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

[Posted: 9:30 AM EDT] Equities are weaker this morning two days before China/U.S. trade talks.  Uncertainty reigns on the Syria/Kurd issue.  Brexit looms. Here are some of the details:

China:  There are two news items regarding China that have sent equities lower.  First, the U.S. has added 28 Chinese entities to the “Entity List”, including eight companies and 20 public security bureaus.  This action is tied to the suppression of Muslim minorities.  The U.S. has indicated that this action is unrelated to the trade talks, but it’s hard to see how China will not tie the two together.  It seems as though the White House either wanted the action to signal a hard line on upcoming negotiations, or this is an “own goal”.  China has indicated it will respond to the U.S. action.  Second, the administration is considering adding limits on pension fund investments in Chinese stocks.  Although this isn’t as aggressive as a move to force delisting, it will limit the ability of Chinese companies to tap the U.S. financial system.  In addition, there are reports that the U.S. is considering rules limiting the ability of indexes to own Chinese stocks.  Also under consideration is a move to block U.S. investments into China.

It is hard to see how these moves will facilitate a good outcome from Thursday’s talks.  The Chinese delegation has already indicated it will cut its visit short by one night.  As we noted yesterday, we have perceived a general notion among equity investors that some sort of deal will get done to get a “win.”  Perhaps, but the well looks rather poisoned at this point.

In addition to the trade friction, further evidence emerged of rising tensions between the two nations.  First, the NBA found itself in China’s crosshairs after an official with the Houston Rockets offered public support for Hong Kong protestors.  The NBA, fearful of losing access to what has been a growing market, began backing away from the comments, with the Rockets ownership apologizing for the tweets.  The NBA isn’t the only American entity backing away from criticizing China.  Car companies have apologized for offending China by using the Dali Lama in advertising.  Airlines no longer show Taiwan as a separate entity.  However, one profile in courage has emerged, the founders and writers of South Park.  After an episode of the show criticized China for its censorship practices, China blocked the cartoon from its airwaves.  The creators of South Park responded with a mock apology dripping with satire.

We may still see a deal this week, but it appears to us that the odds of one are falling.

Syria:  In the immediate term, it isn’t entirely clear what is going on with Syria in the aftermath of President Trump’s decision to withdrawal from the Kurdish zone in northern Syria.  After the president indicated his intentions, he was showered with negative comments from GOP senators, a rare rebuke from this group.  As the White House took criticism from these circles, the president tried to walk back the withdrawal, threatening economic sanctions if Turkey did something the U.S. opposed.  The TRY fell on the news.  Meanwhile, if the U.S. is going to stand in the way of Turkey, it doesn’t appear that Ankara got the memo, as Turkish troops are preparing to invade.   As noted above, it isn’t clear what the near term U.S. strategy is on this issue.  However, the long-term strategy is crystal clear, and has been consistent for the last two administrations; the U.S. is getting out of the Middle East and a power vacuum is almost certain.

Brexit:  It is now clear that the Brexit talks are dead.  Instead of touring European capitals to negotiate the Irish border, PM Johnson is preparing for elections.  MPs have been trying to find some sort of middle ground between a hard Brexit and remaining.  This middle ground has proven to be elusive, and U.K. voters are likely to face a stark choice; hard Brexit, or a Corbyn led government.  This unappealing choice has been evolving for the past two years.  The path?  We expect Brexit to be delayed, new elections to be called and we will see which of these outcomes the voters favor.  In the short run, it likely means a weaker GBP.

United States-Russia:  House Foreign Affairs Committee Chairman Engel said yesterday that the Trump administration is considering a U.S. withdrawal from the “Open Skies” treaty of 2005, which allows signatories to make surveillance flights over each other’s territory.  While some lawmakers have complained that Russia is using overly-intrusive cameras on the flights, and isn’t providing reciprocal access to the United States, others are concerned that a withdrawal would mark the third major arms-control agreement ended or put at risk by the administration.

Odds and ends:  The U.S. and Japan have finalized a trade deal.  Four EU nations agree on a migrant relocation program.  The U.S. is taking steps to protect U.S. tech firms from foreign regulation.  This is happening at the same time as more state attorney generals are looking to expand the group investigating the same firms.

View the complete PDF

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

[Posted: 9:30 AM EDT] Happy Monday (is it just me? Or are weekends getting shorter?)!  It’s a big week—the Fed releases its minutes on Wednesday, we get CPI on Thursday and Chinese officials are in town for trade talks.  Here are some of the details:

China talks:  It appears that Chinese officials are not open to making a broad trade deal with the U.S.  Current thinking is that China will push for a narrow agreement, wanting a removal of sanctions in return for some grain purchases.  The most important development is that China will not agree to change its industrial policy, a key demand of the U.S.  We suspect China is betting that the president needs a win as we are a mere 13 months from the next election.  In addition, with political turmoil in the U.S. rising, China likely believes it has the upper hand.   Unspoken in this stance is perhaps the idea that Beijing thinks there may be a new president in 2020, and that might lead to a different negotiating position.  President Trump has consistently held that he won’t accept a small deal; although the president is mercurial, his position on trade does appear to be a core belief.  There seems to be a general belief in the financial markets that Trump will accept a small deal to declare victory; we remain unconvinced and would not be surprised to see the trade talks end without an agreement, which would be bearish for risk assets.

Strike continues:  According to reports, contract negotiations between the UAW and General Motors (GM, 34.91) are not going very well.  The union has rejected the latest offer from the car company.  It appears the two sides, though still talking, remain far apart.  The UAW wants new workers to reach full pay quicker, something GM is reluctant to accept.  However, looming over these talks are worker fears that as the transportation system moves to electric, the number of workers required to build cars will fall as electric cars have fewer parts and are easier to assemble.  GM likely sees the move to electrification as a way to reduce its assembly force and thus will likely fight hard to prevent job guarantees.  As the strike heads into its third week, we will start to see the outage affect the macro data; claims should start to rise, and layoffs could begin to spread into the dealer network and independent parts suppliers.

Pity the Kurds:  The U.S. has begun moving troops out of northern Syria, as Turkey is preparing military operations against the Kurds.  Turkey fears Kurdish autonomy on its southern border in Iraq and Syria because it could build into separatist movements among Turkish Kurds.  The Kurds have been allied with the U.S. since the no-fly zones were established after the Gulf War and have been steadfast allies.  Although the Kurds are a fine fighting force, they will likely struggle to resist the Turkish military.  We will be watching to see how Assad and the Russians react to this incursion, as it could mean Turkey intends to expand its territory into what was once Syrian territory on the pretense that it is combating Kurdish separatists.

There are three items will we be watching.  First, the Kurdish forces, which were instrumental in destroying most of Islamic State’s power in Syria, will now be distracted and weakened which could potentially set the stage for a revival of the Islamic State.  Second, this could mark the beginning of a rapprochement between the U.S. and Turkey, after a long period of worsening relations (see our Weekly Geopolitical Report from August 5, 2019).  Third, the troop withdrawal will likely be seen as confirmation that President Trump has abandoned the Carter Doctrine and has no stomach for being involved in Middle Eastern military operations.  The third point is especially important, as it suggests Iran will be emboldened by the move.

Germany:  August industrial new orders came in worse than expected, with a seasonally-adjusted decline of 0.6% instead of the expected rise.  In a sign that the world’s manufacturing recession may be spreading beyond trade-oriented sectors, the decline was driven by a sharp 2.6% fall in domestic orders.  Overall orders in August were down 8.9% year-over-year.

Unrest update:  Despite a ban against face masks, masked protests were widespread in Hong Kong over the weekend.  Now that the National Day holiday is behind us, we will be watching to see how much longer Beijing will tolerate the unrest.  Meanwhile, in Iraq protests continue despite harsh retaliation by the government and paramilitary groups.  So far, the protests have not affected oil flows, but we are watching closely for that development.

Brexit news:  A Scottish court refused a petition by Remain supporters that would have forced the PM to ask for an extension if an agreement isn’t reached with the EU.  The judge argued that the Benn Act prevents a hard Brexit, so the court order was unnecessary.  Remainers fear that Johnson will violate the act and may exit on Halloween despite the legislation.  Meanwhile, the EU is signaling to the U.K. that a new proposal on the Irish border will be necessary by Friday.

Iran news:  China’s state oil company has pulled out of a plan to develop part of Iran’s offshore natural gas field.  Although China does conduct business with Iran despite sanctions, apparently the Chinese company decided not to run afoul of the U.S.  In another interesting development, Iran has detained a Russian journalist.  Although there is a tendency to view Iran and Russia as allies, both are trying to dominate the Middle East and could very well end up at loggerheads.

Portugal:  Prime Minister Costa and his center-left Socialist Party won Sunday’s elections, boosting their seat total to 106 in the 230-seat parliament.  Although Costa still needs to find allies to gain a majority, the results suggest Europe’s center-left parties are regaining their appeal after the rise of right-wing, populist parties in recent years.

China reserves:  China’s foreign reserves fell more than expected to $3.092 bn compared to forecasts of $3.106 bn.  For the most part, reserves remain steady and the larger than expected decline may reflect less dollar exposure; if so, as the dollar appreciates the non-dollar portion of reserves would decline in value.

Odds and ends:  Talks with North Korea appear to have broken down, although the State Department has put a positive spin on discussions.  The National Association of Business economists are projecting sub-2% growth for 2020.  A heads-up—you will likely see the linked chart show up often today.

View the complete PDF

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

[Posted: 9:30 AM EDT] Happy employment Friday!  We cover the data below, but the quick take is that the report is mixed.  The drop in the unemployment rate to 3.5%, a new cycle low, is impressive.  However, wage growth for non-supervisory workers fell to 3.5% from 3.6%, and the growth rate for all workers fell rather markedly to 2.9% from 3.2%.  The headline payroll number came in at 136k, a bit below expectations.  The data has triggered a risk-on trade, with interest rates rising amid stronger equity prices.  Here is what else we are watching this morning:

The economy and the Fed:  Yesterday’s ISM services data came in soft and added to concerns that the economy was coming under pressure.

This index is generally a coincident indicator and doesn’t signal recession until it crosses 50.  It also doesn’t have a long history, but the data is clearly in a downtrend.  Unlike the manufacturing index, the exports portion was a bit weak but most purchasing managers were reporting steady export orders.  Unfortunately, the subsector that showed the most profound weakness was employment, which has fallen from 56.2 in July to 50.4 in September.

Weaker economic data is raising expectations that the FOMC will accelerate rate cuts.  Vice Chair Clarida seemed to support this notion.  Hopes of easing likely led to yesterday’s equity market recovery.  However, the drop in the unemployment rate (see below) will make it hard for the Phillips Curve faction of the FOMC to agree to a rate decline.

Brexit:  PM Johnson’s plan for the Irish border fell with a thud in Brussels.  Although there hasn’t been an outright rejection yet, it is unlikely that the plan as it is currently constructed would get all 27 nations to agree.  Johnson has suggested he is open to other concessions but it isn’t obvious if they would be material.  Meanwhile, Johnson is working on Parliament to see if they will approve his exit proposal.  He might be closer than one would think.  To pass, there are three groups he needs to win over.  First, there is the matter of the 21 former Tories who he kicked out.  He needs all of them.  He needs all 9 DUP members.  To get over the line, he needs some defections from Labour.  There are a number of Labour MPs who come from Leave boroughs that might vote for Johnson’s plan.  In fact, this is the primary reason why Labour has not actually taken a position on Brexit; the party is divided, and Corbyn would lose MPs if he elects to support Remain.  If Johnson can get his deal passed and the EU rejects it, it appears to us that the U.K. will leave on Halloween.

Next week’s trade talks:  In light of market weakness, there is some speculation that the administration will at least agree to a truce.  That would entail a postponement of tariffs and at least a jump in Chinese agricultural imports.  However, a postponement without anything on intellectual property would look weak and it would be hard for the Trump administration to accept.  Additionally, China views the U.S. as an unreliable negotiating partner because, from their perspective, the administration changes its position after a deal has been made.  This charge is not exactly fair; instead, we suspect there is a high level of “strategic ambiguity,” where both parties say the same thing but mean something quite different.  In reality, we don’t think either side is willing to make the concessions necessary to make an arrangement but neither wants a “blow up” either.  There is also a narrative that Xi may simply wait out Trump and hope for a more compliant administration in 2020.  Beijing may want to rethink that position.

Masks off:  Carrie Lam will make it illegal to wear masks at protests.  We doubt these measures will have an immediate effect, but it will make it easier for the government to arrest protestors who otherwise will be vulnerable to tear gas.

Israel:  Prime Minister Netanyahu has agreed that if he is able to form a unity government with opposition leader Gantz, and if he is then indicted for bribery, fraud and breach of trust, as is widely expected, he will retain his title but give up his powers to an “interim premier.”  The coalition negotiations are currently deadlocked, but the deal could help move things forward.

India:  The Reserve Bank of India slashed its benchmark short-term interest rate to a nine-year low of 5.15%, from 5.40% previously.  That marked the fifth rate cut in a row as the economy has slowed due to heavy corporate debt on weak consumer confidence.  In fact, the RBI also cut its forecast of economic growth in the year ending in March 2020 to 6.1% from 6.9%.

Odds and ends: Civil disorder has developed in Iraq.  Although it appears to be driven by opposition to widespread government corruption, such unrest can be co-opted by outside actors (read: Iran) to disrupt oil flows or to mask attacks in the region.  Although the situation in Kashmir has not been in the news lately, warnings that the conflict could escalate have been issued, cautioning that the problem could go nuclear.  EU migration commissioner Avramopoulos warned that “irregular” crossings from Turkey into Greece are on the rise again.  That raises fears of a new immigration crisis that could give nativist, populist parties renewed energy despite recent signs they may be on the wane.  The risk of renewed political instability would likely weigh on Eurozone stocks and the EUR.  Finally, we are monitoring the impeachment inquiry, but until it has a direct effect on the financial markets our commentary on the issue will be limited.

View the complete PDF

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

[Posted: 9:30 AM EDT] Equity markets are mostly flat this morning after two sharp down days.  Johnson has a new Brexit plan.  The WTO approves U.S. retaliatory tariffs against the EU.  Here is what we are watching this morning:

Equity worries:  Equity markets have taken a bruising in the first two days of the quarter.  Worries about global growth are front and center, but other issues are important as well.  First, with Chinese negotiators coming to Washington next week, there is hope that at least a truce will emerge.  In fact, a narrative is developing that suggests President Trump will make a deal with China because he needs equities to rally and he needs a “win” amidst impeachment investigations and slowing growth.  Perhaps.  However, the president has suggested on numerous occasions that he views the trade conflict with China as politically supportive; in addition, there is growing support for confronting China in Congress.  Thus, if the administration takes a partial deal it might backfire.  Another point to consider is what China wants.  There is no doubt a trade war hurts both sides.  The issue isn’t who suffers the most but who has the greater ability to absorb pain.  China probably can win on this one; Xi runs a surveillance state and has much more control over his media.  China probably won’t accept anything other than a full removal of tariffs, something we doubt the U.S. will accept.  If the meetings next week don’t offer something to the markets, and tariffs are applied as scheduled, further weakness is likely.

Second, there is a worry that the Fed may react too slowly to problems in the economy, as it did in 2007.  We note recent speakers have struck an optimistic tone on the economy, which may make it more difficult to cut rates quickly.  It is hard for an institution that has relied on the Phillips Curve for decades to cut rates when unemployment is this low.  History shows, unfortunately, that policymakers tend to wait until the evidence is abundant to support easier policy.  Usually by that point, it’s too late.

EU tariffs:  The WTO has confirmed that Airbus (EADSY, 31.34) received illegal subsidies and gave the U.S. permission to apply $7.5 bn of retaliatory tariffs against EU products.  The USTR has drawn up a list of products he recommends to be taxed.[1]  In addition to these tariffs, President Trump will decide by November 13 if he will place tariffs on autos and parts that could be worth up to $100 bn.  EU leaders are quietly begging Congress to prevent this from happening.  Even though talks with China loom large, the potential that the trade conflict could shift to Europe doesn’t appear to have been discounted by the market; otherwise, we would likely see a much weaker EUR.

On the other hand:  All isn’t lost on trade.  Despite the impeachment proceedings, Congress does appear to be making progress on USMCA.  Getting that deal done would likely be positive for Canada and Mexico.

Johnson’s plan:  PM Johnson released his Brexit plan.  It’s rather convoluted, involving a customs border and a separate regulatory border.  So far, the EU has reacted cautiously, not because it thinks the plan has merit but because it fears Johnson will use rejection to argue that the EU will never agree to an acceptable plan and a hard Brexit is the real goal.  In our opinion, Johnson’s goal is to get new elections.  He would prefer not to have a hard Brexit but feels that is a better outcome than constantly extending the deadline.  What Johnson seems to want is Brexit followed by elections; if the U.K. is out of the EU, then the Brexit Party has no reason for existence and the Liberal-Democrats have no issue to run on.  Labour is hopelessly split and the Tories will likely romp to victory.  There is only one problem with this plan—if a hard Brexit proves to be the economic disaster that many have warned against, it’s hard to see how Johnson can win an election.  Whether or not these dire forecasts are correct is an empirical question, but therein lies the risk of where Johnson seems to be heading.  Of course, if everything breaks his way, an even better outcome is that the EU caves and accepts his plan, he pulls the U.K. out of the EU on time and is the conquering hero.  But, the aforementioned “Plan B” of leaving without a deal is also acceptable.

Hong Kong:  The city’s cabinet will meet Friday to approve using a colonial-era emergency powers law to get control over the ongoing anti-China protests.  One measure being considered would be a ban on publicly wearing the masks that protestors use to protect themselves from tear gas.  We suspect the government’s further clampdown will likely spawn more, not less, protests.

Turkey:  U.S. national security officials say Turkey seems to be preparing to send troops into northeastern Syria to attack the U.S.-allied Kurdish forces battling ISIS there.  If a large attack transpires, the officials say the U.S. may have to pull its remaining 1,000 or so troops out of Syria, potentially allowing ISIS to regroup.

Ukraine:  While President Zelensky may be in hot water over the U.S. impeachment inquiry, that shouldn’t detract from his success in easing tensions with the pro-Russia separatists in eastern Ukraine.  This week, his government signed a deal with the separatists, Russia and EU monitors for a limited troop withdrawal and local elections in separatist-controlled areas as soon as Kiev gets control over its border with Russia.

Energy update:  Crude oil inventories rose 2.4 mb compared to an expected draw of 0.6 mb.

In the details, U.S. crude oil production fell 0.1 mbpd to 12.4 mbpd.  Exports and imports both fell 0.1 mbpd.  The rise in stockpiles was mostly due to falling refinery demand (see below).

This chart shows the annual seasonal pattern for crude oil inventories.  This week usually signals the beginning of the autumn build season.  We have already troughed stocks but expect them to rise 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 decline in refinery utilization will likely continue for the next two weeks and should begin to rise by mid-October.  During this period, inventories usually rise.  However, the extent of the rise will depend on Saudi production.

Based on our oil inventory/price model, fair value is $66.51; using the euro/price model, fair value is $47.84.  The combined model, a broader analysis of oil prices, generates a fair value of $53.63.   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 rise.  Reports that the KSA has lifted output to pre-attack levels has put further pressure on oil prices.   We also note that Iraqi PM Mahdi has imposed a 24-hour curfew in response to two days of large demonstrations against government corruption and high unemployment that have killed 18 people.

View the complete PDF

---

[1] Front and center are single-malt Irish and Scotch whiskies.

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

[Posted: 9:30 AM EDT] It’s another risk-off day so far this morning.  Residual worries about the economy continue to dominate.  Here is what we are watching this morning:

Reviewing ISM manufacturing:  As you are all aware by now, the ISM manufacturing data for September came in quite weak.  Here is the chart that most caught our attention.

The ISM asks purchasing managers a series of questions about the various parts of their business operations.  The group asks if conditions are better/the same/worse or higher/the same/lower on various aspects of their business.  The indexes that are printed are compilations of these questions.  However, the data about respondents is also available.  The above chart looks at export order responses.  Note the sharp rise in manufacturers reporting lower export orders and the plunge in firms reporting higher export orders.  This is a significant breakdown and puts the export orders index at 41.0, the lowest level since April 2009.  The trade war is having an increasingly negative effect on the economy.

The ISM data along with soft construction orders have taken the Atlanta FRB’s GDPNow forecast for Q3 GDP down 40 bps; the current forecast is 1.8%.

Brexit:  PM Johnson is expected to reveal his Brexit proposal, his “final offer.”  Rumors suggest he will call for customs checks on each side of the border, but inland (thus avoiding the “border” itself), with a time limit that will give both sides four years to actually work out a trade agreement.  We don’t see the EU accepting the deal; so far, it has rejected anything that has border controls.  By framing it as a final offer, Johnson will try to blame a hard Brexit on the EU.  We still think recent legislation will prevent a sudden Brexit, although it will require the EU to agree to another extension, which is likely to occur because the EU expects new elections and may hope that a new government might call off Article 50 altogether.  That scenario, however, is unlikely.  The most probable outcome is continued limbo; new elections probably don’t solve anything.  We expect that none of the parties would garner a majority in an election and any resulting government will be unstable.  The underlying problem is that the U.K. is nearly equally divided on this issue.  Remaining means a large part of the population believes they were denied their win in the first referendum, and leaving means that a large part of the population believes the country is making a huge mistake on a fairly small majority (at least considering the importance of Article 50).  In the meantime, we expect a stalemate—no exit on Halloween, new elections, inconclusive results.

More on repo:  The Fed is starting to grapple with the regulatory thicket that has led to the need for repeated repo operations to keep the money markets functioning.  First, as we suspected, the data shows that the large banks are holding the bulk of the cash in bank reserves.  The four largest banks in the U.S. held $377 bn of cash reserves at the end of Q2, well more than the remaining 21 banks in the top 25.  Large banks must meet a “liquidity coverage ratio” (LCR), assets that include cash and Treasuries.  However, the large banks are also required to meet intraday liquidity targets for which cash is the only asset that meets the regulation.  It looks like the requirements for safety have put a premium on cash and other liquid assets for the larger banks and the Fed has misjudged how much excess reserves the system needs to meet these requirements.  In other words, the repo crisis is starting to look like a regulation problem.  That doesn’t mean the regulations should be changed (after all, safety first, kids), but, given the regulations that are in place, the balance sheet needs to expand.  However, the Fed will likely be divided on expanding the balance sheet because it will appear to be another form of easing that may trigger an excessive response from the asset markets.  The other alternative is daily repo operations which is, at best, only a temporary solution.  We look for a balance sheet expansion but only after the Fed prepares the financial markets for the additional reserves.

Zuckerberg strikes back:  Last April, Facebook’s (FB, 175.81) CEO and founder, Mark Zuckerberg, suggested that the populist-left wanted to break up his company.  In comments to employees, he indicated he would fight such measures.  Senator Warren was the explicit target; she responded sharply to the comment.  How this all plays out remains to be seen; Facebook is an important medium for political ads, and it is possible the company could “tip the scales” to candidates with less interest in anti-trust actions against the firm.  We do note that Silicon Valley is getting behind Warren as her poll numbers improve.

Huawei:  Huawei (002502, CNY, 3.200) claims it has begun making 5G equipment without using U.S.-supplied components.  It is unclear how successful the firm has been with this action but if its claims are true then it would add to evidence that the tech world is dividing between China and the U.S., meaning nations will need to decide on which side they will ally.

Germans will be Germans:  As the ECB prepares to restart its quantitative easing program in November, the head of Germany’s Bundesbank, Jens Weidmann, warned that he would oppose all attempts to lift the limits on bond buying.  Currently, the ECB has given itself a limit of 33% of asset purchases, meaning the bank can only buy up to that limit with respect to a country’s government debt as well as debt in supranational and non-bank private sector debt.  The rule is designed to maintain some level of fiscal responsibility among member countries.

Mr. Weidmann’s comments highlight the growing dissent among central bankers in the Eurozone.  Rising trade tensions and sluggish growth have led a push for aggressive monetary easing to address these problems.  Ironically, Germany would likely benefit from monetary easing as the country has already contracted in two quarters within a year, and four quarters within the last five years.  Germany’s aversion to debt-fueled growth has added to market concerns of a prolonged slowdown, which have contributed to a drop in European equities.

Despite its reluctance to accept expanded monetary stimulus from the ECB, the German government has begun drawing up plans for a fiscal stimulus package if the economy were to approach recession.  The plan involves the government investing in projects that are designed to improve efficiency and boost confidence as well as stimulus in the form of tax write-offs and subsidies.  Although the stimulus plan is viewed as a safeguard in the event of a recession, it has been reported that parts of the plan have already been rolled out.

North Korea fires another missile: The launch came a day after the U.S. and North Korea agreed to resume nuclear talks.  The missile launch highlights the level of impatience that North Korea has in getting an agreement that would lead to sanctions relief.  Previous discussions about sanctions relief stalled in February after the president refused to remove all sanctions.  The U.S. has described the launch as provocative but has not formally withdrawn from the meeting.

Odds and ends:  Today marks the second anniversary of the Catalan independence referendum. In recognition of this day, thousands of protesters took to the streets to express their frustration.  Peru appears to be without a government as the president dissolved the legislature and the legislature appointed a new president.  Finally, a lesson in central banking—don’t tell people, especially depositors, not to panic.

View the complete PDF

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

[Posted: 9:30 AM EDT] Happy Q4!  Although there is a lot of news, not much is market-moving.  A poorly received bond auction in Japan has lifted bond yields around the world.  Here is what we are watching this morning:

China’s anniversary:  China held its 70^th anniversary parade.  There were lots of soldiers and military equipment, including a hypersonic missile.  During the parade, protests continued in Hong Kong.  There were reports that a protestor was shot with live ammunition; this is a serious escalation.  Now that the anniversary is past, we will be watching to see how Xi handles the Hong Kong situation.  We doubt we will see anything as blatant as the Tiananmen Square event.  Instead, we would expect a steady suppression of protests designed to slowly reduce the number of participants and make the protests appear to be tapering off.  We note that China has been moving security personnel and military groups toward Hong Kong.  Essentially, this buildup could be used to eventually stifle the uprising.  One thing to keep in mind is that China spends much more on domestic security than on its military.

We note that Xi’s speech had much to say about unity.  The Chinese state is trying to do something it has never done in its history, which is to have a strong economy that is unified.  Throughout its history, periods of strong economic growth have led to divisions between the outward-looking coastal regions and the interior.  When Mao unified the country, he did so by cutting off China from the world, which allowed him to tie the coast to the interior.  Deng’s economic reforms have led to economic divisions again that, so far, have not led to political divisions.  However, Xi’s behavior, including a massive crackdown on “corruption,” the suppression of the Uighurs and of religion, points to a leader trying to force unity on the country while maintaining growth.  If history is any guide, Xi will have to choose between a strong economy or a unified country.  Our best guess is that he will choose the latter if forced.  That would mean slower economic growth not just for China but for the world.  It is also worth noting that some of Xi’s “colleagues” may prefer the other option; perhaps this is why he spent his first term purging the party.  For now, we expect Xi to try to have both growth and unity, but that may not be possible.

Japan:  The country’s value-added tax officially rises to 10% today, from 8% previously.  While VAT hikes have derailed the Japanese economy in the past, today’s relatively smaller hike isn’t causing as much concern, in part, because it could be offset by a system of differentiated rates, cashback rewards and spending related to the upcoming rugby World Cup tournament.  Although the VAT hike is being taken well and Japanese equities remain firm, as noted above, the Japanese bond market is tumbling after the Bank of Japan said yesterday that it will slash purchases of longer term bonds in an effort to steepen the yield curve.  Meanwhile, the Government Pension Investment Fund said it will pivot toward buying more foreign debt.

Brexit:  PM Johnson has told the Tories that he expects to “know by the weekend” if he can get a Brexit deal done by the end of the month.  The issue remains the Irish backstop.  There are rumors that Johnson will propose customs clearance centers on both sides of the Irish frontier.  Johnson has denied the rumors; having customs on both sides of the border is a potential problem because the ones on the Northern Ireland side would become targets for the IRA.  We don’t think this is going to work.  If Johnson can’t sway the EU, then expect a delay in Brexit and new elections.  One interesting side note is that the U.K. apparently exports a significant amount of its trash to the Netherlands, where it is separated and some is incinerated and the rest recycled or landfilled.  If there is a hard Brexit, the Brits will have to handle their own rubbish, which could become a political problem for the Johnson government.

A cautionary tale:  For 24 hours last week, the U.S. shut down its air command center at the Al-Udeid Air Base in Qatar and shifted operations to South Carolina.  It was described as a drill, but the timing does suggest the U.S. has concerns about the safety of the base and is testing its backup plan.  This comes on reports that Saudi Arabia is trying to ease tensions.  So far, Iran has been playing “hard to get” with regard to a meeting with the U.S.

United States-North Korea:  The United States and North Korea said working-level talks on denuclearization will resume on Saturday.  The talks may show whether progress can start again now that hardliner John Bolton is no longer U.S. national security advisor.  If progress can be made, it would probably feed into the developing bullish narrative of reduced tensions in Asia.

Peru:  Frustrated with legislators refusing to pass his popular anti-corruption proposals, President Martín Vizcarra ordered the dissolution of Congress and new elections.  However, Vice President Aráoz declared the move illegal and had herself voted in as the new leader, potentially setting up a period of continued political uncertainty.

Odds and ends: Riots emerged on the Greek island of Lesbos, where a fire broke out in a refugee camp.  Although it hasn’t caught the attention of the media, refugee flows have been increasing recently.  Greece is working to improve conditions.  Italy has increased its budget deficit projections but will seek to avoid a conflict with the EU.  The WTO is warning that world trade is slowing and that this factor will likely weaken global growth.  The dollar share of world reserves has declined to its lowest level in six years; the JPY was the greatest beneficiary.  Finally, surveys are suggesting that banks are tightening credit conditions on smaller firms.

View the complete PDF