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.

Hong Kong is deteriorating rapidly.  Trade talks continue, but friction is emerging.  Global economic data was ‘meh.’  Powell follows up his Congressional testimony today.  Worries about disease.  Here are all the details and more:

Hong Kong:  Conditions in Hong Kong continue to deteriorate.  As we noted yesterday, the protests have moved from being a merely weekend event to daily.  Protestors are increasingly destroying public property, such as tollbooths and vandalizing train stations.  They are also aggressively disrupting auto traffic by lighting up barricades.  Today, the area closed schools due to the civil disruption.   Mainlander students have been threatened and attacked by Hong Kong students; groups are arranging to rescue these students.  Civil order is breaking down in a profound manner; violence by both sides is elevated, and Hong Kong citizens have been remarkably tolerant of the disorder.  So far, Beijing has not cracked down but the increasing violence is reaching a point where a harsh reaction is increasingly likely.  Our take is that a full-blown crackdown will likely make any conciliatory moves on trade by the administration impossible.  The violence, if not quelled soon, is becoming a risk to financial markets.

Trade:  According to reports, trade talks are stalling over agricultural purchases.  On the surface, this doesn’t make any sense.  Chinese food prices are soaring, and a clear remedy is to import agricultural products in massive quantities.  Additionally, U.S. farmers and ranchers have that supply.  The problem comes down to process.  USTR Lighthizer has a long history in forming trade agreements with clear targets and responses if the targets are not met.  The U.S. is demanding that China “provide monthly, quarterly and annual targets for purchases.”  It is likely that if these numbers are not met, the U.S. would be able to retaliate with additional tariffs.  China has good reason to avoid hard numbers; by forcing Chinese buyers to purchase American goods, they could find themselves unable to arbitrage lower prices from other sources.[1]  China is making concessions in other areas, e.g., opening its markets to U.S. poultry.

In addition to farm product issues, China is apparently balking at strong enforcement mechanisms for technology transfers.  At the same time, the U.S. is reluctant to remove any tariffs without clear concessions from China.  China, of course, wants to see the U.S. remove tariffs to begin talks.  It is possible that both sides believe they need a narrative that shows the other side capitulated.  If so, the odds of a deal are much longer than the market currently thinks.

Global economic data:  Japan’s GDP rose an annualized 0.2%, the weakest growth this year.  The data was adversely affected by some one-off events, such as Typhoon Hagibis, but trade friction with South Korea and a slowing Chinese economy are also causing problems.

China’s data mostly disappointed investors.  China’s industrial production came in weaker than forecast, up 4.7% from last year, less than the 5.4% expected.  Private firms showed the most weakness, as state-owned firms’ production was steady.

Investment was also weak, rising 5.2% through the first nine months of the year compared to the same period last year.  Capital spending dipped to 3.7% in October, down from 4.8% in September.  Retail sales disappointed as well, rising 7.2% compared to forecasts of +7.8%.

About the only bright spot was Germany, who saw its GDP rise 0.1%, avoiding the layman’s definition of recession (two consecutive negative quarters of GDP growth) but still very sluggish growth.

Powell:  The testimony was modestly dovish.  In this press conference after the last meeting, Powell seemed to suggest the risks to the economy were balanced.  At the testimony, he seemed to signal that there was perhaps more risk to the downside, suggesting that the odds of the next move being a cut is higher.

Germany-Russia:  The German parliament has passed one of the final legal changes needed for Russia to complete its Nord Stream 2 gas pipeline to Germany.  The law exempts the project from EU rules forbidding one entity to be both the producer and the supplier of natural gas.  If the pipeline is soon completed as expected, the U.S. administration has threatened to impose sanctions on it, which would likely be a source of tension and headwinds for European stocks.

United States-North Korea:  After signaling its frustration at stalled denuclearization talks over the last several months, North Korea yesterday threatened to take a “new path” if the United States and South Korea resume the joint military exercises next month as planned.  Any resumption of North Korea’s provocative acts would likely hurt Asian stocks.

Brexit:  The Liberal Democrats have indicated they would not join a coalition with Labour if Corbyn is the PM.  The Brexit party will still run candidates in key Labour seats, a disappointment to the Tories.

Turkey:  Turkish President Erdogan received a warm welcome from President Trump yesterday.  However, his meetings with Senate leaders did not go well.  The Senate is rather unified on defying Turkey, and could force the president to veto sanctions at some point.

Bugs:  If there isn’t enough to worry about, the CDC warns that new viruses, bacteria and fungi that are resistant to antibiotics are resulting in 35k deaths per year.  China has confirmed at least two cases of pneumonic plague.  This version is a less known type of plague (bubonic caused the Black Death) but is actually more of a problem.  The pneumonic version can be transmitted human to human via the lungs; bubonic requires a flea bite.  So far, the Chinese situation appears under control but if it were to spread, it could be difficult to control.  It is curable with antibiotics.

Odds and ends.  Gang activity, originating in Sweden, has prompted Denmark to reinstitute border checks on ground traffic coming from northern countries.  Supporters of Juan Guaido seized the Venezuelan embassy in Brasilia, creating a standoff with security officials from both Venezuela and Brazil.

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[1] This is a short-run problem.  Agriculture commodities tend to close arbitrage windows fairly quickly; it would not even be unheard of for U.S. supplies to buy Brazilian grain to meet China’s quotas.  But, such arrangements mean that China will likely pay higher prices.

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

[Posted: 9:30 AM EST]

We are seeing some risk-off activity this morning as the markets digest the president’s speech yesterday.  Chair Powell goes to Capitol Hill today.  The IEA opines on energy.  Turkey’s leader comes to Washington.  Impeachment hearings begin today.  Spain has a new coalition (sort of).  Here are all the details and more:

The speech:  For the most part, the speech was a campaign event, with the president highlighting the economy.  However, the area that financial markets were focused on, trade relations, was not all that upbeat.  He did say that the U.S. and China were “close” to a deal but did not offer any insights as to what the deal would look like or when it would be signed.  It does appear that tariffs are the issue holding up an agreement.  It appears the U.S. will only reduce tariffs in exchange for actual changes in Chinese behavior.  There is little evidence that China will make substantial changes; in fact, the ones recently offered, changes in foreign investment laws and a stable CNY, are in China’s interest anyway.  However, the capture of intellectual property will likely continue.  What was ominous about the speech was that if no deal is made, the president promised more tariffs to come.  We still have not heard the fate of European auto sanctions, although a postponement is expected.  A couple of other trade items of note.  The White House is threatening to block the approval of the WTO’s budget which might shut down the organization on New Year’s Day.  Long Yongtu, the Chinese trade official who negotiated his nation’s entry into the WTO, is hoping Trump wins reelection because “he is easy to read.”  This comment may offer an insight into the Chinese leadership’s view of the election.  At the same time, Long is a senior leader and the report may simply reflect his views.  Our take is that China would prefer an establishment Democrat to Trump, but would rather have Trump than a populist Democrat.

Powell:   In yesterday’s speech, the president continued to lambaste the Fed; so far, there isn’t a lot of evidence it has had much of an impact.   Today, Powell faces his biannual testimony to Congress.  We expect him to be questioned about the recent rate cuts but also face an inquiry about the balance sheet.  Powell has been at the job long enough now that he probably won’t trigger any market moves.

The IEA:  Two items of note from the organization’s annual report.  First, the group sees peak oil demand in the next decade and second, shale oil will grow in importance, overshadowing OPEC.  The group did warn that energy efficiency gains were slowing, which supports the idea of higher gasoline taxes.

Turkey:  President Erdogan comes to Washington today for contentious meetings with the U.S.  Relations have become strained over arms purchases from Russia and Turkey’s actions against the Kurds.  Congressional opposition to Turkey is mounting, with Congress accusing Turkey of genocide against Armenians and pressing Trump to cancel the meeting.   President Trump is expected to offer Turkey a compromise on trade and sanctions.  Turkey has warned that if the U.S. and EU don’t ease sanctions, IS fighters could be released.

Impeachment:  As readers have likely noticed, we are not spending much time on impeachment because we doubt the president will be removed from office.  However, this doesn’t mean the action doesn’t matter.  The time spent on this issue will reduce bandwidth for other actions; the government could still run out of money later this month.

Spain has a new government:  The Socialists and the populist left party Podemos have formed a tentative coalition arrangement.  Although welcome news (another round of elections would likely be pointless) these two parties do not form a majority, so the coalition will still need support from minor parties that hold seats.

British election news:  Pressure is rising on Nigel Farage to completely withdraw his party from the upcoming election.  Labour has been facing cyber-attacks.  In what might be the most interesting development, videos of Johnson endorsing Corbyn and the latter supporting the former have emerged.  These are examples of “deepfakes” where hackers take video footage and meld it into a fake video that appears to say something rash.  There is rising concern that such videos, which look shockingly real, may become part of elections across the West.  This is the first time we have seen them in a “live” election.

Hong Kong:  Hong Kong violence continues to escalate.  The unrest may affect upcoming local elections, set for November 24^th.

Trouble in Israel:  Israel killed the leader of Islamic Jihad in Gaza yesterday.  Baha Abu al-Ata died in a guided missile attack.  He had been leading a series of missile launches into Israel.  Hamas, who runs Gaza, will probably shed few tears over the assassination.  Islamic Jihad is backed by Iran and is likely causing trouble for Israel to distract it from issues on its northern border.  At the same time, Hamas has little interest in a hot war with Israel at this time.  Meanwhile, relations between Jordan and Israel have definitely cooled, which is a concern for Israeli leaders.

Tech expanding its reach: Big tech’s search for consumer data has spread into healthcare. The Financial Times reports that health websites in the UK have been sharing people’s medical data with advertisers. Big tech firms Google (GOOGL, 1,297,21), Facebook (FB, 194.47), and Amazon (AMZN 1,778.00), as well as smaller ad-targeting agencies were accused purchasing this data. The ability to leverage consumer data is critical to big tech’s growth model, but we fear that its ability to do so may be reaching its apex. Governments across the world are growing distrustful of big tech, especially regarding its usage of data. As a result, there is growing talk about ways to regulate the acquisition and selling of data across the world. So far, it appears that Europe has been at the forefront of this movement, but the U.S. appears to be not far behind. In the U.S. big tech scrutiny has become bipartisan, presidential candidate Andrew Yang has argued that big tech should pay consumers for data access, while Republican Senator Josh Hawley of Missouri has been working on legislation to regulate tech’s ability to monetize data. If this trend continues, it will likely be bad for equities going forward.

The recession is over?  Recession fears in financial markets have clearly receded.  Investor surveys and fund manager cash positions suggest a surge in confidence.  Although we doubt this degree of optimism is justified, it is right on time for a Q4 rally.

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

[Posted: 9:30 AM EST]

It’s a quiet morning from the cold Midwest.  Auto tariff delay expected.   The president speaks in New York.  Investment may be weakening, and imports offer a warning.  Here is what we are watching this morning:

Tariff delay:  The decision on whether to apply sanctions on European autos is due tomorrow, but all indications suggest that the White House will delay the decision for another six months.  Talks continue and there is some speculation European automakers may move additional production to the U.S.   In an interesting development, it appears USTR Lighthizer was working on a “mini-deal” with European negotiators, which was designed to reduce tariffs on chemicals and fisheries products.  The Europeans turned down the proposal, citing rules that the WTO generally frowns upon such bilateral arrangements.  What we find interesting about this proposal is that it appears Lighthizer may be spearheading efforts to negotiate small trade wins for the administration, likely for political reasons as we head into 2020.  We doubt that the overall position of the administration has changed; trade restrictions are still preferred, but postponements and small trade deals are the likely path for the next year.  After that, we would look for a resumption of hostilities.

The president speaks:  President Trump will give a talk at the Economic Club of New York at noon EST.  We expect mostly a speech highlighting the economic successes of his administration, but the market’s focus will be on anything said about trade talks with China.  We doubt we will hear anything of substance but there is always a chance that something new will emerge.

United States:  With most S&P 500 companies having reported their third-quarter earnings, a new analysis of the reports suggests capital expenditures were up a modest 3.2% in the period.  That’s roughly in line with the tepid growth in the second quarter, but the companies indicated the growth rate will slip to just 1.8% in the fourth period, underlying the continued slowdown spawned by weaker global demand, Brexit, and the U.S.-China trade war.  The news is likely to be negative for U.S. equities.

Import warning?  West coast ports are reporting a sharp decline in import activity; inbound container handling fell 14.1% last month compared to a year ago.  Imports have a close relationship with overall consumption; the decline in imports is being blamed on trade uncertainty but if some of the drop is due to falling orders, it could be a sign of economic weakness.

This chart shows the relationship between the annual average of consumption and import contribution to GDP.  In 1947, the two series were correlated at -57%, but beginning in 1973 the correlation has been -71%.  Since 1970, every recession has included a positive contribution from imports; since imports are a drag on growth, this means that the decline in import growth becomes a positive contributor to GDP growth.  At present, import’s contribution is barely negative at -12 bps, the smallest since Q1 2013 when this segment reported a -6 bps contribution.  If the aforementioned shipping data merely represents trade war fears, it’s likely that the data is merely picking up changes in trade patterns.  In other words, other parts of the world could be making up for losses from Asian trade.  However, if it is reflecting overall weakness, it’s an early warning that there are problems developing.

United States-Japan-South Korea:  A day after the chairman of the U.S. Joint Chiefs of Staff called on South Korea to reverse its decision to end an intelligence-sharing pact with Japan, the Japanese government said Defense Minister Taro Kono and South Korean Defense Minister Jeong Kyeong-doo will discuss the matter on the sidelines of the ASEAN defense ministers’ meeting in Thailand on November 23, just ahead of the pact’s scheduled termination at the end of the month.  There is a significant chance that the two sides will merely use the occasion to repeat their positions in the continued dispute over Japan’s behavior in Korea before and during World War II.  However, given the intensifying U.S. pressure, it wouldn’t be a surprise to see some kind of agreement come out of the meeting, especially as both countries benefit from sharing intelligence on the common threat from North Korea.  If U.S. pressure does result in a cooling of tensions, it will serve as a reminder that even as the United States pulls back from its traditional role as global hegemon, the process will not necessarily be linear.  From time to time, officials will remember the U.S. interests in freezing old tensions like the one between Japan and South Korea and will take steps to cool those tensions.  All the same, the broader trend is for less U.S. engagement in the world rather than more.

Germany:  Despite the continued headwinds from weak global growth and trade tensions, the latest Zew index of investor sentiment in Germany improved much more than expected to -2.1 from -22.8 a month earlier.  Data due on Thursday could still show Germany slipping into recession, but the Zew data raise hopes for a quick turnaround.  The news should be positive for European equities.

Italy:  New data suggest Italian banks have been a prime beneficiary of the ECB’s recent “tiering” of its negative interest-rate system.  Banks’ deposits at the ECB are now exempt from negative rates up to a certain amount, and Italian banks’ deposits at the ECB had been €38 billion lower than their maximum exemption.  In October, the data showed they therefore borrowed some €48 billion at negative rates from banks elsewhere in the Eurozone and increased their deposits at the ECB by some €37 billion, boosting profits through the arbitrage.  Given that the weakness in Italian banks has been a significant reason for pessimism about the Eurozone, any evidence that ECB policy adjustments are helping the sector should be helpful for Eurozone equities.

Hong Kong:  For the past several months, protests have mostly been a weekend affair.  Students and young office workers, the most active in the protests, tended to go to school and work through the week and turn out on the weekends.  This week’s activity suggests the unrest is starting to bleed into the workweek and is becoming increasingly violent.  Increasing anger at the police is the apparent catalyst driving the extension of unrest.  Our position on Hong Kong is that Beijing will only move the PLA into the territory as a last resort.  A massive crackdown would likely push the U.S. Congress to send bills to the White House that would sanction China, putting the president into a very difficult spot.  If he signed the bills, trade talks would likely be over and positions between China and the U.S. would harden.  If he vetoed the bills, he would be open to the charge in the upcoming election of being “soft on China.”  At the same time, what has occurred in Hong Kong is “writing the script” for nationalists in Taiwan, and undermining support for unification.

Evo’s out—now what?  Evo Morales has moved on to Mexico, who granted him asylum, leaving a power vacuum.  Those who opposed Morales were unhappy with his increasingly authoritarian behavior and his violation of the constitution’s ban on a fourth term as president.  Unfortunately, that’s about all the opposition agrees on.  It isn’t clear who will replace him and what kind of support, or mandate his replacement will enjoy.  There is the potential that civil unrest could rise and, in the worst case, spread into neighboring countries.  We continue to monitor events.

Chile:  President Piñera’s effort to end his country’s political protests by offering a rewrite of the constitution appears to be falling flat.  For the protestors, the problem is that Piñera proposed the rewrite be led by the corruption-plagued Congress.  For investors, the problem is that the rewrite creates a risk that Chile’s free-market economic model might be changed.  Chilean stocks fell 1.5% yesterday.

Oil production decline?  Financing difficulties and generally disappointing prices are leading to warnings from domestic oil firms that drilling activity is set to slow.  This may not lead to an immediate supply decline, but by later next year the slowing should become more noticeable.

Odds and ends:  European signatories to the Iran nuclear deal are “extremely concerned” over recent reports of increased uranium enrichment activities.  China is lifting its export quotas for rare earths, perhaps in a bid to prevent the loss of market share to emerging competitors.  China has used rare earths in the past as a political weapon; this increase may suggest an abandonment of that policy.

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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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