by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy employment day!  We cover the data in detail below but the headline numbers are reflecting a strong economy.  Payrolls came in at 209k, with revisions adding a modest 2k.  Expectations called for a 180k rise.  The unemployment rate was on forecast at 4.3%, down from the prior month at 4.4%.  The mystery of wages remains; average hourly earnings rose by 2.4%, below the 2.5% forecast.  Equity markets are up on the news, interest rates have ticked higher and the dollar is rising.  See our comments below for charts and other details.

Overall, news flow was quiet overnight.  Here are the news items we are following:

Mueller issuing subpoenas: Special Counsel Mueller has started issuing subpoenas through the Washington Grand Jury.  We won’t comment on the content or the direction of the investigation but we did note market action yesterday.  After the announcement, the S&P dipped but the decline was met with buying and the index closed nearly unchanged.  This is a consistent pattern we have seen recently; because there is so much sideline liquidity, modest market drops seem to attract new buying in short order.  This was the topic of last week’s AAW.[1]  As long as cash levels remain high, we doubt that market declines can be sustained.  However, we do note that the dollar weakened.  The forex markets seem to be the place where political fears are being expressed.  The JPY was especially strong and this currency is often one of the flight to safety currencies.  Thus, if we get news out of this investigation that raises concerns about political stability, equity losses might be shallow and short lived but dollar weakness could accelerate.

Mulvaney supports clean debt ceiling bill: Mick Mulvaney, the White House budget director, came out yesterday in support of a clean debt ceiling bill.  Mulvaney is sympathetic to the Freedom Caucus agenda and was pushing for spending cuts in return for raising the debt ceiling.  His decision to support a clear raise will provide political cover for the Freedom Caucus to also support a clean rise.  If the U.S. can avoid a debt ceiling crisis it will remove a key near-term risk to the financial markets.

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[1] See Asset Allocation Weekly, 7/28/17.

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Washington is shutting down for August, earnings remain solid and news flow is rather quiet.  Here’s what we are watching today.

BOE holds steady: The BOE held everything steady.  Its QE remains in place and rates were left unchanged.  The Monetary Policy Committee (MPC) voted 8-0 to keep buying Gilts but had two dissenters on rates, with two wanting hikes.  BOE Governor Carney warned that inflation is rising but also noted that wages are not keeping pace, meaning real wages in the U.K. are contracting.  This situation puts the BOE in a difficult spot; if it raises rates to ease inflation it will further harm households seeing weak wage growth, but if it allows inflation to keep rising it will further cut real wages unless wage growth improves.  We do expect rates to rise in the U.K. in the coming year but, like here, the pace of hikes will be slower than in the past.  The GBP fell sharply on the news and Gilt yields declined.

A “clean” debt ceiling hike?  Politico is reporting[1] that Senate Majority Leader McConnell and House Speaker Ryan are quietly trying to build a coalition of centrists from both parties to pass a straight increase in the debt ceiling.  This would avoid spending cuts from the Freedom Caucus and spending amendments from Democrats.  It isn’t clear if such a coalition is possible.  On the one hand, the debt ceiling is obscure enough that progressive opposition probably won’t be strong.  On the other hand, creating this coalition will isolate the Freedom Caucus and highlight internal GOP divisions.  Another complication is that the Democrat Party leadership will be sorely tempted to pay back the GOP for the series of debt ceiling crises President Obama endured.  And, that same leadership doesn’t want to pass a clean bill only to see the GOP push tax cuts on them soon after.  So far, financial markets expect smooth sailing on this issue; we remain concerned.

Energy recap: U.S. crude oil inventories fell 1.5 mb compared to market expectations of a 3.3 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 this week there was no oil sold out of the Strategic Petroleum Reserve.  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; the seasonal trough isn’t usually hit until mid-September.  Thus, we should see further stock withdrawals over the next six weeks.

Based on inventories alone, oil prices are overvalued with the fair value price of $47.18.  Meanwhile, the EUR/WTI model generates a fair value of $56.55.  Together (which is a more sound methodology), fair value is $53.38, 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.

Oil prices have recovered from earlier weakness and are stalling at about the midpoint of the recent range.

This chart shows the nearest oil futures price; we have placed a box that highlights the price range of $45 to $55 per barrel.  We have also set a downtrend line from the past three price peaks.  Prices are struggling to break that downtrend line, but if they do manage to move higher then resistance rests at $52 and $54 per barrel.  We would not expect prices to break out above $55.

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[1] http://www.politico.com/story/2017/08/03/debt-ceiling-republicans-clash-congress-241263

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It was a quiet overnight trade.  The Reserve Bank of India did cut rates as expected.  Here are the trending news items we are watching:

Trade war with China: Several media outlets are reporting that the administration is opening a broad investigation into China’s trade practices with regard to intellectual property.[1]  China has pressed U.S. companies to reduce licensing fees, demanded joint ventures and is now requiring tech firms to set up China-based data centers if they want to do business in the country.  Complaints from U.S. companies over China’s behavior have been rising for some time.  Previous administrations and the companies themselves have tolerated these behaviors; the former to maintain relations and the latter to maintain access to Chinese markets.  However, U.S. companies have become increasingly jaded about prospects for growth in China.  We suspect that in the coming years China will be forced to see its growth fall by at least 50% to constrain debt growth.  At lower growth rates, the indignities that China enforces become a bigger issue.  Of course, the president ran on a protectionist platform, promising to boost jobs by reducing the trade deficit.  Up until now, the administration was offering China continued supportive trade relations if the Xi government constrained North Korea.  Now that it is apparent China is either unable or unwilling to act on North Korea, the president is moving on trade against China.  It’s difficult to measure the impact from a trade war with China.  Bilateral trade conflicts are complicated—we could see trade flows simply move to other nations and China won’t be all that affected.  On the other hand, given the complexity of global trade we may see unexpected outcomes, both positive and negative.  One thing to remember about trade is that the outcomes are full of tradeoffs.  Improving the standing of one party almost always comes at a cost to another.  The uncertainty factor alone could dampen both business and consumer sentiment.

Growing divisions within the White House: In one sense, this isn’t news.  After all, we have seen a number of firings from this administration.  However, one trend we are starting to notice is that cabinet members and others are directly contradicting the president.  President Trump clearly wants better relations with Russia, while VP Pence visits the borderlands in Russia’s near abroad and supports expanding NATO, a red line for Putin.  The president supports Saudi Arabia and the GCC against Qatar, while again SOS Tillerson visits to broker a peace deal and suggests that the GCC’s demands on Qatar are excessive.  President Trump engages in harsh rhetoric against North Korea; SOS Tillerson says today the U.S. does not seek regime change in the Hermit Kingdom and tells Kim Jong-Un that “we are not your enemy.”[2]  President Trump strongly suggests that he would like to decertify Iran[3] and scuttle the nuclear deal President Obama negotiated with Tehran; both Tillerson and DOD Mattis indicate Iran is meeting its treaty obligations.[4]  The AP is reporting that Mattis and CoS Kelly agreed early on in the Trump presidency that one of them should always be in the U.S. “to keep tabs on the orders rapidly emerging from the White House.”  Increasingly, we are seeing members of the cabinet moving to constrain the president.  So far, Trump is submitting to these actions.  It remains to be seen how long he will tolerate these differences.

The debt ceiling: Treasury Secretary Mnuchin suggested yesterday that the Democrats should support efforts to raise the debt ceiling.  The party leadership declined the offer.  There are rumblings from the Freedom Caucus that they will demand spending cuts to raise the ceiling.  This wing of the GOP is starting to look like it intends to hold its own party and the White House hostage.

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[1] https://www.wsj.com/articles/u-s-plans-trade-measures-against-china-1501635127 (paywall)  https://www.nytimes.com/2017/08/01/business/trump-china-trade-intellectual-property-section-301.html?hp&action=click&pgtype=Homepage&clickSource=story-heading&module=first-column-region&region=top-news&WT.nav=top-news&_r=0

[2] https://www.ft.com/content/485dffe8-76fd-11e7-90c0-90a9d1bc9691?emailId=5981537c1d69e900049eab93&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22 (paywall)

[3] https://www.nytimes.com/2017/08/02/opinion/trump-killing-iran-nuclear-deal.html

[4] https://www.reuters.com/article/us-usa-tillerson-iran-idUSKBN1AH5E7  http://www.cnn.com/2017/04/19/politics/tillerson-iran-deal/index.html

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Global equity markets are higher this morning on the second day of Gen. Kelly’s tour as Chief of Staff (CoS).  Here are the news items we are watching:

The “Mooch” is out: Anthony Scaramucci left his role as communications director.  It isn’t completely clear if he was fired or resigned but, in reality, CoS Kelly wanted him gone.  This is a warning shot to the White House staff that a new regime is in place.  Kelly has apparently moved to restrict access to the president and to better control the processes within the White House.  This order is desperately needed.  The U.S. is facing rapidly escalating challenges and a dysfunctional executive branch is not helpful.  Kelly’s appointment is potentially the first step toward bringing order.  Sadly, a lot of political capital has been squandered and thus the administration’s ability to meet its goals is reduced.

Stepping up tensions with Russia: VP Pence is traveling in the Russian “near abroad,” speaking in Estonia and Georgia.  He spoke in both places—in the latter, he offered U.S. support for adding Georgia to NATO, and in the former, he reassured leaders there that the U.S. is prepared to continue its defense via NATO and supports putting the Patriot missile system in the Baltic state.  The Pentagon has proposed supplying Ukraine with anti-tank weapons, a move opposed by both France and Germany.  The president would have to approve the arms sales to Ukraine; we expect he will.  Pence’s comments will escalate tensions with Russia, and it isn’t obvious that the U.S. is prepared for conflict in Europe.  Meanwhile, Russia is sending up to 100k troops to the eastern edge of NATO territory as part of military exercises.

Tensions rise in Venezuela: The Maduro government, in the wake of Sunday’s election, has re-arrested two opposition leaders, Antonio Ledezma and Leopoldo Lopez.  The U.S. has applied personal sanctions on President Maduro and other sanctions are being considered.  Venezuela is moving rapidly to end democracy and install an authoritarian regime.  The key question is, “Can the country afford it?”  The Venezuelan economy is in shambles, with accelerating inflation and growing shortages of essential items.  One problem that hasn’t gotten much attention is increasing emigration.  Until recently, most of those fleeing the country have been in the upper and upper-middle classes.  Evidence of their flight can be found in Florida real estate.[1]  The next wave will likely be less affluent Venezuelans fleeing malnutrition and political chaos.  They will, at least initially, end up in neighboring countries but we wouldn’t be surprised to see them eventually attempt to come to the U.S.

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[1] https://therealdeal.com/miami/2017/07/30/venezuelan-flight-capital-takes-multiple-routes-to-south-florida/

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy St. Ignatius of Loyola Day!  The weekend was news heavy—here’s what we are watching this morning.

A new Chief of Staff: Reince Priebus was removed from the Chief of Staff position at the White House late Friday.  Although it does appear he resigned the day before, his removal played out on national TV with him standing in the rain on the tarmac in Washington.  Gen. John F. Kelly moved from DHS to the Chief of Staff role and begins his job in earnest today.  There is much being discussed about the problems Kelly will face in trying to streamline the Byzantine organizational structure of the Trump White House.  From a market perspective, probably the most important signal this appointment sends is that Gary Cohn is the frontrunner for Fed Chair.  There was speculation that Cohn could become Chief of Staff if (or when) Priebus was removed.  Of course, if Cohn took that job, it reduced the chances that he would take the FOMC role.  With Kelly’s appointment, Cohn remains in the running.  Although we think odds still favor Cohn getting the Fed Chair position, it wouldn’t shock us if Trump decides to keep Yellen in place.  Yellen is a dove and Cohn would probably be more hawkish.  In addition, it should be noted that Priebus’s exit from the White House reduces establishment GOP influence.  The establishment GOP generally favors higher rates—establishment Republicans tend to be creditors who like low inflation, a strong dollar and higher interest rates.  Trump has made it clear he isn’t a hawk on monetary policy and thus may find Yellen is a better fit for his policy goals.  We still think odds favor Cohn to replace Yellen but the likelihood isn’t overwhelming.

On to taxes…maybe?  Congressional Republicans have signaled that with the failure to repeal Obamacare the agenda will move to tax reform.  However, the president continues to urge lawmakers to pass a repeal measure.  Each day that tax reform (or cuts) are delayed means more political capital is lost and reduces the odds that anything gets accomplished.  Lurking in the background is the debt ceiling.  The Freedom Caucus is apparently planning to trade spending cuts for permission to raise the limit; this may mean we could see a shutdown develop by late September or early October.

Another North Korean missile test: North Korea successfully launched another ICBM and, by all accounts, this one could reach the continental U.S. and maybe all the way to the Midwest.  The U.S. response was multipronged.  First, American B-1 bombers flew over South Korea, accompanied by South Korean F-16s.  Second, the South Koreans requested and the U.S. approved longer range missiles in South Korea.  Third, the U.S. is strongly considering additional sanctions against China to encourage China to pressure Pyongyang to restrain its behavior.  The North Korean problem is a major concern of ours as the U.S. is rapidly facing a binary choice of either accepting North Korea as a nuclear state or fighting a very costly war on the Korean peninsula.  Although the more likely outcome is the former, President Trump is capable of aggressive action.

The Russians toss U.S. diplomats: Russia didn’t initially respond to the Obama administration’s decision to remove some Russian diplomats and close two Russian facilities but, in light of recent sanctions, the Kremlin his decided to send 755 U.S. diplomatic personnel home.   Despite attempts by the president to improve relations, it appears that the trend of a new cold war with Russia has resumed.

The mess in Venezuela: The Venezuelan government held an election on Sunday to select a constituent assembly to create a new constitution.  The vote was rigged by design; voters only got to select the members of the assembly, not decide whether the constitution should be rewritten.  The government claims eight million Venezuelans voted, but independent observers think it was about half that level at best.  It is unclear where we go from here.  The Trump administration has threatened sanctions if the elections were held.  We are waiting to see what the U.S. will implement.  At a minimum, we expect the administration to restrict access to the U.S. financial system.  At worst, the U.S. could ban Venezuelan exports.  Given that Venezuelan crude oil is heavy and sour, there are few outlets for its oil.  China and Russia are especially nervous because they are significant creditors to the regime.  If the government falls, the incoming government may repudiate the debt.  We are seeing signs that the economic situation is becoming untenable.  Venezuela is having difficulty generating inflation because it can’t print enough banknotes.  The country imports its currency from foreign printers and, since they haven’t been paid, new currency isn’t coming in which is stabilizing prices.  In addition, the market for dollars has seized up in Venezuela as those holding greenbacks are hoarding them and won’t trade them at any price.  If Venezuela collapses, it may be short-term bullish for crude oil.

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by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Unlike the past few days, there was a lot of news overnight.  Here’s what happened:

The Senate fails to “repeal and replace”: In the wee small hours of the morning,[1] three GOP senators joined the full contingent of Democrats to kill any chance of ending the ACA.  After seven years of opposing Obamacare, the GOP had no real replacement plan.  Healthcare is hard.  The Charlie Gard situation in the U.K. shows the fears Americans have over a single-payer system.  On the other hand, medical care spending in the U.S. is very high and the outcomes we enjoy from that spending are not superior to what is seen elsewhere.  The GOP, in retrospect, couldn’t figure out how to reduce costs and maintain coverage.  The troubling part of the ACA is rising costs, which will continue to plague the law.  At the same time, both the ACA passage and the failure of its replacement scream for some sort of bipartisan solution.  Sadly, in our highly divided political environment, bipartisan actions are usually career-enders for politicians.  Anyway, now that the healthcare situation is behind us, we can move on to tax reform.

Taxes?  We expect the House and Senate to move on to tax reform.  Financial markets were never all that concerned about healthcare but are keenly focused on tax reform.  Unfortunately, there don’t appear to be any detailed tax proposals prepared.  The White House, Treasury and congressional leaders issued a six-paragraph statement of goals yesterday.  The only detail we received is that the beleaguered border adjustment tax (BAT) is now officially dead.  Although controversial, the BAT actually resolved a couple of problems.  First, it was a major revenue generator; using a BAT would have created enough revenue to allow for large marginal cuts.  Second, it accomplished the president’s goals of improving America’s trade imbalance by raising import prices (although a stronger dollar would have offset some of this effect).  It was terribly unpopular with retailers and refiners (who import oil) but quite popular with manufacturers.  Our read is that the president found it too complicated and it reduced his ability to micro-focus on firms and industries to harm or help over trade.  But, without it, we will probably see smaller cuts in marginal rates.  Congressional Republicans want tax reform that is revenue neutral.  The White House appears less concerned about deficits and may press for much bigger cuts than Congress can live with in the absence of offsets.  Another sideshow we will be watching is Steve Bannon, who lobbed a proposal to raise the highest marginal tax rate to 44% on incomes over $5.0 mm.  That idea will be an anathema to the establishment GOP but might actually be a powerful bargaining chip to attract Democrat votes.  We will be watching to see how quickly the establishment GOP moves to kill this idea; Grover Norquist will probably be front and center on this issue.

The Mooch fires away: Anthony Scaramucci was in the press over the past two days expressing extreme displeasure with Chief of Staff Priebus and Senior Advisor Bannon, using colorful language that we won’t repeat here.  Although interesting to watch, it could have an impact on financial markets if the tensions lead to resignations and firings in the White House.  The White House appears thinly staffed as it is; this kind of tension may lead to exits which would exacerbate problems and reduce the effectiveness of the president.

The Russians respond: After the elections, President Obama forced the Russians to leave two facilities in the U.S. that had long been suspected of being listening posts.  Obama made this move in response to evidence of Russian interference in the U.S. presidential election.  Russia didn’t initially respond to the U.S. moves, likely in order to see how the incoming administration would act toward Russia.  The recent sanctions overwhelmingly passed by Congress have triggered a Russian response; the number of people tied to the U.S. embassy in Russia will be reduced to 455 people, the same number of diplomatic staff Russia has in the U.S.

Iran has an ICBM, too: Iran launched a missile that is capable of reaching space and can carry a payload of 550 lbs.  Although Iran still remains compliant to the deal it signed with the Obama administration, the Trump administration is clearly unhappy with the deal and is threatening to scuttle it.  If the Iran deal is rescinded, we would expect Iran to rapidly move to finish the nuclear cycle and build a weapon.  How the U.S. and Israel react to such a development will be clearly worth watching.  It’s possible the U.S. could launch airstrikes against Iran’s nuclear facilities; a more likely outcome would be a nuclear arms race in the region.

Amazon disappoints: We usually don’t comment on individual stocks in this report but the tech sectors (and the NASDAQ) are lower this morning after Amazon (AMZN, 1046) earnings came in below expectations.  Shares are off 3.6% in the pre-market trade.  Given the dominance of a few tech stocks in driving the overall indices higher, an earnings disappointment might lead to a broader consolidation.  At the same time, as we discuss in this week’s Asset Allocation Weekly Comment below, there is still enough sideline cash to likely prevent a significant pullback in equities.

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[1] https://www.youtube.com/watch?v=sqCLsp5owY8