Daily Comment (October 17, 2018)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Markets are mixed this morning as strong earnings led to a surge in tech stocks but weaker earnings from automakers due to rising costs are likely weighing on investors.  Here are the stories we are following today:

Mueller to release key findings: Special Counsel Robert Mueller is expected to release a report providing an update on the Russia investigation after the November midterms.  In the report, Mueller is expected to discuss whether there is evidence of collusion between Russia and President Trump during the 2016 election, as well as whether the president was guilty of obstruction of justice following the firing of former FBI Director James Comey.  President Trump has claimed the investigation to be illegitimate and has been pushing for its conclusion or, at minimum, a limit in its scope.  The president’s legal team is currently mulling over whether to provide a written response to questions provided by Mueller as the president may not be willing to sit for a face-to-face interview.  Although the consequence of this report will likely depend on the outcome of the mid-term elections, the worst-case scenario would be a report suggesting there is evidence that President Trump is guilty of either allegation mentioned.  If the Democrats were to win a majority in both houses they will be pressured to push for impeachment, which would likely weigh on U.S. equities.  That being said, we believe a Democratic win in the Senate is unlikely.

President Trump’s Middle East dilemma: The president continues to face pressure to take a tougher stance against Saudi Arabia following the suspected killing of journalist Jamal Khashoggi.  On Tuesday, President Trump came to the defense of Saudi Crown Prince Mohammad Bin Salman (MBS) after members of his party refused to accept the Saudis’ claim that rogue agents were responsible for the killing.  In an interview with the Associated Press, President Trump compared allegations that MBS had knowledge of the murder to the sexual assault allegations Brett Kavanaugh faced earlier this month.  The president’s willingness to protect the crown prince is likely related to his desire to not backtrack on Iranian sanctions.  If the president wants to follow through on his plan to implement more sanctions on Iran, he will need Saudi Arabia’s help in offsetting the loss in oil supply.

Chinese debt bubble? Rising debt levels in China have sparked concerns of a possible infrastructure bubble developing within the region.[1]  According to an S&P report, local Chinese governments may have accumulated ¥40 trillion ($6 trillion) worth of hidden debt that is not reflected in official figures.  Although China has been pushing for more credit restrictions throughout the country, it appears rising trade tensions with the U.S. have led to lax enforcement of those restrictions.  The report suggests the local governments may have turned to local government financing vehicles (LGFV) to bypass restrictions in an attempt to stimulate regional growth.  This method allows the local governments to use land rights as collateral for loans; as a result, the credit-worthiness of the bonds are backed by land sales.  Furthermore, the relationship between debt and land values has encouraged local governments to build more infrastructure within their respective regions regardless of whether there is sufficient demand to support it.  The report is concerning because it suggests that financial markets may be more fragile than previously thought and also calls into question the CPC’s ability to stimulate growth throughout China amidst rising trade tensions with the U.S.  We will continue to monitor this situation.

U.S.-UK Brexit deal: UK Prime Minister Theresa May is facing growing pressure to secure a deal with the EU in order to start negotiations with other sovereign countries.  The UK’s bid to stay in the public procurement alliance has been stalled and is expected to lose access to the group following its exit from the European Union.  Although the WTO is likely to come to a provisional agreement following Britain’s exit, the suspense will still be a burden for PM May as she struggles to seal a Brexit agreement.  Meanwhile, the Trump administration has informed Congress that it would like to negotiate a new bilateral agreement with the UK following its departure from the EU, but the UK is forbidden to negotiate bilateral agreements while it is still part of the single-market.  The longer it takes PM May to secure a deal, the harder it will be for her to create smooth transitions following departure.

Trump attacks the Fed: President Trump has gone on the offensive against the Federal Reserve, claiming it is the biggest threat to the U.S. economy.  Over the past few weeks, the president has taken to Twitter and the press to attack the Fed’s decision to tighten monetary policy.  The market currently anticipates a fourth rate hike in December following strong economic growth, rising inflation and a tightening labor market.  The Fed minutes released later today will likely provide more insight into what the Fed might do in December.  That said, any perception that the Fed is prioritizing the president’s opinion on economic data will likely hurt the Fed’s credibility, which is important to its ability to anchor inflation expectations.[2]

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[1] https://www.ft.com/content/adabd0ae-d0f3-11e8-a9f2-7574db66bcd5

[2] For further discussion on politicizing the Fed, see our most recent Asset Allocation Weekly published 10/12/18 (also found on p. 6 of this report).