The business cycle has a major impact on financial markets; recessions usually accompany bear markets in equities. We have created this report to keep our readers apprised of the potential for recession, which we plan to update on a monthly basis. Although it isn’t the final word on our views about recession, it is part of our process in signaling the potential for a downturn.
In October, Q3 earnings came in stronger than expected, the Federal Reserve cut rates for a third time this year and the U.S. and China continued to negotiate what is being called a “phase-one” trade deal. Meanwhile, the manufacturing sector continued to show signs of weakness and consumer confidence slowed. Currently, our diffusion index shows that seven out of 11 indicators are in expansion territory, with several indicators approaching negative territory. The index for October fell 60 bps from +0.575 in the prior month to +0.515.
The chart above shows the Confluence Diffusion Index. It uses a three-month moving average of 11 leading indicators to track the state of the business cycle. The red line signals when the business cycle is headed toward a contraction, while the blue line signals when the business cycle is headed toward a recovery. On average, the diffusion index is currently providing about six months of lead time for a contraction and five months of lead time for a recovery. Continue reading for a more in-depth understanding of how the indicators are performing and refer to our Glossary of Charts at the back of this report for a description of each chart and what it measures. A chart title listed in red designates that indicator is signaling recession.
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA
[Posted: 9:30 AM EST]
Good morning all! Equities are trading stronger as fears of a recession have been calmed by upward revisions to GDP for the third quarter. Below are the stories we will be tracking today:
Mexico infrastructure: On Tuesday, Mexico’s government announced the first phase of its infrastructure program for 2020-24. The program includes 147 projects that range from railways and ports to water and tourism, and it will cost $43 billion. The announcement comes a day after official data revealed that the Mexican economy dipped into recession this year.
Keeping in line with his pledge not to expand the fiscal deficit, President Andres Manuel Lopez Obrador, often shortened to AMLO, has called on business leaders to pitch in. At this time, it appears the project has the backing of Mexico’s richest man, Carlos Slim, but may struggle to find help from abroad. A recent dispute by the Mexican government over a gas pipeline has raised fears that this administration may not honor its contract. In addition, investors are not confident that the projects are profitable as a lot of the projects mentioned were old ones that weren’t completed. As a result, we are not confident the projects will be enough to get the country out of its current rut. We also suspect that if the economy worsens the president will come under increased pressure to boost government spending.
More repo uncertainty: As the end of the year approaches, there is growing speculation that a liquidity squeeze could lead to another surge in repo rates. The surge that took place earlier this year was largely attributed to banks needing funds for corporate tax payments, whereas this time a surge could occur in response to banks trying to meet regulation requirements. Last week, banks were given an assessment of their systematic importance to the global financial system, in which it was determined the amount of capital needed to be held against assets. Since many of the major banks are close to the capital threshold, there are fears that these banks may be hesitant to lend toward the end of the year. Although the Fed has stated that it is prepared to act to prevent a liquidity crunch, there are concerns that banks could be gaming the system in order to ensure they keep expanding their balance sheets. Currently, there doesn’t seem to be an obvious fix to liquidity markets, outside of forcing banks to borrow from the discount window. Therefore, we are not confident that the Federal Reserve has a plan to end its balance sheet expansion anytime soon.
Hazardous weather: There have been tumultuous weather conditions throughout the country, but particularly in the Northwest and Pacific regions. Heavy snow and “stronger than hurricane-force winds” have already disrupted flights and closed some major highways. Although this may be good news for those looking for an excuse to avoid family during Thanksgiving, this will likely have a negative impact on the economic data, particularly construction and retail sales. As a result, we would not be surprised if economic data for November were weaker than expected as bad weather conditions typically lead to slower economic activity.
NHS on the table? Labour Party leader Jeremy Corbyn revealed that he has a dossier proving that the U.S. demanded the National Health Service (NHS) be included in trade discussions. Specifically, Corbyn stated that the U.S. wanted the patents for drugs for pharmaceutical companies to be extended, which would prevent companies from creating cheaper generic versions. The NHS is a sensitive topic in the U.K. as most people would like its funding to be increased and remain publicly controlled. That said, PM Johnson has not always been forthright about the NHS. During the run-up to the Brexit vote, Johnson drove around in a red bus that claimed leaving the EU would allow the U.K. to use the £350 million it spends per week to remain in the EU to fund the NHS; this claim was later debunked. Accordingly, the public’s trust in PM Johnson could be seriously undermined if the allegation is true. That said, we are still confident the election is PM Johnson’s to lose.
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA
[Posted: 9:30 AM EST]
It’s very quiet this morning. (N.B. The Wednesday report will be the last one for this week; have a great Thanksgiving.) Chair Powell gave an upbeat speech. Trade negotiations continue. Chairman Xi is having a rough time lately. There was a major art heist in Germany. Here are the details:
Powell speaks: Chair Powell gave a speech to the Providence Rhode Island Chamber of Commerce yesterday. The content was generally upbeat. Although he did hint that the central bank had overestimated the strength of the economy earlier in the year, the recent cuts are designed to extend the current expansion. He also noted that the Fed was committed to bringing 2% core PCE inflation, which would require continued easy policy. Overall, there wasn’t a whole lot of new information in the speech, but it does confirm that the bias of policy is to lower rates but, for now, policy should remain stable.
Trade: Although we remain somewhat doubtful that a material deal will be struck with China, the two sides are continuing to talk. China is signaling it thinks an agreement will be reached. Why our doubts? First, both sides seem to continue to believe the other side needs a deal more, a condition conducive to miscalculation. Second, the underlying positions are hardening. Liu He, China’s lead trade negotiator, said earlier this week that the Xi government wants a “stronger, better and bigger” state economy. The influence of the state on China’s economy is one of the primary concerns of the U.S. Subsidies from the state are seen as unfair competition. On the U.S. side, the Voice of America and Radio Free Asia have joined forces to create a new service called “Global Mandarin,” a development that will likely not sit well with Beijing. We may get an interim arrangement. It may temporarily slow the deterioration of relations. However, over time, the strategic competition will continue to fester.
In other trade news, there is apparently progress on USMCA. Global trade data from the CPB World Trade Monitor indicate that activity fell 1.3% in September from August. A recent economic paper concludes that the incidence of the China/U.S. tariffs is mostly falling on company profit margins. China’s CNY depreciation didn’t offset the tariffs and companies have not shifted the costs of the tariffs to retail. The key unknown is if this condition will continue indefinitely.
Chairman Xi’s, no good, very bad week: As we noted yesterday, local elections in Hong Kong were a landslide victory for pro-democracy parties. The fallout from this political event is now starting to develop. First, Beijing was certain that the vote would support its favored candidates, so much so that reports suggest they already had their “victory” narratives in place and didn’t even consider a loss. This is one of the problems with elections for authoritarian regimes; sometimes, voters surprise the leadership. Beijing seemed to believe that the silent majority of Hong Kong citizens viewed the protestors as destructive and thus would vote for stability. Most likely, this was the message Carrie Lam was telling her minders. Now, Chairman Xi has a dilemma. If he wants conditions to calm in Hong Kong, he likely needs to give the pro-democracy movement a “bone”; he needs to give some level of political reform. However, allowing a vote on leaders is not the direction the CPC wants to go, and we expect Beijing to reject such a notion. There are reports the CPC has set up a new monitoring body for Hong Kong, evading the established liaison office. This new body is likely in response to what Beijing sees as the official group’s inability to send reliable information to the CPC leadership. Reliable information is always a problem for authoritarian regimes; local officials have an incentive to spin positive narratives and thus, surprises such as the Hong Kong protests can emerge. One of the features of democracy is that the vote becomes a form of reliable information. Of course, the leadership has to be open to hearing it; the current narrative out of the CPC is that foreign intervention is the cause for the unrest.
The Hong Kong vote isn’t the only headache affecting Chairman Xi. There are reports a Chinese spy has defected to Australian authorities, and is telling tales of interference in Hong Kong and Taiwan. The CPC is attempting to discredit the alleged spy, but the defection is a problem for China.
In other China news, the PBOC issued a warning that rising household debt is creating economic risks and will demand a policy response. Investors are already skittish about China’s corporate and local-government debt, so they won’t want to hear about another debt problem. They also won’t want to hear about a potential clampdown on mortgage, or consumption lending when the Chinese economy is already in a secular slowdown and is struggling with the U.S.-China trade war to boot. The news is therefore negative for Chinese stocks.
Russia-Ukraine-European Union: Russian President Putin and Ukrainian President Zelensky talked by telephone yesterday to discuss a new deal allowing Russian natural gas to pass through Ukrainian pipelines for delivery to the EU. The current deal expires January 1, and EU-mediated talks for a new contract are expected to start next week. The aim of the talks is to avoid disruptive gas shortages like those caused by Russian-Ukrainian disputes in 2006 and 2009.
Odds and ends: The U.S. and Australia are working together to build supplies of non-Chinese rare earths. Although climate change remains a divisive political topic, there is one area where there appears to be little doubt of its occurrence, the insurance industry. Property insurers are lifting premiums for areas subject to specific weather events, e.g., tornadoes on the central plains, but are also simply refusing to ensure areas prone to wildfires. China issued $6.0 bn of sovereign bonds denominated in dollars; the auction was oversubscribed by more than 3x and the amount was a new record for China’s dollar issuance.
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA
[Posted: 9:30 AM EST]
Happy Monday! This will be a short week for U.S. markets. (N.B. The Wednesday report will be the last one for this week; have a great Thanksgiving.) It’s a modest risk on day so far. There was some positive trade news. Tories continue to poll well as election platforms are released. Democracy supporters do well in Hong Kong local elections. Here are the details:
Trade:China is calling for more protection of intellectual property rights, a key demand from the U.S. It is unclear if this paper is an outline for actual legislation and enforcement. It is also unclear if the USTR will view this change as adequate protection. Official Chinese media says the two sides are “very close” to a Phase 1 deal; however, it is increasingly looking like the Phase 1 may be all that we get. Both sides need a truce which a Phase 1 deal would offer. But, the relationship between China and the U.S. is now at the level of strategic competition and further progress is unlikely. If a deal is struck, it is, on its face, bullish for equities. What is difficult to discern is how much optimism over a deal is already discounted. Cash levels remain high (although retail MMK did dip modestly last week) and so we would not be surprised to see another upleg in equities if an agreement is announced.
Hong Kong: Pro-democracy candidates scored a resounding victory in the local council elections over the weekend, winning 85% of the 452 contested seats and gaining a majority in 17 of the 18 councils amid extremely high turnout. The local councils have only limited authority on low-level issues like street repair and garbage collection, but the results are being taken as a sign of broad support for the anti-China protests that started early last summer. Municipal Chief Executive Lam promised to “listen to the views of the public with an open mind and seriously reflect on it.” Chinese media on the mainland merely announced the completion of the elections. Chinese leaders were probably hoping that the increasingly violent protests would sour the broader Hong Kong public on the anti-China, pro-democracy movement. Now that the elections have shown that isn’t happening, Beijing will probably be more reluctant to embark on a sharp crackdown, so some of the headwinds for Hong Kong assets will probably ease.
Brexit: As part of the election process, U.K. parties publish “manifestos” or platforms on what policies they want to enact. In some respects, these are much more important in U.K. elections; party platforms in the U.S. are more like “wish lists” that are rarely looked at except by political junkies. However in a parliamentary system, where control of the legislature gives executive power, winning a majority means the manifesto will likely become the roadmap for policy. The Labour manifesto, released last week, is a return to Britain’s post-WWII socialism. The Tory manifesto is mostly about not raising taxes and delivering Brexit. Polling is showing two notable trends. First, the Tory lead over Labour is continuing around +10%. Second, the Brexit Party is fading fast, which is good news for Johnson as Farage’s party is his only threat to his right flank. We also note that former PM Blair and the Liberal Democratic Party have both separately called for voters to cast their ballot “tactically” to deprive either the Conservatives or the Labor Party of a majority in order to pave the way for a second referendum on Brexit.
Germany: The Ifo Business Climate Index rose to a seasonally-adjusted 95.0, improving from a revised 94.7 in each of the previous two months and reaching its highest level since July. The index hasn’t fallen in three straight months, suggesting Europe’s economic slowdown could be bottoming out. If so, that should help give a boost to European stocks in the near term.
Canada: The government has announced it will not introduce legislation to end a strike at Canadian National Railway Co. (CNI, 90.42), despite growing disruptions for agriculture, chemical and energy producers. The strike is now in its fourth day, and given that CNI is the country’s largest railroad, there is some risk the walkout could have a noticeable impact on the Canadian economy and stocks, if it continues.
Mexico: In an initial estimate, third-quarter GDP came in essentially unchanged from the previous quarter, after stripping out seasonal impacts and price changes. Just as important, revisions showed GDP fell slightly in each of the previous three quarters, and in four of the last five quarters, suggesting the Mexican economy is mired in recession. GDP in the third quarter was actually down 0.3% from the same period one year earlier. The news is likely to be negative for Mexican and broader Latin American stocks.
(NB: Due to the Thanksgiving holiday, the next report will be published on December 6.)
The health of the consumer is critical to the future path of economic growth. For the most part, consumption is accounting for most of the growth in the economy.
This chart shows the four-quarter average of the contribution to real GDP from consumption compared to the net of the contribution from government, investment and net exports. Over recent business cycles, the contribution outside of consumption has diminished. The other sign from the data is that the risk of recession rises when consumption’s contribution declines below 2%.
Household debt plays a role in consumption. The New York FRB has a data series on consumer debt that has just been recently updated. The balance of household debt is now $13.95 trillion, a new record high. However, on a per capita basis, we remain below the previous record.
From its peak of $53.0k in Q3 2008, this measure of debt declined to $44.5k in Q3 2013. Since then, it has gradually increased. However, it has not reached levels that would trigger significant concern. In the last expansion, per capita debt growth was 10.9%; in this expansion the average growth is -0.4%.
As a percentage of the total, housing debt has been declining relative to auto and student loans.
In 2012, housing represented about 76.9% of outstanding household loans; it now stands at 70.5%. Both student and auto loans have increased. The median credit score for mortgages is a rather strong 763.
Auto loans is a bit lower, at 710, but credit quality has been improving, mostly a reflection of higher delinquencies. Lenders appear to be increasing their caution.
Overall, the data suggests that the areas of greatest concern are auto and student loans; lenders do appear to be addressing the auto loan issue by becoming more selective in granting credit. Student loans, which have a 90+-day delinquency rate of around 10% since 2012, are ultimately a public policy issue, but until this issue is resolved these loans will have an adverse impact on spending. If there is going to be a financial crisis, this data would suggest it probably won’t come from the household sector.
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA
[Posted: 9:30 AM EST] Episode #3 of our Confluence of Ideas podcast is now available.
Happy Friday! It’s a slow news day this morning. Financial markets are rather calm. We cover the global PMI data in the foreign section. Here is what caught our attention this morning:
Watching Corbyn: For the upcoming U.K. elections, Labour leader Corbyn unveiled his party’s policy manifesto. The policy proposals are a clear rejection of Tony Blair (and Bill Clinton’s) “third way” of center-left politics. Instead, it is being billed as a return to the 1970s; we would suggest that characterization isn’t radical enough. It would be more like the massive shift in the U.K. economy that occurred after WWII, with sweeping nationalization and much higher taxes on upper income earners. Sometimes the U.K. acts as a leading, or perhaps coincident, indicator of U.S. political trends; for example, Margaret Thatcher preceded Ronald Reagan by about a year and Tony Blair was a contemporary of Bill Clinton. The Brexit issue reflects rising populism in the U.S. One of the key questions for the 2020 election is whether a center-left or a populist-left candidate represents stronger opposition to a right-wing populist incumbent. If Corbyn does poorly in next month’s election, the Democratic Party leadership might conclude that the populist wing isn’t the right path to take. Thus, there may be an imbedded lesson for our election in the upcoming British poll.
China trade: We are hearing both Presidents Xi and Trump saying that a trade deal remains possible. Given the length of time that this phase one deal has taken, we are worried that we may see a “buy rumor, sell fact” action in the markets even if a deal is made.
A cautionary tale: Although the U.S. health care system is littered with flaws, the tort bar, for all its extremes, does act as a threat to poor medical practices. Under a single payer system, we doubt the government would tolerate such annoyances. A report from the U.K. suggests that a single payer system has its own issues as well.
Hong Kong: The territory will hold local council elections on Sunday. These are usually minor affairs with the focus on local issues (noise control, rubbish pickup, etc.) Currently, these seats are dominated by mainstream supporters of the mainland. However, the pro-democracy movement is fielding a large number of candidates, turning the vote into a referendum of sorts on the protest movement. The president has not signed the recent Hong Kong bill. Tokyo and Singapore are trying to lure Hong Kong’s finance industry away from China.
ECB:Christine Legarde gave her first policy speech yesterday and pressed governments to boost investment spending. In some respects, this is an old tune. Finding profitable public, or private investment is difficult. It may be harder to find public investments in a developed economy that actually lifts productivity. However, there is an important embedded signal in this speech; monetary policy may be exhausted and if further stimulus is going to occur, it probably has to come from the fiscal side. Moving the Eurozone this direction will take all of Legarde’s ample political skills. Germany continues to view balanced budgets as a moral imperative and until this view changes, getting increased fiscal spending will be next to impossible.
A tariff twist: There has been much written about who pays the tariffs. The economic term for who pays the tax is called “incidence.” Often, it’s not as simple as it seems. For example, most people believe the payroll tax is shared between the worker and the firm but that’s not usually the case. Most of the time, the worker pays both sides, not just what he sees on his pay stub, because the firm reduces his pay for part, or all the employer portion of the tax depending on labor market conditions. In other words, in the absence of the payroll tax, wages would likely be higher. For tariffs, the incidence is even more difficult to discern. If the foreign firm is determined to maintain market share and faces a price inelastic demand curve, the foreign firm reduces the tariffed item’s price to offset the tax. However, if the foreign firm faces a price elastic demand curve, the tariff may be absorbed by domestic producers, or in higher prices to consumers.
Central bank independence: Judy Shelton, a nominee for Fed Governor, is suggesting that central bank independence isn’t sacrosanct. Although this stance is a reversal from commonly held beliefs since the 1970s, in fact, central bank independence does ebb and flow. During the 1930s into the early 1950s, the Fed got its rate policy from the Treasury to facilitate the latter’s borrowing program. If we are heading into a period of reflation, weakening central bank independence is an element to that project. So, Shelton’s nomination to the Fed should not come as a surprise.
Global financial markets: Managers at the massive hedge fund Bridgewater Associates have reportedly bought $1.5 billion worth of puts on the S&P 500 and Euro Stoxx 50, in a bet that the U.S. and/or European markets could fall significantly by next March. Our analysis suggests there is indeed a heightened risk of recession later in 2020. If so, we think that would imply the equity markets might start falling around mid-year.
Colombia: Hundreds of thousands of demonstrators marched through Bogotá and other cities yesterday to protest corruption, insecurity, and inequality, but it appears the government was able to keep them better controlled and less violent than the protests in places like Hong Kong and Chile. The youthful protests around the world are acting like a contagion, with activity in one country inspiring demonstrations elsewhere, but Colombia’s experience suggests governments could minimize the impact through good preparation and tightened security ahead of the protests. For example, the Colombian government mobilized 170,000 military and police personnel ahead of the demonstrations, shut its border, and imposed a curfew in at least one major city.
Bolivia: To end the political violence since former President Morales was forced from office for allegedly rigging his October 20 reelection, interim President Añez presented a draft law to annul that vote, call a new election, and name a new electoral board to oversee it. The actual date of the new election would depend on when the bill is passed into law.
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA
[Posted: 9:30 AM EST] Episode #3 of our Confluence of Ideas podcast is now available.
Financial markets this morning can best be described as “becalmed.” Not much is moving We cover the Fed minutes and the recent gyrations with trade. OECD downgrades 2020 growth. Yesterday’s energy data is recapped. Here are the details.
Fed minutes: The minutes had no discernible impact on financial markets. Here are the general takeaways from the report:
Policymakers are signaling that they think the current policy rate is appropriate. At the same time, there is ample evidence to suggest that the preponderance of risks is to the downside. Thus, we can conclude that the next move is most likely for lower, not higher rates.
Even this rate cut was not easy. Although the majority apparently supported it, there were two official dissents. Additionally, seven presidents don’t vote each year. The minutes suggested that at least a couple of members vied this cut as a “close call.” This adds to evidence that additional reductions in rates will require clear evidence of slowing.
One of the unknowns about the labor market is if the modest slowdown in payroll growth is due to a weakening economy, or the natural consequence of near full employment. The minutes suggested the members are leaning toward the latter explanation. If they are wrong, and the slowing is an early sign of weakness, the odds of a policy mistake are increased.
In the review of recent money market turmoil, it isn’t obvious if the Fed really understands what has occurred. Perhaps the best analysis of this issue can be found here. If Zoltan Pozsar is correct, the Fed really hasn’t solved the problem. We might see a repeat of the September problem at year’s end. One issue is that the discount window, which allows banks to borrow directly from the Fed if they are short on reserves, is no longer used on fears of creating reputational risk. This development is forcing banks to hold excess reserves.
In discussions, the FOMC is cool to negative nominal rates, instead planning on forward guidance and balance sheet expansion if the zero lower bound is touched again. Our concern is that the Fed’s apparent “success” with these tools in the past has led them to overconfidence.
So, overall, probably not more rate cuts this year, but the odds of a hike are very low.
Here is a technical assessment of the potential decline:
(Source: Bloomberg)
This is the S&P 500 from the summer of 2017. With a couple of violations, the index has moved in a broad upsloping channel since the initial peak after the tax cut passed. Clearly, last year there was a serious violation of the channel; another one occurred recently. If the trade talks are doomed, a pullback to the September lows is likely, or a bit more than 10% from the recent high. Falling to the lower line of the channel would put the index around 2800. That’s probably a reasonable set of parameters for the market over this issue.
Here are the most recent developments on trade. There is breaking news that the U.S. may not implement tariffs scheduled for Dec. 15th if the Phase I talks fail. The White House has not confirmed this report. This decision, if true, would suggest that the White House realizes that adding tariffs to all Chinese imports will affect consumer goods and may be rather unpopular. If so, this might mean that the last leg of tariffs may never be implemented and thus tariffs have become a less potent threat. China has invited the U.S. negotiating team to Beijing for new talks; the U.S. is reluctant to go without clear evidence China is willing to meet U.S. demands. President Trump has blamed China for the lack of progress on trade. China is promoting continued talks. In a warning, former Secretary of State Kissinger warned that if the U.S./China trade conflict isn’t brought under control, the potential exists for it to spiral into a scenario similar to WWI; we would agree with this assessment.
On Dec. 10th, the WTO appeals courts will stop functioning due to the lack of judges. The U.S. has prevented new appointments, effectively ending the WTO’s ability to resolve trade disputes. If the WTO collapses, it will likely mark the end of the post-WWII (but especially the post-Cold War variant) globalization.
Global growth: The OECD is warning that the world is heading toward a low growth rut due to trade disputes and low investment rates. It is projecting 2.9% GDP growth for the world in 2020; any level under 3% is generally considered a recession.
Japan: Prime Minister Abe’s push to amend the country’s pacifist constitution to allow a stronger military hit a roadblock, as parliament members agreed to cancel a discussion of a required change in Japan’s referendum law. With only two weeks left in the parliamentary session, the move basically prevents any movement on the issue for the rest of the year.
Canada: Prime Minister Trudeau has announced a significant shake-up to his cabinet. Most important, Foreign Affairs Minister Chrystia Freeland, who led the country’s negotiating team during the recent U.S.-Mexico-Canada trade deal, has been elevated to the role of deputy prime minister in charge of provincial and territorial affairs. That could help Trudeau overcome the nascent separatist sentiment in Alberta and Saskatchewan that has developed in response to his national carbon tax and other environmentalist policies. By developing Freeland’s expertise in domestic issues, it should also help set her up for a run at the prime minister’s role in the future.
Colombia: While political protests have burgeoned in Chile, Bolivia, and Ecuador, and as political and economic problems have intensified in Venezuela, Brazil, and Argentina, it seemed Colombia was a bastion of stability. Today, however, unions and anti-government protestors have launched a massive national strike to protest some of the same issues that have caused unrest elsewhere in South America, i.e., corruption, inequality, and political rigidity. The spread of the unrest to Colombia, and the potential for a violent government response will be negative for South American assets going forward.
Energy update: Crude oil inventories rose 1.4 mb compared to an expected build of 1.5 mb.
In the details, U.S. crude oil production is unchanged at 12.8 mbpd. Exports rose 0.4 mbpd while imports rose 0.2 mbpd. The rise in stockpiles was mostly in line with expectations.
(Sources: DOE, CIM)
This chart shows the annual seasonal pattern for crude oil inventories. We are approaching the end of the autumn build season, which implies we will see a modest drop during the month of December before the usual seasonal rise in Q1.
We continue to monitor the autumn refinery maintenance season.
(Sources: DOE, CIM)
This week’s rise is normal, but utilization remains below average. Run rates should continue to rise into the new year.
Based on our oil inventory/price model, fair value is $56.79; using the euro/price model, fair value is $49.14. The combined model, a broader analysis of the oil price, generates a fair value of $51.12. We are seeing the divergence between dollar and oil inventories narrow as the dollar weakens and oil stocks rise. We expect the Saudi IPO process to support oil and any positive news on the trade front would be supportive for oil prices as well.
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA
[Posted: 9:30 AM EST] Episode #3 of our Confluence of Ideas podcast is now available.
It’s a risk-off morning at mid-week. There are three items of note in the overnight news. First, the Senate has passed the Hong Kong democracy bill. Second, the debate between Johnson and Corbyn was mostly a draw. Third, the Fed minutes are out today. Here are the details.
Gaming out the Hong Kong democracy bill: The Senate, in a rare example of bipartisanship, voted unanimously to pass its version of the Hong Kong democracy bill. The bill would require the secretary of state to annually certify that Hong Kong remained sufficiently independent to warrant its special status as a global financial hub. It would also allow the president to place sanctions on individuals who have been deemed to have suppressed human rights in Hong Kong. A similar set of legislation passed the House unanimously in October. There are some differences between the two versions, but with such strong support in the legislature, it is highly likely that a single version will emerge soon from the conference committee. China has already condemned the action and is urging the White House to veto the bill.
This legislation complicates the trade situation with China. Even with a veto, given the strong support in both houses, the president would be forced to spend prodigious levels of political capital to prevent an override. Although China might view a heroic but failed effort as good enough to maintain progress on trade, more likely the Xi regime will view the bill as an affront to its sovereignty and that would be enough to end negotiations. In addition, the president has to be careful with overt support for China. As we have noted before, Bill Clinton used the Bush administration’s reaction to Tiananmen Square against the president in the 1992 campaign. Protecting China would be used against the president in the 2020 campaign. On the other hand, if phase one of the trade deal fails, financial markets will not take it well and that will also be a negative for the upcoming election. President Trump reiterated that he will raise tariffs if China doesn’t make a deal with the U.S., suggesting he believes his bargaining position is stronger than Beijing’s. At the same time, China continues to press for a rollback in tariffs, which may signal that Beijing believes it holds the upper hand. Equities have made new highs, in part, based on expectations of a modest trade agreement. If the deal fails, it would be reasonable to expect at least a return to the low end of the channel the S&P has been trading in for nearly the past two years.
In other China news, Beijing is arguing that the recent Hong Kong court decision to overrule the government’s ban on protestor masks was illegal. Essentially, the PRC is arguing that such decisions are for Beijing to make. Such heavy handed responses make it difficult for the U.S. to argue that Hong Kong deserves its special status.
The Fed: The Fed will release the minutes of its most recent meeting. Although the notes are heavily sanitized, they should offer some insight into the level of dissention on the FOMC. In 2024, we will get the full transcripts of this year’s meetings. It will be fascinating to see just how divided this Fed is. The higher the level of dissention, the greater the hurdle to future easing.
The PBOC: China’s banks are following the PBOC’s lead; the latter cut the Loan Prime Rate earlier this week and banks are cutting lending rates by a similar amount. All indications are that the PBOC will become more aggressive in the coming months to offset a decelerating economy.
The rise of MMT: As we have hinted in the past, it appears Modern Monetary Theory (MMT) is becoming the most relevant alternative to orthodox economic thinking. Later today two expert witnesses, Randall Wray and Olivier Blanchard, are expected to testify before the House Budget Committee. The focus of the discussion will be on whether widening budget deficits have an adverse impact on the economy; in which MMT would argue only if it leads to inflation. The impact on these hearings reflects a growing desire to increase deficits to boost growth. Over the past ten years economic growth in the U.S. has averaged just a little over 2%. In addition, traditional theories that hold that widening deficits leads to higher inflation have been somewhat unfounded during this expansion. Currently, the fiscal deficit is approaching $1 trillion for the first time since the financial crisis, while inflation as determined by the Personal Consumption Expenditure (PCE) still remains well below the Federal Reserve’s inflation target of 2%. As plans such as Medicare-for-all and the Green New Deal become more prevalent in policy discussions, we expect MMTers to grow in prominence.[1]
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA
[Posted: 9:30 AM EST] Episode #3 of our Confluence of Ideas podcast is now available.
It’s rather quiet this morning with a modest risk-on tone to the markets. Yesterday, on the other hand, was active. Trump and Powell met. The government might shut down due to a lack of funding legislation. Hong Kong remains in turmoil. Bolivia is in turmoil too. Tory poll numbers improve. Trade news and other times from northeast Asia. Here are the details.
The president and the chair:President Trump and Chair Powell met at the White House yesterday. Meetings between these two officials are not historically all that unusual but have, at times, led to strong pressure from the White House. Both the president and the chair felt compelled to offer a public comment. The president continues to press the Fed for easier policy.[1] Chair Powell continues to protect the independence of the Federal Reserve. Of all the Fed related items out yesterday, the most intriguing, in our opinion, comes from Boston FRB Rosengren. He opposed the last rate cut; in fact, he has opposed all the most recent cuts. However, this isn’t because he is an inflation hawk. He is part of a small but growing faction of what we call “financial sensitives” who worry that rate cuts to lift price inflation are destabilizing the financial system. This stance is probably never going to dominate Fed thinking because it would put the bank in an impossible position; it would be setting policy based on financial conditions. Imagine a chair indicating rates were lifted because the P/E was too high. However, what makes the financial sensitives interesting is that they would take financial conditions into account when setting policy and if conditions are easy, they would be hawkish. In some respects, Rosengren, Brainard and Evans are perhaps the three FOMC members that would be the most difficult for markets to take. As a matter of record, neither Rosengren or Evans will be voters next year.
Government shutdown? With all the focus in Washington on impeachment, the need to fund the government is being lost in the noise. However, the potential for a shutdown in the next two weeks is rising.
China-Hong Kong:China’s parliamentary committee on law and labor issued a statement of “strong dissatisfaction” with Monday’s Hong Kong court decision overturning the city’s ban on protest masks. To make matters worse, a committee spokesman noted that under Hong Kong’s mini-constitution, China’s parliament has the final say on whether a municipal law is legal. By implying yet another trampling on Hong Kong’s autonomy, the statement is likely to further inflame the ongoing anti-China protests, which have already been weighing on the city’s economy and financial markets. Meanwhile, politicians and professors helped negotiate the evacuation of hundreds of protestors who had been holed up at the Hong Kong Polytechnic University. Under the deal, police said they wouldn’t immediately arrest anyone under 18, and would be lenient to any older protestors. However, approximately 100 protestors who don’t trust those assurances are reportedly still in the facility, and it isn’t clear what the police will do to get them out. We also note that Congress is getting increasingly active on condemning China. If a bill that condemns China’s actions in Hong Kong passes Congress, the president will almost be forced to veto it or see the trade talks fail.
Bolivia: Although Bolivia’s current (and self-proclaimed) interim President Jeanine Áñez said she would operate a caretaker government until the next elections, in fact, she has moved to unwind much of the nativist and populist policies of her predecessor, Evo Morales, currently enjoying exile in Mexico. Bolivians have noticed and are starting to express their opposition.
United States-South Korea: Negotiations on the financial burden sharing for U.S. military forces in South Korea broke down today, just six weeks before the current agreement expires. The U.S. side reportedly walked out of the talks after the South Koreans balked at quintupling their current annual contribution of almost $1 billion. He who pays the piper gets to call the tune, but the Trump administration finds little motivation in controlling the U.S. security environment around the globe. Rather, its motivation is in reducing the costs of global hegemony, even if that risks damaging relationships with allies like South Korea or Japan.
United States-North Korea: State media in Pyongyang claims the Trump administration proposed resuming the U.S.-North Korea nuclear talks in December, ahead of the year-end deadline for new ideas set by Kim Jong Un. However, the report didn’t say whether the North Koreans would accept the offer.
Iran: The Islamic Revolutionary Guard Corps have threatened to crack down on the continuing protests against a hike in fuel prices. The massive, violent protests suggest the renewed U.S. sanctions on Iran are creating social tensions as planned, though it isn’t clear whether the government will feel enough pressure to meet U.S. demands.
Eurozone Monetary Policy: Almost 60% of German banks are now charging negative interest rates on at least some large corporate deposits, while more than 20% are doing the same for large retail deposits, based on new data. The growing prevalence of negative rates in high-saving Germany is likely to generate stronger pushback against the ECB’s loose monetary policy, and help turn policymakers’ attention toward looser fiscal policy to stimulate economic growth.
Brexit and the elections: PM Johnson reversed himself on corporate tax cuts, citing costs. The Labor Party continues to strike a hard-left stance in its campaign for the December election, today releasing a hyper-intrusive, rigid plan for reining in business. This may account for recent polling action showing a surge for the Tories. Meanwhile the EU is warning Britain that a comprehensive trade deal by the end of next year is probably impossible, meaning that either a small deal is done, or hard Brexit occurs anyway.
[1] This is nothing new. We have nothing in the historical record of a president begging the central bank for higher rates.
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