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

[Posted: 9:30 AM EDT]

It’s Monday in late August, the last one of summer.  Global equity markets moved full circle overnight.  Here is what we are watching:

The trade war:  We were in the midst of writing Friday’s comment when China announced its retaliation against the most recent U.S. tariffs.  This action was not completely unexpected.  China had signaled that it would retaliate to the most recent tariff increase.  However, it became clear that President Trump was incensed; in a series of tweets, he lashed out at China and the Fed.  In what was perhaps the most momentous action, the president indicated that he planned to force U.S. companies out of China.  The powers the president is invoking, the International Emergency Economic Powers Act of 1977 (IEEPA), has generally been used for geopolitical events, not trade conflicts.  However, even if the president can’t actually force companies to leave, the political pressure to draw down operations in China will be enormous.  After the market closed on Friday, the White House announced additional tariff measures on Chinese goods, effectively putting levies on all Chinese imports.  There were some voices suggesting that these actions looked a bit like the president was pulling his punches.  Apparently, the president agreed with this analysis, indicating that he wished he had been tougher.

Equity market reaction on Friday was swift; stocks fell hard despite a rather supportive speech from Chair Powell.  As is often the case, the White House does tend to be attuned to market developments and we have seen a series of comments designed to walk back some of the negativity.  First, Economic Director Kudlow and Treasury Secretary Mnuchin both signaled that the president isn’t going to order American firms out of China.  Second, the president stated that he got a call from Chinese officials indicating they wanted to talk, giving the impression that Beijing is caving.  Chinese officials have disputed this account.  This attempt to ease worries is a hallmark of this administration; they are clearly conscious of the reaction of various constituencies and react rather quickly to adverse feedback.  Still, in the long run, it’s hard to make everyone happy.

Here is our take on the developments.  From the time of Trump’s election, we framed his administration as a dynamic tension between the right-wing establishment and right-wing populists.  The president won the election mostly because he ran as a populist, promising to deglobalize by restricting immigration, balancing trade and ending the offshoring of jobs.  However, given his background, there was a case to be made that in office he would govern as an establishment figure, and he mostly did from the inauguration until February 2018.  Regulations have been aggressively curtailed and taxes, especially on capital, were cut.  He did keep pressing for a border wall and deployed restrictions on immigration.  Although deglobalization was clearly a priority, it looked further down the list from the concerns of the establishment.  Until February 2018, action on trade was mostly symbolic; there were tariffs on steel, but nothing broad.  However, in Q1 last year, Trump began actively moving on broader sanctions on China and Mexico.  Nevertheless, even with these moves, it was still difficult to see whether these actions were merely for show or if there was really a march toward serious trade restrictions.

China’s initial reaction to Trump appeared to be to offer small changes that would give the U.S. president actionable headlines, e.g., large purchases of grain.  For a while, this policy appeared to be working.  However, USTR Robert Lighthizer had bigger ideas.  He wanted changes in China’s trade regulations that would be written into law, including intellectual property reforms.  Last May, it looked like a deal was to be made.  However, China made it clear that it would make promises but viewed changes to law as an infringement on sovereignty.  China’s position is disingenuous—in general, trade law does restrict sovereignty and is really the essence of such law.  Lighthizer wasn’t willing to accept that outcome; China decided it wasn’t willing to accept what it appeared to have agreed to, and relations have slowly deteriorated…until last week, when the deterioration accelerated.

The recent yield curve inversions have led to analysis by strategists, including us, about the state of the economy and when a recession might occur.  So far, the state of the economy is weakening, but still okay.  However, as we thought about the situation this weekend, we were reminded that since the 1960s recessions have tended to have two sources, policy error (mostly monetary) and geopolitical events (1973-75, 1990-91).  This escalation of the trade war may be putting us into the second category.  The problem with the geopolitical recessions is that history isn’t much of a guide because each event is unique.  The 1973-75 recession was mostly due to the oil shock—the rapid increase in gasoline prices shook consumer confidence.  In June 1973, crude oil traded at $3.56 per barrel; by January, it was up to $10.11, at a 284% rise.  Assuming $55 per barrel now, that would be like $156.19 per barrel in Q1 2020.  In October 1973, the Conference Board’s consumer confidence index was 107.5; 15 months later, it was 43.2.  The 1990-91 recession was triggered by the Persian Gulf War.  Oil prices rose then as well but the fears about war reduced consumer confidence from 113.0 in December 1989 to 55.1 by January 1991.

Geopolitical recessions are tougher to time and, in the current case, there is still a chance of a resolution.  However, we don’t see how either side can easily walk back the current turmoil despite today’s optimistic comments.  The escalation of the trade conflict is increasing the likelihood of recession and, perhaps more troubling, is changing the calculus of estimating the downturn.  In other words, obsessively watching for traditional signs of recession may be less effective if we are going to experience a geopolitically induced downturn.

Complicating matters is the notion that the president seems to believe that being tough on trade is a positive factor going into 2020.  It might be, but winning reelection during a recession is a rare accomplishment, last done by Calvin Coolidge.  It’s still not too late to pull back the trade issue, but trade restrictions do appear to be a core belief of President Trump.  And, in his defense, the China issue does need some sort of resolution as the status quo was running out of runway.  However, presidents who do hard things are usually not rewarded for their actions; President Carter’s appointment of Paul Volcker probably saved the U.S. economy but cost him the election.  This is the risk that President Trump seems to be accepting.

So, where are we now?  The remaining elements of the establishment wing of the administration, Mnuchin and Kudlow, are trying to keep trade talks in place and are talking up the economy.  The populists, especially Peter Navarro, are pressing for greater confrontation.  The president tends to vacillate between the two positions depending on his read of the political situation.  So, uncertainty will continue, but this path may end up leading us into a downturn.

The G-7:  This summit may go down in history as the one where it was no longer possible to paper over the differences between world leaders.  President Trump was at odds with other members; President Macron, in a “stick in the eye” move, invited Iran’s foreign minister to stop by.  Macron did give President Trump a “heads up” at a private lunch on Saturday afternoon.  Still, the move by Macron could not have sat well with SoS Pompeo and NSD Bolton.  PM Johnson got nowhere with the EU and now insists he won’t pay the £39 bn “divorce bill.”  This G-7 meeting was clearly difficult, but that isn’t to say nothing was accomplished.  President Trump indicated that a U.S./Japan trade deal is near completion.  This announcement came after President Trump and PM Abe disagreed over recent missile launches from North Korea.  In addition, France and the U.S. did come to a compromise on the former’s recent tech tax.

Jackson Hole:  In addition to Powell’s speech, BOE Governor Carney made headlines calling for a new reserve currency to replace the dollar.  The problems with having a national currency as the global reserve currency are nothing new.  Keynes saw the flaw at the Bretton Woods meetings in 1944 and the Triffin Dilemma emerged in the 1960s.  The problem essentially is that as the world economy grows, the demand for the reserve currency grows with it, forcing the reserve currency nation to constantly expand its current account deficit to supply the world with its currency.  This widening current account deficit distorts the economy of the reserve currency and puts us in the position we are now—the drive to deglobalization is, in part, due to the demands of supplying the reserve currency.  However, moving to a multi-lateral reserve base solves nothing; for the reserve system to work, some nation must be willing to be the global importer of last resort.  Otherwise, there will be a lack of global liquidity. The U.S. was generally willing to play that role during the Cold War because it became part of the system of communist containment.  However, the end of the Cold War and the massive expansion of China have put tremendous pressure on the dollar reserve system; the 2008 Financial Crisis was partly due to foreign nations dumping their saving on the U.S. financial system and demanding safe assets, which expanded mortgage lending.

Can a new system be developed?  Only if global nations are willing to give up monetary sovereignty.  The real solution is not a basket of currencies, but a global central bank that would manage the supply of the global reserve currency.  The battle for control of this entity would be epic.  Carney isn’t wrong in his concerns, but his solution won’t work.

Hong Kong:  As the city’s ongoing anti-China protests turned violent again yesterday, Hong Kong police used water cannons against the demonstrators for the first time.  In one skirmish, an officer even used his gun to fire a warning shot into the air.  In the meantime, Hong Kong Chief Executive Carrie Lam reportedly met over the weekend with a range of politicians, academics and business people who urged her to make concessions to the demonstrators, but there are no signs of such a move yet, and Hong Kong’s economic activity and assets continue to face headwinds from the situation.  Of course, the Hong Kong economy also continues to suffer from weakening economic growth abroad and the U.S.-China trade war.  New data today shows Hong Kong’s exports in July were down a sharp 5.7% year-over-year.

European Union:  Officials connected with the European Commission are considering ways to simplify and soften the Eurozone’s government debt rules so that they put less pressure on countries struggling with an economic downturn.  Although Italy isn’t mentioned as a reason for the move, the measure would likely help ease tensions between the EU and Rome.  It could even help undermine the populist League party of Deputy Prime Minister Matteo Salvini, which would probably be positive for Italian assets.

Middle East:  It appears that Israel may be engaging in widespread attacks on Iranian proxies in Lebanon, Syria and Iraq.  So far, Israel has only confirmed action against Syria on a base that Israel believes was launching drone strikes on its territory.  What we may be seeing here is Israel taking advantage of Iran’s current problems caused by sanctions.  Iran’s economy is under severe pressure from sanctions and this is undermining its ability to maintain its network of proxies across the region.

Negative interest rates:  The use of negative rates, or NIRP, has been controversial, to say the least.  Europe has been the most aggressive in deploying negative rates.  For the most part, European banks have been reluctant to inflict negative rates on depositors, fearful of disintermediation and political repercussions.  German politicians are considering legislation that would make negative deposit rates illegal.  This is a profoundly bad idea.  The most likely response from banks would be to simply refuse to accept deposits.  Although the academic community is somewhat sympathetic to NIRP, in practice, it’s really a divine message that monetary policy is exhausted.

Mexico:  The Mexican government reached a preliminary deal with four private energy firms to resolve a dispute over a major new natural gas pipeline from Texas to Mexico.  Under the agreement, Mexico would no longer have to pay stepped up transport fees over time, as in the original contract.  Instead, the transport fees would essentially be leveled.  Mexico would pay higher fees for the first 10 years of the pipeline’s operations, but it would realize savings afterward.  The deal is likely to keep concerns alive about the sanctity of contracts under the populist government of President Andrés Manuel López Obrador.

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

[Posted: 9:30 AM EDT] Happy Friday!  It’s quiet this morning in front of Chair Powell’s presentation.  Here is what we are watching:

BREAKING: China to levy tariffs on another $75 bn of U.S. exports.  Bonds and gold rally, while equities, oil and copper decline.  Oil, soybeans and auto exports were specifically targeted.

Powell:  Between the minutes and a series of interviews suggesting a wide disparity of views, there is growing sentiment, which we tend to share, that Chair Powell will struggle to bring the committee to make aggressive rate cuts.  We suspect his speech today will try to create a narrative that will support future action.  A set of variables could be established as guideposts; three possibilities might include persistently low inflation, global economic weakness or the dampening of investment from the trade war.  Another key idea to remember is that Powell doesn’t necessarily have to make the members of the committee happy, he merely needs their votes.  The members know that if Powell can’t sway the committee and he resigns, then the White House may press for a new chair who is an ideologue.  Thus, the committee members may grudgingly accept rate cuts to avoid turmoil.

Recession worries: Although the media coverage of any White House often sensationalizes divisions and concerns within the executive branch, recent reports of concerns about the economy probably have an element of truth.  Worries about the economy, especially in the year before the election, have been evident in most administrations.  We have seen earlier governments attempt to tag the Fed with blame if the economy slumps; again, nothing unusual here.  Presidents Johnson, Nixon, Reagan and Bush (H.W.) all engaged in attempts to sway monetary policy.  We lived through an unusual détente since Clinton where the White House and the Fed left each other alone.  That informal peace accord has clearly ended and we have returned to the earlier tensions.

Therefore, in light of these worries, we have seen a number of trial balloons floated, including indexing capital gains taxes to inflation, a payroll tax holiday and other unspecified tax cuts.  To some extent, the problem is that the trade conflict with China was bound to have adverse economic repercussions.  It’s possible the president didn’t believe that, but his advisors should have been aware.  At the same time, presidents sometimes have a policy goal so important to them that they engage in that policy even though it adversely affects other goals.  It looks to us that President Trump deeply believes the trade regime established after WWII isn’t working for the majority of Americans and a strong case can be made that this is true.  Both sides of the populist wings have turned against trade and only the elites still believe in it (mostly because they benefit greatly from overall globalization, of which free trade is an element).  The problem for the president is timing.  He spent his “golden period”[1] deregulating and cutting taxes.  If these were the president’s most deeply held goals, then he did the right thing.  However, it appears to us that changing the postwar trade regime may be his most deeply felt goal; if so, he should have done that first.  If he had moved on trade immediately after winning the election, then we would likely be past the worst effects by now and the disruption of supply chains would not be threatening the business cycle.

Given today’s news out of China on tariffs, it seems unlikely that tensions can ease without one side caving.  China seems to be banking on the idea that the U.S. needs a deal more than it does because of looming elections.  The U.S. doesn’t appear open to backing down and the recent move to tie conditions in Hong Kong to a trade deal likely reduces the odds of a deal.  It is quite possible that the most effective policy to lift the economy in the short run would be a reduction in trade tensions.  The problem is that neither side appears open to a way out of this conflict.

G-7: The G-7 meets this weekend, with the members deeply divided.  As we noted yesterday, the host nation, France, has already indicated that it won’t deliver a communiqué.  Macron wants to talk about the fires in Brazil, while President Trump wants to talk about France’s recent tech company tax.  The EU would like to ease trade tensions with the U.S.  Although we don’t expect this meeting to have a major market impact, the divisions among the leading democracies are problematic and an indication of the deglobalization that is underway.

Italy: Parties were given until next Tuesday to form a government.  The center-left and populist-left parties are continuing to negotiate.  Although these parties have been at odds for a long time, the prospect of a government dominated by the populist-right is concentrating their efforts.  If the negotiations fail, it doesn’t necessarily mean immediate elections.  Instead, we could see the president of Italy install a caretaker government until the budget process is completed.

Brexit: PM Johnson continues to hear the same message from EU leaders: the backstop is necessary and negotiations are futile.  It is becoming difficult to see how a hard Brexit is avoided unless Parliament stops it from happening.

Champions: The EU is floating a plan to create a €100 bn sovereign wealth fund to create “European champions” in the technology space to compete with the U.S. and Chinese tech giants.  Although the sentiment makes sense, we have doubts that money is the problem.  After all, rates in Europe are below zero in many markets.  The key is allowing companies to “move fast and break things,” something Europe doesn’t seem too comfortable with allowing.

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[1] We consider the first 18 months of a president’s first term as the most important.  This is the period when a president can get the most accomplished and therefore one should try to move their highest priority goals through before the summer of the year before the election year.

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

[Posted: 9:30 AM EDT]

We cover the Fed minutes below!  The G-7 summit is this weekend.  Tensions between Japan and South Korea are rising.  Quietly, overnight, the CNY fell to an 11-year low.  Here is what we are watching:

The Fed minutes: There were three points that emerged from the minutes:

1. The members are divided. Although the two dissents made it clear that divisions exist, the issues appear to run deeper.  We know for sure that two members officially wanted to keep rates unchanged, but the minutes indicate that “several” wanted to maintain the target.  This means that either some of the regular voters (governors plus NY FRB president) reluctantly went along with the rate cut decision as long as it was framed as a “mid-course adjustment” or the hawks are centered among the regional bank presidents.  We suspect the former statement is probably more accurate.  At the same time, two participants wanted a 50 bps cut.  Given that Bullard came out favoring only 25 bps, we suspect Kashkari had a partner; if we had to guess, Daly probably wanted a larger cut.   Overall, if the majority are going along reluctantly, future rate cuts may be harder to generate than the market expects.
2. The financial stability faction is getting visibility. In our taxonomy of FOMC members, we divide the group into traditional hawks, doves and moderates, with a fourth faction called financially sensitives.  The first three still maintain the Phillips Curve as their guide but shade policy toward either greater worry about inflation (the hawks) or unemployment (the doves), or they try to balance between the two (the moderates).  The financially sensitives are a new breed that worry about policy causing valuation issues in financial markets.  The committee is currently dominated by moderates; we estimate nine members are in that group.  There are four doves (including nominee Waller) and two hawks.  The financially sensitive group numbers three.  If our analysis is accurate, the financially sensitives are especially eloquent in their presentations because they received a rather high level of mention in the minutes.  Or, its membership is growing and we may be underestimating the size of this group.  If this group is getting larger, policy will tend to become hawkish as equities rally (or, to put a finer point on it, when the VIX falls below 15).
3. Another surprise emerged in the discussion of the balance sheet. A “number” of participants suggested that QE worked so well it probably should have been deployed more aggressively.  It doesn’t appear this is a majority opinion, but it does look like this position was favored by a significant minority.  At the same time, the language seems to indicate that the FOMC has little interest in negative interest rates.

Overall, market reaction was somewhat mixed.  Equity markets took the news in stride.  The most hawkish reaction probably came from the dollar, which rallied after the report.  Bond yields also rose on the report.  Our take is that the minutes were a bit hawkish but the FOMC did try to leave itself room to adjust in the future.  The bottom line, though, is that Powell has his work cut out for him if he wants to take the committee to a more aggressive easing stance.

The financial markets have not changed their opinion in the wake of the report; the deferred Eurodollar futures are still signaling a serious inversion, and are projecting another 90 bps of easing over the next two years.

At the same time, the Mankiw Rule is suggesting that the last thing the Fed should be doing is cutting interest rates.  The Taylor Rule is designed to calculate the neutral policy rate given core inflation and the measure of slack in the economy.  John Taylor measured slack by using the difference between actual GDP and potential GDP.  The Taylor Rule assumes that the Fed should have an inflation target in its policy and should try to generate enough economic activity to maintain an economy near full utilization.  The rule will generate an estimate of the neutral policy rate; in theory, if the current fed funds target is below the calculated rate, then the central bank should raise rates.  Greg Mankiw, a former chair of the Council of Economic Advisors in the Bush White House and current Harvard professor, developed a similar measure that substitutes the unemployment rate for the difficult-to-observe potential GDP measure.

We have taken the original Mankiw rule and created three other variations.  Specifically, our model uses core CPI and either the unemployment rate, the employment/population ratio, involuntary part-time employment and yearly wage growth for non-supervisory workers.  All four variations compare inflation and some measure of slack.  Here is the most recent data:

This month, the estimated target rates all rose substantially.  Not only did inflation rise but the labor markets showed strength.  Three of the models, the ones using the unemployment rate, wages and involuntary part-time employment, all rose 20 bps to 40 bps and suggest the last thing the FOMC needs to do is ease.  Even the most dovish model, the variation using the employment/population ratio, rose by 20 bps and is flirting with neutral.  This analysis explains why so many members of the committee are reluctant to support an aggressive easing stance; the basic model that the Fed has used for years is calling for tightening.  Thus, the potential for disappointing the financial markets is elevated.

Jackson Hole: Now that the minutes are out of the way, the market’s focus will shift to the annual meeting in Wyoming.  Powell’s speech at Jackson Hole is scheduled for 10:00 EDT tomorrow, but the “festivities” begin today.  As our discussion of the minutes show, it will be very difficult to create a narrative for further easing that will sway the FOMC.  Greenspan would likely come up with some novel story to carry the day, but we can’t think of any other Fed chair who could pull this off.  Thus, the odds of disappointment are elevated.

South Korea v. Japan: The current spat between these allies centers around the issue of reparations surrounding the colonial period and WWII.  Japan argues that its previous actions have fully satisfied the responsibility for its past.  It’s unlikely that South Korea (or North Korea, for that matter) will ever fully absolve Japan for its past actions.  During the Cold War, the U.S. essentially forced these nations to work together as allies to contain communism.  However, with U.S. influence waning, old tensions are resurfacing.  South Korea has announced it will no longer share classified military information with Japan.

G-7 and Brexit: PM Johnson met with Chancellor Merkel yesterday.  Essentially, Merkel didn’t offer Johnson much, which suggests she would like to see the backstop issue resolved but that it is up to the U.K. to do that.  Johnson will meet with Macron next.  We are starting to see a realization among the pundits that the U.S. will be more than happy to make a free-trade deal with the U.K. after Brexit, but the outcome will likely make Britain a vassal state of Washington.  As noted yesterday, the G-7 won’t even try to issue a joint communiqué, an indication of the deep divisions within the world’s most significant democracies.

Looming tariffs: Although most of the tariffs on China were delayed, some will go into effect September 1.  China warns that new tariffs will raise tensions and vows to retaliate.  The earlier mentioned drop in the CNY is likely part of the response.  In other China news, companies are reporting that pulling supply chains from China is apparently harder than it looks.

Italy: Salvini’s attempts to force new elections may not work out.  For the next two weeks, parties will try to form a government to avoid fresh elections.  The center-left and populist-left parties are trying to form a coalition and elections will not be necessary if they are successful.

The establishment strikes back: The left-wing establishment has never been on board with President Trump, while the right-wing establishment has had a mixed relationship.  Until February 2018, the president talked like a populist but his policies were in line with establishment goals—taxes were cut, especially on the upper income brackets, and there was a massive pullback in regulation.  However, since February of last year, the administration and the right-wing establishment have diverged on trade and immigration policy.  We are now seeing establishment “mouthpieces” becoming increasingly critical of trade and immigration policy.

Trouble on the farm: My former colleague at A.G. Edwards, Bill Nelson, used to conduct a farm tour that moved through the Midwest corn belts and reported up close and personal on the condition of the crops.  It was an arduous task and fortunately for Bill he doesn’t have to do that anymore.  Pro Farmer is currently conducting a tour and is bringing some USDA officials along for the ride.  Farmers have been upset with the USDA, which has been rather optimistic about the prospects for this year’s crop despite damage caused by an unusually rainy spring and early summer.  These rosy estimates have depressed prices and apparently angered farmers to the point where government officials have been threatened.  Federal Protective Service agents have been dispatched to investigate the incidents.  Farmers are also upset with the administration’s decision to grant ethanol waivers to refiners which reduce demand for corn.

Energy update: Crude oil inventories fell 2.7 mb compared to an expected draw of 1.4 mb.

In the details, U.S. crude oil production was unchanged at 12.3 mbpd.  Exports rose 0.1 mbpd, while imports increased 0.5 mbpd.  Refinery operations rose 1.1%.

This chart shows the annual seasonal pattern for crude oil inventories.  Seasonal stockpiles are stabilizing a bit below the usual seasonal trough.  The summer driving season is rapidly coming to a close, but crude oil inventories usually don’t rise until late September when refinery maintenance begins.

Based on our oil inventory/price model, fair value is $61.72; using the euro/price model, fair value is $50.45.  The combined model, a broader analysis of the oil price, generates a fair value of $53.60.  We are seeing a clear divergence between the impact of the dollar and oil inventories.  Tensions in the Middle East have lessened and we are heading into a weaker demand period; thus, weaker oil prices in the short run are likely.  We do note that Alberta will continue to constrain oil production, although producers are being given a higher production ceiling.

In other oil-related news, Russian oil companies are moving to price oil in euros.  Over the years, there have been nations that have attempted to move away from dollar pricing.  Both Iran and Iraq tried when they were under sanction.  Russia’s decision does make some sense; not using dollars might allow it to skirt U.S. sanctions, which tend to depend on intersections with the U.S. banking system.  However, we doubt this will begin a wholesale shift away from dollar pricing for oil simply because the purchasing power of the dollar is so strong now that not taking in dollars is expensive for most nations.  After Brexit, the U.K. will dramatically reduce its strategic oil reserve.  OECD nations are required to hold oil in reserve as part of a global strategic reserve system designed, in part, to weaken OPEC’s ability to embargo oil and drive the price higher.  However, the EU has stricter rules than the OECD regarding the level of oil required to be held.  When (if?) the U.K. leaves, it will reduce its strategic reserve to the OECD level, which will put around 50 mb out for bid.  This action could lead to lower Brent prices post-Brexit.  The U.S. and Venezuela have been engaged in backchannel talks.  According to reports, Diasdado Cabello has been leading the talks on the Venezuelan side.  A deal would be bearish for oil prices at some point, although it might take years before Venezuela’s oil industry recovers.  Sanctions on Iran are having an effect; reports indicate it is in the deepest recession since the Iran-Iraq War.

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

[Posted: 9:30 AM EDT]

It’s Fed minutes day!  Equities are higher this morning, in what we are dubbing the “Seinfeld rally” because it seems to be driven by…nothing!  Although there was news overnight (which we discuss below), none of it reasonably explains the rally we are seeing so far.  The president won’t be visiting with Denmark’s PM Mette Frederiksen as was previously scheduled because she rebuffed his offer to buy Greenland.  Here is what we are watching:

The Fed minutes: The report comes out at midday; the minutes are a heavily sanitized version of the interactions between committee members, with words like “few” or “some” that get scrutinized like scriptural text for meaning.  The reality, which is better seen in 2024 when the transcripts come out, often reveals sniping and side comments that show what the members really think.  Still, we will work with what we have and the important question we hope to answer from the report is whether Powell can pull the committee along to cut rates faster.  We are seeing continued comments from members, the most recent from the San Francisco Fed, that the last rate move was precautionary and not necessarily the start of a more profound cutting cycle.  In our view, the breakdown of the committee suggests that Powell will struggle to get more than one more rate cut this year out of the FOMC.  Too many members are still working within some form of the Phillips Curve framework and will push back against rate cuts with low unemployment in place.  However, there is a growing contingent that wants to conduct policy with an eye on the financial markets, and this group worries that additional stimulus will simply show up in the financial markets as “froth” and create financial instability.  At the same time, as we note below, Powell is facing relentless pressure from the White House to cut rates aggressively.  The chance of disappointment from the minutes is rather high.

Italy: We thought that, in the end, Salvini would make a deal to keep the government in place.  Turns out, we were wrong.  Conte, the PM, resigned before the no-confidence vote and now the president is working to figure out if a replacement government can be formed.  There are four likely outcomes from this:

1. New elections. The timing is bad because the government is in the middle of budget negotiations. Polling suggests the League and associated parties would probably prevail in a new government, sending shockwaves throughout Europe.  This would be the equivalent of the AfD taking control of Germany or Le Pen’s National Rally governing France.
2. The current coalition could decide to hold together a while longer to get through the budget process.  To some extent, this may simply be delaying the inevitable.
3. A broad anti-League coalition. A grand coalition of sorts could form a government; however, this would require some elements of the non-League right and the center and populist-left. It might stave off elections, but the coalition would be unstable.
4. A narrow anti-League coalition. It would exclude the right-wing but would still require a center-left and populist-left government to form.  More stable than option three, but not by a lot.

It appears to us that the most likely outcome is new elections.  That’s risky for Salvini because surprises can occur, but the surge of right-wing populism in Europe seems to be strengthening.  What we find interesting is that the financial markets have taken the news in stride.  In fact, the spread between Italian and German sovereigns actually narrowed with the resignation.  Perhaps markets are more comfortable with the League without the Five-Star Movement, or, more likely, it’s hard to get overly concerned about Italian governments simply because they fail with such regularity.

White House recession worries: The White House is clearly concerned about the chances of a recession in the upcoming year.  Officials were on various Sunday news shows talking up the economy.  As noted above, Fed criticism is continuing.  In addition, the administration is considering additional fiscal measures to lift growth.  These ideas include a payroll tax cut, indexing capital gains taxes to inflation and perhaps even delaying or removing some tariff measures.  As we noted yesterday, measures to boost the economy are common in this year of the election cycle, which is part of the reason why the year before the election tends to be good for equities.  However, that trend has been somewhat stunted by trade concerns this year.

Boris goes to Europe: PM Johnson is on his way to Europe to meet with Chancellor Merkel and President Macron.  Johnson’s message to the EU will be clear—the U.K. is leaving on Halloween unless the EU gives ground on the Irish backstop.  Johnson is under the impression that opposition to a hard Brexit in Parliament is signaling to the EU that the exit on Halloween is a hollow[1] threat.  Johnson seems to think that the EU will break if there is an unmistakable signal that a hard Brexit is imminent.  We think he is wrong.  When faced with the economic disruption the EU will experience from a hard Brexit, Johnson believes the EU will react; in other words, Britain will be willing to suffer more from a hard break compared to the EU.  That calculation might be true; however, we think Johnson might not appreciate how hard it is to get a unanimous position from the EU on any topic.  As a result, once established, it takes extraordinary circumstances to reopen negotiations within the EU, which are nearly always tortuous.  To some extent, playing “chicken” with the EU is a bit like competing with an opponent whose steering wheel is locked.  There may be good reason for the EU to “veer,” but it just can’t.

ISIS on the rise?  As the U.S. gets closer to securing an agreement with the Taliban, it appears that elements of ISIS are making themselves more known.  Today, top U.S. negotiator Zalmay Khalizad is expected to arrive in Qatar to discuss the remaining parts of a withdrawal agreement. In said agreement, the Taliban would sever its ties with al-Qaeda and assist in counter-terrorism measures.  Following the bombing of a wedding that took place on Saturday in Kabul, the effort to secure a deal has been complicated by growing doubts that the Taliban will be able to follow through in countering terrorist threats from ISIS.  As a result, this could mean the U.S. withdrawal, which was originally slated to be 5,000 troops, might be lower.

Russia-U.S.: Following the U.S. withdrawal from the Intermediate-Range Nuclear Forces (INF) Treaty, the relationship between the U.S. and Russia has become more tense.  Yesterday, Russia showed displeasure that the U.S. has begun testing cruise missiles by stating it believes the U.S. had likely been working on the missile prior to its withdrawal from the INF Treaty.  Later that day, President Trump attempted to de-escalate tensions by calling for Russia to be reinstated into the G-7.  It appears that despite the president’s attempt to normalize relations between the two countries, the relationship between the U.S. and Russia appears to be in its worst shape since the Cold War.  Although we do not expect conflict to arise soon, we do anticipate that both sides will reinforce their military capabilities.  Russia will attempt to show the world that it is still a major factor, and the U.S. will likely do so in an attempt to deter perceived threats to its interests in the Pacific.

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[1] See what we did there!

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

[Posted: 9:30 AM EDT]

Markets are mostly quiet this morning, more typical of late August.  Here is what we are watching:

G-7 Summit: Japanese government sources say the Group of Seven (G-7) summit this weekend in France will probably not adopt a joint communiqué because of the deep disagreements between the various countries regarding free trade and climate change.

Italian no-confidence vote: Italy’s legislature will vote today as to whether it will continue with its current government or force new elections.  Although we think the odds that the government falls are not that high (members seem cool to the idea), anytime a vote is held unexpected outcomes can emerge.  If Deputy PM Salvini had his way, he would bring down the government and become the new prime minister.  While this outcome is likely at some point in the future, it probably won’t happen today.  A Salvini-led government would be a problem for the EU; he has been pressing to violate EU fiscal rules and would likely foster a governance crisis for the union.

Brexit letters: PM Johnson is trying to prod the EU into reopening negotiations; he sent a note to Donald Tusk, the president of the European Council,[1] indicating that the Irish backstop should be removed and in its place, well…that part’s not clear.  Mr. Tusk rejected the proposal.  The Irish backstop is a real problem for Brexit; the EU won’t allow a free trade border to exist with a nation that isn’t in the EU, which is what Johnson seems to want.  That’s why Theresa May accepted the backstop which effectively keeps Britain in the trading union without the ability to influence it.  Essentially, if Britain wants to leave, a hard border on the Northern Ireland/Ireland frontier will return.  Additionally, that will seriously complicate Britain’s ability to negotiate a free trade deal with the U.S.  It looks to us like the odds of a hard Brexit are rising.  A looming constitutional crisis could emerge as Johnson tries to overcome opposition in Parliament to a hard Brexit.  In addition, dissention in Parliament could trigger new elections.

United Kingdom-China: The British consulate in Hong Kong has announced that one of its employees has been detained in mainland China since making a business trip there in early August.  The detention could be Chinese retaliation for a telephone call that British Foreign Secretary Raab made to Hong Kong Chief Executive Carrie Lam earlier this month.  In the call, Raab lobbied for an investigation into the issues surrounding the anti-Chinese political protests that have been plaguing Hong Kong, which Beijing sees as its own internal affair.

Social media firms accused China of spreading disinformation about Hong Kong protestors, and the firms have removed accounts with suspected ties to Beijing that have been involved in disseminating such disinformation.  These firms will likely face retaliation from Beijing.

More stimulus: The year before the election year tends to be a good year for equities.

To create the data for this chart, we index the Friday close for the S&P 500 going back to the first week of January 1928 for a four-year period.  We repeat the process for every four-year period to the present; this gives us a consistent presidential cycle.  Note that in the second year, after the November midterms, equities tend to rally strongly until around mid-year of the last year before the election.  Part of that rally is the removal of uncertainty surrounding the midterm elections, but often presidents act to stimulate the economy to either improve the odds of reelection or support the party in power.  This year generally fits that pattern.

And, right on cue, the White House is pressing for economic support.  First, the president has subjected the Federal Reserve to strong criticism, pressing for aggressive rate cuts.  Second, the White House is apparently considering a payroll tax cut.  A payroll tax cut would be a significant move for the economy.  It would affect almost all workers and, unlike the earlier tax cuts, the benefit would mostly go to the bottom 80% of households in terms of income share.  We have seen such reductions in the past; the Obama administration cut the rate by 200 bps in 2011 and 2012, but the rate returned to its earlier level after the two-year break.  The administration has denied the report, but we doubt that a measure such as this isn’t at least being considered.

Syria-Russia-Turkey: Syrian forces and their Russian allies have bombed a Turkish military convoy making its way toward an observation post set up to help diffuse tensions in northwestern Syria.  Ankara claims the convoy was merely trying to resupply the post, but the Syrians and Russians say it was bringing supplies to anti-government rebels in the area.

Russia-Ukraine: French President Macron and Russian President Putin agreed at a summit yesterday that there may be a new chance to resolve the military conflict in eastern Ukraine, based on the election of the new Ukrainian president, Volodymyr Zelensky.  Earlier this month, Zelensky called for fresh peace talks between his government and Russian-backed separatists in the region.

Russia: Two more radiation-monitoring stations in Russia have gone dark, adding to evidence that the government is trying to hide what happened in the apparent test failure of a new nuclear-powered cruise missile last week.  A total of four monitoring stations connected with the Comprehensive Nuclear Test Ban Treaty have now gone silent.

Iran: State-run media are casting the release of the Iranian oil tanker seized in Gibraltar last month as a sign that Iran can stand up to the economic sanctions imposed on it by the United States.  Iranian politicians reportedly believe the tanker was released only because the country’s Revolutionary Guards retaliated by seizing a British tanker.  That could encourage further such actions by Iran, which will keep tensions high in the Persian Gulf and maintain some measure of a risk bid for oil.  Meanwhile, as the released tanker steams toward Greece, the U.S. government has issued a warning that any entity that provides support to the ship or her crew would be subject to U.S. “immigration and potential criminal consequences.”

Mexico: In another worrying sign for the viability of contracts under leftist President Andrés Manuel López Obrador, the Mexican government has demanded $900 million from the builders of a major natural gas pipeline that is supposed to deliver natural gas from Texas to Mexico.  The government is demanding the money as compensation for construction delays, and it has already forced the builders to enter into arbitration.  Separately, the government is trying to reduce the capacity and usage charges it faces under the contract for the project.

Colombia: Agricultural officials in Bogotá have confirmed that a soil fungus that has devastated banana plantations throughout Southeast Asia has been detected in Colombia, the top global exporter of the fruit.  While the fungus isn’t dangerous to humans, it prevents trees from producing and is considered so dangerous that it could eventually eliminate all Cavendish bananas, which make up 95% of world exports.

Odds and ends: Yesterday, we reported that the Business Roundtable moved to change the focus of business from promoting shareholder value to a broader goal of stakeholder value.  Shareholders have responded unfavorably.  The Reserve Bank of Australia discussed unconventional policy at its August meeting.  Japan allowed more exports of high-tech materials to South Korea, easing recent tensions.  Another reason for the recent U.S. attraction to Greenland—rare earths.  And, ISIS isn’t completely eliminated yet.

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[1] The European Council is a body whose members comprise the heads of state of the EU governments, along with the presidents of the European Council and the European Commission.  Although it has little formal power, it’s informal power is significant as it is the “talking shop” for the leadership of the EU.

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

[Posted: 9:30 AM EDT]

Happy Monday!  Equity futures are pushing higher again this morning after the U.S. gives Huawei (002502, CNY 2.95) a 90-day extension.  It’s a big week—Fed minutes, the Jackson Hole meeting and the G-7 next weekend.  Treasury yields are higher and gold is retreating.  Here is what we are watching:

The Fed: We will get the Fed minutes at mid-week.  Although these reports are heavily sanitized (comparing the minutes to the transcripts that come out in five years is an interesting exercise), given the degree of dissent at the last meeting the minutes might offer some insight into how fast Powell can push the committee to further easing.  The other big event is the annual central bankers meeting in Jackson Hole, WY, sponsored by the KC FRB.  Chair Powell will speak on Friday under heavy pressure from the White House and financial markets.  To some extent, Powell probably needs a new narrative to use for more aggressive easing.  In the past, Fed chairs have deployed new frameworks to make major adjustments to policy.  For example, Volcker shifted from rate setting to money supply targeting in order to aggressively raise rates without it looking like the Fed was merely implementing austerity (it was).  Greenspan argued that rising productivity allowed policymakers to avoid the straitjacket of the Phillips Curve in the late 1990s, keeping policy rates lower than they otherwise would be.  Sadly, Powell may not have the intellectual “chops” to create a new regime; perhaps Jim Bullard (St. Louis FRB) could offer him one.  If Powell wants to use the current paradigm to cut rates, he will likely face continued resistance from traditional hawks and Phillips Curve adherents.

U.S.-China Trade: President Trump tweeted over the weekend that trade talks with China are going well, and that U.S. and Chinese negotiators might soon meet in Washington again.  Chief Economic Advisor Larry Kudlow said the negotiators would have at least one more telephone call in the next week or two to lay the groundwork for the next round of face-to-face meetings. This suggests those meetings wouldn’t happen until at least September.  Separately, Trump provided a positive readout on his Friday dinner with Tim Cook, the CEO of Apple (AAPL, 206.50).  According to Trump, Cook made a compelling argument that the new U.S. tariffs against China are disproportionately affecting Apple, while giving an advantage to South Korea’s Samsung Electronics (005930.KS, 43,600).  Since that probably raises the chance of some tariff relief for the company, Apple is rallying so far today and helping to pull the rest of the market along with it.  On the other hand, we note that although over the weekend Kudlow announced a three-month extension of licenses for U.S. firms to sell to Chinese telecom firm Huawei (002502.SZ, 2.95), the president last night said U.S. companies ultimately shouldn’t be doing business at all with the Chinese firm.

Although the president’s postponement of tariffs has led to a lift in equities, it should be noted that not all tariffs were delayed and the ones that will be implemented early next month matter.  We also note that the president is making reference to Hong Kong in comments, signaling to China that a harsh crackdown will adversely affect trade talks.

We also want to mention an editorial by Robert Samuelson, quoting one of our favorite books[1] and authors, Charles Kindleberger.  In this book, Kindleberger introduced the idea of “hegemonic stability theory” and argued that the Great Depression was caused by a global power vacuum; essentially, the U.S. was unwilling to accept the superpower role and the U.K. was unable to maintain it.  This situation led to a collapse in global trade and supported the rise of fascism.  Samuelson correctly notes that we are seeing somewhat similar conditions today.

PBOC: The PBOC unveiled a new policy rate, called the “loan prime rate,” which will replace the benchmark lending rate.  The rate is derived from quotes on prime loans from 10 major banks and has been published since 2013, but it is basically unused in setting policy.  After tomorrow, commercial banks will be required to price loans off the loan prime rate.  Since the loan prime rate does trade a bit below the benchmark lending rate, at least for now, this move is something of a modest easing.

Recession talk: This weekend, talk shows were dotted with administration officials downplaying the odds of recession.  Despite the attempt to lift spirits, worries about recession are mounting.  The chart below shows relative interest in the word “recession” in searches.  It has reached its highest point in a year and in the past five years (not shown).

The yield curve has prompted this surge in interest.  Additionally, as worries mount, analysts are looking at other variables that might either confirm the recession signal from the financial markets or offer some insight into timing.  As a general rule, the earliest warning signs tend to have the highest false positives, or the most variability in terms of timing.  One industry that has a generally good track record in signaling downturns is the recreational vehicle industry.  RVs are purely discretionary products; thus, their sales tend to signal how optimistic consumers are in the business cycle.  Here at Confluence, we have a long history in analyzing this part of the economy.  Recent evidence from this industry is clearly worrisome, suggesting a downturn is likely.

Hong Kong: Hundreds of thousands of protestors demonstrated against China’s growing influence in Hong Kong yet again over the weekend, with police water cannons on standby, but reports indicate the organizers were successful in keeping the protests peaceful.  That suggests the protestors are able to adjust their behavior in order to maintain or even build further support among Hong Kong’s population.  This could help stave off any crackdown by Beijing – a move that would probably be negative for the financial markets – but it also risks sapping the momentum from the protests and allowing Beijing to wait it out.

There are reports that capital flight issues are starting to emerge from Hong Kong.  In the short run, this may undermine the Hong Kong dollar’s peg to the U.S. dollar.  However, in the long run, it creates the issue discussed by Albert Hirschman[2] as to whether one exits under deteriorating conditions or agitates for change.  This issue will become increasingly important with Hong Kong as those who can may simply leave, increasing the odds that Beijing will be able to bring the territory under a single government.

United Kingdom: A leak of Prime Minister Boris Johnson’s contingency plan for a no-deal Brexit – dubbed Operation Yellowhammer – shows that the government thinks “EU Exit fatigue” has discouraged many companies from properly planning for an abrupt, chaotic exit from the European Union on October 31.  The plan envisions three months of chaos at British ports, shortages of food and fuel, nation-wide political unrest and the imposition of a hard border between Northern Ireland and the Republic of Ireland.  Separately, the outgoing president of the European Commission, Jean-Claude Junker, will miss the G-7 meeting on Friday due to an emergency gallbladder operation over the weekend.  That will deprive Johnson of one of his last opportunities to pressure the EU for a new withdrawal deal to replace the deal negotiated by the former prime minister, Theresa May.

Russia: Although former Soviet dissidents aren’t being allowed to mark the event, today is the 28^th anniversary of the attempted coup against Soviet President Mikhail Gorbachev, which led to the breakup of the USSR, the demise of Soviet communism and the eventual rebirth of Russia as a kleptocratic, corporatist state under President Putin.  Last week’s apparent explosion of an experimental nuclear-powered cruise missile illustrates the extent to which Russia is also trying to rebuild its military strength and reestablish its military technology effort.  New reports say two nearby radiation monitoring stations connected with the Comprehensive Nuclear Test Ban Treaty have gone silent since the missile mishap, illustrating how Russia is also trying to cloak its new military buildup, just as the Soviet Union would have done.  Old habits die hard.

Greece: Finance Minister Christos Staikouras said in an interview that Greece’s new center-right government will implement a comprehensive tax reform plan that would cut corporate and personal income taxes, reduce the value-added tax, streamline tax incentives and eliminate the emergency levies imposed during the Greek debt crisis over the last decade.  Staikouras vowed that the plan would be implemented without violating Greece’s bailout promise to maintain a primary budget surplus of 3.5% of GDP.

Saudi Arabia: Iran-backed Houthi rebels in Yemen attacked a Saudi oil and gas facility with 10 drones over the weekend, but Saudi officials said the attack only resulted in a fire that has already been controlled.

United States: In the midst of last week’s market turmoil, President Trump held a previously undisclosed conference call with the chief executives of three of the largest U.S. banks.  It’s not clear who initiated the call or what exactly was discussed, but it wouldn’t be a surprise if the bankers gave Trump an assessment of the current economic situation and the risks arising from the administration’s trade policies.

Times they are a-changing: The U.S. Business Roundtable has issued a statement suggesting that the sole focus on shareholder value is no longer viable.  This notion, which was famously supported by Milton Friedman, is an element of the equality/efficiency cycle.  When one is in an efficiency cycle, the focus on shareholder value alone is usually championed.  However, when equality becomes more important, other factors emerge.  We examined this issue in a recent WGR series (here and here).  Such concerns will almost certainly lead to lower margins as CEOs begin to balance the needs for profits along with consumer concerns and improving the lot of its employees.

Odds and ends: If you buy a house in Denmark, the bank will pay you for your trouble in an era of negative interest rates.  Germany is considering a modest fiscal expansion but only if conditions worsen.

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[1] Kindleberger, Charles. (1973). The World in Depression, 1929-1939. Berkeley, CA: University of California Press.  Ed. Note: we have a review of this book on our website; see link at the top of this report.

[2] Hirschman, Albert. (1970). Exit, Voice, and Loyalty: Responses to Decline in Firms, Organizations and States. Boston, MA: Harvard Press.