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

[Posted: 9:30 AM EDT] Happy Monday!  It’s the last day of the quarter and there is a lot going on.  Let’s dig in.  Here is what we are watching this morning:

Happy Anniversary!  The Communist Party of China (CPC) will hold major celebrations this week for the 70^th anniversary of the CPC’s takeover of the mainland.  Tomorrow, a large parade will be held.  Meanwhile, it was another weekend of protests in Hong Kong.  Chairman Xi has been trying to bring Hong Kong under Beijing’s control since coming to office.  Xi’s policy has been to homogenize China culturally; he has cracked down on Islam and Christianity, and clearly does not want any other social narrative but that of the CPC.  The actions in Hong Kong are affecting Taiwan’s view of the mainland and may make the island even more determined to remain separate from Beijing.  In other China news, PMIs came in better than forecast.

Capital issues:  Equity markets took a tumble on Friday on reports that the U.S. is considering delisting Chinese equities from U.S. financial markets.  The administration has denied the reports, but we note these ideas have been floating around Congress for some time.  As our recent WGRs[1] note, attacking the trade deficit from the current account doesn’t really work in a floating exchange rate environment.  But, attacking it from the capital account can be very effective.  Similar to the Baldwin/Hawley bill, which would force the Fed to ease policy to achieve a weaker dollar and allow the Fed to levy taxes on foreign Treasury buyers, delisting measures would affect China through the capital account.  China has a serious debt overhang and is likely considering something akin to debt/equity swaps to eventually resolve the problem.  Getting foreigners to “participate” would be a reasonable desire.  Delisting would dramatically reduce China’s ability to tap global financial markets and thus force the debt adjustment onto China.

Financial markets were affected by the reports.

It makes sense that the administration would downplay the delisting news in front of this week’s anniversary (see below) and trade talks in mid-October.  However, we doubt this will be the last word on the issue.  As the aforementioned WGRs noted, the capital account would be an effective avenue to address deglobalization.  Restricting foreign access to U.S. financial markets is part of that process.  On a related note, China has been reducing its foreign direct investment, in part, due to worries over the trade deal and also due to some rather questionable investments.

European Union:  The European Parliament will hold confirmation hearings this week for incoming European Commission President von der Leyen’s slate of commissioners.  Several of her nominees are already in trouble because of financial conflicts of interest, and observers worry political bickering will push the process well beyond November 1.

Trouble for Johnson:  PM Johnson isn’t just struggling to deal with a difficult Parliament.  His wayward past is also bubbling up to hurt his ability to lead.  And, the DUP is cooling to the possibility of a trade deal that keeps Northern Ireland in the EU trading zone.

Repos continue:  The Fed carried out repos again this morning among increasing fears that the Federal Reserve may have given the NY FRB presidency to the wrong guy.  John Williams was appointed to the position in April 2018.  Williams had an illustrious turn as president of the San Francisco FRB and is a well-respected monetary and financial market economist.  His work on “R*” has shaped monetary policy for the past decade.  However, he is not a “market guy.”  Historically, the president of the NY FRB has had experience in the “plumbing” of the financial system.  Ed Corrigan and Bill McDonough had long experience on “the desk.”  Tim Geithner had broad international experience.  However, there was some departure from the streetwise presidents with Bill Dudley, and Williams had little financial market experience.  Complicating matters, last May, Williams fired two long-term veterans, Simon Potter, who had been at the NY FRB since 1998 and ran the markets desk since 2012, and Richard Dzina, who had been with the bank since 1991.  Reports suggest that Williams wanted to change the management structure of the markets desk and apparently decided these leaders were not helping that effort.  It is also important to note that the Fed hasn’t really had to conduct repo operations since 2009 when QE flooded the banking system with reserves.  There may be a lack of experience on the trading desk in the execution of these actions.  Although Williams’s academic work shows clear expertise in theoretical monetary policy, he may have a gap in understanding the actual operations of the financial system.  We suspect Williams will acquire this knowledge in due time, but the actions of the NY FRB have done little to inspire confidence.

Austria elections:  Sebastian Kurz’s party had a strong showing in this weekend’s elections, with the center-left and the populist-right losing support.  The Greens showed a dramatic improvement.  Kurz now has his pick of coalition partners.  He could return to the chastened populist-right to form a government, or break tradition and bring the Greens into government.   We will be watching to see how Kurz chooses because it could indicate how the political situations of other European nations may evolve.

Happy New Year!  Rosh Hashanah began yesterday evening and will end tomorrow evening.  We usually mark market performance on the Gregorian calendar, but here is a chart showing how we have done over the past year using the Hebrew calendar.

It’s been a good year for gold and bonds, but rather “meh” for stocks.

Saudi Arabia:  Fitch’s Ratings cut Saudi Arabia’s long-term, foreign-currency debt rating to A from A+, citing the increased geopolitical and military risks that became evident in the recent attacks on the country’s oil infrastructure.  Importantly, the agency said it saw a risk of further attacks that could hurt the country’s economy.

Odds and ends:  Protests continue in Moscow.  The Houthis are claiming a major victory against Saudi forces in Yemen.  Crown Prince Salman warns of “skyrocketing” oil prices if the world does not bring Iran to heel.  As one would expect given the turmoil, voter turnout in Afghanistan was light.

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[1] See WGRS, Weaponizing the Dollar: The Nuclear Option, Part I (9/16/19) and Part II (9/23/19).

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

[Posted: 9:30 AM EDT]

Hurray for Friday!  It has been a tumultuous week as we approach the end of Q3.  Markets are generally quiet this morning.  U.S. economic data was a bit soft (see below).  There are two elections over the weekend, in Afghanistan and Austria.  The media is fully focused on the impeachment issue.  Here is what we are watching this morning:

BREAKING: Oil falls on reports that the U.S. has offered to remove all sanctions in exchange for talks.  Reports have not been confirmed by the White House.

Releasing the doves:  Michael Saunders, one of the more hawkish members of the Bank of England, said today that the BOE may need to reduce rates even if a no-deal Brexit is avoided because growth has been dampened due to the turmoil caused by the issue.  The GBP fell on the news.

Elections:  In the midst of instability, Afghanistan is holding elections this weekend. Islamic State (IS) has become increasingly active in the country, not only attacking the official state but also the Taliban.  According to reports, IS and al Qaeda officials have been in talks as well.  Overall, it is hard to see how elections can be conducted in such an atmosphere.  The sitting government, fearing the U.S. wants to pull out of the country and make a deal with the Taliban, likely wants a mandate that an election victory would grant it.  Look for terrorist acts and general insecurity this weekend.

Meanwhile, in Austria, Sebastian Kurz is poised to return to power as he leads the center-right to a likely win…but not a majority.  Kurz will need to build a coalition; polls suggest his People’s Party will gain about 35% of the vote.  He could join with the center-left Social Democrats to form a unity government, or the populist-right Freedom Party to create a conservative coalition.  Thus, the election itself has little drama, but the post-election coalition decision will be the real event.

Labor unrest:  The GM strike continues into its 11^th day, but it does appear that negotiations are coming to a close; however, the issues still needing to be resolved are the most difficult, so it would not be a surprise to see talks extend into next week.  Meanwhile, the Chicago Teachers Union has authorized a strike.  A teachers union strike in a major city tends to bring serious disruption as students (about 300k) have nowhere to go during the day.

Falling confidence:  Economic confidence in the Eurozone fell to over four-year lows as the industrial sector slows.

Although not necessarily at recession levels, the decline is pronounced and supports easier ECB policy.  The EUR is weaker on the news.

China trade:  China continues to buy U.S. agricultural goods, framing the purchases as a confidence-building measure rather than the fulfillment of a desperate need.  High-level talks are scheduled for October 10.

Impeachment talk:  Reflecting the many lines of inquiry that could be touched off by the White House whistleblower complaint, Kremlin spokesman Dmitry Peskov said Russia hopes the United States will not release the transcripts of calls between President Trump and President Putin.

Odds and ends:  The U.S. is sending a Patriot missile battery and 200 troops to Saudi Arabia.  Former VP Biden is proposing a financial transactions tax, likely in response to proposed wealth taxes from other Democratic party presidential candidates.  The German Bundestag voted to open talks with Albania and North Macedonia on EU entry.  The Census Bureau reports that large U.S. cities saw a decline in younger residents as Millennials and Gen-X exit cities for less expensive housing markets.  The Indonesian government is now facing a wave of student-led demonstrations.  The protests are targeted mostly against a new law being pushed by President Widodo’s conservative Islamic supporters, criminally banning sex and cohabitation outside of marriage.  In Egypt, the outbreak of political and anti-corruption protests that broke out last week look set to continue as protest leaders are calling for further demonstrations today.

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

[Posted: 9:30 AM EDT]

Markets are rather quiet this morning.  The IMF has a new leader.  The head of the DNI testifies today before the House and Senate Intelligence Committees.  The House testimony will be public, while the Senate will be closed.  We expect the media to remain focused on the impeachment issue.  Here is what we are watching this morning:

Impeachment update:  Before we start, we want to correct something we said yesterday.  We implied that we didn’t think the president would be impeached.  That’s not exactly what we meant.  We would not be surprised if the House impeaches the president but think the odds of a conviction in the Senate are near zero.

After another 24 hours, here are some additional thoughts on the impeachment issue:

1. Although we suspect this event will look more like the Clinton impeachment rather than the Nixon one, history doesn’t necessarily tell us very much. The fact that there are only two events in recent history means we simply don’t have enough of these circumstances to draw clear conclusions.  Our expectation is that these proceedings will probably help the president more than hurt him.  However, our confidence in that expectation isn’t all that solid.  To frame just how current conditions affect these events, imagine the Clinton impeachment in the #MeToo era.  Democratic Party senators would have been torn between trying to protect their party’s president and allowing him to get away with what was clearly an inappropriate relationship.  In other words, in the late 1990s, what President Clinton did was framed as an unfortunate dalliance.  In the current world, such actions, especially by older, powerful men against younger women, are not tolerated.  In today’s world, Clinton may have been removed from office.  So, we will have to play this one by ear because each one of these is unique.
2. Americans have little knowledge of the degree of corruption in Ukrainian politics. There have been chemical attacks on candidates.  Former leaders have been jailed.  The country elected a young comedian hoping he might be able to clean things up.  If we see Ukrainian officials testify before Congress, it will be quite a show.
3. Ukrainian President Zelenskiy will likely be making some apology calls to EU leaders over the coming week.

The German resigns:  Sabine Lautenschläger, the German representative and only woman on the ECB’s executive board, has resigned over recent easing actions by the ECB.  She was in her sixth year of an eight-year term.  Germany, along with other northern European nations, has become increasingly unhappy with the easy money policies of the ECB.  Draghi was able to force his will on the ECB, in part, because he has the intellectual “chops” to argue for his position.  It will be interesting to see how Legarde handles this growing hawkish opposition to easy policy.  It is possible that she will not be able to stand against it.  We will also be closely watching to see who Germany appoints to replace Lautenschläger.

More repo:  Like the cowbell, the financial system can’t get enough Fed repurchase operations.  The NY FRB will increase the size of the repo operations to $100 bn from $75 bn.  It appears that the Fed is focusing on the largest banks’ reserve hoarding as the reason for why there appears to be a scarcity of liquidity in the repo market.  If the large banks are, in fact, hoarding reserves, the key question then becomes, “why?”  We suspect it is regulation uncertainty causing this behavior, but will be watching to see if other reasons emerge.

United States-Japan:  At the UN yesterday, President Trump and Japanese Prime Minister Abe signed a trade deal that will cut Japanese agriculture tariffs and U.S. industrial duties.  However, the agreement is seen as limited.  It doesn’t appear to open up major new markets, nor does it produce major new momentum for the U.S.-China trade negotiations.

North Korea-South Korea:  Recent reporting suggests North Korea secretly annexed and occupied a small South Korean island near the countries’ maritime border, sparking a scandal for the South Korean government.  The government denies the islets are really South Korean territory, but reporters have found evidence that they were considered so in the past.

China:  Chinese buyers continue to lap up U.S. agricultural products.  At the same time, U.S. hardwood lumber exports to China have fallen 40% this year, after China’s imposition of 25% retaliatory tariffs on the product.  This helps explain why major timber REITs have fallen in price over the last year, while REITs as a whole have surged.  On another topic, the PBOC  auctioned 10 billion yuan of six-months bills in Hong Kong to shore up the yuan exchange rate.  The trade war has also affected global trade.  The Netherlands Bureau for Economic Policy Analysis has a World Trade monitor; for the first seven months of 2019, world trade contracted.

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 rose 0.1 mbpd to 12.5 mbpd, a new record.  Exports fell 0.2 mbpd, while imports fell 0.7 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.  As we approach the end of the spring/summer inventory withdrawal, we are starting the autumn rebuild period at a sizeable deficit.  For the past two weeks, we have seen small builds but, as the chart shows, the seasonal gap is still significant.  Without aggressive increases in stockpiles, we will likely continue to lag seasonal patterns which, on its own, is bullish.

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

The drop in refinery utilization will likely continue for the next three weeks; utilization should begin to rise by mid-October.  During this period, inventories usually rise.  However, the usual seasonal rise will depend on Saudi production.

Based our oil inventory/price model, fair value is $67.53; using the euro/price model, fair value is $48.17.  The combined model, a broader analysis of the oil price, generates a fair value of $54.23.  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 rise.  Prices will remain sensitive to Saudi output and tensions in the Middle East.

On the Middle East, conflicting trends are emerging.  The Kingdom of Saudi Arabia (KSA) is arguing that it’s oil production is recovering quickly, claiming it is producing around 8.0 mbpd, mostly from other fields and facilities that were not affected by the recent attacks.  However, it is not clear if the production has any use; if the oil can’t be processed to rid it of impurities and imbedded gasses, it can’t go anywhere.  So far, the KSA has been fulfilling its export requirements by using storage, but it is unclear how much longer it can maintain exports by draining stockpiles.  So far, markets are obviously giving the KSA the benefit of the doubt and pushing prices lower.

As the KSA supplies the oil market, calming supply fears, the U.S. continues to “turn the screws” on Iran.  The White House has barred senior Iranian officials from entering the U.S.  In addition, in the midst of trade talks with China, the U.S. has sanctioned Chinese firms that have conducted oil trade with Iran.  Tightening conditions probably increases the likelihood of a lashing out by Iran; even if there is another attack on the KSA, U.S. support for the kingdom may be tepid at best.  We view the geopolitics as bullish.

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

[Posted: 9:30 AM EDT]

Good Morning.  Global equity markets are under pressure this morning on sentiment concerns.    Here is what we are watching:

A volatile day:  Yesterday was a volatile day in the financial markets as two issues dominated.

1. The U.N. speech: President Trump’s address to the U.N. was hawkish.  He reiterated his “America First” stance, criticized China for its intellectual property acquisition tactics and defended his use of tariffs.  His remarks on China were quite strong, suggesting that the country’s economic development policies were unfair to the U.S. and the rest of the world, and that America’s trade policy was designed to force China to change those policies.  China is continuing to make what appears to be good-will gestures on trade; today, for example, they purchased pork.  However, we note that China’s pork supply situation is precarious; it is quite likely that China is framing these purchases as good-will gestures when, in reality, it really needs the “other white meat” due to supply shortages caused by the African Swine Fever virus.  We also note that China wants tariffs removed as preconditions for a broader deal, which isn’t likely.  Financial markets want a deal with China; it may not occur.  The president also singled out Iran for its repressive regime and its threat to Middle East peace.  He also argued for the defense of borders.  Overall, the talk suggested that the administration was not likely to ease its stance on China, and that deglobalization remains the likely path of policy.
2. Impeachment: Speaker Pelosi indicated she would support an impeachment inquiry against President Trump over the Ukraine issue.  Impeachment proceedings raise market uncertainty.  We have only had three such events in American history, and only two in an era of modern financial markets.  The events really don’t tell us much about how equity markets will behave during impeachment proceedings.

This chart shows the weekly S&P 500 Friday close.  We measure the Nixon impeachment from October 9, 1973, the Friday before the “Saturday Night Massacre,” until his resignation.  The Nixon impeachment event (it’s important to remember that he resigned before the articles of impeachment were sent to the Senate) occurred in a major bear market for equities.  Although the political actions likely played a role in the drop, it’s important to note that the impeachment nearly coincided with a recession (the downturn began in November 1973 and continued into March 1975) and oil prices rose 235% from October 1973 to January 1974.  Thus, the impeachment probably played a role in the market decline, but other factors were also important.

Same data as above.  We time Clinton’s impeachment from the House of Representatives vote to conduct an impeachment inquiry until the president was acquitted by the Senate.  The economic environment was generally positive, and equity markets were in a strong bull market.  We do note that equities had declined during impeachment due to the collapse of Long-Term Capital Management, and the Russian debt default.  Thus, some of the gain is exaggerated. Still, this shows that if economic and market conditions are favorable, the bearish impact of impeachment is probably muted.

So, what should we think about with this impeachment issue?  Here are our preliminary thoughts:

1. Impeachment is not a judicial process, but a political one. Barring a revelation that is egregious, it is highly unlikely the Senate, by a two-thirds majority, will vote to enforce impeachment.  In fact, it is possible that majority leader McConnell might not even hold a vote on the articles.  We don’t expect the president to actually be impeached.
2. It will have an impact. Legislative activity will grind to a halt.  USMCA probably won’t get passed this year.  Congress is funding the government with short-term spending bills making the odds of a temporary closure elevated.  The White House will be distracted, and due to the constant turmoil, may not have the “bench” to deal with impeachment and all the other issues the nation faces.  Fortunately, the White House does have strong figures involved in the China and Europe trade negotiations.  However, the bad news is that they are not always unified, and the president may struggle to act as an arbiter between the two sides if he is consumed with impeachment.
3. Iran may take advantage of this turmoil. The Mullahs likely believe the chances of getting a favorable deal with the U.S. improve with a different president.  Thus, Iran may be emboldened to escalate tensions in the region.  Under impeachment, if the president decides to attack Iran in response to an escalation, he could be accused of a “wag the dog” tactic.  This accusation would not be unprecedented.  President Clinton launched bombing raids on al Qaeda targets in August and December of 1998; the first occurred when Monica Lewinsky was about to testify on the scandal, and the latter as the House was about to vote on articles of impeachment.  Clinton had defensible reasons for the bombing, but the timing did look suspicious.  At the same time, one does not need to be a Ph.D. economist to know the global economy is weak and the U.S. economy is approaching stall speed.  An event that drives oil to $100+ per barrel would probably be enough to tip the world and the U.S. into a full-blown recession.  History shows that re-election during a recession is rare.
4. It’s late in the political cycle. Andrew Johnson’s impeachment event was also near the end of his term.  In some respects, the inquiry could cloud the president’s re-election campaign.  It also might garner him sympathy.  However, it’s important to note that the last two impeachment events occurred in second terms.  Thus, they had a different impact on the subsequent election, compared to a president under the cloud of impeachment who is running for re-election.  In addition, it makes it hard for Democratic party candidates to discuss plans and goals for office when the media’s focus is mostly on the impeachment proceedings.  Thus, the impeachment will also affect the Democrats nominating process.  (Our quick take?  The Ukraine issue probably hurts Biden and helps Warren.)
5. There are already warnings from commentators that this impeachment could “hurt the presidency.” If the U.S. is withdrawing from hegemony, the president’s powers, which expanded during the superpower period, will likely be curtailed over time.  The Constitution has been “stretched out of shape” during America’s hegemony period mostly because a superpower has to make decisions quickly, and the weak executive envisioned by the founders doesn’t fit with hegemonic responsibilities.  However, if the U.S. isn’t going to maintain its superpower role, there is less need for a strong executive.  Thus, some reigning in of the executive would be expected, and this impeachment fits in that scenario.
6. Our focus will remain on the economy and markets. Given the tumultuous nature of the Trump presidency, the sentiment impact may not be all that profound.  Financial markets have become accustomed to constant political turmoil, and thus should be able to digest this situation too.  However, as noted above, we do have two concerns.  First, it may be difficult to manage relations with China in the midst of this turmoil; if Lighthizer becomes the dominant figure in the chaos, there will be no deal with China.  Second, we fear the financial, but especially the oil, markets are underestimating the risk of further Iranian escalation.  As a result, these two areas will be where we most closely monitor events.

Boris:  PM Johnson returns to the U.K. today to face a hostile Parliament.  The Supreme Court ruling was a serious blow.  Under normal circumstances, the poor management that Johnson has delivered (lost his majority, had his own brother leave the party, humiliated by Luxembourg, rebuked by the Supreme Court) would have led to his ouster by now.  However, these are not normal times, to say the least.  What happens now?  In mid-October, the EU has meetings where the U.K. either must have a plan to leave the EU or, based on recent legislation, Johnson must ask for an extension to the end of January.  Assuming that there is no plan to offer (and it doesn’t look likely), we will probably see an extension and new elections.  At this point, the most likely outcome from the elections is a hung Parliament, with the potential for a caretaker government and perhaps a second referendum.  However, the odds of a hard Brexit are less likely.

Wealth Tax: Presidential candidate Bernie Sanders has joined Elizabeth Warren in endorsing a tax on assets for individuals that have a net worth of more than $16 million, and married couples with a net worth of over $32 million. The revenue for the proposed tax would be used to promote government programs such as universal healthcare. In addition to its appeal to labor, the idea has become increasingly popular with members of the capital class, with Bill Gates stating that he “wouldn’t be against the tax.” Moreover, although a wealth tax makes conceptual sense, it doesn’t appear to be all that practical. The primary issue is that the value of one’s assets is somewhat subjective; therefore, there is a strong incentive for people to undervalue their assets on their tax returns.  Even though the government could just send auditors to value these assets, it would likely prove overly burdensome. Another proposed solution to the problem would be for the government to have the right to buy assets at the listed price, but even that seems burdensome. However, as we have mentioned in the past, this wealth tax is just another example of the country moving away from an efficiency cycle, and into an equity cycle.  We have doubts that a wealth tax will ever be enacted; other nations that have tried to implement them tended to abandon the effort because of the difficulty in processing the levy.  However, the mere threat tends to have a dampening effect on asset prices.

Magnets:  The U.S. is importing rare earth magnets at the fastest pace since 2016.  Most likely, firms are concerned that the supply will be curtailed if the U.S. and China can’t reach a trade agreement, so they are stockpiling the materials.

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

[Posted: 9:30 AM EDT]

Good morning!  Boris gets bad news.  Europe is turning on Iran.  China is looking to control its large firms.  President Trump will address the U.N. General Assembly today.  Here is what we are watching this morning:

The U.K. Supreme court rules against PM Johnson:  In an 11-0 verdict, the U.K. high court ruled this morning that the Johnson government acted illegally when it prorogued Parliament.  John Bercow, the speaker of the Parliament, has indicated lawmakers will return tomorrow morning.  The GBP rallied modestly on the news.  It is unclear exactly what happens now.  The current government is in minority.  Under current law, Johnson needs a two-thirds majority to call elections and earlier attempts to bring elections have failed.  However, the official opposition party, Labour, is a mess—it is obvious the next election will be about Brexit and the party doesn’t have a clear stance.  And, there is a looming deadline coming on Halloween.  There is not enough time to create a new arrangement and it remains possible that the U.K. could crash out of the EU simply because no one can figure out how to avoid it.  It appears the most logical solution would be a delay of Brexit and new elections to form a government with a full mandate to do something.  However, it is just as likely that new elections will not bring a clear path to either leaving or staying in the EU due to the deep divisions within the U.K.

Here is a way of thinking about this issue.  The EU and globalization in general offer citizens of a particular nation a tradeoff—prosperity for sovereignty.  In other words, joining a supranational union (the EU), or large multinational trade deals (WTO, TPP, TTIP, NAFTA) requires participating nations to give up some level of sovereignty.  In return, the broad trade arrangement makes economies more efficient and supports growth (prosperity).  However, when the fruits of that prosperity are not shared among the majority of households, a common condition in Western nations at present, those “left behind” are not necessarily better off economically but have given up sovereignty as well.  As a result, the position of the left-behinds is that getting sovereignty back can’t hurt, and they don’t feel they are giving up much prosperity either.  This group becomes the opposition to globalization.  This problem is, to some extent, the heart of the globalization debate and is key to the Brexit issue.

Isolated Iran:  In a somewhat surprising development, France, Germany and the U.K. have all blamed Iran for the recent missile and drone attack on Saudi Arabia.  PM Johnson has called for a new deal, which would effectively end (JCPOA).  This is an interesting turn of events; the EU has created a financial workaround for Iran to continue exporting, although it hasn’t been very effective.  We suspect two factors are in play.  First, the EU is deeply worried that an outbreak in hostilities would lead to oil shortages negatively affecting Europe’s economy and second, we doubt these nations would make such statements if they thought the U.S. would use them to justify military action.  In other words, these leading EU nations must believe that the Trump administration is not likely to use military force.  Thus, the EU has turned on Iran, leaving the Mullahs increasingly isolated.

So far, the bet against the U.S. using military action against Iran has been a good one.  At present, the only military action that appears to be under consideration is cyber, which has the characteristic of deniability.  Despite the appearance that escalation isn’t likely, we caution that conditions can change.  Iran is in a difficult spot; sanctions are crushing its economy, and the U.S. is in no hurry to negotiate.  No other nations appear interested in helping them out.  Desperation in Iran may lead to further aggression.  The creator of the archetypes of American foreign policy, Walter Russell Mead, has an op-ed today where he notes that Trump is a Jacksonian, and he lays out “red lines” that would likely trigger a military response.  For now, time is on the side of the U.S.  There is no need to escalate, but that doesn’t mean Iran won’t.  It is quite possible that financial markets are underestimating the chances of a conflict and higher oil prices.

We are from the government and are here to help:  China announced it will place CPC officials in 100 private firms in China.  The official reason given for this move is to “boost local manufacturing,” but it is rather obvious that the goal is to force these firms to follow government directives.  For years, Chinese law has given the government power to place officials in firms for monitoring purposes.  However, prior to Xi, firms were allowed near complete freedom to operate. That may be changing.

China and trade:  Equity markets continue to tick higher on hopes of a trade thaw. Treasury Secretary Mnuchin said he expects top-level U.S. and Chinese trade negotiators to meet during the week of October 7.  Mnuchin also claimed some progress was made at last week’s deputy-level meetings.  However, we have two areas that suggest caution.  First, the DOJ reports that China is accelerating its theft of trade secrets.  Second, Matt Pottinger has been appointed deputy national security advisor.  Pottinger is considered a hawk on China, meaning that an important figure in the administration will be likely framing a hostile policy toward China.

European Union-Italy:  EU leaders agreed to adjust their immigration policy to help the new government in Rome.  Germany and France would automatically take in some migrants rescued in the Mediterranean, while other EU nations would volunteer to take in some refugees landing in Italy.  The deal could help to stabilize EU politics by undermining anti-immigrant populists.

China:  Commenting on three regional banks rescued by various entities since May, central bank chief Yi warned that some regional lenders have overstretched into high-risk loans, and that their top shareholders would face “primary responsibility” if they failed.  Yi said he wouldn’t sharply cut interest rates, but he did ask banks to lend more to local clients in the real economy.

Odds and ends:  The opposition to Maduro in Venezuela appears to be fracturing, meaning it will be even more difficult to oust the current government.  In a surprising development, the Bolsonaro government in Brazil has slashed tariffs on more than 2300 products.  Traditionally, Brazil has leaned toward import substitution policies for development, meaning it created tariff barriers which allowed local firms to make goods that could be more cheaply imported.  Reversing this policy will tend to lower inflation and increase productivity; it will also, at least initially, increase unemployment and local firms will face import competition.

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

[Posted: 9:30 AM EDT]

Happy Monday!  It’s the Autumnal Equinox today.  For sports fans, it’s a wonderful time of year.  Baseball playoffs are being set.  The NFL is in full swing, and college football is operating too.  The NHL preseason has begun. The GM strike rolls into its second week.   Here is what we are watching this morning:

BREAKING:  U.K. SUPREME COURT WILL ISSUE RULING TOMORROW MORNING ON PROROGUING PARLIAMENT.

The U.N. General Assembly meetings begin:  Although we doubt anything of substance will emerge from these meetings, Iranian leaders will be in town and discussions about climate change are on the agenda.  Ukraine’s president will also attend.  The U.S. is likely to try to move the U.N. to criticize Iran’s recent attack on Saudi Arabia, but we are not optimistic on this front.  We are monitoring the recent whistleblower accusations, and the widespread youth protests for climate change legislation.  However, we haven’t moved beyond monitoring because, so far, these issues have not affected financial markets.  Nevertheless, impeachment proceedings could dampen investor confidence (or not…it might ease trade tensions).  On climate change, we do expect that action will be taken at some point; our focus now is on how the costs of the legislation will be allocated.

Weak Eurozone economy:  The Eurozone PMI data (see below) came in soft, at 50.4, just above the 50 expansion line.  Financial markets moved from risk-on to risk-off on the news.  There is great concern that the Eurozone will drag the global economy into further weakness.

Saudi Arabia and oil:  Oil prices declined in the wake of the Eurozone PMI data despite news that repairs to the Saudi infrastructure will likely take much longer than expected, according to private contractors hired to assist in recovery efforts.  Worries about demand, caused by slowing global growth, are keeping oil prices from rising on the bullish supply news.

Trade:  On Friday, President Trump’s comments that he didn’t want a partial deal with China, that he didn’t need a deal for re-election and reports that a Chinese trade delegation called off visits to farms led to a hard selloff in equities.  It turns out that the U.S. asked the Chinese to cancel their visit, worried about the public framing of the tour.  Trade uncertainty may be the most important issue that the financial markets are dealing with.  Regular readers are familiar with our charts that show U.S. retail money market balances have been ballooning over the past 18 months.  The last time we had such an increase in these balances, was into the teeth of the financial crisis.  In general, money market funds are generally utilized by higher income households, so the increase in these balances is likely (a) reducing buying power for equities and (b) represents potential liquidity that could propel equities to significantly higher levels.  We think the chart below may explain the money market accumulation.

The blue line (left scale) is the U.S. Economic Policy Uncertainty Index for trade policy.  The index is created by noting the mentions of trade policy and trade issues in the media.  When such words are mentioned with greater frequency, the index rises.  We have smoothed the day with a 12-month moving average.  Note that the increase in the uncertainty index closely matches the increase in money market balances.  It appears that concerns about trade and deglobalization have raised investor fears and triggered a desire to build cash balances.  We note that the WSJ is reporting on the rise in household saving, especially among wealthier households.  Although tax cuts probably played a role in the saving accumulation, the above chart suggests that worries about trade are affecting saving behavior as well.  What this data tells us is (a) the trade issue has likely been the major factor behind the current sideways equity market and (b) a resolution of the trade deal could bring these liquidity balances back to the equity market, triggering a very strong rally.  At this juncture, we don’t see a reversal in the trade situation anytime soon; if anything, deglobalization is one of the few bipartisan positions in our fractured politics.  However, if there is a cooling of tensions, it could be quite bullish for equities.

The repo issue:  It does appear that the Fed has addressed the immediate problem of spiking repo rates with a series of monetary injections.  However, the NY FRB is now working to figure out why this happened in the first place.  Apparently, bank officials are looking at the problem of concentrated bank reserves but seem to believe that the concentration is occurring with the small banks, not the larger ones.

Japan:  The Japanese military failed to track several of North Korea’s recent short-range missile launches, apparently because of their low and irregular trajectories.  Separately, satellite imagery from two U.S. private-sector organizations show North Korea building a structure to launch its newly developed ballistic missile submarines.  Along with last week’s successful missile and drone attacks on Saudi oil facilities, the reports suggest a greater risk that rogue states like North Korea and Iran can now overcome U.S. missile defense systems.  This should keep geopolitical risks high, and help maintain a risk bid for crude oil.

Iran:  The Iranian government said it will release the British-flagged oil tanker Stena Impero, which it seized in July after Gibraltar’s seizure of an Iranian tanker.  Since the Iranian tanker had long since been released, the release of the British ship right after last week’s attack on Saudi oil facilities suggests the move is meant to confuse Iran’s adversaries and obfuscate its true intentions.

Egypt:  Protestors rallied against President Al Sisi over the weekend.  Although the number of protestors was only in the hundreds, it was Egypt’s first significant bout of demonstrations in years, and the first to openly call for Al Sisi’s ouster over corruption charges.  Coupled with Iranian threats and inconclusive Israeli elections, unrest in Egypt would help bolster oil prices.

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