How much attention is the FOMC paying to international factors? It appears to be quite a lot. We have documented that the financial markets are clamoring for a rate cut. We have seen some of the more popular yield curves invert and the implied LIBOR rate from the Eurodollar futures market, two years deferred, has moved into easing territory.
The chart on the left shows the aforementioned implied LIBOR rate. In Q3 last year, the implied rate was 3.30%; it has fallen to just above 1.60%, a decline of 170 bps. The chart on the right compares the implied rate to the fed funds target. When this implied rate falls below the target, it is a signal to policymakers that monetary policy is too tight. The Bernanke Fed mostly ignored this indicator, unlike his predecessor, and Bernanke had to deal with the deep 2007-09 recession. This indicator is giving clear evidence that the Fed should be cutting rates aggressively.
However, the signals from the domestic economy are not supporting a rate cut. The ISM Manufacturing Index is well above 50; since the Federal Reserve began confirming the policy rate, it is rare to see rate cuts when the index is above 50.
We have indicated when the ISM index falls below the 50-expansion line with vertical lines. The only time we saw significant rate cuts without the ISM index below 50 was in 2007, when financial markets were under clear stress. In May 2007, the Chicago FRB National Financial Conditions Index, an index of financial stress, was reading -0.67.[1] By August, it had risen to -0.13 and turned positive in November.
In this cycle, international pressures seem to be guiding policymakers to act.
This chart shows the fed funds target with the Global Economic Policy Index. This index measures mentions of economic or policy uncertainty in 20 nations; the index is weighted by GDP, adjusted for purchase power parity. A rising reading suggests increases in policy uncertainty. This chart supports Chair Powell’s continued references to overseas issues when calling for easing.
To some extent, there is a worry among market participants that the Fed is simply creating a narrative to allow it to ease, reducing pressure from the White House while maintaining some element of independence. The third chart suggests the Fed does have good reasons for acting to lower rates. With trade wars, the immigration crisis in Europe and the U.S., the potential for conflict in the Middle East and worries about a currency war, the level of global policy uncertainty is historically elevated. This factor, we believe, reflected in the financial markets, is what is prompting the desire to cut rates. We do expect a significant level of dissent among FOMC voters but, in the end, we look for two rate cuts this year, unless global stress levels unexpectedly diminish.
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA
[Posted: 9:30 AM EDT]
Happy Friday! As slow as the news is trickling in today, it’s clear that we’re deep into the dog days of summer. Nevertheless, we have seen a few interesting tidbits, like an initial estimate showing moderate economic growth and falling inflation here in the United States. Overseas, it looks like we’re in for another weekend of mass political protests in Hong Kong. Here’s what we are watching most closely:
U.S. economic performance: In the first of three regular estimates, U.S. gross domestic product (GDP) grew at an annualized rate of 2.1% in the second quarter, beating expectations but still marking a slowdown from the unrevised 3.1% rate in the first quarter (see additional details below). Compared with the same period one year earlier, GDP was up 2.3%. That means growth over the last year was slightly better than the average annual increase of 2.1% over the last two decades. As usual, most of the growth over the last year came from increased personal consumption spending. Finally, in a broad measure of inflation, the second quarter GDP price index rose at a rate of 2.4%, rebounding from its dip to 0.9% in the first quarter, which is still generally moderate. We don’t think these figures will change expectations for the Federal Reserve’s policy meeting next week. If anything, slowing growth coupled with moderate inflation should bolster expectations for a cut in the benchmark fed funds rate.
U.S. fiscal policy: The House of Representatives late yesterday approved the White House Democratic compromise bill to lift the federal government’s debt limit and establish high-level budget parameters through July 2021. If the bill now passes the Senate as expected, it would remove the risk of a debt default or new government shutdown until after the 2020 presidential elections. Separately, the White House announced additional aid to U.S. farmers hurt by the administration’s trade skirmishes. The new program will provide up to $16 billion for crop farmers based on the estimated impact of foreign tariffs across their county.
Hong Kong: Demonstrations against China’s influence in Hong Kong will continue this weekend, with protest leaders targeting the city’s airport in hopes of raising global awareness of their concerns. Separately, activists are also planning a protest against the police department’s lack of action when organized crime gangs known as “triads” attacked and beat dozens of anti-China protestors last weekend. As we’ve mentioned before, it looks like the city government, or perhaps Beijing’s liaison office, may have enlisted the triads to help control the weekslong protests. That’s reminiscent of how government officials in Russia and other rogue nations work hand-in-hand with criminals to achieve their goals (especially in cyberspace). If that’s really happening in Hong Kong, it would seem to reflect a new level of desperation for the government and a new low in its relationship with Hong Kong’s citizens.
North Korea: New imagery analysis from private sector researchers indicates that North Korea has continued to produce long-range missiles and nuclear weapons even as leader Kim Jong-un is negotiating a denuclearization deal with President Trump. In addition, analysts at the Defense Intelligence Agency say the North Koreans have probably produced about a dozen new nuclear bombs since Kim and Trump first met in Singapore last year. Separately, North Korean state media has explicitly tied yesterday’s short-range missile launches to its anger over upcoming U.S.-South Korean military exercises. We suspect President Trump will continue to look past such developments for now, but if North Korean provocations continue, they could eventually force Trump to break off the talks.
Russia: The Russian central bank today cut its benchmark short-term interest rate to 7.25% from 7.50%. Echoing the concerns driving many central banks to loosen policy, policymakers primarily based their decision on reduced inflation pressure and weakening growth prospects.
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA
[Posted: 9:30 AM EDT]
Good morning! The big news today is the ECB. Although the central bank for the Eurozone did not cut rates as hoped, the narrative of the statement was dovish. However, the press conference dampened the bullish enthusiasm. Here is what we are watching:
The ECB: Financial markets were leaning toward a rate cut from the ECB this morning. That didn’t happen, but the narrative of the decision indicated that the bank is examining a number of options beyond a mere rate reduction, which may include long-term forward guidance (no rate hikes for years) and the potential for expanded QE (other assets beyond sovereign debt.) In the press conference, it became clear there is dissention among the members of the ECB on the path forward. ECB President Draghi admitted there wasn’t a unanimous path to new stimulus and this may have delayed the rate cut. Financial markets reacted to the statement in a bullish fashion; interest rates fell, the EUR declined and equities rallied. The press conference, especially the apparent divisions within the ECB, tempered the bullishness. It appears to us that the ECB will likely not just lower rates but also add other measures; however, the second part might not be as aggressive as financial markets had hoped.
Despite the slowdown, Germany remains steadfastly against fiscal stimulus. This somewhat irrational reluctance to lift spending or cut taxes almost requires that Germany take aggregate demand from the rest of the world via exports.
When the EU began negotiations with the U.K. over its exit, the former had one of two paths it could take. The first was to take a soft line to avoid the disruption that the British exit would have on both the EU and U.K. economies. Although the British were at greater risk from leaving, the EU would be harmed as well. The other path was to take a hardline stance based on the superior position the EU had in negotiations. This position had the benefit of sending a signal to other nations that might think about leaving (read: Italy) that divorce from the EU would be very costly. The EU, mostly driven by France, opted for the second option. Since PM May generally was not in favor of a hard Brexit, she eventually accepted what appears to be an unfavorable deal.
The risk of the EU’s position is precisely a Boris Johnson-type figure. Because of the EU’s harsh stance in negotiations, there was always a chance of a nationalist reaction from Britain. Although British voters remain profoundly divided, and if another referendum were held it is quite possible the initial outcome could be reversed, it was naïve on the part of the EU to not expect a nationalist reaction to the perceived humiliation. The EU’s stance is understandable; it feared that if the U.K. got a “good” deal, others might be tempted to follow its path. However, that doesn’t mean the hardline position was without its own costs.
We don’t expect the EU to blink under the threat of a hard Brexit. The costs to Britain will be high and its exit timing is particularly bad. It is still not clear that Johnson can get a no-deal Brexit through Parliament; he may need to risk new elections. A hard Brexit will be very difficult for Ireland, and Scotland may decide it should leave the U.K. and rejoin the EU. Simply put, this could get messy and, sadly, it appears the odds of bad outcomes are rising. And so, Halloween awaits…
United Kingdom-Australia: In a development that will likely encourage the new U.K. government, Australian Prime Minister Scott Morrison said London and Canberra could seal a free-trade deal “within weeks” of Brexit. British and Australian officials have been informally discussing a trade deal for almost two years, but they can’t proceed to formal negotiations until the U.K. is no longer a member of the EU.
North Korea: The South Korean military says North Korea fired two short-range missiles into the Sea of Japan this morning. The missiles, which appeared to be a new type, reached an altitude of some 30 miles and flew some 270 miles and 430 miles, respectively. North Korea is also hinting it may resume nuclear testing. Separately, North Korean Foreign Minister Ri Yong Ho canceled a trip to Thailand in which he had been expected to meet U.S. Secretary of State Mike Pompeo. The missile launch and meeting cancellation were probably meant as a reminder that North Korea could revert to its previous provocative military moves if there isn’t faster progress on the U.S.-North Korea denuclearization talks.
Greenspan approves: Former Fed Chair Greenspan supports a rate cut due to weak overseas economic activity, suggesting this is what he did in 1998. Although there is little doubt of a rate cut next week, the Greenspan approval makes the move a near-certainty.
A side effect from the Japan/South Korea spat: The current dispute between Japan and South Korea, which at its heart is mostly about the issue of reparations and Japan’s colonization of the Korean Peninsula in the years before WWII, is affecting supply chains for tech firms. This is additional evidence that the steady erosion of U.S. hegemony is having an effect on globalization in ways beyond the mere securing of sea lanes.
France: An unusual heat wave is spreading across Europe this week, worsening a years-long drought, cutting crop yields and forcing governments to enact draconian conservation measures. France has been especially hard hit, with a record-high temperature of 105 degrees Fahrenheit expected today. The extreme heat is even generating new risks that the fire-damaged Notre Dame cathedral could collapse. The architect overseeing its repair warned yesterday that the physical forces are becoming more unbalanced as the remaining portions of the wooden roof are still waterlogged from the firefighters’ hoses but the heat is drying out the limestone walls too quickly.
Turkey: As feared when President Erdogan sacked the former central bank governor in early July, the Central Bank of Turkey today slashed its benchmark short-term interest rate to 19.75% from its previous setting of 24.00%. As justification, the new governor and his policy committee said weakening global economic activity has led to “heightened downside risks to inflation.” In reality, however, President Erdogan has been pushing the institution to cut rates even in the midst of continuing high inflation and a weak lira. The lira has strengthened today, but that may simply reflect that investors had already priced in a major cut and now hope for some stability from the central bank.
Brazil: In an unusual effort to spur the economy, President Bolsonaro said his government will allow workers to take up to 500 reais from their individual unemployment accounts, which Brazilian law requires them to keep. Such one-off “gifts” are often ineffective in producing lasting economic benefits, but they could boost confidence and growth in the very short term.
Energy update: Crude oil inventories fell 10.8 mb last week compared to the forecast drop of 3.8 mb.
In the details, refining activity fell 1.3%, well beyond the 0.2% decline forecast. Estimated U.S. oil production fell by 0.7 mbpd to 11.3 mbpd; Hurricane Barry likely affected both production and refinery utilization. Crude oil imports rose 0.2 mbpd, while exports increased by 0.8 mbpd.
(Sources: DOE, CIM)
This is the seasonal pattern chart for commercial crude oil inventories. We are now well within the spring/summer withdrawal season. This week’s decline is consistent with the seasonal pattern in terms of direction but was larger than normal. In fact, the current level is below the usual seasonal trough that occurs in September. We would not be surprised to see a bounce in inventories next week as the effects of Hurricane Barry dissipate.
Based on oil inventories alone, fair value for crude oil is $59.48. Based on the EUR, fair value is $52.31. Using both independent variables, a more complete way of looking at the data, fair value is $54.04. This week’s sharp drop in stockpiles has boosted the fair values for oil alone and for the combined model, while the euro model’s fair value fell slightly. Worries about global growth are putting some bearish pressure on oil prices. Reports that Saudi Arabia and Kuwait have come to an agreement on production from the Neutral Zone, an area claimed by both nations, pushed oil prices lower late yesterday.
In terms of geopolitics, Iran is suggesting it might consider a swap of tankers with the U.K. It is not clear if the U.K. will agree to this because it creates a precedent of “tit-for-tat” that might be destabilizing. The U.S. said yesterday it would escort U.S. ships in the Persian Gulf seen as facing threats from Iran. We note that the U.S. and Europe have competing plans on protecting Gulf shipping; we suspect the U.S. plan will eventually win out. At this point, however, the markets have not built in any significant geopolitical risk. This is something of a surprise since tensions remain elevated and thus oil prices could jump significantly if an event occurs.
The business cycle has a major impact on financial markets; recessions usually accompany bear markets in equities. We have created this report to keep our readers apprised of the potential for recession, which we plan to update on a monthly basis. Although it isn’t the final word on our views about recession, it is part of our process in signaling the potential for a downturn.
Economic data released for June suggests the economy remains strong but is showing some signs of weakness. Currently, our diffusion index shows that 9 out of 11 indicators are in expansion territory, with several indicators approaching warning territory. The index currently sits at +0.757.[1]
The chart above shows the Confluence Diffusion Index. It uses a three-month moving average of 11 leading indicators to track the state of the business cycle. The red line signals when the business cycle is headed toward a contraction, while the blue line signals when the business cycle is headed toward a recovery. On average, the diffusion index provides about four months of lead time for a contraction and two months of lag time for a recovery. Continue reading for a more in-depth understanding of how the indicators are performing.
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA
[Posted: 9:30 AM EDT]
Good morning! Mueller testifies today; we mistakenly expected it yesterday. Although the testimony will be the focus of the media, it probably won’t move the financial markets. Here is what we are watching:
Trade optimism:Equity markets rallied yesterday on news that the U.S. and China will begin face-to-face meetings at the end of the month. We expect a few “good faith” actions. The U.S. will likely grant some export waivers on tech trade with Huawei (002502, CNY 3.23). China will probably buy soybeans from the U.S., although the amounts will likely be modest. The fact that meetings are occurring is positive, but the chances of a comprehensive agreement are small because neither side can get a deal without it looking like they gave in to the other. Thus, we expect negotiations to continue into next year.
Tech action: The government is moving against the tech sector. First, the DOJ is opening a new anti-trust review of the industry. This review will likely be lengthy and may weaken merger activity. Second, the DOJ is reviewing encryption with the idea that the government may demand a “key” to private encryption for national security purposes. If this goes forward, it will tend to shift encryption into the “gray market.” Third, the FTC is forcing the CEO of Facebook (FB, 202.36) to personally certify that his company is protecting consumer privacy; if the firm fails to take appropriate steps, it could make Mark Zuckerberg personally subject to legal action. Perhaps the most significant risk to the tech sector is government regulation. Although the Trump administration has generally leaned toward deregulation, the trend beyond party politics has been to reduce the power of this sector through regulation. The impact of regulation on equity performance is somewhat mixed (the breakup of Standard Oil was positive for shareholders, for example); however, we would expect regulation will attempt to inject some competition into the industry that, at least at first, will probably be taken as negative.
Weaker global growth: The flash PMI data from Europe (see below) was weak and suggests the continent is heading into recession. This data may mean tomorrow’s ECB meeting will lean toward a more dovish tilt. The data tends to confirm what we heard from the IMF yesterday. The international situation is probably playing a key role in the Fed’s move to lower rates, although there are signs of weakness here as well.
China escalation: Beijing is making somewhat veiled threats that it may use military force against protesters if the local government requests such support. China has been consistently indicating that it believes the West is behind the protests, a common trope employed by authoritarian regimes in the face of civil unrest. China also reiterated threats against Taiwan’s independence movement in a national security report, indicating it would use military force against a decision to declare separation. Using the military against Hong Kong would almost certainly trigger a Western response, although we doubt the U.S. or Europe would go to war to maintain Hong Kong’s system.
While all this is happening, the Beijing Auto Group (BMCLF, USD 0.67), a State-Owned Enterprise (SOE), has agreed to make an investment into the German automaker Daimler (DMLRY, 13.43). The investment will represent 5% of the company. The Zhejiang Geely Holding Group (GELYF, 1.55) owns about 10%, meaning that two Chinese companies, one of them an SOE, holds about 15% of this iconic German company. Such investments highlight the problem of deteriorating relations with China; although both Europe and the U.S. acknowledge that China’s rise is problematic geopolitically, the economic ties may make responding to the geopolitical challenge difficult.
Boris as PM: Boris Johnson is nearly finished with the process of taking office. The EU has already signaled that it doesn’t intend to renegotiate the current agreement. Johnson is pushing to at least have the threat of a no-deal Brexit, which the IMF notes is a major risk item for the global economy. With regard to the China discussion above, Johnson said his government would be very pro-China and would keep the U.K. the most open economy in Europe for Chinese investment. In fact, in a break with U.S. policy, Johnson said his government would be “very enthusiastic about the Belt and Road Initiative,” whereby China is providing massive funds for infrastructure development from Asia to Europe in an effort to build its global influence.
Iran: Iranian President Rouhani indicated that Iran is ready to negotiate but only if talks don’t mean “surrender.” We suspect that “surrender” for Iran would mean the U.S. forces Iran to abandon its goal of being the regional hegemon. That is exactly what the U.S. is demanding, or at least the hardliners in the administration, SoS Pompeo and NSD Bolton. On the other hand, Trump might just be willing to negotiate a deal that would look a lot like the JCPOA. The problem is that the goals of the U.S. and Iran are not really compatible. If the U.S. continues to want to constrain Iranian hegemony, which the Gulf States and Israel both support such constraint, it’s hard to see how the issue can be resolved. As a result, we expect the U.S. to simply play for time while continuing to apply sanctions, and Iran to try to break out of its box by further escalation.
European heat wave: France is dealing with extreme heat, with new temperature records being set.
I’m writing to you at the end of a week in which the Dow Jones Industrial Average crossed 27,000 for the first time ever and in which the S&P 500 crossed 3,000 for the first time ever. There’s something about these market averages reaching “all-time highs” that increases fears in the hearts of investors. Now, this isn’t necessarily a bad thing. After all, the formula for successful investing is not just buying low, but selling high. By the way, many investors seem to get those activities confused, particularly when they let their emotions get the best of them and “run with the herd.” Emotional investing inevitably leads to buying high and selling low. So, there’s a sense in which it’s nice to find someone leaning the right way when prices are high.
I’d like to point out, however, that high prices don’t necessarily equate to high valuations. Years ago, I read a piece by Warren Buffett that made this clear to me. On this subject of all-time high prices, he noted that a passbook savings account, where the interest is compounded daily, hits an all-time high price every day! No one would argue that this savings account is over-valued; it is simply growing on plan. Over the long-term, that is exactly what the U.S. stock market does, albeit with more volatility. As the U.S. economy grows over the decades, and the profits of American businesses grow with it, the market prices of U.S. stocks should regularly hit all-time highs. The year-to-year irregularities of profit-growth, combined with the ebbing and flowing of investor sentiment, mean that the all-time highs don’t occur daily, as with your savings account, but we shouldn’t be shocked when they periodically occur.
In the past I’ve referred to Oscar Wilde’s famous saying that, “A cynic is a man who knows the price of everything, and the value of nothing.” Knowing the price is easy: it’s reported every day! Thus, journalists write stories about the S&P 500 crossing 3,000. Everyone with a smartphone knows when it happens. But not nearly as many stories are written about the value of the S&P 500, as to whether at 3,000 it’s over-valued, fairly valued, or under-valued. Your smartphone can’t tell you that. Knowing the value of anything (stocks, bonds, real estate, artwork, etc.) requires diligent study into both the nature of the item to be valued and the market for it. When studying the market for an item, one must study both the prevailing market and the historical market. This is the hard stuff of investing.
So, you may ask, is the S&P 500 overvalued at 3,000? In our opinion, no, it’s fairly priced. As we noted in our January letter, we thought the fourth quarter 2018 sell-off had reduced the market to prices that reflected excess pessimism about the future of profits, and therefore represented a buying opportunity. Thus, it was under-valued. By our April letter, that discount had been erased by a strong first quarter rally, taking the market averages back to where they had been the previous September. We thought then that stocks were fairly valued. Three months later, the S&P 500 is now just 3.5% higher than it was in April. Relative to expected earnings, dividends, the economic climate, and the interest rate environment, we continue to think the market averages are fairly valued. They’re not “dirt-cheap,” but they’re not “over-priced” either. This is where stock market valuations usually dwell, where the short-term upside opportunity and downside risk are in balance. This is why we at Confluence don’t play a short-term game. For short-term investors, the risk and return structure usually offers difficult odds.
We much prefer the long-term game. The only way to enjoy the long-term compounding effect of the U.S. economy, as described above, is to take a long-term perspective of investing; the odds in this game are much better. And you may enjoy the all-time highs.
We appreciate your confidence in us.
Gratefully,
Mark A. Keller, CFA CEO and Chief Investment Officer
Johnson:Boris Johnson gathered 92,153 votes compared to Jeremy Hunt’s 46,656, a nearly 2:1 margin. Clearly, among the Tory faithful, Johnson is their choice. Theresa May will be PM for the next 24 hours, taking questions from the House of Commons tomorrow. Shortly thereafter, she will make her farewell address while Johnson visits the Queen. After that, May will officially tender her resignation and Johnson will take office.
Brexit: No surprise here but Johnson has to deliver a “deal or no deal” by Halloween. The EU might grant Johnson more time but it doesn’t look like it will budge on the agreement that PM May negotiated. A key fact often overlooked is that the EU must have unanimity on a treaty, thus changing what has been negotiated would require another round of EU negotiations that may or may not settle on a new arrangement. The question for history is whether PM May was a bad negotiator or simply didn’t have a strong position to start with. We suspect it was more the latter. We would not be surprised to see snap elections; the current coalition of the Tories and the DUP is facing by-elections that could reduce the ruling coalition to one seat. If there are new elections, a coalition government between the Conservatives and Brexit Party would not be a shock if the Brexit supporters are a majority of voters. If Remain is the trend, the Liberal Democrats might cobble together a loose coalition of Remain MPs in the major parties. A second referendum might also occur. Our expectation is that British politics will remain sloppy. One interesting note is that the government feels the need for a PR campaign in Northern Ireland on the benefits of Brexit.
The economy: The British economy may be in recession The GBP has been weakening. The BOE governor is set to resign and no one seems to want the job. The primary economic support tool in case of a hard Brexit may be a weaker currency. In democracies, leaders get tagged with economic performance even if they have little influence.
Johnson has his work cut out for him. For those hoping for some sort of resolution in the next 12 weeks, that might not occur. Instead, it looks like more turmoil is on tap.
A budget deal:Congressional leaders and the White House have reached an agreement. Spending is set to rise sharply. Defense is budgeted for a $738 bn increase over the next fiscal year, while non-defense spending will be up $632 bn. The fringes of both parties are not happy. On the left, social goals, such as ending the Hyde Amendment or restrictions on defense spending to prevent a border wall, won’t be pursued. On the right, the deficit hawks are fuming. Some members of the House GOP are pushing the president to reject the deal. Although President Trump is capable of reversing position, the usual triggers of criticism in the right-wing media haven’t emerged quite yet. President Trump was never all that interested in austerity. Going into an election year, he should be even less so. We would expect him to agree to the deal and sign the bill.
There are currently 3.6 mm Syrian refugees living in Turkey. The EU sends funds to Ankara as aid for these refugees to keep them in Turkey and away from Europe. Turkey has suddenly started sending some Syrians back into northern Syria. It appears public resistance to the presence of Syrians in Turkey is leading to the crackdown. It is unclear if this action is systemic or simply for show in order to quell public unrest. Nevertheless, if Syrians in Turkey begin to believe they will be susceptible to deportation, we would not be surprised to see the refugees flee toward Europe again, perhaps creating another crisis for the EU.
As tensions between Iran and the U.S. remain elevated, there is growing concern that the “theater” of the conflict might shift to Iraq. The U.S. has 5.2k troops in the country. There are large Shiite militia groups in Iraq, many with some affiliation with Iran. The potential for these militias to begin targeting U.S. citizens in Iraq is high. The U.S. has been taking steps to address this issue. Non-essential embassy personnel have been moved out and several oil companies report they have removed their workers from Iran. However, one response from Iran to U.S. sanctions could be to destabilize Iraq.
U.S.-China trade: The U.S. Congress recently passed defense-policy bills that would block transit agencies from using federal money to buy railcars and buses made by Chinese-controlled companies or companies subsidized by the Chinese government. Interestingly, at least one Democratic lawmaker has tied the proposal not only to the need to protect U.S. industry, but also to the risk that the Chinese could install cameras or other intelligence-gathering devices on the equipment in order to spy on U.S. citizens. That echoes the Trump administration’s purported concerns about Chinese telecom firm Huawei (002502.SZ, 3.22). It also suggests that spying risks may become an all-purpose justification for clamping down on Chinese imports.
Russia-China-Japan-South Korea: South Korea’s defense ministry said Russian military planes violated the country’s airspace over the Sea of Japan this morning, flying over the disputed Dokdo islets claimed by both Japan and South Korea. The flyovers are another example of Russia’s growing aggressiveness in probing South Korea’s defenses and demonstrate that it doesn’t recognize the country’s claim to the islands. Adding complexity to the situation, other reporting suggests that, at one point, Chinese military planes joined the Russian jets in an encroachment on South Korea’s air defense identification zone. Reflecting how risky the moves are, Japan and South Korea both scrambled fighter jets, and South Korea fired hundreds of warning shots to chase off the bombers.
Hong Kong: Pro-Democracy legislators yesterday criticized the Hong Kong police force for failing to stop a gang of thugs who beat and injured dozens of participants in last weekend’s anti-Chinese political demonstrations. The legislators and other observers have suggested the police have enlisted organized crime groups known as the “triads” to intimidate the demonstrators, while obscuring any link with the Hong Kong government. If true, that would seem to sync with similar government-criminal partnerships in other countries over recent decades, such as Russia and Iran. The efforts have been successful in many respects, so we’ll have to see if the embattled government of Hong Kong Chief Executive Carrie Lam will make further use of them.
Germany: In a new sign of economic slowing in Europe’s heartland, a new survey by the Ifo think tank shows employers are responding to weak order books by cutting workers’ hours. The phenomenon is especially widespread among vehicle manufacturers, where 30% of the companies surveyed reported that they had instituted “short-time” work. Overall, 3.8% of manufacturers have cut workers’ hours, and Ifo expects that figure to rise to 8.5% in the coming months.
The Fed: Although the Fed is in its “quiet period” before it meets, Judy Shelton, a candidate for an open governor spot, said today that she would support a 50 bps rate cut. We suspect Shelton will face strong opposition to nomination.
In mid-August 2016, I published a two-part series titled “Thinking about Thinking” (see Part I and II). Occasionally, I will be asked which WGR is my favorite or most important. I generally refer readers to the aforementioned reports.
One facet of that report is the three statements of knowledge—a priori analytic statements, a posteriori synthetic statements and a priori synthetic statements. The first are logic statements, where the subject is contained in the predicate. These statements are always true but generally trivial, essentially tautologies. To say “all unmarried men are bachelors” is true if one defines all bachelors as unmarried men. The second type of statements are inductive in nature. We observe the world and draw generalized conclusions about it. Such statements are always conditional. The concept of such statements was well described by Nicholas Taleb in The Black Swan.[1] Ornithologists in Europe suggested that black swans didn’t exist because no one had ever seen one. Then, someone from Europe traveled to Australia and, lo and behold, black swans exist. A posteriori statements are true only until contrary evidence is found. Since science is built on induction, the notion of “settled science” is faulty; what we know from science is true based only on what we know now. But, if contrary evidence emerges, concepts based on induction must adjust.
The real battleground in philosophy are a priorisynthetic statements. These are essentially “self-evident truths” that we believe to be true in all cases and are not derived from experience. The skeptical Scottish philosopher David Hume argued that a priori synthetic statements were not possible. Instead, he suggested that such statements were based on experience and thus a posteriori. Emmanuel Kant tried to rescue a priori synthetic statements by suggesting that humans were born with the ability to impose patterns of thinking on the world. In other words, we don’t actually perceive the world directly but we do so through the filter of one’s mind. This filter essentially impresses our views on reality and allows us to make a priori synthetic statements.
Although Kant’s attempt to “save” a priori synthetic statements has generally thought to have failed, there is an insight from Kant’s thought that is useful. Essentially, people tend to think in paradigms. In other words, we adopt a certain worldview or narrative for how things work and then impose them on reality. The problem is, of course, that our worldview or paradigm may not be true. In fact, almost by design, paradigms of reality are mere models and thus will be incomplete. At the same time, the paradigms we adopt shape how we interpret the world. Thus, it makes sense that we understand the models that we adopt to be aware of their strengths and weaknesses.
In this report, we will examine supply and demand as a model of markets and suggest that at the macro level a different model, the “Economic Triangle,” might offer better insights into how the political economy actually operates. We will discuss how the Economic Triangle explains the way various economic participants operate and how political factors affect the triangle. Next week, we will show how the Economic Triangle fits into the major economic systems, offer two contemporary examples, and conclude with market ramifications.
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA
[Posted: 9:30 AM EDT]
Happy Monday! It’s going to be a busy week. The media will be mostly distracted with Mueller’s testimony. Boris Johnson is set to become PM on Tuesday. The ECB meets on Thursday with an outside chance of a rate cut. China’s version of the NASDAQ opened with a bang. And, GDP comes on Friday. Here is what we are watching today:
Iran tensions: Last week, Iranian forces seized a British petroleum tanker; oil prices are higher this morning on fears of escalation. The U.K., distracted with the PM change, is mostly marking time before deciding how to respond. So far, the British are avoiding a military response. It appears that a Royal Navy vessel tried to prevent Iran from seizing the tanker, but Iran was undeterred, a signal that Iran isn’t all that worried about escalation. There was one interesting development—former Iranian president Mahmoud Ahmadinejad is arguing that Iran should negotiate with Trump. He believes that Trump is breaking with America’s foreign policy tradition and might be willing to make a comprehensive deal. Ahmadinejad is a controversial figure, to say the least. He has a strain of anti-clericalism in his background and is beloved by the poor in Iran. His comments suggest Iran may be more divided on the path forward than comments from government leaders may indicate.
China news: There is much to report. Here are some items we are following:
For the seventh straight weekend, sections of Hong Kong were brought to a standstill by large demonstrations against the growing Chinese influence in the city. The demonstrations were reportedly the most chaotic yet, with police firing barrages of tear gas against the protestors. In fact, some protestors went so far as to deface a Chinese central government office, spraying black paint over the official emblem on the building. In an apparent effort to generate backlash against the protestors, Beijing has allowed images of that attack to spread on social media. All the same, it’s not entirely clear whether there is a big risk of a violent crackdown by Beijing. Reports last week said the central government’s evolving plan for the crisis excludes the use of military force, and the local authorities may have been encouraged by a pro-government demonstration of some 300,000 on Saturday. Another interesting development is that police inaction against protests in some areas has led to speculation that some officers have been in collusion with the demonstrators, although it could simply be that the police are being spread thin by the continuing, widespread unrest. We note that Chinese leaders will be meeting soon in Beidaihe for their summer retreat. We suspect Xi will get an earful from former leaders on how to handle Hong Kong.
The governments of China and Cambodia signed a secret agreement in April giving the Chinese military exclusive rights to use part of a Cambodian naval base on the Gulf of Thailand, not far from a large airport being constructed by a Chinese company. Access to the naval base and airport would greatly enhance China’s ability to project power, enforce territorial claims, and protect economic interests in the region around the South China Sea. Just as concerning, it appears to indicate a decision by the Cambodian government to place its bets on China as a preferred military and economic partner, reflecting the perils of U.S. disengagement in the area. The move also follows China’s establishment of a military base in East Africa in 2017, and the building of heavily fortified, artificial islands in the South China Sea since 2014. The Chinese military initiatives, coupled with the ongoing U.S.-China standoff over trade policy, continue to infuse an element of geopolitical risk into the markets. China and Vietnam are dealing with a standoff in the South China Sea.
In an interesting reversal, Philippine President Duterte is demanding that the U.S. honor its mutual defense treaty after Chinese ships rammed a Filipino fishing boat. Duterte has flirted with improving relations with China and shunned the U.S. in recent years, but after finding that relations with China can be difficult he suddenly wants to invoke old friendships. Although U.S. policymakers may be inclined to let Duterte suffer, this is actually a good opportunity for the U.S. to improve relations with the Philippines and close off the first island chain.
As further evidence that countries are emulating the United States’ weaponization of trade tariffs, China announced it will impose anti-dumping tariffs on stainless steel imports from the European Union, Japan, South Korea, and Indonesia. According to the Ministry of Commerce, those countries are selling stainless steel billets and hot-rolled stainless steel plates in China at prices below their cost of production.
China’s foreign investment is making its way into areas critical to Russia’s geopolitical interests. Belarus is getting support from Chinese investment. For now, it’s all smiles between Putin and Xi, but tensions will almost certainly rise if China’s influence spreads to Russia’s near abroad. China and Russia are natural enemies; China has been expanding its investment into the “stans” for some time and moving onto the European plain would eventually become a serious threat.
Brexit news: Boris Johnson is likely to be the new PM tomorrow. He is already facing a cabinet crisis. The current Chancellor of the Exchequer, Phil Hammond, and the Justice minister, David Gauke, announced they will resign if Johnson wins because they cannot support a hard Brexit. Being politics, there is always someone willing to step in but what makes this disruption troubling is that, without an extension, the U.K. will leave on Halloween. The time taken to build a cabinet is lost to either preparing to make a new deal or preparing for exit.
Pakistan’s in town:Pakistan’s president, Imran Khan, is in Washington today. We would not expect much beyond a photoshoot. The U.S. and Pakistan do have mutual needs. The war in Afghanistan needs Pakistan’s support and the Pakistanis need U.S. economic help. But, Pakistan’s primary worry is India and it wants a government in Afghanistan that it can trust to give it strategic depth. The Taliban is seen as Pakistan’s best partner, so cooperation from Islamabad is going to be limited.
Ukraine: In the Ukrainian elections we previewed last week, pro-Western President Volodymyr Zelenskiy’s Servant of the People Party has apparently won an outright majority in parliament. That could help give Zelenskiy the political capital needed to pursue a peace deal with Russia and the Russian-backed separatists who control parts of the country’s east. In addition, it should help Zelenskiy with a number of initiatives important to the economy, such as combatting corruption, strengthening the rule of law, and easing the sale of agricultural land.
Italy: The leaders of the ruling coalition, Deputy PMs Matteo Salvini and Luigi Di Maio, are expected to meet tomorrow to calm a row over the former’s acceptance of Russian political funding. Italy is the only Western nation ruled by a “Nader coalition” of both left- and right-wing populists. We have been watching to see how this government works since being in office. The verdict so far is not so good, which may suggest that a Nader coalition doesn’t work in practice…or it may simply reflect the chaotic nature of Italian politics.
Bullard as Chair? We were a bit surprised when St. Louis FRB President Bullard turned down a chance to become a Fed governor. Instead, his director of research became the candidate for the job. Perhaps Bullard turned down the job because he has higher ambitions; there are reports Bullard would “love” to become Fed Chair. Bullard is a committed dove and would likely fit into what President Trump wants but he isn’t a “Trump guy” that would be more loyal to the president than to the Fed. Still, for the president’s goals of easy monetary policy, Bullard would be a good pick…if the job were open.
Goodbye to float? Float is the money that is made when a transaction is between destinations. Big banks have been working on a system of real-time payments; so has the Fed. The big banks don’t want the competition, and small banks are terrified that the big banks will dominate them if they control payments. Although the focus has been on whether the real-time payment system will be in private or semi-public hands, what we find most interesting is that the era of “free money” for banks may be coming to an end.
[1] Direct investment is the purchase or building of physical assets in a nation. Buying financial assets is considered portfolio investment. Direct investment is considered a strong signal of confidence by foreign investors because the foreign entity is subjecting itself to the host nation’s legal system and the investment is always at risk of expropriation.
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