by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] There was a lot of news over the weekend.  Here is what we see as important:

North Korea fears ease: Although worries remain about an escalation of tensions with North Korea, as we noted last week, there is no evidence of U.S. mobilization for an attack on the peninsula.  There are no carriers near North Korea, there have been no evacuations of American civilians from South Korea and no overt preparations for war (e.g., confining troops to base, increased training activities).  Although the president’s comments are clearly belligerent, his words are not a real signal of a march to war.  We suspect this is a bargaining tactic, one that he has used in his private sector life.  The problems with this sort of rhetoric are twofold.  First, it creates the “boy crying wolf” problem.  The more he makes statements that appear stronger than what the U.S. is ready to implement, the less foreign powers will pay attention.  Second, a president must be careful in his threats because they can bolster the foreign power that is the target of ire.  Think of President Bush’s “axis of evil.”  One of these powers has collapsed, while the other two have either developed nuclear weapons or were at the brink before deals were brokered.  Foreign governments must take threats from the superpower seriously.  By threatening North Korea (and Venezuela, too), the leader can now legitimately argue that the country faces an existential threat and should back the person in office.  It also supports building weapons of mass destruction to protect from regime change.  Still, for now, an easing of tensions has led to a reversal in risk-off trades from last week—the dollar and equities are stronger, while bonds, gold and forex are weaker.

Not much of a correction: Last week we did see a pullback in equities.  However, the major indices rose on Friday and are higher this morning.  Although we remain concerned about the level of complacency in the financial markets, there appears to be simply too much available liquidity to investors to sustain a major correction.  The chart below shows the level of retail money market funds along with the S&P 500.  The orange bars show periods where retail money market funds approached $900 bn.  These periods coincided with equity markets eventually losing momentum and correcting.  Current levels are well above $900 bn, suggesting that there is ample cash available to buy equities.  Until we approach $900 bn in money markets, we expect selloffs to remain shallow.  Of course, events and recessions can overwhelm cash; the former is a worry, the latter much less so.

Trade: Today, President Trump is expected to unveil an executive order investigating Chinese appropriation of U.S. technology which would prepare for trade restrictions if such a finding is made. The administration had delayed this action while the UNSC was negotiating sanctions on North Korea, but now, with sanctions in place, the president has decided to move forward.  China is very concerned about trade restrictions; we expect China to react with promises to build productive capacity in the U.S. as a way to blunt trade impediments.  The U.S. is also expected to begin formal NAFTA reform negotiations later this week.

Charlottesville: We won’t recap the weekend events because that is being done across the media.  Here is the issue we are watching.  The GOP establishment doesn’t want to be associated with the alt-right.  Right-wing populists are less opposed to this group.  The split in the GOP is becoming increasingly obvious and will be a threat to Republican elections over the next three years.  There are rumors that Steve Bannon may be ousted from the White House.[1]  If he goes, the influence of right-wing populists will be diminished, though not completely eliminated.  On the other hand, the Democrat Party faces similar divisions.[2]  We note that there were four major candidates in the 1860 presidential election.  Although Lincoln won easily in the Electoral College, he took less than 40% of the popular vote.  Current political divisions are deepening.  How this affects financial markets remains to be seen, but a +20 P/E for the S&P seems inconsistent with volatile political divisions.

View the complete PDF

---

[1] http://www.cnn.com/2017/08/13/politics/trump-advisers-bannon/index.html

[2] https://www.nytimes.com/2017/08/12/us/politics/elizabeth-warren-democrats-liberals.html?emc=eta1&_r=0

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Commentary from the White House remains belligerent, but U.S. equity futures appear to be stabilizing.  Here is what we are watching:

U.S. v. North Korea: In a press event yesterday, President Trump doubled down on his bellicose rhetoric against North Korea.  He added to it this morning, saying the U.S. has prepared “military solutions” that are “locked and loaded.”  Although we are sure some plans are in place, we also note that there are no carrier groups in theater; the U.S.S. Carl Vinson and the U.S.S. Theodore Roosevelt are both in training exercises off the U.S. West Coast.  The U.S.S. Nimitz, which was in the Far East in the spring, is now in the Persian Gulf.  We estimate that two of these vessels could be near North Korea in two to three weeks.  We also note that “non-essential diplomatic and military personnel” in South Korea have not been ordered to leave.  If a major military operation is to be executed, we would expect two and preferably three carriers in the Far East and non-essential personnel to be evacuated.  Thus, any military operations that could be executed now would be air attacks from Guam, Japan and South Korea.  Although potent, attacks from these sources would be limited.

We were actually more interested in comments from SOD Mattis yesterday, who warned North Korea to “cease any consideration of actions that would lead to the end of its regime and destruction of its people.”  Although Mattis is still pressing for a diplomatic solution to the current problems with North Korea, this warning should be taken seriously; attacking the U.S. will lead to an overwhelming response that will likely lead to the end of the Kim regime.  Essentially, Mattis is suggesting that a military strike on the U.S. could trigger a devastating response.

We still think the odds of an actual conflict are low, but the risk is rising.  It will be interesting to see how financial markets handle today’s market close.  Does a trader want to go home for the weekend with a levered long position in equities?

The problem of positioning: As we have noted before, the Federal Reserve appears to be attempting to manage financial conditions as an unofficial third mandate.  All the financial conditions indices we monitor remain at low levels (although they will tick up next week).  We have serious doubts as to policymakers’ abilities to manage financial stress, but it does appear that low interest rates and perhaps an enlarged balance sheet have given investors comfort.  In response to the third mandate, investors have been increasingly shorting volatility.  The position has worked.

This chart overlays the VIX ETF (VXX, 13.29) and the inverse VIX ETF (XIV, 78.18).  Over the past five years, holders of the VXX have suffered huge losses, while holders of the XIV have done well, especially since mid-2016.  Obviously, yesterday we did see a spike in volatility and the XIV dropped sharply.  Our concern is that investors have taken the “don’t fight the Fed” advice with regard to the third mandate and have increasingly shorted volatility.  The problem is that the Fed doesn’t have direct control over financial stress.  Thus, this positioning by investors aligns with the goals of policymakers; sadly, policymakers lack the tools to enforce their goals.  Shorting volatility is a bit like “pocketing nickels in front of freight trains.”  The position works well most of the time but, when it doesn’t, the reversals can be significant.  Our worry is that if investors decide to abandon these short volatility positions, it could lead to selling pressure in the equity markets as money managers who target volatility will be forced to reduce share levels as volatility rises.

With the release of the CPI data and yesterday’s FOMC action, we can upgrade the Mankiw models.  The dip in the core CPI rate (see below) did affect the Mankiw Rule model results.

The Mankiw rule models attempt to determine the neutral rate for fed funds, which is a rate that is neither accommodative nor stimulative.  Mankiw’s model is a variation of the Taylor Rule.  The latter measures the neutral rate using core CPI and the difference between GDP and potential GDP, which is an estimate of slack in the economy.  Potential GDP cannot be directly observed, only estimated.  To overcome this problem with potential GDP, Mankiw used the unemployment rate as a proxy for economic slack.  We have created four versions of the rule, one that follows the original construction by using the unemployment rate as a measure of slack, a second that uses the employment/population ratio, a third using involuntary part-time workers as a percentage of the total labor force and a fourth using yearly wage growth for non-supervisory workers.

Using the unemployment rate, the neutral rate is now 2.97%.  Using the employment/population ratio, the neutral rate is 0.85%.  Using involuntary part-time employment, the neutral rate is 2.19%.  Using wage growth for non-supervisory workers, the neutral rate is 0.92%.  There wasn’t much change from last month; two of the models, the employment/population ratio and non-supervisory wage growth, are suggesting the Fed has achieved neutral policy.  The other two remain elevated and indicate that 200 bps of tightening are necessary to achieve neutral.

To a great extent, the issue for policymakers remains the proper measure of slack.  The danger for the financial markets is that the proper measure is either wage growth or the employment/population ratio but policymakers believe slack is best measured by either involuntary part-time employment or the unemployment rate.  If one of the latter two is their measure, policymakers will likely overtighten and prompt a recession.  Since inflation remains tame, it probably makes sense for the Fed to hold steady for a while to see if inflation does accelerate.  That’s what we expect the FOMC to do; so does the market.  Fed funds futures are not looking for another rate hike until mid-2018, which is why the dollar is weakening.  As long as inflation remains tame, the pace of hikes will remain slow.

OPEC woes: As we noted yesterday, U.S. commercial crude inventories contracted sharply and have fallen rather impressively this summer.  However, oil prices remain stalled on worries that OPEC output discipline is weakening.  The data support that concern.

This chart shows the Bloomberg estimate of OPEC production, which is consistent with other sources of this data.  Since March, OPEC output has jumped almost 0.9 mbpd, with much of that coming from states that were not given quotas, such as Nigeria and Libya.  Saudi Arabia needs to press the other members to bring this production down if it wants oil prices to rise further.

Grain woes: Grain prices plunged yesterday after the USDA lifted production and ending inventory estimates for corn and soybeans.  The government also lowered its estimates for prices and farm incomes.  Higher inventories and lower prices will put economic pressure on the agriculture sector and give some leverage to China in trade talks.  After all, the economic pressures in the farm belt would be exacerbated if China were to retaliate against American farm products due to trade restrictions it faces from the U.S.

View the complete PDF

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Global equity markets are lower this morning as tensions surrounding North Korea rise.  There is a growing chorus of commentators warning about a repeat of 1987 (maybe because we are approaching the 30-year anniversary?), which would be momentous because that crash was the last major one that was not associated with a recession.  We have our doubts that a major correction is in the offing but, if it is, it should probably be treated as a buying opportunity.  The softer than expected PPI data (see below) has put some downward pressure on the dollar and boosted Treasuries.  It didn’t have much of an effect on equities. We get the CPI data tomorrow.

North Korea: The Kim regime has indicated it is drawing up plans to fire up to four missiles at Guam, which is a U.S. territory and the home of the Anderson AFB, a major base in the region.  The symbolism of such a threat is high; Guam, although not a state, is close to being one.  Persons born in Guam are American citizens.  The territory has a non-voting delegate to the U.S. House.  It has no electoral votes but it does participate in the primary process, so it has a modest effect on the presidential race.  Thus, attacking Guam isn’t exactly like attacking an American state, but it’s close.  We suspect the Kim government intends to land the missiles in the waters around Guam.  This would represent the closest attack on what should be described as American soil so far by North Korea.  It’s not clear how the U.S. will respond to such a launch if it transpires.  NBC is reporting[1] that the U.S. is drawing up plans to attack North Korean missile sites pre-launch (so-called “left of launch”) that would likely be executed by B-1 bombers[2] currently located in Guam.  Another alternative would be to use anti-missile defense systems to hit North Korea’s medium-range missiles after launch.  Attacking North Korea left of launch risks escalating the situation; not attacking assumes the North Korean missiles will fall harmlessly into the sea and not actually hit Guam.  We are treading into difficult territory here and the steady flight to safety in assets is warranted.

Mixed messages: The “fire and fury”[3] comments from President Trump, which were apparently his own, have been downplayed by his secretary of state and secretary of defense.  We do know that Chief of Staff Kelly has actively worked to limit the reading material of the president to create a consistent message.  Still, with the president’s use of social media and his personality, it will be nearly impossible to prevent such statements.  The worry is how they are interpreted by the rest of the world.  Already, Japan and South Korea are looking to boost their own defenses, in part on concerns that they can’t accurately predict how the U.S. will react to events.  Although we believe this rearming is a natural consequence of the U.S. reducing its superpower role, this process may be accelerating as the world observes how the U.S. behaves in light of foreign policy crises.

Trump v. McConnell: A war of words has erupted between the president and the Senate majority leader.  The latter, citing the lack of experience in the White House, has chastised the president for creating impossible deadlines that lead to the impression of failure on the part of Congress.  The White House has pushed back, suggesting that McConnell is ineffective and should be working more diligently to get legislation passed.  This spat is counterproductive.  All presidents want things to happen fast; political capital is perishable and thus patience isn’t a virtue.  On the other hand, senators only face a vote every six years and not all at once, so a more deliberate pace is part of the legislative structure.  In our observation, the key to speed in the Senate is sequencing.  Presidents should offer the easiest and most bipartisan legislation first to get bills passed quickly even if this legislation isn’t a high priority.  Instead, administrations tend to pursue the most aspired legislative goals that are often partisan in nature and consume lots of political capital and take a lot of time to pass.  If we are correct, President Trump should have started with infrastructure, which would have built his bipartisan credentials and would have passed easily.  Bill Clinton often remarked that he should have started with welfare reform instead of his ill-fated health care changes.  The president will need McConnell to create tax reform (or cuts) and so this argument isn’t helpful toward that goal.

Energy Recap: U.S. crude oil inventories fell 6.5 mb compared to market expectations of a 2.1 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.  Again, there was no oil sold out of the Strategic Petroleum Reserve this week.  The authorized sale is nearly complete as 16.2 mb have been released out of an authorized 17.0 mb.

As the seasonal chart below shows, inventories are usually well into the 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 isn’t usually hit until mid-September.  Thus, we should see further stock withdrawals over the next five weeks.

Based on inventories alone, oil prices are overvalued with the fair value price of $49.36.  Meanwhile, the EUR/WTI model generates a fair value of $64.36.  Together (which is a more sound methodology), fair value is $59.54, meaning that current prices are well below fair value.  The most bullish factor for oil currently is dollar weakness, although the rapid decline in inventories is also supportive.  Prices are essentially at fair value based on inventory levels but, thus far, oil prices have completely ignored the weaker dollar.  We do expect that the dollar will begin to have a bullish impact on oil prices in the coming weeks.

View the complete PDF

---

[1] http://www.nbcnews.com/news/north-korea/b-1-bombers-key-u-s-plan-strike-north-korean-n791221

[2] One of the reasons for using B-1s is that they are no longer fitted to carry nuclear weapons.  Thus, there would be no confusion from North Korea misconstruing this as a nuclear attack.

[3] https://www.nytimes.com/2017/08/08/world/asia/north-korea-un-sanctions-nuclear-missile-united-nations.html

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s not quiet today.  There is a lot of news, almost all geopolitical.  We are seeing modest “flight to safety” in financial markets this morning, with equities in retreat while Treasuries, gold, the Swiss franc and Japanese yen move higher.  We don’t expect any equity pullbacks to be all that meaningful, beyond a normal correction.  The U.S. economy is far from a recession and there is ample liquidity, so, barring a geopolitical event, a correction probably remains a buying opportunity.  Although this is a reasonable base case, the potential for a tail event is also elevated.

North Korea: Yesterday, a number of media outlets reported that North Korea has successfully miniaturized a nuclear device into a warhead, meaning it is probably now a member of the nuclear club in that it has a deliverable nuclear weapon.[1]  The Defense Intelligence Agency has concluded that not only has North Korea overcome the hurdle of building a warhead, but it probably has 60 nuclear weapons.  Although this estimate may be at the high end of the confidence band, it still suggests that the threat of a nuclear North Korea is no longer a future theoretical problem.  President Trump responded with unusually harsh language,[2] threatening “fire and fury” from the U.S.  The U.S. possesses overwhelming force; North Korea’s 60 warheads are up against 6,800 American warheads.  In addition, the U.S. has three delivery options and far more experience in nuclear war.  So, American presidents are usually more understated in their comments because they can be.  The problem with these comments is that they may be misinterpreted by Kim Jong-Un as a precursor for war.  We note that SOS Tillerson tried to walk back some of the rhetoric today by suggesting there are no imminent threats.  North Korea has responded by suggesting it is targeting Guam.  Anderson AFB has a significant number of strategic air assets, including B-52, B-1 and B-2 bombers along with support aircraft; taking out that airbase would reduce the direct threat to North Korea.  On the other hand, it would likely trigger a massive U.S. response, especially if a nuclear weapon is deployed.  We still put the probabilities of war at a low level but they are rising.  If North Korea with nukes is intolerable, as American presidents have indicated, some sort of response would seem to be necessary.  What that response will be in reality remains to be seen.  We do note that the latest reports on U.S. carrier groups indicate that none are in theater.  Thus, we are at least two to three weeks away from mobilizing forces for military operations against North Korea.

Maduro’s growing problem: There are increasing reports of dissention within the Venezuelan military.  So far, the government has been able to control the military but it does appear that an increasing number of units are engaging in mutinous actions.  The Chavez government armed civilian groups in the cities, which could act as a counterforce to a coup.  On the other hand, these civilian groups are probably no match for regular soldiers.  Sadly, the existence of these armed civilian groups could mean that a coup evolves into broad civil conflict.  The history of Latin America is littered with military coup solutions to chaotic civilian governments, so such an outcome in Venezuela would not be a shock.  So far, we haven’t seen any noticeable disruption to oil flows.

Zuma survives: Yesterday, we reported that President Zuma of South Africa was facing his sixth no-confidence vote.  And, because this one was a secret ballot, the odds were higher that he might be ousted.  In fact, it appears that 24 ANC members did vote against their president, but it wasn’t enough to lead to a failure of his government.  It will be interesting to see how Zuma handles these defections but, for now, it looks like he will survive.

View the complete PDF

---

[1] https://www.washingtonpost.com/world/national-security/north-korea-now-making-missile-ready-nuclear-weapons-us-analysts-say/2017/08/08/e14b882a-7b6b-11e7-9d08-b79f191668ed_story.html?utm_campaign=New%20Campaign&utm_medium=email&utm_source=Sailthru&utm_term=.bf8beede2be1

[2] https://www.nytimes.com/2017/08/08/us/politics/trumps-harsh-language-on-north-korea-has-little-precedent-experts-say.html?emc=edit_mbe_20170809&nl=morning-briefing-europe&nlid=5677267&te=1

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Financial markets remain quiet.  Here are some of the headlines we are following:

Zuma out?  South Africa’s president, Jacob Zuma, faces a parliamentary vote of no-confidence today (around 9:45 EDT).  That isn’t exactly news as this is the sixth such vote Zuma has faced.  There is ample evidence of corruption which accounts for the earlier no-confidence measures.  Zuma heads the African National Congress (ANC), which holds 249 out of 400 seats in parliament.  Under normal circumstances, we would expect most ANC members to maintain party discipline and keep Zuma in office.  However, parliamentary leaders have decided to make this a secret ballot, which increases the odds that Zuma may be ousted.

What is interesting about this vote is that hopes of his ouster have actually lifted the exchange rate.

This chart shows the ZAR/USD exchange rate in ZAR per USD; we have inverted the scale.  When the vote was announced late yesterday, the ZAR jumped.  We are seeing some profit taking in front of the vote.

Equities behaved in a similar fashion.

This chart looks at trading of the South African Top-40 equity index over the past 10 days.  The market has been trending higher recently but, just like what we saw with the ZAR, equities jumped when the vote was announced yesterday.  We are seeing some modest position squaring in front of the vote.

Normally, political turmoil weakens financial markets but it is clear that investors have concluded they would be better off without Zuma.  We will be watching the no-confidence outcome later this morning.  Although a secret ballot may doom Zuma, it will still take 50 ANC members to vote against their leader to oust the president.  If Zuma does lose, his government will resign en masse and the country will have a caretaker government for 30 days until new elections are held.   Investors are obviously expecting a better manager to be elected.

Saudi cut to Asia: Saudi Arabia announced today it will cut some exports to Asia in September in a bid to boost prices.  This is a risky move as it will likely encourage Russia and Iran to take market share from the kingdom.  Obviously, the Saudis hope that this won’t happen and oil prices will lift.  The news has stabilized oil prices this morning in front of the weekly data.

Trump delays trade action against China: The administration plans to delay a trade investigation regarding China’s intellectual property in the wake of China’s vote to sanction North Korea at the UNSC.  The administration has been using trade “carrots and sticks” with China in hopes that it will force the Kim regime to the bargaining table.  Comments from Pyongyang do not indicate any softening of positions; in fact, if anything, the new sanctions have hardened positions.  Still, for economic nationalists who want the president to impede imports, it’s becoming clear that Trump isn’t an ideologue on this issue.  He views the trade situation instrumentally, meaning that it is something to bargain around.  Therefore, if he can use the threat of trade impediments to encourage China to press North Korea, he will “trade away” import restrictions for North Korea.

View the complete PDF

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s a quiet Monday morning in August.  Washington is mostly on recess and families are squeezing out the last few days of summer before school begins.  Here are the notable news items.

Sanctions on North Korea: The UNSC voted unanimously to apply further sanctions on North Korea.  If fully implemented, they would cut the Hermit Kingdom’s trade by about a third.  The real surprises were the “yes” votes from China and Russia.  We note that China’s foreign minister, Wang Yi, had intensive talks with his North Korean counterpart at the ASEAN meetings in Manila over the weekend, calling on North Korea and the U.S. to ratchet down tensions.  The Chinese media pressed the U.S. to ease off North Korea as well.  Despite these comments from Chinese sources, getting UNSC sanctions approved on North Korea is a major diplomatic win for the Trump administration.  We suspect part of China’s compliance involved hopes to delay trade tensions with the U.S.  Vetoing sanctions would have certainly triggered a U.S. reaction on trade.  We also suspect Russia went along because China voted in favor of sanctions.  Still, it’s a win for the administration; now we will be watching to see if the sanctions are implemented.

Iran’s widening reach: The NYT carried a report over the weekend that Iran is expanding its influence in Afghanistan by working with the Taliban.[1]  Iran has already widened its influence in Iraq as well.  Essentially, in areas where the U.S. has fought two wars since 2003 America has failed to build replacement governments for the Hussein regime and the Taliban.  Iran is rapidly filling this void.  On the surface, Taliban and Iranian cooperation appears odd.  The former, a hardline Sunni group, would generally view Shiites as an anathema.  However, the key point that is often missed is that Iranians should probably be thought of as Persians first and Shiites second.  As Persians, the Iranians are working to expand their influence and are less concerned with religious issues.  There is no easy solution to this issue in the Middle East.  The Obama administration appeared to have concluded that Iran was going to run the region and thus was willing to cooperate with them; the Trump administration is not comfortable with that position but doesn’t really have an alternative to containing Iranian influence.

A coup in Venezuela?  Turmoil in Venezuela remains extremely elevated.  The newly “elected” body to rewrite the constitution appears to be taking power and opposition leaders are being arrested again.  Over the weekend, there were reports of a military uprising.  This looks rather suspicious to us; if there was an uprising, it was in the lower officer ranks and this is little evidence of success.  Instead, we suspect this was a “false flag” operation of sorts.  If the Maduro regime can convince its internal opposition that it faces a potential coup it will tend to solidify support.  Thus, it wouldn’t surprise us if this was staged.  So far, there is no evidence that oil supplies have been affected by the problems in Venezuela.

OPEC meets: The oil cartel is meeting with selected non-OPEC members to monitor quota compliance.  As summer comes to a close, we are about five weeks away from the usual seasonal trough in inventories.  Although we have seen a drop in U.S. commercial crude oil stockpiles, current levels are not low enough to support prices much higher than current levels.  Thus, there are hopes that OPEC can engineer some sort of cuts in output at this meeting.  We doubt we will see much other than promises to improve compliance.

View the complete PDF

---

[1] https://www.nytimes.com/2017/08/05/world/asia/iran-afghanistan-taliban.html