Daily Comment (January 30, 2018)
by Bill O’Grady and Thomas Wash
[Posted: 9:30 AM EST] It’s another red day. Treasury prices have turned lower, equity futures are falling for the second straight day and oil is also lower. Gold and foreign currencies are higher. Here is what we are watching:
A medical shakeup: Amazon (AMZN, 1417.68), Berkshire Hathaway (BRK, 323,500) and JPMorgan (JPM, 116.20) announced they are forming a company designed to explore lowering health care costs by starting with their own employees. Warren Buffett, the legendary investor, was quoted as saying, “The ballooning costs of health care act as a hungry tapeworm on the American economy,” a rather graphic description. The three companies employ over one million workers (although not all are in the U.S.) and they have indicated the new venture will not have a profit incentive. The inclusion of Amazon is very interesting. As NYU Professor Scott Galloway noted in his recent book, The Four, Amazon has capital costs of zero due to its loyal investing base. If the company moves into the high capital cost sector of health care, it will have a significant impact. Health care stocks tumbled on the news.
SOTU: The major media is consumed with anticipation of tonight’s State of the Union address. As we noted yesterday, we expect a teleprompter speech with the usual “common man in the crowd” asides. We doubt we will hear too much on new programs; tax cuts were the major policy goal of the GOP and anything beyond that is too internally divisive for the party to support. Thus, we don’t expect anything market-moving from the speech.
However, that doesn’t mean there won’t be anything interesting. In modern times, the opposition party offers a response to the SOTU. To highlight the divisions within the Democrat Party, there will be five responses. Rep. Joe Kennedy (D-MA) will deliver the “formal” response. There will be a Spanish-language response by Elizabeth Guzman, a state legislator who recently won a seat in the Virginia state legislature. Sen. Sanders (I-VT) will offer a direct retort to the SOTU (most of these speeches are made before the president talks and thus are not really “responses” to the SOTU). Maxine Waters (D-CA) and former Maryland Congresswoman Donna Edwards will also give responses. Perhaps nothing highlights the internal divisions within the Democrat Party more than the fact that the party can’t coalesce around one person to offer an official response to the president’s address.
So far, none of the political divisions have had much effect on financial markets. There have been long periods of gridlock in Congress, which have reduced the chances of significant policy changes and, for the most part, policy has mostly favored capital over labor. Anti-trust regulation has mostly been benign and taxes are steadily being cut. We don’t see that changing anytime soon. At the same time, there are problems facing the country, such as entitlements, the lack of educational effectiveness, spiraling health care costs, inequality, etc., that require a measured political response and those issues are not being addressed. A NYT op-ed asks if a third party may emerge from this morass. It’s worth a read.
Brexit trouble: A leaked government report suggests that Brexit will make the U.K. economically worse off, regardless of the structure of the exit. There is growing pressure for PM May to leave; however, given the state of Brexit negotiations, no strong candidate has emerged to take the position. Simply put, she is probably still in power because no one else has any better ideas of how to structure Britain’s exit from the EU. Given all this uncertainty, the GBP has been appreciating recently against the USD. This is because the former had become deeply undervalued after the Brexit vote sell-off and it remains well below fair value as calculated by relative inflation rates (our fair value is around $1.64). Still, it will be hard for the GBP to achieve fair value given the lack of clarity on Britain’s exit.
The Czech vote: Czech Republic voters reelected Milos Zeman last week to the presidency. An anti-EU, anti-NATO, pro-Russia and pro-China politician, Zeman won by a narrow margin, only 175k votes. He represents a growing trend of populism that is dominating central Europe and could easily include Italy after the March elections. The financial markets are mostly ignoring these political risks because, thus far, they haven’t affected trade or foreign investment. In other words, right-wing populism has mostly been co-opted by business interests. As long as that remains true, populism should not adversely impact financial markets.
Cape Town concerns: Our firm, Confluence Investment Management, resides in Webster Groves, MO, a leafy older suburb of St. Louis, a city that sits on the “confluence” of three major rivers—the Mississippi, the Missouri and the Illinois. Although it’s an older city that has suffered some of the problems of the “rust belt,” it is blessed with one very critical resource—lots of fresh water. Thus, from our perspective, the travails of Cape Town, South Africa are jarring. This major city is running out of fresh water. The area has suffered through three consecutive years of drought; conditions are so dry that they usually only occur every three centuries. Authorities in Cape Town are limiting citizens to about 13 gallons of water per person (an 8-minute shower consumes about 15.8 gallons). Of course, in the face of restrictions, households have been hoarding water before they take effect. Lack of water is causing rising security issues in the city and may pressure the national government to funnel resources to Cape Town, which will strain government finances.
Catalan crisis II: After another standoff with the Spanish government, Catalonia has decided to indefinitely postpone the election of a new regional president after the Spanish High Court ruled that Carles Puigdemont, the sole presidential candidate, is ineligible to participate. In October, Puigdemont fled to Belgium to evade charges of sedition and misuse of public funds after his party staged an illegal election and declared independence. After his departure, Catalonia was forced to form a new regional government at the behest of the Spanish government, which now rules Catalonia directly. Despite having the support of the majority of seat-holders in the Catalan parliament, Puigdemont is restricted by parliamentary regulations which state that the president needs to be present in order to formally accept the role; Puigdemont could be arrested if he tries to fulfill this obligation. The speaker of the house, Roger Torrent, has reassured the public that he does not plan on nominating another candidate for the position and the new election will eventually take place.
The Catalan parliament’s reluctance to hold elections may be partially due to desires to regain autonomous rule from the Spanish government. Electing Puigdemont would be a hard sell as it not only violates Catalan parliamentary regulations but would likely lack legitimacy. It has been rumored that Puidgemont, if elected, would seek to rule Catalonia while remaining in Belgium. As a result, we expect the formation of a regional government to be stretched out as long as possible while the Spanish government tries to do everything in its power to undermine the separatists. This will not likely have an effect on the euro in the short run, but it will lead to more uncertainty in Spain if problems persist.
 Galloway, S. (2017). The Four: The Hidden DNA of Amazon, Apple, Facebook and Google. New York, NY: Penguin Random House.
 They have since stated the declaration of independence was not a formal declaration but a symbolic declaration.