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 Monday!  It’s a busy week, with the Fed and ECB meeting, elections in the U.K. and Algeria, and looming new China tariffs.  The WTO is close to being effectively closed.  Talks between Ukraine and Russia are being held in Paris this week.  Worries about repo are elevated.  Here are the details:

BREAKING NEWS: PAUL VOLCKER HAS DIED AT 92.

Central banks: The FOMC meets this week.  No change in policy is expected, although we will get new dots and forecasts and a press conference.  We would not expect any dissents.  It is also worth noting that we get the usual rotation of regional bank presidents in January.  Thus, Evans (Chicago), Bullard (St. Louis), George (Kansas City) and Rosengren (Boston) roll off and are replaced by Mester (Cleveland), Kashkari (Minneapolis), Kaplan (Dallas) and Harker (Philadelphia).  Taken as a group, they are (in our estimation) a bit more centrist than the 2019 roster.  If Waller and Shelton get approved this year, the Fed will be much more dovish in 2020.  Meanwhile, Legarde will lead her first ECB meeting this week since replacing Draghi.  Again, policy is expected to be maintained.  Legarde is planning the ECB’s second strategy review since it was created.

Elections: Boris Johnson continues to hold a double-digit lead in the polls with the vote looming on Thursday.  Johnson plans to move quickly to remove the U.K. from the EU, with 2020 being the year both parties negotiate their trade relationship.  Employers are beginning to realize that Brexit will mean a smaller pool of laborers; good news for workers, bad news for profits.  Meanwhile, elections are set in Algeria to replace the Abdelaziz Bouteflika; however, the candidates approved by the military regime are seen as status quo and therefore a low turnout is expected.  The vote probably won’t quell underlying tensions.

Trade: If a trade deal isn’t made with China, new tariffs will be implemented by the weekend.  We would not be surprised to see the taxes postponed.  Meanwhile, it appears the USMCA is close to ratification.  However, as the deal nears, business interests are worried that the measures taken to placate Democrats have reduced the attractiveness to business.  Mexican Foreign Minister Ebrard said his government would oppose any effort to have U.S. inspectors operating within Mexico to enforce the pact’s labor rules, but he welcomed the use of arbitration panels to resolve disputes over labor standards.

WTO: Tomorrow, the WTO will likely cease to be a functioning body.  The appellate court, which adjudicates trade disputes, has seven judges.  The U.S. has refused to approve new members.  The current court is down to three judges, the minimum for a quorum, and two judges’ terms expire tomorrow.  Thus, the WTO will no longer have the legal apparatus to judge trade disputes.  The U.S. has become jaded with the WTO.  At heart, the issue is about sovereignty.  All trade deals reduce sovereignty; a fully sovereign nation is an autarky.  However, the WTO, especially this court, makes judicial decisions out of the hands of the nations involved.  This structure does limit U.S. power and the Trump administration has been keen to increase American bargaining power by conducting bilateral trade arrangements.  At the same time, the loss of this appellate body means that nations will have no forum to bring disputes and power will now be the final arbiter instead of rules governing trade.  In one sense, that development will boost U.S. leverage with individual nations but tend to undermine the broader American strategy of building large trade coalitions.

Repo: Last September, the repo market seized up, leading to a spike in short-term interest rates.   Year-end will likely create similar conditions.  The Fed has rapidly expanded its balance sheet (but don’t call it QE!) to try to ensure ample liquidity, but worries remain.  Why is this happening?  There are three reasons.  First, post-crisis regulation has signaled to banks to be hyper-safe.  Although the official data would suggest banks are “swimming” in excess reserves, the banks are putting a premium on having liquidity, partly due to stricter regulations and partly due to stress testing.  Thus, even 10% overnight rates were not attractive enough to risk the wrath of regulators.  Second, the Fed decided to reduce the size of its balance sheet in an attempt to normalize monetary policy.  The FOMC was not sure what level of balance sheet was necessary after 2008; September offered a clue.  Simply put, the Fed cut its balance sheet too much.  Third, the BIS has indicated that hedge funds were aggressively using repo funding to leverage up rather mundane arbitrage trades to “juice” returns.  This led to excessive leverage.  The good news is that the Fed is well aware of the looming repo issue and has taken steps to address it.  The bad news is that we don’t know if the actions are sufficient.  Thus, there is a chance of a repeat of September or worse in the next three weeks.

Ukraine: Russia and Ukraine, along with Germany and France, are holding talks to deescalate tensions.  There are worries over whether the new Ukrainian president, Volodymyr Zelensky, is savvy enough to negotiate with Vladimir Putin.  The concerns are that Zelensky will cede too much to Putin; given that Ukraine is embroiled in the U.S. impeachment process and Germany and France seem interested in improving relations with Russia, Ukraine may not have much leverage in talks.  The IMF has tentatively approved a new $5.5 billion loan program for Ukraine, offering a vote of confidence for President Zelensky, a former comedian recently elected with a mandate to fight corruption, improve the economy and manage Russia’s incursions against Ukraine.  The next WGR being published later today will provide an update on the situation in the country and explain how final approval of the IMF loan has been in question because of Zelensky’s ties to a Ukrainian oligarch.

China: Beijing has ordered all government offices and public institutions to stop using foreign computer equipment and software within three years.  Analysts estimate up to 30 million pieces of hardware will need to be replaced under the initiative, with the vast majority swapped out by the end of 2021.  The order could become a headwind for a range of Western technology firms.

North Korea: Ahead of Kim Jong-un’s year-end deadline to resume U.S.-North Korean denuclearization talks, North Korea’s state-run media said on Saturday that the military had resumed testing long-range missile components.  The tests appeared to involve liquid-fueled engines.  With North Korea’s renewed provocations getting only minimal coverage in the Western media, there is an increased chance that the country will keep pushing to create an attention-getting crisis in the coming weeks and months.

Pensacola shooting: There was a shooting at a U.S. Naval base in Pensacola over the weekend.  The assailant was a Saudi national who was receiving training at the base.  Officials are investigating to see if there was a broader terrorist plot.  President Trump is attempting to downplay the Saudi connection, likely concerned it will weaken relations between the two nations; the Florida congressional delegation isn’t pleased.

Finland: The Social Democratic Party selected Transport Minister Sanna Marin as its new leader, setting up a parliamentary vote for her to become prime minister later this week.  All four parties in her ruling coalition are led by women, and three of them are in their 30s (Marin is just 34).  The question is whether they’ll be able to survive against the surging nationalist right.

Odds and ends: There were large protests in Hong Kong over the weekend.  Cement prices in China have jumped, suggesting the Xi regime may be pump-priming through investment as GDP slows.  Turkey and Libya have inked a deal to allocate maritime borders; the agreement overlaps other nations’ interests and is raising concerns in the Mediterranean.

View the complete PDF

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

[Posted: 9:30 AM EST]

Happy employment day Friday!  We cover the data below, but the quick read is that the report was a blowout—payrolls rose much more than forecast and the unemployment rate fell.  It is bullish for equities, bearish for gold and Treasuries.  In other news, strikes continue in France.  There is additional optimism on trade.  German industrial production is weak.  OPEC promises to cut output in the wake of the Saudi IPO.  Here are the details:

Looking for something to listen to this weekend?  Episode #4 of the Confluence of Ideas Podcast has been released.  It’s all about the Equality/Efficiency Cycle.  Enjoy!

Trade:  China announced it is waiving retaliatory tariffs on pork and soybean imports, a necessary procedural step to increasing purchases of these items.  Ag imports have been a keep demand of U.S. trade negotiators, so this official action is a favorable sign of progress.  Comments from China suggest that talks are still making progress.  However, there are warning signs that the Uighur bills making their way through Congress might put a halt to trade talks.  President Trump passed the Hong Kong bill, but it does appear that China is signaling that if the Uighur legislation is passed, trade progress will be at risk.  The Hong Kong and Uighur tensions do not seem to be easing; we are starting to see commentary that would lead to further tensions between the two countries which would harden positions.  Despite the aforementioned progress, Chinese firms are reportedly stockpiling computer chips.

Strikes:  Massive strikes shut down France yesterday and the walkout appears to be extending through today.  The labor action, as we noted yesterday, is tied to proposed pension reform, which is designed to raise the retirement age in a bid to shore up finances.  There has been no indication that Macron is softening his stance.  Meanwhile, Finland is facing widespread strikes after industrial unions and companies were unable to agree on new contracts.

German industrial production:  German industrial production slumped, putting the yearly number at a level consistent with recession.

The chart shows the yearly change in the production index; we have put recession bars in place for German recessions.  The current decline of 5.3% would be consistent with recession.

OPEC and Saudi Aramco:  There was good news and bad news.  The good news is that OPEC apparently agreed to an additional 500 kbpd of production cuts.  However, the agreement only extends into the end of Q1, and there is a lack of clarity as to the allocation of the cuts.  So, the short-term nature of the agreement and skepticism over compliance is pressuring oil prices this morning.  Meanwhile, the Saudi Aramco IPO did hit the market yesterday, becoming the largest IPO in history.  We will be watching to see if, post IPO, Saudi Arabia remains committed to maintaining current prices.

Iran:  We have been noting in the past few days that tensions are rising in Iran.  The recent rise in gasoline prices have led to widespread unrest.  The U.S. is considering boosting its troop presence in the region.  A U.S. envoy in the region claimed that there may have been up to 1,000 casualties in the government’s crackdown.  Now Iran is facing pressure from friendly nations over its decision to increase uranium enrichment as France, Britain and Germany will engage a dispute mechanism over this issue.

Japan:  October household spending was down an unexpectedly sharp 5.1% year-over-year, marking the first annual decline in eleven months and the worst annual fall since March 2016.  Much of the decline came from a major typhoon at the time, but it also appears the October 1 hike in the value-added tax may be having more impact than anticipated (see our WGR on the hike here and here).  The jury is probably still out on that until we see the data for November and December.  Still, for the time being, the report is likely to be a negative for Japanese stocks.

Canada:  In a speech laying out his plans for his second term, Prime Minister Trudeau promised lower taxes and expanded international trade, including further support for pipelines to Canada’s west coast to open up new markets for the country’s petroleum production, in spite of his support for measures to battle climate change.  He also laid out a shift to the left on domestic issues like healthcare, where he vowed to add pharmacy benefits to the country’s universal care system.

China:  In a sign that the Chinese government is having trouble getting its hands around the country’s debt problems, a new report shows many listed private firms that have received government bailout funds have reneged on their required debt payments, even after local courts ordered them to pay up.

Indexing:  Germany’s Deutsche Börse has reportedly rolled out a product that allows financial firms to design their own indexes and then outsource their maintenance.  The product is designed to help firms avoid the licensing fees involved in benchmarking against the major indexes.  According to some industry analysts, the product will help hasten the move to “direct indexing,” in which firms hold a customized basket of stocks directly, perhaps relying on a customized index that merely incorporates the firm’s own buy/sell rules.  In other words, the move may help blur the line between passive and active investing.

Odds and ends:  Italy is making noise again about exiting the Eurozone.  If it does, it is not clear if the single currency would survive the blow.  Ukraine and Russia are in talks about the breakaway regions in Ukraine; a top presidential aid to Ukraine suggested that if talks fail, his nation may build a wall to isolate the Russian backed breakaway regions in his country.  A Chinese bank announced steps to limit U.S. dollar transfers in a bid to slow capital outflows.  Kim Jong un is back to riding his white horse, warning he is about out of patience with the U.S.  There has been a recent increase in tensions between the two Koreas, signaling a harsher tone out of Pyongyang.

View the complete PDF

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

[Posted: 9:30 AM EST]

It’s a “Seinfeld” equity market this morning—equity futures are advancing on nothing in particular.  Tory optimism is rising.  There’s a general strike in France.  U.S. is worried about Iran.  Here are the details:

Brexit:  The GBP has been steadily rising in the past few days on increasing optimism that the Tories will win a majority of seats in Parliament.  The opposition to the Tories remains hopelessly divided, with the Lib-Dems reiterating they won’t join a coalition led by Corbyn.  PM Johnson, is laying out an aggressive legislative agenda on his assumed victory.   Although a Tory victory is bullish for the GBP, the rally may be tempered by the next step in the process; once Parliament passes Johnson’s exit bill, the U.K. will need to start negotiations on a free trade agreement with the EU.  That won’t be pretty.  The general consensus is that a $1.35 GBP/USD is likely the target after a Tory win.  It’s quite possible we could get there before next week’s vote.

France:  The Macron government is proposing pension reforms; unfortunately, no one seems pleased with the plan.  So, in response, a massive general strike, the largest since 1995, is occurring today.  Transportation will be paralyzed, and large protest marches are planned.  We don’t expect the unrest to extend in time, but the strike will clearly grab the attention of the government.

OPEC and Saudi Aramco:  The Kingdom of Saudi Arabia (KSA) is expected to price its IPO on Saudi Aramco today.  Reports suggest $8.50 per share will be the going price.  The IPO is a scaled-down version of what was originally proposed but still large.  Meanwhile, the KSA needs a high price for oil for a successful IPO and support from OPEC+Russia is key to that effort.  However, perhaps a reflection of the youth of the Crown Prince, the Saudis are threatening a historic tool of punishing quota violators by flooding the market with oil and depressing the price of oil.  We don’t expect anything rash to occur in the near term; but, once the IPO is priced, it would not be out of character for the KSA to try to recapture market share.

Iran:  The U.S. has announced it is considering a significant boost in troop strength in the Middle East.  The administration is thinking about a 14k increase in soldiers along with more military hardware.  It is not clear what has prompted this consideration.  Israel has been expressing concern about Iran’s actions.  There are reports Iran has moved short-range missiles into Iraq; it is not exactly clear who is being targeted by these missiles.  Not to get overly “John Nash” but one cannot help but notice the proposed increase in troop strength and the threat by the KSA to flood the market with oil.  A sharp drop in oil prices would likely lift consumer sentiment in the U.S. in an election year.  However, it should also be noted that a lower oil price isn’t an unalloyed positive for the U.S. economy compared to a decade ago.  Iran may be escalating tensions in response to sanctions in an attempt to increase the risk premium in oil prices; the KSA could thwart that goal by raising output after the IPO.

Trade update:  China has reiterated that any Phase 1 deal will require tariff rollbacks.  The Senate is expected to approve a bill punishing China for its repression of the Uighurs, mirroring a similar bill recently passed in the House.  So far, these bills affecting Hong Kong and Xinxiang have not derailed trade talks, but they probably haven’t helped the process, either.  Treasury Secretary Mnuchin has expressed worries about an OECD effort to create a harmonized digital tax.  The U.S. dominates this space and thus the tax will probably have the most adverse impact on American firms.  Speaker Pelosi is pushing to remove legal protections for online content which is currently part of USMCA.  If she is successful, the tech firms will likely oppose the new NAFTA.

United States-North Korea:  The Chief of the General Staff of North Korea responded to President Trump’s threat of military force earlier in the week, saying the United States would face “horrible” consequences if it took any action against his country.  Although the dustup hasn’t been getting much coverage in the press, there probably is an increased chance of provocative North Korean military action as we approach the end of the year – Kim Jong Un’s deadline for making new progress in the U.S.-North Korea denuclearization talks.

U.S. Economy:  In a new Financial Times/Peterson Foundation poll, 61% of likely voters said this year’s stock market gains had little or no impact on their financial wellbeing.  Only 40% of respondents were even aware the market has risen this year.  The report is being presented as a sign that the market’s gains may not help President Trump’s reelection prospects as much as he thinks.

Germany:  Preliminary data shows German factory orders unexpectedly fell at the start of the fourth quarter.  After stripping out price changes and seasonal impacts, October manufacturing orders declined 0.4%, coming up far short of expectations for a small gain, and erasing much of September’s revised increase of 1.5%.  Compared with October 2018, orders were down a sharp 5.4%.  The figures call into question the recent sense that Europe’s economy might be bottoming out, so they’re likely to put negative pressure on European stocks today.

Energy update:  Crude oil inventories fell 4.9 mb compared to an expected draw of 1.5 mb.

In the details, U.S. crude oil production was unchanged at 12.9 mbpd.  Exports fell 0.3 mbpd while imports declined 0.2 mbpd.  The rise in stockpiles was greater than expected mostly due to rising refinery operations.

This chart shows the annual seasonal pattern for crude oil inventories.  The autumn build season has come to a close and we would expect modest declines in inventory into year’s end. We continue to monitor the autumn refinery maintenance season.

This week’s rise is seasonally consistent, but utilization still remains below average.  Run rates should mostly stabilize into the new year.

Based on our oil inventory/price model, fair value is $58.43; using the euro/price model, fair value is $48.95.  The combined model, a broader analysis of the oil price, generates a fair value of $51.40.   We are seeing the divergence between the dollar and oil inventories narrow as the dollar weakens and oil stocks rise.  We have oil market information in the above commentary.

View the complete PDF

 

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

[Posted: 9:30 AM EST]

Yesterday, trade worries with China led to a selloff.  This morning, optimism has returned and equities are higher.  Protests in Iran turn increasingly deadly.  Thoughts on the U.K. elections.  Here is what we are watching this morning:

Trade:  Yesterday, equity markets tumbled on comments from President Trump who indicated that a trade deal might not happen this year, and on reports from the commerce secretary that additional tariffs on China could be implemented on Dec. 15^th.  Well, that was yesterday.  Today is today and optimism has returned.  First, media reports suggested that the president’s comments yesterday may have been nothing more than a bargaining tactic.  Negotiators for the U.S. and China indicate that talks are continuing and nearing an agreement.  Complicating matters is that the House passed the Uighur Act of 2019, which would call on the White House to attach sanctions on members of the CPC Politburo.  Although China has warned that if this bill becomes law, it will retaliate, if the Hong Kong bill is any indication, it won’t affect trade.

What do we make of all this?  We have noted that if the president really wanted to address the trade imbalance, which is really about saving and capital flows, he has had a couple of opportunities to address this issue systemically.  The first was during the tax reform discussions; there was a border adjustment tax that would have applied tariffs in such a way to equalize prices.  That idea never gained traction.  The second remains the Hawley-Ballwin bill, which we discussed in detail here and here.  The Competitive Dollar for Jobs and Prosperity Act would get at the heart of the problem by applying sanctions and capital flows, not trade. However, it would indirectly, but effectively, take trade policy away from the White House and give it to the Federal Reserve in the form of setting the exchange rate.  The reality is that the president seems more intent on making headlines and swaying policy by swinging market sentiment by how he talks about trade.  In other words, as Bloomberg’s Tracy Alloway noted, the lasting legacy of the Trump presidency may be the use of tariffs as a flexible policy tool.  Trump doesn’t really want to solve the trade issue directly; he wants to shape the behavior of foreign nations on an ad hoc basis with the use of tariffs.  Of course, what that means for markets is continued uncertainty.   Although this does keep the president’s name in the news, it does have a cost; investors have been building cash positions based on fears surrounding trade.

This chart shows the 12-month average of the trade policy uncertainty index[1] and retail MMK funds.  We started to see a strong accumulation of liquidity as trade concerns increased.  There are a couple of takeaways from this chart; first, despite rising cash levels, equity markets have moved higher but would likely be even higher in the absence of the trade tensions[2] and second, if the trade issue is resolved, or at least temporarily eased, a FOMO rally in stocks could be significant.

A few other trade items of note.  First, Japan has officially approved the U.S. free trade agreement.  Second, the Johnson government is apparently considering its own digital sales tax that appears similar to the controversial one passed by France.  We would not expect President Trump to bring up this issue with elections just over a week away, but if the U.K. proceeds with this plan, look for trade friction to rise with Britain.  Third, Mexico is balking at a demand from House Democrats to give U.S. inspectors the right to unilaterally investigate Mexican firms for labor law violations.  It is unclear if the USMCA can pass without this provision.  It is also unlikely that Mexico will approve such intrusive inspections.

Iran:  The gasoline protests have become increasingly deadly.  Reports now suggest that somewhere between 208 to 450 Iranians have died at the hands of state security.  Hard liners of the regime are trying to pin the unpopular price hikes on the Rohini government.  There are reports the Trump administration, viewing the unrest as a sign their sanctions policy is working, is considering additional sanctions.  The more desperate the Iranian government becomes, the more likely it is to at least consider attacking a neighbor to distract its unhappy Iranians.

U.K. elections:  As the poll looms on Dec. 12, we are seeing a few interesting developments.  There has been increasing discussion of “tactical voting” by the Remain camp.  The Remain parties are divided between the SNP, the Lib-Dems and Labour.  The idea is that voters who want to support Remain should vote for one of these parties in their districts with the best chance of beating the Tory MP candidate.  However, there are two problems with this concept.  First, it requires accurate polling.  In a vote for a Lib-Dem, a Labour and a Tory MP candidate, the Remain voter has to be confident that a vote for the Lib-Dem or the Labour candidate can overcome the Tory candidate.  If the polling isn’t definitive, the likely outcome would be to split the Remain vote and swing the seat to the Tory candidate.  The second problem is that even if the Tories are denied a majority, it isn’t obvious who would lead a SNP/Lib-Dem/Labour government.  The SNP is really only concerned with Scotland and thus would not provide the PM.  The Lib-Dem and Labour party agree on little, even on the Brexit issue.  The former wants to revoke Article 50 outright, while Labour wants another referendum.  Our base case is that tactical voting will fail, and the Tories will carry the election.

The second issue is that Labour has touted a document indicating that the Tories would allow the U.S. to dictate changes to trade laws that would undermine the National Health Service.  Reports have emerged that suggest this report may be nothing more than Russian disinformation.  This situation highlights something we may see next year in the U.S. presidential election; damming reports circulate that have no basis in fact but lead voters unsure what to believe.

View the complete PDF

---

[1] This index measures mentions of trade issues in the news media; it was created by Economic Policy Uncertainty.

[2] At the same time, one should treat that last statement with some caution; the Fed might have raised rates faster and higher in the absence of the trade issue.

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

[Posted: 9:30 AM EST]

Trade worries continue to weigh on equity markets.  NATO meeting starts tomorrow.  Here is what we are watching this morning:

Trade:  The trade issue is getting increasingly messy and equity markets are falling.  Here are some of the issues:

1. France and tech taxes: The Macron government has applied a “digital services tax” primarily aimed at U.S. tech firms.  Based on the USTR recommendations, the U.S. is threatening to retaliate against champagne and cheese, and the retaliation being considered isn’t small; a tariff of 100% against $2.4 bn of French imports is on the line.  France, through the EU,[1] is vowing to retaliate.
2. EU and aircraft: The U.S. is threatening additional tariffs in a case against Airbus (EADSY, USD 36.02).  The WTO, earlier in the year, agreed with the U.S. position that state subsidies by the EU to Airbus violated trade laws and opened the door for U.S. trade sanctions.  Although the WTO gave the U.S. limits on the degree of retaliation, the USTR has indicated it may move beyond these limits.
3. Brazil and Argentina: As we noted yesterday, President Trump indicated that the S. would restore steel and aluminum tariffs on Brazil and Argentina in response to currency depreciation.  Both the Brazilian real and the Argentine peso weakened due to unrelated issues (overly easy monetary policy in the former, fears of bond default and a leftist swing in elections on the latter) but the president appears to be viewing currency weakness as a reason for applying tariffs.  This reasoning opens a new avenue for tariffs, although it may be a bit like using gasoline to douse a fire.  Under conditions of floating exchange rates, tariffs usually lead to currency depreciation in the targeted country.  Adding more tariffs will likely lead to additional depreciation.  Still, if this is where trade policy is going, the dollar could continue to defy gravity and appreciate further.
4. China: Commerce Secretary Ross indicated that if China didn’t agree to a trade deal in 12 days, the tariffs planned for December 15^th will go into effect.  These would be the tariffs on the $156 bn of Chinese imports that have been, so far, unaffected by earlier tariffs.  This basket would primarily affect consumer goods and could be much more damaging than those applied earlier.  President Trump has indicated that he was under no deadline to do a deal with China, suggesting that a Phase 1 agreement may not occur anytime soon.  Meanwhile, China is hinting that it may create a “blacklist” of “unreliable” U.S. firms; it is unclear what being on that blacklist would mean, but nothing about it sounds like it would be favorable.
5. S Congress: Although there is a tendency, in our hyper partisan age, to view political trends as tied to party, in reality, there are underlying factors that are shaping U.S. policy.  In other words, to think that we will see a sudden reversal in trade policy with a new president is probably unwise, because what President Trump is doing on trade is, in some fashion, a reflection of rising dissatisfaction among the electorate on the impact of trade.  The GOP, long a bastion of free trade, has mostly adopted the president’s trade policy.  Individually, many express discomfort with the trend, but the reality is that the wave of deglobalization is underway and trying to stop it probably puts a Congress member’s political career at risk.

For the financial markets, much of the recent rally in equities has been tied to some sort of truce on trade.  If that isn’t going to develop, the rally is at risk.  The trade conflict does appear to be having an impact on the economy.  The chart below shows the manufacturing PMI spread between the U.S. and China.  We have placed a vertical line at February 2018, when the trade conflict with China increased.  The ISM manufacturing index has declined relative to China since then.

NATO:  Member nations are gathering in London for meetings starting tomorrow.  The treaty group is at some sort of crossroads.  French President Macron has been highly critical of NATO, calling the treaty organization “brain dead.”  President Trump has also criticized the EU for “free riding” U.S. defense spending. Additionally, Turkey has been unhappy with NATO, angry that the U.S. and EU opposed its actions against the Kurds.  Turkish President Erdogan is threatening to scuttle a plan to support the Baltics if NATO doesn’t declare various Kurdish groups as terrorist organizations.  NATO worked best when it had a clear adversary; some leaders are suggesting NATO should turn its focus to China.  China has suggested taking such a stance would turn the EU into a U.S puppet.  Meanwhile, PM Johnson simply hopes the meeting goes off without a bombshell that would hurt his election chances, as the vote occurs in nine days.

Iran:  The repression of protests over the recent increase in gasoline prices continues.  U.S. sanctions have not succeeded, so far, in bringing Iran back to the bargaining table, but they have clearly caused severe harm to the Iranian economy.

Russia-Germany:  Federal prosecutors in Germany believe Russian intelligence agents have carried out yet another extraterritorial assassination on a NATO member’s soil.  This time, the target was an ethnic Chechen-Georgian national who fought against Russia in Chechnya and was murdered in a Berlin park this summer.

Finland:  Prime Minister Rinne has resigned after losing the support of the Centre Party, a key coalition ally, over his handling of a postal strike that spread to other sectors before being settled last week.  If a new prime minister can’t be chosen from the existing coalition, there may be new elections that could bring the Eurosceptic Finns Party to power.

Japan:  Officials have provided more detail on the government’s planned fiscal stimulus package.  The package will total some ¥13 trillion (about $120 billion), almost all of which would be spent in the fiscal year beginning in April.  The stimulus could be a positive for Japanese equities, but it is likely to heighten concern about the country’s massive debt load.

China-Hong Kong:  The former chief economist for China’s state-owned Bank of Communications, Law Ka-chung, said he was forced to resign because he is a Hong Konger.  He also said mainland firms in the city are increasingly purging Hong Kongers and imposing strict censorship on them.  That suggests that besides China’s overt efforts to bring Hong Kong under closer control, there is also a creeping sinisization being carried out via commercial firms.  That’s probably a further headwind for Hong Kong stocks, on top of the continued anti-China political protests that have hurt the economy so much and the threat of a violent Chinese crackdown.

Brazil:  Adding to yesterday’s data suggesting a potential recovery in Chinese manufacturing, data today shows Brazilian GDP rose by a better-than-expected 0.6% in the third quarter.  Not only was that an improvement from the 0.5% rise in the second quarter, but it was also the best increase since the beginning of 2018.  Nevertheless, Brazil is still recovering only ploddingly from its painful 2014-2016 recession.  GDP in the third quarter was up just 1.2% from the same period one year earlier, far short of its average annual rise of 2.3% over the last two decades.

Odds and ends:  Sweden, long a champion of negative nominal interest rates, appears set to abandon the practice, concluding the policy is ineffective.  We are seeing an uptick in corporate bond defaults in China; it seems that financial authorities are willing to allow defaults, likely to reduce debt growth by injecting a bit of fear into lenders.  However, China is new to defaults (they weren’t legal until 2014) and we are watching to see if the financial system finds itself facing a cascade of bad corporate debt.  Although the Brent crude oil benchmark will live on, Brent crude oil itself appears to be coming to an end.  The last remaining wells are expected to be capped next year.

 

View the complete PDF

---

[1] France cannot implement trade actions by itself.  The digital services tax is a domestic tax structured to put the incidence on U.S. tech firms but it is not a trade action. For nations of the EU, trade rules are made at the EU level.

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

[Posted: 9:30 AM EST]

Welcome back!  Hope all had a great holiday; it’s now December, the last month of 2019.  Ursula von der Leyen finally gets to take over as head of the EU commission.   It’s a modest risk-on morning.  Here are the details:

China:  A few news items of note.  First, PMI data (see below) came in better than forecast. The official manufacturing PMI for November rose to a seasonally-adjusted 50.2, up from 49.3 in October and 49.8 in September.  For the first time since April, the index now stands above the 50 level that points to expanding activity.  The November Caixin-Markit PMI, which is more heavily weighted toward private firms and exporters, remained in expansion territory for a fourth straight month and rose to a three-year high of 51.8.  The figures are being taken as a tentative sign that the Chinese economy may be on the verge of accelerating again.  That’s proving to be a positive for global risk assets so far today.

Second, PBOC governor Gang suggested the world economic downturn “will stay for a long time” and dismissed unconventional easing as a policy tool.  Third, positions on trade appear to have hardened; the Global Times, a mouthpiece for the CPC, indicated that a Phase 1 trade deal will require the rollback of current tariffs, something unlikely to occur.  With both the U.S. and Chinese economy looking somewhat better, both sides likely believe their position has been strengthened and thus the urgency to make a deal is reduced.  Fourth, although Chinese officials are unhappy with the recent Hong Kong human rights bills, Beijing is not tying the bills to trade.  Instead, it is limiting the actions of U.S. NGOs[1] and has said it will no longer allow U.S. military ships or aircraft to visit Hong Kong.

A world of unrest:  There are a plethora of protests around the world; here is a quick guide;

1. Malta: Over two years ago, an investigative journalist named Daphne Galizia died in a car bombing.  The murder occurred as she was investigating corruption in the government.  A degree of unrest has continued since her death and has reached a fever pitch recently.  Protestors demanded the resignation of PM Joseph Muscat; he has agreed to leave next year when his Labor party picks a replacement.  A Maltese businessman has been charged in the murder; however, it seems unlikely that there was no involvement of government officials in the event.
2. Hong Kong: After a period of post-election peace, peaceful protests over the weekend were met with tear gas.
3. Iran: The protests that began last week following a cut in gasoline subsidies has become increasingly difficult for the regime to contain.  Repression has escalated, with at least 180 fatalities.   Cheap gasoline is part of the social contract Iran has made with its citizens; such arrangements are common with OPEC nations[2] and raising prices to a fraction of global prices tends to trigger strong reactions.  The problem for the Iranian leadership is that this price increase is hitting the ones the regime relies on for political support, and thus the risks to the government may be higher than expected.  On a side note, in what has to be a classic act of tone deafness, a number of European nations have joined the Instex payment mechanism, a European alternative to S.W.I.F.T., designed to allow Iran to avoid U.S. sanction.  Taking such steps in the midst of Iranian repression is remarkable.
4. Iraq: Continuing protests against widespread corruption and the influence of Iran on Iraqi politics has led to the resignation of the prime minister.  Similar to what we are seeing in Lebanon, Iraqis want to change the current power sharing arrangement between the Shiites, Kurds and Sunnis to broaden representation.
5. Czech Republic: Saturday, the eve of the 30^th anniversary of the Velvet Revolution, brought an estimated 200k to the streets of  Prague protesting the corruption of the current government.

There is a common theme in all these protests—a growing disenchantment with the ruling elites who are seen as protecting their own interests against the needs of the majority.  There are clearly local catalysts, but the common element is anger against government leaders.

OPEC:  The cartel and Russia meet this week in Vienna to discuss extending current output curbs. On Friday, doubts about the extension sent crude prices tumbling.  We are seeing a partial recovery this morning as Saudi Arabia is lobbying for extending current cuts to mid-2020.  Additionally, in a surprise move, Iraq is touting an additional cut of 400 kbpd.

Germany:  Chancellor Merkel’s junior coalition partner, the Social Democratic Party, elected two new leaders that have vowed to pull their support for the government unless it veers sharply to the left.  Merkel’s fall isn’t necessarily imminent, but the development confirms that her days in power are numbered.  It also suggests that in the coming years, Germany could adopt much more fiscal stimulus than at present.

Hong Kong:  The city government released a forecast showing Hong Kong’s budget will be in deficit in fiscal year 2019-2020, marking its first shortfall in 15 years.  The deficit stems from the economic disruptions from months of mass anti-China protests.  The government also said Hong Kong’s October retail sales were down a whopping 24.3% year-over-year.

United States-Brazil-Argentina:  Opening an unexpected new trade battle, President Trump said he would restore retaliatory tariffs on steel and aluminum from Brazil and Argentina.  To justify the move, the president suggested Brazilian and Argentine officials have been deliberately devaluing their currencies, even though the depreciations make sense in the context of economic issues like falling interest rates in Brazil and political fears in Argentina.  The unexpected new trade battle has taken a bit of wind out of the market, in spite of the positive news on Chinese manufacturing.

European Union:  Finland’s government (which currently holds the EU’s rotating presidency) proposed cutting “cohesion” funding to poorer countries to 1.07% of gross national income.  That would fund the program at much less than the 1.30% of GNI proposed by the European Parliament and the 1.11% proposed by the European Commission, but it would be much closer to the 1.0% of GNI demanded by rich countries like Germany.

Brexit:  In an interview with the Financial Times, EU financial services chief Dombrovskis warned British financial firms could lose access to the EU market if Britain’s post-Brexit rules on financial stability and consumer protections stray too far from EU standards.  Other EU officials have recently made similar threats, which suggests:  a) EU officials fear the economic competition that could come from a lightly regulated “Singapore-on-the-Thames” Britain after it leaves the EU, and b) Those officials may be willing to play hardball to keep Britain bound more closely by EU rules.  With the election a mere 11 days away, the Tories continue to poll around 43%; however, Labour is surging, and given the collapse of the Brexit party, a Labour-Liberal/Democrat-SNP coalition would actually pull 50% of the vote.  It isn’t completely clear if such a coalition can form, but it may be the only real threat to a Tory government.

View the complete PDF

---

[1] Who are already restricted.

[2] Venezuela also offered cheap petrol.