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.

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

[Posted: 9:30 AM EDT]

Welcome back!  Three-day weekends are great, but now we get to pile five days of work into four!  Trade worries continue to weigh on risk assets.  Brexit appears to be reaching some sort of resolution.  Hurricane Dorian dominated the weekend news flow.  Here are the details and other items we are watching:

Trade: On Sunday, a new set of tariffs went into effect.  Although it will take a few weeks, we may start to see it show up in the inflation data by November.  The focus has now shifted to meetings between trade negotiators later this month.  Both sides are struggling to figure out when to hold talks and who should participate.  If Liu He doesn’t make the trip, it will suggest the meetings are simply window dressing.  The U.S. has a 5% bump on $250 bn of Chinese exports due to come into effect on October 1 (from 25% to 30%) and a 15% increase on December 15 for the remaining $200 bn in imports.  There is hope that these may be delayed or reduced, but the lack of consensus on either side makes adjustments difficult.  On a hopeful note, China’s retaliation doesn’t really go into full effect until December.  At the same time, China has important party meetings in early October, and there is no way the Xi government can be seen as caving to U.S. demands before those meetings.

Meanwhile, China is taking steps to adjust to the effects of tariffs.  Additional stimulus is being planned, although the scale remains relatively constrained mostly due to concerns about debt capacity.  We note that the CNY has been allowed to quietly weaken.  While the currency fixes have been steady, the PBOC isn’t making much of an effort to force the market rate to the fix, suggesting it is allowing the currency to offset some of the impact of the tariffs.

China is also opening new fronts in the public relations battle.  In a press release denying that it stole smartphone camera technology from a Portuguese company, Chinese telecom giant Huawei Technologies (002502.SZ, 3.19) tried to turn the tables by claiming the FBI is harassing and threatening Huawei employees to get them to turn against the company.  It also said the U.S. has launched cyberattacks against it.  Given the continued U.S.-China trade war, growing concerns about China’s digital warfare capabilities and the Trump administration’s more aggressive use of offensive cyberwarfare operations, we actually think the accusation rings true.  If so, it is probably a good example of how the administration is conducting a full-court press against China, which bodes poorly for any near-term cooling of tensions.  In another sign of Chinese pushback against the U.S., the Ministry of Public Security touted its efforts to restrict fentanyl shipments since May.  After President Trump demanded Chinese action to help deal with the U.S. opioid crisis, China could have taken some additional steps as a show of good faith.  By pushing back instead, China seems to be signaling that it’s done making concessions, at least for now.

The global economy continues to suffer the effects of the trade conflict.  Chinese PMIs over the weekend were stable but didn’t improve.  The rest of the world, on the other hand, is struggling.

China: Vice premier and Politburo member Hu Chunhua told a meeting of top officials last week that surging pork prices – resulting mostly from an epidemic of swine fever that has decimated pig herds – have become a “major political risk.”  To get control over prices, Hu called for greater financial support for pig farmers and setting pork production targets for each province, though outright price controls can’t be ruled out.

Brexit: The situation with the U.K. and Brexit is getting as complicated as determining who is in the NFL playoffs three weeks before the end of the season.  Here is the rundown:

1. MPs move to kill hard Brexit. The “rebel alliance” of MPs within the Tories is joining forces with opposition groups to vote on a bill that would prevent PM Johnson from leaving the EU without an agreement.  In case a deal with the EU isn’t reached, the bill requires Johnson to ask the EU for an extension until January 31, 2020.  The bill requires an extraordinary measure, the so-called “Standing Order 24” that allows MPs to debate important matters.  This debate and subsequent vote can only occur if the Commons Speaker, John Bercow, gives permission.  It is widely expected that he will grant the debate.  The odds of passage are high, but it would need to move quickly through the House of Commons and House of Lords to become law by early next week when Parliament shuts down.
2. If passed, what does Johnson do? The most aggressive action would be for Johnson to call for new elections.  By calling new elections, Parliament would be dissolved immediately and the delay bill will be dead.  But, there is a catch.  For a sitting PM to dissolve Parliament and call snap elections he needs a 66% vote; a mere majority won’t do it.  Of course, if Johnson loses the delay bill and can’t muster enough votes to call elections, he will be mortally wounded politically.  A vote of no-confidence could follow.
3. No-confidence may be the plan. Labour’s Corbyn has been pining for a general election but it isn’t obvious he would win.  K. politics has become jumbled in the Brexit process, with the two leading parties split.  In other words, the Tories and Labour are both divided over this issue, which would argue that new party arrangements are called for.  We would expect Johnson to make Brexit the key part of his platform in a new election to thwart the effect of the Brexit Party; some Tory MPs would likely defect to another party, putting their seats at risk.  Meanwhile, it isn’t obvious where Labour would fall on this issue.  Former PM Blair rightly warns that Labour is falling into an “elephant trap” and would likely lose a general election.  Complicating matters further is that Labour has just released a radical economic platform that may be too extreme to win a majority.  Johnson could easily move an election away from Brexit and toward Corbyn.  New elections are risky for all parties, but it may be the only way to break the current gridlock.  If elections are called, we would expect them before the Halloween exit deadline.

The GBP fell on the turmoil to historic lows but hasn’t collapsed.  Despite the concerns, so far, there is enough uncertainty to prevent either a strong relief rally or a meltdown.  But, as we have described above, there is enough that can go wrong that the risks of a volatile move in either direction are elevated.  For now, investors should remain cautious.

Hong Kong: The situation remains grim.  There were massive demonstrations over the weekend, with water cannons spewing blue water (a new twist on the tactic, making demonstrators easier to identify for arrest) and lots of tear gas.  The Chinese government’s Hong Kong and Macau Affairs Office continues to assert itself amid the continuing anti-China political protests in Hong Kong.  Today the office said the protests are looking more like the “color revolutions” that have toppled governments in Eastern Europe and the Middle East.  It also warned that it has the legal power to declare a state of emergency in the city, and outlined several steps it might take to get control over the situation, including the possible introduction of “patriotic education” into Hong Kong schools.  The office is still focusing on threats to diffuse the crisis, but the risk of a disruptive crackdown can’t be dismissed.

Argentina: Over the weekend, the government imposed capital controls in an effort to contain its latest debt and currency crisis.  Under the controls, residents aren’t allowed to buy more than $10,000 of foreign currency per month.  The peso jumped on the news, but it’s not yet clear whether its recent plunge will resume.

Italy: In another nail-biter in European politics today, Italy’s left-wing Five Star Movement will conduct an online poll of its members on whether to approve a deal with the center-left Democratic Party for a coalition government.  The deal is generally expected to be approved, but if it fails it would add to the sense of political chaos in Europe and weigh on assets ranging from the euro to Italian stocks and bonds.

Japan: Prime Minister Abe said he will reshuffle his cabinet on September 11.  Reports indicate most key players in the cabinet will keep their jobs, but Economic Revitalization Minister Toshimitsu Motegi may be promoted to foreign minister to reward him for his work negotiating the new trade deal with the United States.

Australia: In order to break China’s near monopoly on rare-earth and other critical minerals, the Australian government said it will support more than a dozen private-sector mining projects centered on those materials.

German regional elections: Germany held regional elections in two former East German states.  The AfD made a strong showing but the CDU did win the most votes.  Both the hard-left and the SPD had weak showings.  Overall, the results avoided the most unsettling outcome (an AfD majority), but also showed that the centrist parties are still struggling to gather votes.

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

[Posted: 9:30 AM EDT]

It’s the last business day of “cultural summer” (the autumn equinox doesn’t occur until September 23), but the summer season generally ends with Labor Day.  Trade optimism continues to buoy equities.  There are elections in Germany over the weekend.  Hurricane Dorian is bearing down on the Atlantic Coast of Florida.  Here are the details and other items we are watching:

China trade:  Optimism abounds but the evidence of progress is rather thin.  There are reports that trade negotiators are maintaining “effective communication” but it isn’t clear what exactly that means.  Both sides appear to be trying to look reasonable and seem to be seeking a way to reduce tensions.  However, underneath all the happy talk are increasingly long odds that the negative impact of the trade tensions can be avoided.  Here are few items of note:

1. The CNY dropped sharply in August, its biggest monthly fall in 25 years. Although the usual reaction to tariffs is currency depreciation, we expect the PBOC to resist further sharp declines.  First, Chinese firms are holding around $500 bn of dollar-denominated debt and CNY weakness increases the cost of debt service.  Second, fears of currency weakness tend to lead to capital flight in China; there are reports that authorities in China are increasing their efforts to contain outflows.
2. There has been a timing problem with trade tensions. Recall Q4 2018…equity markets were declining, in part on trade concerns, which led Presidents Xi and Trump to declare a temporary ceasefire.  One of the factors that led to this easing of tensions was that China had passed its party meetings.  China has informal meetings in August (which have just concluded) and major party gatherings in the first week of October.  It’s difficult for any Chinese leader to concede anything to foreigners until these meetings have passed.  This year is particularly sensitive because it is the 70^th anniversary of the founding of the communist government on the mainland.  Chairman Xi is slated to give a major policy speech on October 1 to commemorate the event.  Giving that speech while making concessions to the U.S. is just about impossible.  Thus, we may have meetings between negotiators next month, but we would not expect any breakthroughs unless the U.S. completely caves, which looks highly improbable.
3. Although reports of contacts continue, both sides are preparing for more of the worst. China is said to be measuring its exposure to U.S. technology firms as it prepares a “blacklist” of unreliable U.S. trade partners.  The Trump administration is considering a plan to reduce taxes by the amount raised by the tariff levies.  If the U.S. were planning to pull back on tariffs, it would not need to create a mechanism to recycle the revenue.
4. Nazak Nikakhtar, the acting chief of the Commerce Department bureau reviewing U.S. company license applications to trade with Chinese telecom firm Huawei (002502.SZ, 3.06), has mysteriously resigned in order to return to the more junior position she previously held elsewhere in the department. The licenses to trade with Huawei have become an important bargaining chip in the U.S.-China trade dispute.  As an inducement to China, President Trump has promised the licenses would be issued, but none have been granted to date.  Nikakhtar’s curious decision to step back to a lower-level role suggests there was something about the process that she found unpalatable.
5. Pain from the trade war is rising. S. businesses complain their Chinese operations have been adversely affected by the trade war and are warning that the conflict is hurting their overall business.  The Peterson Institute has a fine summary of the impact we have seen from the trade war.
6. Although the process is slow, it does appear that some operations are moving out of China. India is attempting to become a destination for this outflow.  However, there is scant evidence that production is coming back to the U.S., a goal of the administration.
7. There is a risk that the trade war could trigger a financial event, most likely in China. Two items caught our attention, in addition to the aforementioned level of dollar debt held by Chinese firms.  First, the PBOC is trying to contain potential problems in smaller banks that could be at risk to the slowing economy.  Second, the Chinese youth, unlike their parents, are spending heavily and racking up debt to maintain their lifestyle.  They could be vulnerable to a decline in growth.  Although the Xi government would appear to be able to absorb more pain than the Trump administration, one must be careful not to overestimate Chinese resilience.  At the same time, as noted in point two, the odds of a deal before mid-October are very low.

German local elections:  Germany will hold state elections in Brandenburg and Saxony on Sunday, 9/1.  The AfD is making a strong showing; if the CDU loses, it could undermine Merkel and her successor, AKK.  In addition, a poor showing might tempt the Social Democrats to exit the grand coalition and bring down the government.

Hong Kong:  The municipal police have arrested several high-profile democracy activists on charges of instigating unlawful demonstrations.  Those arrested include Joshua Wong, a key leader of the “Umbrella Movement” in 2014, and Agnes Chow, a leader in Wong’s group, as well as two elected officials and the former head of a student union.  Wong and Chow were later released on bail, but the arrests are seen as a warning for anyone trying to organize further protests like those that have been going on all summer.  More ominously, two other well-known activists were attacked and beaten by masked assailants, suggesting the government could still be using organized crime figures – or at least their tactics – to intimidate demonstrators.  After the Hong Kong government’s refusal yesterday to grant a permit for another big demonstration on Saturday, its organizers officially cancelled it, but other democracy and anti-China activists are calling for unsanctioned protests.  The potential for miscalculation and violence remains high, which will likely continue to be a cloud over the Hong Kong economy and assets.

In a report that should dispel hopes that Beijing will make concessions to the Hong Kong protestors, Hong Kong Chief Executive Carrie Lam evidently proposed a formal withdrawal of her controversial extradition bill this summer, but Chinese officials rejected the idea.

Brexit:  Courts in Scotland and Northern Ireland have both declined to issue an immediate injunction against Prime Minister Johnson’s plan to suspend Parliament in order to prevent legislation that would block a no-deal Brexit.  Instead, both courts have scheduled hearings on the matter next week, but legal experts suggest the suspension is a prerogative of the prime minister that is not subject to review.

Otherwise, the game of chicken is on.  PM Johnson is pressing for talks with the EU to damp down the outrage over closing Parliament.  The opposition is considering a no-confidence vote, even picking up some Remain Tories, but that requires getting behind a caretaker government led by Jeremy Corbyn, a distasteful option.  The EU shows little sign of changing anything; Ireland remains upset with the U.K. over the backstop.  Again, as we noted yesterday, despite all the turmoil, the GBP is holding its own, suggesting that we may be seeing a short-term bottom in the currency.

Japan:  In its budget request for the fiscal year starting April 1, the Defense Ministry proposed converting a destroyer into Japan’s first post-World War II aircraft carrier, and buying U.S.-made F-35B jet fighters to arm it.  The proposal is consistent with Prime Minister Abe’s drive to revamp the country’s pacifist constitution and adopt a more muscular, independent approach to national defense.  As they continue to push for the U.S. to step back from its traditional role as global hegemon, President Trump and his administration will likely applaud the possibility that Japan could soon be able to shoulder more responsibility for its own defense.  However, it’s important to remember that a future carrier could also allow Japan to project power in ways that might be at odds with U.S. interests, such as pressuring South Korea over the disputed Dokdo islands.

Iran:  There is apparently growing sentiment in Iran that it will be forced to acquiesce to talks with the U.S. because President Trump might win a second term and the Iranian economy probably won’t be able to withstand another five years of sanctions.  If this is the case, Iran will probably try to ramp up its disruptive actions in the Middle East to improve its bargaining position.  The risk, of course, is that it overreaches and triggers a military response.  Of course, hawks within the administration would support escalation; we note that Israel is uncomfortable with U.S. and Iranian talks.  This situation is bullish for oil until talks ensue.

Odds and ends:  Ridesharing firms are deploying a massive lobbying effort to thwart attempts by legislators that would make it more difficult to treat their workers as independent contractors.  There is evidence that wealthy Americans are cutting back their spending, perhaps signaling a loss of confidence.  Argentina suffered a three-notch downgrade by Standard and Poor’s.  The country’s long-term foreign debt now carries a CCC rating.  ECB hawks are pushing back against Mario Draghi’s planned easing expected next month.  There are increasing reports that businesses are simply unable to find workers in some markets, a reflection of tight labor market conditions and a growing lack of mobility among American workers.

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

[Posted: 9:30 AM EDT]

Risk-on has returned on trade optimism.  Italy has a government.  Brexit thoughts.  Fifty-year T-bonds?  Here are the details and other items we are watching:

China: Equity futures rebounded after China indicated that it would not retaliate against the latest U.S. tariff increases.  That news raised hopes that there may be a cooling in trade tensions.  China also indicated it “hopes the U.S. will create conditions necessary for September talks.”   We have our doubts that this lack of retaliation is a breakthrough.  China is running out of items to apply tariffs to and is probably considering measures other than trade to retaliate.

For example, China indicated yesterday that it would extend its “social credit” system to monitor and manage foreign companies.  The social credit system is an evolving program in China that measures the behavior of Chinese citizens on a number of different scales and assigns them a number that can affect school entries, loans, government services, etc.  By moving to a similar system for companies, Beijing is working to structure a program where it can reward firms for doing what China wants, and punish them for bad behavior, on a systemic basis.  To some extent, all nations monitor firms that operate in their countries, both foreign and domestic.  However, this overt scoring system has Orwellian overtones and is raising concerns among foreign firms operating in China.  In the current environment, it would be expected that China might reward U.S. firms that rebuff American government efforts to enforce trade sanctions.

The Chinese government is reportedly studying the extent to which Chinese technology companies are dependent on U.S. suppliers.  The research apparently aims to gauge whether those firms could withstand further shocks from the U.S.-China trade war.  It could also be used to plan for weaning the companies off their dependence on U.S. technology.  In sum, it’s the kind of thing you would expect to see in an intensifying trade war and a splintering of the global economy into regional spheres.

The Xi government is moving to adapt to a less integrated world by changing its focus on internal growth, especially emphasizing its major cities.  This is something of a reversal of the policies of recent years which tried to boost growth in China’s interior through direct investment and lending.  The tension between the faster growing and more cosmopolitan coastal regions and the interior have been a feature of Chinese history for centuries.  Typically, China can be rich and divided or poor and united; this policy reversal will likely lead to the former.

Hong Kong: The municipal police department has turned down a permit request for a major new anti-China protest on Saturday near the Chinese government’s liaison office.  The permit request was submitted by the Civil Human Rights Front, which has organized some of Hong Kong’s biggest protests over the last four months.  This event was to commemorate Hong Kong’s rejection of electoral restrictions that Beijing wanted to implement.  Although permit refusals aren’t unheard of in Hong Kong, this one has the potential to stoke anger and prompt an unsanctioned, violent demonstration over the coming weekend.

Japan: Bank of Japan board member Hitoshi Suzuki warned in a speech today that any move by the central bank to cut interest rates further would do more harm than good.  Suzuki warned that financial institutions might try to mitigate the pain of lower rates by charging fees on household deposits, as has happened in Europe, and he said that could cool consumer sentiment.  He also said excessively low interest rates could discourage banks from lending, which would offset the benefit of any policy easing.

South Korea: The finance ministry’s proposed budget for the next fiscal year would boost spending by a whopping 8%, even after considering the stimulatory supplementary spending added to this year’s budget.  The stimulus, which is its biggest since the Global Financial Crisis a decade ago, is designed to counter the headwinds from weaker economic growth abroad and the U.S.-China trade battle.

United States-Japan-South Korea: In an exceedingly rare development, the South Korean government has summoned the U.S. ambassador in Seoul and demanded that the U.S. butt out of the Japan-South Korea dispute over Tokyo’s behavior before and during World War II.  That dispute itself is a symptom of the U.S. backing away from its traditional role as global hegemon.  Along with Seoul’s failure to give the U.S. advance warning of its recent withdrawal from an intelligence-sharing program between Japan-South Korea, the castigation of the U.S. ambassador amounts to a significant slap in the face that would have been hard to imagine at the height of U.S. hegemony a couple of decades ago.

Italy: We have a government!  President Sergio Mattarella offered Giuseppe Conte a renewed term as prime minister with the support of the center-left Democratic Party and the left-wing, anti-establishment Five Star Movement.  If Conte is confirmed by the parties, it would leave former Deputy Prime Minister Matteo Salvini and his right-wing populist League party out of power.  The move is positive for Italian assets, in particular, and European assets, in general, but we remain skeptical that the two new coalition partners can maintain peace among themselves for very long.  However, there was a clear relief rally in financial markets.

Italian bond yields fell sharply, and the spread against German bunds narrowed.  This news does reduce the risk of a Eurozone crisis emanating from Italy, at least for the time being.

Brexit: Yesterday, we reported on Queen Elisabeth approving PM Johnson’s request to prorogue Parliament until mid-October in a bid to shorten the time between their return and the Brexit deadline.  This action will make it very difficult for Parliament to block the U.K. exit from the EU.  This move by the PM seems to increase the odds that there will be a “hard Brexit,” a crashing out of the EU.  To paraphrase Sherlock Holmes, the “dog that didn’t bark” is the GBP.  It did weaken a bit but did not make new lows on the news.  There are a couple of reasons why.  First, it’s possible the currency is so cheap that it may not have much room to decline further.

This chart shows our purchasing power parity model, which values exchange rates based on relative inflation.  As the chart shows, the pound is deeply undervalued, approaching two standard errors below fair value.  Although we have speculated that we might test the 1985 lows, putting the GBP around $1.09, the lack of selling on what should be bearish news may be signaling the worst is over.  Second, the markets may be taking a more nuanced view of Brexit; although there will be disruptions, they may not be as dire as predicted and being short here, at such a “cheap” level, could leave one vulnerable to a short-covering rally.  It’s still too early to tell, but if the exchange rate holds in the face of this current turmoil then we may be reaching a bottom.

Argentina: With the country on the verge of its ninth sovereign default, Finance Minister Hernán Lacunza said the government will ask its creditors to accept delayed repayment on some $101 billion of debt.  The request would apply to approximately $7 billion of short-term local debt, $50 billion of long-term private debt held mostly by foreigners and $44 billion of debt from the IMF.  Lacunza claimed the move was driven merely by liquidity issues, rather than a solvency problem, but the debt may actually be untenable given the steep drop in the peso since President Macri’s primary election defeat in early August.

Century bonds?  Treasury Secretary Mnuchin indicated yesterday that the Treasury is considering ultra-long bonds.  Given the low level of interest rates, issuing such bonds makes sense.  But, an added benefit from this move is that it would likely steepen the yield curve.

Odds and ends: Mnuchin also indicated that his department is not considering dollar intervention at this time.  Chairman Xi is planning to deliver a major address in early October to mark the 70^th anniversary of Mao’s takeover of mainland China.  GOP senators would like to open hearings on Bill Dudley’s op-ed to question whether the Fed is acting to affect election outcomes.  Recent polls suggest that more voters are seeing economic deterioration compared to expansion, an ominous sign for President Trump’s re-election.

Energy update: Crude oil inventories fell 10.0 mb compared to an expected draw of 2.3 mb.

In the details, U.S. crude oil production rose to a new record, up 0.2 mbpd to 12.5 mbpd.  Exports rose 0.2 mbpd, while imports declined 1.3 mbpd.  Refinery operations fell 0.7%.  The large drop in stockpiles was mostly due to the decline in imports.

This chart shows the annual seasonal pattern for crude oil inventories.  Seasonal factors clearly fell hard this week and are now well below the seasonal trough.  However, the summer driving season is rapidly coming to a close, so further inventory declines of significance are unlikely.

Based on our oil inventory/price model, fair value is $64.93; using the euro/price model, fair value is $50.22.  The combined model, a broader analysis of oil prices, generates a fair value of $54.51.  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.

On the geopolitical front, there may be a division developing between President Trump and other members of his administration.  The president has indicated he wants to talk; SoS Pompeo doesn’t seem to be on the same page.  Neither does John Bolton.  Overall, we would bet on the president; his long-term goal is to avoid entanglements in the Middle East and he wants a new deal with Iran but not regime change.  Any thaw with Iran would tend to weaken oil prices.  At the same time, Israel is stepping up attacks on suspected Iranian proxies in a bid to prevent Iran from arming these groups.  These attacks carry the potential for escalation.

President Andrés Manuel López Obrador is reportedly backtracking on his opposition to private-sector participation in the country’s energy sector.  Next year, according to a senior official, the government will once again allow private companies to bid for energy exploration rights in the Gulf of Mexico, and the president will allow state oil company Pemex to resume joint ventures with private companies, as provided for in a 2013 energy reform that the president has criticized.  Increased private-sector participation is probably essential to reversing Mexico’s continuing oil production decline, so the news is certainly positive.  However, López Obrador’s behavior to date still suggests some risk to property rights, the sanctity of contracts and private enterprise under his leadership.

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