Daily Comment (November 5, 2018)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Equity markets are mixed this morning on the eve of a big week. Midterm elections are tomorrow (don’t know about you, but we won’t miss the political ads), and the FOMC ends its meeting on Thursday. Here is what we are watching this morning:

Elections: The decision markets put the odds of a Democrat-controlled House at 68%.[1] That will lead to divided government and likely gridlock. Although there is some concern that a divided government could bring the reversal of policy on taxes and perhaps regulation, in reality, the president can veto laws and, with the Senate almost certain to remain in GOP hands (decision markets put the odds at 87%),[2] the ability to actually move legislation is nil. That being said, we wouldn’t be surprised to see an infrastructure bill make it through. We will be watching for attempts by the House to undermine the White House on trade policy. We doubt they can do much (the executive branch has great latitude on trade), but attempts will likely be made. At the same time, look for the Democrat party leadership (read: center-left establishment) to try to restrain the investigation and impeachment activities that the populist left is clamoring for. The Democrat Party establishment fears that a parade of investigations could make President Trump a sympathetic figure, much like Bill Clinton during the impeachment. We are not expecting significant disruption, in any case.

FOMC: This is a non-press conference meeting so don’t expect much. In fact, we would be surprised by any statement change or dissents. The meeting is a non-event except that it will lay the groundwork for a December hike.

Iran sanctions: Sanctions go into effect today. The U.S. is implementing all the sanctions that were in place before the nuclear deal. Initially, it appeared the U.S. was going to exempt the S.W.I.F.T. network. News of this exemption triggered a reaction in Congress; Ted Cruz was considering sponsoring legislation to force the administration to include the bank messaging system. However, by adding specific Iranian banks to the sanctions list, the S.W.I.F.T. network will be pulled into the sanctions regime.[3] Because some nations were given exemptions, there had been an impression that the sanctions on Iran would not be all that stringent.[4] This narrative, coupled with recent increases in inventories, has been bearish for oil prices. However, even for nations that are allowed to buy Iranian oil, it isn’t obvious if they can make financial arrangements. For example, financial sanctions may restrict the availability of insurance for cargos. Thus, the sanctions may be more effective than currently thought.[5]

Law of the Jungle: President Xi of China lashed out at U.S. trade policy, calling it a return to the “law of the jungle.”[6] Xi was speaking at an international business fair in Shanghai over the weekend. The strong rhetoric may signal that the hope of a truce in the trade war with China is unlikely. Xi did suggest he was planning to reduce import tariffs[7] but actual moves to lower trade barriers have tended to disappoint. If there is no thaw on the trade front, financial markets will likely take this as a bearish factor.

The BOJ to tighten? In a speech to business leaders, BOJ Governor Kuroda indicated that the massive monetary stimulus that has been in place for years is likely coming to a close.[8] Although actual rate tightening probably isn’t imminent, once policy turns, the JPY could appreciate significantly. On a purchasing power parity basis, the JPY is fairly valued around ¥60. In general, an appreciating currency is a negative factor for the Japanese economy.

Troika of Tyranny: National Security Director Bolton has dubbed a new group of evil nations the “troika of tyranny.”[9] The members are Cuba, Venezuela and Nicaragua. All three are leftist nations. He used his speech to outline new sanctions on Cuba and Venezuela and is threatening U.S. action against Nicaragua.[10] Specifically, the sanctions against Venezuela restrict the gold trade; the Maduro government has been using gold reserves to skirt U.S. financial sanctions. Although it’s hard to see how new sanctions could make things worse in Venezuela (they are already awful), we have noted a steady stream of refugees pouring out of the country.[11] If conditions deteriorate further, the outflow could increase and a new “caravan” of Venezuelan refugees could be heading to the U.S.

Business groups side with Modi versus RBI: Recently, we have discussed a conflict that has developed between India’s central bank and the government. The latter is trying to influence monetary policy, mostly to moderate tightening. The RBI has pushed back and its governor has threatened to resign. It is not a huge surprise that business groups, interested in easy money, have decided to align with the government in this spat.[12] Of course, anything that undermines the independence of the central bank will tend to pressure the exchange rate and could hurt financial asset values.[13]

Update on the CDU: The FT carried a flattering portrait of Friedrich Merz, a candidate for head of the CDU.[14] Last week, we touched on the candidates for Merkel’s party leadership. Merz represents a wing of the party that is socially conservative and market friendly. As we noted earlier, Merz was effectively bumped out of politics by Merkel 16 years ago.[15] Merz would likely pull disgruntled former CDU voters that have drifted to the AfD; he has a hardline stance on immigration. An ally of Wolfgang Schäuble, Merz would also likely be a stanch defender of the rules-based fiscal order, which would pit Germany against Italy. At the same time, Merz isn’t a Euroskeptic; he supports European integration and may be closer to French President Macron.[16] Given the history between Merkel and Merz, if he does get control of the CDU, Merkel’s position as chancellor will likely become untenable. However, we would expect a Merz government to end Merkel’s immigration policy and not tolerate Italy’s actions on its fiscal budget. How this unfolds in Germany will bear watching.

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[1] https://www.predictit.org/markets/detail/2704/Which-party-will-control-the-House-after-2018-midterms

[2] https://www.predictit.org/markets/detail/2703/Which-party-will-control-the-Senate-after-2018-midterms

[3] https://www.ft.com/content/644d3400-e045-11e8-a6e5-792428919cee?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[4] https://www.politico.com/story/2018/11/02/iran-sanctions-957017?utm_source=POLITICO.EU&utm_campaign=73ebdd39f9-EMAIL_CAMPAIGN_2018_11_05_05_32&utm_medium=email&utm_term=0_10959edeb5-73ebdd39f9-190334489

[5]https://www.ft.com/content/6eef944e-c6ef-11e8-ba8f-ee390057b8c9

[6] https://www.ft.com/content/34e388ee-e0af-11e8-a6e5-792428919cee?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[7] https://www.reuters.com/article/us-china-trade/chinas-xi-jinping-promises-lower-tariffs-more-imports-idUSKCN1NA053

[8] https://www.ft.com/content/1d2c8e46-e0bc-11e8-a6e5-792428919cee?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[9] https://www.axios.com/trump-bolton-bolsonaro-against-venezuela-9d05e18e-dd68-4854-a254-1f83840c86c3.html

[10]https://apnews.com/26d89514878441f58273c8d91a5deff2?utm_medium=AP&utm_source=Twitter&utm_campaign=SocialFlow&stream=top

[11] See WGRs, The Venezuelan Migration Crisis: Part I (9/17/18) and Part II (9/24/18).