Breaking up is hard

Published at 14:47 11 Oct 2019 by . Last edited 16:33 11 Oct 2019.

After some 30 years of being the global supercouple, Chimerica—the geopolitical equivalent of Brangelina—are breaking up, and it is likely to be a messy and ungraceful affair. The era of cooperation between the US and China is over and an era of competition has already begun, even if the equity markets have not yet realised that. The realistic best-case outcome remains an interim agreement that would stop tensions intensifying, rather than improving relations.

Don’t forget to recycle
Meanwhile, the markets continue to respond in Pavlovian fashion to the Trumpian dog whistle of ‘I think there’s a good chance for a trade deal’, despite continual disappointment. The fact that both sides keep recycling ‘agreements’ that had already been agreed but present them as ‘new’ only underscores the state of negotiations. Soybean purchases and currency agreements had already been agreed for some time, so it was really nothing new when such agreements were presented again this week.

Late this week, reports surfaced that President Trump would grant special licenses for some US companies to do some business with Huawei, a Chinese pre-condition for an interim deal. But even this is a recycled plan that Trump outlined after meeting Chinese President Xi Jinping at G20 summit in June. No details were provided on which companies might be licensed and how national security concerns would be addressed. Time will tell.

However, the reality is that even an interim agreement is about optics and changes nothing. To quote Senator Marco Rubio, ‘what we’re going through here is not just a trade dispute but a much-needed rebalancing in our relationship’. The granting of limited licenses, just like recycled agreements on currency and soybeans purchases, are the equivalent of putting lipstick on a pig.

Of course, this is not a linear process. There will be periods of escalation followed by attempts at strategic pause, but each side will be opportunistic and seek not to undermine their own domestic priorities. For the US, the priority is its economy, which is already exhibiting signs of stress. For Trump specifically, the priority is the 2020 election cycle. For China however, it is about banking sector recapitalisation and, perhaps more importantly, the development of an endogenous technology ecosystem.

Rocket man (not that one)
The technology sector should take note of the episode involving the Houston Rockets and the broader NBA this week with regard to the now-deleted tweet by the Houston Rockets General Manager Daryl Morey in support of the protests in Hong Kong. The NBA is refusing to apologise and is now facing the ire of the Chinese government and, to some extent, the Chinese public with a very clear threat—if you want to do business in China, you have to toe the party line. All this over basketball. Imagine if it was companies involved in artificial intelligence or other security and defense-related industries.

QE or not QE, that is the question
Meanwhile, US Fed Chairman Jerome Powell and a bevy of Fed speakers basically pre-announced this week that the Fed is going to begin net asset purchases again, likely as soon as next month. They are going to pains to differentiate this from the previous quantitative easing (QE) programmes, insisting that this is a means to provide sufficient liquidity to the system within current policy. The absolute level of purchases will be much smaller than during previous rounds of QE and Fed officials do not see this as providing additional accommodation (though many in the markets will refuse to believe this). The fact that the Fed Chair chose not to announce this during a regular FOMC meeting at the end of the month underscores the desire of the Fed to separate what they see as technical adjustments to provide ample liquidity to the system versus traditional monetary policy.

The markets see a further rate cut at the October Federal Open Market Committee (FOMC) meeting as a done deal (80% priced in the market). Both Powell and Vice Chair Richard Clarida, the two most important voices on the FOMC, did nothing to disabuse the markets of this notion in their public communications in the past week. But they remain committed to the ‘mid-cycle adjustment’ mantra that began in July and do not want to signal to markets that they are going to keep cutting rates at every subsequent meeting, unless there is a further deterioration in the economic outlook, which has deteriorated but is not yet nearly as bad as the markets often seem to think. On the flipside, Fed officials desperately want to avoid a communications miscue like in December 2018, where they announced a sharp tightening of financial conditions that they subsequently needed to respond to and then reverse.

Meanwhile, there are still a wide range of opinions within the FOMC on whether or not the Fed has cut rates enough to support the economy. There were already two dissents against the September rate cuts and a number of officials have publicly stated that they think the 50 basis points (bps) the Fed has already done is sufficient (Charles Evans) or want to wait and watch how things develop (Robert Kaplan). Outside of disappointing market expectations, it is clear that there are a significant number of Fed officials who, all else equal, would probably like rates to remain on hold in October. One of the rationales for holding off would be to keep some powder dry in case the hard data start to echo the soft data, as we highlighted last week (see Macro digest: Controlling the narrative, 4 October 2019). Should the data turn undeniably bearish, a much larger cut may be required in December—not to mention the appropriate signalling of even more cuts to come after that. While the Fed has claimed to be data-dependent for some time, perhaps more so than before, the data releases between now and the October Fed meeting will take on some outsized importance, with retail sales and consumer confidence likely to get extra scrutiny.

Fig 1: US PMIs  Fig 2: Fed rate cut probabilities (%)
Source: ISM, Energy Aspects Source: CME, Energy Aspects

Earlier this year, a significant portion of Capex was delayed because of uncertainty surrounding the trade dispute between the US and China. Increasingly, companies are now starting to cancel those Capex plans (some of it related to very specific factors like the grounding of the Boeing 737 Max, and the recent GM strikes). Even so, the slowdown in US manufacturing has been thus far manageable and, in fairness, has to a large extent been driven by the slowdown in activity in the US oil and gas sectors. But it is the slowdown in the service sector in the last few months that is catching the market’s attention. Some 75% of jobs in the US are tied to the service sector and it represents a big chunk of the US economy. So, the slowdown in the services sector is becoming a worry, and hence the need for the Fed to have flexibility and, just as importantly, dry powder.

We would caveat that the service sector is under-represented in the monthly data grind. While the services PMI is important, we, and more importantly the economists at the Fed, still consider it a ‘soft’ indicator. The services PMI is weaker, but there is as yet no sustained indication that the sector is crashing. If anything, housing has been surging, claims remain on the lows (a very coincident indicator) and corporate executives remain pretty optimistic about the outlook (surprisingly, all things considered). The point is not to say that all is well, but rather that the Fed is going to be a bit slower to make a judgment that the non-manufacturing part of the economy is keeling over. If they do make that judgement, however, we would expect the response to be forceful and rapid. This is the situation where they could cut 50 bps at a meeting and signal a further 50 bps cut in the future. If the deterioration seems even more rapid, it is not crazy to think they will cut by 100 bps in a single meeting and remain open to the idea of cutting by more in the future. We are nowhere near that point today. But given the recent wavering in the data, it is also reasonable to say that this is a non-zero probability on a three- or six-month horizon.

Impeachy keen
The White House response to the impeachment inquiry has been to adopt the Republican strategy that salvaged Brett Kavanaugh’s nomination to the Supreme Court—dismiss allegations, deflect the facts and discredit the Democrats. President Trump and the Republican party are now waging an aggressive counterprogramming effort, that, much like with the Kavanaugh confirmation, will feed into a 2020 strategy that is being built on energising the Republican base. But whipping the base into a frenzy risks alienating moderate Republicans and independents.

Of course, should Elizabeth Warren win the Democratic nomination, that may not be as big a worry. While we understand the impulse to start deciphering what a Warren presidency might mean for markets, we would caution that it is still very, very early. Often, policies undergo significant revision both during the primary season and after it, when candidates refocus on pitching to the full electorate and not just their active party base. Warren is currently fighting Bernie Sanders to position herself as the far-left candidate of choice. Ultimately, we think Warren will overcome Sanders and, when he drops out, she is likely to try to appeal more to the middle ground of the party (let alone of the country). So we would expect to see an evolution of her views.

Should Sanders drop out of the race, we believe that Warren will hoover up the 40% of the Democratic primary electorate in a divided field. It is unclear if Joe Biden can assuage concerns about his age as well as the accusations of wrongdoing related to Ukraine. As we noted last week, for the White House, the decision to double down on Ukraine is as much about knocking down Biden (who they feel still has the best shot to beat Trump) as it is to boost Warren (who they feel, like Hillary, is unelectable).

For the Democrats, the question remains—can someone else emerge to occupy the centre if Biden stumbles. Until then, Warren will be considered the Democratic frontrunner. The best thing that could happen for Warren right now would be for Sanders to drop out of the race, which would allow her to pivot to winning the middle while not having to also compete for the left. But Warren’s policies are not yet set in stone and are unlikely to fully materialise until she becomes the clear frontrunner.

The Outlook
Brent: Shipping continues to dislocate the physical market, with crude differentials rising sharply in the east and differentials in the west weakening. However, both moves have not nearly been enough to offset the massive spike in freight rates (see Figure 3) due to the combination of sanctions on Chinese shipping company COSCO (see E-mail alert: Freight soars after US sanctions Chinese firms for dealing with Iran, 27 September 2019), several companies refusing to use ships linked to Venezuela and some ships tied up in dry docks for installing scrubbers ahead of IMO 2020. While paper markets (reflected in Brent spreads) have given up some gains to accommodate higher freight rates, physical differentials have not budged much. The most-affected region is the US, where the combination of higher crude exports coupled with a drop-off in long-haul imports (due to OPEC producers cutting exports to the West as a part of the OPEC+ deal) has left the region significantly short of VLCCs. Unlike West Africa and the Middle East, which are the big crude export hubs, loaders have to ballast VLCCs and other vessels back to the US, incurring an additional cost and eroding export margins significantly. This remains a bearish headwind to WTI timespreads in particular and is ultimately positive for Brent spreads as there will be lower US exports. But in the near term, soaring freight rates are also affecting the ability of those holding long spread positions in Brent at the prompt as, in many cases, they are having to shed positions to pay for the higher freight costs. We expect dislocations to continue until freight stabilises, even as the physical market remains incredibly strong at a time of peak autumn refinery maintenance.

Fig 3: Freight dirty USGC - China 270kt $/t Fig 4: Prompt benchmark crude spreads, $/b
Source: Argus Media Group, Energy Aspects Source: Bloomberg, Energy Aspects

WTI: We have been constructive deferred WTI timespreads all year based on our below-consensus forecasts for US production growth, our call for WTI-Midland to strengthen and our expectation that US exports will continue to rise. That said, Cushing balances face a few headwinds in October that may ultimately lead to a stockbuild of just over 1 mb for the month, weighing on prompt WTI timespreads.

But beyond that, the next few months could be very important for perceptions of US production growth in 2020. In most balances, the US continues to carry the bulk of the growth in supply, which in turn is helping to reinforce the view of an oversupplied market in 2020. But increasingly, things are not adding up in the US and the data has been disappointing what now looks to be overly aggressive growth forecasts at the start of this year. We have recently revised our US crude and NGL growth forecasts lower for 2019 and 2020. We now expect 2019 US crude output to average 12.15 mb/d and 2020 to average 12.96 mb/d, a growth of only 0.81 mb/d in 2020. For NGLs, we are now forecasting 4.88 mb/d in 2019 and 5.32 mb/d in 2020, a growth of roughly 0.44 mb/d in 2020. This puts total US liquids growth average for the year at 1.25 mb/d in 2020. Notably, the growth in the December to December exit rate for crude in 2020 will be much lower at roughly 0.60 mb/d. These numbers are still much lower than the consensus and most of the reporting agencies (see E-mail alert: US crude and NGL growth forecast reduced for 2019 and 2020, 7 October 2019).

Energy Aspects global liquids balance, mb/d
Source: Energy Aspects

Yasser Elguindi, Market Strategist
+1 646 760 8100 (direct)

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