by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA

[Posted: 9:30 AM EST]

The fifth episode of the Confluence of Ideas podcast has been posted.  “Arriving at Decisions” examines the issues that surround making decisions under conditions of uncertainty.

Happy Friday!  With the world still in New Year’s holiday mode, there’s little interesting news in most countries, but that doesn’t include Iran and Iraq.  In what’s likely to be a watershed moment for the whole Middle East, yesterday the United States assassinated one of Iran’s most important and influential military leaders as he traveled to the airport in Baghdad.  As discussed below, that’s likely to produce an ongoing risk of retaliation, escalation and miscalculation.   Here’s our take on what’s happening:

United States-Iran: Overnight, a U.S. airstrike ordered by President Trump killed Qassem Soleimani, the chief of the Iranian Revolutionary Guards’ foreign forces.  Also killed was Abu Mahdi al-Mohandes, the deputy commander of an important Iran-allied militia force in Iraq.  The action took place in Baghdad as the two were driving to the city’s airport.  Justifying the strike as defensive, the Pentagon said Soleimani was actively developing plans to attack U.S. diplomats and service members in Iraq.  Meanwhile, Al-Mohandes’ militia had been harassing U.S. forces in Iraq, including this week’s attempt to storm the U.S. Embassy in Baghdad.  With Iran already suffering mightily from the U.S. sanctions against it and its nuclear program, and with many Middle Easterners starting to push back against Iran’s interference in their countries, the blatant assassination of such an important, high-level Iranian official is certain to invite retaliation.  Supreme leader Ayatollah Ali Khamenei has already vowed “tough revenge.”  A key question for the future is what that revenge will look like:  A military strike on Saudi Arabia, or Israel?  Assassination of a CIA station chief, or U.S. military officer?  Disruptive computer hacking?  The increase in tensions and the risk of escalation, or miscalculation have already driven up oil prices and sparked heavy buying of safe-haven assets like gold and government bonds, while global equities are falling so far today.  However, it’s important to remember that any Iranian revenge attack may come with a lag.  If that happens, investors could soon be lulled into a false sense of security.  This might allow risk assets to recover and safe-haven assets to sell off again, but the reality is that Iranian mischief could come out of the blue at any moment, just like the missile that killed Soleimani and Al Mohandes.

United States-Turkey-Libya:  In a call yesterday, President Trump warned Turkish President Erdogan against sending troops to Libya to support its UN-backed government.  Official U.S. policy is to support the government, but Trump has expressed sympathy for warlord Khalifa Haftar, who is trying to overthrow it with the help of Egypt, Saudi Arabia and Russia.

United States:  Despite the euphoria in the financial markets as the New Year trading began yesterday, it’s important to remember there are not just geopolitical risks, but also some lingering economic risks to keep in mind.  For example, it’s still possible that the Fed’s interest-rate cuts last year may have come too late.  Separately, the Philadelphia Federal Reserve has issued a report noting that nine states are expected to be in recession in 2020, including Pennsylvania, New Jersey, Delaware, West Virginia, and Iowa.

Australia:  The nation’s massive wildfires are intensifying again as hot, windy conditions return.  Today the Australian navy began evacuating thousands of people stranded in tourist towns along the country’s eastern coast, and Victoria’s territorial government has declared a state of emergency.  Importantly, Prime Minister Morrison continues to take blame for heading off to Hawaii for a vacation in the midst of the crisis.  During his visit to New South Wales after his return, residents reportedly refused to shake his hand and forced him to retreat to a car amid strong heckling and swearing.  It’s too early to know exactly how much the disaster will impact Australia’s economy, or political stability but there does appear to be a significant risk to Australian assets.

Mexico:  Banco de Mexico yesterday released the minutes from its December policy meeting, with the document showing officials were concerned that a 20% hike in Mexico’s minimum wage scheduled for January 1 would increase price pressures, even though last year’s 16% hike of the minimum wage didn’t prevent a steep drop in inflation.  The policymakers did decide to cut their benchmark short-term interest rate to 7.25%, compared with 7.50% previously, but the cut was seen as timid considering the way Mexican inflation has recently been cooling.

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by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA

[Posted: 9:30 AM EST]

The fifth episode of the Confluence of Ideas podcast has been posted.  “Arriving at Decisions” examines the issues that surround making decisions under conditions of uncertainty.

Happy New Year everyone! Global equities began 2020 with a bang, as markets responded favorably to news that the People’s Bank of China will increase the supply of cheap funding to banks. In addition, the euro weakened against the dollar after weak manufacturing PMI data from Italy and Germany elevated fears that the Eurozone is heading for another year of anemic growth. Here is what we will be watching today:

S&P 500: In 2019, S&P 500 had its highest annual return since 2013, rising 28.9% from the prior year. A reversal of Federal Reserve policy, abated fears of an earnings recession as well as a thaw in trade tensions were likely the biggest contributors to the rise in returns. Furthermore, it is also worth noting that the index likely benefited from a time period bias due to a series of negative market events taking place toward the end of 2018. These events included: A Fed rate hike, a government shutdown and rising tariffs on Chinese and U.S. goods. To say that investors were pessimistic in the beginning of 2019 would be an understatement. That said, we believe that despite the rise in optimism there are still some reasons to be a bit cautious going into 2020.

Here are our concerns:

• Rising wages and the resumption of tariffs will likely weigh on corporate profits in 2020. Therefore, it will likely be very difficult for the market to avoid an earnings recession if firms don’t start raising prices.

• It will be a while before we know whether the Federal Reserve lowered rates in time to avoid a recession. As we have mentioned in prior reports, a common misconception is that a yield curve inversion signals a recession. In reality, it is the reversal of the inversion that signals a recession is imminent as shown in the graph below. In fact, a recent survey from the Conference Board showed that U.S. chief executives are concerned about a recession taking place in 2020.

 

• Lastly, if a series of negative market events toward the end of 2018 led to a surge in 2019, it is logical to assume that a positive market event such as the Phase one trade deal toward the end of 2019 will make it unlikely that a rise of similar magnitude will take place toward the end of 2020. In fact, given the volatile nature of this trade war, we wouldn’t be surprised if there is a snapback in trade tensions sometime this year.

People’s Bank of China: On Wednesday, China’s central bank reduced its reserve requirements for banks and signaled that it will continue to lower borrowing costs for businesses. This move by China is designed to bolster its economy after several years of slower growth by boosting investment. Recently, China has encouraged banks to lend to more small businesses. In March 2019, the Chinese government set out a goal to boost small business financing by 30 percent. In order to reach these goals Chinese banks have increased lending to subprime borrowers, as many of the credit-worthy businesses have been reluctant to borrow. Although default rates have skyrocketed over the past three years, it is not a huge market concern at this time. That said, it is something that we are monitoring closely.

Odds and ends:  Tensions between the U.S. and Iran have escalated after protesters sieged the U.S. Embassy in Baghdad. North Korean leader Kim Jong-un announced that his country will abandon a self-imposed moratorium on testing nuclear weapons and long-range ballistic missiles. Israeli Prime Minister Benjamin Netanyahu is seeking immunity from corruption charges as the country prepares for another round of elections.

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by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA

[Posted: 9:30 AM EST]

N.B.  A couple of items.  First, the Daily Comment will go on hiatus from Dec. 23, 2019, to Jan. 1, 2020.  Publication will resume on Jan. 2, 2020.  Second, the fifth episode of the Confluence of Ideas podcast has been posted.  “Arriving at Decisions” examines the issues that surround making decisions under conditions of uncertainty.

Happy Friday!  In fact, it should be an especially happy day, as several important uncertainties are formally being removed.  The House has given its OK to the U.S.-Mexico-Canada trade deal, and the Senate has approved funding for the federal government for this fiscal year.  In the U.K., parliament is formally debating Brexit and is expected to pass the deal easily.  Here’s what we’re watching today:

United States-Mexico-Canada:  The House of Representatives yesterday voted 385-41 to approve the “USMCA” trade agreement.  The update to NAFTA will now need to be approved by the Senate, most likely early next year.  The Canadian parliament also still needs to approve the deal, but as of yet there is no set schedule for a vote in either of its chambers.  Only Mexico has approved the deal so far, but since the United States and Canada are both expected to follow suit, it appears that the uncertainty regarding North American trade is dissipating, which is probably one key reason for the ongoing rally in stocks.

U.S. Federal Budget:  The Senate has approved the two appropriations bills necessary to fund the federal government through the fiscal year ending September 30.  If President Trump signs the bills before the end of today, as expected, there will be no new government shutdown.  The news is likely to be positive for stocks as it removes yet another potential source of uncertainty.

United Kingdom:  Parliament today began debating Prime Minister Johnson’s Brexit withdrawal deal with the EU.  The bill is widely expected to pass with a comfortable majority, helping to remove a bit more uncertainty regarding Brexit.  That’s likely a positive for European stocks, although it’s important to remember that there is growing concern that Britain may not be able to secure attractive trade deals with the EU, or the United States in the coming year or so. Separately, the government announced that the new head of the Bank of England will be Andrew Bailey, a longstanding official at the central bank who is currently the head of its regulatory office.  The well-respected Bailey is considered a “safe pair of hands,” so the decision is likely to be positive for British assets.  All the same, it is still not clear where he will take British monetary policy when he officially assumes his post on March 15.

U.S.-China Trade:  Chinese leader Xi Jinping reportedly doesn’t plan to attend January’s World Economic Forum meetings in Davos, Switzerland.  That eliminates one potential venue for him to meet President Trump for a formal signing of the “phase one” U.S.-China trade deal.  However, China still plans to send its top trade negotiator to Washington in January so he can sign the deal.

European Union-China:  The new president of the European Council, Charles Michel, said he will push the EU to prioritize deeper economic ties with China while also protecting its own markets.  In doing so, he vowed that the EU’s international trade policies would not be dictated by the United States.  The statement amounts to pushback against U.S. efforts to re-set relations with China, but it also reflects the slow-growing EU’s reliance on exports.

India:  Thousands of Muslims and social activists today staged another round of protests against Prime Minister Modi’s new, Hindu-friendly citizenship law, in defiance of the government’s ban on public gatherings.  It still seems Modi will eventually get control over the protests (especially because of his clampdown on the internet and communication services yesterday).  That helps explain why Indian stocks have been able to push to new record highs this week.  However, today’s defiance against the public-meeting ban suggests he still has his work cut out for him.

Lebanon:  Christian, Sunni and Shiite political leaders (including Hezbollah) have agreed that the country’s new prime minister will be Hassan Diab, a former education minister who is now the vice president of Lebanon’s top university.  As described in our WGR from December 2, Lebanon’s “confessionalist” power-sharing system requires the prime minister to be a Sunni Muslim, but many parliamentary Sunnis refused to vote for Diab, suggesting the real winners in the negotiations were Hezbollah, the Maronite Christians and maybe even the youthful demonstrators that brought down the former prime minister two months ago.  Since the move helps reduce uncertainty regarding Lebanon, there is still no firm news on what Diab will do to address the country’s financial and debt crisis.

North Korea:  Thousands of North Korean laborers are streaming out of Russia ahead of a Sunday deadline to avoid UN sanctions.  The exodus will end one of North Korea’s last remaining sources of foreign funds.  It may therefore help stoke the country’s recent new provocations aimed at the United States.  Reports indicate U.S. intelligence is closely monitoring North Korea for a potential Christmas Day missile launch.

U.S. Junk Bond Market:  Moody has issued a report warning that this year’s rally in low-rated bonds has left them vulnerable to a significant fall in value next year.  As shown in the charts near the end of this article, U.S. high-yield bonds have provided a total return of 13.97% for the year through yesterday.  With the Fed’s 2019 interest-rate cuts, the recent improvement in some economic indicators and the new easing of global trade tensions, some of that strong return may well be justified.  However, according to Moody, “If the anticipated improvement in fundamentals governing corporate credit do not materialize, a significant widening of high-yield bond spreads is likely.”

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by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA

[Posted: 9:30 AM EST]

N.B.  A couple of items.  First, the Daily Comment will go on hiatus from Dec. 23, 2019 to Jan. 1, 2020.  Publication will resume on Jan. 2, 2020.  Second, the fifth episode of the Confluence of Ideas podcast has been posted.  “Arriving at Decisions” examines the issues that surround making decisions under conditions of uncertainty. 

Good morning, possibly at the dawn of a new era of non-negative interest rates . . . or at least that’s a possibility given today’s news out of the Swedish central bank, as discussed below.  There’s also more evidence that any end to the world’s negative interest rates may be matched by a revival of fiscal stimulus.  Here’s what we’re watching today:

Sweden:  In a sign that the era of negative interest rates may be ending, today the Swedish central bank raised its benchmark short-term interest rate to 0% from -0.25% previously.  Even though Swedish economic activity has been cooling in recent quarters, the policymakers justified the rate hike by citing the widespread worry that negative rates, which have prevailed in Sweden since 2015, could be distorting the financial markets and might be encouraging undue risk-taking.  The policymakers indicated they would be open to cutting rates again if necessary, but they said the more likely scenario would be for rates to stay at 0% for a long time, especially since inflation-adjusted rates remain sufficiently negative to support growth.  European bonds are selling off and yields are rising on concerns that the Swedish move could be the beginning of a trend, even though the Bank of England today held its benchmark rate steady at 0.75%, and the Bank of Japan held its key rate at -0.1%.

European Union:  Even as the era of negative interest rates may be ending, we’ve been noting a gradual shift in policymakers’ openness to looser fiscal policy, i.e., increased government spending, wider deficits and increased debt.  The latest evidence of that came today in a speech by the EU’s new economics Commissioner Paolo Gentiloni.  In the speech, Gentiloni warned that the EU’s strict budget rules, if they were fully enforced, would be inconsistent with the region’s current low-growth, low-inflation environment.  According to Gentiloni, “it may not be a problem in a normal macroeconomic environment, but, as I have said, the conditions that we are living through are not normal.”  Gentiloni also said he would begin a review of the EU’s deficit rules in early 2020.  Coupled with Bundesbank President Weidmann’s recent warning against a balanced-budget “fetish” in Germany and the return to fiscal stimulus in Japan, this could well be a trend worth watching.  Looser fiscal policy would likely help boost growth in developed countries in the near and medium terms, though with increased debt risk over the longer term.

France:  Seeking to end the mass protests and strikes against his proposed pension reform, President Macron said he would be open to delay boosting the retirement age to 64 from the current 62 if another way can be found to balance the books.  Government officials have been discussing the idea with union leaders yesterday and today.  We view the proposal positively because even if the age provision has to be delayed in order to end the protests, the rest of the reform is focused on providing much-needed simplification and efficiency.

United Kingdom:  Former shadow foreign secretary Emily Thornberry said she will be a candidate to replace Labour Party leader Corbyn.  At least two other shadow ministers, Keir Starmer and Rebecca Long-Bailey, are expected to throw their hats into the ring in the coming days.  While Labour will be in no position to exercise much influence in the new parliament, its focus now will be on how to rehabilitate itself for the future.  The key question that party members are mulling over is whether to stick with Corbyn’s radical agenda or shift to the center.

China:  Even as the markets have rallied on the easing of U.S.-China trade tensions (including China’s announcement today of tariff exemptions for certain U.S. chemical and petroleum goods), it’s important to remember that China is still working to assert itself in other spheres.  This week, the Chinese navy commissioned its first domestically-built aircraft carrier, the Shandong.  New reporting indicates that in the event of war with Taiwan, the Shandong is primarily meant to bottle up U.S. bombers in Japan and Guam while China’s other carrier, the Russian-built Liaoning, provides air superiority over Taiwan itself.

Russia:  President Putin today is holding his annual marathon news conference.  In noteworthy statements so far, Putin refused to say whether he might try to stay in power beyond the official end of his term in 2024, and he defended the recent law that he signed to deem certain media outlets as “foreign agents.”

India:  Protests against Prime Minister Modi’s new citizenship law continue, prompting the government to shut down communication services and prohibit public gatherings in locations around the country.  Police have reportedly arrested hundreds of protestors, but it still looks like the pushback against the law is limited mostly to Muslims.  The government’s clamp down on communications and public gatherings therefore has a good chance of keeping the tensions under control.  As if to confirm that, Indian stocks rose to yet another record high today.

United States-South Korea:  U.S. and South Korean negotiators failed to reach an agreement on cost sharing for the U.S. troops stationed in South Korea, but the U.S. side hinted it would no longer stick to President Trump’s demand that Seoul quintuple its contribution to $5 billion per year.  If the U.S. side backs off that number when the negotiators next meet in January, it would likely help improve relations between the two countries, and allow them to focus more strongly on the reviving threats and provocations from North Korea.

U.S. Investment Regulation:  Yesterday, the SEC approved a proposed rule that would expand the number of people allowed to invest in private securities, private equity funds and hedge funds.  For example, the rule would allow such investments by people with a basic broker’s license, even if they don’t meet the annual income threshold of $200,000 or the net assets threshold of $1,000,000.

Energy update:  Crude oil inventories fell 1.1 mb compared to an expected draw of 1.8 mb.

In the details, U.S. crude oil production was unchanged at 12.8 mbpd.  Exports rose 0.2 mbpd while imports fell 0.3 mbpd.  The decline in stockpiles is near expectations.

This chart shows the annual seasonal pattern for crude oil inventories.  The early winter draw season is underway and will continue into early 2020.

Based on our oil inventory/price model, fair value is $58.54; using the euro/price model, fair value is $50.23.  The combined model, a broader analysis of the oil price, generates a fair value of $52.35.  We are seeing the divergence between the dollar and oil inventories narrow as the dollar weakens.

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by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA

[Posted: 9:30 AM EST]

Good morning, all. So far, the overnight news has been relatively mum as fears of an ongoing trade war appear to be dissipating. Meanwhile, rising concerns of a “hard” Brexit have weighed on the pound. Below are the stories we will be following today:

Weaker dollar in 2020: Following the agreement of the “phase one” trade deal, there has been a growing consensus that the U.S. dollar will likely weaken in the coming year. As we have written in previous reports, one of the setbacks of imposing tariffs is that it generally leads to currency strengthening. There are a few possible explanations for this:

1. Targeted countries may decide to weaken their currency through easy monetary policy, which would therefore soften the impact of the tariffs.
2. If tariffs are successful at getting countries to purchase more U.S. goods, it will lead to a boost in demand of the U.S. dollar and result in U.S. dollar appreciation.
3. When tariffs adversely hurt a country’s economy, it can lead to capital flight in which foreign investors seek refuge by purchasing assets in another country, thereby leading to currency depreciation in the host country.

That being said, a rollback of some tariffs should lead to a weakening of the dollar as investors attempt to move away from U.S. assets, which are generally considered havens. Furthermore, if this trend persists it will likely be bullish for foreign equities.

The chart above shows the year-over-year change in the Real FRB Broad Trade-Weighted Dollar Index. The index measures the strength of the U.S. dollar relative to the currencies from 26 of the country’s most important trading partners. The trend spiked in the beginning of the year but has been slowing down since April.

China agriculture purchases: There are growing concerns that the partial trade pact may not live up to expectations. In the trade pact, China has agreed to purchase at least $40 billion worth of agricultural products annually over the next two years; this would almost double its largest purchase order of nearly $25 billion in 2013 and 2014. The biggest concern about the deal is that it has not been formally put on paper; therefore, it is difficult to discern where China will make purchases. Despite the need for pork and soybeans, skeptics wonder whether China has a need for $40 billion worth of agricultural goods and may try to make up for it by purchasing non-agricultural products such as crude oil and natural gas. At this time, the formal written agreement is under review, so the commitment has yet to be finalized. Nevertheless, unless there is something in the agreement that leads investors to believe this deal will not hold, we expect the agreement to have little effect on equities.

Fears of manufacturing slowdown: Despite the reduction in global trade tensions, there are growing fears that manufacturing production will not pick up as fast as many would hope. On Tuesday, Boeing (BA, 327) announced that it will be halting its production in January of one of its flagship products, the Boeing 737 Max, as it undergoes regulatory reviews following crashes of two of its planes. Arguably the biggest U.S. manufacturing exporter, the company’s decision to halt production is expected to have an impact on the economy. Earlier this year, the company reduced its production of the plane from 52 per month to 42, resulting in a slowdown of durable goods orders. Accordingly, the halt is expected to result in a slowdown in inventory accumulation for Q1 2020 but will likely spike whenever the company decides to restore production.

Odds and ends: The U.S. has given up its efforts to stop the Nord Stream 2 gas pipeline. Brazilian equities have been hit due to concerns about the country’s economy. Data released by the BLS showed that many of the counties the president carried in the 2016 election were arguably in recession at the time.

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