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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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.

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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.

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