by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s the last day of August.  Here is what we are watching today:

Russian bank problem: Otkritie is a bank in Russia that has become insolvent.  The bank has close ties to the government and has apparently enjoyed rapid growth by absorbing the assets of smaller failed banks, often buying the assets at a deep discount.  Some of the deals are less than transparent and there are concerns that the bank’s management may have enriched itself at the expense of the state.  Otkritie represents about 3.7% of Russian bank assets,[1] making it the fourth largest bank in the country.  This is important because, if not contained, it could trigger a broader financial panic.  Although we do expect the Russian central bank to engineer a bailout, the potential for a broader problem does exist.  Bank panics are crises of confidence; they can occur easily and once underway become difficult to contain.

Kurds to vote: The Kirkuk Provincial Council voted on Tuesday to hold a Kurdistan independence referendum on September 25.  Iraq, the U.S. and Turkey will oppose this vote because a “yes” vote could begin the process of a Kurdish breakaway region.  Although Iraq probably can’t militarily force the Kurds to remain in Iraq, Turkey does have the capacity to prevent the creation of a Kurdish state, something it has opposed for nearly a century.  This vote should be viewed in the broader context that the post-WWI borders drawn up by French and British colonialists are steadily eroding and creating conditions where conflict could become constant.

New America: The NYT reports[2] that the New America Foundation, a center-left policy shop, has fired one of its members, Barry Linn.  Linn was the director of the Open Markets program that operated at New America.  Linn was thus part of the think tank and wrote extensively on the dangers of industry concentration, especially in technology.  According to reports, Linn supported the EU’s recent €2.4 bn fine on Google (GOOGL, 943.63). [3]  All this seems rather appropriate; an analyst who studies industry concentration commenting on a fine levied by a legitimate government against anti-competitive behavior would be a normal part of the job.  However, New America received more than $21 mm in funding from Google and others tied to the company.  Eric Schmidt, Google’s executive chairman, was also the chairman of New America until last year.  Linn’s comments were taken down from New America’s website, but then they returned.  Later, Linn was relieved of his duties.

We have watched the steady concentration of market power in the tech sector for years.  As students of history, the behavior of the tech industry now is strikingly similar to the behavior of the robber barons of 1890-1910.  It should be noted that the former era ended when President Teddy Roosevelt began a trust-busting campaign that eventually led to the Sherman Anti-Trust act.

Why do we comment on this?  First, equity markets have been supported by the performance of the tech sector, especially the large cap area of the sector.  Although there is no doubt that the companies in this sector provide wildly popular products and services, they are sometimes provided from the aggressive suppression of wages.  In the earlier era, the trusts often abused their market power by high prices.  The tech companies, for the most part, don’t act in this fashion.  In fact, their influence in improving market transparency is one of the causal factors for keeping inflation at bay (technology’s role in globalization should not be underestimated either).  But, the tech firms have kept a lid on wage growth, sometimes through nefarious means.[4]  Although Google denies any role in Linn’s firing, it looks pretty obvious that Anne-Marie Slaughter[5] felt compelled to quash Linn’s complaints.  If the government concludes that the tech sector’s influence has become dangerous, we could see attempts to constrain it through regulation.  This could mean that the large firms are broken up (à la Standard Oil) or heavily regulated, which may affect equity market performance.

Second, the tech issue exposes the political fault lines in the U.S.  The center-left establishment, primarily the establishment of the Democrat Party, is tightly aligned with the tech sector.  Technology has less representation in the center-right, the establishment wing of the GOP.  Interestingly enough, populist leaders on both the right and left are becoming quite jaded with the tech firms.[6]  Political support for the tech sector may be narrowing, which may increase the likelihood that an adverse regulatory environment will develop.

We live in an age of mostly unfettered technological change; that wasn’t always the case.  In the past, regulators would slow the advent of new technology through regulations that made the investment in new technology appear less attractive.  As a thought experiment, how attractive would it look to shift to driverless trucks if two human drivers had to be in the cab and paid even if they had nothing to do?  In an era of low inflation and low inflation expectations, there will be a growing temptation to preserve jobs by limiting the disruptive effects of technological change.  The “ham-fisted” firing of Mr. Linn is perhaps an indication that the sector’s leaders are becoming concerned.  This is a trend we will continue to monitor.

Energy Recap: U.S. crude oil inventories fell 5.4 mb compared to market expectations of a 2.0 mb draw.

This chart shows current crude oil inventories, both over the long term and the last decade.  We have added the estimated level of lease stocks to maintain the consistency of the data.  As the chart shows, inventories remain historically high but they are declining.  In fact, we are now below last year’s seasonal low, made in September.

As the seasonal chart below shows, inventories are usually well into their seasonal withdrawal period.  Even with the SPR sales, we have already seen a larger than normal seasonal decline; in fact, the drop is rather remarkable.  It should be noted that the seasonal trough is coming soon.

Based on inventories alone, oil prices are deeply undervalued with the fair value price of $55.05.  Meanwhile, the EUR/WTI model generates a fair value of $64.39.  Together (which is a more sound methodology), fair value is $60.13, meaning that current prices are well below fair value.  Although the most bullish factor for oil currently is dollar weakness, the rapid decline in inventory levels is also supportive.

So far, the oil market is assuming that Harvey will be bearish for oil prices.  This makes sense, although it should be noted that oil inventories took several weeks to rise during Hurricane Katrina.

This chart shows when Katrina made landfall, indicated by the vertical blue line on the chart.  It dissipated about eight days later.  Note that inventories declined.

During Katrina, refinery operations did drop significantly.  We expect them to decline again but in a much quicker fashion this time.

What the markets may be missing is that crude oil imports will drop as well.  Obviously, U.S. oil production is significantly higher now than it was in 2005.  But, this weakness in oil prices is probably not justified given the rather impressive decline in inventories and dollar weakness.  Still, we expect the markets to need evidence of slower inventory increases before prices recover.

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[1] https://www.ft.com/content/efc08f26-8d96-11e7-9084-d0c17942ba93?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56 (paywall)

[2] https://www.nytimes.com/2017/08/30/us/politics/eric-schmidt-google-new-america.html?_r=0

[3] https://www.nytimes.com/2017/06/27/technology/eu-google-fine.html

[4] https://www.theguardian.com/technology/2014/apr/24/apple-google-settle-antitrust-lawsuit-hiring-collusion

[5] Ms. Slaughter is a proponent of the “responsibility to protect” doctrine, a Wilsonian interventionist foreign policy stance. https://en.wikipedia.org/wiki/Anne-Marie_Slaughter

[6] http://www.breitbart.com/tech/2017/07/28/report-steve-bannon-wants-google-facebook-to-be-regulated-like-utilities/ and https://www.recode.net/2016/6/29/12060804/elizabeth-warren-apple-google-amazon-competition

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy GDP day!  We cover the GDP data below, but the report showed 3.0% annualized growth.  Interest rates have ticked higher and the dollar is recovering from yesterday’s weakness.  Here is what we are following this morning:

Harvey hits Louisiana: After slamming Texas with massive rains, TS Harvey moved back over the Gulf of Mexico (GOM) and has made a second landfall just east of the Texas/Louisiana border.

The market most sensitive to the storm in the short run has been energy.  This morning, the massive Motiva 600 kbpd refinery announced it would shut down due to flooding.  Gasoline futures jumped about four cents per gallon on the news but have settled back.  Crude oil prices continue to slide on fears that depressed refining activity will lower demand; in addition, the Texas coast is the exporting hub for U.S. crude oil so we would expect a decline for a while.  We are probably on the “backside” of this crisis, but the rebuilding will be slow and it is likely the damage from Harvey will be extensive.

On the other hand, the need for emergency rescue spending may end the drama around the debt ceiling.  Texas is a red state and the GOP would usually want to exercise caution on spending, worried that lawmakers would try to sneak pet spending projects into an emergency bill.  If the Texas contingent puts forth a clean aid bill, it could create conditions of bipartisanship and lead to an easy debt ceiling vote.  If so, this outcome would reduce the potential for a government shutdown later next month.  After all, shutting down FEMA in the middle of a massive recovery effort would be a huge unforced error.

North Korea update: Kim Jong-un renewed his threats on Guam, suggesting the missile test over Japan was a test for attacking the U.S. base on the U.S. territory.  Meanwhile, President Trump did say that “all options are on the table” with North Korea.  In the midst of all this noise we are trying to figure out if there is a “signal” from this mess.  Although Japan was angry with the violation of its airspace, it didn’t attempt to shoot down the missile.  There are three potential reasons.  First, perhaps Japan has little faith in its anti-missile defenses and didn’t want to shoot at the North Korean missile for fear the impotence of the defense system would be revealed.  Although possibly true, if Japan actually believed it was under attack, an unreliable system is better than none.  Thus, the lack of Japanese response to the overflight suggests something else.  A second explanation is that Japan knew in advance that the missile was unarmed.  There have been reports of backchannel discussions with North Korea[1]; it is quite possible that interested parties were told in advance of the launch.  If Japan thought this missile was the opening salvo of a nuclear or chemical attack, it would make sense to use its anti-missile defense even if it is rather unreliable.  On the other hand, if one knew in advance that this wasn’t an actual attack, revealing the unreliability of the anti-missile defense wouldn’t make much sense.  Third, reactions from South Korea and the U.S. suggest that North Korea had made it clear that this missile launch wasn’t a preemptive strike, which would add to evidence that this launch was indicated in advance among these backchannel contacts.

This doesn’t mean war is more or less imminent.  The fact that the sides are talking is better than if they were not, but nothing has really changed.  North Korea’s ultimate goal is peninsula unification under Pyongyang’s rule.  In its estimation, the primary obstacle to this goal is the U.S.  Thus, the goal is to either talk the U.S. out of the region or make the U.S. look ineffective as a defender.  The flaw in the discussion is that North Korea may not be strong enough militarily to defeat South Korea.  Authoritarian regimes consistently underestimate the fighting resolve of democracies; they observe the divisions that naturally occur in the democratic process and “see” weakness.  At the same time, North Korea’s actions may not be helping its goal; there are reports that National Security Advisor McMaster and his South Korean counterparts are considering the movement of U.S. strategic assets to South Korea.  This would include the basing of B-1, B-52 and F-35 warplanes that are not currently on South Korean soil.  The U.S. is considering short-range ballistic missiles in South Korea as well.

Market action: One characteristic we have noted is that there is enough liquidity in the financial markets that equity pullbacks tend to be shallow and short.  We saw some of that yesterday; although the market opened lower, it moved higher throughout the day as the North Korean situation didn’t deteriorate further.  To measure liquidity, we have been using retail money market funds (MMK).

This chart shows the level of retail money market funds and the S&P 500; we have placed orange bars on the chart to show periods when the level of money market funds approached $900 bn.  At that point, equities have tended to weaken; in our opinion, this is because buying power is depleted.  Current liquidity levels are high enough to put power behind the “buy the dip” mentality we have been seeing in stocks for a while.  Barring a recession or some other factor that increases the demand for liquidity (war would do it, by the way), we expect this pattern to continue.

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[1] http://nypost.com/2017/08/11/white-house-has-quietly-engaged-in-back-channel-talks-with-north-korea/

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Financial markets are in “risk on” mode this morning after the North Korean missile test.  Treasuries and gold are higher, while equities and the dollar are weaker.  In fact, the EUR broke above the 1.200 level for the first time in two years.  Here is what we are watching this morning:

The North Korean missile test: North Korea launched what appeared to be a medium-range missile over Japan late yesterday afternoon (Eastern Daylight Time).

In Japan, warning sirens blared and text messages were sent to residents of the northern areas of Japan to take cover.  This is the third North Korean missile to overfly Japanese territory since 1998.  This test complicates the situation significantly.  The recent missile tests, in which three short-range missiles flew into the Sea of Japan, have been seen as something of a conciliatory gesture by the Kim regime.  The U.S. refrained from severely criticizing North Korea after this earlier launch.  However, yesterday’s action is far more provocative.  The U.S. has been Japan’s defender since the end of WWII.  If the U.S. is seen as not defending Japan, it will raise fears that American policy in the region has changed and likely bring a sharp escalation of defense spending among our allies.

In response, South Korea dropped eight MK-84[1] bombs from four South Korean Air Force warplanes near the 38^th parallel as a show of force.  The UNSC is meeting to discuss additional sanctions.  Overall, though, it is doubtful that sanctions will have much of an impact.  So far, the Trump administration’s response to yesterday’s action has been guarded.  The president hasn’t mentioned anything on Twitter yet and is visiting Texas today; thus, the opportunity to say anything provocative may be delayed.  It should be noted that during last week’s rally in Phoenix the president suggested his tough talk appeared to be working as Kim Jong-un was not acting out; that perception has been shattered by this launch.

Overall, North Korea’s action is quite worrisome.  This missile proves it can attack American military bases in Japan and Guam.   The launch appeared to come from a mobile launcher that was positioned near Pyongyang; most of the time, North Korea launches missiles from remote areas.  If the site is confirmed, this launch would suggest that Kim is putting missiles near areas of high population with the idea that the U.S. is less likely to strike missile sites before launch if they are near civilians.  If North Korea can demonstrate it can hit the U.S. mainland, Kim Jong-un may decide to test the idea that the Trump administration won’t risk a major U.S. city if Guam or Tokyo is attacked.  In other words, if North Korea lobs a nuclear weapon on Guam, will the U.S. respond with a major nuclear first strike and risk a city in the western U.S.?  Simply put, the North Korean situation is getting complicated fast.  If conditions continue to escalate, it will put additional pressure on equity markets and the dollar.

Harvey update: Although the storm isn’t over yet, it does appear that some refining capacity is being restarted.  Currently it appears that about 2.2 mbpd (roughly about 12.5% of capacity) is either down or at sharply reduced levels.  However, there are reports that some refiners, especially those south of Houston, are in the process of trying to restart their facilities.  Those facilities closer to Houston and the Ship Channel may take weeks before they can restart.  The Houston economy is roughly the size of Chicago; it will have a modest dampening impact on Q3 and Q4 GDP (perhaps a 0.2% drag on GDP), but that will be offset early next year by rebuilding.

More on tariffs: Last month, China and the U.S. were near an agreement where the former would cut its steel productive capacity in lieu of trade restrictions.  According to reports, Commerce Secretary Ross supported the decision but President Trump rejected it.  Instead, the president wants tariffs.  There are probably two reasons for this.  First, the president likely views any Chinese overture on trade skeptically.  Although the steel industry has too much global capacity, every producer wants some other producer to take the cuts.  Thus, China’s offer, if legitimate, was important.  However, there is no way for the U.S. to enforce China’s actions.  In the final analysis, the president may not have trusted China to follow through.  Second, tariffs are clear evidence to his base that he is taking steps to cut the U.S. trade deficit.  In other words, capacity cuts may or may not work and they are not obvious to the American people that U.S. steel jobs are being protected.  Tariffs are clear and convincing.  As we noted yesterday, tariffs invite retaliation.  We would expect China to put trade barriers on U.S. natural gas and agriculture products in response.  In addition, tariffs will make China less open to cooperating on the North Korean issue.

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[1] This weapon is the largest of the MK-80 series of standard purpose weapons; although an unguided bomb, it is potent.  At 2,000 lbs, it is considered the third largest bomb in the U.S. conventional arsenal.

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It was a busy weekend of news.  Our thoughts and prayers go out to our friends in Texas.  Here’s what we are watching:

Harvey: TS Harvey made landfall going into the weekend as a category 4 hurricane.  Usually, hurricanes make landfall, move inland and dissipate within a couple of days.  Harvey isn’t that kind of storm.  First, instead of moving inland, the storm stalled over the Houston-Corpus Christi area and sat there, dumping prodigious levels of rainfall.  Complicating matters is that Harvey is expected to return to the GOM later today to gather more moisture.  Rainfall totals in excess of 40” are expected over parts of the Houston area, with the rain spreading into Louisiana.  Here we discuss some of the key effects on energy and the economy.

Energy: The Houston Ship Channel is perhaps the energy center of the U.S.  The area is loaded with refiners, pipelines, import and export facilities and offshore production.

Current estimates indicate that about 3.0 mbpd of refining capacity have been taken offline.  Some of these facilities will be back within a few days (on the above map, each box is a refinery), but the ones in Houston could be down for weeks.  A rough calculation of the Houston refineries[1] indicates that 2.3 mbpd, or about 13% of total U.S. capacity, will be idle for weeks.  This loss of refining capacity has several effects on oil prices.  On the one hand, the loss of refining capacity will reduce demand.  On the other, the Eagle Ford production area is relatively close to the rain bands and there are reports that some areas have been shut in.  This production area represents about 1.3 mbpd.

In addition, the Houston Ship Channel and the Louisiana Offshore Oil Port are the key oil import facilities and thus we would expect a decline in oil imports.

The market reaction thus far is declining crude oil prices, while gasoline prices are higher.  This has widened the crack spreads (the spreads between product and crude oil).

The chart above shows the spread between a barrel of gasoline versus a barrel of WTI.  The spread has jumped over $2 per barrel.  The spread between Brent and WTI has also widened over $2.00 per barrel (see below).  The widening of Brent-WTI will tend to discourage imports to the U.S. and, if the oil can be shipped, U.S. exports.  Unfortunately, the port outages in Texas will tend to dampen oil exports (and imports).

Overall, so far, we believe the impact on oil prices is probably a bit overdone; in the end, there are crosscurrents that will probably end up being more of a wash.  For refiners outside the Houston/Louisiana area, this event should be bullish.  That is the highest probability outcome.

The Economy: The economy will also be affected by this disaster.  Initially, the impact is negative.  Houstonians will be out of work for a while, which will boost initial claims for unemployment.

This chart shows initial claims around Hurricane Katrina.  There was a spike in claims of about 100k during that event.  Harvey may actually be larger.  The impact isn’t permanent; within about a month it dissipates.  As time goes on, the impact of rebuilding will be positive for GDP.  Although the impact on the nation’s wealth, in terms of lost infrastructure, means the U.S. balance sheet takes a hit, the “income statement,” or GDP, actually rises to rebuild what has been lost.

The rise in claims may lead the FOMC to hold off on rate hikes until the situation improves.  This factor, coupled with the potential for a government shutdown/potential default by the end of September, will almost certainly leave rates unchanged.  We will likely still see a reduction in the balance sheet.

Bring me tariffs!  Axios is reporting that President Trump is angry at the globalists surrounding him and wants tariffs.[2]  There is movement on trade; NAFTA renegotiations are underway and the U.S. is investigating Chinese IT trade practices.  However, the president has promised tariffs to the populists and he wants to provide them.  Tariffs have been falling since WWII, replaced mostly by non-tariff barriers, e.g., regulations, trade inspections, etc.  The president actually has a good bit of freedom in setting tariff policy and can move without much influence from Congress (although we do note Mike Lee (R-UT) has proposed legislation to curb the president’s tariff powers).  The problem with tariffs is that they are transparent and invite retaliation.  For example, if China sees its steel or solar panels affected by tariffs, one can fully expect retaliation against U.S. agriculture.  Perhaps the most effective tool has already been locked away—the Border Adjustment Tax would have likely been effective in reducing the trade deficit, although at the cost of higher inflation and a stronger dollar.  On the other hand, if the president is seeking lots of signing ceremonies, tariffs have that characteristic.

Jackson Hole: Perhaps the most important item from the meeting is what wasn’t said; ECB President Draghi didn’t directly come out and call for a weaker EUR and the Eurozone currency jumped to new highs.  In current central bank practice, it is considered improper to directly discuss the exchange rate.  And, with a U.S. president inclined to trade barriers (see above), talking down the currency would have likely triggered a reaction from the White House.  Still, the expectation is that the ECB is slowly moving to tighten and the FOMC probably won’t move as much as expected.  This is leading to a weaker dollar. 

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[1] https://www.eia.gov/special/disruptions/?src=home-b1

[2] https://www.axios.com/axios-sneak-peek-2477874318.html?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiossneakpeek&stream=top-stories

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] South Korean war games: Pyongyang has repeated its threats of retaliation in response to the South Korean war games, contending that the drills act as a precursor to the imminent invasion of North Korea.  Pyongyang reportedly threatened that the U.K. would face a “miserable end” if it participates in military drills alongside the U.S. and South Korea.  The Kim regime has always disliked these annual exercises and belligerent comments are common when the drills are being conducted.  On Thursday, Reuters reported that the North Korean state media released photos of designs for a new intercontinental ballistic missile, which they believe will be able to strike anywhere in the U.S.  The increased belligerence of the North Korean regime will likely bolster the U.S. claim that the world should take more actions against the regime to deter its nuclear ambitions.

Cohn next?  In an interview with the Financial Times, Gary Cohn expressed dismay with President Trump’s response to the events in Charlottesville.  Cohn, who is Jewish, told the FT that he felt enormous pressure to resign after the president blamed “both sides” for the violence that erupted.  It was rumored that Cohn had briefly considered stepping down from his position as economic advisor following the president’s remarks, but decided against it due to speculation that he will replace Janet Yellen as chair of the Federal Reserve.  It is unclear how the president will react to this interview.  On the one hand, he tends to react poorly to public criticism; on the other hand, he seems to like Cohn and probably won’t oust him over the interview.  Regarding the Fed chair position, the interview could affect it either way.  If Trump wanted him out, he could move him to the Fed.  However, he could also use it as punishment.  We still favor Cohn for the Fed chair job but we view it as 60/40; in other words, odds favor Cohn but there is a chance that Yellen may remain as well.

Tax reform: President Trump is expected to release information about tax reform next week. Following the failure to repeal Obamacare, the focus has turned to tax reform as the president tries to get his legislative agenda back on track.  Thus far, the president has failed to deliver a detailed tax plan.  According to the FT, the president will begin campaigning on a simpler tax code in order to spur economic growth.  Axios reports that the president will let the GOP handle the details of the plan and have it come out of the House Ways and Means committee.  At this point, it is unclear how much Trump will look to cut taxes.

Jackson Hole: Today, Mario Draghi will speak about the developments from Jackson Hole; the topic of discussion is thought to be monetary policy’s impact on inflation.  Market participants are hoping Draghi will give clues as to whether or not the ECB will continue its bond buying program.  However, we expect the ECB president to remain coy.  The Federal Reserve and the ECB have been receiving pressure for their respective monetary policies.  In the U.S., the Federal Reserve’s hawkish approach is seen as undermining future GDP growth; in Europe, the ECB’s dovish policy has been accused of causing market bubbles.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Iran strikes back: Saudi Arabia’s plan to isolate Iran may have backfired.  The WSJ reports that Qatar has decided to restore diplomatic and bilateral trade ties with Iran despite pressure from the Gulf Cooperation Council (GCC), a coalition of Arab countries that also includes the United Arab Emirates, Bahrain and Egypt.  Earlier this year, Saudi Arabia and the other members of the GCC decided to cut off all diplomatic ties and impose trade and travel bans on Qatar due to its supposed ties with terrorist organizations.  The demands imposed by the coalition not only included curbing ties with Iran, but also shutting down Al Jazeera and expelling extremists from its territory.  Although the blockade has had a negative impact on Qatar, it did little to force the government into submission but rather into the arms of Turkey and Iran.  This outcome will likely strengthen Iran’s reach throughout the Middle East as it attempts to expand its influence in the region.  For decades, Saudi Arabia and Iran have been battling to become the sole regional hegemon in the Middle East.

South Korean war games: Pyongyang has expressed displeasure with the ongoing war games taking place between the United States and South Korea.  North Korean officials have complained that the exercises are just “rehearsals for an invasion” and have threatened to provide a relevant response.  War games between the U.S. and South Korea occur annually and are designed to test war readiness.  In June, Beijing proposed a “double freeze” scenario in which North Korea would cease its nuclear and ballistic missile tests in exchange for the U.S. halting its war games; the deal was promptly rejected by Washington.  Tensions have simmered between Pyongyang and Washington as the U.S. has been successful in applying sanctions on North Korea to curb its nuclear and ballistic missile program.  The war games are scheduled to continue until next Thursday.

Energy recap: U.S. crude oil inventories unexpectedly rose 3.2 mb compared to market expectations of a 3.5 mb draw.

This chart shows current crude oil inventories, both over the long term and the last decade.  We have added the estimated level of lease stocks to maintain the consistency of the data.  As the chart shows, inventories remain historically high but have been declining.  In fact, inventories are now at their lowest level since mid-2015.

As the seasonal chart below shows, inventories are usually approaching the end of the inventory withdrawal season.  The usual decline is about 10% from April to September; this year is about the same but on a lower level.  Overall, this has been a good withdrawal season and does suggest that the supply situation is tightening.

Based on inventories alone, oil prices are overvalued with the fair value price of $53.30.  Meanwhile, the EUR/WTI model generates a fair value of $64.03.  Together (which is a more sound methodology), fair value is $60.51, meaning that current prices are below fair value.  Fears of continued excess supplies are weighing on market sentiment, but it appears to us that oil prices are rather undervalued.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Trump attacks Washington and the media: President Trump made his first major speech on immigration yesterday in Phoenix, Arizona, during which he placated his base by threatening to shut down the government if the border wall isn’t funded, alluding to a withdrawal from NAFTA and attacking the media.  His speech will likely heighten tensions within the GOP as it appears the president is willing to protect his base at all costs even if it means challenging members of his own party.  In recent weeks, Republicans have become increasingly concerned with the president’s handling of domestic events and many have expressed reservations about funding a border wall due to the impact it may have on the national debt.  His threat to shut down the government appears to be a rebuke of Mitch McConnell, who stated earlier this month that there was a zero percent chance of that happening.  Trump’s speech will likely increase the rift in his relationship with McConnell, which reports suggest was caused by the failure to repeal Obamacare.

Soft power diplomacy: Trump’s foreign policy shift seems to have taken root with increased actions against China, Russia and Egypt.  Yesterday, the WSJ reported that the U.S. Treasury has expanded its sanctions to firms in Russia and China due to their involvement in Pyongyang’s nuclear and ballistic missile program.  The escalation of sanctions is aimed at forcing North Korea to the negotiating table.  Additionally, the Washington Post reported that the State Department is going to withhold $195 million in military aid from Egypt and has also withdrawn $96 million in other aid due to human rights violations in the country.  The shift in diplomacy reinforces speculation that the military establishment’s influence has grown in the Trump administration; as a result, we expect the president’s foreign policy to resemble those of his predecessors, President Obama and President Bush.

Yesterday’s market action: The dollar rallied as did equities.  For the past several months, the dollar has tended to weaken during periods of U.S. political dissention and strengthen on evidence of policy stability.  Dollar sensitivity to political uncertainty is rather unusual.

This chart shows the economic policy uncertainty index compared to the EUR.  The two series are essentially uncorrelated.  The behavior we saw yesterday has been something we have noted recently.  Investors have generally not been willing to sell equities in the face of turmoil but have sold the dollar instead.  Both the dollar and equities rallied strongly after President Trump’s disciplined and well delivered speech on Monday regarding the war in Afghanistan.  However, we noted lots commentary suggesting that the president has moved on from populism, citing the speech and Steve Bannon’s exit from the White House.  However, the president seems to have a “soft spot” for populist ideas.  Simply put, although it is possible that the president has moved to become an establishment Republican, it’s unlikely that he has changed.  Thus, the potential for more market uncertainty remains.

The Navy puzzle: The U.S. Navy has been hit with a series of mishaps this year. In January, the U.S.S. Antietam ran aground near Yokosuka, Japan.  In May, the U.S.S. Lake Champlain hit a South Korean fishing vessel.  In June, the U.S.S. Fitzgerald hit a container ship, and this week, the U.S.S. John S. McCain struck an oil tanker.  The Navy is reviewing the situation.  Bloomberg[1] notes that one possibility is that the Navy is trying to do too much without enough resources.  From 1998 to 2015, the Navy shrunk by 20% to 271 vessels.  The demand for the Navy’s services may simply exceed the number of ships available to perform the work safely.  However, there is another theory circulating that is much more ominous.  On June 22^nd, the Global Positioning Satellite system was manipulated; 20 vessels on the Black Sea reported a location 20 miles inland, near an airport.  This was the first confirmed instance of GPS “spoofing.”  Although the Navy uses encrypted GPS and should be protected, commercial vessels are not and thus could be vulnerable to manipulation.  There is some evidence that Russia may be behind this GPS spoofing; it would be consistent with Russia’s “hybrid war” concept and shows how a nation with much less economic power can “punch above its weight.”[2]

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[1] https://www.bloomberg.com/news/articles/2017-08-22/why-do-u-s-navy-ships-keep-crashing

[2] https://www.newscientist.com/article/2143499-ships-fooled-in-gps-spoofing-attack-suggest-russian-cyberweapon/ and http://www.mcclatchydc.com/news/nation-world/national/national-security/article168470432.html