Daily Comment (January 18, 2019)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy Friday!  Equities are moving higher this morning.  Here is what we are watching today:

About those tariffs: Yesterday, equity prices were jolted higher on reports that the Trump administration was considering rolling back tariffs on China.

(Source: Barchart)

This chart shows March S&P futures; note the jump around 1:30, where the index rose 25 full points.  The report came from the WSJ[1] and indicated that Treasury Secretary Mnuchin is spearheading a negotiating tactic to remove some or all of the Chinese tariffs to show good faith to Beijing and use this action to make a longer term deal.  Needless to say, the Lighthizer/ Navarro wing of the party will reject this tactic out of hand.  Instead, this report suggests that this story was a Mnuchin-led leak to show the president how positive equities would react to a significant reduction in trade tensions with China.  If our take is correct, the real audience for the report was President Trump.  The report was denied soon after and equities fell about as fast as they rose, which bolsters the case that the equity markets would look quite favorably on an easing of the trade front.  At the same time, equities have been drifting higher, most likely on hopes of a trade thaw.

As we noted yesterday, there is a strong incentive on both sides for a short-term cessation of trade hostilities.  China and the U.S. are dealing with slowing economic growth and President Trump is dealing with the run-up to elections in 2020.  At the same time, the long-term outlook for relations between China and the U.S. is becoming a serious risk factor.  Therefore, any short-term peace must be viewed in the context of problematic long-term relations.

Brexit and the EU: There really isn’t much more to say on this topic from the U.K. perspective.  PM May and opposition leader Corbyn are at an impasse as the latter wants May to guarantee there won’t be a sudden exit on March 29, which she has no interesting in doing because it would remove most of her bargaining leverage.[2]  Thus, British politics is in deadlock with no clear way forward.

Meanwhile, the EU is discovering Wilde’s observation.[3]  The EU did not want to make the U.K. exit easy.  Its leaders feared that a smooth exit would encourage others to leave the EU as well.  The EU especially didn’t want to give the impression that a departing country could deal with the EU on an “a la carte” basis, picking the parts it wants and rejecting the rest.  In the case of Britain, the EU has made it clear that the only way to have access to the free trade area is to accept the free movement of peoples within the EU.  Given that goal, the EU plan has worked splendidly.  The U.K. is in political chaos and the potential for a hard Brexit, which is only wanted by a minority, is rising.

However, the EU is discovering there are costs to it as well.  The economic disruption from a hard break will hurt the U.K. significantly as 40% of its trade is with the EU, but that also means it will be disruptive to the EU.  In addition, a U.K. out of the EU changes the balance of power within the union; France has been moving quickly to fill the void created by London’s exit.  France has always viewed the EU as a force multiplier for its policy goals but the rise of Germany and the U.K.’s inclusion, along with the massive increase in the union with the addition of Eastern European nations, has diluted France’s impact.  In addition, the U.K. is important to continental security as most of Europe has weak militaries.  A U.K. separate from the EU makes Europe less safe.[4]  Unfortunately for the EU, there really isn’t anyone to negotiate with in the U.K.  PM May was politically damaged by the historic loss of her Brexit plan; if anyone else wanted to be PM, they surely should be able to win after that drubbing.  However, Parliament also showed that Corbyn isn’t a popular replacement.  Now, if the EU wants to avoid a U.K. exit, it isn’t clear who they would tell.

Financial markets are mostly convinced that both sides will agree to extend the March 29 deadline.  For now, we agree that such an extension makes sense.  However, it is important to note that EU Parliamentary elections will be held in May.  It would be rather awkward for the U.K. to participate given that it wants to leave but, if the deadline is extended, it may be hard to prevent British voters from casting ballots for representatives who, at some point, will no longer be in the EU.  In addition, the EU is facing its own demons.  The European Parliament has backed a plan to make EU fund access conditional to nations that “back the rule of law.”[5]  That is a direct swipe against Hungary but also other Eastern European nations, such as Poland.  The EU is finding it difficult to integrate both Western and Eastern Europe; funding support is one lever the West can use against the East.

Goodfriend out?  In November 2017, President Trump nominated Professor Marvin Goodfriend to the Federal Reserve Board of Governors.  The choice always seemed odd to us.  President Trump has made it abundantly clear he wants a dovish FOMC and Goodfriend is a hawk.  Goodfriend’s positions were always controversial, but one policy he supported was a codified 2% inflation target; since there is no codified unemployment rate, a congressional mandate for 2% (or less) inflation would turn the Fed into the Bundesbank or its successor, the ECB.  Again, one can make a perfectly reasonable argument for ending the dual mandate because it can put the Fed into a position where meeting one target necessarily requires violating the other.  But, if one wants a perpetually dovish Fed, a codified 2% inflation mandate isn’t the way to accomplish this goal.  So, we have been expecting the president to nominate someone else.[6]

One factor in the choice of filling open governor seats has been the evolution of the Trump presidency.  All presidents tend to lean on experienced advisors early in their terms.  Thus, the first cabinets and advisor groups tend to be “all-stars” from the major political parties.  However, these all-stars also have their own policy agendas and use their White House positions to achieve these agendas.[7]  Over time, presidents realize the goals of the all-stars can differ from those of the president.  For example, President Obama’s foreign policy was spearheaded by Hillary Clinton in his first term; in his second term, Ben Rhodes was the leader.  The Fed governor selections, thus far, appear to be centrists out of central casting, likely recommended by Treasury Secretary Mnuchin.  Trump has two remaining vacancies; we expect the president to take control of these open positions and pick two doves.  Although we have seen no indications, we would offer Minneapolis FRB President Kashkari and St. Louis FRB President Bullard as dovish candidates who would likely make it through the nomination process.  Two doves would seriously undermine Chair Powell’s attempts to raise rates as two governor dissentions would make the chair look weak and likely lead to his resignation.

Oil talk: The potential for additional sanctions on Venezuela is leading some Gulf Coast refiners to scramble for heavy crude.  Crude oil comes in grades based mostly on viscosity (heavy/light) and sulfur content (sour/sweet).  Gulf Coast refineries invested heavily in equipment that would allow them to efficiently process heavy/sour crude oil, which is usually cheaper than light/sweet.  However, fracked oil tends to be light/sweet, so the bulk of the new U.S. output isn’t ideal for these refiners.  The two primary sources for heavy/sour have been Mexico and Venezuela.  The former has seen production steadily decline, while the latter is not only facing falling output but sanctions could further reduce supplies.[8]  This has led several oil companies to quietly inform the White House that further sanctions on Venezuela may be counterproductive.  Meanwhile, the State Department is clarifying its positon on Iranian sanctions waivers.  It looks like five nations will get further waivers, three will be cut off and Iranian oil exports will be capped at 1.1 mbpd.[9]  If true, that would reduce the odds of a major supply disruption.

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[1] https://www.wsj.com/articles/u-s-weighs-lifting-china-tariffs-to-hasten-trade-deal-calm-markets-11547754006

[2] https://www.ft.com/content/c0138c7c-1a4b-11e9-9e64-d150b3105d21?emailId=5c41582afd5a4e000407e783&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[3] “When the gods wish to punish us, they answer our prayers.”

[4] https://www.nytimes.com/2019/01/17/world/europe/brexit-eu-brussels.html?emc=edit_mbe_20190118&nl=morning-briefing-europe&nlid=567726720190118&te=1

[5] https://www.politico.eu/article/budget-hungary-poland-rule-of-law-european-parliament-backs-plan-to-link-eu-funds/?utm_source=POLITICO.EU&utm_campaign=6fcd43d665-EMAIL_CAMPAIGN_2019_01_18_05_37&utm_medium=email&utm_term=0_10959edeb5-6fcd43d665-190334489

[6] https://www.cnbc.com/2019/01/17/goodfriends-nomination-to-the-fed-appears-in-doubt.html

[7] We note reports that SOS Pompeo is being wooed for the open seat in the Kansas Senate.  Pompeo’s neoconservative (Wilsonian) views on foreign policy are clearly in opposition to President Trump’s Jacksonian policy stance.  The Senate seat would give Pompeo a graceful exit now and prevent a fight in the future.  https://www.washingtonpost.com/powerpost/mcconnell-courting-pompeo-to-run-for-open-senate-seat-in-kansas/2019/01/17/aa29f4aa-1aaf-11e9-9ebf-c5fed1b7a081_story.html?utm_term=.a0bc3c5762a7&wpisrc=nl_todayworld&wpmm=1

[8] https://www.reuters.com/article/us-usa-refineries-venezuela/u-s-refiners-scramble-as-white-house-eyes-venezuela-sanctions-idUSKCN1PB2ZX?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosmarkets&stream=business

[9] https://af.reuters.com/article/energyOilNews/idAFL3N1ZI1ID