Daily Comment (July 19, 2019)
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA
[Posted: 9:30 AM EDT]
Happy Friday! Fifty years ago today, Apollo 11 orbited the dark side of the moon as a precursor to the landing. In market news, it is still all about monetary policy. Tensions with Iran are rising. Here is what we are watching today:
It’s all about monetary policy: We had three central banks cut rates in the wee hours of the U.S. morning yesterday. Then, around midday, NY FRB President Williams delivered what appeared to be a blockbuster, hinting that when policy rates are low, measured cuts are less effective and faster measures are needed. This news caught financial markets by surprise and rapidly lifted the sentiment toward a 50 bps cut at the end of July. Equities reversed course and rallied strongly on the speech. In a rare occurrence, the NY FRB tried to “clarify” the boss’s comment (suggesting à la Greenspan of “if I seem unduly clear to you, you must have misunderstood what I said…”), and indicated that Williams didn’t really signal a larger than expected rate cut. Other known doves didn’t support the bigger cut but Williams’s comments are important. First, he is the president of the NY FRB, the only regional bank that is a permanent voting member of the FOMC. All the other regional banks vote in a rotation, every three years. Second, he is considered a policy wonk and can back up the statements he makes with monetary theory, unlike others without similar training. Simply put, he may be able to sway others on the committee to his position on the strength of his argument. It is possible that we could see dissents on both sides; some preferring no cuts (KC FRB President George) and others, such as Williams, calling for bigger reductions. What we found interesting, though, was the market reaction. Clearly, the behavior yesterday shows that equity markets are almost solely focused on rate reductions.
Tensions with Iran: President Trump indicated that the U.S. downed a suspected Iranian drone. Wall Street Journal reporters aboard the U.S.S. Boxer in the Persian Gulf say the drone was actually downed electronically by a new system that detects the aircraft and then jams its communications link with its remote pilots. The revelation of this new weapon is newsworthy in itself, but it’s especially notable that the system is nonlethal, meaning it could provide defensive capability without necessarily spurring a response from the adversary. The engagement with the U.S.S. Boxer, one of six other U.S. warships in the area, included an Iranian military helicopter buzzing the U.S. vessel. Iran disputes the American claim of downing the drone. Although this news lifted oil prices on fears of geopolitical risks to supply, Iran did offer an “olive branch” of sorts, saying it would agree to intrusive inspections if the U.S. lifted sanctions. The U.S. didn’t move to take Iran up on the offer as it isn’t clear whether Iran is proposing anything beyond what has already been agreed upon. But, it does make clear that the sanctions are biting. Treasury Secretary Mnuchin told our European allies that they must either abide by U.S. sanctions on Iran or leave the dollar system. We note the Trump administration announced new sanctions yesterday against several more Iranian companies and individuals for helping the country procure materials for its nuclear program.
In other news concerning the Middle East, the U.S. has sent additional troops to Saudi Arabia. Meanwhile, allies in the region and elsewhere are trying to cope with U.S. policy against Iran. Persian Gulf states are struggling to build a solid front to confront Iran based on U.S. direction. In some respects, they like the tougher attitude that the Trump administration is taking toward Iran compared to the Obama government, but they are becoming concerned about the potential for war. Meanwhile, allies have shown reluctance to participate in protecting Persian Gulf shipping from Iranian threats. This position may be a mistake; although previous U.S. administrations would simply shoulder the burden to protect oil flows, the Trump administration, supported by shale oil production, may be less generous and simply allow oil flows to decline. That isn’t necessarily how it will go (the president does clearly pay attention to oil prices and abandoning oil tankers to the tender mercies of Iran will likely lift oil prices into an election year), but the threat is probably higher than the Europeans realize. In the Yemen conflict, Gulf State allies are quietly exiting the fight, leaving the Saudis increasingly responsible for continuing the conflict. This war is turning into something of an albatross for the crown prince; Saudi Arabia is asking for greater U.S. involvement, which we doubt will be forthcoming.
Finally, the IEA has revised its 2019 oil demand growth forecast to 1.1 mbpd, down from 1.2 mbpd in June and much lower than the 1.5 mbpd earlier this year. Fears of weakening demand have pressured oil prices lower this week.
Brexit: Boris Johnson, poised to become the next British PM next week, was dealt a blow before even taking office as Parliament voted to prevent him from pursuing a no-deal Brexit by closing the legislature. The vote highlights the problem Johnson (or, for that matter, Theresa May) faces, which is a divided party; nearly 40 Tories voted for the measure. There are hints from the new EU Commission president that she might be open to an extension, which would drive the Brexit supporters crazy; however, if Johnson can’t deliver a program (and it is hard to see how he can, given the current structure of Parliament) then an extension may occur. On the other hand, he might be better off taking his chances on snap elections. On a related note, with Mark Carney set to exit the leadership of the BOE, the bank is struggling to find anyone to take the job due to the uncertainties surrounding Brexit.
Ukraine: In recent weeks, we’ve noted several reports suggesting the new president of Ukraine, Volodymyr Zelenskiy, may be making progress in his effort to resolve the war between his government and Russian-backed separatists in the country’s eastern region. As we’ve noted, Zelenskiy and Russian President Putin have talked by phone about enhanced multilateral talks on a peace accord, and the two governments are discussing the possible release of Ukrainian soldiers seized by Russia last year. Now, the Ukrainian military and the separatists have also implemented a deal in which each side pulled back one kilometer from their previous fighting positions in certain segments of the front line, although distrust remains and the fighting hasn’t stopped completely. Perhaps just as important, Zelenskiy has taken a sympathetic approach toward Ukrainian citizens in the separatist-held territories, whom the previous president had treated as collaborationists. Zelenskiy’s well-received moves have made his Servant of the People Party the frontrunner in this weekend’s snap parliamentary elections. Given President Putin’s commitment to Russia’s traditional defense strategy, which emphasizes holding or controlling buffer territories to protect the Russian homeland, we see no chance that he would reverse Russia’s 2014 annexation of the Crimean peninsula or grant Ukraine full autonomy. However, if Servant of the People wins big, as expected, Zelenskiy may have the political capital needed to make additional peace concessions to Russia, which could eventually convince Putin to rein in the separatists and allow for a Russia-dominated modus vivendi between the countries.
Tech observations: First, finance ministers from the G-7 countries reached a preliminary, high-level agreement on how to tax multinational firms. The first principle they agreed on was that all multinational companies should be subject to a minimum level of global tax, similar to a measure in the U.S. tax reform of 2017. To ensure that big, digital services firms can’t escape taxation, the second principle was that countries should be able to tax firms based on both their digital and physical presence in the country. More specific rules are due to be hammered out by January.
The Europeans are beginning to realize that fining the large tech firms doesn’t really change their behavior. Regulators are starting to explore actions that change the business model of these firms.
Second, cyberattacks appear to be increasing. In a report on its “AccountGuard” service, which helps political campaigns and other policy-oriented organizations detect cyberattacks, Microsoft (MSFT, 135.42) said it has detected almost 800 attacks by nation-state hackers against enrollees in the program just over the last year. Most of the attacks originated from Russia, Iran, and North Korea, although China was also active. The attacks are being seen as potentially laying the groundwork for further attacks to influence the U.S. elections in 2020.
NSO Group, a privately held Israeli company, has developed software that can unknowingly gather user information across servers and the digital cloud. This software would allow a body (government, terrorist group, etc.) to gather a significant amount of information on a person. Another threat? Audio deepfakes are coming, which is software that records a person’s voice and can create inflammatory statements from that audio. One can easily imagine how this could affect a political campaign but it could also be used for someone trying to drive a stock price lower.
A budget deal? It appears negotiators are very close to a budget deal. Spending has been agreed upon but how it will be funded remains unresolved. Speaker Pelosi (D-CA) has set today as the deadline for an agreement.