.
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA
[Posted: 9:30 AM EST]
Happy Monday! Much of the U.S. is digging out of wintry weekend weather. Equities continue their grind higher. Tensions in Iran soar after the government admitted it accidently downed a Ukrainian airliner. The DPP wins big in Taiwan. The U.S./China trade deal is expected to be signed on Wednesday. Here are the details:
China trade: The U.S. and China are set to sign the Phase One trade agreement on Wednesday. Overall, there isn’t that much there. China has made promises to buy U.S. agricultural products but the numbers being discussed appear to be unworkable. China has agreed not to weaken the CNY. Although the PBOC did allow the currency to weaken last year, currency weakness runs the risk of triggering capital flight. Thus, this isn’t a major “give” by Beijing. At the same time, tariff levels on China remain elevated. We suspect the trade front will be quiet in 2020 through the election. Interestingly enough, the U.S. and China are planning to restart an Obama-era forum for regular meetings between the two countries.
Japan: With the government about to dispatch a navy unit to help patrol the Persian Gulf, a new Kyodo News poll shows 58.4% of Japanese voters are opposed to the move. Only 34.4% supported it. Not only do these numbers show how unpopular the dispatch is, but it also suggests Prime Minister Abe still hasn’t been able to swing the public toward his view that Japan should revise its pacifist constitution to allow greater military development.
Venezuela: New reporting explains an additional issue that played into the government’s ham-handed effort last week to regain control over the National Assembly by shutting out opposition leader Guaidó. To boost Venezuela’s plunging oil production and help revive the economy, President Maduro wants to turn oil operations over to foreign investors from countries such as Russia and China. To do so, however, he would need to overturn his predecessor’s law prohibiting such deals, and that requires the cooperation of the legislature. To date, it still isn’t clear whether Guaidó or Maduro’s loyalists will have final control over the National Assembly.
Austria: In an interview with the Financial Times, right-wing Chancellor Kurz said he remains committed to strict immigration controls despite needing to form a coalition with the left-wing Greens. He said the government’s top priorities would be immigration control and climate change, followed by tax cuts and efforts to spur the country’s competitiveness.
The Stormont returns: The Stormont is the capitol building of the Northern Ireland legislature. The body has been suspended for three years as Sinn Fein, which supports unification, left the government over a public spending scandal. Since then, Northern Ireland affairs have been run out of Westminster. The suspension likely hurt Northern Ireland’s interest in the Brexit process because it reduced its regional power. An agreement over the weekend will bring regional power back to Northern Ireland; a key element of the agreement was an injection of cash from London. Meanwhile, it appears that Irish voters will be heading to the polls next month as Taoiseach Varadkar had planned for new elections after Brexit. Varadkar’s government is a minority and was only able to govern due to an agreement among the parties to rule while Brexit negotiations were underway.
In our 2020 Outlook, we discussed three risks to the forecast, with one of them being a “melt-up” or a dramatic rise in stock prices. One of the key factors that could bolster higher prices for risk assets would be the idea that the FOMC has engineered a soft landing, which is best defined as a tightening cycle that doesn’t result in a recession.
In December 2015, the Fed raised the policy rate by 25 bps, lifting the rate from 0.125% to 0.375%. The conventional policy models, mostly based on the Taylor Rule, suggested that a series of rate hikes was likely.
This chart shows four variations of the Mankiw Rule, which is different from the Taylor Rule in how it measures slack in the economy. The former used the unemployment rate, while the latter uses the difference between actual and potential GDP. We prefer the Mankiw Rule because labor market measures are easily observable, whereas potential GDP is not. We have created four variations of the Mankiw Rule using various measures of the labor market. In the chart above, the area highlighted in yellow shows that all the Mankiw variations were suggesting the policy rate was too low and the Fed needed to raise rates aggressively. The financial markets feared tighter monetary policy but, as the chart shows, after an initial hike the Yellen Fed paused for a year before raising rates again.
Why did this pause occur? A contributing factor appears to be fragility in the financial markets.
This chart shows the 12-week average of the VIX index of S&P 500 volatility and the fed funds target. Note that the VIX rose above 20 with the rate hike in December 2015. It is possible the FOMC worried about triggering broader financial problems by raising rates and thus paused to allow financial markets to “calm down” before raising rates further.
In the recent tightening cycle, the Powell Fed raised rates until the VIX broke 20; soon after, the Fed lowered rates even though the Mankiw Rules would suggest further tightening was in order. The Fed would be loath for the financial markets to conclude there is a “Fed put,” but, given how sensitive consumption has become to asset values, avoiding a recession may require guiding policy to prevent volatility from rising.
So, if this is what the Fed is doing, what does it mean for equities? We indexed the S&P 500 to early February 2016, when it became clear that Yellen would keep policy on hold, and January 2019, when Powell signaled at least a pause in tightening. The idea is that equities should benefit if the Fed avoids a “hard landing.”
The two periods are generally tracking each other; if this pattern continues, the current S&P 500 would end up at 3532.56 by late November. This analysis is clearly not foolproof as one episode of a soft landing won’t necessarily generate a repeat performance. Nevertheless, we are tracking relatively closely so further gains in stocks are possible if a recession is avoided. The trick is avoiding recession; accommodative monetary policy is probably a necessary, but not completely sufficient, condition for avoiding a downturn.
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA
[Posted: 9:30 AM EST]
Happy employment day Friday! We cover the data in detail below, but the quick take is that the data is a bit soft as nonfarm payrolls rose by only 145k, less than the 165k forecast. The big news was a plunge in non-supervisory worker wages, mostly due to base effects from minimum wage laws enacted last year. In other news, it appears Iran shot down the Ukrainian airliner. Brexit passes. Strikes continue in France. Taiwan’s elections. Here are the details:
Ukraine airliner: Evidence is mounting that the downed Ukrainian airliner was hit by a surface-to-air missile launched from Iranian territory. The suspected weapon, SA-15, is a Russian-made system that uses a mobile launching platform. Simply put, this isn’t the kind of weapon that is used by proxy groups. In Iran, this system is managed by the Islamic Revolutionary Guard Corps (IRGC). Iran is disputing the evidence and has expressed willingness to turn over the black boxes to foreign governments for analysis. The current consensus of opinion is that Iran likely made a mistake; in the current environment, it is likely that Iranian air defense personnel were anxious about potential retaliation and thought the civilian aircraft had hostile intent. It is unclear how this incident will play out but, if the Malaysian Air Flight 17 offers any insight, not much will occur.
Brexit passes: In rather anticlimactic fashion, the Brexit bill passed the House of Commons 330-231; the bill now moves to the House of Lords where it will pass and become law. From this point, the focus will be on the trade negotiations. The early look from Michel Barnier is that talks will be difficult. The EU will do everything it can to prevent the U.K. from becoming a “Singapore on the Thames,” forcing Britain to accept EU regulations. We expect London to push back on this position. Our take is that the two sides will come up with a deal but not in 12 months; however, an extension won’t be a market-moving event.
Taiwan elections: Beijing will be watching this weekend’s elections in Taiwan closely; a big win for the DPP would suggest that tensions in Hong Kong have swayed opinions on the island that the PRC believes is a breakaway province. In fact, China is doing more than watching—it is actively trying to affect the outcome of the vote. We are watching to see how effective their measures are because we would not be surprised to see similar actions tried in the U.S. elections.
France: Transportation workers extended their strike into the sixth week, making it the longest labor action in French history. Workers are concerned about President Macron’s plans to reform the country’s convoluted pension system. Although it is generally acknowledged that reform is needed, workers don’t trust the president and fear that “reform” will mean longer working lives and less money for retirement.
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA
[Posted: 9:30 AM EST]
Financial markets are taking on a clear risk-on bias; equities continue to lift, bonds, gold and oil are struggling. Here are the details:
Ceasefire: As we noted yesterday, Iran launched missiles against U.S. bases in Iraq. The attack was a mere pinprick, with no casualties reported. At the time of our publishing, the White House hadn’t officially responded, but in a press conference President Trump made it clear that he viewed the Iranian action as tolerable and no further military response was necessary. To some extent, the Iranian missile attack almost seemed choreographed. The U.S. knew the action was coming and moved troops out of harm’s way. The Iranian media is claiming numerous casualties, suggesting that Iran felt it had to respond but didn’t want to start a war. The “needle” Iran is trying to thread is to appear strong but avoid a direct military conflict with the U.S. We will be watching to see how successful they are in their quest.
For the time being, equity markets are getting just about everything they could want. A war in the Middle East has been avoided. Monetary policy is accommodative. The Phase One trade deal with China appears to be on its way. All this good news doesn’t mean that there aren’t concerns but in the immediate term, conditions for equities are clearly favorable.
United States-Iran-Canada: Although it looks like the U.S. and Iran are stepping back from any military conflict, it may be important to keep an eye on the airliner crash that killed 176 people in Tehran just hours after Iran’s retaliatory attack on U.S. bases in Iraq yesterday. According to Ali Abedzadeh, the chief of Iran’s aviation agency, the plane was on fire before it hit the ground, and investigators remain open to the possibility that it was hit by a projectile or explosion. That could give Iran an opening to accuse the U.S. of bringing down the plane. Indeed, given that Iran has likely been chastised by the assassination of Gen. Soleimani, we would now expect it to redouble its political pushback against the U.S. in the Mideast. Pressuring Iraq to expel U.S. forces will be a top focus, but it also might be helpful for Iran to create suspicions that the U.S. had reverted to terrorism. Such suspicions could also help drive a wedge between the U.S. and key allies like Canada, since over 60 of those killed in the plane crash were Canadians.
China: Although China’s headline CPI remains elevated at +4.5%, pork price increases finally appear to be slowing. Pork prices rose 97% in December, down from 110% in November. PPI continues negative, but only down 0.5%. Overall, the inflation situation in China remains a concern but the momentum does appear to be heading in a positive direction. Car sales in China fell again, down 7.4% from last year, at 20.7 mm units. The new respiratory virus we mentioned yesterday is apparently a coronavirus. This virus type is best known for causing the common cold. The bad news is that it is a new virus; the good news is that it doesn’t seem to spread via human to human contact.
Taiwan-China: In the run-up to Taiwan’s presidential election on Saturday, Foreign Minister Wu said that if incumbent President Tsai Ing-wen wins as expected, she plans to pursue a “sustainable, predictable and peaceful relationship” with China. The statement is being seen as an olive branch to Beijing, which could help solidify the president’s status as frontrunner in the race and help calm market concerns about future confrontation.
Brexit: The EU and U.K. are starting the process of trade talks. The British stance appears to be attacking trade by individual market rather than by building a grand bargain. By moving piecemeal, negotiators can continue to make progress and can likely go beyond the 2020 deadline if enough progress is made. However, there are a couple of dangers in this plan. First, by not working in a unified fashion, loopholes could develop that will be unforeseen during talks and second, there is the potential to become unexpectedly stuck on an issue that becomes contentious. Still, this looks like the best plan available given the short time frame.
At the same time, Bank of England Governor Carney said central bank officials are considering a new round of monetary stimulus “to reinforce the expected recovery in U.K. growth and inflation.” The threats of a delayed trade deal and looser monetary policy have combined to push the GBP sharply lower.
World Bank: The World Bank issued its global GDP forecast for 2020; it is looking for a modest rise to 2.5%, up from 2.4% in 2019. Trade concerns are a key factor in weakening growth. This forecast represents a downgrade of 0.2% from those made earlier in 2019.
France: Today left-wing trade unions are staging their fourth mass demonstration against President Macron’s proposed pension reform. Several unions have been on strike since early December, and even the moderate Confédération Française Démocratique du Travail is urging its 600,000 members to take part in a protest on Saturday. The strikes and protests come despite a series of government concessions. If Macron can consolidate the pension system and raise the retirement age as planned, the French budget would likely see big savings and the economy would probably get a boost. However, it remains unclear whether Macron will be successful.
Spain: Socialist Party leader Sánchez was finally sworn in as prime minister yesterday, after his coalition with the radical-left Podemos Party gave him a two-vote majority in parliament. That may seem like a fragile hold on power, but the Spanish constitution says a prime minister can’t be brought down by a no-confidence unless an absolute majority of legislators votes for an alternative candidate. Given Spain’s fractured parliament, that is seen as quite difficult. For now, Sánchez will be in a decent position to push his agenda of increased government spending, reforming labor laws to bolster unions and negotiating with Catalonia over its place in the republic. We think that will be positive for Spanish stocks in the near term.
The Chamber: Tom Donohue, the CEO of the chamber of commerce, will deliver a speech today, where he is expected to support issues like climate change legislation and infrastructure investment. He is also expected to support immigration liberalization. As the GOP becomes increasingly populist, the divergence seen between the party and the chamber reflects the fact that populism isn’t business friendly.
Energy update: Crude oil inventories rose 1.2 mb compared to an expected draw of 3.0 mb.
In the details, U.S. crude oil production was unchanged at 12.9 mbpd. Exports fell 1.4 mbpd while imports rose 0.4 mbpd. The rise in stockpiles was unexpected.
(Sources: DOE, CIM)
This chart shows the annual seasonal pattern for crude oil inventories. Because this is the first week of the year and the data is indexed to that week, the current reading and average are both equal to 100. 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 $63.59; using the euro/price model, fair value is $51.74. The combined model, a broader analysis of the oil price, generates a fair value of $55.39. 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 seemly easing, softer prices are more likely in the coming weeks.
There are two unknowns; first, does last night really represent all that Iran plans on doing in retaliation? Second, will President Trump take the off ramp and not react to yesterday’s missile strike? Let’s take the second part first. It would fit the president’s past patterns to not react to the missile attack. No Americans died in the event which appears to be one of his red lines. If a pinprick missile strike is considered to be enough to compensate for the killing of Soleimani, it seems like that outcome is favorable to the U.S. Which leads us to the first question. We have serious doubts that Iran believes it has fully retaliated. However, direct military confrontation is not the usual path Iran takes in projecting power. The missile strikes buy the regime time; it can tell its citizens it acted, and we suspect the Iranian media will play up the attack to make it appear more damaging than it was. Still, we doubt yesterday’s response will be the final retaliation; though, it may take months before we see the next action and, in the meantime, financial markets will likely show less concern over this issue…assuming our assessment of the second question is accurate.
Venezuela: Juan Guaido isn’t done yet. After President Maduro tried to oust Guaido as the head of the National Assembly, Guaido and his supporters stormed the building, pushing past security personnel to give Guaido the opportunity to take the oath of office and return as head of the legislature. So, for now, Venezuela remains divided.
Libya:Forces led by General Khalifa Hifter have taken control of Surt, a city on the central coast of Libya. Hifter is generally considered a secular leader and controls most of eastern Libya. The U.N. backed government, which has Islamist group support, is centered in Tripoli but has been struggling to hold territory against Hifter’s forces. The Libyan civil war is attracting outside influence; Russia and Egypt have generally been supporting Hifter while Turkey recently sent troops to support the Tripoli government.
Taiwan: Voters on the island go to the polls on Saturday in an election that is being framed as a choice between freedom, or dominance by Beijing. Events in Hong Kong loom largely over this election. China has aggressively intervened to swing the vote to the KMT candidate. The incumbent, President Tsai Ing-wen, the DPP candidate, was trailing in the polls in the spring but has seen her fortunes improve while the KMT’s candidate, Han Kuo-yu, has slipped badly in the polls. Hong Kong is the primary reason. Taiwanese politics tend to swing based on attitudes towards China. The KMT, which represents the Nationalists from the mainland who lost to Mao in 1949, tend to favor closer ties to the PRC, whereas the DPP tends to favor looser ties. The crackdown in Hong Kong undermines the “one country, two systems” formula that emerged in the transfer of Hong Kong to PRC control in 1997. If Tsai wins, as it appears she will, tensions between Taipei and Beijing will likely increase.
Silicon Valley strikes back: Once staunch opponents of trade protectionism, U.S. tech giants are now backing tariffs against French goods. The reversal comes on the heels of a controversial French digital services tax that hit firms such as Facebook (FB,213.06), Amazon (AMZN,1906.86) and Alphabet (GOOG, 1393.34). As the world moves away from global free-trade toward more regional free-trade, it is likely that Big Tech will come under pressure from other countries due to an increase in both scrutiny and competition. Therefore, we are not confident that the signing of the “phase one” trade deal with China will lower global trade tensions as much as the financial markets expect. That said, it is also becoming more likely that the traditionally left-leaning Silicon Valley are becoming more open to forming an alliance with moderate leaning conservatives.
Brussels vs UK: On Wednesday, European Commission President Ursula von der Leyen warned the UK that it must adhere to a “level playing field” of rules to protect European companies from unfair competition. The warning comes as both sides prepare to restart negotiations on a Brexit agreement, following PM Boris Johnson’s decisive victory in December. The posturing by the European Union, highlights the growing uneasiness that the bloc has about the UK’s departure. On Tuesday, PM Johnson revealed his “fast-track” trade deal, in which he stated that the UK should have the right to diverge from certain EU rules. Officials from the EU fear that the condition laid out by PM Johnson, could lead to a creation of a hard border, which could potentially disrupt supply chains. Given ongoing geopolitical risks, we are not confident that the bickering between the UK and the EU will have much of an impact on equities in the short-term, however, there may be long-term ramifications if a deal is not reached by the end of the month.
Cyber-attacks in Texas: On Tuesday, Texas Governor Greg Abbott announced that the state saw a surge in infiltration attempts by foreign operatives; 10,000 attempts per minute in the last two days. Although Iran was implicated, it is believed that other countries have also attempted to gain access to the Texas network. At this time, the state reports that is has been able to block all attempts to gain entry, but has not elaborated on where the attacks are targeting. Despite Texas’s success in preventing attacks, hackers were able to successfully hack into the U.S. Depository Library Program earlier this week. As we have mentioned in prior comments, warfare is much more likely to happen with computer viruses than with bombs. Hence, we do not expect Texas to be the only state affected going forward.
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA
[Posted: 9:30 AM EST]
Financial and commodity markets are rather quiet this morning as we await Iran’s response. Investor sentiment is starting to recover as risk assets are recovering. China reported its foreign reserves. We are watching a new pneumonia emerging from China. As a side note, Kenny Loggins is 72 today. Here are the details:
Iran: Other than confusion over the U.S. troop presence in Iraq, there wasn’t much news overnight. The U.S. is further bolstering its presence in the region, adding B-52s and more troops. We suspect this action is designed to give the U.S. tools to respond to any Iranian response. Oil prices have started to retreat after initially rising. As we noted yesterday, the key to a sustained rise in oil prices is the triggering of hoarding. If that fails to occur, it is unlikely that oil prices can move significantly higher. Global demand is modest at best and supply, including what OPEC has in excess capacity, is ample. Obviously, all that changes if Iran does something that seriously disrupts oil flows. Still, in the absence of any sort of attack, it will be difficult to hold prices at current levels. However, that doesn’t mean other effects aren’t starting to show up; farmers are worried that wheat sales to the region could be affected.
China: There were a few items of note. First, China is grappling with an outbreak of a new respiratory illness. So far, nearly 60 people in the city of Wuhan have been officially diagnosed with this disease. The worry is that this event could resemble the SARS virus in 2003; medical officials in Hong Kong and Singapore have issued health alerts. SARS had a noticeable, but short term, effect on China’s economic growth.
We have placed a vertical line representing the SARS outbreak. Second, foreign reserves rose in December, to $3.108 bn, up $12 bn and mostly on forecast.
Third, China has indicated it won’t increase its grain quotas, raising questions about how the country will meet the requirements of the Phase One deal. It is possible that the U.S. will get the bulk of the quotas and other suppliers will lose market share, but it also could mean that China has no intention to meet the terms of the upcoming agreement.
Fourth, Indonesia is standing up to the China’s incursions into South China Sea. China considers all the waters in the “first island chain” as under its control. Although we doubt Indonesia can withstand China’s efforts alone, with allies, the country may be able to help contain China’s behavior in the region.
Fifth, Chinese financial regulators are moving to direct household saving into the Chinese equity market. Although Chinese investors can certainly invest now, the directive, which didn’t have any details, could be similar to a forced program to change household saving patterns. Chinese households have tended to prefer real estate for excess saving; this program could force diversification on that saving. It could also cool a real estate market that has been prone to overheating and support the conversion of corporate debt to equity (firms could issue stock to pay down debt). This may be a plan to address China’s debt overhang (with the risk being born by households). This action could be bullish for Chinese equities.
Spain: It appears that PM Sanchez has been able to form a government with the populist left Pademos Party, making Spain one of the rare left-wing governments in Europe. However, the coalition doesn’t have a majority and will depend on support from several small parties to govern. We doubt this arrangement will hold for very long.
United States-France: U.S. Treasury Secretary Mnuchin and French Finance Minister Le Maire have agreed to work on a compromise over France’s new tax on digital services offered by big U.S. technology firms. The attempt at compromise aims to avert the prospect of new U.S. retaliatory tariffs of 100% on certain French goods.
Venezuela: A day after police barred opposition leader Juan Guaidó from entering the National Assembly and legislators voted to replace him as their leader, Vice President Pence reiterated the U.S. position that Guaidó is Venezuela’s “only legitimate” leader. However, it is still unclear how much political support Guaido retains after his effort last year to oust President Maduro petered out.
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA
[Posted: 9:30 AM EST]
Happy Monday! It’s another risk off morning, as issues surrounding Iran dominate the news and the markets. We update the situation in the Middle East this morning. In other news, Hong Kong has a new administrator and Phase One of the U.S./China trade deal should be signed by the 15th. Here are the details:
Iran’s retaliation—we expect Iran’s retaliation to the event to be potentially broad. We list some of the potential areas of risk below:
Iran announced it is essentially ending the Joint Comprehensive Plan of Action, commonly known as the Iran Nuclear deal. This is no huge shock; Iran had been slowly violating the terms of the agreement in response to U.S. sanctions. However, officially ending it does have ramifications. If Iran “sprints” toward developing a deliverable nuclear weapon it will likely force Israel to at least consider direct air strikes on suspected nuclear sites. In the past, an Israeli attack was difficult to coordinate as the raid would have to use airspace of unfriendly nations. However, under the current situation, we would expect Saudi Arabia to be more than open to allowing overflights. We should also note that “deliverable” doesn’t necessarily mean a warhead on a missile; Iran might have a device it could detonate at ground level, carried by a proxy. This plan would have its own complications but can’t be completely ruled out. A “dirty bomb” could be used as a terror weapon against targets in the region.
Gulf shipping could be at risk. Although we believe that Iran can’t permanently close the Persian Gulf, it could reduce oil flow for a few months and push oil prices much higher.
There could be a more serious attack on Saudi oil facilities. Although the last attack was serious, it could have been much worse, and it is possible Iran “pulled its punch” on this attack to avoid escalation. Escalation now may be the watchword.
We would expect a cyberattack against the U.S. and allies. Although historical analogies are never perfect, the divergent interests and interlocking relations in the Middle East is somewhat similar to Europe prior to WWI. The trigger for that war was the assassination of the Austrian archduke and his wife, caused, in part, by complicated Balkan politics. What turned a regional issue into a massive war was outside power involvement. We don’t expect outside powers to come to Iran’s aid. Although China and Russia have somewhat friendly relations with Iran, they probably won’t risk war with the U.S. to support Iran. However, we would not be shocked to see Russia, China, and maybe even North Korea support Iran in a cyberattack on the U.S. This support is possible because attribution of cyberattacks can be very difficult. Thus, these outside powers could “cover their tracks” behind an Iranian effort and act as a force multiplier. There is already evidence that Iran is taking action in the cyber theater. Researchers at cybersecurity firm FireEye and the think tank Atlantic Council say they have already found evidence that Iran has stepped up its use of social media accounts to spread pro-Iran propaganda following Soleimani’s killing.
We would expect Israel to become a target for Iranian proxies. Hezbollah has been cautiously avoiding triggering a war with Israel; but this event may remove that caution.
We would also expect a global assassination effort against American military, business and political officials. Historically, Iran and its proxies have been very effective in the Middle East in these efforts. They also had success in South America, some in Europe, but little in the U.S. Thus, Americans overseas are likely now targets.
What we don’t expect is a conventional military response. Iran’s conventional military power is limited and not all that effective. Although it can’t be completely ruled out, an invasion of Iran is highly unlikely as is conventional warfare by Iran against its neighbors, excepting naval action in the Persian Gulf.
Iraq is at the crossroads—Iraq’s underlying problem is that it was never a normal nation, but a colonial construct. For most of its history it was ruled by a Sunni minority and doesn’t have a natural basis for nationhood. The more Iran pressures Shiites in Iraq to participate in actions against the U.S., the more Sunnis and Kurds will be open to separation from Baghdad. The decision over the weekend by the Iraqi Parliament to demand the U.S. troops leave Iraq was not binding and only occurred because Sunni and Kurdish lawmakers didn’t participate in the voting. It is important to remember that the rise of Islamic State was supported by Sunnis in eastern Syria and Western Iraq and another Sunni state could emerge there if Iranian pressure becomes overbearing.
Oil is the key risk—since the early 1980s, geopolitical oil disruptions have become relatively short term in nature. Even the Gulf War didn’t keep oil prices high for more than a few months. The memories and historic gasoline price hikes and the notorious gas station lines are fading from the collective memory as baby boomers age. We have seen a steady stream of pundits in the financial media telling us that oil is nothing to worry about. If there is going to be a problem, it will come from hoarding. Under conditions of supply uncertainty, consumers will hold oil for precautionary purposes, driving up demand and prices. If the uncertainty is high enough, it can lead to excessive price increases, well beyond what inventory levels would suggest.
This chart shows the price of West Texas Intermediate with U.S. commercial crude oil stocks. Under normal circumstances, inventory represents the difference between supply and demand, and so there should be an inverse correlation between stockpiles and price. In other words, rising inventories should bring lower prices and vice versa. However, under conditions of hoarding, some of the inventory build represents precautionary demand and the correlation can turn positive. The chart above shows the relationship of these two variables since 1973, when OPEC became the global swing producer. Although the majority of the time the correlation is inverse, there have been significant periods of positive correlation, especially in the 1970s into the mid-1980s. In this period, unrest in the Middle East (two wars, the Yom Kippur War and the Iran-Iraq War, the Iran Revolution) led to constant fears of supply shortages and hoarding behavior. We also saw a short period of positive correlation from 2003-07, on “peak oil” fears and the rapid rise of Chinese oil demand.
The West has several tools available to dampen hoarding activity. First, the OECD nations and China have strategic reserves which, in theory, can be used to distribute supply globally to dampen hoarding. Second, the rise of U.S. shale production has created an important supply buffer outside the Middle East, where the vast majority of OPEC’s excess oil capacity resides. These may be enough to prevent hoarding. However, there is potential that these two factors may fail to prevent the hoarding instinct. First, the strategic reserves work because in a crisis, the OECD, through the IEA, would take control of national strategic reserves; in other words, the IEA could demand the U.S. sell oil to Panama from the U.S. SPR. This program has never actually been executed, but in the current nationalist environment, we think the odds of U.S. taxpayer provided oil being sold outside the U.S. to prevent hoarding in Central America is extremely unlikely. Second, the shale oil supply only dampens hoarding if it is available for export. In the case of a supply emergency, the temptation to close off American oil exports will be very high. Thus, WTI prices might stay low relative to world prices, but global prices, represented by Brent, might soar. The potential for oil prices disrupting global economic growth is probably as high now as it was in the 1970s. And so, the “playbook” of assuming that geopolitical events in the Middle East only have a short-term impact on oil prices, the pattern seen since 1985, may not be as operative as the parade of analysts on the financial media seem to think.
S. is going mostly alone–British Prime Minister Johnson, German Chancellor Merkel and French President Macron issued a joint statement calling for de-escalation of the U.S.-Iran conflict. After U.S. Secretary of State Pompeo complained that the Europeans weren’t being supportive enough following the assassination of Iranian Revolutionary Guards General Soleimani, British officials offered tacit approval of the U.S. action. All the same, reports indicate the British were given no advance warning of the assassination. We suspect they found that perturbing, as it meant they couldn’t move their hundreds of troops and contractors in Iraq out of harm’s way beforehand.
China-Hong Kong: The Chinese government replaced its top representative in Hong Kong with Luo Huining, a former provincial leader who is expected to be tougher on the city’s continuing anti-China protests. Even though Beijing’s many similar baby steps haven’t led to a bloody confrontation, or clampdown yet, such a move is likely to keep alive the risk of such an outcome, so it will probably be negative for Hong Kong stocks.
Venezuela: Opposition leader Juan Guaidó, who as head of the National Assembly declared himself interim leader of the country last year, was voted out of his legislative role and replaced by opposition deputy Luis Eduardo Parra. Ahead of the vote, police prevented Guaidó and his supporters from entering the legislative building, prompting U.S. Secretary of State Pompeo to accuse President Maduro of orchestrating the vote through an “undemocratic campaign of bribery and intimidation.” Guaidó’s supporters then held an impromptu vote to re-elect him, but it is not clear whether he will retain the confidence of the country’s anti-Maduro forces. We would score this as at least a short-term win for Maduro that will prolong Venezuela’s misery.
Turkey-Lebanon: President Erdogan said Turkey has already started sending soldiers to Libya to help its UN-backed government fend off rebel attacks, in defiance of President Trump’s call last week for Turkey to stay out of the conflict. Erdogan insisted the Turkish troops would have no direct combat role, suggesting their Syrian militia allies would lead the fighting.
India: In a sign that Prime Minister Modi’s Hindu nationalist movement is gathering force, a mob of Hindu rightwing activists stormed India’s most prestigious secular academic institution, Jawaharlal Nehru University, and commenced beating students and faculty members they accused of being insufficiently nationalist. It’s not clear whether the storming was sanctioned, or organized by Modi’s Hindu nationalist government, or whether it was spontaneous. In either case, accumulating incidents like this point to a potentially destabilized social situation that could eventually be negative for Indian stocks.
Global Cocoa Market: In devastating news for the world’s chocolate lovers, the West African countries of Ivory Coast and Ghana have agreed to form a cocoa cartel and will try to boost the price of the main ingredient of chocolate to $2,900 per ton from the current $2,500 per ton. Together, the two countries produce almost two-thirds of the world’s cocoa, so market participants are anticipating prices will rise substantially.
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