Daily Comment (July 3, 2018)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] From all of us at Confluence Investment Management, have a safe and happy Independence Day!

The “dog days” of summer officially begin today.[1]  It looks like a risk-on day so far.  U.S. financial markets close early for the mid-week Independence Day holiday.  Equity markets close at 1:00 EDT and bond markets close one hour later.

A German deal: Chancellor Merkel and Interior Minister Seehofer reached a deal[2] on immigration yesterday, preventing a potential government collapse.  Germany will create transit centers on the German/Austrian frontier to collect asylum seekers from across the EU.  The plan is to give Germany the right to send those immigrants back to the nation where they first arrived.   Seehofer wanted to see asylum seekers immediately turned away from the border.  Merkel refused to endorse that plan, fearing it would end the Schengen rules which have created passport-free travel within the EU.  An end to Schengen would certainly undermine EU unity, which is already under stress.

Although this compromise was seen as a loss for Seehofer, Merkel has clearly backed away from her 2015 position of nearly open borders for refugees.  And, the reaction of other EU nations toward the German plan appears hostile.[3]  Austria announced it is considering measures to protect its southern border from immigrants.  Austria is arguing that Germany is taking “national measures” instead of EU measures to deal with asylum seekers.  If this policy becomes the norm, it would represent a major retreat from EU rules of free movement.

Perhaps the most important takeaway from this row is that the mainstream parties are being steadily pulled toward populism.  This event is just another example of the retreat from globalization.  Obviously, this is not just a European issue but is roiling the U.S. political landscape as well.  One comment we hear often is that politicians will back away from populist policies when they adversely affect equity markets.  To some extent, Wilbur Ross indicated that the administration isn’t moving policy based on equity market performance.[4]

CNY jawboning: Chinese authorities eased concerns that the PBOC is using a weaker CNY to offset the impact of tariffs against Chinese goods.[5]  PBOC Governor Yi Gang tried to calm markets by suggesting the dollar’s recent strength against the CNY is due to “pro-cyclical behavior.”  There were reports that state banks were buying CNY, a form of quasi-public currency intervention.  Without tightening monetary policy, such moves will have a limited impact on stemming CNY weakness.  The rally in the CNY has lifted global equity markets.

NATO warning: The White House has sent a stern warning to NATO members indicating that they need to boost their defense spending.[6]  The problem of NATO “freeriding” on the U.S. security guarantees has been a constant complaint by American presidents.  However, the concern was somewhat half-hearted; the success of NATO was based on resolving the “German problem.”  Due to the lack of natural geographic defenses (no mountains or impassable rivers), Germany was vulnerable to invasions from east and west since its unification in 1870.  The inability of Europe to resolve German insecurity was the primary cause of two world wars.  The U.S. solved the problem by essentially taking over Germany’s defense.  Not only did this resolve German militarism, but it forced Germany to follow U.S. foreign policy.  This was true of most of the rest of Europe as well (France did try to hew its own foreign policy, with some success).  If Germany rearms, it will almost certainly, at some point, want to manage its own foreign policy.  History suggests the outcome won’t be favorable.  It is not unreasonable for the U.S. to prompt NATO to pay more for its defense but the U.S. must be ready for Europe to break away from America’s orbit in terms of foreign policy.

Oil prices: Oil prices continue to move higher this morning on growing skepticism that Saudi Arabia and Russia have enough spare capacity to offset production shortfalls in Venezuela and Libya and the impact of sanctions on Iran.  In addition, U.S. production is hitting pipeline bottlenecks, a legacy problem based on an American oil supply system that was built for importing oil as opposed to supplying oil domestically.  President Trump is clearly aware of the potential negative effects of higher gasoline prices; we would not be shocked to see an SPR withdrawal announcement to try to cap recent price increases.

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[1] https://www.almanac.com/content/what-are-dog-days-summer

[2] https://www.ft.com/content/126ab2d6-7e0f-11e8-bc55-50daf11b720d

[3] https://www.ft.com/content/767e8bc6-7e96-11e8-bc55-50daf11b720d

[4] https://www.cnbc.com/2018/07/02/cnbc-transcript-us-commerce-secretary-wilbur-ross-on-cnbcs-squawk.html

[5] https://www.ft.com/content/1e49cc2c-7e73-11e8-bc55-50daf11b720d

[6] https://www.nytimes.com/2018/07/02/world/europe/trump-nato.html?emc=edit_mbe_20180703&nl=morning-briefing-europe&nlid=567726720180703&te=1