Daily Comment (September 17, 2019)

by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA

[Posted: 9:30 AM EDT]

After a wild day yesterday, markets are rather quiet.  The FOMC meeting starts today, the new Saudi energy minister is conducting his first press conference at 1:15, and Israel is holding elections.  Here is what we are watching this morning:

The aftermath of the Saudi strikes:  Here are three items we are following in the wake of the missile and drone attack on Saudi oil facilities:

  1. The retaliation issue—although President Trump suggested the U.S. was “locked and loaded,” it appears he is not in a hurry to escalate the situation. Although the president says it “appears” Iran was behind the attack, he also indicates he does not want war.  In addition, the White House seems to be suggesting the U.S. is going to be led by Saudi Arabia’s decision on Iran.  Part of the reluctance is probably due to the lack of attractive alternatives.  It is hard to see how the U.S. could find additional economic sanctions (Iran is heavily sanctioned already), and mere sanctions would look like a weak response to a historic attack.  A blockade against Iran is an option, but how one determines when “victory” is achieved is difficult.  In other words, what would have to occur to lift the blockade?  Additionally, a blockade could put U.S. Navy vessels in harm’s way.  Limited airstrikes against the Iranian defense industry (to weaken its capacity to build missiles and drones) is probably the most likely response, but that action could escalate.  The president doesn’t want a war this close to an election that could spike oil prices and undermine his reelection chances.  Also, like his predecessors, he would really prefer less involvement in the Middle East.  However, as we noted yesterday, doing nothing or something less than a proportional retaliation runs the risk of ending the Carter Doctrine.
  2. The negotiations issue—the Ayatollah Khamenei has announced that there will be no talks on any level with the U.S. This decision effectively ends any chance of a diplomatic solution.
  3. The “how did this happen” issue—one of the unanswered questions is how did the Saudis not have adequate defense against this attack? The KSA’s defense spending ranks third in the world with total defense spending and first relative to the GDP, at 8.8%.  We haven’t seen much written on this issue, other than Russia’s offer to sell the KSA the S-400 system.  In our estimation, there are two potential reasons why the kingdom was unable to protect these key facilities from a combined drone and missile strike.  First, pure incompetence.  The leadership was more concerned with a terrorist or ground attack and simply didn’t consider this sort of strike.  Thus, the defense that was purchased was inadequate.  Second, the defense system was adequate but was disarmed by a cyber-attack.  If the answer is the first reason, it’s inexcusable.  If it’s the second, it’s terrifying because it means that missile defense systems are vulnerable.  We don’t know the answer to this issue but will continue to watch for information.

What now?  OPEC and Russia appear to be using this event to drain global inventories.  OPEC and Russia’s output policy has been designed to slowly reduce global stockpiles; with the KSA partially offline, the cartel appears to be using this situation to accelerate the process.  If so, this should keep a bid to oil prices.  We note that the KSA has already signaled to customers that October oil loadings will be delayed.  The risk of much higher prices is tied to the U.S. response to this attack.  At this juncture, the White House is exhibiting caution, which reduces the odds of a spike.

Venezuela heats up:  The situation in Venezuela has become a stalemate in recent weeks.  The U.S. has mostly exhausted economic sanctions and the Venezuelan economy is moribund, so additional measures probably won’t have much of an impact.  The U.S. has no interest in a military response.  However, we are seeing tensions rise between Colombia and Venezuela.  The former is accusing the Maduro regime of harboring guerrillas, and of planning bombings against Colombia’s capital, Bogota.  Leaders in the region are calling for the activation of the 1947 Rio Treaty, a mutual defense treaty among Latin American countries.  We will be watching to see if a group of nations in the region will build a military force to remove the Maduro regime.  Although Venezuela’s oil production has declined precipitously, Colombia does produce 0.9 mbpd and a conflict could reduce supplies in an already tight world.

Islamic State:  Secretive ISIL leader Abu Bakr al-Baghdadi issued an audio message urging his followers to redouble their fight against nonbelievers, and their efforts to build an Islamic caliphate, in spite of the group’s severe weakening and loss of territory.  The message is a reminder that ISIL hasn’t been completely destroyed, and that it will probably continue to pose a terrorism threat in the near term.

Trade:  Liao Min, China’s vice-minister of finance, is in route to Washington to begin preliminary trade talks.  USTR Lighthizer remains committed to a comprehensive trade agreement with China, something that China does not appear to want.  Again, this issue underscores the differences within the Trump administration on trade; the Lighthizer/Navarro wing want a broad agreement that will encompass not only trade but intellectual property and security, while the Mnuchin/Kudlow wing want a narrow agreement that only affects trade.  The president vacillates between the two camps.  In general, we watch Lighthizer; if he does not get his way, we would expect him to resign and if he does, we will get a narrow deal.  If he stays, we doubt China will agree to anything before the elections.  Meanwhile, the U.S. and Japan appear to be near a trade agreement.

Hong Kong:  Illustrating the negative impact of the continued anti-Chinese political protests, and the threat of a violent Chinese crackdown, private investors are reportedly pulling millions of dollars of gold out of Hong Kong.  The pullout not only reflects concerns that China could restrict capital outflow from the city, but also that protests at the municipal airport and other facilities could impede shipments.

Italian politics:  Just after the center-left and populist-left formed a government, former Italian PM Matteo Renzi announced he is leaving the center-left Democratic Party to create a new centrist group similar to what Macron has created in France.  His decision will weaken the current coalition, and could end up bringing down the government.  We are seeing a backup in Italian sovereign yields this morning.

Russia:  Another powerful Russian has floated the idea of amending the country’s constitution to allow President Putin to stay in power after his current term ends in 2024.  Sources close to the Russian leadership say Putin currently thinks he and his United Russia Party are strong enough that they don’t need to worry about the future yet.  However, the Russian oligarchs and others who have profited from the Putin regime are worried about losing their favored positions, so they’re laying the groundwork for legal changes that could keep Putin in power.

View the complete PDF