by Bill O’Grady, Kaisa Stucke, and Thomas Wash

[Posted: 9:30 AM EDT] The global political situation remains fluid.  In France, President Macron won an apparent smashing victory in the first round of parliamentary elections, winning nearly 32% of the vote and faring much better than the conservative parties, which captured around 20%.  The National Front picked up 14% of the vote and the Socialists polled in the single digits.  The second round of elections will be held on June 18 when the En Marche Party is expected to capture 400 to 440 seats out of 577 seats.  This is an impressive victory for a new party.  The vote will give this new party and Macron a dominating hold on the legislature.  Macron is promising to implement what can be best characterized as a neo-liberal policy, intending to lower taxes and end the 35-hour workweek.  France never really adopted neo-liberal policies during the Reagan-Thatcher period so it would be a major change if they are implemented.  On the other hand, Macron wants to create an EU fiscal mandate, which will surely be opposed by the Germans.  All in all, Macron will have domestic political support.

While France appears to be moving to the right, the U.K. seems to be leaning toward unreconstructed socialism.  Jeremy Corbyn pines to renationalize various industries that were privatized under Thatcher and initially nationalized by Labour after WWII.  Although the Tories did win the majority of seats in the last election, they will struggle to form a government and the odds of another election soon are rising.  After last week’s embarrassing loss, there is growing speculation that Theresa May will be forced to step down from her post as party leader while the Tories try to regather themselves.  David Davis, the minister overseeing Brexit, has stated that Brexit negotiations will not start on June 19 as planned but will likely take place sometime next week.

We are seeing a penchant for newness as there are high levels of discord across Western societies.  We have seen the rise of hard-left and hard-right parties, but what has been consistent across the West is a willingness by voters to try something new.  Corbyn and Trump are calling for different policies but are clearly outside the mainstream.  These persons become attractive because voters are desperate for something new, hence why France decided to go with a very young president and a new party promising neo-liberal, market-friendly policies.  So far, financial markets are handling these divergences without major problems, although one could argue that currency and fixed income markets have moved while equities continue to mostly ignore political discord.  We don’t know if this can last indefinitely, but it is clearly in place now.

In the Middle East, Qatar is still looking for a diplomatic solution to the blockade formed by Saudi Arabia.  Qatar has been accused of funding terrorism, a claim that it has vehemently denied.  SOS Tillerson has called for a de-escalation of the blockade, stating that it is hindering U.S. military operations within the region as well as being wrong on “humanitarian” grounds.  It is worth noting that Qatar hosts the largest U.S. military base in the Middle East.  As such, the Pentagon has also weighed in, stating that the blockade does not currently hinder its operations but rather its ability to plan for longer term military operations within the region.  Alongside SOS Tillerson’s calls for de-escalation, Trump has issued a statement praising the blockade as possibly leading to the end of terrorism.  Trump’s conflicting viewpoints from members of his administration have become somewhat routine.  That being said, the Trump administration’s inability to formulate a coherent foreign policy could lead to the U.S. losing clout around the world.

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by Bill O’Grady, Kaisa Stucke, and Thomas Wash

[Posted: 9:30 AM EDT] In Britain, Theresa May’s decision to call a snap election in order to win a larger mandate backfired last night.  The Tories, who were supposed to win more seats, lost their majority and barely squeaked out a plurality.  Final results show that the Tories lost 12 seats, falling to 318 in Parliament, and their rivals in the Labour Party won 31 seats, increasing their total to 261.  This outcome is seen as a stunning loss for the Tories who now need the help of a minority party in order to secure the additional eight seats needed to form a government.  As of right now, the Democratic Unionist Party (DUP), a party from Northern Ireland that won 10 seats, is likely to help the Tories form a government but will not form a coalition.  Despite the market’s negative reaction, there is growing sentiment that the election has possibly paved a way for a “soft” Brexit.  The voting results suggest that May’s insistence that “no deal is better than a bad deal” may have hurt the Tories in anti-Brexit strongholds such as London.  In the event that May fails to form a government, Jeremy Corbyn, leader of the Labour Party, will likely have to make concessions to the DUP (10 seats),  Liberal Democrats (12 seats) and the Sottish National Party (35 seats) in order to form a government, all of whom are strongly in favor of a “soft” Brexit.  That being said, May is expected to retain her role as prime minister as Brexit negotiations begin in 10 days, but it is unclear whether she will be able to retain her role as party leader in the long term.  The GBP is currently down 147 bps relative to the dollar from the prior close.

Yesterday’s testimony by former FBI Director Comey is being spun furiously by both sides.  Our take is that it’s damaging but not fatal.  It doesn’t appear that there is a clear case of obstruction.  Comey’s decision to leak is normal for Washington but it does taint his image.  Former AG Lynch came off badly.  For the financial markets, probably the best model to think about this issue is not Watergate, but Whitewater.  There may not be much here, but the administration’s handling of the issue keeps leading to concern that “something” is being covered up.  That means the special investigation will continue for months, if not years, and will be a distraction for the administration.  If they are going to have any legislative success, they need to figure out how to manage this distraction.

Yesterday, the Federal Reserve issued its Financial Accounts of the U.S. for Q1, otherwise known as the “Flow of Funds” report.  It offers a plethora of useful and interesting data about the economy and the health of important sectors of the economy.  The charts below show a few of our favorites.

The chart below shows net worth as a percentage of after-tax income.  It has reached a new record high as financial assets rise and housing prices recover.

Deleveraging has slowed, but we are still seeing households lower their debt levels relative to after-tax income.

We are seeing a steady healing of the real estate sector.  Owners’ equity in real estate continues to approach 60%, which history would suggest is “normal.”  In other words, as we approach this level, we could see homeowners and potential buyers view home buying as a less risky activity.  If so, we could see a boost in homebuilding that would help the economy.

 

The Flow of Funds report also publishes national income data.  Labor picked up modestly in Q1 but its share remains depressed.  The steady loss of share is likely a factor in the rise of political populism.

Rental income reached a new high, one of the factors that has made real estate investments attractive.

Our last chart examines the income from interest and dividends.

Dividends are currently about 6% of national income, with interest income under 3%.  The last time we had dividends consistently exceeding interest income was in the 1950s and early 1960s, a period of financial repression.  This chart portrays investor preference of income-producing equities.

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by Bill O’Grady, Kaisa Stucke, and Thomas Wash

[Posted: 9:30 AM EDT] In Iran, a gunman and suicide bomber attacked the Iranian parliament and the Ayatollah Rullah Khomeini shrine.  The Sunni-led group ISIS has claimed responsibility for both attacks, its first significant attack in Iran, which is majority Shiite.  According to the Iranian news media, previous attempts have been thwarted over the past three years.  These attacks have raised fears that the ongoing sectarian violence may spread throughout the Middle East.  If conflict persists, we expect oil prices to rise as conflicts in the region typically disrupt oil production.  As of this morning, oil has been trading lower than the previous day’s close as the U.S. has increased oil exports.

In a morning tweet, Trump announced that he has nominated Attorney General Christopher Wary for FBI director.  Wary had previously worked as the assistant attorney general under the Bush administration.  This announcement comes a day before former FBI Director Comey’s testimony, and amidst a number of headlines regarding Trump’s contentious relationship with AG Sessions.  It would seem prudent to simply wait for Comey to testify but the comments will be the focus of the media come Thursday.  So far, equity markets are mostly shrugging off the news as it is widely believed that Comey will stop short of saying that Trump tried to obstruct justice.  It is worth noting that the dollar has been weakening and Treasuries have been showing price strength; gold has also been stronger.  There are some concerns in the financial markets but the attention has been outside the equity space.

Bloomberg reports that the ECB is considering downgrading its inflation outlook through 2019 and slightly revising its GDP forecast higher.  The downgrade is due to pessimism as to whether energy prices will rise in the future.  Despite Eurozone strength, the ECB is likely to remain dovish for the foreseeable future.  This report comes a day before the ECB is due to hold its policy meeting.  Currently, the euro has fallen 54 bps relative to the USD.

Yesterday, the JOLTS report showed a surge in job openings and only modest hiring.  The chart below illustrates the odd behavior of the labor markets.

The blue line on the chart shows the ratio of hires to openings; when the ratio is below one, it means there are more openings than hires and would suggest a tight labor market.  The JOLTS report doesn’t have a long history but the ratio has never been this low.  Note that the previous business cycle low, in 2006, led to wage growth of 4%.  It is shocking that labor markets can seem to be this tight and wage growth remain subdued.  It may be that labor fears of being substituted for machines or the huge pool of discouraged workers are keeping wage growth low, but, clearly, firms are looking for workers and struggling to fill positions.  Basic economic theory would suggest that if demand is this strong, the price of labor should rise unless the supply curve is perfectly flat; if that were the case, the openings would be filled.  This gap will likely encourage the FOMC that the proper course for monetary policy is to tighten further.

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by Bill O’Grady, Kaisa Stucke, and Thomas Wash

[Posted: 9:30 AM EDT] Although there has been some market uncertainty due to political risks in the U.S. and U.K., the overnight news was relatively quiet.  Market jitters seem to be due to concerns that tax and healthcare reforms have stalled, doubts as to whether Theresa May will be able to pull off a decisive win in Thursday’s election and the Middle East’s isolation of Qatar.

Today, President Trump is meeting with congressional GOP members to get an update on healthcare and tax reform.  Republicans have been reluctant to put the bill to a vote without receiving any support from Democrats.  The Russian investigation and the travel ban have made Democrats hesitant to support any initiatives promoted by the Trump administration.  It is believed that President Trump would like healthcare reform put to a vote by summer and tax reform by fall.  Former FBI Director James Comey could possibly play a role in ensuring that Congress is able to meet this deadline, assuming his testimony doesn’t further implicate President Trump in the Russian investigation.  Congress has about 80 days left to pass legislation for this congressional session.

In the wake of the London Bridge attack, Theresa May has faced calls that she should resign as prime minister.  While serving as home secretary, May agreed to cut the police budget by 18% which is believed to have contributed to a drastic reduction in the police force.  Her opponents suggest that had the police budget not been cut, the attack could have been prevented.  Although this assumption is probably baseless, it is likely to resonate with many Brexit supporters.  May’s fondness for ambivalence suggests that these critiques will force her to pivot toward a harder stance with the EU.[1]  A hard Brexit would heighten uncertainty for businesses located in the U.K., hence we are bearish on the GBP.  That being said, polls still suggest that May’s party should win in Thursday’s election.

Qatar remains at odds with its neighbors, but a bit more interesting information has emerged.  According to the FT,[2] what has angered the rest of the Gulf Cooperation Council (GCC) states is that Qatar paid up to $1.0 bn to jihadist groups linked to al Qaeda and Iranian militants, in part to secure the release of a group of Royal Family falconers who were kidnapped in Iraq on a hunting trip.  Qatar has been accused by the GCC of funding various militant groups, perhaps to ensure these groups don’t attack Qatar.  According to reports, these payoffs were so egregious that they prompted the recent harsh measures taken by the GCC.  We suspect this will be a temporary event, but if the embargo evolves into a blockade, a military conflict could emerge.  It will be interesting to see how Iran would manage such an event.

The Atlanta FRB GDPNow forecast is still indicating a strong Q2 GDP report.

The contributions to growth suggest that one percent of the growth is coming from inventory accumulation.

Consumption has remained rather steady and this forecast doesn’t include the recent employment data.  We are concerned about the softer residential investment and weak government spending but, overall, the data for Q2 suggests a good recovery, at least so far, and should lift H1 growth levels.  At the same time, this solid data should support the FOMC in raising rates on the 14^th.  Fed funds futures put the odds of a rate hike at the next meeting at just above 90%.  Interestingly, the odds of a hike in September remain around 35%, while we see a greater than 50% chance of a third hike this year at the December meeting.

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[1] The Economist has nicknamed her “Theresa Maybe.”

[2] https://www.ft.com/content/dd033082-49e9-11e7-a3f4-c742b9791d43 (paywall)

by Bill O’Grady, Kaisa Stucke, and Thomas Wash

[Posted: 9:30 AM EDT] Although financial markets are quiet, there is a lot happening in the news.  Here is what we saw as important:

President Trump ready with two Fed governor nominations: The president, according to numerous media reports, is prepared to fill two of the current three vacancies on the FOMC.  Randal Quarles, a former Treasury official, is said to be the selection to replace Tarullo, who was acting as the governor with the regulation mandate.  His public statements suggest he would likely roll back regulations on the banks and his appointment would be welcomed by the financial services industry.  The other selection is Marvin Goodfriend, an economics professor at Carnegie Mellon; he has broad experience working as a researcher in monetary policy.  Media reports touted comments he has made critical of QE and his support of a “rules-based” policy for setting rates as evidence that he would be a hawkish “offset” to Yellen.  However, deeper research suggests this is a facile analysis of his broader work.  Goodfriend opposed QE mainly because he was much more supportive of negative interest rates.  Of course, the major problem with negative rates is that they create a positive return for cash.  Thus, negative rates should trigger massive cash hoarding if the rates become negative enough.  His solution to this problem would be to devalue cash by having the central bank no longer exchange 1:1 currency for reserves.  In other words, the value of cash held would be allowed to adjust as well.  We remain unsure how this would work in practice but suffice it to say that to suggest Goodfriend is a hawk is probably a misjudgment.  In fact, his views appear radical enough to suggest we may be installing the next Kocherlakota.

Terror attacks in London: Again, the U.K. was the target of another attack over the weekend.  IS has claimed responsibility but we don’t yet know how involved the group was in the attack.  It isn’t clear why London was the target unless terrorists groups want to undermine the May administration.  Although these attacks are clearly not on the scale of 9/11, they are effective insofar as they terrorize.  Thus far, these attacks have had little effect on financial markets and, in fact, the more often they occur, the more markets become inured to them.

Thursday is a big day: On Thursday, former FBI Director Comey is expected to testify before Congress, the British hold elections and the ECB holds its regular meetings.  The Comey testimony runs the risk of further distracting the administration from tax reform, health care, etc.  In the U.K., the polling spread remains in the single digits, with the latest poll showing the Conservatives holding a 7% lead, although some polling from late last week showed the race as a dead heat.  We still expect the Tories to win but a narrow victory would defeat May’s reason for calling snap elections, which was to build a larger mandate to negotiate Brexit.  Finally, the ECB may begin hinting about tapering and rate increases.  If so, the EUR may get a boost.

The PRI in Mexico squeaks out a win: A quick vote count in the state of Mexico gives the governorship to Alfredo del Mazo, the candidate of the ruling PRI.  The last count shows the PRI up 32.3% to 31.3%.  This election was seen as a harbinger for next year’s national elections.  The PRI has ruled the state of Mexico for 88 years and so a loss here would suggest that the leftists under Andres Manuel Lopez Obrador[1] might win the presidency.  We caution that this final vote hasn’t been tabulated so the PRI may still lose this state.

Qatar isolated: Bahrain, Saudi Arabia, Egypt and the UAE, among others, have severed diplomatic ties to Qatar.  Diplomats are being sent home.  The severing nations are angry with Qatar for their supposed ties to Iran and its support of the Muslim Brotherhood.  Less than two weeks after the president’s visit to Saudi Arabia, the anticipated coalition against Iran and terrorism appears to be fracturing.  We note the U.S. operates out of the Al Udild Air Base in Qatar; the base is used for air operations against IS.  So far, we don’t know if operations will be disrupted due to this diplomatic spat.  Religious authorities in Saudi Arabia are accusing the leadership of Qatar of religious illegitimacy.  Conspicuous in its absence is Pakistan.  The Pakistanis have been cool to the Saudis’ tensions with Iran and any sort of conflict with Iran would be problematic without Pakistan’s support.  Overall, we have seen such tensions before, although not to this degree; in fact, the actions being implemented are commonly part of war.  Thus, this is an issue that bears watching.

The Israelis do have “the bomb”: There was a report in the weekend NYT[2] that Israel was planning to detonate a demonstration nuke in the Sinai in 1967 if its forces were being overwhelmed.  This was to serve as a warning to the Arab states that the costs would be catastrophic if they tried to make good on their promise to “push Israel into the sea.”  The plan was never executed because the IDF won a quick victory in the 1967 Six-Day War.  On the 50-year anniversary of this conflict, the report reveals what Israel has refused to acknowledge, which is that it is a nuclear power.

The White House is pushing infrastructure: The White House seems to be preparing to unveil a plan to rebuild U.S. infrastructure this week.  It appears to rely heavily on local direction and money, with only modest federal involvement and funding.  Needless to say, state and local governments are less than impressed.  The idea of state and local government funding is a pre-1930s conception; it only works if the projects generate enough cash to service the debt drawn to pay for them.  Thus, toll roads and other service fees are required to build projects.  Although such constraints should lead to better projects, the public has gotten used to federal funding and it would be a shock to force car owners to rent or buy electronic pass units to drive around.  We note that the president is expected to unveil a partial privatization of the air traffic control system today.

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[1] See WGRs: The Rise of AMLO: Part I, 3/13/17, and Part II, 3/20/17

[2] https://www.nytimes.com/2017/06/03/world/middleeast/1967-arab-israeli-war-nuclear-warning.html?emc=edit_mbe_20170605&nl=morning-briefing-europe&nlid=5677267&te=1