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.

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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.

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[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.

 

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[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.

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[1] Who are already restricted.

[2] Venezuela also offered cheap petrol.

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.

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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.

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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.

Odds and ends:  The civil war in Libya is creating conditions for Islamic State to rebuild.  China’s efforts to build a presence in the Arctic is showing up in Norway.  Natural gas, already struggling under a supply overhang, is facing additional competition from biogas.  U.S. GDP has become almost completely dependent on consumption; uncertainty on a number of issues continues to weigh on business investment.  The WSJ looks into malinvestment in residential real estate and the potential impact on the wealth of Baby Boomers.  Initial offerings for special-purpose acquisition companies (SPAC)—public companies that use IPO’s to raise cash specifically for acquisitions—reached a new record.   This development is probably a consequence of low interest rates spurring speculation.

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