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

[Posted: 9:30 AM EDT] The IMF gives details on weakening global growth.  Brexit is at a crossroads.  Trade tensions with China remain.  Update on Syria.  The National League has its pennant winner; the Cardinals, meanwhile, have much in common with private equity.  The latter spent billions on alleged unicorns that turned out to be donkeys wearing traffic cones on their heads; the Cardinals spent millions on alleged hitters…anyway, here are the details:

Global growth:  As we went to the deadline yesterday, the IMF had just released its updated global economic forecast for 2019 and 2020.  The details are sobering.  The body described the world’s economic situation as “precarious” and reduced growth rates for this year to 3.0%, down from 3.3% in its April forecast.  That would be the slowest growth since 2009.  Next year’s growth is forecast for modestly better, at 3.4%.  The IMF blamed the trade wars and slow monetary policy responses for the downgrade.  World trade is forecast to fall to a 2.5% growth rate, with 90% of the world’s nations looking for slower growth.   The U.S. saw its forecast rise to 2.1% from below 2% in April.  China is forecast to see growth fall below 6% this year.

If trade tensions were to ease, growth would likely recover.  However, such a shift isn’t likely, or expected.   For most of the postwar period, a weaker U.S. economy could drag the rest of the world into lower growth, but the reverse wasn’t necessarily true.  However, due to increased global integration, there is a higher probability that a slower world economy will adversely affect the U.S.

Brexit:  Talks between the U.K. and EU continue, but the problems that bedeviled Theresa May’s Brexit plan have resurfaced for Boris Johnson.   The EU’s red line is no hard border on the Ireland/Northern Ireland frontier.  Johnson seems amenable to that outcome, but has to craft a plan that effectively jettison’s Northern Ireland without the Unionists discovering it.  So far, Johnson also hasn’t managed that hurdle, although the DUP in his government have not rejected the proposal out of hand.  In fact, the DUP may be swayed, in the end by money; there are reports that the Unionists are asking for “billions, not millions” to secure their votes.  Johnson’s problem, like May before him, is all about votes. His plan isn’t attractive enough to bring in votes from outside the Tories, so he needs the Unionists to pass the plan.  Another issue has emerged; Johnson’s vision of the U.K. after Brexit is far different than May’s.  The latter saw Britain apart, but similar to Europe; the former sees the post-Brexit U.K. as a low tax, low regulation alternative to Europe, an outcome that gives EU leadership the willies.  Additionally, there is another complication—Labour is warming to the idea that it might support Johnson’s plan, but only if it includes a second referendum; in other words, the Johnson plan would get tentative approval but only after the public confirms it.  The GBP has eased from yesterday’s strong rally on worries over talks.

China and trade:  The House has passed the Hong Kong Human Rights and Democracy Act; if passed, it would require the executive branch to determine whether political developments in Hong Kong justify its special treatment as a separate trade area.  Beijing, not surprisingly, isn’t happy with this development, threatening unspecified retaliation if it becomes law.  As we noted yesterday, Beijing is pressing the U.S. to rollback $ 50 bn of existing tariffs before agreeing to buy U.S. agricultural products.  Increasingly, there are doubts China will buy all these products anyway.

The Turkish incursion:  The White House continues to take criticism from both wings of the establishment, with strong exception being taken about the impact of sanctions.   VP Pence and SoS Pompeo are in route to Ankara to try and sell Turkish President Erdogan on a ceasefire.  We doubt the U.S. delegation will have much success.  The real worry is whether Russia and Turkey will end up in a direct conflict.  If that were to occur, it would involve a NATO member and the question is, if Article 5 were invoked, would the rest of NATO come to Turkey’s aid?  If NATO demurred, it would seriously question the security guarantee that NATO membership provides, and give Putin something he has desired all along; to break up NATO and give Russia the opportunity to retake eastern Europe.

Repo Rebellion: Following the Federal Reserve’s decision to expand its balance sheets, money market funds, who are among the largest holders of US treasury, have expressed resistance to the measure. Because money market funds are only able to buy assets with no more than 13 months of maturity, it would be more profitable for them to hold on to the US treasuries as opposed to selling its share of treasuries to the Fed and then going back into the market to buy debt with potentially lower yields. The resistance from money market funds will likely add to the angst of the Federal Reserve, as attempts are made to get cooperation from financial institutions to resolve the liquidity concerns in the repo market.

Odds and ends:  France has given a non to Albanian and Northern Macedonian bids to join the EU.  There are an increasing number of areas where a $100k income isn’t enough to buy a home.   Kim Jong un mounted a strong steed as a show to highlight the anger of the North Koreans over continued sanctions.  North and South Korea played to a 0-0 draw in a World Cup qualifying match in Pyongyang in front of an empty stadium.  Apparently, the North Korean leadership was uncomfortable with the potential loss to its southern rival so it implemented a news blackout and didn’t allow spectators.  In the Democratic Party debates last night, the tech sector was a prime target.   There are reports that confirm the U.S. responded to the Iranian attack on Saudi Arabia with a cyber strike.

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[1] We know, “dog bites man,” right?

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

[Posted: 9:30 AM EDT] Commercial bankers come back to work today.  The Middle East is a mess, but oil prices haven’t budged.  There was little progress on Brexit, but hope remains.  The Chinese trade deal continues to hit snags; China also released a batch of economic data.  Here are the details:

BREAKING:  IMF LOWERS GLOBAL GROWTH FORECAST TO 3%, LOWEST SINCE THE GREAT FINANCIAL CRISIS. 

Middle East:  The Turkey/Syria situation is devolving at great speed.  As we noted yesterday, Syria and Russia have become the Kurds new ally against Turkey.  The likely cost to the Kurds?  Living again under Assad’s control.  The U.S. imposed sanctions but they were less onerous than feared, and the TRY rallied on the news.  A Saudi diplomat called the U.S. action in Syria a “disaster.”   Russia is working to fill the power vacuum– Alexander Lavrentiev, Russia’s special envoy to Syria, said Turkey’s invasion of northern Syria is unacceptable and was not agreed with President Putin in advance.

As our most recent WGR notes, the Carter Doctrine has been in trouble since 9/11.  What we are seeing now is the logical conclusion of a path we have been on for nearly two decades.  What is happening in the Middle East is a foreshadowing of what will eventually occur in Europe and the Far East.  We suspect that two areas of the world are watching what is happening to the Kurds with great interest—the Baltic states and Taiwan.  They have to wonder if the U.S. will back them from Russian or Chinese aggression.

Chinese trade:  China still hasn’t called last week’s meeting a “deal.”  This reluctance is partly due to China’s concern that President Trump won’t adhere to any agreement.  Our suspicion of what is happening to the U.S./China relationship is strategic ambiguity isn’t working anymore.  For years, both China and the U.S. would say the same things, but mean something quite different; as long as the “bluffs were not called” this didn’t matter much.  Now, the U.S. is forcing clarity, something China isn’t used to.  A new example emerged today.  The U.S. believed that in return for delayed tariffs (that were set to begin yesterday), China was to buy $50 bn of U.S. agricultural products.  Today, China suggested that to be able to make these purchases, the U.S. will need to roll back some of the tariffs currently in place.  China has also indicated it wants more talks before signing any agreement.  Meanwhile, Treasury Secretary Mnuchin has indicated that if a deal isn’t signed next month at APEC, the U.S. could go ahead and implement tariffs announced for mid-December.  The problem with these negotiations is that both sides think they have the upper hand and can, at some point, dictate terms.  As long as this condition exists, getting a deal done will be difficult.

China economic data:  China’s CPI rose 3.0%, a bit more than forecast, driven mostly by an 11.4% jump in food prices.  Pork prices rose 69% from last year, a key factor in the rise of food prices.

Meanwhile, PPI is still deflating.

Total credit grew 12.5% from last year, in line with the past three months.

Overall, the data shows that China has a serious food inflation problem; the fact that it is trying to negotiate lower tariffs in the face of a nearly 70% rise in pork prices is remarkable.  At the same time, deflation at the producer level is a warning sign of weaker growth, and likely reflects problems tied to the trade conflict.

 

Brexit:  We are seeing conflicting messages coming from the EU.[1]  The Finnish PM Antti Rinne, currently the EU’s president (it rotates among members) said overnight that the talks “need more time.”  However, the EU’s chief Brexit negotiator, Michel Barnier, suggested that a withdrawal deal is still “possible.”  We continue to believe that if Johnson wants a deal before Halloween, he has to “lose” Northern Ireland; in other words, he has to put the trade border at the Irish Sea and leave Northern Ireland in the EU customs union.  His current plan is trying to finesse this outcome by leaving Northern Ireland in the U.K. trade zone but adopting EU trade rules depending on the destination of the export or import.  If Johnson doesn’t abandon the Unionists, he will face new elections with a viable Brexit party on his right flank.  We suspect that Johnson will eventually abandon the Unionists which would give him a strong position in upcoming elections.

 

Global Bond Markets:  In his first investment outlook since retiring in March, former PIMCO bond king Bill Gross said that with a global bond market dominated by negative-yielding bonds, investors should favor stocks with a secure dividend.  However, he also warned that future stock price gains are likely to be muted as the impact of falling interest rates fades.

 

Odds and ends:  Spain is in turmoil after a Spanish court jailed pro-independence Catalan leaders.  The decision will complicate November elections.  Although Poland’s populist PiS party won the weekend’s election, it failed to control the upper house, making its win less impressive.  Although we rarely comment on U.S. elections this early, we are closely monitoring developments.  Apparently, Mayor Bloomberg is noting that the establishment “lane” may be opening and is considering running for the Democratic Party nomination.  The 2020 election has the potential to be as divisive as the 1860 election due to stark divisions among American voters.

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[1] We know, “dog bites man,” right?

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

[Posted: 9:30 AM EDT] It’s Columbus Day!  Treasury markets are closed but equity exchanges are open.  Today looks like a “upon further review day” as markets reverse Friday’s optimism.  Here are some of the details:

Trade:  After touting the progress made on Friday, the mood has shifted this morning.  China has announced it wants more talks before signing anything at the APEC summit.  Additionally, all that grain China said it would buy?  Apparently, Beijing hasn’t committed to making those purchases.  Meanwhile, the U.S. has delayed the tariffs that were due to start tomorrow; The December tariffs, however, are still on schedule.  Overall, the Phase One agreement doesn’t seem to have much to it.

The general takeaway is that Xi got a win last week.  Perhaps the most insightful comment came from an unnamed Chinese official, who noted China was fortunate that the Trump administration waited for more than a year before tackling the trade issue.  By the time the trade policy change began, it was too close to the next election.  Now the president can’t easily risk the economic disruption that comes from trade tensions.  This is a classic mistake presidents often make; they don’t realize their power is at a peak at the inauguration, and is mostly spent about 18 months later.  This White House focused on tax cuts and reversing the ACA; if the most important goal was changing the trade relationship with China, that is where the focus should have been from day one.

So, what now?  This situation has an air of May; recall that in May, we thought we were close to a deal only to have Beijing reverse its position.  China has even more incentive now to drag out negotiations, confident that election pressures will reduce Washington’s room to maneuver.  Overall, the trade issue with China will continue to hang over the financial markets; we are seeing weaker equities on these reports this morning.

As a side note, the EU is preparing new trade weapons against the U.S. that expand beyond the retaliation allowed by the WTO.  It appears that the WTO is rapidly becoming obsolete, no longer offering a framework to deal with trade disputes.

China:  According to the General Administration of Customs, September merchandise exports were down 3.2% year-over-year, driven by a 22.0% fall in shipments to the United States.  That helps explain why China has been so focused on resolving the trade dispute.  A trade deal now may help, but the damage from the slowdown in trade to date is probably already baked into the Chinese economy.  Euphoria on a trade deal could still give a boost to Chinese assets, but if the actual economic data remains in the doldrums, that boost may be limited or short-lived.

Brexit:  On Friday it also looked like progress was being made.  Those hopes are being dimmed in the early light of Monday.  Although nothing official has been released, there is enough in the press to suggest that Johnson would leave Northern Ireland in the U.K. customs union, but treat the tariffs on goods differently based on their final destination.  The EU, which wants Northern Ireland in the EU customs union, has called the plan “devilishly difficult.”  The good news is that both sides are still talking.  The bad news is that both sides remain divided, with little time to complete a deal.  The GBP fell on the news.

Turkey:  This week’s WGR explores the breakdown of the Carter Doctrine, the explicit commitment of the U.S. to stabilize the Middle East.  It’s breaking down at a rather furious pace.  Turkey is aggressively invading Kurdish controlled areas of Syria, even “bracketing” U.S. forces in artillery attacks.  The U.S. is removing our troops from the region.  The Kurds are turning to Russia and Syria for aid.  The U.S. is prepared to apply additional sanctions to Turkey; Germany has warned Erdogan to halt the offensive, and has cut off some arms exports to Turkey.

We have been forecasting for some time that the U.S. was allowing the world’s three prime conflict zones, the Far East, Europe and the Middle East to “thaw” after freezing them during the Cold War.  The Middle East is especially problematic because many of the nations in the region that currently exist did not evolve naturally, but were artificial constructs of the colonial era.  The U.S. studiously maintained these borders to maintain stability.  As the U.S. withdraws from the region, the evolution of statehood is developing which will be messy.  The U.S. withdrawal is creating massive power vacuums that others are rushing to fill.  Although oil prices are lower this morning, the overall geopolitical conditions suggest increasing instability, which should put a risk premium in the price at some point.

QE, not QE:  The Fed has announced it will buy $60 bn worth of Treasuries per month over the next six months to relieve funding pressure in the repo market.  Chair Powell has made it clear this isn’t QE, and focused on the fact that the Fed will only be buying T-bills.  This expansion of the balance sheet should allow the Fed to ease what has been daily open market operations to inject liquidity into the banking system.  Despite this balance sheet announcement, these open market operations will continue into Nov. 4^th.  What caught our attention about this action is the timing.  The Fed could have simply kept up with the daily funding operations until the next meeting.  We don’t know if this means that Powell is concerned he can’t get enough votes to cut rates later this month and was worried that if no cut emerges, that news would have swamped the balance sheet expansion news.  We have noted rising opposition to further cuts and would not be surprised to see the next cut delayed into December.

Odds and ends:  Spain’s Supreme Court has sentenced a group of Catalan leaders to as much as 13 years in prison for their role in organizing the region’s illegal 2017 referendum on independence and subsequent declaration of independence.  Madrid has reportedly sent hundreds of extra law enforcement personnel to Catalonia in anticipation of widespread protests against the sentence.  In Poland, the conservative-nationalist Law and Justice Party handily won Sunday’s parliamentary elections with 44.4% of the vote.  That should give the party an outright majority in the legislature, albeit a slim one.  In Ecuador, after 11 days of protests against a decree eliminating a longstanding system of fuel subsidies, President Moreno has struck a deal with indigenous activists to withdraw and replace it with a milder version.  Since scrapping the subsidies would have saved $1.3 billion per year, the problem now will be how to meet the fiscal targets of Ecuador’s IMF debt program.  Japan is starting the recovery process from a Super Typhoon.  The UAW has increased its strike pay, suggesting the union does not expect a resolution soon.  The strike will bring lower job growth in the employment data for October.

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

[Posted: 9:30 AM EDT] Happy Friday!  It’s a day starting with great optimism.  It appears that a mini-trade deal may have been struck with China.  There seems to be progress on Brexit.  On the darker side, an Iranian oil tanker was struck by missiles in the Red Sea.  Here are the details:

The trade deal:  U.S. and Chinese negotiators appear to have made some progress on a trade deal.  This won’t be the trade deal but a trade deal, a confidence-building measure toward a larger agreement, or at least a truce.  Here is a rough sketch of what seems to be developing.

1. The U.S. will offer some sort of tariff relief. It is unclear which of the two tranches of tariffs, one set to begin in four days and the other in December, will be rescinded (unlikely) or postponed.  China will press for them to be withdrawn; the U.S. will want to keep the threat hanging over the trade talks to keep China at the negotiating table.  If the tariffs are merely postponed, it will dampen the bullish impact.
2. China will offer to buy lots of agriculture products. This action serves several constituencies.  The farm sector, which has been suffering greatly, will be helped.  This will also help the president’s reelection campaign.  China will be able to reduce food inflation.
3. A currency deal will likely be struck. Why?  Because it’s mostly unnecessary.  The U.S. is clearly upset that in a floating forex arrangement, the impact of tariffs is usually blunted by currency depreciation.  Thus, it wants to prevent China from using a weaker CNY to offset the tariff threat.  However, China was reluctant to use currency depreciation as a tool.  A weaker CNY tends to trigger capital flight, so the PBOC wasn’t poised to depreciate its way out of tariffs anyway.  Nevertheless, getting China to promise to not depreciate its currency does allow both sides to declare progress in the negotiations.
4. The intellectual property issue will probably not be resolved, but some minor arrangements could be made. However, USTR Lighthizer considers this a key point of the trade talks and wants changes in Chinese legislation to enshrine it.  We don’t think this one is resolvable and this will be one of the key sticking points if talks fail.
5. Huawei (002502, CNY 3.06) remains, from the U.S. perspective, a global security threat. We might see some extension in waivers from Washington but would not expect the U.S. to “green light” the company.

So, if we got this right, where does that leave us?  We will get a market lift and may make new highs.  Investors have been very cautious this year, and FOMO might drive a strong Q4 lift.  The risk is that what we have outlined above may be nothing more than a delay.  Beijing will likely want to delay because it might get to negotiate with a different president after the elections.  The administration should accept a delay because it could either prevent or delay a recession long enough to support the president’s reelection chances.  However, there is still a lot that can go wrong.  China may not accept a mere delay in tariffs.  The U.S. may not accept promises on intellectual property.  In these talks, each side has consistently overestimated its own position and underestimated the other side.  It is also important to remember that we could see what looks like an agreement in Washington only to see the deal scotched when Chinese negotiators return home.  That happened, in effect, last May.  What would help bring a deal now is if both sides convince themselves that this is a temporary agreement that buys them much needed time. 

Brexit:  After meetings between the PMs of the U.K. and Ireland, both claimed to have seen “a pathway to a deal” on Brexit.  European Council President Donald Tusk said there were “optimistic signs.”  It is still not to be revealed what changed but, whatever it was, it appears to be significant.  Michel Barnier, the EU Brexit negotiator, thinks enough of the deal to open intensive negotiations.  The GBP soared on the reports.

There is a clear change in sentiment.  What happened?  Well, we don’t know for sure but the fact that the EU is suddenly interested suggests to us that Johnson has agreed to keep Northern Ireland in the customs union and put the trade border at the Irish Sea.  Obviously, we don’t know this for certain, but here is our reasoning:

1. The DUP (Irish Unionists) have been strongly opposed to this measure for good reason. Once the Northern Ireland economy is effectively separated from the U.K., it’s probably just a matter of time before unification with the Republic of Ireland will occur.  In PM May’s government, the DUP was what allowed her to have a majority.  However, PM Johnson likely realizes that if he can deliver Brexit and then hold elections, he will likely win a smashing victory and won’t need the DUP, or Northern Ireland, anymore.  Recent polls show the Tories with a 35% share and the Brexit party with 12%.  If Brexit is executed, the two groups of voters will likely coalesce around the Conservatives and give them a near-majority.  History suggests getting 45%+ of the vote will almost certainly give Johnson a strong majority in Parliament.  To put it bluntly, Johnson is securing his election by selling out the Unionists.
2. The EU position on Brexit has been clear—no trade border in Ireland. The EU wasn’t even really open to a time-limited deal.  The sudden enthusiasm exhibited by Varadkar and Barnier suggests they got what they wanted and want to seal the arrangement before opposition can develop against it.

Essentially, the impasse was the Irish border.  If that’s resolved, there is little to stop a deal.

Iran:  An Iranian state-owned shipping firm claimed one of its oil tankers in the Persian Gulf was damaged by two separate missiles this morning.  The Iranian foreign ministry hasn’t yet assigned blame for the attack, and since ship-tracking services show the vessel is now sailing at normal speeds, there is some doubt as to whether the attack really occurred.  If it didn’t really happen, it would suggest Iran is trying to manufacture a justification for new, explicitly Iranian attacks after the likely Iranian attacks on Saudi oil facilities last month failed to draw the U.S. into the region.  On the other hand, if the attack really did happen, there is a chance that it was instigated by the U.S. and/or Saudi Arabia in retaliation for the attacks on Saudi Arabia.  As might be expected, the risk of escalating tensions has boosted oil prices today.

On a side note, oil shipping costs have soared after the U.S. sanctioned a Chinese tanker company for violating the ban on Iranian oil exports.  Apparently, the ban has cut shipping capacity and led oil exporters to scramble to secure space on tankers.

Hong Kong:  To apply “new innovative tactics to deal with the cunning rioters,” municipal Police Commissioner Lo Wai-chung has promoted the former commander of the department’s elite tactical squad to be his new operations chief.  That signals a potential shift in how the police deal with the continued anti-China protests, but not necessarily a Chinese army-led crackdown.

Russia-Ukraine:  As more evidence of slowly improving relations between Russia and Ukraine, the foreign minister of Ukraine said Russia will soon return three naval vessels that it attacked and impounded in November 2018.  Two dozen Ukrainian sailors detained in the incident were released in early September.

Poland:  Jaroslaw Kaczynski and his conservative-nationalist Law and Justice Party look set to comfortably win Sunday’s parliamentary elections.  While that would ensure continuity in government policy, it would also ensure that Poland will continue to be at odds with EU leaders in Brussels.

Japan:  A typhoon considered to be the equivalent of a Category 4 hurricane is due to hit central Japan this weekend.  According to the country’s Meteorological Agency, the typhoon could trigger record rainfall on par with a 1958 storm that left more than 1,000 dead or missing.

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

[Posted: 9:30 AM EDT] As the Nationals staged a remarkable comeback to earn the right to play the Cardinals for the National League pennant, the financial markets were roiled over conflicting stories of the trade talks.  Turkey threatens the EU.  The EU issues an ultimatum to Johnson.  The ECB and the FOMC are divided. Here are the details:

A night of whipsaws:  Equity futures had a wild night.

This chart shows December S&P futures intraday trade.  Last night as the Cardinals were finishing off the Braves, futures plunged on reports the trade talks were not going well.  The China negotiation team was considering leaving early.  Then, around 8:00, there were reports that China might agree to a currency pact similar to the one considered last May.  As the chart above shows, equities rebounded on the news.  The dollar is weaker this morning on talk of the currency pact, although in reality, the agreement would really do nothing more than ask China to fix the CNY/USD rate.  We doubt China would maintain that rate if the U.S. expanded tariffs.  The Trump administration then moved to increase the number of licenses for Huawei (002502, CNY, 3.25) which is viewed as a minor concession.

All these actions and counter actions make it difficult to tell what is really going on.  We suspect the U.S. side would prefer to avoid the market downdraft that will likely occur if the talks lead nowhere.  At the same time, trade has been an area of strength for the administration; despite differences on the negotiating team, they have mostly held a united front.  We suspect a “mini-deal” might break that unity and is something to be avoided.  The focus today will be on the talks; we think the likelihood of a mini-deal is less than the market expects (hence the sharp decline last night), and thus if the negotiations end with nothing of substance, look for short-term equity weakness.

Turkey:  The media is covering the dissention between the president and numerous advisors and senators in great detail.  We won’t go over them here.  There are three items that we think are important about this event.

1. This action is part of a path we have been discussing for more than a decade. The U.S. is backing away from its hegemonic role, and slowly ending its “freezing” of three conflict zones, Europe, the Far East and the Middle East.  This didn’t start with Trump but with Obama.  Elements of the U.S. policy apparatus have concluded the U.S. doesn’t have the will to maintain security in all these areas.  The first to go was the Middle East.  President Obama wanted to “lead from behind” in Libya, and withdrew U.S. forces from Iraq without much of a fuss.  He also put a timeline on the surge of troops in Afghanistan, signaling to the Taliban that all they needed to do was wait.  He set “red lines” in Syria and then refused to enforce them.   President Trump’s policies are similar.  He wants out of the Middle East too. The primary difference between the two administrations is that Obama was prepared to leave Iran in charge of the Middle East; Trump didn’t like that idea but has likely found no one else really is able to dominate the region, and thus the Middle East is turning into a “jump ball”.  Russia, Turkey and Iran are all trying to position themselves as dominators of the region.  This is a recipe for unrest.  Look for IS to return to the stage in this political vacuum.
2. The political establishment on both the left and right want to maintain U.S. hegemony, but don’t want to pay for it. In other words, higher income households want to enjoy the benefits of hegemony (continued globalization), but are unwilling to pay higher taxes to fund those who fail to benefit from hegemony.  They will fight a rearguard action against America’s withdrawal, but we believe the tide of history is turning against them.  What the establishment is doing is a bit like the counterreformation.  It didn’t put Protestantism into retreat, but it did slow down its gains.
3. Perhaps the most important element of Turkey’s invasion to the financial markets is that the EU condemned the invasion. Erdogan has unveiled his most potent tool to force the Europeans to heel; he is threatening to release Syrian refugees to Europe.  We suspect EU officials will become quiet on this issue.

Divided central banks:  The Fed minutes showed the FOMC divided on policy.  There was clear concern about the trade war.  We think the worry is correctly placed, but monetary policy might not be very effective in countering it.  There was one surprise in the minutes.  There wasn’t as much discussion about the repo issue and the balance sheet as we expected.  This fact is a bit unsettling, as it suggests the leadership may not fully appreciate the gravity of the situation.  At the same time, there was a focus on the inflation mandate with some indications the FOMC might lean toward an average inflation target.  This would mean easier policy going forward.

Meanwhile, it is looking a bit like Mario Draghi “went rogue” at the last policy meeting.  The decision to restart QE came over the objections of bank officials, the technocrats that provide research and support for the members.  Given the divisions on the ECB, we will be watching to see if Legarde can maintain this policy direction, or if the staff and the northern Europeans will curb the policy ease.

Brexit:  As we have noted, our path going forward is that no deal will emerge before Halloween, the U.K. will ask for an extension of Article 50 into late January, and new elections will be held in the U.K. to establish a mandate for moving forward.  In every forecast, there is a risk of error.  Such a risk is emerging.  As PMs Johnson and Varadkar plan to meet today, the EU has issued an ultimatum—either the U.K. accepts that Northern Ireland will remain in the customs union, or there is no withdrawal agreement.  We don’t think Johnson will accept the customs union idea, so the next outcome is that the EU would see no point in giving an extension causing a hard Brexit to occur on Halloween.  We doubt the EU really wants an unmanaged departure but that might occur.  At the same time, we want to reiterate that we still believe the path we have outlined is the most probable outcome.

Bank rules:  The Fed began easing rules for smaller banks, which will reduce the regulatory burden and capital rules, about a year ago.  It is now extending these rule changes to foreign banks with operations in the U.S.

Taiwan:  In light of the turmoil in Hong Kong, Taiwan President Tsai Ing-wen gave a speech defending the island’s independence.  This talk will likely get the attention of Beijing, and it won’t be well received.  We will be watching to see how the PRC retaliates against Tsai for the comments.

China:  Highlighting the hard choices Western governments and companies have to make now that the political and economic ambitions of China have become more clear, Apple (AAPL, 227.03) has removed an app criticized by Chinese state media for being a tool of anti-China protestors in Hong Kong.  In this example, at least, it appears the company has decided that staying in the good graces of the Chinese government, and preserving commercial opportunities in China is more important than defending traditional Western values, like the free flow of information.

With trends suggesting the world’s economy, financial markets, and technological system will bifurcate into a Chinese-dominated bloc and a U.S-dominated bloc by 2030, Swiss private bank Julius Baer has issued a report arguing a robust portfolio will require diversifying across both blocs.

Energy update:  Crude oil inventories rose 2.9 mb compared to an expected build of 2.0 mb.

In the details, U.S. crude oil production rose 0.2 mbpd to 12.6 mbpd, a new record.  Exports rose 0.5 mbpd while imports fell 0.1 mbpd.  The rise in stockpiles was mostly due to rising output and 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 next week and rise soon after.

Based on our oil inventory/price model, fair value is $65.41; using the euro/price model, fair value is $46.93.  The combined model, a broader analysis of the oil price, generates a fair value of $52.79.   We are seeing a clear divergence between the impact of the dollar and oil inventories.  Given that we are into the maintenance season, we normally would 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] On the eve of trade talks, hopes of a thaw are boosting risk markets this morning.  Powell coos.  Fed minutes at 2:00.  Here is what we are watching today:

Trade thaw?  Equity futures lifted this morning on reports that China, despite all the turmoil over visas and the NBA, is open to a limited trade deal.   According to reports, China signaled a willingness to buy more agricultural products in exchange for delays in tariffs.  It appears that Beijing is taking a page from the Abe playbook; Japan recently signed a limited trade deal with the U.S. making a promise to buy U.S. agricultural products and to delay more contentious issues for later.

There are good reasons on both sides to accept this arrangement.  First, a trade deal will improve market sentiment and reduce recession fears.  The trade conflict has hurt economic sentiment on both sides.  The slowdown in the U.S. is obvious and there are reports that retail activity during China’s “golden week” the first week of October, was rather soft.  Second, President Trump and President Xi will meet in November at the APEC meetings, and a partial agreement allows both to save face and promise further talks.  Third, China may believe it can get a better deal with a different U.S. leader.  Thus, signing a small deal now that delays tariffs and hoping for a new president makes sense.

The great unknown is how President Trump will react.  Helping the farm sector would improve his electoral standing in the Midwest.  We note that weather forecasts are becoming much colder for the northern parts of the corn belt with the potential for snow.  The corn crop hasn’t completely matured in these regions (the formal term is “dented”); cold and snow will ruin much of the crop, reducing it to silage.  The region could use a break.  Additionally, there is ample evidence that the White House pays attention to the equity indices.  At the same time, this partial deal isn’t what the president campaigned on, and he does believe that being tough on China is a positive for his supporters.  Our take?  The past nearly three years since his election have shown that predicting Trump’s behavior is difficult.  So, we think the odds of rejection are 55/45.  In other words, we lean toward rejection, but not with any strong conviction.

In other China news, Beijing has established its plan of retaliation to U.S. visa restrictions.  This weekend, China and India will hold a summit meeting; the line of control on the Indian/China frontier is likely to be discussed.  The recent trade blacklist from the U.S. will affect China’s AI plans.  Carrie Lam had not ruled out asking for help from Beijing to quell unrest; such a move would likely end Hong Kong’s special status.

Turkey’s incursion:  Turkey has announced that its military has moved into northern Syria, into the region controlled by the Kurds.  We may see sanctions applied to Ankara, but it doesn’t appear that the U.S. will take stronger measures to oppose this action.  At the same time, the threat of sanctions will likely limit the extent of the invasion.

Easing, not easing:  Chair Powell indicated that the FOMC will likely authorize an expansion in the balance sheet to address recent repo volatility.  However, he took great pains to argue that this action is not QE.   In one sense, this is a difference without a distinction.  The financial system should be indifferent to the intention of the balance sheet expansion.  However, market participants do pay attention to intention, so the impact of balance sheet expansion might not be all that impressive.  What will likely be the key factor is size of the expansion.  If it turns out to be more that $250 bn, it will, in reality, be QE.  The Fed minutes will be out this afternoon; although participants hang onto every word, we don’t expect the document to tell us very much.  Overall, the FOMC is divided on policy.

Brexit:  Recriminations continue on both sides.  Our expectations remain the same.  Johnson will sputter and shout but, in the end, he will extend Article 50 into late January.  The EU will grumble but accept the extension.  Corbyn will bring a no-confidence vote, and elections will be held.  The election is the big unknown.  The U.K. electorate will be faced with giving a mandate to the Conservatives who will use that to crash out of the EU, or give it to a multi-party mix of the SNP, the Liberal-Democrats and Labour which will run on a second referendum.  The second referendum will be “do you want to stay in the customs union or reject Article 50?”

Still, this outline isn’t certain.  UK PM Boris Johnson is expected to advise the Queen that she can not sack him if he loses a no confidence vote. The basis of his argument is based on a 70-year old constitutional convention known as “Lascelles Principles,” which the Queen could refuse to dissolve parliament under three conditions: 1) The existing parliament was capable of doing its job, 2) if a general election would be detrimental to the national economy and 3) if the British monarchy can rely on finding another prime minister who could govern for a reasonable period with a working majority of in the House of Commons. Johnson is expected argue that if the Queen were to sack him it would likely lead to economic chaos as a result of the looming Brexit deadline. At this time, it is unclear whether the Queen is willing to accept his advice but there have been rumblings that she was considering sacking him.

Protests:  We have been noting protests in Hong Kong for some time.  However, there are a couple of others we want to note.  First, protests in Algeria never really ended.  The military government likely hoped that pushing out the former leader would end the unrest, but the protestors don’t seem to want to merely accept another elderly military leader.  Second, Haiti is entering its fourth week of protests.  If these persist, we could see a rise in Haitian refugees moving to Mexico and the U.S.  Third, protests continue in Iraq with more than 110 people killed.  Fourth, Ecuador President Lenin Morena was forced to move its government out of the capital town of Quito, in response to his decision to cut fuel subsidies as Ecuador implements austerity to improve the odds it can get a debt relief package from the IMF.

Odds and ends:  A top secret unit from Russia appears to be engaging in all sorts of audacious actions to undermine Europe.   Research from Berkeley indicates that the effective tax rate for the 400 richest families was less than that of the bottom 50% of households.  Effective tax rates take into account all taxes—Federal income and corporate, social security, state and local—giving a more complete picture of the rate paid.  Wealthy households can afford to hire professionals to take steps to reduce taxes.  In addition, since social security taxes “max out” they become less of a burden for the wealthy and this tax only touches wages, not capital income.  This isn’t to say that the wealthy pay less, but less from each dollar earned.

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