Daily Comment (November 14, 2018)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT]

(NB: The Daily Comment will go on hiatus beginning Wednesday, November 21st, returning on Monday, November 26th.)

There is a lot going on this morning.  Let’s dig in:

Brexit—the end of the beginning: Yesterday afternoon (EST), the EU and the U.K. announced that a tentative deal over Brexit had been reached.[1]  Currently, we don’t know all the details as the 400+ page document is being kept from the public until the cabinet gets a chance to read it.[2]  Once the cabinet has completed its review, we expect it will be distributed to the press and public.  So far, PM May is acting as if she has the support of her cabinet; we would not be shocked to see a resignation or two but, for the most part, we think she has the majority of the cabinet on board.[3]  As we noted yesterday, she won’t have the support of her entire coalition.  There is an element that simply wants a hard Brexit (essentially, an exit without any provisions) with the hope that other nations will come flocking to make trade deals with the U.K.  Although this might happen, it could take years and, in the meantime, the U.K. would not have favored status with anyone.  Plus, a hard Brexit will lead to a hard border at the Northern Ireland/ Ireland frontier which could lead to a return of the unrest that plagued the area for decades.  To pass the agreement through Parliament, May will need around 20 to 25 Labour defectors.  Labour head Corbyn sees this vote as an opportunity to bring down the government, force elections and perhaps take power.  However, we are not sure he has the broad support of the Labour Party (center-left Blairites don’t care much for him) and they may vote for the deal simply to deny Corbyn this goal.

Here is a summary of the general outline of the agreement:[4]

  1. The U.K. will pay an exit fee of €40 bn to €45 bn to ensure that the rest of the EU won’t be forced to pay additional funds because of Brexit. Essentially, the U.K. will contribute to EU budgets for 2019 and 2020.  Some payments, especially for pensions, may continue as long as 2064.
  2. EU citizens living in Britain and U.K. citizens in the EU will live under existing EU residency and security laws. Future EU rulings on non-residents won’t be binding but the U.K. agreed to give “due regard” to any changes.
  3. The transition period will last through December 31, 2020, and can be extended once by mutual agreement. This will allow time for the EU and U.K. to negotiate a free trade agreement.
  4. Northern Ireland will remain in the customs union indefinitely. This condition will only change by a new agreement.
  5. The U.K. will also remain in the customs union,[5] which will allow for the free movement of goods from Northern Ireland to the rest of the U.K. While in the customs union, the U.K. will be forced to abide by EU rules on competition.[6]
  6. Governance will be conducted through independent arbitration, which means that neither the U.K. nor the EU is bound by the court decisions of the other.

One note to remember: there are no real surprises here.[7]  MPs may not like what is in this deal but the outline has been evolving for some time.  This agreement does not offer the U.K. full independence from the EU.  As long as the U.K. is in the customs union, it can’t make its own free trade agreements.  But, a hard Brexit—a full break with the EU—would shut down trade and financial arrangements between the two entities and make EU citizens living in the U.K. essentially refugees living under U.K. law.  The disruption would be massive; we would expect Gilt yields to soar and U.K. equities to plunge along with the GBP if this agreement isn’t accepted.  In the long run, the U.K. may be better off, but in the short run, the cost may be an economic dislocation that would be historic.  The EU got the deal it wanted because it is betting that, faced with the customs union or catastrophe, Parliament will vote for the former.  As we noted yesterday, we would not be shocked by a “TARP-like” event, where Parliament votes the deal down only to face an immediate market crisis, which prompts another vote in Parliament or maybe another referendum.  Our bottom line is that the odds of a hard Brexit are not trivial but it’s also not the most likely outcome.  It makes much more sense to make this deal and then adjust the arrangement over time.  However, that doesn’t mean that reason will prevail.

So, what does this mean for U.S. markets?  A hard Brexit would likely bring a knee-jerk flight to safety trade—Treasuries rally, equities fall, gold rallies, dollar rallies and GBP drops.  If May wins the day, look for U.K. assets, especially the GBP, to rally strongly.

Car tariffs on hold for now: The Trump administration has decided to hold off on car tariffs for the time being.[8]  We find that equities tend to rally anytime the “globalists”[9] in the administration win, although we note that equities failed to hold gains after positive trade comments from Kudlow yesterday.  In fact, market action has been disconcerting; rallies tend to fade, which suggests that investors are using rallies to reduce equity exposure.  We would not expect this pattern to remain but, until it shifts, rallies may struggle to hold.

Italy dares the EU: Italy has made it clear to the EU that it doesn’t intend to make any changes to its budget, effectively daring the EU to apply sanctions.[10]  The sanctions would come from the EU’s “excessive deficit procedure.”[11]  Bottom line, it would mean that the EU would fine Italy 0.2% of its GDP for violating the fiscal rules.  The EU has never actually implemented such sanctions, even when Germany violated these levels in the early aughts.  Italy’s real risk isn’t from EU sanctions—it’s from the financial markets pushing up borrowing costs and triggering a financial crisis.  Italy, realizing this risk, has called on its citizens to buy bonds.[12]  Such appeals to patriotism generally fail; in fact, it often leads well-informed domestic investors to flee domestic paper.  The broader risk comes from the so-called “doom loop.”  Bank regulations force banks to allocate capital to the assets it holds based on how regulators perceive risk.  Regulators, captured by governments, treat sovereign debt as risk-free (as long as rating agencies deem it investment grade) and thus banks tend to hold higher yielding sovereign paper.  If a sovereign runs into trouble, the contagion vector is the banking system.  This is why the Greek crisis was such a problem; French and German banks held Greek bonds and thus Greece was forced to accept austerity to bail out these banks.  Italy could bring similar problems on a much larger scale.[13]  Of course, Italy’s issues are well known, and investors have been dumping Italian bonds, which is why their yields have been rising.[14]  Unfortunately, this has led Italian banks to hold more of their nation’s bonds, which is pressuring the Italian banking system.[15]  Our view is that if Italy stays in the Eurozone, the populist fiscal expansion will end in tears.  However, the real threat from Italy to the Eurozone is if Italy concludes it would be better off outside the currency bloc.  We doubt the EUR survives Italy’s exit.

The European Army: Although we would not expect a European Army to emerge in the short run,[16] French President Macron’s proposal is a natural outgrowth of changes in U.S. policy.[17]  The U.S., as part of its Cold War policy, deliberately froze three conflict zones in Europe, the Far East and the Middle East.[18]  American taxpayers mostly funded the maintenance of these areas because U.S. policymakers were convinced that if the nations in the region tried to create their own security arrangements it would lead to conditions that brought about two world wars.  Although the costs to the U.S. were substantial, the U.S. has not fought another mass mobilization world war.  Although President Trump has been explicit in his goal of not funding the security of these conflict zones any further, we would argue that this sentiment predated his administration.  President Bush’s foreign policy before 9/11 was to reduce America’s security footprint.  VP Gore ran on the opposite side of that argument.  President Obama wanted to “lead from behind.”  This was all about trying to figure out how to adjust U.S. foreign policy to the post-Cold War world.  To date, no administration has solved that riddle.  But, if you tell the Europeans they are going to foot the bill for their security, it should come as no surprise that the EU will decide its own security arrangements.  Now, we have serious doubts that the EU can create a functioning army as the nations rarely agree on anything.  But, a more likely outcome is that the “European army” is really the “Wehrmacht.”  We suspect this is why Macron is trying to lead this effort to make it a joint French/German-led army.

Energy: It’s the tale of two markets.  Natural gas prices remain on a tear due to cold weather.  Meanwhile, oil prices fell sharply yesterday.  The decline in oil prices has caught the attention of OPEC, which is now pressing for a much larger cut in production, perhaps as much as 1.4 mbpd.[19]  The DOE reports its data later this morning.  The API reported a large inventory build and we would expect something similar from the government data.  At the same time, seasonally, we are coming to a period where inventories tend to decline.  Thus, we would not be shocked to see oil start to find support at these levels.

Chinese data:China’s economic data remains soft, especially in property and real estate.[20]  Although monetary policy has eased to some extent, so far, it hasn’t been able to arrest the slowdown.  We would expect the Xi regime to try to boost growth further.  Of course, all eyes remain on the upcoming G-20 meeting at the end of the month, where Chairman Xi and President Trump are expected to meet to discuss trade.

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[1] https://www.nytimes.com/2018/11/13/world/europe/britain-eu-brexit-deal.html?emc=edit_mbe_20181114&nl=morning-briefing-europe&nlid=567726720181114&te=1

[2] https://www.ft.com/content/cfe7c108-e7e3-11e8-8a85-04b8afea6ea3

[3] https://www.ft.com/content/40380478-e766-11e8-8a85-04b8afea6ea3

[4] https://www.ft.com/content/693b88b0-e804-11e8-8a85-04b8afea6ea3

[5] https://www.politico.eu/pro/brussels-wants-permanent-post-brexit-customs-union/?utm_source=POLITICO.EU&utm_campaign=1bbbacff3e-EMAIL_CAMPAIGN_2018_11_14_05_27&utm_medium=email&utm_term=0_10959edeb5-1bbbacff3e-190334489

[6] https://www.ft.com/content/c97af42a-e761-11e8-8a85-04b8afea6ea3?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[7] https://www.ft.com/content/c4847aca-e7f9-11e8-8a85-04b8afea6ea3

[8] https://www.ft.com/content/a6be46ba-e768-11e8-8a85-04b8afea6ea3 and https://www.bloomberg.com/news/articles/2018-11-14/u-s-said-to-hold-off-on-trump-s-car-tariffs-after-trade-meeting

[9] Mnuchin and Kudlow

[10] https://www.ft.com/content/e41de7c4-e793-11e8-8a85-04b8afea6ea3?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56  and https://www.politico.eu/article/italy-refuses-to-bow-to-brussels-budget-demands/?utm_source=POLITICO.EU&utm_campaign=1bbbacff3e-EMAIL_CAMPAIGN_2018_11_14_05_27&utm_medium=email&utm_term=0_10959edeb5-1bbbacff3e-190334489

[11] https://www.ft.com/content/5e7b5e9c-e312-11e8-8e70-5e22a430c1ad

[12] https://www.ft.com/content/319b334a-e28e-11e8-8e70-5e22a430c1ad?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[13] https://wolfstreet.com/2018/05/27/which-banks-are-most-exposed-to-italys-sovereign-debt-other-than-the-horribly-exposed-italian-banks/

[14] https://www.reuters.com/article/italy-debt-foreign-holdings/update-1-foreign-holdings-of-italian-bonds-hit-15-month-low-in-june-idUSL5N1W03O8

[15] https://www.marketwatch.com/story/heres-why-investors-remain-uneasy-about-italys-banks-and-the-doom-loop-2018-10-08

[16] https://www.nytimes.com/2018/11/13/world/europe/merkel-macron-european-army.html?emc=edit_mbe_20181114&nl=morning-briefing-europe&nlid=567726720181114&te=1

[17] https://www.politico.eu/article/europe-army-angela-merkel-emmanuel-macron-donald-trump-getting-what-he-wanted/?utm_source=POLITICO.EU&utm_campaign=1bbbacff3e-EMAIL_CAMPAIGN_2018_11_14_05_27&utm_medium=email&utm_term=0_10959edeb5-1bbbacff3e-190334489

[18] See WGR, The Mid-Year Geopolitical Outlook (6/25/18).

[19] https://www.reuters.com/article/us-oil-opec/opec-partners-discuss-oil-supply-cut-of-up-to-1-4-million-bpd-sources-idUSKCN1NJ15W

[20] https://www.ft.com/content/ecff5f86-e7c4-11e8-8a85-04b8afea6ea3?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56