Daily Comment (October 29, 2018)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Equity markets in the U.S. are rebounding this morning as investors begin to edge back into the market after a hard decline.  Here is what we are watching this morning:

German elections and Merkel: On Sunday, the German state of Hesse held local elections.  Although local elections don’t always impact national or global politics, the election in Hesse became a referendum on Chancellor Merkel’s government.  The results were not favorable for the ruling coalition.  Merkel’s CDU fell from 38.3% to 27.0%, and the SDU dropped to 19.8% from 30.7%.[1]  Meanwhile, the Greens took 19.5% of the vote, up from 11.1%.  The populist right-wing AfD won 13.2% of the vote, tripling its 2013 share.

In response to two difficult regional elections, Hesse this weekend and Bavaria earlier this month, Chancellor Merkel announced she is giving up her post as party leader, will not seek another term as chancellor and will end her political career at the end of her term.[2]  Her term officially ends in 2021 but it is also possible that a new CDU leader will remove her from the chancellor position before her term ends.  This announcement represents a potential watershed moment for Europe.  During the Eurozone crises of 2011-12, Merkel was able to placate the hard money wing of the CDU but also give enough support to the southern European nations to prevent a collapse of the Eurozone.  If a hardline member of the CDU takes control, discussions with Brexit and the Italian situation could become rocky.  On the other hand, it’s hard to imagine any German political figure giving the impression that they support a “blank check” to nations like Italy.  So far, market reaction has been mild, probably because Merkel remains chancellor.  But, if she is replaced before her term officially ends, pressure on the EUR could rise.

Brazil election: In the other election last Sunday, Jair Bolsonaro easily won the run-off in Brazil, 55.4% to 44.6%.[3]  This result was expected.   Bolsonaro is a controversial right-wing populist who makes critical comments about women, gays, etc.  But, what supported his candidacy was somewhat less about him and more about the deep level of corruption in the left-wing coalition.  The left-wing coalition’s most promising candidate was prevented from running because he is in prison on corruption charges.  Thus, it isn’t a huge surprise why voters wanted a change.  How Bolsonaro governs will be worth watching.  He has suggested an affinity for the period of military rule, which may mean he wants to eliminate the limitations that a democratic government puts on its leaders.  His economic consultant is Paulo Guedes, a University of Chicago grad; advisors from this school tend to support free markets.[4]  So far, financial markets have favored this outcome but it remains to be seen how the new president will actually govern; it should be noted that populism from either wing isn’t necessarily friendly to capital.

S&P and Italy: Last week, Italy avoided another rating agency downgrade as S&P affirmed its credit rating at BBB, two levels above the line that demarks investment grade, but did signal a “negative” outlook.[5]  If the credit rating agencies took Italy to below investment grade, the ECB would probably not be able to purchase Italian debt either as part of QE or for open market operations.  The impact on Italian interest rates would be negative and might force Italy’s exit from the Eurozone.  In light of this news, Italian financial assets are rallying this morning.

Brexit update: Although PM May continues to defy pundits predicting her political demise, she continues to struggle to manage her divided party.  May is pushing for an exit of indefinite length, which the hard Brexit faction refuses to accept.[6]  The hard Brexit faction does not want an indefinite stay in the European Customs union because being in that union will prevent the U.K. from negotiating any new free trade deals.  It is still unclear how Brexit will work.  And, the hard Brexit supporters can’t prove why any nation would be pressed to make a free trade agreement with the U.K.  After Brexit, it will be a fairly large but mostly isolated economy.  Despite promises of wanting a free trade agreement with the U.K., the U.S. will likely be more focused on an agreement with the EC and Japan.  Simply put, it will be hard to move the U.K. higher on the trade agenda.  China might be willing to make a deal but only with onerous conditions.  A messy Brexit would be quite bearish for the GBP, which is already undervalued.  On the other hand, it’s possible that May won’t be able to stay in power, triggering new elections.  In that case, Labour would likely win and it isn’t completely obvious whether a Corbyn government would jettison Brexit.

Austria and Italy: In another interesting development, Austria is considering a plan to offer citizenship to German speakers in the South Tyrol region.  This area, which was once part of the Austro-Hungarian Empire, has been part of Italy for years.  Some parts of the region became part of Italy after WWI, while the rest has been in Italy for nearly a century.  As the map below shows, this area is well within the Italian border.

(Source: By Fobos92 – Own work, CC BY-SA 4.0, https://commons.wikimedia.org/w/index.php?curid=59057562)

The Austrian government has offered citizenship to German and Ladin speaking Italians, which comprise about 64% of the population.  It has not made a similar offer to Italian speakers.[7]   Although this has the look of a political stunt, it has generated some support within South Tyrol among the German and Ladin speakers.  Rome, obviously, was not impressed.  Although we doubt Austria will go through with this action, the proposal does highlight that the borders of Europe do not necessarily reflect the ethnic and religious makeup within each nation.  The European Union project was, in part, designed to offset these divisions by focusing on the “European citizen.”  However, if the EU weakens, it would not be a shock to see a surge in the claims Austria is considering.

China and Japan: In the face of trade pressure from the U.S., two long-time opponents, China and Japan, are trying to improve relations.[8]  The two leaders, Chairman Xi and PM Abe, met last week for the second time since Xi took office.  The leaders agreed to a $30 credit swap line and pledged cooperation on development projects.  Although further cooperation will be difficult, the pressure being exerted by the Trump administration will tend to create an environment where some degree of collaboration is necessary.

Softening on Iran? The WSJ reports[9] there are divisions within the Trump administration over the implementation of sanctions against Iran.  Specifically, Treasury Secretary Mnuchin wants to allow Iran to have access to the S.W.I.F.T. network, while National Security Director Bolton does not.  The network, the backbone of international bank communications, is critical to global banking.  Being excluded from the network effectively isolates a country and makes it nearly impossible to conduct international trade.  Earlier sanctions against Iran did exclude the country from the network and were effective in pushing Tehran into negotiations.  However, there is a risk to deploying this sanctions option on a regular basis.  The U.S. does not directly control S.W.I.F.T.; banks join willingly.  If banks begin to believe that the U.S. will constantly use the network to enforce sanctions, there will be a growing demand for alternative networks.  The Russians and Chinese are already working to develop a payment network for their own trade, for example, with EU support.[10]  If Iran loses access to the S.W.I.F.T. network it would severely undermine its ability to sell oil and may force the mullahs to make a new deal.  However, in the longer run, disrupting S.W.I.F.T. may lead the world further down the road of deglobalization and could take away a powerful tool for U.S. sanctions.  Perhaps the U.S. should treat S.W.I.F.T. sanctions as a very powerful weapon that is rarely used.

In related news, there has been a surge in U.S. soybean exports to Iran.[11]  Sales this marketing year (which began last month) are at 335k tonnes, up from zero compared to last year.  Two trends are driving the sales.  First, China has implemented tariffs which have cut sales to that nation.  Second, as Iran faces new U.S. sanctions it is stockpiling key commodities before implementation.

Iran sanctions do have costs to the U.S.  As our oil analysis shows, based on domestic commercial crude oil inventory and the dollar, oil prices should be in the low $60s.  We suspect that fears of supply constraints once sanctions are implemented have kept prices higher than their basic fundamentals.  The president has tried to keep oil prices from rising by criticizing OPEC and the Saudis, calling for more oil production.  However, production capacity is constrained and there may simply not be a way for producers to offset the full loss of Iranian output.  And so, there may be an argument that would support lighter sanctions to keep oil prices stable.  The same case could be made for U.S. farmers.  Allowing some food imports into Iran might mitigate price pressures on grain.  Of course, less than a full crackdown on Iran will make sanctions less effective.  We may see a less draconian sanctions regime initially with future tightening.

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[1] https://www.wsj.com/articles/german-voters-deal-merkels-coalition-another-setback-1540749894

[2] https://www.ft.com/content/0feb3b7a-db5c-11e8-8f50-cbae5495d92b

[3] https://www.nytimes.com/2018/10/28/world/americas/jair-bolsonaro-brazil-election.html?emc=edit_mbe_20181029&nl=morning-briefing-europe&nlid=567726720181029&te=1&login=email&auth=login-email

[4] Pinochet in Chile used University of Chicago-trained economists in his government.

[5] https://www.ft.com/content/a8fd6508-d92d-11e8-a854-33d6f82e62f8

[6] https://www.bloomberg.com/news/articles/2018-10-25/brexit-talks-said-to-be-on-hold-as-may-s-team-can-t-agree

[7] https://www.dw.com/en/italy-and-austria-spar-over-german-speaking-south-tyrol-dual-citizenship-rumors/a-44813995

[8] https://www.ft.com/content/160b3666-d8e3-11e8-a854-33d6f82e62f8

[9] https://www.wsj.com/articles/u-s-hesitates-over-scope-of-finance-sanctions-on-iran-1540483196

[10] https://www.presstv.com/Detail/2018/10/26/578126/Russia-China-Swift-Alternative

[11] https://www.ft.com/content/2213d3fc-d89b-11e8-a854-33d6f82e62f8