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

[Posted: 9:30 AM EDT]

The ECB delivers.  The U.S. is delaying tariffs on China.  Here is what we are watching this morning:

The ECB:  In the statement, the ECB restarted QE to the tune of €20 billion per month and cut deposit rates to -50 bps.  The benchmark rate was left unchanged, meaning negative rates won’t be applied to retail investors.  Forward guidance is now open-ended and results targeted; in other words, stimulus is no longer guided by the calendar (this is similar to how QE3 was managed in the U.S.).  Two new changes were implemented that give this package power.  The first is that negative rate tiering will be introduced.  This is potentially a very powerful tool.  Essentially, even under conditions of negative interest rates, tiering can introduce a profitable lending spread for banks.  For example, if the ECB offers loans to banks at -100 bps, even if banks lend at -50 bps, they are still earning a positive spread.  Using tiering, there is no limit to how low negative rates could go.  The second change is that term lending will be repriced and expanded.

In the press conference, in his prepared statement, Draghi (in his swan song press conference) lowered inflation and growth forecasts, blaming trade tensions between China and the U.S. for lower inflation and growth.  The tweet response from President Trump was noted (see below), but he continues to hew the line that monetary policy in Europe is not designed to guide the exchange rate.  That has been the official line of the G-7 central banks for years, allowing the dollar to weaken during U.S. QE and the weaker EUR and JPY under unconventional stimulus by those nations’ central banks.  Central banks argued that they were conducting policy for domestic reasons only.  Although this line is part of the old regime of policy, under President Trump, the argument probably doesn’t hold.  Next week’s WGR discusses the currency issue in detail.

Market reaction was interesting.  At first, the EUR and rates rose, likely because there wasn’t a cut in the deposit rate and QE was less than expected.  European bank stocks initially rose.  However, as the broader ramifications of the package were realized, bank stocks fell, interest rates plunged and the EUR fell sharply.  The decline in the currency caught the attention of the commander in chief, who remains sharply critical of the Fed.  The decline in the EUR may be the most problematic element of the ECB policy; we would expect the U.S. to refocus on EU trade negotiations, and what looks like a deliberate attempt to weaken the currency will likely trigger a more hostile position from U.S. trade negotiators.

We are seeing a similar reaction in U.S. markets.  Gold prices jumped, Treasury yields fell and equities rose.

Tariff delay:  To avoid applying a tariff hike on the 70^th anniversary of the CPC’s capture of mainland China, the White House has delayed implementation for two weeks, making them effective on October 15.  According to reports, the delay was a direct request from top Chinese trade negotiator Liu He.  Thus, it has the air of a favor.  In response, the Chinese Ministry of Commerce welcomed the move and claimed Chinese buyers were already making inquiries about buying more U.S. agriculture goods.  The apparent baby steps toward reconciliation are welcomed as U.S. and Chinese negotiators prepare for another round of trade talks in the coming weeks.  Hopes of an early end to the trade war are providing a small boost to risk assets so far today.  However, the moves over the last day still seem quite modest to us.  There is still no assurance that the two sides can reach an amicable agreement.

China is attempting to separate trade talks from national security issues, hoping that by separating the issues it can more easily reach a trade agreement.  Separating the issues may prove to be difficult; we note the Pentagon has issued a list of military-linked Chinese companies that the U.S. and allies are expected to avoid for security issues.  Compliance with this list will, by design, affect trade.

Brexit:  It is becoming clear that if a Brexit deal is going to be reached, it will be resolved over the Ireland border issue.  If Johnson gets an election and wins a majority, he would no longer need the DUP.  In that case, we would not be surprised to see him put the trade border in the Irish Sea and put Northern Ireland within the EU, for purposes of trade.  If this happens, it will likely accelerate the eventual unification of Ireland.  Although this document was leaked earlier, the government’s worst case for a hard Brexit is dire.  The Brexit camp argues, with some degree of credibility, that the Remain camp has engaged in “project fear” to scare voters into voting to remain. This document suggests that without planning, a hard Brexit could be disastrous, at least in the short run.

Germany:  The respected Ifo Institute cut its forecast for German economic growth to just 1.2% in 2020 and 1.4% in 2021 as it warns that the continued pullback in the country’s manufacturing will spread to the services sector and push up unemployment.  The slowdown in Germany’s factory sector is by now well recognized, but the idea that it could spread to other sectors has gotten less attention.  As manufacturing also slows in the U.S., a key question is whether that slowdown will eventually start to undermine U.S. services and employment.

Japan:  Prime Minister Abe has named Shinjiro Koizumi, the son of former Prime Minister Junichiro Koizumi, as his new minister for the environment.  Although the younger Koizumi is only 38 years old, and while this is his first cabinet position, the fact that he inherits a political base from his popular father is being taken as a sign that he has a bright future in politics and could even be a possible successor to Abe.

Japan-South Korea:  As part of his cabinet reshuffles, Abe also named Isshu Sugawara as his new international trade chief, and Sugawara has already vowed that Japan won’t back down in the Japan-South Korea dispute over Tokyo’s behavior in Korea before and during World War II.  Reflecting the U.S. pullback from its traditional hegemonic role in geopolitics, Japan and South Korea continue to slap trade restrictions on each other because of the dispute.  In addition, Seoul today formally requested that the International Olympic Committee ban Japan’s “rising sun” flag at next summer’s Tokyo games, claiming the flag is a symbol of Japan’s brutal imperialism in the past.

Space, the Final Frontier:  In other news from South Korea, the government announced it would postpone the launch of its lunar orbiter until July 2022.  That disappointment follows the apparent crash landing of India’s lunar lander on the moon’s south pole last weekend.  Despite the failures, the big trend that many investors aren’t paying attention to is that with advancing technologies and falling costs, multiple countries are stampeding into space exploration.  Significant lunar and deep-space projects are now being conducted not only by the U.S., Russia and China, but also by countries like Israel, India and South Korea.  The efforts often involve both public and private entities.  This often unrecognized “megatrend” could potentially have significant investment implications in the future.

Energy update:  Crude oil inventories fell 6.9 mb compared to an expected draw of 2.8 mb.

In the details, U.S. crude oil production was unchanged at 12.4 mbpd.  Exports rose 0.2 mbpd, while imports fell 0.2 mbpd.  Refinery operations rose 0.3%.  The drop in stockpiles was the combination of steady output, higher refinery demand, a rise in exports and a fall in imports.

This chart shows the annual seasonal pattern for crude oil inventories.  As we approach the end of the spring/summer inventory withdrawal season, we are starting the autumn rebuild period at a sizeable deficit.  Without aggressive increases in stockpiles, we will likely continue to lag seasonal patterns which, on its own, is bullish.

Based on our oil inventory/price model, fair value is $68.61; using the euro/price model, fair value is $47.97.  The combined model, a broader analysis of the oil price, generates a fair value of $54.46.  We are seeing a clear divergence between the impact of the dollar and oil inventories.  Given that we are nearing the end of the summer driving season, the bullish impact of inventories will likely diminish in the coming weeks; a sideways to lower price path is the most likely outcome.

We have seen two divergent geopolitical trends.  The first being the change in command in the Saudi oil ministry to a member of the Salman family is considered bullish for oil as the royal family wants higher oil prices to support the IPO of Saudi Aramco.  We note that Russia and Saudi Arabia are calling for better compliance on output cuts.  The ousting of John Bolton increases the odds of negotiations with Iran.  So far, the two have mostly balanced themselves, but if talks open up with Iran, prices will likely fall further.  We also note that the IEA is warning that slowing demand in 2020 will likely lead to higher stockpiles and lower prices.

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

[Posted: 9:30 AM EDT]

It is 9/11, the 18^th anniversary of the terrorist attack on New York and Washington.  Equity markets are mostly steady this morning.  We are rotating in equities.  China gives in (a little) on trade.  Bolton’s out.  Here is what we are watching this morning:

China trade:  China announced it will exempt a range of goods from the 25% extra tariffs that were implemented last year.  However, notably, corn, soybeans and pork failed to make the list.   Drugs, non-grain animal feed and lubricants were exempted.  Although the action does suggest that China may be making a good faith effort to improve the environment for negotiations, the move itself is quite limited.  Still, any sign of hope will be welcomed.

China market news:  There were a couple items of note on China and its impact on markets.  First, China has removed quota limits on foreign investment.  This action would suggest China is interested in attracting foreign investment; we note that the previous quotas had not been fully utilized, so this action probably won’t trigger a major influx of new funds.  Second, although China’s foreign reserves held steady in August, Hong Kong’s fell 3.5%, or about $15.6 bn.  This drop suggests that capital flight is probably starting to develop.  Third, China’s car sales fell for the 14^th consecutive month.  There are growing concerns about China’s economy and its impact on the U.S. and global growth.

Bolton:  John Bolton either resigned or was fired yesterday.  There were reports that he was signed by the Patriots, but those have not been confirmed.  Usually, the removal of a national security director isn’t a market event.  When Trump’s two previous directors departed, H.R. McMaster and Michael Flynn, they weren’t market-moving events.  However, Bolton’s departure did have a dramatic effect on the oil markets, which fell sharply on the news.

Every president “learns on the job.”  There really is no position that prepares one to be president of the U.S., although a governor may be the best learning experience.  However, what we usually see is that a new president starts with a deep team of notables, especially if the new president’s party has been out of office.  There are a lot of people who have been waiting to take a role in a new administration.  However, over time, presidents begin to figure out the job and want to be around people who will execute the policy of the president, not try to shape it.  Bolton and Trump were not of the same mindset.  Using Mead’s taxonomy,  Bolton was a mix of Wilsonian and Jacksonian archetypes, but leaned mostly to the former.  Thus, he was more of a neoconservative, wanting to use force against a myriad of enemies.  President Trump, on the other hand, is nearly a pure Jacksonian.  This archetype tends to be isolationist unless provoked.  Thus, we would expect Trump to attack Iran if it would engage in an action that killed an American but not use force as a matter of policy goals.  Bolton, on the other hand, wanted to use force against Iran as a matter of policy.

As presidents begin to shape their own administrations, they tend to remove those who have been trying to shape the president.  Those who follow the initial group of aides and cabinet members tend to be less notable but more willing to execute the president’s wishes.  Although the media will act as if what we are seeing is completely unique to this administration, the shifting is normal, although it may be happening faster with this one.

SoS Pompeo is the remaining member of the national security and foreign policy staff.  Although he is probably a similar archetype to Bolton, he has a better personal relationship with the president and seems more willing to execute policy.  What we expect to see going forward is more of a Trumpian foreign policy with less interference.

This probably means the odds of negotiations with North Korea and Iran are likely.  We may even see some thaw with Venezuela.  President Trump likes face-to-face meetings with leaders to solve what have been intractable problems.  Bolton opposed such meetings, as does Pompeo, but he will go along (at least for now).  Additionally, we do not expect Pompeo to stick around, either.  He seems to be considering a Senate run.  What is most interesting about President Trump’s foreign policy is how it is shifting the GOP from a Hamiltonian/Wilsonian stance to a Jacksonian one.  We will be watching to see if this shift becomes permanent or ends when Trump leaves office.  A Jacksonian foreign policy probably isn’t conducive for hegemony; America seems okay with ending that role, but the rest of the world is still dealing with the shock.

EU news:  Margrethe Vestager, the EU commissioner who has gone after the large tech firms, has been given a rare reappointment.  Usually, new EU leaders select an entirely new slate.  This is unwelcome news for the U.S. tech giants.  Political negotiations in Spain have failed and new elections are likely.  German economic think tanks are forecasting a recession for Germany.  Although the new government in Italy is less confrontational than the previous one, in terms of fiscal policy, the trend is the same.  Italy’s current proposed budget will violate EU guidelines.  We will be watching to see if this new government is given some “wiggle room” to support non-populist governments.

Turkey:  President Erdogan has a plan for Syrian refugees.  Either the U.S. and Turkey create and secure territory in Syria for over one million refugees or Turkey will release these refugees into Europe.  Turkey has an estimated 3.6 mm Syrian refugees, but the EU has an arrangement with Turkey.  Over the past four years, Europe has given Turkey $6.7 billion to keep these refugees from coming into Europe.  Erdogan is indicating this isn’t enough.  The Turkish president has wanted a buffer zone in Syria to (a) gain territory in Syria, and (b) create an area it controls to push Kurds further away from his border.  Although the U.S. has agreed in principle to establish this zone, it seems unlikely that President Trump will support a major U.S. effort to put in troops to secure this zone and create a buffer that undermines an American ally in the region, the Kurds.  Erdogan is accusing the U.S. of backing away from the deal.  If the agreement falls through, another European refugee crisis is in the offing, which could be bearish for the EUR and European equities.

The rotation:  In the past few days, we have seen an impressive rotation in equities, with value and non-momentum stocks gaining, while growth and momentum have taken a hit.

Along with the momentum/value reversal, Treasury rates have jumped, and the yield curve has steepened.  There is no doubt that the momentum/growth areas had become “crowded” and value was due for a bounce.  The issue now is whether this is the beginning of a broader trend or a mere correction.  If it’s going to be more than just a correction, we will likely need to see long-duration Treasury rates continue to rise, and for that to occur we would need to see a significant reversal of easing expectations.  In general, shifts in value to growth usually require P/E contraction.  Although long-term interest rates are not the sole determinant of P/Es, they are important.  Thus, what we are seeing is probably not a reversal in trend but a correction.

Brexit news:  Boris Johnson’s decision to prorogue Parliament was ruled “unlawful by the Scottish court.”  The ruling sets up a possible showdown in the Supreme Court.  In response, the ruling members of Parliament have asked to be summoned back to debate the issues surrounding Brexit, which Johnson is likely to deny.  The Supreme Court is expected to take up the issue next week.

In addition to the ruling, PM Johnson received flak from members of the rivaling Labour Party for not making enough progress in Brexit negotiations.  With seven weeks left until Brexit, it is believed that PM Johnson has not made substantial progress in securing a deal.  One of the primary hurdles to negotiations is the Irish backstop.  PM Johnson has asked for it to be removed from the deal completely but has not offered an alternative to the backstop.  There are rumors that he is exploring building a bridge that would link Scotland and Northern Ireland, but nothing has been formerly proposed.  One of the major risks to the proposal is that there are believed to be undetonated WWII bombs located in the water.

As the Brexit deadline looms closer, it is becoming clear that PM Johnson may not be able to come up with a Brexit deal; therefore, assuming elections are not called, the likelihood of a no-deal Brexit is really elevated.  Countries within the EU such as Spain and France have begun preparing for the worst.  This morning, Spanish PM Pedro Sanchez asked Spanish businesses with commercial ties to the U.K. to evaluate their exposure, and create contingency plans in the event of a no-deal Brexit.  France, which gave its businesses the same directive last week, also began testing a smart border in Calias, which is where a lot of French goods are transported to the U.K.  We expect a frantic adjustment if a no-deal Brexit happens, as it will be unclear how the U.K. and European countries will cope with the sudden withdrawal.

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

[Posted: 9:30 AM EDT]

Good morning!  Equity markets are a bit lower this morning, although there is a huge amount of rotation in the sectors.  Chinese inflation data was mixed.  Parliament is prorogued.  Here is what we are watching this morning:

Is the ECB set to disappoint?  Mario Draghi leaves the ECB on Halloween and he is trying to deliver one last burst of stimulus.  Talk of new rate cuts, tiered negative rates and new QE have been offered but there is growing concern that Draghi, a lame duck, won’t be able to deliver.   Growing opposition among the members of the ECB centers on the idea that things aren’t all that bad, at least not bad enough to warrant such aggressive actions.  This situation is important, because if Draghi can’t implement these measures, it’s unlikely his successor, Christine Legarde, will be able to push measures through, at least immediately.  Legarde is not considered an economic heavyweight and thus probably won’t be able to sway the members on the strength of her arguments.  Instead, she will likely need time to build a consensus on the committee to bring any changes into place.  If the ECB falls short, look for a further rise in long-term rates, weaker gold prices and a stronger EUR.  We don’t view these market reactions as the beginning of a long-term trend.  The European economy is still struggling and will need additional stimulus.  Although there is a glimmer of hope for fiscal loosening (see below) if economic conditions don’t improve, we will likely see the ECB eventually adopt what Draghi is proposing.  But, in the short run, we think the odds of disappointment are elevated with the aforementioned results.

A fiscal expansion in Germany?  German officials are starting to make noise about a fiscal expansion and there is growing speculation that policymakers are working on ways to get around the balanced budget rules.  To some extent, this is a “no duh” moment; Germany has ample fiscal capacity (negative yielding sovereign debt is a clear indication of its existence).  Europe, and, for that matter, the world, needs Germany to shrink its current account surplus and fiscal expansion could do the trick.  However, despite the obvious need, Germany has a deep-seated aversion to fiscal expansion and inflation.  Actual deficit spending probably doesn’t occur without a full-blown recession in place.  Nevertheless, if the policy mechanisms are in place, fiscal expansion could be implemented quickly.

Brexit:  Prime Minister Johnson has lost a second vote on having a snap election, as the Labour Party and other opposition groups refused to allow the ballot in order to ensure that Johnson asks the EU for a delay with Brexit, as now required by law.  Since parliament is now on leave for the next five weeks, the earliest an election can take place is November.  Recent polling shows Johnson is still the most popular British politician, with much higher support than Labour Party leader Jeremy Corbyn.  However, he doesn’t necessarily have a majority, and he continues to lose support from traditional Conservative Party stalwarts who reject his drive toward a no-deal Brexit.  In the House of Lords, the Duke of Wellington announced he would quit the party to protest Johnson’s program.  As Johnson becomes increasingly hemmed in, there are some signs that he may be shifting his position.  In talks yesterday with Prime Minister Varadkar of Ireland, Johnson said Northern Ireland and the Republic of Ireland could trade agricultural and food products under EU rules, although that idea would be strongly resisted by British nationalists on grounds that it would weaken the status of Northern Ireland in the United Kingdom.

We may see the GBP drift higher as positions are squared in front of the return of Parliament in mid-October.

Chinese inflation:  China released PPI and CPI for August.  The data told two stories.  On the CPI data, it’s all about pork.

Overall, CPI rose 2.8%, while core CPI rose by only 1.7%.  Food prices jumped 10.2%, led by a 47% rise in pork prices caused by the African Swine Fever pandemic.  There are rising concerns about the political impact of the pork issue.  However, despite the spike in prices, there has been no movement by China to increase its buying from the U.S.  This may occur if conditions continue to deteriorate, but probably not before the CPC meetings in early October.  Meanwhile, the PPI data shows evidence of renewed deflation

Tech troubles:  Tech firms are facing two threats.  First, more than 40 state attorney generals have joined a bipartisan probe into large tech firms, including Facebook (FB, 188.76) and Alphabet (GOOG, 1204.41), in a broad anti-competitive probe.  Perhaps the greatest threat to the large tech platforms is regulation and the fact that this is state-level, broad and bipartisan will make fending off this action through lobbying very difficult.  Second, California is about to pass new labor laws that will force companies that rely on “gig workers” to reclassify them as employees.  Many of these platforms struggle to attain profitability even with the 1099 structure; the regulatory burden of making their workers W-2 employees will either (a) destroy the model, or (b) require much higher prices.

European Commission:  Incoming European Commission President Ursula von der Leyen is naming her top lieutenants today, and perhaps the most important news is that current Competition Chief Margrethe Vestager will continue in her role.  Vestager has aggressively pursued anti-trust actions against a number of major U.S. and foreign technology firms, including assessing huge fines.  This aggressive approach to enforcing market competition rules will now likely continue, which will add some measure of risk to international firms doing business in Europe.  In a nomination that has implications for Brexit, the EU’s trade chief will be Phil Hogan of Ireland.  The new economic policy leader will be Paolo Gentiloni of Italy, and the responsibility for defense, the single market and industrial policy will be in the hands of Sylvie Gouland of France.  The nominees will face questioning by the European Parliament later this month, after which the legislators could reject them as a team or pressure von der Leyen to give them different jobs.

Iran:  Although it isn’t catching the attention of the media, tensions in the Middle East surrounding Iran and its proxies are heating up again.  First, Iran is trying to pressure Europe into breaking U.S. sanctions by steadily violating the nuclear deal through increased uranium enrichment.  With the U.S. exit from the agreement and the reimplementation of sanctions, Iran is arguing that it is no longer bound to the deal.  However, it had initially complied (sort of) to try to encourage Europe to violate American sanctions.  Nonetheless, despite efforts to create a method of evading the U.S. financial system, in practice, the Europeans are not buying enough Iranian goods to support the Iranian economy.  In addition, it does appear that one of the fears of opponents of the nuclear deal, the fear that Iran might cheat, may have been realized.  Israel has been arguing that Iran violated the arrangement by illegally stockpiling fissile material.  The IAEA reports that it has  found traces of nuclear material in a warehouse.  Finally, Hezbollah has downed an Israeli drone as tensions rise in the region.  All of this is bullish for oil prices, which have been bolstered by the change of leadership in the Saudi oil industry.

Spain:  An advisor to the European Court of Justice warned today that Spanish banks may have violated consumer protection laws by the way they explained a widely used mortgage price index to borrowers.  As might be expected, the potential for lawsuits and fines is weighing on Spanish bank stocks today.

North Korea:  First Vice Minister Choe Son Hui was quoted in state-run media today as saying Pyongyang is ready to restart denuclearization talks with the United States later this month.  At the same time, however, the country launched two more short-range missiles, likely as a warning that Washington needs to get back to the bargaining table.

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

[Posted: 9:30 AM EDT]

Happy Monday!  Global equity markets are edging higher this morning.  China’s economic data was a bit soft.  Russian local elections were a rebuke of Putin.  The Brexit saga continues in Ireland.  Here is what we are watching this morning:

Russia:  In Moscow’s city council elections over the weekend, the ruling United Russia Party of President Putin lost more than one-third of its seats in spite of its aggressive efforts to keep opposition candidates out of the competition over the last several months (as we discussed in our Weekly Geopolitical Report on July 15).  United Russia will still have a majority on the council, with 24 of the 45 seats, but opposition legislators will gain a significant soapbox to stand on with 20 seats.

Russia-Ukraine:  As part of a Russia-Ukraine prisoner swap, two dozen Ukrainian sailors detained by Russia last November have been released.  Ukraine also secured the release of 11 other Ukrainians held by Russia, while Russia got dozens of Russians and other citizens that Moscow wanted.  The swap suggests Ukraine’s new president, Volodymyr Zelenskiy, is continuing to make progress on diffusing tensions with Russia.  Although we doubt Zelenskiy can reverse major Russian moves such as the annexation of Crimea, he could potentially ease or end Moscow’s support for Russian separatists in Eastern Ukraine.  That, in turn, could take some wind out of Russian sanctions sentiment in the West.

Iran:  An Iranian foreign ministry spokesman said the crude oil tanker previously seized and released from Gibraltar has unloaded its cargo, apparently in Syria.  That would seem to violate Iran’s promise to Gibraltar authorities that the oil would not go to Syria, which is under European Union sanctions.  The apparent breaking of the promise will likely keep tensions high between Iran and the West, helping keep oil prices higher than they otherwise would be.

China data:  Exports fell 6.0% in August compared to July, while imports fell a more modest 2.7% (CNY terms; media headline data is using USD terms).  It does appear that the combination of tariffs and slowing global growth is putting pressure on China’s export sector.  Exports to the U.S. plunged 16% from last year but some of that decline is likely due to transshipments, where Chinese exports go to other nations and eventually end up in the U.S.  Overall, exports from China are declining and the Xi government is going to have to either find other sources of demand or begin to more aggressively stimulate.  There are growing worries among investors that China’s economy is weaker than the official data suggests.

One factor that will help is that foreign reserves remain ample.

Reserves were mostly steady in August.  The fact that reserves are holding up suggests that the recent CNY volatility hasn’t triggered significant capital flight and signals to the PBOC that steady, modest depreciation can be implemented without triggering investor unrest.

A China trade thaw?  There are reports of a “mini-deal” where the U.S. would delay the October 1 tariffs and ease the pressure on Huawei (002502, CNY 3.24) in return for agriculture purchases.  At first glance, this seem like an uneven offer.  The tariffs cover $250 bn of imports and giving in on Huawei would look bad.  To make this work, China’s purchases would have to be huge.  If the administration takes this deal, it would suggest they are worried about the impact of the trade deal on the economy and markets.  The “whiff” of an agreement is helping to lift stocks.

Hong Kong:  Protests continued in Hong Kong; protestors waved American flags in an attempt to gain sympathy from U.S. lawmakers.  We don’t expect much movement on Hong Kong until after the party meetings in early October.  Although we are not seeing anything overt, there is talk of “grumbling” about Xi’s leadership; after all, he now faces unrest in Hong Kong that doesn’t appear to be abating and he has “lost” China’s relationship with the country’s most important trading partner, the U.S.  Xi has solidified power with the purges he held in his first term.  Thus, he will probably remain in power, but his grip may be weakening and we might see new leadership emerge if conditions don’t improve.

Brexit:  PM Johnson suffered yet another political blow when his work and pensions secretary, Amber Rudd, resigned over the weekend.  She left because she doesn’t believe Johnson really wants a deal with the EU.  Johnson is in Dublin today to try to heal frayed relations with Ireland; the Irish have already indicated that they don’t expect much from the meeting.  Meanwhile, France has suggested that if the U.K. doesn’t have anything new to offer, it might not agree to an extension.  Although we think this is a bluff, Macron is rather tired of Brexit and would rather see Britain off and regroup with the remaining EU members.

Meanwhile, there is swirling speculation about what Johnson’s next moves might bring.  We do not expect him to ask for snap elections for a second time; odds of passage are very small.  From there, things could get weird.  There is speculation that Johnson might offer a vote of no-confidence on his own government, which would only need a mere majority.  This action would bring down the government, resulting in a caretaker government and new elections.  Another possibility would be him quitting and petitioning the Queen to appoint opposition leader Corbyn to take power, only to immediately make a no-confidence motion, which he might win, bringing new elections.  There is also speculation that Johnson might reject the will of Parliament and not ask for an extension of Article 50.  That would trigger a constitutional crisis.  Thus, there is the potential for significant turmoil in the next six weeks; the fact that the GBP (that’s Great Britain pound, not peso) is holding steady does suggest we may be reaching a price level where most of the bad news is discounted.

A Saudi shakeup:  Crown Prince Salman fired Energy Minister Khalid al-Falih, replacing him with his older half-brother, Prince Abdulaziz bin Salman.  This breaks a longstanding tradition where the Royal Family leaves the oil industry in the hands of the technocrats.  Although this does put a family member in charge of the oil industry, the new energy head has extensive experience in the Saudi oil industry.  Why the shift?  We suspect there are two reasons.  First, the former energy minister was “slow walking” the Saudi Aramco IPO; the crown prince wants to use funds from the sale of the state oil company to fund his plans to develop the kingdom’s economy away from its dependence on energy.  Second, oil prices have languished under al-Falih; the crown prince wants oil prices in the high $60s to low $70s to boost revenue in the short run and to lift the IPO price.  If our analysis is correct, we will (a) see rapid movement on the IPO, and (b) see further output restrictions and higher oil prices.  Oil prices are modestly higher this morning on the news.

Mexico:  The government of left-wing President Andrés Manuel López Obrador has released a proposed budget for 2020 that aggressively assumes the economy will grow 2% next year, versus just 1% this year.  The budget also assumes Mexican oil production will grow 15% next year, despite years of declines.  Based on those assumptions, the document claims the government can boost spending on an array of social programs, while still keeping the overall budget deficit at just 2.1% of gross domestic product (GDP).

The Taliban talks:  We won’t spend a lot of time on this issue because it had little immediate impact on the financial markets.  But, in a bid to accelerate a deal, President Trump tried to broker a meeting between the Taliban and the Afghan government.  However, a Taliban bombing that killed a U.S. soldier led the president to call off the meeting.  The meeting underscores the problem for superpowers, which is the issue of extricating from these sort of conflicts.  On the one hand, Afghanistan isn’t critical to U.S. security.  This is the problem seen during U.S. hegemony; how does the hegemon maintain credibility and avoid entanglements?  This problem bedeviled Truman, Johnson, Clinton, Obama and, now, Trump.  Trump campaigned on getting out of these types of conflicts, but leaving usually means exiting without “finishing the job” because it may be nearly impossible to do so.  However, staying and maintaining credibility leaves one fighting an endless war.

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

[Posted: 9:30 AM EDT]

Happy employment data Friday!  We cover the data in detail below but here is the snapshot—it was mixed.  The payroll report was soft, but wage growth and the household survey were rather strong.  Financial markets are taking the report as weak, focusing on the payroll data.  In other news, Powell speaks today, the PBOC reduced reserve requirements and Robert Mugabe has crossed over the earthly veil.  Gold is lower on the rebound in interest rates.  Here are the details and other items we are watching:

China:  As widely anticipated, the People’s Bank of China reduced the amount of reserves that commercial banks are required to hold at the central bank.  The reserve requirement ratio will be cut by 50 basis points for most banks, and by 100 basis points for certain medium and small institutions.  The cut is expected to increase the amount of funds available for lending by approximately $126 billion.  The move is part of a modest package of stimulus measures that the government has been rolling out over recent months to cushion the economy from the U.S.-China trade war.  Investors are likely to cheer the move, but it’s still not clear how much the measures will really help.  Excessive debt throughout the economy will probably continue to limit borrowing, while uncertainty over the trade situation will likely keep weighing on investment and hiring.

Hong Kong:  Fitch Ratings has downgraded its credit rating for Hong Kong to AA from AA+, with a negative outlook, based on increased political instability.  The company suggested Beijing’s reaction to the city’s continued anti-China protests pointed to less policy flexibility for Hong Kong’s government and greater integration with the mainland, which would imply that the city’s rating should be closer to the A+ rating assigned to China.  The downgrade is another reason to think Hong Kong assets will remain under pressure in spite of Chief Executive Lam’s withdrawal of her controversial extradition bill this week.

Trade uncertainty:  Although there is no doubt that the administration’s trade policy is having an impact on the economy, getting a precise gauge on the effect is difficult.  A research group, PolicyUncertainty.com, has created a series of uncertainty measures based on the level of news reporting on a category, the number of tax code provisions due to expire and the dispersion of forecasts among economists on a certain category.  With regard to trade, we are at the highest level of uncertainty since the initial NAFTA negotiations.

A research paper by economists at the Federal Reserve suggests the trade situation will probably reduce U.S. GDP growth by about 1%.

Recessions tend to come from two causes—policy errors and geopolitical events.  The former is measurable by looking at the economic data.[1]  The latter is trickier.  Although we pay close attention to geopolitical issues, each event is unique and the impact of such events tends to be cumulative, therefore assessing causality to a particular incident is difficult.  The trade conflict falls into this category; we view the administration’s trade policy as part of America’s rejection of the hegemonic role that we have shouldered since 1945 and so the anti-trade policy, in one form or another, will outlast President Trump.[2]  Our worry is that the trade war could either (a) accelerate the onset of recession, or (b) deepen a recession when one occurs.  If the Fed researchers are right, a 1% decline in GDP next year, due to the trade conflict, will reduce growth to the point where a recession will be difficult to avoid.

United Kingdom:  Labour Party shadow chancellor John McDonnell warned today that if he had control of the Treasury, he would impose severe constraints on British financial firms.  McDonnell said he would work especially hard to ban large bonuses, which he said are offensive to people and a large source of inequality.  Increased regulation of financial services would be consistent with the radical left-wing program laid out by Labour Party leader Jeremy Corbyn, which includes the nationalization of multiple industries and huge increases in the minimum wage.  McDonnell’s statement therefore illustrates the kinds of policy risks that would arise in Britain if Prime Minister Johnson loses power to Corbyn.  More broadly, we think it also reflects the left-wing direction that today’s populism might be headed toward after transitional figures like President Trump and Prime Minister Johnson pass from power.

Brexit:  Even if Prime Minister Johnson can extricate Britain from the EU as he wants, many observers have noted that he would probably have only limited bargaining power in any post-Brexit trade negotiations with the United States.  Now, it appears he’s also undermining his position for any post-Brexit negotiations with the EU.  Johnson’s team this week warned the EU that they wanted to abandon prior commitments made by Theresa May to keep British environmental and social standards similar to the EU’s in order to secure a bilateral trade deal.  Various EU officials say that would make it very difficult to gain approval for a deal.

There is another facet of Brexit that is worth exploring.  The Brexiteers may be underestimating the role of Ireland in Brexit.  We, like others, are guilty of focusing on the major powers in the EU—thus, we pay close attention to what is happening in Germany, France, the U.K. and Italy.  However, an important element to joining the EU is the power it gives the smaller nations in Europe.  A small nation in Europe that isn’t part of the EU has little power; it will never have a significant enough military to protect itself from larger powers and its economy is subject to the influence of the larger states in the EU and the world.  By joining the EU, the small states get the protection of NATO and have a vote on economic policy.  Thus, the EU may be seen, at times, as a constraint on the larger nations but it is a force multiplier for the small states.

This factor is playing a role in the Irish backstop issue.  The smaller EU states are viewing the Brexit supporters’ position on the backstop as a big nation attempting to push around a smaller one.  This dynamic could make it very difficult for the EU to give any ground on the backstop issue; it isn’t just that it is hard to come to a unanimous agreement among the EU nations, but it’s also that the smaller states see this as a test of how the EU will support a smaller state against a “bully.”  In the end, if the U.K. follows through on Brexit, the eventual deal may require that Northern Ireland remains in the EU trading area to ensure the trade zone integrity of the EU.  One proposal made by the negotiators was to put the trade border at the Irish Sea, effectively keeping Northern Ireland within the EU trade zone.  When former PM May lost her party’s majority in snap elections, she was forced to form a coalition with the DUP, a unionist party in Northern Ireland.  The DUP strongly opposed the prospect of Northern Ireland remaining in the trade union, rightly fearing that this will be the first step in unifying Ireland.  If PM Johnson were to win the upcoming election and continue to press for leaving, the eventual cost of Brexit might be Northern Ireland.

Japan-South Korea:  Even though the dispute over Japan’s behavior in Korea before and during World War II has cooled a bit recently, new ordinances in two South Korean cities show it still isn’t completely over.  The city councils of both Seoul and Busan have passed nonbinding ordinances designating 284 Japanese firms as “war crimes companies” and discouraging purchases from them.

Iran:  The Iranian government announced that it would cease following restrictions on its nuclear research contained in its 2015 nuclear deal with the West.  That follows earlier moves to violate the deal’s limits on how much nuclear material it could stockpile and how highly it could enrich uranium.  The violations aim to put more pressure on European governments to come up with compensation for U.S. sanctions imposed after the U.S. pulled out of the agreement.  The violations are likely to keep tensions high in the Middle East, which should continue to keep oil prices higher than they would be otherwise.

Mexico:  The chairman of the Chamber of Deputies budget committee, who is a key member of left-wing President Andrés Manuel López Obrador’s party, has introduced a bill to apply Mexico’s value-added tax (VAT) to digital services.  Currently, internet services and the like aren’t subject to the tax in Mexico.

Energy update:  Crude oil inventories fell 4.8 mb compared to an expected draw of 3.5 mb.

In the details, U.S. crude oil production fell 0.1 mbpd to 12.4 mbpd.  Exports were unchanged, while imports rose 1.0 mbpd.  Refinery operations fell 0.4%.  The drop in stockpiles was mostly due to reduced production.

The above chart shows the annual seasonal pattern for crude oil inventories.  As we approach the end of spring/summer inventory withdrawal, we are starting the autumn rebuild period at a sizeable deficit.  Without aggressive increases in stockpiles, we will likely continue to lag seasonal patterns.

Based on our oil inventory/price model, fair value is $66.39; using the euro/price model, fair value is $53.44.  The combined model, a broader analysis of the oil price, generates a fair value of $57.68.  We are seeing a clear divergence between the impact of the dollar and oil inventories.  Given that we are nearing the end of the summer driving season, the bullish impact of inventories will likely diminish in the coming weeks; a sideways to lower price path is the most likely outcome.

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[1] We have a report on this.  See our Business Cycle Report.

[2] Interestingly enough, Chairman Xi seems to agree with our assessment that what we are seeing is a fundamental change in the world order.

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

[Posted: 9:30 AM EDT]

Trade optimism is lifting risk assets; equities are up, while gold, the dollar and Treasuries are down.  Here are the details and other items we are watching:

An observation:  One of the most difficult tasks humans face is trying to deal with low probability/high impact events.  If something can happen that is highly unlikely but extremely positive or negative, our minds tend to become a muddle.  This situation explains why lotteries flourish; anyone with a modest understanding of basic statistics realizes that a lottery is a voluntary tax paid by those who fail to understand how the numbers work.  And yet, money is wagered 24/7 in these long-shot bets.  Anyone who has raised teenagers can see this problem work out first hand.  Teens will take completely unnecessary risks for inconsequential benefits and then be shocked when the unlikely outcome occurs and causes an expensive consequence.[1]

Financial markets struggle with this issue constantly.  In fact, we have options markets available to give us tools to deal with these circumstances.  Nicholas Taleb has made a career out of making small wagers on unlikely but very consequential events that occasionally pay off enormously.  Still, most of the time, the unlikely event doesn’t occur and we, like the teenagers we once were, go our merry way.

Today is an interesting example of this situation.  Equities are up sharply on hopes of a trade deal with China due to the news that the two parties will meet in October.  Although there is hope that something might come of these meetings, positions have hardened and anything beyond a truce would be surprising.  This isn’t the only situation that may be improving.  A hard, Halloween Brexit appears unlikely as PM Johnson has suffered a series of electoral defeats.  Like a cat playing with a mouse, Jeremy Corbyn continues to delay the inevitable general election, keeping Johnson in Downing #10 with little power.  In Hong Kong, the fear was an invasion of the island by the PLA; instead, we are seeing grudging concessions that probably won’t stop the protests completely but will likely reduce the intensity over time.  And, in Italy, fears that the League would gain control and trigger a Eurozone crisis have been eased by a new leftist government.

Market strategy, in part, requires one to look out for what can go terribly wrong.  At the same time, there is a realization that, most of the time, things work out ok.  Unfortunately, the longer things work out ok, the more complacent we become.  Hyman Minsky noticed this issue, dubbing it the “financial instability hypothesis.”  In effect, the longer conditions remain stable, the more investors are inclined to take more risk, eventually creating conditions where a financial crisis cannot be avoided.  It’s a bit like forestry management that never allows a fire to develop.  Over time, the underbrush that would normally be reduced by small fires becomes so thick that a small fire becomes a big one.  Our industry is characterized by Cassandras who are always projecting the end is near, along with permabulls who assume everything will always be ok.  What we try to do, as is likely true with most strategists, is hew a path between these extremes.  Most of the time, the worst is avoided; but, when the worst occurs, “it leaves a mark.”  In some respects, holding to either extreme is intellectually easy.  Cassandras are wrong most of the time, but when they are right their calls appear to be spectacular.  Permabulls are right most of the time, but it can feel like they are “gathering nickels in front of freight trains.”

So, where does all this leave us?  Although trade talks with China may bring us to a truce, we don’t think that China is going to fundamentally change its approach to trade and there isn’t much evidence to suggest that President Trump sees much risk from his trade policy.  To the president’s credit, he has concluded that China is a strategic competitor and so, regardless of the outcome of the current round of talks or who wins the White House in 2020, our relations with China are changed for good.  The U.K. is going off on its own; even if a new referendum rescinds Article 50, its relations with the EU will be forever fraught because of Brexit.  In addition, the Brexit debate has exposed societal divisions that plague not only the U.K. but the West, in general.  Hong Kong is eventually going to come under control of Beijing and its current freedoms are likely to be lost; capital and human flight are likely.  This outcome not only affects Hong Kong but Taiwan as well; if anything, the protests in Hong Kong may have increased the odds that Taiwan won’t rejoin the mainland peacefully.  Italy has suffered during its tenure in the Eurozone; either Germany changes its export-driven economy or Italy will need to leave the Eurozone at some point.  Today, it looks like these potential crises have been averted, and if this optimistic sentiment continues, we will likely challenge the recent highs in the equity indices.  However, the structure beneath has not changed.

In the PBS drama Doc Martin, Luisa, the nurturing, lovely wife of the curmudgeonly Doc Martin, purrs to a frightened young girl:

“No one’s going to die.” Martin, as affectless and socially clueless as always, counters, “Yes you are. Everyone’s going to die.” Before adding, “But not today.”

This line is a decent reflection of what investors face; there are a myriad of low probability/high impact events that can occur that would have either a very positive or negative impact on one’s portfolio.  This is the business we have chosen.  Our take on events?  As we have been saying, it’s too early to take an overly defensive stance in portfolios but the time to do so is probably on the foreseeable horizon.  Stay tuned…

U.S.-China Trade:  The United States and China have both confirmed that their top-level trade negotiators – Chinese Vice Premier Liu He, U.S. Trade Representative Robert Lighthizer and U.S. Treasury Secretary Steven Mnuchin – will meet again in early October to try to resolve the countries’ trade dispute.  Lower-level officials will meet in September to prepare for the meeting.  The prospect of further meetings offers a glimmer of hope that the trade war can be reversed, so risk markets across the globe are rallying today.  However, it’s important to remember that the countries remain fundamentally at odds on their trade goals, so there is limited hope for meaningful progress at the talks, even as the dispute continues to weigh on global investment and trade.

Hong Kong:  Municipal Chief Executive Carrie Lam said today that she alone made the decision this week to formally withdraw her controversial China extradition bill, which sparked the massive political protests of recent weeks.  While that decision has been taken as a positive, prompting a surge in Hong Kong assets yesterday, it’s important to remember that she also insisted that to “withdraw” the bill was substantively no different than her decision to “suspend” it earlier in the summer.  The withdrawal announcement was already being taken as too little, too late by many protest leaders.  If Lam’s statement is now taken as confirmation that nothing has really changed, there’s an even greater chance that the protests will continue, which would probably weigh on Hong Kong stocks again.  That’s especially true if it looks like the government and police continue to clamp down on demonstrators, sometimes apparently working with organized crime groups to harass them.  Today, masked assailants threw Molotov cocktails at the home of media mogul and democracy activist Jimmy Lai Chee-ying.

United Kingdom:  You know things are going badly when even your family abandons you, and that’s what has happened to Prime Minister Johnson today.  The prime minister’s brother, Jo Johnson, announced he would leave his position as universities minister and give up his seat in parliament to protest the government’s headlong drive toward a no-deal Brexit.  The bill requiring the prime minister to ask the European Union for a delay in Brexit completed its passage through the House of Commons last night and is expected to get through the House of Lords by the end of Friday, allowing it to return to Commons on Monday.  However, a spokesman for Prime Minister Johnson said he will not make the request to the EU even if the bill becomes law.  Having lost any hope of blocking that bill, the Johnson government is pushing for a new election in order to secure a mandate for its Brexit policy, but yesterday parliament also voted against snap elections.  In a final blow, influential Conservatives are pressuring Johnson to reinstate 21 legislators that he purged from the party yesterday for voting against him on the measures.

Eurozone:  In testimony related to her nomination as the chief of the European Central Bank, yesterday Christine Lagarde said Eurozone governments should adopt stimulative fiscal policies to accelerate economic growth.  Lagarde insisted that “central banks are not the only game in town” and she is not a “fairy” who can magically prompt greater growth through monetary policy alone.  We still don’t see a lot of movement toward greater use of fiscal policy to promote economic growth around the world, but if the trends toward economic sovereignty and populism play out as we expect, we do think greater fiscal stimulus will be more widely adopted down the road.

Italy:  Yesterday, the new Democrat-Five Star coalition government announced its lineup of ministers, and the appointments suggest there will be fewer disputes between Italy and the EU over the country’s budget deficit, debt and migration policy.  Importantly, the new finance minister, Roberto Gualtieri, is a member of the center-left Democratic Party who previously served as the chairman of the economic and monetary affairs committee in the European Parliament.  Even if Gualtieri pushes for new spending or tax cuts to boost the economy, as the Five Star Movement will demand, we think EU leaders will be more flexible with him than they were with the more combative previous coalition composed of the Five Star Movement and the far-right League.  In sum, the developments in Italy are now looking more supportive of European risk assets.

Sweden:  Although yesterday the Riksbank held its benchmark short-term interest rate unchanged at -0.25%, its policy statement reiterated that policymakers soon plan to start hiking rates again.  The projected rate hikes would be milder than previously planned, but the policy stance is at odds with most major central banks.  That’s at least partially explained by the recent weakness of the krona and the general outperformance of Scandinavian economies in recent years.

Argentina:  Some of the country’s largest international creditors held informal discussions this week on President Macri’s proposal that they “voluntarily” accept delayed repayment on some $100 billion of government debt.  Most importantly, the participants agreed that any debt deal would require a commitment from Alberto Fernández, the populist leader of the opposition Peronist party who is currently the frontrunner in the upcoming presidential elections.

Central bank issues:  Although financial markets in Europe and the U.S. continue to project aggressive easing by the Fed and the ECB, internally, there is growing opposition to taking strong actions.  Yesterday, we noted the differences between Jim Bullard and Eric Rosengren.  Today, we see there are elements within the ECB opposing Draghi’s plan for stimulus.  A divided Fed will likely lead to a modest rate cut later this month, not the more aggressive action discounted by the financial markets.

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[1] Yes, this did happen to us.  It involved an unnecessary decision to drive at night and a deer.  Enough said…

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

[Posted: 9:30 AM EDT]

Yesterday was busy; the ISM manufacturing data disappointed and there was lots of Brexit news.  Here are the details and other items we are watching:

Boris’s terrible, horrible, no-good, very bad day:  PM Johnson had a rough day yesterday.  First, his government fell into minority status as MP Phillip Lee left the Tory Party to join the Liberal-Democrats.  Second, despite threats of ouster, 21 MPs of his own party broke ranks and voted to pass a bill that would delay a no-deal Brexit.  The last time a PM lost his first vote in the House of Commons was William Pitt the Younger in 1793.  So now, Johnson is in power but has lost control of Parliament.  His party is deeply and perhaps permanently divided.  His predecessor, Theresa May, studiously avoided the path Johnson has taken on fears that it would divide the Conservatives.  Johnson criticized her management but has revealed why she acted as she did.

Johnson is moving to call snap elections, but it is not obvious that Parliament will support the motion.  According to the Fixed Term Parliaments Act, Johnson needs a two-thirds majority to trigger an election.  MPs fear he will set the date after Halloween, thus bringing a hard Brexit.  As a result, it is unlikely that Parliament will approve an election before securing a delay in Brexit.  Corbyn has been supporting an early election but is apparently rethinking his position.   We would not be surprised to see a new Brexit referendum before new elections.  It should be noted that Labour may be as divided as the Conservatives are with regard to Brexit.  A referendum would “clear the decks” and allow for elections on issues other than leaving the EU.

So, where are we now?  Essentially, PM Johnson is running a minority government that won’t be ousted until some sort of delay on Brexit is established.  Johnson gambled that he could hold his party together by threats of expulsion and that ploy failed.  Now, he probably can’t even choose when he will face voters.  The fact that Brexit will likely be delayed has boosted the GBP overnight.  There are still twists and turns to monitor but, overall, it is less likely that the U.K. will leave on Halloween.  At the same time, Brexit has upended U.K. politics; even with new elections, it isn’t obvious how the vote will turn out. This is because the two main parties are divided over this issue and the parties that have a clear stance (Lib-Dems to remain; Brexit Party to leave) may not be able to pull together a government to run the country.

Lam retreats:  Carrie Lam, Hong Kong’s chief executive, has formally withdrawn the extradition bill.  Hong Kong equities rallied on the report, but the move has been seen as “too little, too late.”  Lam is also setting up an investigation to examine the fundamental causes of the unrest, but is stopping short of a commission of inquiry, a demand of the protestors.  Although there is speculation that this modest retreat is being orchestrated by Beijing to ease trade tensions, we doubt this is the case.  Our take is that Lam wants to divide the protestors, isolating the most hard-core members who want full democracy from those who were just upset by the extradition bill.  Although this might have worked a few weeks ago, it may simply be too late to effectively divide the group.

Iran:  A series of cross-currents are emerging on Iran.  First, France is offering Iran a $15 bn bailout contingent upon Iran dialing back its nuclear activities.  The money, in the form of a letter of credit, would allow Iran to import goods and use the LOC to acquire hard currency for the transaction.  The U.S. isn’t likely to go along with this effort, but so far the Trump administration hasn’t pushed back aggressively.  Second, Iran is preventing U.N. inspectors from investigating nuclear facilities, increasing tensions about the nuclear deal that is still in place between Iran and the other signatories to the agreement.[1]  Third, there are fears that Iran will aggressively increase uranium enrichment, perhaps as high as 20%, if it doesn’t get relief.  Such a move would be very provocative and raise fears that Iran is “making a dash to a bomb.”  Fourth, Iran claims the U.S. is showing “some flexibility” with regard to oil sales.  Although details are lacking, the comment suggests the U.S. is allowing some sales to go forward.  There are two possibilities, the first is that the U.S. is easing up on Iran to encourage talks.  The second possibility is that the administration wants lower oil prices and cutting Iran some slack might be helpful in bringing down energy prices.  Fifth, the U.S. is implementing its patrols for the Persian Gulf, which does increase the odds of an incident.  And sixth, President Rouhani has indicated he will not meet with President Trump unless sanctions are lifted.

All this turmoil should help support oil prices but, at least for now, worries about global growth are overwhelming the impact of geopolitics.  Iran is clearly pressing the EU to break with the U.S. over Iran’s oil sales, but we doubt that Europe will take that step.  If it doesn’t, Iran will probably continue to escalate its uranium enrichment, which will give the hawks within the Trump administration a reason to press for a military solution.  However, unless it attacks the U.S. military directly, we doubt President Trump will support military action against Iran.

ISM manufacturing:  We will have more to say on this item in the near future but the ISM manufacturing index dipping below 50 has raised some alarm bells.

Although we are seeing a lot of recession talk on this dip, we would caution that you really need a reading under 45 before a clear signal of recession is indicated.

Perhaps the more worrisome development was that the reading on inventories exceeded new orders.

We smooth the difference with a three-month moving average.  A reading in this measure of more than minus two points is usually consistent with recession.  We are barely negative now but building inventories with falling new orders is not a good sign.  This news put pressure on the equity markets yesterday.

Fed news:  On Tuesday, St. Louis Fed President James Bullard and Boston Fed President Eric Rosengren gave opposing speeches as to whether the Fed should cut rates in its next meeting. Rising trade tensions and a decline in manufacturing have led many to speculate that the Fed will look to cut rates at the next meeting, even though strong employment still suggests that the economy doesn’t need additional stimulus.  Currently, Bullard seems to be in favor of the former, and Rosengren the latter.  The opposing viewpoints suggest there is a growing likelihood of another dissent in the next agreement.  Earlier this year, Bullard dissented from the Fed’s decision to maintain interest rates as opposed to cutting, while Rosengren is expected to dissent if rates are lowered.  Although dissents are not highly unusual, frequent and contrasting dissents suggests the Fed is deeply divided.  One of Fed Chairman Jerome Powell’s biggest weaknesses is that he is not a trained economist and, as a result, he lacks a strong ideological base to fall back on.  If dissents become more common, it would undermine Powell’s authority.  At the same time, it is important to note that governor dissents tend to carry more weight than those from regional presidents, who are not permanent voters.

Italy has a government:  The Five Star Movement ratified the new coalition, allowing a new government to take power.

USMCA:  The trade agreement with North America is still facing a vote.  Some Democrats are pressing for a deal to be approved.  These supporters mostly come from conservative-leaning districts and the idea is that passing USMCA would be popular in these areas.  However, labor doesn’t appear to be on board, which would lead the populist wing of the Democratic Party to oppose the measure.

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[1] The U.S. formally exited the agreement in May 2018.