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

[Posted: 9:30 AM EST]

It’s Veterans’ Day; Treasury markets are closed but equities trade today.  Risk assets are lower this morning. A lot of global political news.  Update on trade.  Here is what we are watching this morning:

Global political news:  There was a plethora of political news over the weekend.  Here is a recap:

1. Spain—The country held elections and the outcome, as expected, was muddled. PM Sanchez’s Socialists won the majority of seats but actually ceded three seats compared to the last election.  His party won 28% of the vote, down from 29% in the last election.  The populist right wing Vox party was the big winner, gathering 15% of the vote, up from 10% last election.  Given the distribution of seats, there is no natural path to a coalition.  Sanchez may either govern with a minority, or try a grand coalition with the center right.  However, all outcomes point to another election.
2. Bolivia—Eva Morales, the current president who claimed to have won recent elections, was “encouraged” to step down by the nation’s police and military. Recent elections were marred with fraud and unrest was rising.  In addition, Morales’s re-election appeared to violate the constitution he implemented.   It is not clear who will govern Bolivia; Carlos Mesa came in second in the disputed election last month; new elections may be necessary.  Mexico has offered Morales exile.
3. Brazil—Former Brazilian President Luiz Inácio Lula da Silva, commonly referred to as “Lula,” was released from prison over the weekend. The Supreme Court of Brazil ruled that he was imprisoned before all of his defenses had been exhausted.   There is evidence to suggest prosecutors engaged in unscrupulous behavior to imprison Lula before the last elections.  The return of Lula is a significant political threat to the Bolsonaro government.  Lula was implicated in corruption and may still return to prison at some point.  But he is popular and offers a left-wing alternative to the current regime.
4. U.K.—In an unexpected retreat, Nigel Farage announced this morning that his Brexit party won’t run party candidates against Tories in next month’s election. That decision greatly reduces the threat form the right flank for Johnson and increases the odds he will win the upcoming election.  The Tories continue to lead in the polls.  Meanwhile, the Scottish National Party has informed Labour that if it wants its support in building a government, it will have to agree to a new independence referendum.  Moody’s has lowered its outlook on the U.K. due to Brexit.  The GBP rallied on the news.
5. Chile—After weeks of political protests primarily against inequality, the government acceded to a key demand of the demonstrators by agreeing to draft a new constitution to replace the current one, which dates back to the dictatorship of Augusto Pinochet. It is still unclear how effective the move will be in ending the tensions and restoring calm to Chile’s markets

Trade news:  President Trump cooled recent market ardor by indicating he wasn’t planning on rolling back any tariffs.   We may get further clarification this week from the president himself, who speaks to the Economic Club of New York tomorrow.  Meanwhile, Peter Navarro continues to indicate that there will be no rollback in tariffs.  Meanwhile, on Wednesday, the U.S. will decide on auto tariffs; the auto industry is lobbying for a postponement.

Hong Kong:  A protestor was apparently shot with live ammunition from close range, and reportedly is in critical condition.  Six pro-democracy lawmakers were also arrested.  Protestors apparently set a man on fire.  Although tensions remain high, Beijing has been careful not to crack down with excessive force because Hong Kong remains a key conduit for Western finance.

China data:  China’s inflation remains elevated due to pork supply issues.

Overall CPI rose 3.8% from last year led by a 15.5% jump in food prices.  Pork inflation is up 100%, a doubling of prices, over the past year.  The African Swine Fever is the culprit for reducing supply.  Core CPI, on the other hand, remains well contained, at +1.6%.  Loan growth in October was weaker than forecast, rising CNY 661 billion, down from CNY 1.69 trillion in September.  Despite easing by the PBOC, loan growth is stagnant and will likely need further stimulus to lift growth.

Macron speaks:  This weekend’s Economist reported on a long interview with French President Macron.  He discussed, at length, the withdrawal of the U.S. from European security, calling NATO “brain dead.”  The interview was widely discussed across Europe; Polish Prime Minister Morawiecki strongly criticized French President Macron’s suggestion last week that Europe could no longer rely on the United States fulfilling its mutual defense commitments under NATO.  Turning the tables, Morawiecki questioned whether France would fulfill its obligation to spend more on defense.  Although Macron’s position is unpopular, we tend to think Macron is right.  Europe’s key problem is that it hasn’t been able to integrate Germany into the continent since its founding in 1870.  The only system that kept the peace for an extended period involved the U.S. providing a security guarantee.  Without it, Germany will need to rearm; how it does so without triggering fear is the question.

Saudi Aramco:  The company has released a prospectus for its December 5^th pricing.  It does not indicate the total amount to be floated or the valuation.  The company has pledged a $75 bn dividend through 2024 to increase investor interest.  Another item of interest was the slide in profits caused by the attack on its oil gathering facilities.

European Central Bank:  As further evidence that ultraloose monetary policy has probably hit its economic and political limits, members of the ECB’s top policymaking council are preparing to tell newly inaugurated ECB President Lagarde that they want greater control over interest-rate decisions.  That sets up a potential disappointment in the Eurozone’s bond market, since investors are currently pricing in another rate cut next spring.

Oil market news:  Iran claims it has found a 53-billion-barrel reserve.  This news has not been confirmed.  Venezuela is selling oil cheaply in a bid to evade U.S. sanctions.  There are reports that shale-focused petroleum companies are preparing to pump less oil and gas, calculating that it’s better to spend and produce less today while hoping for higher commodity prices in the future.  The article quotes an estimate that shale producers expect to spend 17% less in 2020 than in 2019.  While the article suggests this renewed discipline will be financially beneficial for drillers, it doesn’t mention that there would also likely be economic costs.  As in 2014 to 2016, when plunging crude prices discouraged new drilling, the impact would probably range from decreased demand and pricing for steel to slower employment growth in the oil patch.  Coupled with the headwinds from the trade war and the lingering impact of the previously tight monetary policy, reduced oil and gas investment will mean a continuing risk of economic slowing and weaker equity markets going forward.

Odds and ends:  Farmers are turning to other lenders as banks shun the sector.  As a result, borrowing costs are rising.  The practice of auto lenders to wrap “underwater” trade-ins into new, higher interest loans examined here.  The unemployment rate for recent college graduates has increased.

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

[Posted: 9:30 AM EST]

Market action is a bit odd this morning; risk-on assets are trading lower but risk-off are weaker as well.  We suspect sentiment remains high but there are some concerns about the trade details.  CEOs are much more pessimistic than the population, in general.  Iran is threatening again.  Here is what we are watching this morning:

China trade:  Optimism about a trade deal has sent global equities higher, pushing the S&P to new records.  However, we are noticing a bit of doubt creeping into market sentiment.  Although there has been talk of tariff rollbacks, we note they started on the Chinese side.  It is quite possible China is trying to frame the deal in public and, given the positive market reaction, force the U.S. to capitulate or suffer a downdraft in risk assets.  It appears to us that the administration is divided.  Larry Kudlow has said that any deal will include a tariff rollback; Peter Navarro and others do not agree.  In an interview this morning on NPR, senior U.S. trade advisor Navarro reiterated his statement yesterday that a “phase one” trade deal is still not finalized and there has been no agreement to roll back any of the tariffs that the United States and China have already imposed on each other.

We know from how negotiations went in May that the establishment faction in the White House (Kudlow, Mnuchin) thought they had a deal.  The trade hawk faction (Navarro, Lighthizer) told the president that China was reneging on the deal.  President Trump blew up the agreement and equity markets tumbled.

The Chinese Communist Party is trying to “re-trade” the agreement, said Stephen Bannon, former White House adviser. He added that rolling back earlier tariffs “goes against the grain” of the original October agreement.

“There’s nothing that Trump hates more” than someone backtracking on a deal, he said.

The consensus narrative in the financial markets is that we will get a short-term deal that will pause the trade war until the elections.  That narrative makes a lot of sense; over the past 25 years, consumption has become increasingly sensitive to asset prices and so a stronger equity market going into 2020 should help the president’s reelection.  But, as the above quote shows, there is a streak in Trump’s behavior that he viscerally reacts against being taken as a fool.  If he concludes that China has been “front-running” the narrative to trap him into rolling back tariffs, it would not be a surprise if he scuttles the whole deal.  We are not out of the woods quite yet.

China:  There are more reports of smaller, provincial banks suffering bank runs in the face of continued slowing in China’s economy and a government crackdown on risky lending.  Beijing has already bailed out three regional banks this year.  This week, there was a notable run on Yingkou Yanhai Bank, the country’s third-fastest growing bank in terms of loan growth between 2011 and 2018.

Hong Kong:  After the death of a youth who was injured near a recent anti-China protest, his fellow students rampaged through the Hong Kong University of Science and Technology, vandalizing the president’s residence and multiple student facilities.  The death is likely to encourage further protests and violence over the weekend, adding yet more downward pressure on the Hong Kong economy and financial markets.

Japan:  Prime Minister Abe has told his government to develop a 15-month fiscal stimulus plan to get ahead of the slowdown in global growth, an expected drop in construction after next year’s Tokyo Olympic Games and the risk of weaker demand after the October hike in consumption taxes (discussed in our recent Weekly Geopolitical Reports from October 28 and November 4). Abe’s plan would include a supplementary budget for January through March 2020 and then increased spending for the fiscal year ending March 2021.  The scale of the stimulus hasn’t been decided yet, but it will focus on infrastructure repair and investment.  What’s notable here is that it’s just one of many signs we’re seeing that politicians around the world are getting more comfortable with the idea of loosening government purse strings to boost economic growth.  Part of that stems from a realization that ultraloose monetary policy has probably already done about as much as it can.  Just as important, politicians are realizing that they could take advantage of extremely low interest rates, at least to begin with.  After Abe’s announcement, for example, Finance Minister Aso said the government might finance the stimulus program with 50-year bonds, despite his ministry’s previous reluctance to borrow beyond 40 years.

NATO:  In an interview with The Economist, French President Macron said Europe must face facts regarding the “instability of our American partner” under President Trump.  According to Macron, Europe’s situation is becoming more tenuous as the United States retreats into isolationism, so it “must become autonomous in terms of military strategy and capability.”  Macron’s statement has already gotten pushback from NATO Secretary General Stoltenberg, German Chancellor Merkel and British Foreign Secretary Raab, but we think it confirms just what we’ve been saying.  As the U.S. steps back from its traditional role as global hegemon, it will encourage or even require many foreign actors to rearm and strike out on their own path to protect their national interests.  That’s likely to produce a more chaotic international security environment and unfreeze many old disputes, which will ultimately raise risk premiums and cut into the value of many types of assets.

Federal Reserve:  FRB Atlanta President Bostic said the Fed’s decision to cut interest rates last week was unneeded, and that he would have voted against it if he were on the policy committee this year.  The statement adds to the growing sense that U.S. rates are likely to stay on hold and that there’s a high bar for additional rate cuts in the near term.

CEOs vs. the rest:  The Conference Board collects lots of survey data, including consumer confidence and CEO sentiment data.  The spread between the two series is at a record point.

(Source: Axios)

As a recession indicator, this one isn’t very useful.  There is no specific level of spread that signals a recession, although a reading under -60 has been consistent with downturns.  A narrowing of the spread from low levels is usually the sign that a recession is near.  Or, to put it another way, the CEO survey is something of a leading indicator of a downturn in consumer sentiment.  In the current context, a drop in consumer confidence should be treated as a sign that a downturn is more likely.  So far, consumer confidence is holding up rather well.

Iran issues:  As noted earlier this week, Iran has been increasing its uranium enrichment, which is slowly undermining the nuclear deal.  Adding to pressure is a decision by Iran to bar a U.N. nuclear inspector from entering a nuclear facility and has prevented her from leaving Iran.  Iran claims she tested positive for explosive nitrates.  This provocation is occurring as the U.S. and Israel are pressing European signatories to the Iran deal to abandon it.  If the nuclear deal completely fails, we would expect Iran to steadily increase its uranium enrichment activities.  Whether or not it moves to make weapons-grade material will depend on if it thinks it will get a response from either Israel or the U.S.  At this point, we don’t think the Trump administration will react, and Israel doesn’t currently have the ability, using conventional weapons, to prevent Iran from having nuclear capabilities.  This means, of course, that if Israel really believes Iran is an existential threat, it should use its (officially denied) nuclear capability to launch a first strike against Iran.  If the U.S. doesn’t want to attack Iran, one way a nuclear war could be averted would be to give Israel the most potent “bunker buster” conventional bombs which, so far, the U.S. has declined to offer.  The bottom line is that the oil market is mostly ignoring this issue; however, there is a small, but not zero, tail risk of significant magnitude.

Odds and ends:  Italy is now the most risky credit in the Eurozone.  The EU says that the U.S. won’t apply auto tariffs on European auto exports.  China has lifted a ban on Canadian pork and beef imports, applied after the arrest of a Huawei (002502, CNY 2.57) executive.  It appears the move isn’t a signal of a thaw, but rather that China may simply need the meat.

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

[Posted: 9:30 AM EST] The second episode of the Confluence of Ideas podcast is available!

Trade optimism is lifted again this morning—risk assets are higher.  The Happy Meal is 40 years old today.  Trouble in techland.  More on EU deposit insurance.  DOE report.  Here are the details:

Trade:  Reports indicate the U.S. and China are preparing a phased reduction of tariffs.  The details are scarce; so far, the reports suggest a rollback of tariffs on a proportional basis.  However, it is still unclear if this news means that existing tariffs or proposed tariffs are part of the agreement.   In some respects, we don’t know much more on this issue than we did yesterday.  We still don’t have a venue for a signing ceremony and the mechanics of the tariff reductions are still unknown.  If it ends up that we simply see tariff reductions but nothing new to show for it but agricultural purchases, it’s hard to see what the point of the tariffs were in the first place.

There is an element of the rollback that looks like the U.S. is trying to avoid economic problems before the election.  If that is the case, there are two issues that emerge.  First, China will press hard to get as much as it can in this phase because it likely concludes that American negotiators are in a disadvantageous spot.  Second, if Trump wins reelection, look for the tariffs to return.  We still believe that tariffs and trade impediments are a core position of this president and the current negotiations represent a tactical retreat, not a surrender.  However, for the short term, a rollback in tariffs and a trade truce is bullish for risk assets.

China financial issues:  China’s massive debt accumulation over the past 15 years has been well documented and, at some point, this mountain has to be addressed.  Debt problems are difficult to avoid; investment is hard because it’s about predicting the future and there will always be mistakes made.  It’s always important to remember that the opposite side of debt is an asset; in other words, one party’s debt represents another party’s asset.  When a debt problem emerges, the political system is where the “cost of adjustment” is decided.  In other words, how much pain will the debtor suffer relative to the creditor?  China appears to be moving to address this issue.  After years of forcing creditors to continue to provide credit to dodgy borrowers, the government appears to be allowing firms to fail and bankruptcy courts to adjudicate the adjustment costs.  We view this as good news.  Dealing with the problem is much better than simply putting it off.  However, the process will almost certainly slow economic growth; in fact, forcing the economy to slow is a necessary component because pushing growth increases the odds of malinvestment.  A slowing Chinese economy will adversely affect a world economy that has been dependent on Chinese growth but dealing with the debt issue in a systemic fashion reduces the likelihood of a financial crisis.  The key unknown is if the CPC can manage expectations and its own legitimacy in the face of slowing growth.  Chairman Xi has consolidated power and has a favorable chance to manage this transition.  But, it isn’t certain he can maintain the legitimacy of the CPC which had staked its reputation on delivering growth.  In related news, Chinese financial officials appear to be consolidating the banking system to stabilize it and avoid runs from small bank failures.

 

October foreign reserves rose $12.7 bn, a bit more than forecast.

China-Hong Kong:  In what may be Beijing’s new approach to quelling the anti-China protests in Hong Kong, a key advisor to the Chinese government warned the city would suffer dire consequences if it doesn’t adopt a national security law as required by its mini-constitution.  Adopting such a law would likely allow a clampdown on the protests under the guise of being a home-grown policy; failure to adopt the law would be a ready excuse to fire municipal Chief Executive Lam.

United Kingdom:  With the campaigning for the December election now in full swing, all the major parties are trying to gather support by promising big hikes in government spending.  For example, Chancellor Sajid Javid of the ruling Conservative Party, which probably has the best chance of winning the election, today announced a change in the government’s fiscal rules that will allow for spending £22 billion more on public infrastructure like roads and railways each year going forward.  Not to be outclassed, the Labor Party said it would loosen its fiscal targets to allow for £55 billion more on public investment each year.  Fearing a post-election borrowing binge, PIMCO Chief Investment Officer Andrew Balls says he is therefore steering clear of gilts.

Eurozone:  The European Commission cut its forecast for the Eurozone’s 2019 GDP growth to just 1.1% – a pace it said was “usually associated with the brink of recession.”  Citing its pessimism regarding trade tensions, the risk of a disorderly Brexit and soft global manufacturing, the Commission also cut its growth forecast to 1.2% for both 2020 and 2021.

Japan:  For the first time in two years, a special Diet commission has resumed debating a first-ever amendment to Japan’s pacifist constitution.  Although the amendment would focus on changing the law related to referendums, it would also touch on Prime Minister Abe’s dream of revising the war-renouncing Article 9 in order to allow Japan to boost its military and take a more muscular approach to international affairs.  Changing Article 9 would not only require winning a two-thirds majority in both chambers of the Diet, but it would also require winning a majority in a national referendum.  A key question is:  Does anyone really want to see Japan rearm?

Tech:  The technology firms can’t seem to get out of their own way.  There are reports that Twitter (TWTR, 29.54) employees engaged in spying activity on behalf of the Saudi government.  The state of California is investigating Facebook’s (FB, 191.55) privacy practices, accusing the firm of not complying with subpoenas.   With regards to Facebook, internal emails surrounding Whatsapp appear to indicate that the former may have engaged in anti-competitive practices.

They are Germans, after all:  Yesterday, we noted that Germany was warming to EU-wide deposit insurance.  The headlines suggested a breakthrough.  Well, it appears that this “warming” has come with caveats.  Essentially, Germany wants

1. Banks to buffer their exposure to government bonds with equity;
2. An almost radical reduction of non-performing loans;
3. A harmonized corporate tax base for banks.

Point #1 would be deadly for Italy, forcing banks to increase their capital because they hold lots of Italian government bonds.  Point #2 will make banks in Greece engage in massive asset liquidation and point #3 undermines Ireland’s corporate policy.   Without changes, the German plan looks dead on arrival, but simply putting it out there will allow Germany to say it supports bank deposit insurance; so, it has some PR value, but little more.

In other German news, Defense Minister Annegret Kramp-Karrenbauer, who is also leader of the governing Christian Democratic Party, said in a speech today that Germany should be “more courageous” in pursuing its strategic interests and should take a more muscular approach to international security, including boosting its defense budget and beefing up its military presence in Africa and Asia.  In part, her appeal probably reflects pressure from President Trump.  However, it also probably reflects the new dynamics we’ll see as the United States pulls back from its traditional role as global hegemon.  A key question is:  Does anyone really want to see Germany rearm?

Spanish elections:  Spain goes to the polls on Sunday for the fourth time in four years.  Voting intentions suggest it will probably lead to another inconclusive result.

BOE:   The Bank of England, as expected, left rates unchanged but there were two dissents calling for a rate cut.  The GBP fell on the news.

Energy update:  Crude oil inventories rose 7.9 mb compared to an expected build of 2.0 mb.

In the details, U.S. crude oil production was unchanged at 12.6 mbpd.  Exports fell 1.0 mbpd while imports declined 0.6 mbpd.  The unexpected rise in stockpiles was mostly due to falling exports and weaker refinery demand.

This chart shows the annual seasonal pattern for crude oil inventories.  We are now into the autumn build season which usually lasts into early December.  This week’s rise is normal, but the pace is accelerated.

We continue to monitor the autumn refinery maintenance season.

This week’s drop in utilization is unusual; we would expect a recovery next week.

Based our oil inventory/price model, fair value is $58.53; using the euro/price model, fair value is $50.13.  The combined model, a broader analysis of the oil price, generates a fair value of $52.23.   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 has been lifting oil prices as well.

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

[Posted: 9:30 AM EST] The second episode of the Confluence of Ideas podcast is available!

A German breakthrough?  Since unification, Germany has supported the EU with certain qualifications.  The primary goal, at least from the German point of view, is to prevent giving the rest of the profligate Europeans free access to German saving.  As part of that fear, Germany has resisted the creation of a Eurozone bond, a bond that would have the full faith and credit of all the nations of the Eurozone.  Although such a bond would be a significant competitor to the U.S. Treasury and raise the likelihood that the EUR would become a viable reserve currency, Germany has feared that its free-spending neighbors would borrow using this bond and force Germany to make good on the paper.  So far, a single bond hasn’t developed and that means a foreign nation holding EUR as reserves must choose a national bond to hold.  Given the divergence in yield and credit quality, this can be a difficult choice.  Another area of disagreement has been over deposit insurance.  It would be better for the Eurozone, since everyone has the same central bank, to have a unified regulatory structure.  This would include unified deposit insurance.  However, for reasons similar to its opposition to a Eurobond, Germany fears that a bad failure in another Eurozone nation could force German savers to spend money to bail out foreign depositors.  That opposition may be cracking.  Germany’s finance minister, Olaf Scholz, indicated he might support a unified deposit insurance program.  If such a program does develop, it would reduce the risk for Eurozone banks and likely give their equities a lift.

China’s Eurobond: Although the Eurozone doesn’t issue a Eurobond, apparently China does.  China has just issued a Euro-denominated bond, the first in 15 years.  The Chinese financial authorities sold €4 bn of bonds with seven-, 12- and 20-year maturities.  Half of the proceeds were issued in the seven-year at a 0.197% yield, with the remainder split equally between the other two maturities.  The 12-year carried a yield of 0.618% and the 20-year has a yield of 1.078%.  Demand was quite strong, with a bid/cover of 4.87x.  Part of the reason demand was strong is that China is considered a safe credit (even though it can’t print euros) and the seven-year yield compares favorably to a -0.5% German yield.  We suspect China has issued this paper to diversify its funding base; foreign-issued EUR paper is only about 5% of the world’s foreign denominated bonds, with USD dominating nearly all the rest.

China trade: Optimism on a trade deal is high.  Both sides seem to want a deal, and there is evidence that the Chinese leadership is preparing its citizens for a partial, not complete, removal of tariffs.  The Chinese position seems to be a measured and proportional removal of tariffs on both sides.  There is a problem with this plan, unfortunately, which is that the U.S. has a much larger target of Chinese imports to apply tariffs.  A pure one-for-one removal will leave China at a disadvantage.  This issue may be leading Chinese negotiators to overplay its hand.  In effect, China seems to want a near full removal of tariffs for opening up agricultural trade and promising to guard intellectual property.  This would seem to take away President Trump’s favorite trade tool—the tariff.  If China is really insisting that the U.S. forgo future tariffs for what it has offered, this will look like a cave by the U.S., something the White House probably won’t accept.  This all means that risk markets have been rising on expectations of a trade agreement; if that deal fails, as small as it will likely be, the reaction will be negative for equities.

On a side note, Europe is becoming worried that the focus on U.S. and China trade is leaving Europe out of the discussion.  The Chinese vice premier recently canceled a trip to Brussels.

Saudi Aramco IPO  Our suspicions that the Saudis would want to push up oil prices into the IPO have been confirmed.  The kingdom may need all the help it can get; foreign buyers will likely remain cautious about the geopolitical risk of the Saudi state oil company.

A weird world we live in: Greek sovereign bonds are on a tear.  It’s 10-year yields, which hit 34.8% in December 2011, are currently yielding 1.20%.  That’s right…that’s significantly less than the current U.S. 10-year at 1.85%.

The reason?  European inflation remains low and Greece has cleaned up its act after the near debacle earlier this decade.  However, we agree it makes little sense to believe that the risk of Greece is less than the U.S.  After all, Greece still is issuing bonds in a currency it can’t print.  Perhaps this is the clearest evidence yet of the distortions caused by low and negative policy rates.

Odds and ends: Russia has moved a small number of troops into Libya to support Khalifa Hifter.  This action is further evidence of Russia expanding its influence in the Middle East.  The U.S. is expanding the military mission in Syria solely to control the oil fields.  China is signaling that it will back stronger action to stabilize Hong Kong.

 

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

[Posted: 9:30 AM EST] The second episode of the Confluence of Ideas podcast is available!

Optimism over trade remains elevated; equities are moving higher and safety assets, Treasuries and gold, are suffering.  Here are the details:

China trade: There is a lot of news on trade.  First, there has been active consideration on both sides to roll back tariffs to secure a deal.  Reports indicate that the U.S. might remove the 15% tariff on $112 bn of Chinese goods.  Any agreement likely will also remove the $156 bn of tariffs scheduled for mid-December.  What is China offering?  The key “give” is to buy more agricultural goods, but the promise to buy $50 bn over two years is really more about returning to status quo ante.  In 2016 and 2017, China purchased around $20 bn each year.  Lifting to $25 bn per year is an improvement, but not a blockbuster.  For farmers, this deal would be welcome, but they probably would have preferred to have avoided the issue altogether.  The second part of China’s offer is to stabilize the CNY/USD.  We are seeing signs of that already.  However, this also isn’t a big ask; China has been worried that an overly weak currency could trigger capital flight and there is also concern about China’s growing corporate dollar-denominated debt.  Thus, the weaker CNY threat was probably more symbolic than real.  Third, China has offered rather vague promises to open up certain markets and respect intellectual property.  We harbor serious doubts that China will follow through on these promises in any significant manner.

So, we will likely get a deal. In the end, it’s hard to see how much progress was made.  The ultimate goal of the trade conflict was to force China to change its economic model.  Using the savings identity, 0 = (I-S) + (G-Tx) + (X-M), China’s private sector oversaves, leaving a negative balance in the first term of the equation.  To balance, either the government needs to run larger deficits or the nation needs to run a trade surplus.  The U.S. wants an end to the private sector oversaving.  We would argue that tariffs are probably not the best way to force this change; the bill proposed by Senators Hawley and Ballwin would likely be more effective.[1]  In the end, there was much turmoil but not much evidence of progress.

Still, this outcome is supportive for equities.

When tariff reductions are being considered, equities tend to rise, as do commodities.  When new tariff threats emerge, the opposite occurs.  Given the cautious positioning seen in the financial markets, a significant lift in equities would not be a huge surprise.  At the same time, the president has proven he can turn quickly to put tariffs back into the conversation.  Increasingly, though, this looks like it might be a second-term issue.

Government shutdown?  As noted earlier, we have not commented much on the domestic political situation, mostly because it hasn’t had a measurable impact on financial markets.  However, the current tensions might spill over into an area that would matter.  Without new spending bills, the government might be forced to shut down somewhere in the next seven weeks.  A shutdown could dampen this current “era of good feelings” and pressure equities.

China easing?  The PBOC made a modest cut to its new policy rate, the Medium-Term Lending Facility, to 3.25% from 3.30%.  The five-basis point move won’t trigger a huge economic response, but it is likely that this action will be the first of a few to ease monetary conditions in China.  If China were to move more aggressively to boost its economy, along with trade peace, we could see a further lift to risk assets.

Iran: In a bid to say it won’t be ignored, Iran announced it will increase its uranium enrichment activity.  This move further erodes the Iranian nuclear deal and will make it more difficult to European nations to support Iran against U.S. sanctions.  Although this move might increase tensions in the region, we doubt the U.S. will respond to this action; Iran is already heavily sanctioned, and the U.S. has no inclination to engage in military action against Iran.

Asia trade: The China-led Regional Comprehensive Economic Partnership (RCEP) is beginning to look like a dud.  In recent meetings India refused to join, reducing the impact of the partnership.  The rest of the members refused to ink an agreement.  China did try to spur activity, with Chairman Xi at the Shanghai Trade Expo touting his nation’s love of imports, but his comments didn’t help talks at the RCEP meetings.  Part of the reason might be China’s behavior in the region, which has not instilled confidence.

Other China news: There was little official news from the Fourth Plenum meetings.  However, as the meetings ended, some items have filtered out.  First, Ren Xuefeng, the CPC secretary for Chongqing, committed suicide at the meetings by leaping off the roof of the hotel where the gathering was being held.  There are rumors swirling that he may have been part of a purge by Chairman Xi, or was caught up in a local scandal.  Second, the general consensus from the meetings’ end is that Xi is firmly in control.  Third, the meetings did discuss Hong Kong.  We note that Hong Kong’s leader, Carrie Lam, has been called to Beijing for an unscheduled meeting with Vice Premier Han Zheng.  The latter is the state leader in charge of Hong Kong.

In other China news, officials of TikTok, the Chinese subsidiary of the privately held ByteDance, have refused to testify at congressional hearings that were scheduled for today.  The company, popular with Americans, is under scrutiny for its privacy controls.  The U.S. has launched a national security review of the company.

China-Taiwan: Two months before Taiwan’s presidential election, the Chinese government is offering sweeteners to Taiwanese companies and individuals to ensure a pro-Beijing outcome.  For Taiwanese businesses operating on the mainland, the measures would provide preferential land-use rules, the right to invest in passenger and air cargo services, and the ability to apply for financial guarantees from local government funds.  For Taiwanese individuals studying or living on the mainland, the measures would ease property purchases and provide Chinese consular protections when traveling abroad.  As we reported yesterday, China’s wooing comes as the Trump administration pressures Taiwan to restrict its technology sales to Chinese telecom giant Huawei (002502.SZ, 2.57).

United States: A Financial Times report shows the Trump administration launched just 25 new cases alleging criminal antitrust violations in 2019, marking the biggest drop-off in enforcement since the 1970s.  The figures highlight the administration’s focus on company-friendly deregulation, even as its trade and immigration policies get more attention from the press.

A return of the swing producer?  OPEC has acknowledged that its production will likely decline over the next five years due to the encroachment of shale production and rising climate activism dampening overall demand.  The report by the cartel seems to suggest that it will not fight to boost market share, and instead will reduce its own output to maintain prices.  This is the traditional role of the swing producer in the oil markets.

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[1] For details, see our Weekly Geopolitical Reports, Weaponizing the Dollar: The Nuclear Option, Part I (9/16/19) and Part II (9/23/19)

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

[Posted: 9:30 AM EST] The second episode of the Confluence of Ideas podcast is available!

Happy Monday!  Optimism reigns—everything is awesome!  Trade optimism, helpful monetary policy, decent earnings and modest economic growth are propelling U.S. equities to new highs.  The Saudi Aramco IPO is on.  Here are the details:

Trade optimism: Commerce Secretary Ross had a number of positive comments on trade over the weekend.  First, the secretary is “optimistic” on the first phase of the U.S./China trade deal.  On November 13, the U.S. is scheduled to decide if it will apply tariffs on European cars; according to Ross, those tariffs may not be necessary.  In addition, Japan reports that the U.S. may be lifting tariffs on its auto exports to the U.S.  Although all this news is positive, there are a couple of issues to note.  First, China is reiterating that its “core concern” is the lifting of all punitive tariffs, which seems highly unlikely.  Second, the American Chamber of Commerce warns that the successful “phase one” of the trade deal is mostly about supporting the farm belt and does little or nothing to bring structural change to China’s economy.  Overall, the trade news appears to be causing a clear relief that conditions aren’t going to get worse in the near term.  However, the longer-term issues are nowhere close to a resolution.

Unrest continues: Hong Kong marks its 22^nd weekend of protests and turmoil.  A pro-democracy politician was brutally attacked by an unnamed assailant.  Protests continued in Iraq; security forces there killed a 17-year-old.  Protestors attacked and temporarily stormed the Iranian consulate in Karbala as well.  Lebanon also saw widespread protests in its northern city of Tripoli.  The protests in Lebanon are putting noteworthy pressure on Iran’s ally in the country, Hezbollah.  For years, Iran’s modus operandi was to support protesters and the oppressed around the region.  For example, it supported Hamas even though it is a Sunni organization.  However, in Lebanon, Hezbollah is pressing to maintain the status quo.  This is what happens when a nation becomes, or desires to be, a regional hegemon; it no longer favors unrest because it prefers stability.

Saudi Aramco: At long last, the Kingdom of Saudi Arabia announced it will begin the process of taking its state oil company, Saudi Aramco, public.  It appears the company will have a valuation of $1.5 trillion, which is less than the royal family had initially hoped.  The IPO prospectus will be issued on November 9, with share trading likely in December.  There are two macro issues worth noting from this IPO.  First, although there is likely a myriad of reasons for the IPO, the fact that the Saudi royal family is selling part of the “family jewel” suggests concern about the long-term viability of oil.  Second, once the sale is made, we could see Saudi oil policy shift to retake market share.  It is possible the Saudis have been trying to prop up the price of oil in order to boost the valuation of the IPO.  Once the sale is made, the kingdom can more easily allow the price to fall to capture market share.  Given the obvious financial vulnerabilities in the shale patch, this might be a good time to boost output and depress prices.

Brexit update: One question that was hanging over the upcoming election was the path the Brexit Party would take.  If Nigel Farage, the party leader, was comfortable with the plan that PM Johnson had negotiated, he could simply stand down and one could reasonably expect Brexit Party voters would drift to the Tories.  If Johnson had managed to get his deal passed, the Brexit Party would have lost its reason for existence.  Over the weekend, Farage made his position clear—he has been pressing Johnson to scuttle his deal to get support of the Brexit Party.  Johnson refused and now Farage has indicated he will contest the election by putting up candidates from his party across the country.  Recent polling shows both Labour and the Conservatives are seeing improvement, while the Liberal-Democrats, the Brexit Party and the Greens are all falling.

United States-China-Taiwan: Over the last year, the Trump administration has repeatedly asked Taiwanese President Tsai Ing-wen to help cut the flow of technology to Chinese telecom giant Huawei Technologies (002502.SZ, 2.57).  Specifically, the administration has been pressing Tsai to restrict the amount of semiconductors that Taiwan Semiconductor Manufacturing (TSM, 52.10) can sell to Huawei.  TSM accounts for almost 25% of Taiwan’s stock market, and sales to Huawei account for some 10% of its total sales.  If Tsai succumbs to the pressure, it would likely be negative for TSM and Taiwanese stocks, in general.

China-East Asia: Negotiations have been completed to establish a new free trade deal between China and the 10 members of the Association of Southeast Asian Nations (ASEAN).  The “Regional Comprehensive Economic Partnership” focuses on trade in services, investment, dispute resolution and intellectual property.  Signatories reportedly see it as a way to maintain free trade as the U.S. becomes more protectionist.  Tellingly, the Trump administration only sent lower level officials to the associated U.S.-ASEAN summit being held in Bangkok today.  In response, ASEAN leaders only sent three heads of state to the meeting.

Japan-South Korea: On the sidelines of the big ASEAN meeting today, Japanese Prime Minister Abe and South Korean President Moon held their first meeting since last September, before the countries’ dispute flared up over Japan’s behavior in Korea during World War II.  Reports say the meeting was friendly, and more substantial talks on the dispute could still be scheduled.  Separately, the speaker of South Korea’s legislature said a bill has been drafted to facilitate “voluntary” donations from Japanese companies to South Koreans who had served as slave laborers before and during the war.  It is looking increasingly likely that some such deal could be the way this dispute is resolved.  A resolution of the dispute would likely be positive for both Japanese and South Korean equities.

Odds and ends: The head of the Hungarian central bank had an FT op-ed over the weekend in which he argued that the Eurozone is a failure and that an exit procedure should be established.  Saying such things out loud is generally not done in Europe but, overall, we tend to agree with Mr. Matolcsy.  One of the reasons home prices have been strong is that homeowners are staying in their homes longer than they used to.  A combination of fears of capital gains taxes and the inability to find another affordable property has led to a dearth of new supply.  Increased building activity would help, but the fears triggered by the 2008 Financial Crisis are likely dampening the risk tolerance of builders.  Today marks the 40^th anniversary of the storming of the American Embassy in Tehran.  There is a surprising degree of concentration in the electric vehicle battery industry and that concentration is centered in China.  JP Morgan (JPM, 127.80) has indicated that, due to regulations, it has moved $130 billion of excess cash into Treasuries and has sold off loans; this action was done to meet capital rules.  The U.S. and North Korea may resume talks in mid-November.  There are unconfirmed reports that the Turkish Air Force has attacked PPK sites in Iraq; this would be a serious escalation if true.  Bitcoin prices have apparently been manipulated!  Who knew?

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