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

[Posted: 9:30 AM EDT]

Happy Friday!  Equity futures are higher this morning on hopes that the president is further retreating on tariffs.  Treasury yields are higher and gold is retreating.  Central banks around the world are moving to ease.  Here is what we are watching:

Backing away?  There are signs that President Trump may be looking for an off-ramp for his recent tariff threats.  The presidents of China and the U.S. are reportedly in contact and some movement on fentanyl is possible which, if met, would give the U.S. a reason for pulling back or delaying the tariff threat.  There are reports that the president is getting concerned about the economy.  Although the general response from the administration on economic fears are centered around overly tight monetary policy, history shows that incumbent presidents who face recessions for whatever reason tend to be blamed for the downturn.  Thus, even if it is true that monetary policy is too tight, voters don’t care; the president in office suffers the loss.

Although yesterday’s retail sales data suggests that consumption remains strong, it is clear the trade conflict is weighing on other parts of the economy.  A long list of nations, mostly export-dependent, are seeing serious economic pressure.  The fear is that these nations may drag the U.S. into a downturn as well.  Backing away from the trade conflict would remove a worry from the economy and would clearly lift market sentiment.

Monetary policy: Although yesterday’s retail sales data was impressive, it probably won’t cause the FOMC to hold steady on policy next month.  We note that Fed officials are signaling cuts, although there is no evidence that aggressive action is being considered.  It should also be noted that the Fed isn’t alone in easing; more than 30 other central banks are also cutting rates.  More importantly, the ECB appears ready to not just cut rates but to become more aggressive in QE.

Fiscal policy: There are reports that both China and Germany are considering fiscal stimulus.  The former has already conducted some actions, while the latter is usually reluctant to spend.  This action would be important; the saving identity shows why:

0 = (private investment – private saving) + (taxes – spending) + (exports-imports)

Persistent trade surplus nations usually have excess private saving over investment.  If they run a balanced fiscal account, to balance this identity, exports>imports by the exact level of the excess private saving.  So, a trade deficit has nothing to do with how much your consumers prefer foreign goods and everything to do with macroeconomic policy.  If China and Germany (especially Germany) were to lift fiscal spending, their trade accounts would be closer to balanced as the government deficit would be used to absorb the excess saving rather than the trade account.

A lift to growth: The Atlanta Fed’s GDPNow estimate for Q3 GDP rose 40 bps on yesterday’s data.

The contribution data suggests the economy is mostly being supported by the consumer.

Outside the consumer, the rest of the components of GDP are a wash.  Of course, strong consumption will tend to boost imports, so some offset is expected from net exports in the wake of rising consumer activity.  However, some of that consumption is also resulting in inventory reductions, which are also a drag on growth.  An interesting side note comes from reports that auto dealers are holding excess inventory, which may mean they will be forced to aggressively price product to rebalance their market.

China and Hong Kong: Widespread protests are expected for the 11^th consecutive weekend.   We reported yesterday that Chinese security officials are making a clear show of force in what is likely a bid to intimidate the protest movement.  So far, it isn’t working.  If China were to use the military against the protestors, we don’t see how the U.S. would not react with some sort of economic sanctions at a minimum.

The chief executive of a major Hong Kong airline has submitted his resignation “to take responsibility” for airline staff who have supported or participated in the city’s anti-Chinese political protests.  The resignation of Rupert Hogg, CEO of Cathay Pacific Airways (CPCAY, 6.68), shows how Beijing is trying to rein in private businesses for its own political purposes.  As such, the incident is another negative dimension to the ongoing protests.  The disruptive protests have helped drive down Hong Kong stocks over the last month, but reporting today says the declines have been muted by strong inflows from Chinese investors.  Those purchases could simply reflect mainland investors trying to take advantage of the drop in Hong Kong valuations.  However, there is some chance that the purchases also come from state-owned entities under the direction of the central government, which wants to maintain Hong Kong’s attractiveness as a global financial center.

India: The Hindu nationalist government of Prime Minister Narendra Modi announced that it would relax some of the communications and social restrictions it imposed on Jammu and Kashmir on August 5, when it said it would withdraw the Muslim-majority region’s autonomy.  To date, the clampdown seems to have been successful in limiting protests against the loss of autonomy.  However, while the government’s justification for the move was largely economic, the clampdown has reportedly brought the region’s economy to a standstill.

Mexico: Banco de México yesterday cut its benchmark short-term interest rate to 8.00%, marking its first rate cut in five years.  The policymakers said the 4-to-1 vote to cut the rate was based largely on the fact that Mexico’s inflation rate has recently moderated, leaving the “real” benchmark rate too restrictive.

North Korea: The North Korean military launched two more short-range ballistic missiles today, marking the fifth test firing in the last month.  The missile tests are largely an effort to protest the current U.S.-South Korea military exercises, but it’s important to remember that the tests also give the North Koreans a chance to refine and improve their missile technology. 

Venezuela: China announced it will stop buying oil from Venezuela in response to U.S. sanctions.  There are reports that Maduro is cracking down hard on the military with suspected coup plotters facing torture or worse.  This strategy is risky because if Maduro decides to pick on the wrong military figure then the brass might turn on him, and that would almost certainly end his time in office.

Iranian oil tanker released: Gibraltar has released a Iranian oil tanker that was being held by the Royal Navy.   If this action signals a de-escalation of tensions, it would put downward pressure on oil prices.

United States-Greenland: A report yesterday afternoon said President Trump has expressed an interest in having the United States buy Greenland.  The general response so far seems to be incredulity and irritation on the part of Denmark (which owns Greenland) and pushback even from right-wing Danish politicians.  However, to gauge how far this could go, it’s important to remember some historical precedents.  President Jefferson’s purchase of the Louisiana Territory and Seward’s purchase of Alaska will be on everyone’s mind, but there are much more direct precedents, too.  In 1916, the U.S. bought the Danish West Indies, which we now know as the U.S. Virgin Islands, to make sure they didn’t fall into German hands as a result of World War I.  Then, in 1946, President Truman offered to buy Greenland for $100 million, but Denmark rejected the idea.  A key reason for Truman’s interest in the purchase was national security.  The U.S. ultimately gained an air base at Thule, north of the Arctic Circle, and to this day it maintains multiple radar and other military assets on the island that are vital to the developing competition with China and Russia in the far north.  In fact, the U.S. last year took steps to thwart a Chinese effort to build three airports in Greenland.  Finally, the island also has valuable natural resources that may have caught Trump’s eye.  We’ll see if this develops into anything more.

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

[Posted: 9:30 AM EDT] Equity futures have rebounded in the past hour, likely on news that President Trump and Chairman Xi are exchanging letters and talking on the phone.  Economic worries continue to dominate.  And, how will we remember the Hickenlooper campaign?  Here is what we are watching:

Economy and markets: Equity markets took a beating yesterday, while interest rate markets enjoyed a strong rally and the 30-year T-bond dipped under 2% for the first time in history.  Global equities continued to weaken overnight as China vowed to retaliate against U.S. tariff measures.  Adding to worries were vague comments from President Trump, who, for the first time, appeared to link the tensions in Hong Kong to trade talks.  Some of the president’s advisors have been pressing for a hardline reaction to China’s handling of the situation, but so far the president has resisted commenting strongly on this issue.  However, as we noted above, we have seen a rebound develop after it was revealed that the two leaders have been in contact.

Equities have been slumping on worries about global growth.  There are reports noting that the growing trend of economic nationalism is playing havoc on global trading patterns.  Even the reliable WSJ editorial page is becoming critical of White House trade policy.

However, the yield curve is front and center in market and media commentary as the two-year/10-year spread inverted yesterday.  As we have noted, several other permutations of the yield curve have inverted already, including the fed funds/10-year, which is used by the Conference Board in calculating the leading economic indicators.

Journalists, seeking clarity, correctly indicate that each recession has been preceded by an inversion of some sort.  This is true, as far as it goes.  However, it is rare for the media to delve into the notion of the “false positive,” a signal that isn’t followed by an event.  The yield curve is a powerful indicator, one that should not be ignored.  However, it isn’t perfect and has been subject to false positives in the past.

Let’s use the 10-year/fed funds measure as an example.  This indicator failed to invert for the 1957 and 1961 recessions, but, since then, it has inverted prior to each downturn.  However, it also signaled two false positives, one in the mid-1960s and one in 1998.  In both those cases, a recession was avoided due to aggressive actions by the FOMC to cut interest rates.  So, if the Fed were to act aggressively, a recession might be avoided; simply put, it isn’t inevitable.  But, the odds of a downturn are elevated, and that fear has weighed on financial markets.

We would not be surprised by an equity market recovery in the wake of yesterday’s drop.  As we see in this morning’s activity, glimmers of hope on trade are enough to trigger rebounds.  After all, as the above chart indicates, the inversion tends to predate the recession by a rather long period.  Nevertheless, it does make sense to be aware that the odds of recession are elevated.

Japan-South Korea: In a speech today, South Korean President Moon Jae-in struck a conciliatory tone toward Japan, vowing to “join hands” with Japanese leaders if they choose dialogue to overcome the continuing dispute concerning Japanese-Korean relations before and during World War II.  This adds to evidence that the countries may be ready to step back from the dispute in which both sides have weaponized trade rules.  Reports yesterday said senior Japanese and South Korean officials will meet on the dispute in Guam on Friday and Saturday.  Separately, Japanese Emperor Naruhito today repeated his father’s groundbreaking expression of “deep remorse” for Japan’s behavior in the 1930s and 1940s.

Hong Kong: There are more reports of Chinese security personnel amassing near Hong Kong, with one article discussing how tens of thousands of Chinese military police are conducting drills in a large sports stadium in Shenzhen.  Satellite imagery shows over a hundred armored personnel carriers and other vehicles parked inside the facility.  Officials claimed that previous drills were merely in preparation for the anniversary of the People’s Republic of China on October 1, but the apparent continuation of security deployments raises the prospect that Beijing is about to clamp down on anti-Chinese protestors in Hong Kong – a move that would probably have painful political and economic costs for China and further undermine global investor sentiment.  One especially important implication of a violent crackdown is that it would signal to the Taiwanese that they could be subject to the same treatment.  Taiwan is also becoming increasingly leery of China’s intentions under the nationalist policies of President Xi Jinping.  Today, Taiwan’s government released a plan to boost its defense spending by 8.3% in 2020.  That would be the island’s biggest defense budget boost since 2008.

United Kingdom: Labour Party leader Jeremy Corbyn has released a plan to thwart Prime Minister Johnson’s apparent intention for a no-deal Brexit.  Under Corbyn’s plan, a coalition of opposition parties led by Labour would try to bring down the Johnson government via a no-confidence vote in early September.  Labour would then try to form a temporary government whose mandate would be limited to asking the European Union to extend the current Brexit deadline of October 31 and call new elections.  In any such elections, Corbyn vowed that Labour would run on a platform of holding a new referendum on Brexit.  At least some opposition parties have already expressed reservations about the plan, especially due to its slant toward Labour, in general, and Corbyn, in particular.

Canada: The government’s independent ethics watchdog said Prime Minister Trudeau violated conflict-of-interest laws when he pressured his former attorney general to settle a corruption case against the Canadian engineering company SNC-Lavalin (SNCAF, 12.99).  The controversy is old news, but the formal decision by the ethics board is likely to further undermine Trudeau’s position in the country’s October elections.

United States-Iran: Just when the United Kingdom and Iran seemed ready to resolve their dispute over the Iranian oil tanker Grace 1, which Britain detained in Gibraltar last month, the U.S. Department of Justice today filed a motion in Gibraltar to seize the ship.  The British originally seized the ship for violating sanctions against Syria, but the legal basis for the U.S. motion isn’t clear.

Argentina: President Macri has announced several emergency economic measures aimed at stopping the plunge in the Argentine currency and shoring up the economy.  The peso and the economy are in a tailspin after Macri’s poor performance in last weekend’s primary elections sparked concern that the populist, unorthodox Peronists will return to power.  However, the emergency measures, such as a hike in the minimum wage and a freeze on gasoline prices, may not be sufficient enough to make a difference.

Cybersecurity: As we continue to see signs of a political shift toward increased economic sovereignty and higher regulation in at least some areas, it appears that cybersecurity may be one reason for a clampdown on the technology industry.  Reports today say the hacker who stole huge amounts of cloud-based data from Capital One (COF, 83.45) also broke into more than 30 other firms’ cloud systems.  Democratic Senator Ron Wyden of Oregon is demanding that cloud service providers take further action to protect data.

Energy update: Crude oil inventories unexpectedly rose 1.6 mb compared to an expected draw of 2.3 mb.

In the details, U.S. crude oil production was unchanged at 12.3 mbpd.  Exports rose 0.7 mbpd, while imports increased 0.6 mbpd.  Refinery operations fell 1.6%.

The above chart shows the annual seasonal pattern for crude oil inventories.  We are seeing a modest recovery in inventories after nearly two months of declines that put the level of inventories 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.

Based on our oil inventory/price model, fair value is $60.84; using the euro/price model, fair value is $50.96.  The combined model, a broader analysis of the oil price, generates a fair value of $53.62.  We are seeing a clear divergence between the impact of the dollar and oil inventories.  If President Trump is successful in bringing the dollar lower, it would be bullish for oil prices.  Recession fears are acting as a bearish factor for oil prices as well, overcoming worries about geopolitical disruptions.

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

[Posted: 9:30 AM EDT] It’s mid-week in what has been a busy week.  President Trump blinks (sort of) on trade.  Equity markets don’t follow through, mostly due to lingering trade uncertainty and mounting evidence of global economic weakness.  Hong Kong remains a flashpoint.  Here is what we are watching:

Trade: In a surprise move, President Trump announced delays in the majority of announced tariffs until December 15.  Looking at the goods affected, there was a clear decision to avoid tariffs on consumer goods before Christmas.  Risk assets were emboldened by the announcement.  All in all, more than $150 billion of goods were affected by the delay.  Both sides agreed to resume negotiations.

This action appears tactical in nature.  Delaying the implementation doesn’t mean they have gone away.  It is interesting that the president framed the action as a way to avoid issues for the holidays, perhaps a tacit acknowledgement that consumers may pay at least some of the tariffs.  If that is true, then delaying the tariffs into the year before elections is a risky ploy.  It also signals to China that the White House may be less tolerant of inflicting pain on the U.S. economy and therefore may make Beijing less open to concessions.

If the goal was to lift confidence and financial markets, the effect was short-lived.  Risk markets did rally strongly but are giving back everything today.  Equities, from a technical perspective, are starting to look soft; fading rallies is not a good sign.

What happens as we approach December 15?  We suspect it will all depend on how the economy looks.  If the economy is struggling, the tariffs may remain in place.  At the same time, there will be a political calculus at work as well.  If the president believes the tariffs improve his chances of reelection, they will probably go forward.  But, overall, we think the economy will be the key variable and we would envision further delays if deceleration continues.

Weakening global growth: A key factor for today’s equity weakness is a batch of soft economic data abroad.  German GDP fell into negative territory.

Although the data was near expectations, a negative reading isn’t welcome and the odds of two consecutive negative quarters, the “working” definition of recession, is highly likely.  This data highlights the fact that the major European nations are likely in a downturn.  German economic sentiment fell to its lowest level since 2011.

China released a series of weak numbers as well.  Industrial production came in weaker than forecast, at 4.8% (Y/Y%), well below the 6.0% expected.  As the chart below shows, this is the weakest showing since 2008.

Retail sales also slumped.

This data raises questions about the effectiveness of Chinese stimulus measures.  Given China’s history (and the continued problems in Hong Kong), we would expect the Xi administration to return to more aggressive stimulus measures if the economic slowdown continues.

Slumping global growth will almost certainly bring easier policy from the FOMC.  As various permutations of the yield curve either invert further or approach inversion, the signal from the financial markets is clear that the Fed needs to cut rates.  Unfortunately, given the fact that we had two dissents last meeting, it may be hard not only to lower rates but to move more than 25 bps.  The other worry, of course, is that a rate cut might not matter all that much.

Finally, it’s worth noting that the Eurozone and China are both export-dependent.  Germany has essentially turned the Eurozone into a broader version of itself, making it heavily dependent on foreign sales, and China’s development model was based on exports.  Thus, the trade conflict is affecting China and Europe much more than the U.S., which is less dependent on exports for growth.

Yield curve inversion: Today, U.K. and U.S. bonds inverted after a stream of bad economic data from Germany and China triggered a flight to safety into 10-year bonds.  Because yield curve inversions have a strong track record of predicting recessions, they are often followed closely by investors.  That being said, the yield curve inversion in the U.K. is probably the bigger concern as its economy had contracted in Q2 and there are still growing concerns about the impact Brexit will have on the economy.  Meanwhile, the U.S. yield inversion has grown; the yield on the 10-year Treasury was already lower than the three-month Treasury bill.  At this time, we do not expect a recession to take place in the U.S. in the immediate future as consumption still appears strong, but we are becoming more vigilant as financial markets appear to be sending a strong signal that the economy may be more vulnerable than we realize.

Hong Kong: The scene at the Hong Kong airport was tense yesterday as violence erupted.   Apparently, protestors attacked two men thought to be undercover agents for Beijing.  Police attacked protestors in response; there was a moment when it appeared police were about to open fire on the demonstrators.  There were social media pictures suggesting the PLA is mobilizing, although this wasn’t confirmed by the Pentagon.  There is now a court order barring the protestors from the airport and officials are taking steps to prevent anyone other than passengers to enter the airport terminal.  Hong Kong police have brought a hardline former deputy commissioner out of retirement and actions by police have become more hostile since his return.  Chinese media is actively spreading disinformation about the protests, trying to frame the protestors as “terrorists,” perhaps to give them an excuse to use heavy force.  A British MP has indicated he thinks the U.K. should issue passports to Hong Kong citizens, an action that would infuriate Chinese leaders who often refer to the colonial period of British domination to stir nationalist sentiment.  Finally, companies operating in Hong Kong have been activating contingency plans as unrest continues.

Italy—populist coalition collapse?  On Tuesday, Matteo Salvini failed in his plans to call early elections, which will be needed for him to shore up support for his reforms.  Last month, Salvini’s party, the Northern League, was unable to get reforms that included tax cuts through parliament after members of its coalition in the Five-Star party failed to support the reforms.  Following the defeat, Salvini has been angling to call snap elections, a move that might see him become the new prime minister of Italy.  Salvini’s popularity appears to be on the rise, while support for the Five-Star movement has fallen in recent months.

Despite his failed attempt to call a vote on Tuesday, a no-confidence vote is expected to take place on August 20.  If the vote succeeds, Prime Minister Giuseppe Conte will have to submit his letter of resignation and new elections will be held.  In the event of new elections, the Northern League would be expected to win a plurality of the seats, but there are rumors that the Five-Star Movement could align with the Democratic Party to block Salvini from becoming prime minister.  Nevertheless, if Salvini does become prime minister it will likely raise the possibility of Italy’s exit from the Eurozone, which should weigh on the euro and possibly European equities.

The chart above shows how the prediction markets view the likelihood of the dissolution of the Italian government before the end of the year, with each cent representing a percentage point.  As of yesterday, the prediction markets value the possibility at about $0.76, which suggests there is about a 76% chance of the Italian parliament dissolving.  At the same time, even though there will be a no-confidence vote on August 20, it isn’t likely that snap elections will follow anytime soon.  Instead, the coalition leaders have decided to keep the government in place until a government restructuring law is passed.  This action could take up to a year.

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

[Posted: 9:30 AM EDT]

It’s an August Tuesday.  Risk markets are falling again this morning.  Although there is a lot of news most of it is a continuation of recent events.  Here is what we are watching:

Hong Kong:  Protests continue this morning; check-ins have been suspended but airport officials are trying to get some flights off the ground.  These airport protests are having a strong impact; they are keeping the unrest front and center on global media and the Communist Party of China (CPC) cannot ignore the tensions.  Beijing is dealing with the threat of separatism with Hong Kong, something that is a very sensitive issue for Chinese leadership.  Historically, in simple terms, China has tended to be poor but unified, or rich and divided.  When China turns inward, its economy is usually weak, but the country is politically unified. When it turns to the world, it prospers, but mostly from the coasts inward.  During prosperity, divisions develop and outsiders can use those divisions to dominate China.  The current unrest in Hong Kong has echoes of this pattern.  We note, for example, that CPC officials continue to blame outside forces for the unrest.  On its face, this claim is weak; there is no evidence to suggest that foreign intelligence services are supporting the protestors.  However, there is an element of truth to the claim; the protestors are pressing for democracy, which is a Western concept and thus “foreign” to China’s view of governance.

In her press conference today, Hong Kong Chief Executive Carrie Lam refused to say whether Beijing has ordered her to avoid making any concessions to the protestors, such as fully withdrawing the extradition bill that touched off the demonstrations.  At least one municipal legislator said that was tantamount to confirming Beijing is now running the city, and that Lam is now just a “puppet” governor.

We continue to watch to see how long Chairman Xi will tolerate these protests.  He should return later this week from the “summer camp” for CPC leaders.  The policy thus far has been to wait out the protestors.  However, the lessons learned from Tiananmen Square were that crackdowns end protests and the costs of Western reaction are manageable.  Perhaps the only issue keeping the PLA from moving into Hong Kong with tanks is that it would make it clear to Taiwan that there is no “two systems” model for China.  We note that China has been actively trying to sway public opinion in Taiwan using various media outlets.

Crying for Argentina:  Argentine financial markets took a beating yesterday after the incumbent’s poor performance in primary elections.  The fear is that Peronists will return, bringing default, inflation and capital controls back to the country.  In a world of negative interest rates, Argentina stands out—one can get a +12% yield on Argentine “century bonds.”

Fear rising:  Financial markets are signaling increasing levels of fear.  The VIX is up; yield curves are flattening and the U.S. 30-year T-bond yield is close to all-time lows.  Additionally, we are seeing a continued rise in money market funds.

This chart shows the weekly level of retail money market funds with the S&P 500.  The gray bar is shows the recession, the amber bars show periods where money market funds fall below $920 bn.  In this bull market, equities tended to stall when money market funds fell to around $920 bn.  This suggests that equities ran out of liquidity, and had to retrench as households rebuilt cash levels.  As the trade war heated up in January 2018, households started aggressively building cash reserves.  Although equity markets did rise further, the path was far from smooth.  We view this chart as a measure of fear; households are showing a bias toward liquidity even though yields remain rather low.  If a catalyst for confidence was to emerge, there is enough liquidity available to boost equities significantly.  However, such a catalyst isn’t obvious.  If liquidity preference continues to rise, it will be difficult for equities to move higher.

United Kingdom:  A lower-level Scottish court has accepted a petition to decide whether Prime Minister Johnson can suspend or “prorogue” parliament in order to force through a no-deal Brexit.  The court is scheduled to issue its decision on September 6.  Separately, the newspaper that Johnson previously worked for has released a poll claiming that more than half of Britons would support a suspension of parliament in order to force through Brexit, but the poll is being panned for how leading the questions were.

As the U.K. careens toward a hard Brexit, one of the factors that PM Johnson is holding on to is a quick trade deal with the U.S.  We would expect the U.S. to be quite open to such a deal but the costs to Britain might be staggering.  From food to technology and beyond, the U.S. will likely turn the U.K. into a vassal state through trade.

Italy:  The Italian Senate will meet later today to decide when to schedule the no-confidence vote demanded by Deputy Prime Minister Matteo Salvini.  The vote is expected to be scheduled for next Tuesday.  As we’ve discussed previously, we see the potential breakup of the current far-left/far-right government as a sign that such a “Nader” coalition is just too unstable to govern.

Congo:  In preliminary trials conducted since last November, two experimental anti-Ebola drugs were able to sharply cut the death rate from the disease.  When given early, one drug cut the death rate to just 10%, compared with 70% for untreated victims.  Although total deaths from Ebola have been relatively limited over the last decade, the disease has been a risk factor for the frontier markets of Africa.  More broadly, there has been concern about a widescale outbreak of the disease that spreads beyond Africa.

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

[Posted: 9:30 AM EDT] It’s an August Monday.  Equities are under pressure again this morning and risk assets, in general, are weaker.  Here is what we are watching:

China and the dollar: For the third consecutive day, the PBOC fixed the CNY/USD exchange rate above 7.  Although this reference rate was a bit stronger than Friday’s level, it suggests PBOC policy is more about stabilizing the exchange rate at a point weaker than 7 (the higher the rate, the weaker the CNY).  There are two reasons why the PBOC probably isn’t letting the CNY sink lower.  First, there is the constant problem of capital flight.  During previous periods of CNY weakness, foreign reserves fell as Chinese investors moved money out of the country to protect themselves from a depreciation.

This chart shows foreign reserves and the CNY/USD exchange rate.  The CNY began to weaken in early 2014.  From 2014 to late 2016, the currency weakened nearly a full CNY and foreign reserves fell by nearly a trillion dollars. Some of the decline in reserves was due to valuation changes but there were notable levels of capital flight.  China has measures to prevent capital flight but, as the data shows, regulators’ ability to prevent it is limited.  The second issue, as we noted last week, was the high level of dollar-denominated debt in the private sector.  There are reports that private Chinese companies are being forced to sell off foreign assets because they face a shortage of dollars.  There is some debate among analysts as to what this dollar shortage means.  One possibility is that the above chart’s $3.1 trillion of dollar assets is not liquid or is already committed.  In other words, these companies may be facing a real dollar shortage and China may be in bigger trouble than it appears.  The second explanation is that China has ample dollar reserves but doesn’t want to spend them on the private sector.  Allowing (forcing?) private companies who splurged on foreign buying (which may have been related to capital flight) may be in Beijing’s best interest.  The leadership may want to discourage Chinese companies from buying assets overseas and warn foreign lenders that lending to private Chinese companies, even big ones, is riskier than it looks.  We tend to think the second explanation is more likely.  There has been a clear bias toward the state-owned enterprises (SOE) under Chairman Xi, and “starving” the private sector’s demand for dollars while allowing access for the SOEs would fit that partiality.  Still, the reason there is a debate at all is due to the opaque nature of China’s reserve management; it is possible that the first explanation is correct and, if it is, China could be quite vulnerable to market volatility.

China’s lending slows: Chinese lending in July came in weaker than expected.  Total loan growth slowed under 13% as the PBOC tries to rein in lending.

The slowdown highlights the problem Chinese authorities are facing, something similar to what the U.S. saw in 2011-13.  Although monetary policy itself suggests easing, regulatory constraints are hampering the transmission process.  Essentially, the entities that China wants borrowing from aren’t doing so and the firms that need the liquidity are being restricted.  For example, components of private financing, or “shadow banking,” are down for the year.

In other words, China wants to see more borrowing but only by certain borrowers.  If this bias continues, monetary stimulus will likely disappoint.

Authoritarians under pressure: Hong Kong remains a tinderbox as protests continue.  Air traffic was halted due to unrest as thousands of demonstrators flooded terminals.  Protests continue in the city as well.  Beijing is escalating its rhetoric, calling it “terrorism,” which may be laying the groundwork for a military crackdown to restore order.  Meanwhile, there were massive protests in Moscow, dwarfing those of previous weeks.  Although the bulk of the unrest remains in Moscow, there is evidence of smaller actions elsewhere.  One source of trouble for Putin is a disappointing economy.  With Hong Kong, the protests there could trigger a Tiananmen-style response.  If that occurs, capital flight would soar and relations with Taiwan would harden.  In terms of Russia, we expect Putin to remain in control but the fact that protests are happening at all suggests his power is under pressure.  In another interesting sidelight, a massive munitions explosion last week apparently caused a radiation leak, raising speculation that the blast involved a nuclear cruise missile project.  If so, this is yet another setback in Russia’s military technology.

Italy: It is still unclear whether the government will fall, but the uncertainty isn’t helping Italy’s perilous financial situation as it faces credit downgrades.  Salvini had to deny that his party wants to exit the Eurozone; such talk would lead to further capital flight and more downward rate pressure on German Bunds.

Brexit: There is growing talk that MPs may not be able to stop PM Johnson from a hard Brexit if he is determined to go that path.  It is starting to look like the available measures of no-confidence will probably backfire and may deny MPs any role in halting a sudden exit.

Argentina: In a sign that populism may be returning to Argentina, Alberto Fernández of the Peronist party won the nationwide primary election over the weekend by a far larger margin than expected.  Fernández, whose wife is former president Cristina Fernández de Kirchner, received 47.0% of the vote, while the current pro-business president, Mauricio Macri, won just 32.7%.  Investors probably fear the return of the Peronists’ radical, unorthodox economic policies under Fernández and Kirchner, so Argentine assets will likely come under pressure in the coming days.

Deep thoughts: With fond memories of Jack Handey, here are some broader items that caught our attention over the weekend:

1. The waning superpower problem: The FT ran a long thought piece about what happens to the world if the U.S. becomes less involved. We have been discussing this issue for some time; our take is that Americans were sold the policy of containing communism to foster participation in the hard work of hegemony.  But, in reality, containing communism was only a small part of freezing other global conflicts worldwide.  When communism fell, most Americans believed we could end the hegemonic role without realizing that a world without a hegemon is a world at risk of WWIII.  We found the comment section from the aforementioned FT article to confirm that position.
2. Other kinds of inflation: Although price inflation remains sticky, firms will try to maintain margins in other ways. Showrooms may have fewer sales staff; dining rooms may be less clean.  Sizes may shrink.  If tariffs bite, we would expect more tactics like this to maintain margins and price levels.
3. The long expansion: One characteristic of this expansion is that most of the benefits have accrued to a few major metropolitan areas. Much of the rise in growth has not found its way into the rest of the country.  That may be starting to change.  As the cost of living in the supercities becomes onerous, there are reports that some areas of the country are seeing a secondary boom as people leave the “hot” areas for parts of the country that are more affordable.  If this is the beginning of a trend, policymakers will likely try to support it by keeping policy more accommodative.

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

[Posted: 9:30 AM EDT]

Happy Friday! Equities are giving back some of yesterday’s stronger gains.  The Italian government is near a collapse.  U.K. economy disappoints.  U.S. holds off on tech decisions.  And, five decades ago today, the famous album cover photo of Abbey Road was snapped.  Here is what we are watching today:

Italian troubles:  Making good on earlier threats, Deputy Prime Minister and League leader Matteo Salvini withdrew his party from government, and called for new elections.  Despite Salvini’s actions, new elections are not inevitable.  Italy’s president, Sergio Matarella, actually decides if the government will fall, and he might decide to give other parties the opportunity to form a new government.  The legislature is in recess for the summer (after all, it is Europe) and the president probably won’t want to take this action while lawmakers are away.  In addition, the body is working on budgets and bringing new elections at this time could delay that process.

We see two important takeaways from Salvini’s move.  First, as we noted yesterday, this action probably spells the end of the world’s only “Nader coalition,” one described by Ralph Nader in his book Unstoppable,[1] which is a coalition of right-wing and left-wing populists.  Although Nader’s idea of this coalition seems reasonable, the reality is that the differences between the two sides may simply be unworkable.  If so, a coalition between an elite group with a populist group is more likely; perhaps the most enduring one in U.S. politics was engineered by Franklin Roosevelt, who tied left-wing elites to right-wing populists.  This coalition dominated U.S. politics from 1940-65.  Since then, both elite groups have had looser ties with populists, but in reality, the right-wing and left-wing elites have governed as a minority coalition (at least in terms of economic policy) with ties of convenience to populist groups.  This is why we have seen the White House consistently shift between parties.  Second, the move by Salvini is roiling Italian financial markets.  The spread between German bunds and Italian bonds blew out this morning with German yields declining on flight-to-safety buying.  Salvini has been confrontational with the EU and if the government falls and he leads the next one, the odds of the conflict escalating increases.

Commerce delays:  The Commerce Department has decided to delay its decision on granting exemptions for companies wanting to buy equipment from Huawei (002502, CNY 2.83).  What seems to be occurring is that the U.S. wants China to buy U.S. agricultural goods, and China wants the U.S. to ease restrictions on Huawei.  However, both want the other side to make the first move, perhaps in order to show the other side “caved”.  In the 7^th grade, similar disputes are either resolved by each party having a hand on what the other wants and releasing each good on the count of “3,” or by bringing in a third party to hold both goods in “escrow” and releasing each after both sides hold up their end of the bargain.  Apparently, the U.S. and China haven’t experienced these resolution measures.  The decision’s delay is probably behind today’s equity market pullback.

CNY fixing:  For the second straight day, the PBOC has fixed the CNY above seven CNY/USD.  Although Chinese officials are preventing the currency from weakening further, they are also clearly giving up on the previous ceiling at seven.[2]  Meanwhile, the White House jawboning for a weaker dollar continues; next week’s WGR will discuss the potential for a shift in the global forex regime.

Hong Kong:  Tensions remain very high.  China has singled out Julie Eadeh, a U.S. consulate official, for meeting with protest leaders.  Chinese official media is suggesting that the meeting is clear evidence the U.S. is influencing the protesters.  Protests are planned for this weekend; the U.S. has issued a travel warning.  Although the Trump administration has been mostly quiet about the protests, it is clear Chinese officials feel they need to paint the protesters as being influenced by foreigners to frame the protests are unpatriotic.

Global Economic Growth:  Japan and the United Kingdom, which typically represent the two biggest non-U.S. stock markets in the broad international indexes, today both reported their second-quarter economic growth.  Japan’s gross domestic product beat expectations with an increase of 0.4%, as trade headwinds were offset by rising corporate investment.  In contrast, the United Kingdom’s GDP unexpectedly declined 0.2%, marking its first contraction since late 2012.  The U.K. decline, which is driving sterling downward today, came in large part because pre-Brexit stockpiles built up in previous quarters have started to be consumed.

Global Oil Market:  The International Energy Agency cut its forecast for this year’s global oil demand for the third time in the last four months.  After demand in January through May increased at its weakest rate since 2008, the IEA now expects demand in all of 2019 to be up just 1.2 million barrels per day.  The cut in the forecast mostly reflected slowing economic growth around the world and the worsening U.S.-China trade war.  Separately, officials in Tokyo are hinting that Japanese naval forces may be sent to the waters off Yemen in order to help protect oil shipments through the Persian Gulf without unduly antagonizing Iran.  In another interesting development, Iranian oil traders have found themselves being wooed by Western intelligence agencies and surveilled by Iranian officials as the former tries to figure out how Iran is smuggling oil, and the latter tries to prevent the information from getting out.  Additionally, British private guards are being pulled from Persian Gulf shipping on fears they could be captured by Iran and used as potential bargaining chips.

Japan-South Korea:  As a sign that the Japan-South Korea dispute over World War II reparations is still not resolved, the South Korean Environment Ministry said yesterday it would tighten radiation checks on coal ash imports from Japan.  That comes after some positive news yesterday, when Japan approved the export of a key chemical to South Korea.  Although the dispute is likely to remain relatively contained, perhaps the worst aspect of it is that it shows how countries are now using protectionist trade measures as their weapon of choice in international disputes.

Turkey:  Sources say several high-level officials at the central bank have been removed from their posts, just weeks after President Erdogan sacked the previous governor because he “wouldn’t follow orders.”  The move is a sign that Erdogan’s effort to take control over monetary policy goes deeper than originally thought.  It also points to the kinds of developments that might become more common as other leaders – including U.S. President Trump – work to dismantle the independence of their central banks.  Attacks on central-bank independence raises the risk of politically motivated interest-rate cuts, higher inflation and a depreciating currency. However, the lira has responded little to today’s news so far.

Not only is President Erdogan trying to shore up his political fortunes with looser monetary policy, but he is also responding to popular anger over Syrian refugees, by pushing them out of the country.  The problem is that the plan would relocate some 700,000 of the refugees to Syrian territory that Ankara aims to seize from a U.S.-allied Kurdish group.  U.S. and Turkish military forces have in the past almost come to blows over Turkey’s desire to attack the Kurds, so the new plan again raises the risk of a confrontation.

Finally, in late breaking news on Turkey, China apparently negotiated a $1.0 bn swap arrangement with the Central Bank of Turkey, likely a move to shore up Ankara’s foreign exchange reserves.  This action is further evidence that Turkey is being pulled out of the West’s orbit.  Our latest WGR has analysis of the situation in Turkey.

Australia:  As more evidence that cybersecurity is now perhaps the key skillset for Western defense leaders, the new chief of the Australian Security Intelligence Organization will be Mike Burgess, the former head of the military’s top cyber defense agency, who had advised the government to bar Chinese telecom firm Huawei (002502, CNY 2.83) from the country’s new 5G communications network.  As a reminder, the U.S. government announced last month that Michael Gilday, the three-star head of the Navy’s Cyber Command, will be promoted over several four-star colleagues to be the new Chief of Naval Operations.

Russia:  Today marks 20 years since President Boris Yeltsin picked Vladimir Putin to be Russia’s prime minister, launching two decades of Putin’s effort to stabilize the Russian economy, rebuild its military and eventually make it a more assertive global power again.  Radio Free Europe today has a useful review of Putin’s years in power.

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[1] Nader, Ralph. (2014). Unstoppable: The Emerging Left-Right Alliance to Dismantle the Corporate State. New York, NY: Nation Books.

[2] Readers should note that the higher the exchange rate, the weaker the CNY.

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

[Posted: 9:30 AM EDT]

Good morning! Markets are relatively quiet this morning after an impressive reversal in the equity markets yesterday.  We are seeing a backup in bond yields in the past hour on reports Germany may finally be considering fiscal expansion.  Here is what we are watching today:

China news:  For the first time since 2008, the “official” CNY/USD exchange rate was fixed at a level above 7, although it has been trading above that level intraday for the past few days.  Markets are not taking the news too badly because the fixing was stronger than the market was trading, suggesting the PBOC will probably be coming in to support the current level in the coming days.  At the same time, the currency weakening also reflects a slowing economy.  The weaker CNY will likely trigger similar currency declines across Asia.  Currency weakness will tend to help lift economic growth by boosting trade.  Right on cue, China’s trade data for July was stronger than forecast as exports rebounded and imports fell.  Exports to Europe unexpectedly increased while the drop in imports is consistent with a slowing economy.

News on trade was mixed.  China did indicate it was still willing to meet early next month while U.S. trade negotiators draw up a list of goods for tariffs.  It’s hard to see how talks can progress if the tariffs are expanded.  However, news that China was willing to meet contributed to yesterday’s equity rally. China continues to threaten to restrict rare earth exports, which would raise trade tensions.  China is also warning other nations against restricting their imports of Chinese technology.  The U.S. is preparing to ban Huawei (002502, CNY 2.83) technology purchases by the U.S. government.

Although there wasn’t much news from Hong Kong, Chinese officials continue to blame the U.S. for the tensions.  We haven’t seen any evidence that the U.S. is actively supporting the unrest, but it is a strongly held belief among the authoritarian governments that the “color revolutions” are U.S. backed.  That’s a much more comforting notion than believing that citizens aren’t happy.  Beijing is increasing its threats to intervene in Hong Kong if the unrest continues.

Earlier this week, we noted a BIS report that showed China’s dollar-denominated debt was significant, and thus limited the use of currency depreciation as a tool against tariffs.  The details suggest the risk is elevated because over 20% of the dollar lending has occurred in real estate.  If a weak CNY triggers a debt crisis in China, problems in the politically sensitive real estate sector could force Beijing to back down to U.S. demands.

Japan-South Korea:  Although tensions remain high regarding Seoul’s demand for reparations over Japan’s behavior on the Korean peninsula before and after World War II, there are signs the dispute may be cooling.  Japan today approved the export of a key chemical to South Korea, after imposing new export controls over it and other products last month.

A U.S./U.K. trade deal:  Brexit supporters argue that if Britain is free from the EU, it will be able to rapidly negotiate free trade deals across the world, giving a boost to the U.K. economy.  British officials have been discussing a deal with Washington.  SoS Pompeo supported this idea, suggesting he would “have pen in hand” to sign a measure quickly.   We have no doubts this is true.  However, British leverage in talks with the U.S. will be nil and the agreement they get will likely be heavily in America’s favor.  We would expect the U.S. to gain wide access to Britain’s agricultural industry, and finance would come under severe pressure.  Additionally, the British may have no choice other than to accept the terms.

Trouble in Italy:  Tensions within Italy’s ruling coalition continue to worsen, as League members in the Senate helped push through the approval of an Italy-France train link that the Five Star Movement has long opposed.  Disagreements over issues like tax cuts, regional governance, and relations with the European Union have increased the odds that Italy’s experiment with populist government may not last much longer.  Deputy PM Salvini is threatening to pull out of the current ruling coalition if the Five Star Movement doesn’t give into his demands for policy changes and a reshuffling of the cabinet.  The news has lifted Italian bond yields (in a context of falling global yields) and is raising worries about further tensions with the EU.  We have watched this coalition with great interest because it is the only working “Nader coalition” of right- and left-wing populists.  If this government fails, it will suggest that such coalitions are unstable and probably can’t function as governments.

Venezuela:  The U.S. has widened sanctions on Venezuela, implementing a near full embargo on the country.  In response, the Maduro government has withdrawn from talks with the opposition currently being held in Barbados.  Russia has now become the sole supplier of gasoline to Venezuela; it is unclear how the Maduro regime is paying for this product.  Most likely, Russia is supplying gasoline for geopolitical leverage.  Having such leverage over a country in the Western Hemisphere will be highly valued by Russian President Putin because it could help him meddle in regional affairs and keep the United States off balance.  We therefore expect Putin to continue his efforts to keep Venezuelan President Nicolás Maduro in power.  The action by Russia puts its firms at risk of secondary sanctions from the U.S.

Iran:  While Iran keeps harassing oil shipping in the Persian Gulf, new reports illustrate how the effort is sometimes imposing collateral damage on the regime’s few allies.  For example, even when Iran seizes a ship carrying cargo for the United Kingdom, the vessel might be crewed by Indian sailors.  When it seizes a British-owned ship, it might be carrying oil for China.  The risk of angering allies could potentially help mute Iran’s provocative action in the region.

Islamic State:  A report by the Pentagon’s inspector general says the pullout of U.S. military assets in Iraq and Syria is allowing Islamic State militants to regroup and regain their ability to mount attacks.

Food security:  The U.N. is warning that climate change is exacerbating soil erosion and shifting growing areas and seasons in such a fashion that food supplies may be threatened.

Energy update:  Crude oil inventories unexpectedly rose 2.4 mb compared to an expected draw of 3.0 mb.

In the details, U.S. crude oil production rose 0.1 mbpd, to 12.3 mbpd.  Exports fell 0.6 mbpd while imports rose 0.6 mbpd.  Refinery operations jumped 3.4%.

This chart shows the annual seasonal pattern for crude oil inventories.  The decline seen over the past few weeks now puts the level below the usual seasonal trough in September.  This week’s rise wasn’t a complete surprise as, at some point, imports were going to reflect a full return from hurricane disruptions.

Based our oil inventory/price model, fair value is $61.35; using the euro/price model, fair value is $50.72.  The combined model, a broader analysis of the oil price, generates a fair value of $53.64.   We are seeing a clear divergence between the impact of the dollar and oil inventories.  If President Trump is successful in bringing the dollar lower, it would be bullish for oil prices.  Recession fears are acting as a bearish factor for oil prices as well, overcoming worries about geopolitical disruptions.

In other oil news, prices have rebounded from a sharp selloff on two items.  First, the perceived “pause” in China/U.S. trade tensions led to some buying and second, reports the Saudis were considering measures to shore up prices lifted bullish sentiment.  On a different note, Bahrain is reporting that it was hit with a cyber-attack that penetrated important infrastructure.  Iran is the likely attacker.

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