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

[Posted: 9:30 AM EST]

Good morning from snowy St. Louis!  It’s a relatively quiet morning, but there are some developments to note.  It turns out the risk of a hard Brexit hasn’t entirely been eliminated, and French unions are threatening to play the Grinch for Christmas.  Fortunately, fiscal policy and the financial markets look better here in North America.  Here’s what we’re watching today:

United Kingdom:  Reports say Prime Minister Johnson this week will propose legislation prohibiting any extension of the Brexit transition period beyond the end of 2020, even though the exit deal with the EU allows for such an extension if a new U.K.-EU trade deal isn’t finalized by then.  Officials close to Johnson say the proposal merely encapsulates the prime minister’s promise to “get Brexit done.”  However, it’s probably also aimed at boosting the U.K.’s leverage in its upcoming negotiations with the EU for a permanent trade deal – negotiations in which the much larger EU is likely to have the upper hand.  The problem is that negotiating the new deal will be complex and time consuming.  There’s no guarantee that a deal can be put into place by the end of 2020, so any law prohibiting an extension creates a new risk that U.K.-EU trade would suddenly revert to WTO rules, with the U.K. facing tariffs, quotas and other barriers to its Europe-bound exports.  Both British stocks and sterling are therefore down sharply so far today.

France:  Just as unions were preparing to launch today’s latest round of massive protests against President Macron’s proposed pension reform, his hand-picked pension commissioner in charge of the effort was forced to resign for not disclosing almost a dozen paid and unpaid roles in the private sector.  Given the need for France to streamline its pension system, the news is likely to be negative for French assets today.  It also appears the news has emboldened labor leaders, with the chief of one major union issuing a veiled threat to cause massive disruptions over the Christmas holiday next week.

U.S.-China Trade:  Despite the euphoria over last week’s “phase one” U.S.-China trade deal, NAFTA update and U.K. election, it’s important to remember that we’re now in the period where people start focusing on the details and how things will actually play out.  That will inevitably cause some second-guessing and reassessments, which will impact the markets.  Today, for example, there are reports that one way China plans to show a boost in its U.S. imports is to lift its trade war tariff on fuels, and re-route some $10 billion in ethanol imports so they come directly to China, as opposed to being transshipped through Hong Kong.

U.S. Repo Market:  In an important sign that the Fed may have gotten its hands around the issues in the short-term borrowing market, the overnight repo rate barely budged yesterday, even though it was the deadline for quarterly corporate tax payments, and settlement day for recent Treasury bond issues.  When those issues last popped up in mid-September, overnight rates spiked to above 10%.  The Fed responded by flooding the system with cash in the form of short-term loans, which has not only appeared to calm the market down, but will probably also provide a boost to the economy and the broader financial markets.  Add that to the list of uncertainties that have been lifted in recent days (U.S.-China trade, the NAFTA update, and Brexit), and it should be no surprise that the equity markets performed so strongly yesterday.

U.S. Government Budget:  Democratic and Republican leaders in Congress have agreed on a $1.3-trillion package of appropriations to fund the federal government through the rest of this fiscal year, which ends September 30.  The bill would boost discretionary spending by almost $50 billion over last year’s level.  Assuming Congress can soon get the appropriations passed into law as planned, that should avert the threat of a partial government shutdown starting on Friday, so the news is likely to be market friendly.  We note that the legislation includes several other interesting provisions.  For example, it would require IRA investors to start taking their minimum required distributions by the age of 72, rather than 70-1/2 currently.  It would also raise the minimum age for purchasing tobacco products to 21.

Canadian Government Budget:  Canadian Finance Minister Morneau issued updated economic and fiscal forecasts showing the government will tolerate much bigger deficits for the next four years.  In part, the decision to loosen fiscal policy reflects the challenges of running a minority government that relies on the support of left-leaning parties.  More broadly, the move provides additional evidence that governments around the world are warming to the idea of spending more to boost growth, especially now that loose fiscal policy is seen as becoming less effective.  Bigger budgets may very well help goose growth and boost asset prices, though at the expense of higher debt levels later on.

United States-Mexico-Canada:  In an effort to diffuse Mexico’s anger over a provision in the USMCA bill making its way through Congress, U.S. Trade Representative Lighthizer said labor disputes under the new trade deal will still be adjudicated by an independent panel, as agreed to by the United States, Mexico and Canada last week.  According to Lighthizer, the U.S. labor attaches would merely offer “technical assistance” when disputes arise, rather than acting as independent inspectors.  Mexican trade negotiator Jesús Seade said he was satisfied with the U.S. response.  That should help ensure U.S. approval of the deal can happen this week, which should be positive for U.S., Mexican and Canadian equities.

Germany:  Even though Chancellor Merkel’s open-door immigration policy at mid-decade generated intense popular pushback and helped spark the rise of populist leaders throughout Europe, continued economic growth and low unemployment could be reversing the tide.  Against a backdrop of worsening labor shortages, even as growth slows, the Merkel government yesterday held a “skilled labor summit” to discuss ways to bring foreign workers to Germany from outside the EU.  In spite of the political cost of the immigration policy in recent years, Merkel was sufficiently emboldened to say, “What is really important is that we are seen in third countries as a country that is open to the world and interested.”  Just as notable, Finance Minister Scholz said, “We have accepted that we are a country of immigration.”  It’s important to remember that Merkel is a lame duck, so such statements probably have limited political cost for her.  All the same, it will be interesting to see if skilled worker shortages reduce anti-immigrant sentiment and the appeal of populists in Germany, or elsewhere.

Argentina:  The new, leftist government of President Fernández proposed massive spending hikes and still more emergency taxes, including a 30% levy on all imports and a hike in personal wealth taxes.  That’s on top of the big export tax hikes for farm goods announced last weekend.  The moves, which appear to validate investor concerns about the government, are likely to be negative for Argentine stocks.

India:  Prime Minister Modi issued a strong defense of his new citizenship law, which has sparked mass protests across India because of its perceived tying of citizenship to religious affiliation, and discrimination against Muslims.  The statement did nothing to diffuse the protests.  If they continue and grow, the demonstrations could become a headwind for Indian assets.

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

[Posted: 9:30 AM EST]

Happy Monday!  Equities are lifting this morning on continued trade optimism, despite some creeping concerns.  Economic data around the world was mixed; solid for China, weak for the Eurozone.  More debt worries for China. Here are the details:

Trade:  First, the Phase One deal with China.  There is a lot of clutter to work through, but our bottom line is this—if China holds up its end of the bargain, Washington got the better of Beijing.  Here’s why:

1. China has agreed to buy a lot more of U.S. goods. Although there are reports of certain levels of agricultural purchases, the key phase is that China will “import various U.S. goods and services over the next two years in a total amount that exceeds China’s annual level of imports for those goods and services in 2017 by no less than $200 billion.”  Over the past two years, U.S. exports to China have run between $180 bn to $190 bn.  Essentially, China has agreed to boost imports by $100 bn per year over those elevated levels.  So, that would put exports around $280 bn.

Needless to say, that’s a lot.  To hit that number, China should buy lots of U.S. grain and meat products.  Energy too.  For now, China has a clear incentive to buy our commodity products because its food inflation is really high.  Additionally, because China has a two year window, it could be light next year with the promise of lifting purchases in 2021.  So, retaliation on this issue probably isn’t immediate.

2. China agrees to not manipulate its currency. That isn’t a huge “give up” because a weaker CNY creates problems for China.  Currency weakness increases capital flight and raises debt service costs for dollar-denominated debt.  So, Beijing is probably more comfortable with a stable CNY.
3. There is vague language about intellectual property and technology transfer. The language in the agreement, on its face, is a huge win for the U.S. as China supposedly agrees to give up its practice of forcing foreign firms to transfer technology.  However, the lack of details suggests this goal is aspirational and we would be shocked to see China meet U.S. demands on this issue.  If Phase One is going to fail, this is an area of risk.
4. There is also vague language about dispute resolution. There were no details.
5. For all this, the U.S. did not implement tariffs on Dec. 15 and reduced tariffs on $150 bn of Chinese imports from 15% to 7.5%. To put a fine point on it, the U.S. tariff reduction will increase Chinese imports by $10 to $15 bn and in return, the U.S. will increase exports to China by $120 bn.  If China abides by this deal, it is a huge win.  Which means, of course, that the likelihood of compliance is low.  The issue now becomes when does the Trump administration have enough evidence to say China is not meeting the terms of the deal and start putting tariffs back.  The fact that the USTR remains at his post means that if our assumptions are correct, China has to be aware that when they fail to live up to their agreements, Lighthizer will inform the president.  At the same time, we doubt President Trump will want to cause a tariff problem in an election year, so expect mostly trade peace in 2020.  On the other hand, 2021 is a different matter.
6. One final thing on China. We do expect Beijing to make a show of compliance by purchasing lots of U.S. agricultural goods and energy.  That will reduce buying from other nations.  Thus, South America, Indonesia and Australia may be adversely affected by the deal.

Meanwhile, on the USMCA, we noted last week that the AFL-CIO supported the trade agreement.  Of our group, the oldest has been in financial services since 1986.  In that time, we can’t remember American unions supporting any trade deal.  So, it was a bit of a shock to see U.S. unions in support.  Well, now we know why.  The U.S. slipped in a provision that will put U.S. officials in Mexico for the express purpose of monitoring labor conditions in Mexican firms.  Mexico isn’t pleased.  It is not clear how this issue will be resolved.   That’s not the only issue.  Canadian aluminum firms are not happy that they might face competition from Chinese aluminum imported into the trade bloc from Mexico.  Are any of these issues enough to scuttle the deal?  Both Canada and Mexico need the USMCA.  Sovereignty issues can make trade concessions difficult, but we do think that some sort of side arrangement on the inspectors might be enough to keep the deal on track.

China:  Adding to Friday’s positive news of a limited U.S.-China trade deal, Beijing released a trove of data suggesting its modest stimulus measures may have arrested, or even partially reversed its continuing economic slowdown.  Perhaps most important, November industrial production was up a much better-than-expected 6.2% year-over-year, marking its best annual gain since June.  November retail sales rose by a better-than-expected 8.0% on the year.  Fixed asset investment in January through November matched its recent pace with a rise of 5.2% from the same period one year earlier.  The figures should be positive for global equities today.

China debt:  We have been watching China’s debt situation for some time and, as discussed in our 2020 Geopolitical Outlook (out this afternoon), it is one of our key concerns for next year.  Over the weekend, an odd twist emerged.  Beijing has decided to drop a huge number of criminal charges against firms in the private sector due to concerns that the arrest and prosecution of company leaders will only lead to the failure of their firms, unemployment, and of our concern, increase the odds of debt default.

“We should refrain from making arrests or prosecutions or giving harsh sentences whenever possible, because arresting or prosecuting business owners will immediately cause their firms to go under and dozens or hundreds of workers to lose their jobs,” said Zhang Jun, procurator-general of the Supreme People’s Procuratorate, in a televised speech last month.

We are not sure what to make of this development, other than it would seem to reflect an extraordinary level of concern among financial authorities.  The signal it sends to business leaders is that any behavior, with the possible exception of criticizing the government, is acceptable.

The U.S. consumer:  U.S. growth has become almost completely dependent on consumption.  Although wage levels improved and confidence is elevated, we note that retailers are complaining that they are being forced to discount aggressively this Christmas to move merchandise.  This development may not mean that households are struggling.  It is possible that this problem may be more about excess capacity in retailing, or the impact of online shopping.  In addition, shoppers have been “trained” to expect deep discounts and won’t shop if they don’t get them.  However, what the report does indicate is that retail firms are likely facing margin compression from the discounting.

United States-North Korea:  After yet another North Korean missile test on Friday, U.S. Special Envoy to North Korea Stephen Biegun criticized the provocations, but emphasized that the Trump administration is open to resuming denuclearization talks.  Meanwhile, the U.S. Center for Strategic and International Studies released imagery suggesting that North Korea may be preparing for another test of a submarine-launched missile as we approach Kim Jong Un’s year-end deadline for new denuclearization talks.

India:  The riots against India’s new religion-based citizenship law, which we described in our Friday comment, continues to spread and escalate.  The protests have become especially strong on university campuses throughout the country, including Delhi, Mumbai and Hyderabad.  As yet, there is no indication the protests will become a threat to Prime Minister Modi, or Indian assets, but we are watching the situation closely.

Brazil:  Now that President Bolsonaro has managed to push through his well-received pension reform, a poll of Brazil’s legislators shows 52% of them think he will also be able to push through a needed tax simplification bill in early 2020.  Brazil’s tax system is among the world’s most complex and burdensome, so the news should be positive for Brazilian stocks.

A pair of curious developments:  Last month, two Chinese embassy officials drove onto a U.S. military base in Norfolk, VA.  The base houses some Special Operations forces.  The two “diplomats” claimed they were lost.  They found their way back to China.  This event is unusually brazen, and underscores tensions between China and the U.S.  The other odd news item are reports from China that criminal gangs apparently became involved in the spread of the African Swine Virus in an attempt to boost hog prices.  The gangs were smuggling potentially tainted pork across provincial boundaries for profit, and the virus was apparently good for business.

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

[Posted: 9:30 AM EST]

Happy Friday the 13^th!  For the past four years, financial markets have been dealing with elevated levels of uncertainty.  The issue of Brexit dominated the EU, policy shifts by the Trump administration and assertive policies from China all contributed to uncertainty.  This uncertainty didn’t prevent risk assets from appreciating, but we can safely argue that these issues (and others) likely prevented even higher risk asset prices.

This chart shows the U.S. economic policy uncertainty index, with a 12-month average.  Note that uncertainty has been persistently rising since Brexit in mid-2016.  Yesterday, some of the clouds parted, while new ones, which we can see on the horizon, are not yet undermining confidence.  Let’s take a look at what’s changed over the past 24 hours:

The U.K. election:  It was a smashing victory for the Tories.  Although we are still waiting for one district, the nearly final results show the Conservatives with 364 seats out of 650 seats.  With this level of support, PM Johnson should be able to move just about anything he wants through Parliament.  The political shift was astounding and generational.

There were two winners in this election, the Tories and the SNP.  Labour was crushed, as were the Liberal-Democrats.  The DUP in Northern Ireland also suffered historic losses, meaning Johnson will no longer need to worry about placating the Unionists in implementing Brexit.  Here are our initial thoughts on the ramifications of this election:

1. Brexit will certainly occur on Johnson’s terms, most likely before year’s end. The next step is to determine the trade deal.  Johnson will be beholden to the new Tories in the manufacturing north, meaning he will need to protect manufacturing in the upcoming negotiations.  That will probably require an extension for talks, meaning it will take more than a year to complete trade arrangements.  It also means the desires of London’s financial district will be less important.
2. At some point in the next couple of years, Johnson will face the real possibility that Scotland will hold a referendum to leave. He will try to stop it, but he probably can’t.  Losing Scotland will reduce the size of the U.K. and perhaps make it less attractive as a venue for investment.  Northern Ireland may well be on its way to joining the Republic of Ireland, although the republic in the south has recently shown greater reluctance to unification.  Dublin is worried it might face the same problem that West Germany had with East Germany.
3. The U.S. and U.K. will likely see relations improve. Britain may find that embrace less than ideal; we suspect Brits will be eating lots of chlorinated chicken in a few years.
4. Britain has tended to share trends in U.S. politics. The supply side revolution in the U.S. was preceded by the rise of Thatcher in the U.K.  Bill Clinton’s “third way” was shared with the emergence of Tony Blair’s “new Labour.”  The Tories are now a working-class party as this election saw the collapse of Labour’s “red wall” in the manufacturing districts.  The GOP is rapidly evolving in a similar manner.  For the U.S. Democratic Party, the election in the U.K. is clearly worrisome.  Labour was beaten mostly because its leader was so far out of the mainstream that he could not deliver voters beyond the most extreme.  The party will now face the difficult process of redefining itself.
5. As we have noted before, the GBP is deeply undervalued compared to its parity rate. However, the Johnson win and Brexit doesn’t necessarily mean that we rally quickly to parity.  Concerns about the shape of trade deals with the EU and U.S., along with the territorial integrity of the current U.K., will probably temper some of the gains.  Still, moving into a range of $1.400 to $1.3500 is reasonable in the next few weeks.
6. The EU now has to deal with the fact that if the U.K. can exit, so can others.

It would appear that a reading of 40%+ makes one vulnerable to leaving.  On that score, Poland, Slovenia, Croatia and Italy are all potential nations for exit.  Of those listed, Italy would be the most problematic because an Italexit would probably bring down the Eurozone, too.  This may push EU negotiators to hew a hard line against the U.K. in trade talks, but with the caveat that a break in trade with the U.K. will harm the EU as well.

We will continue to monitor developments on this issue but, in the short run, clarity on Brexit is bullish for risk assets.

China trade: Yesterday, reports emerged that the U.S. and China had agreed to a partial trade agreement.  The U.S. would roll back some tariffs and China would agree to buy grain.  However, this morning, China, which had not actually agreed to the deal, seemed to be pulling away.  China is expected to hold a press conference about an hour after the time of this writing, so we will see if they are on board.  Here are two things we are watching.  First, Robert Lighthizer is key; his career has been spent putting together trade deals that force compliance on foreign nations.  China loathes to make such agreements.  If he leaves after this deal, it suggests the Trump administration has backed down.  If he stays, whatever is arranged will likely be hard for China to accept.  Second, if China decides not to accept the U.S. deal, we could see a repeat of what we saw in May—a rapid move to retaliate by the U.S.

Saudi Arabia: In the face of growing uncertainty surrounding U.S. security support, the kingdom is making quiet entries to Iran.  Although the Saudis loath Iran’s government, it does not want a hot war with Tehran and so coming to terms is consistent with Riyad’s behavior.

Shutdown averted: The U.S. has a deal to prevent a government shutdown on December 20^th.   Although we did expect an agreement, this news does remove a potential risk to the financial markets.

United States: The Fed yesterday said it will pump almost $500 billion into the financial system over the new year in an attempt to avoid a repeat of September’s big jump in short-term interest rates.  That would nearly double the scale of its recent interventions into the repo market.  The Fed clearly doesn’t want to call this a return to quantitative easing but flooding the market with liquidity like this is likely to have the same positive effect on the markets.  If it looks like a duck and walks like a duck and quacks like a duck . . . well, it probably is a duck.

China-Hong Kong: Just as Chinese authorities have feared, the prolonged political protests in Hong Kong may finally be inspiring protests in China itself.  Reports point to growing on-line criticism of the government over an ex-employee of telecom giant Huawei (002502.SZ, 3.50) who was detained for 251 days after a labor dispute.  Although the on-line comments are quickly censored, posters are arguing that the detention highlights the need for reasonable bail conditions and shows that the Hong Kong protestors were justified in their protests against a proposed law allowing extradition to China.

India: Riots have erupted across northeastern India in protest against a new law seen as basing citizenship on religious affiliation.  The law, which would give Hindus and other non-Muslim migrants from neighboring Muslim-majority countries a fast track to Indian citizenship, comes just months after Prime Minister Modi revoked the special autonomous status of India’s only Muslim-majority state (see our WGR of September 9).  The protests may not be enough to endanger Modi’s government, but they have been bad enough to force the cancellation of a weekend summit between Modi and Japanese Prime Minister Abe.

World Trade Organization: Trade Commissioner Phil Hogan said the EU will beef up its laws so it can impose punitive tariffs on other countries’ exports, in spite of the WTO’s dispute settlement system being frozen.  In an effort to put the WTO out of business, the United States has blocked the appointment of new judges to the panel, creating a risk that countries previously charged with illegal trade barriers would file ghost appeals that would indefinitely prevent the EU from imposing punitive tariffs against them.

Russia: The central bank today reduced its benchmark short-term interest rate to 6.25% from 6.50% previously, for its fifth rate cut of the year.  The benchmark rate is now at its lowest since right before Russia’s 2014 financial crisis, when Governor Nabiullina hiked it to 17% and let the ruble float free.  Inflation has now fallen below the central bank’s target of 4.0%, allowing Nabiullina to focus on supporting economic growth.  The move will likely be positive for Russian assets.

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

[Posted: 9:30 AM EST]

Markets are quiet today but there is a lot going on.  The U.K. is voting today; so is Algeria.  Israel is facing yet another election.  Legarde holds her first ECB meeting.  We recap the Fed meeting.  The trade situation is updated.  We also discuss the weekly energy data, including the IEA report and more on the Saudis.  So, let’s get to it!

Elections:  The polls in the U.K. close at 5:00 pm EST and exit polling should give us an idea of the outcome shortly thereafter.  Expectations are for a Tory win; for the most part, we are trying to divine how many seats the Conservatives will control.  However, globally, polling has been increasingly unreliable.[1]   The structure of British elections tends to make national polling less useful.  The U.K. uses a “first past the post” system; in any district, the winner, even if it’s a plurality, gets the seat.  So, a large national lead doesn’t necessarily mean a majority of seats.  The other problem in this election is that there remains a high number of either undecided voters or voters who lack strong convictions.  Thus, unexpected swings can occur, such as the Brexit vote.  Recent polling has suggested a narrowing of the Tory lead, which may reflect undecideds coming to a decision.  That trend does raise the risk of a surprise.  An expected Tory win would likely give the GBP a modest lift to around $1.35.  An outright Labour win would send the currency plunging to $1.20 or below.  Paradoxically, a hung Parliament, especially a Lib-Dem/Labour/SNP government, would likely send the GBP soaring (GBP at $1.45 at a minimum) as this array would probably either reject Article 50 and remain in the EU, or bring another referendum.  We think odds favor a Tory win, but there remains a chance of a different outcome.

Algerians, on the other hand, are mostly boycotting the polls rather than participating in electing one of five candidates that the military selected.  Tensions will likely continue to smolder.

Again, political parties in Israel have failed to form a government.  The Knesset has dissolved and new elections will be held next year.

The ECB:  In Legarde’s first meeting, interest rates and bond buying were left unchanged as expected, although the statement suggested that further easing is possible.  We would call the statement modestly dovish.  In the press conference, Legarde quickly took control, telling the assembled journalists that they shouldn’t compare her to earlier presidents, that she will have her own style and methods.  She also announced a strategic review, the first for the ECB since 2003, but offered few details.  During the Q&A, Legarde handled questions smoothly, as expected.  She is a polished political operator.  What she does with these skills will be the most interesting part of her term.

In related news, she inherits a really weak Eurozone economy.  The industrial production data from today confirms this weakness.  October industrial production fell by a seasonally-adjusted 0.5%, as increased output in France wasn’t enough to offset the continued downturn in German and Italian manufacturing.  The reading for October met expectations, but September’s output was revised downward to show a 0.1% decline.  Therefore, production in the Eurozone has now fallen in seven of the last ten months.  Output in October was down 2.2% year-over-year.

 

The FOMC:  As expected, the FOMC left rates unchanged, and there were no dissents.  Two key takeaways from the FOMC meeting’s results.  First, there appears to be general unity that rates will remain steady for the next year.

The yellow dots[2] show yesterday’s meeting compared to September.  Note that for 2020, we have moved from a rather wide dispersion in September to all but four committee members calling for steady policy yesterday.  That being said, no member is calling for further rate cuts, which we think is a bit odd, given that the consensus growth and inflation numbers were calling for tepid growth.  All of these datapoints suggest that a consensus has developed on policy and getting either hikes, or cuts of the policy rate will take a measurable change in economic or market conditions.

Second, the FOMC generally postponed any discussions of NAIRU; unemployment is expected to slowly decline through 2022.   Powell was questioned about the Phillips Curve and the labor market.  Our take is the Phillips Curve remains the dominant model for policy and the committee thinks that there is little they can do to lift inflation aw well as little danger to inflation from high levels of employment.

Third, Powell suggested that the issues in the repo market were technical in nature and would not have a macroeconomic impact.  We disagree with that stance but since the fix, QE4, is readily available, a potential crisis from this situation is unlikely.  However, that doesn’t mean we won’t get a “scare.”

Trade:  President Trump is meeting with his trade advisors today; expectations are for the Monday tariffs with China to be delayed, but that outcome isn’t certain.  Chinese negotiators are said to be in close contact with Washington.  The planned tariffs on China, would they come into effect, would have a much larger impact on consumers compared to the earlier ones.  The planned taxes would affect an array of consumer goods that have few other suppliers, meaning that they would, more likely, directly raise prices to households.  There is high chance that if the tariffs are implemented, inflation would rise, the CNY would depreciate and the Fed may be required to keep rates steady, or consider a hike in the policy rate.  Simply put, it would have an adverse impact on the U.S. economy.  That’s why we expect a postponement.

In related news, a senior Chinese diplomat accused the U.S. of fomenting “color revolutions” in China.  Beijing is launching a public relations campaign to combat “foreign interference” in Hong Kong, suggesting that positions are hardening.  Overall, even if we get a Phase One trade deal, decoupling with China is the trend in place.

France:  President Macron finally unveiled the details of his planned pension reform, which touched off the country’s ongoing nationwide strike.  The plan calls for a more conservative approach to calculating monthly benefits, as well as carrots and sticks to encourage people to retire later.  Union leaders decried the details and called for a continuance of the strike.  If the walkout continues long enough, it could have a noticeable negative impact on the French economy and French assets.

Russia-Germany:  The Russian government has ordered two German diplomats to leave the country, as it retaliates for Germany’s expulsion of two Russian officials last week.  Germany’s action was taken after investigators began to suspect the Russian government assassinated a former Chechen rebel in a Berlin park last summer.  A continued deterioration in relations would threaten to further isolate Russia, whose economy is already burdened by Western sanctions.

United States-North Korea:  Amid signs that North Korea is ramping up its provocative military moves again, U.S. diplomats have reportedly begun meeting with UN Security Council members to plan out a response.  If the escalation in tensions continues, we think investors could unexpectedly face a risky North Korean provocation reminiscent of 2016 and 2017, which would likely be negative for risk assets.

Energy update:  Crude oil inventories rose 0.8 mb compared to an expected draw of 1.5 mb.

In the details, U.S. crude oil production fell 0.1 mbpd to 12.8 mbpd.  Exports rose 0.3 mbpd while imports increased 0.9 mbpd.  The rise in stockpiles was greater than expected mostly due to rising imports.

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 $58.17; using the euro/price model, fair value is $49.85.  The combined model, a broader analysis of the oil price, generates a fair value of $51.94.   We are seeing the divergence between dollar and oil inventories narrow as the dollar weakens and oil stocks rise.

In energy news, Saudi Aramco (2222, Tadawul, SAR, 36.80) rose again today, hitting the crown prince’s goal of a market capitalization of $2.0 trillion.  The prince is facing what many firms learn in going public; they don’t get the full value of their shares at the IPO.  The IEA warns that even OPEC+Russia cuts will be inadequate to prevent rising stockpiles in 2020.  Nearly a year after he claimed to be the new president of Venezuela, Juan Guaido is turning out to be something of a bust.  It is unclear how long Venezuela can continue to limp forward; this pictorial of automobile abandonment in Venezuela is a testament to the tragedy of what this nation has suffered under misguided socialist policies. 

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[1] At the same time, our other “reliable source,” prediction markets, are giving an 85% chance that Johnson is the next PM.

[2] The WSJ notes that the FOMC is becoming jaded on the usefulness of the dot information.  The dots have suggested much more tightening than has actually occurred.  The dots tell us more about the biases (or, more accurately, the hopes) within the FOMC but little about the path of future policy.

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

[Posted: 9:30 AM EST] Looking for something to listen to while shopping?  Episode #4 of the Confluence of Ideas Podcast is now available.  It’s all about the Equality/Efficiency Cycle.  Enjoy!\

Happy Fed Day!  The FOMC meets today; there are no expectations of a rate change, but details will be watched.  The December 15^th China tariffs remain unsettled.  U.K. elections loom and polling may have shifted.  Saudi Aramco (Tadawul 2222, SAR 35.20) began trading today.  Energy is on our radar.  Here are the items we are watching today:

The FOMC:  It’s a foregone conclusion that the Fed will keep policy rates steady.  However, that doesn’t mean there aren’t some issues to watch.  Here is what we are focused on:

1. The NAIRU—The “non-accelerating inflation rate of unemployment” is one of the key components of the Phillips Curve. It is essentially the lowest rate of unemployment before the labor markets tighten and lead to accelerating inflation.  Outside the Fed and academia, the Phillips Curve is a dead letter.  However, people outside those groups don’t set the policy rate.  Our analysis of the FOMC members is that the majority remain adherents to the Phillips Curve.  By most measures, the NAIRU is around 4.2%, meaning inflation should be a risk.  Obviously, that’s not the case.  So, when the facts dispute a theory, adjustment is required.  There are essentially three options.  The first is that the Phillips Curve doesn’t work anymore; that’s our position but if one adopts it then a new theory of monetary policy is required.  Giving up a life’s learning to develop a new theory is really hard and it doesn’t look like most members of the FOMC are willing to do that.  The second is that the estimates of NAIRU are too low.  This option is attractive for a Phillips Curve disciple, but then it requires a hard look at the elements of estimating NAIRU.  Some of those might be short term, or idiosyncratic, and thus could lead to volatility in estimates; in other words, if estimates change to meet the current unemployment rate, the estimate becomes rather useless.  The third is that the current estimate of NAIRU holds but inflation isn’t accelerating for idiosyncratic reasons.  The problem is that would lead a Phillips Curve adherent to be ready to raise rates at any time.  We will be watching to see if (a) the level is adjusted, and (b) if Powell addresses this issue in the press conference.
2. The dots—What signal will the FOMC send on future interest rates? The Fed has been consistently hoping for rates to “normalize.”  Will the FOMC ever conclude that the current environment is normal, and rates may have already peaked?
3. The repo market—The Fed has lost control of the repo market. The daily injections should not be necessary.  There is a clear solution—QE4!  However, another QE could trigger an asset melt-up when what is really happening is that the balance sheet was contracted excessively.  So far, the response has been to buy up lots of short-term T-bills and boost the balance sheet but not call it QE.  That may not be enough.

If we were able to ask questions, we would hammer on points #1 and #3.  We will be watching to see what the journalists ask.

Trade:  USMCA looks poised to become law.  Even the labor unions are on board.  Meanwhile, there seems to be a general consensus that the December 15^th China tariffs will be delayed.  However, Peter Navarro, the president’s trade consultant, told the media that a decision had not been made.  We have worked for bosses who seemed to make decisions based on the last person they talked to.  President Trump is the ultimate “decider” and it isn’t clear if he has made a decision yet.  It would not shock us if the president decides to apply the tariffs; it also would not be a surprise if he delayed their implementation.  Our expectation?  He delays the implementation but only by a month, keeping pressure on China to boost agriculture buying.

Brexit:  A poll by YouGov showed a dramatic narrowing of the Tories lead, causing a selloff in the GBP overnight.

The GBP gapped lower on the report, but has regained some of its earlier losses.  The overall poll tracker still shows that the majority of polls have the Tories with a 10 point lead.  We suspect that the reason polls are shifting is that none of the candidates have much depth of support.   Part of the reason for this development is similar to what we are seeing in the U.S.  Political coalitions are shifting.  In the U.K., traditional Labour strongholds are crumbling and even in Scotland, the SNP may be struggling.  At the same time, the center-right establishment, which would traditionally be solid for the Tories, opposes Brexit.  We suspect the Tories will win outright because the opposition is hopelessly divided.  However, surprises are clearly possible.

North Korea:  Financial markets are ignoring this issue but Pyongyang is clearly getting restive.   Additionally, President Trump faces a threat from his right flank; former NSC Director Bolton leveled a broadside against protecting North Korea at the U.N.  With all the other news circulating, Kim will need to do more to get attention.  We would not be shocked to see an ICBM test launch around Christmas.

Energy:  Chevron (CVX, 117.89) announced a write-down of assets to the tune of $10.0 bn, conceding the supply overhang developing in oil and natural gas.  U.S. natural gas prices have languished this decade as the associated gas production from shale oil has glutted the market.  Although it’s not a completely fair comparison, we note that U.S. WTI and Henry Hub natural gas prices tracked each other closely into early 2006; if we model that relationship and project it to today, the fair value for WTI is around $22 per barrel.

Again, this methodology has some flaws; natural gas is a less global market than oil and, more importantly, oil has a cartel. The fact that the two prices tracked each other from 1993-2006 may have been coincidental.  However, what this model might tell us is what would happen if the Saudis decide to recapture market share.  This fear might be one of the factors behind the underperformance of energy equities.  At the same time, the KSA has an incentive to keep prices up until it fully completes its IPO process.  So, for now, oil prices probably are not in immediate danger.  It’s not just the Saudis that can increase energy supply; so can cows!

US Soybean Production: Brazil is on pace to become the largest producer of soybeans in the world for the second year in a row. The country’s dominance of the market can largely be attributed to the ongoing trade war between the U.S. and China. The 25 percent tariff that China placed on soybeans has forced many of the country’s importers to look to Brazil to fill the void. As the trade war persists, it raises the likelihood that US farmers may not be able to recover the market share that it lost when the war began. In addition, a strong dollar may have exacerbated the problem for U.S. farmers, as a depreciating Brazilian real have made U.S. crops significantly less competitive.  Although some of the currency depreciation may have been due to Brazil lowering their interest rates, much of the depreciation to the U.S. dollar strengthens against global currencies. Last week, President Trump attempted to address the issue by imposing tariffs on Brazilian steel, but it is unlikely to help farmers anytime soon. As the U.S. and China come closer to securing an agreement, it will be interesting to see if the trade dispute will have any long-lasting damage.

Odds and ends:  The global use of the CNY continues to lag the size of the Chinese economy.  We suspect the lack of financial transparency and a less than open capital account are to blame.  The U.S. Army will directly fund rare earths production.  Strikes continue in France.

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

[Posted: 9:30 AM EST] Looking for something to listen to while shopping?  Episode #4 of the Confluence of Ideas Podcast is now available.  It’s all about the Equality/Efficiency Cycle.  Enjoy!

Equities were trending lower this morning; worries about new tariffs scheduled for Dec. 15^th were blamed.   However, prices have flipped into positive territory on reports from China that the scheduled tariffs will be delayed.  Broader trade news is improving.  Russia and Ukraine are in a standoff.   China data was mixed; German data was improved.  Here are the details:

Trade:  It appears the USMCA is near completion in the House with a vote likely before year’s end.  If passed (and we think it is likely) it will be a major win for the Trump administration.  Although there are worries that the U.S. will add new tariffs on Monday, we doubt that the tariffs will be applied this month which should give equities a lift into year’s end.

Russia-Ukraine:  Russian President Putin and Ukrainian President Zelenskiy have reportedly agreed to another ceasefire, troop pullback, mine removal and prisoner exchange in the eastern Ukrainian territory currently held by pro-Russian separatists.  However, there have been many such ceasefires in the five years since Russia annexed the Crimean Peninsula and the separatists rose up in the areas near Donetsk and Luhansk.  The new agreement seems little more than a reiteration of the moribund Minsk agreement of 2014, as we described in this week’s WGR.  Indeed, President Zelenskiy reiterated that the conflict can’t be solved until the Ukrainian government gets full control over its border again.

Foreign data:  China’s November CPI soared to 4.5%, led by a 110.0% rise in pork prices.  Food prices overall were up 19.2%.  However, core inflation fell to 1.5% from 1.6%, suggesting that the food price spike isn’t leading to higher prices in other sectors.

Meanwhile, deflation continues at the producer level, with PPI coming in at -1.7%.  China’s total loan growth was 12.4%, roughly steady with October.  The lack of growth suggests the PBOC will be inclined to ease policy further.

Reflecting the domestic challenges to China’s growth, November auto sales were down 3.6% year-over-year, marking their 17^th straight annual decline.

German investor sentiment improved in December.

North Korea:  After a tweet from President Trump that “Kim Jong Un is too smart” to not denuclearize North Korea as promised, North Korean state media quoted the chairman of its Asia-Pacific Peace Committee as denouncing Trump as a “heedless and erratic old man.”  Increasingly provocative rhetoric and military activities suggest North Korea may be reverting to its risky, confrontational stance of previous years.  Despite recent friction, the U.S. has protected North Korea from U.N. human rights scrutiny.

Odds and ends:  Chinese companies are finding that shifting production to Southeast Asia to avoid tariffs has limits.  The Washington Post reports that internal documents indicate the lack of strategy in the Afghanistan conflict.  There are reports of an ANC plot to push President Ramaphosa out of office.  Protests continue in Malta.  Congress is considering a ban on Chinese rail and bus products.  Blue collar jobs are requiring higher education levels, reducing the ability of manufacturing to create high paying unskilled jobs.

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