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

[Posted: 9:30 AM EDT] Good morning!  It’s a rather quiet day in earnings season.  Mario Draghi holds his last meeting as president of the ECB, Boris Johnson waits for the EU and we have an update on Syria.  Here are the details:

ECB: The statement held no surprises.  The ECB left rates unchanged and QE of €20 bn per month will begin on November 1.  In the press conference, the tone was defiantly dovish.  However, market reaction has been very modest, probably because Draghi will be out in just over a week.

In related news, Germany has nominated Isabel Schnabel to the ECB.  She appears to be more moderate than her predecessors which may reflect an “olive branch” from the Merkel government.

Brexit update: The EU will decide tomorrow on how long it will give the U.K. to leave the bloc.  All indications suggest the decision will be an extension until the end of January.  Meanwhile, the Conservatives are trying to figure out if they should press for an election or wait until after Brexit.  The argument for an election is that a big win would give Johnson a mandate to push through his legislation without amendments.  However, there are three caveats to this decision.  First, Theresa May thought she, too, would win a large mandate; instead, she lost her majority and could only govern with an alliance with the DUP.  Simply put, the polls could be wrong.  Second, the polls could be wrong because the Brexit Party could siphon off Tory votes.  If Brexit is completed, there is no reason for the Brexit Party to exist.  Third, Johnson can’t call an election unilaterally; he either needs Jeremy Corbyn to agree to a no-confidence vote or convince a two-thirds majority to call an election.  Neither option is likely.  The downside of waiting for an election is that Parliament will start debating the withdrawal bill in detail, which will require compromises and amendments that will make Johnson look weak.  The good news on Brexit is that the odds of a sudden exit have diminished considerably.  The bad news is that it will go on longer.

Germany: Christian Kastrop, a former finance ministry official who helped author Germany’s constitutional “debt brake,” said in a Financial Times interview that it’s now time to change the law to allow increased borrowing and greater investment in infrastructure, digital technology and climate mitigation.  It’s one more sign that global sentiment is shifting, slowly but surely, toward looser fiscal policy as the impact of loose monetary policy peters out.

Syria: President Trump, satisfied with the ceasefire and the new buffer zone, has removed sanctions on Turkey.  Kurds are evacuating the buffer zone.  The president couched the quick revocation as a reward for Turkey’s adherence to the five-day ceasefire brokered by the United States, but his statements suggest it was actually a doubling down against the bipartisan criticism he has taken for abandoning the long-time U.S. ally.

China in its place: In a recent speech, SoS Pompeo made the following comment:

We’ve reconvened “the Quad” – the security talks between Japan, Australia, India and the Untied (sic) States that had been dormant for nine years.  This will prove very important in the efforts ahead, ensuring that China retains only its proper place in the world.

He did not elaborate on what he means by China’s “proper place.”  It’s hard to see how that could be anything other than containment.  Needless to say, we are sure that Beijing has read this statement and have no doubts it was not welcomed.  Although some sort of trade deal next month is likely, the fundamental relationship between China and the U.S. has changed and won’t return to the status quo ante.

In another interesting comment, an unnamed U.S. military officer told reporters that the Japanese government should do more to explain to its citizens the threat China means for the region, suggesting Japan should consider an offensive-defensive stance.  This report is additional evidence that the U.S. is steadily removing itself from the stabilization role that it has performed since the end of WWII.

Other China news: In response to slower housing demand, Chinese developers have been cutting prices to spur sales.  It should also be noted that about a fourth of real estate developer debt is dollar-denominated, so any weakness in the CNY could make debt service more difficult.  In the absence of pork, rural communities are returning to eating other proteins.  U.S. senators are pressing Federal worker retirement funds to cease the use of index funds that hold large components of Chinese equities.  In general, economists don’t think that the upcoming “phase one” of the trade deal will reduce recession odds.  We also note that M&A activity between the U.S. and China has plummeted.

Global unrest: Although it hasn’t had much of an impact on markets, we are paying attention to widespread unrest and protests.  One common theme we are noticing is that seemingly modest changes in charges for public services are not being accepted; in fact, the reaction seems far out of proportion.  In general, our observation is that disproportional reactions are usually not due to only the apparent catalyst but have longer roots in the past.  Mass dissatisfaction has lots of factors behind it but underlying them all is a belief that societal elites are not looking out for the interest of the general public.[1]

Japan-South Korea: Japanese Prime Minister Abe held a short meeting with South Korean Prime Minister Lee, who was in Tokyo this week for the enthronement of Japan’s new emperor.  Unfortunately, however, the talks yielded no progress on the dispute over Japan’s behavior in Korea before and during World War II, which we wrote about in a two-part WGR series on Sept. 30 and Oct. 7.

Canada: Even though his Liberal Party lost its parliamentary majority in Monday’s elections, Prime Minister Trudeau said he will not enter into either a formal or informal coalition with rival parties.  That suggests Trudeau will have more freedom to form the government he wants, but it also points to potential stalemates or instability as Trudeau will have to pass legislation – and survive any no-confidence motions – by forming ad hoc coalitions.  On balance, Trudeau’s approach is probably negative for Canadian risk assets going forward.

Odds and ends: We have a new emperor in Japan.  The Riksbank warned in its latest monetary policy report that it would probably hike its benchmark interest rate to zero in December, compared with -0.25% currently.  This action by the Swedish central bank could signal the limits of negative interest rates.  The Turkish central bank yesterday slashed its benchmark interest rate to 14.0% from 16.5% previously, citing decreased inflation pressure and a stabilizing lira.

Energy update: Crude oil inventories fell 1.7 mb compared to an expected build of 3.0 mb.

In the details, U.S. crude oil production was unchanged at 12.6 mbpd.  Exports rose 0.4 mbpd, while imports fell 0.5 mbpd.  The decline in stockpiles was mostly due to rising exports but a rise in refinery demand contributed to the draw.

This chart shows the annual seasonal pattern for crude oil inventories.  We are now in the autumn build season, which usually lasts into early December.  This week’s drop, though modest, is contraseasonal and bullish for crude oil.

We continue to monitor the autumn refinery maintenance season.

This week’s recovery in utilization turned “on schedule.”  We would expect refinery operations to rise steadily into year’s end.

Based our oil inventory/price model, fair value is $62.96; using the euro/price model, fair value is $48.47.  The combined model, a broader analysis of oil prices, generates a fair value of $52.73.  We are seeing a clear divergence between the impact of the dollar and oil inventories.  Given that we are in the maintenance season, we would normally expect inventories to continue to rise.  We have been seeing stabilization of oil prices and would expect that to continue for the next few weeks.

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[1] A good book on this topic is Ages of Discord by Peter Turchin.

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

[Posted: 9:30 AM EDT] Good morning!  An update on Brexit, Carrie Lam on the outs, trade update, Syria update and more on repo.  Here are the details:

Brexit: It was both a good and bad day for Boris.  The good news is that his Brexit bill passed Parliament as he pulled in independents and Labour defectors to pass the measure.  Then, the disappointment followed—lawmakers voted 322 to 308 to delay the legislation for more time to examine what turned out to be a rather large bill.  So, now what?

1. The likelihood of a Halloween exit is not zero, but it is highly unlikely. The EU is already signaling it will offer an extension until at least the end of January.
2. Johnson will press for an election, but that path has two problems:
   1. Labour might not support that outcome; polls suggest Corbyn will lose in an election and he may not want to risk that outcome.
   2. Johnson needs to convince voters in the Brexit Party that he has delivered their outcome by passing the bill. If he can’t, those voters could prevent him from gaining a majority in Parliament.  If Brexit had occurred, the reason for the Brexit Party’s existence would no longer be operative and these voters would likely shift to the Tories.
3. It is possible that, after further review, MPs could decide to implement the passed bill in the 90 days between Halloween and January 31, 2020. In that case, an election would likely follow.
4. There will be attempts at adding amendments. One such addition might be to signal that the U.K. should consider negotiating on a U.K.-wide customs union.  However, that won’t be part of the bill that passed.  Another would be a referendum, but it doesn’t appear that has the votes either.
5. Time is not on Johnson’s side. As MPs have more time to read the complicated document, it is a real risk that the details could cost him some support.
6. Thus, the status quo will be in place for now. The next big decision, or lack thereof, is probably on the election.

Finally, here is an interesting chart on the Brexit issue.  It shows U.K. imports of technology components from the Netherlands.  There is a clear increase in imports from mid-2018, when the Brexit vote occurred.  One issue that develops under conditions of trade uncertainty is that companies and consumers begin to stockpile critical goods on fears of potential supply disruption.  This inventory accumulation, if large enough, can distort economic data, leading to stronger data before the trade disruption occurs and weaker data afterward as the inventoried goods are used up after the trade action is implemented.  What could be happening in the U.K. now is that companies and consumers are building inventories, causing the economy to look stronger than it really is; after Brexit, we could see an inventory “hangover.”

Carrie Lam out?  The FT is reporting that Beijing is planning to force out the current Hong Kong leader, Carrie Lam, with new leadership.  According to reports, Lam will resign at the end of Q1 and an “interim” leader will be appointed by Chairman Xi.  Reports suggest the head of the Hong Kong Monetary Authority, Norman Chan, is the frontrunner to replace Lam.  It is likely that Beijing hopes removing Lam will ease tensions with protestors.  We have our doubts but, clearly, Lam has become unpopular.

Trade update: In a rambling interview with the FT, Wilbur Ross suggested that new trade talks with the EU are possible, which might avert a trade conflict with the U.S.  The U.S. has set a deadline for mid-November on auto tariffs; new talks could delay the implementation or avoid them completely.  Ross also indicated that talks with Chinese negotiators are going well.

Syria: Russia and Turkey have reached an agreement to jointly operate a buffer zone in Syria.  The winners?  Turkey, which now gets what it wanted—a Kurdish-free zone on its southern border.  Other winners are Assad, who ostensibly gets more of his territory back, and Russia, which is rapidly becoming the power broker in the Middle East.  Under the deal, the Kurds have six days to retreat more than 20 miles from the Syrian/Turkey frontier.  We will now be watching to see if Kurdish forces actually retreat or fight against Turkey (and perhaps some Russian forces) to oppose the new zone.  We suspect there will be some fighting but, in the end, without air cover, the Kurds are doomed if they resist.  However, over time, we would expect the time-honored tactic of guerrilla warfare to develop, with Kurdish irregulars harassing Turkish troops guarding the new zone.

Repo: The Fed is continuing to inject liquidity into the system.

Although officials are continuing to argue that all is well, the size and continuous injection of liquidity is concerning.  What we find interesting is that there is a growing dispute over this issue.  The banks are arguing that the liquidity problem is due to excessive regulation, while Sen. Warren and others are countering that this may be a manufactured crisis to force a rollback in regulation.  Here is the problem—if the banks are right and Warren and others prevent changes in regulation, we could end up with a liquidity crisis.  If Warren et al. is right and regulations are rolled back, this could encourage risky behavior and create a financial crisis.  It is critical that regulators figure out who is “on the side of the angels” on this one because getting it wrong could have serious consequences.

Recessions fears rise: According to a report from the National League of Cities, expected to be released on Monday, two-thirds of finance officers in large cities are predicting a recession within the next two years.  As finance managers head into the next fiscal year, many suspect that their government expenditure could outpace revenue.  This is worrisome as a reduction in government expenditure can lead to a slowdown in economic activity in these cities.  In addition, it is widely believed that a slowdown in cities generally foreshadows a broader slowdown on the national level.  Furthermore, fears of localized contractions have been noted on the state level as well.  According the Philadelphia Fed’s state leading indicators, five states are expected to contract over the next six months.

European complications: One of our themes has been that the U.S. is withdrawing from three conflict zones in the Far East, the Middle East and Europe.  Our most recent podcast touches on that theme.  Here are a couple of interesting complications that highlight this issue in Europe.  First, France has been reluctant to expand the EU to include Albania and North Macedonia.  In response, these nations are considering reaching out to China and Russia for support.  Second, in the turmoil surrounding impeachment and Ukraine, Hungary has been a background influence.  After WWI, when the Austro-Hungarian Empire was broken up, thousands of ethnic Hungarians were scattered across Eastern Europe.  Hungary has generally considered this diaspora as part of its citizenry.  The nations in which these Hungarians live disagree.  In 2010, PM Orban issued Hungarian passports to Hungarians living outside of Hungary.  This allowed these Hungarians to vote in Hungary’s elections and they tended to vote for Orban’s party.  However, Ukraine doesn’t allow its citizens to hold dual passports; thus, Orban had a problem with Ukraine, which was expressed by raising corruption issues with the U.S. against Ukraine.  While this is all now part of the impeachment discussion, the bigger issue is that Europe is riven with similar ethnic dispersions.  U.S. power has prevented these issues from dividing Europe, allowing the EU to flourish.  However, as the U.S. withdraws, expect more of these sorts of historic claims to become a destabilizing problem for Europe.

Odds and ends: Zuckerberg goes to Capitol Hill today to discuss Libra.  Facebook (FB 182.34) is now facing an antitrust probe backed by 47 states.  Brazil’s Senate passed an important pension reform bill that should be enacted in the coming weeks.  It will allow the country to bring its retirement spending under control and is a major victory.

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

[Posted: 9:30 AM EDT] Good morning!  It’s rather quiet in the markets this morning.  Trudeau wins another term, but not a majority.  The Brexit saga continues.  No government in Israel.  Some background on Chile.  Here are the details:

Trudeau wins:  PM Trudeau won another term but his party didn’t get a majority, falling 13 seats short.  To govern, he will need the support of either the New Democrats, or the Bloc Quebecois.  The former won 24 seats, the latter won 32 seats.  So far, financial market reaction has been modest as, at least initially, little will change.  However, the parties that he will need to partner with in order to gain a majority are much more left wing, and pushing for strong climate change legislation.  Both parties are not strongly in favor of USMCA.  Thus, we could see a leftward drift in Canadian policy, which would not be favorable for Canadian assets longer term.

Today in Brexit:  Today, at 2:00 EDT, the House of Commons will vote on the Withdrawal Agreement Bill.  This vote is known as the “second reading.”  This is a straight up or down vote on proceeding to further debate.  If it fails, the clock essentially stops; the bill will likely be pulled, and there is a possibility of a hard Brexit.  If it passes, and it appears it will, then Parliament will decide if the bill will be subject to amendments. That vote will likely happen tomorrow.  Labour wants to attach a second referendum for approval; that amendment doesn’t appear to have the votes.  There is also a separate amendment that would mean all of the U.K. will remain in the EU customs union instead of just Northern Ireland.  That amendment might pass.  Johnson, at that point, can either pull the legislation and go to an election, or accept the arrangement, get Brexit done and go to election.  If he wins a strong enough majority, he can then move to remove the amendment.   We expect him to take the second option; he likely feels that if he can deliver Brexit, his chances of winning an election are very strong (and we would agree with this position), and thus he can use that majority to shape Brexit going forward.  It’s important to remember that Brexit is more like the end of the beginning, than the beginning of the end.  Once the exit agreement has been struck, the U.K. and the EU will then decide on what sort of trading arrangement will be put in place going forward.

One side note; there is growing speculation that if Northern Ireland remains in the EU customs union but legally in the U.K., the region will have interesting trade characteristics.  Suppose the Trump administration applies tariffs to the EU post-Brexit.  Those tariffs would apply to the EU but not the U.K.  Northern Ireland would then be in the EU customs union, but not subject to the U.S. tariffs.  This unique condition could make Northern Ireland a haven for EU companies seeking to avoid U.S. tariffs.

Chinese trade:  Chinese officials reported that “substantial progress” had been made during recent talks.  Although there is little evidence that the difficult measures are being discussed, a small deal that can be signed next month looks increasingly likely.  Yesterday’s equity market rally was due, in part, to trade optimism.  However, to push markets to new highs, we will likely need to see the U.S. postpone tariffs due for December.  This is possible; however, the administration will likely only agree to a postponement, not a removal.  If so, the positive impact will be lessened.

A couple of other notes on China; as China negotiates on trade, it is petitioning the WTO for $2.4 bn in retaliatory tariffs.  We also note that, in reaction to slowing economic growth, Chinese officials are returning to a familiar pattern, boosting public works investment to lift growth.

Chile:  Unrest continues to spread in Chile, with 12 reported deaths.  The key problem is inequality.  Chile has leaned towards free markets since Pinochet built the economy on advice from University of Chicago economists.  One of the ways the political class tries to deal with the “pie sharing” problem is to expand the pie; that way, those who currently “have” can receive the same, while those who “have not” can get more.  Chile’s economic problem is its heavy dependence on copper. GDP tends to lag copper prices by about three quarters.

The exchange rate also closely tracks prices of the red metal.  The chart below shows the exchange rate (inverted) relative to the price of copper.

The inequality problem in Chile needs stronger Chinese growth to fix; slowing world growth, but especially in the commodity consuming China, is a problem for commodity suppliers.

Israel: Yesterday, right-wing Prime Minister Netanyahu gave up trying to form a government, so President Rivlin is now widely expected to give a shot to Benny Gantz, the former army chief heading up the center-right Blue and White Alliance.  It appears Gantz could form a minority government if he can strike a deal with leftist and Israeli Arab parties.

Bolivia:  Authorities this morning resumed issuing vote-count updates from Sunday’s elections, with the numbers now showing leftist President Morales likely to win by enough to avoid a runoff.  Initial counts Sunday suggested a runoff would be needed.  After an inexplicable lull in count updates, the huge swing is raising concerns of electoral fraud, and protests have erupted.

Japan:  Emperor Naruhito completed his accession to the Chrysanthemum Throne today, with Prime Minister Abe shouting “banzai” (meaning “10,000 years”), and spectators ranging from Britain’s Prince Charles to South Korean Prime Minister Lee Nak-yon (though, notably, not South Korean President Moon).

Japan-China:  The Japanese and Chinese navies have held their first joint drills since 2011, including the first Chinese naval visit to Japan since 2009.  Despite tensions over China’s claims to the South China Sea, the countries’ leaders reportedly want to improve trade and defense ties as the United States takes a more confrontational, protectionist stance against them.

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

[Posted: 9:30 AM EDT]

Note: After a long hiatus, we have resumed podcasting.  Our new series, titled The Confluence of Ideas, begins with an overview of “Hegemonic Stability Theory” (the program title links to our podcast page).  Our plan is to record a new episode about every 10 days, or three per month.  We hope you enjoy them—let us know what you think!

Happy Monday!  An update on Brexit, and our thoughts on the drug cartels in Mexico.  Unrest is springing up all over the world and so are elections.  Here are the details:

Brexit: The anticipated vote didn’t happen on Saturday.  Instead, Parliament passed a measure that forces PM Johnson to ask for an extension.  He sent an unsigned letter to Donald Tusk asking for the action.  Initially, this vote looked like a major blow for Johnson but, in reality, it appears the vote was to ensure that a hard Brexit won’t occur on Halloween.  Johnson intends to bring his bill up again this week and estimates of votes suggest he will get the 320 needed to pass.[1]  In other words, a slim majority has decided this is the best deal they are going to get and favor Johnson’s plan; they didn’t vote for it on Saturday, opting for the other measure, in order to prevent a hard Brexit.

That being said, there is still a good bit of uncertainty.  Labour may attach a call for a second referendum, this time on Johnson’s bill.  This position might gain favor even if Johnson’s bill passes if the majority is narrow.  If a second referendum is held, there is a rising possibility that the U.K. stays in the EU.  Why?  Because of demographics.  Older voters support Brexit; younger voters don’t.  Over the past 30 months since Brexit started, older voters have died and more young people have become eligible to vote.  The GBP continues to swing based on sentiment toward Brexit; as the odds of a hard Brexit fade, the currency has been appreciating.

Mexico: Last week, in the city of Culiacan, there was a firefight between Mexican troops and gunmen associated with Joaquin Guzman, the son of “El Chapo,” the notorious drug lord.  After capturing the young Guzman, authorities returned him to his “associates” following the cartel’s threats to assassinate Federal officers in their control.  This situation is quite disturbing.  Harkening back to Thomas Hobbes, we give the state a monopoly on violence to protect us from lawlessness.  A monopoly on violence, according to Max Weber, is one of the hallmarks of a nation.  The fact that drug cartels control much of Mexico weakens the government’s claim on sovereignty.  Although this doesn’t necessarily prevent investors from considering Mexico as a destination for funds, the tenuous nature of state control does have to be taken into account.

Unrest spreading: We are seeing civil unrest spreading around the world.  There was another round of protests in Hong Kong on Sunday.  Protestors across the political spectrum came out against corruption in Lebanon.  Meanwhile, in Chile, protests against a fare hike for public transportation are expanding rapidly.  The Pinera government has rescinded the hike but unrest has continued, enough to trigger state-of-emergency declarations.  Eight people have reportedly been killed in the rioting.  Protests have emerged in other South American nations, including Argentina and Ecuador.  The common themes in these protests are opposition to corruption and a reaction against austerity.  We are continuing to monitor Hong Kong, although we suspect that, in the end, Beijing will bring things under control.  The unrest in Chile is escalating and the government’s reaction has been rather harsh.  Chile has been one of the most stable nations in the region, so civil disorder there does raise concerns.  Lebanon is divided, therefore small protests can spin into big ones relatively quickly.

Elections: The Swiss held elections over the weekend, in which the Greens had the best showing.  The center-right will continue to dominate the government.  Vote counting continues in Bolivia.  It appears the vote will be inconclusive and a run-off will be necessary, although the fact that election officials stopped updating results has raised concerns of a “fix.”  Canadians go to the polls today in a race that is too close to call.  Argentina will hold its elections next week.

Germany: The Bundesbank said the country’s economy may have contracted in the third quarter.  If so, it would mean Germany has entered its first recession in six years.  That confirms the view of most analysts, and it suggests continued weakness in the overall Eurozone economy and strong headwinds for Eurozone stocks.

Global fiscal policy: At the annual meetings of the IMF and World Bank over the last week, multiple finance ministers and central bankers suggested the threat of further slowing in the global economy calls for increased fiscal stimulus.  The officials specifically noted that easy monetary policy is now probably at the limit of what it can do to support the economy.

China trade: There was some optimism expressed by China on the progress of trade talks.  However, there were no details offered.  The optimism is helping equities this morning.

Syria: U.S. troops are decamping for western Iraq, although the administration is considering leaving a small contingent in Syria.  Kurdish forces have withdrawn from the border as part of the ceasefire agreement.

Odds and ends: JP Morgan (JPM, 120.56) is announcing a new plan to reintroduce those with criminal backgrounds into the workforce.  Some of this is likely part of recent announcements by the Business Roundtable to move beyond mere shareholder interest in setting policy, but it is also possible that tight labor markets are prompting the move.  Although fears have eased, there are still worries about financial market liquidity.  One of the characteristics of cyberwar is that it can be difficult to determine the source of the attack.  Russia has taken this a step further, instigating attacks and making it appear that Iran was behind them.  It’s getting so hard to find financing in the shale oil patch that some firms are turning to directly securitizing wells.  This action effectively turns ownership of the well over to a special purpose vehicle which pays out production revenue to bondholders.  These bonds could have some interesting characteristics; rising oil prices might actually boost the value.  At the same time, it would shift a number of risks to bondholders, including faster decline rates and regulatory changes.  Mario Draghi presides over his last ECB meeting on Thursday.

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[1] Although there are 650 seats in Parliament, the Commons Speaker and his three deputies don’t vote.  And, Sinn Fein has seven seats in Parliament but refuses to sit in the House of Commons.  That means there are effectively 639 seats, so 320 will pass a measure.

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

[Posted: 9:30 AM EDT]

Note: After a long hiatus, we have resumed podcasting.  Our new series, titled The Confluence of Ideas, begins with an overview of “Hegemonic Stability Theory” (the program title links to our podcast page).  Our plan is to record a new episode about every 10 days, or three per month.  We hope you enjoy them—let us know what you think!

Happy Friday!  China GDP growth eases.  Ceasefire in Turkey.  Here are the details:

China:  Third quarter GDP was up just 6.0% year-over-year, compared with annual increases of 6.2% in the second quarter, and 6.4% in each of the two quarters before that.  The growth rate in the third quarter was not only weaker than expected, but it was also the slowest expansion in some 30 years.  The slowdown stemmed primarily from the U.S.-China trade war, cooling manufacturing investment and weaker income growth; along with the simple fact that the economy is much bigger, and more mature than it was during its peak growth period in the early 2000s.  Of course, China’s true growth rates are widely considered to be even weaker than the official data indicates.  The really intriguing thing about today’s report is that the government was willing to release such a weak number.  Along with its generally limited stimulus measures in recent months, this could reflect a deliberate decision to signal that slower growth is now acceptable and won’t necessarily lead to new fiscal, or monetary policy responses that might worsen the country’s debt load.  The data has therefore weighed heavily on Chinese stocks today, driving them sharply lower.

U.S.-China Trade:  Right before the latest round of U.S.-China trade talks early this month, National Economic Council Director Kudlow arranged for a group of outside economists to meet with President Trump and explain how trade uncertainty is hurting the economy.  Tellingly, Trump reportedly pushed back, blaming the Federal Reserve for not doing enough to boost the economy.  All the same, it is possible that the economists’ message helped convince the president to strike the partial deal with the Chinese.  The question is whether the message will stick long enough to prevent a reversion to Trump’s tough tactics against China.

Ceasefire:  Turkey has agreed to a five-day ceasefire on the southern border, which eases the threat of U.S. sanctions.  However, there are reports that suggest the agreement is already being violated as shelling and drone strikes have apparently occurred.  It appears to us that it is unlikely Turkey will “take its foot off the gas pedal” in this fight, so even this limited ceasefire probably won’t be strictly followed.

Brexit:  There isn’t a whole lot more to say on this topic.  The vote will occur at 4:00 pm (11:00 am EDT), on Saturday.   The law needs the vote of 325 MPs.  So far, Johnson has 287 with certainty.  The DUP’s 10 MPs have already indicated they won’t support the measure, and Johnson pushed 23 former Tories out of his party.  It is expected that a majority of these 23 (not included in the 287) will likely support the measure.  Thus, to push this through, he needs some Labour support.  The FT’s current estimate suggests neither side has this locked up; their headcount is 321 against, 318 for.  That means that Johnson must woo seven of the remaining 11 undecided MPs to pass his plan.  The prediction markets still have the measure failing, 40% to 60%.  However, the odds have improved over the past 24 hours, from a 26% chance of passage.  If the measure fails, the Benn Act requires that Johnson ask for an extension from the EU; we do expect it to be granted, but there is no guarantee it will be.  BREAKING:  FRENCH PRESIDENT MACRON INDICATES HE WILL REJECT AN EXTENSION.   If one of the remaining 27 nations in the EU votes against an extension, a hard Brexit on Halloween would be looming.  Our take?  The chances of more Labour defections is elevated and the chances of passage with a close vote may be higher than it looks, while the possibility of a hard Brexit may move some votes to Johnson’s side.

Japan:  Prime Minister Abe’s cabinet has approved draft legislation that would require foreigners to advise the government before buying more than 1% of Japanese defense-sector stocks.  The move shows how protectionism is moving beyond trade and into the realm of international investment.  As we’ve been discussing recently, similar moves are afoot in the U.S. Congress, with the potential to seriously alter the makeup of the U.S. bond and stock markets as well as the prospects for the dollar.

Japan:  Defense Minister Kono said Japan will send naval ships and patrol planes to the Gulf of Oman to help protect oil shipments through the area.  However, reflecting Japan’s growing confidence in its large and capable navy, the Japanese forces will operate independently rather than joining the U.S.-led coalition being formed to help with that task.

The strike:  Although negotiations between General Motors (GM, 36.19) and the UAW have reached a tentative agreement, the union has decided to maintain the walkout.  This is a bit unusual; normally, once a deal is reached, the union calls off the strike on the assumption that the rank and file will approve.  The agreement, from our reading, doesn’t appear to be all that firm on future jobs; there was no detail released on future investment, and no guarantees on bringing jobs back from Mexico.  Thus, even though there is more money for workers in the proposed contract, passage isn’t certain.

Odds and ends:  Bolivians go to the polls on Sunday to decide if Evo Morales will get a fourth term (a violation of the constitution).   Germany expresses concern over a U.S./EU trade conflict.  China has acquired a lease to the entire island of Tulagi, a major potential threat to Australia and New Zealand.   After the Senate failed to overturn a veto on wall funding, a budget battle looms that could shut down the government next month.  Saudi Arabia has delayed the Saudi Aramco IPO.  Protests against the jailing of Catalan-independence leaders continues to worsen, including violent clashes with police in Barcelona and elsewhere in the region.  However, the violence is starting to cause cleavages in the independence movement.  It is also further weakening the ruling Socialist Party ahead of the elections on November 10.

Energy update:  Crude oil inventories rose 9.3 mb compared to an expected build of 3.1 mb.

In the details, U.S. crude oil production was unchanged at 12.6 mbpd.  Exports fell 0.2 mbpd while imports rose 0.1 mbpd.  The rise in stockpiles was mostly due to continued declines in refinery demand (see below).

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.

The most important information from this week’s data is that we are now well into the autumn refinery maintenance season.

The drop in refinery utilization should end with this week’s data.  However, the decline refining is well more than normal and is having a bearish effect on oil prices.

Based on our oil inventory/price model, fair value is $62.41; using the euro/price model, fair value is $47.31.  The combined model, a broader analysis of the oil price, generates a fair value of $51.74.   We are seeing a clear divergence between the impact of the dollar and oil inventories.  Given that we are into the maintenance season, we would normally expect inventories to continue to rise.  Prices will remain sensitive to Saudi output and tensions in the Middle East.

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

[Posted: 9:30 AM EDT] The EU and the PM Johnson have a deal.  Trade news continues.  Interesting items emerging from the financial markets.  Here are the details:

Brexit:  In the wee small hours of the morning (at least in the U.S.), EU and U.K. negotiators made a deal on Brexit.  Here are the key points:

1. The deal is mostly what PM May delivered with one key difference. The May deal forced the entirety of the U.K. to remain in the EU customs union.  Under Johnson, only Northern Ireland is still in the customs union.  In effect, there is a trade barrier between the British Isles and the Irish Sea.  As we suggested earlier, there was a clear chance that Johnson would sell out the DUP to get a deal.  It looks like he did.  The U.K. will now be able to negotiate new trade agreements with other nations, but Northern Ireland won’t be included in whatever arrangement emerges.
2. The DUP has already come out in opposition. This is to be expected.  However, it should be noted that of the 18 seats in Northern Ireland, seven lean republican (support union with Ireland) and so those seven will likely support the deal.  After all, Northern Ireland’s economic position is enhanced; it will be a member of both the U.K. and EU customs unions and there won’t be a hard border with the Republic of Ireland.  However, for the Unionists this deal is terrifying because it does separate, at least in economic terms, Northern Ireland from the U.K.  That is a step toward unification, although it may be a minor one.
3. At the same time, the DUP rejection will have an effect on hardline Brexit supporters within the Tories. When the DUP rejected May’s proposal, this group (the “European Study Group”) also rejected her plan.  Johnson has to sway this faction without DUP support—not impossible, but not easy either.
4. Johnson agreed to language of “maintaining a level playing field” with EU regulations. In theory, this agreement would prevent the U.K. from becoming the “Singapore on the Thames,” a U.K. that is deregulated and thus a threat to the cozy regulated world of the EU.  However, this promise is in the political section and is non-binding.  Elements of Labour that want Brexit, but want to avoid deregulation might take comfort in this agreement and vote for the deal.  Elements of the Conservatives (and the Brexit party) that want the “Singapore” option will have to trust Johnson, and believe these are simple “weasel words.”
5. The EU will need to accept this deal. All 27.  We suspect they will, but nothing is guaranteed.
6. Johnson wants the EU to signal it won’t give the U.K. an extension, thus framing this weekend’s vote in Parliament as either “Johnson’s deal or hard Brexit.” So far, the EU has not supported this position.  We would not expect them to, but if Juncker does deliver this for Johnson, it would give him tremendous leverage.
7. The GBP initially rallied on news of a deal but has fallen rather sharply on fears thar Parliament will, like it did with May, ultimately reject it. Or, Parliament will require amendments, e.g., approval only after a referendum.  So, there is still risk that this could all fall apart.  Johnson needs 320 votes.  He may not be able to pull this off.   He will likely need Labour votes to win and if Johnson’s deal is passed, he will almost certainly win new elections.  However, if Johnson can get the EU to make this vote on Saturday either by deal or hard Brexit, he might just pull it off.

European Union:  Illustrating how the Brexit deal will affect EU politics, German Chancellor Merkel said Britain’s exit from the union will leave her country with an “excessive burden.”  She therefore demanded that Germany get a rebate from the EU budget.  Given that Germany’s relative weight in the EU will rise after Britain leaves, she may well get what she demands.

European Central Bank:  In a speech yesterday, Bundesbank Chief Weidmann warned against a broadened stimulus policy that many think incoming ECB Chief Lagarde may consider, i.e., buying government bonds in return for infrastructure, or climate change investment.  That adds to similar pushback from French, Dutch and Austrian central bankers.

United States:  The United Auto Workers and General Motors (GM, 36.65) have reached a tentative deal on a new labor contract, although the ongoing strike could continue for as long as two weeks until union leaders approve it.  Whatever the final outlines of the deal, we think the union’s ability to hold out for a full month is a signal of rebounding power for organized labor.  If that rebound continues and broadens, it could eventually become a significant headwind for corporate margins, playing into the environment of greater regulation and increased inflation pressure that we think will evolve over time.

China:  Even if a truce is reached in the U.S.-China trade war, the Chinese government will struggle to reignite growth with fiscal or monetary stimulus measures.  At a conference of local-government development funds this week, officials complained that even if they were given more money, they are running out of attractive infrastructure projects to invest in.  That serves as a reminder that China’s economic slowdown doesn’t just reflect the trade war; it also reflects the fact that the economy is maturing and now has fewer attractive investment opportunities than before.

China:  Based on a survey across 18 cities, Cushman & Wakefield estimates China’s commercial real estate vacancies stood at 20.0% in the third quarter, up from 16.7% in the third quarter of 2018.  The consultancy said the rise in vacancies came not from excess building, but from weaker demand amid the continuing U.S.-China trade war and economic slowdown.

Saudi Arabia:  Confirming our view that the successful missile and drone attacks on Saudi oil facilities last month reflect incompetence, U.S. officials revealed they have struggled to convince the Saudis to upgrade their air defense systems.  According to one official, “We’ve told them their defense system was not up to speed.  But their defense apparatus [and] their central command lack competence.”  Even though the attacks failed to give a lasting boost to oil prices, systemic vulnerabilities in the Saudi air defense network and Iran’s desire to cause pain suggests we may see an even bigger attack from Iran in the future, which could have a larger, more lasting impact on the oil markets.

Odds and ends:  Scotch distillers, facing a tariff jump, are air freighting their precious liquid to the U.S. to beat the deadline.  There has been some rather interesting market action recently.  First, there has been a slew of profitable large option trades that have benefited from policy statements made by the Trump administration.  There are probably three potential reasons (a) insider leaks, (b) really good algorithms, and (c) there have been a number of these positions that haven’t worked but we don’t hear about those.  We reserve judgement for now.  Second, Eurodollar futures options traders are placing bets on negative interest rates.  We doubt these will be profitable, but the fact they are being made is newsworthy.

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