Outlook:

The key data today is industrial production and capacity utilization. Late in the day we get the Treasury's TICS report on capital flows, which is critical to understanding the "hard" real money effects of "soft" sentiment but so hard to read that market players tend to ignore it.

Industrial production is expected to come in near the recent level of 5.1% growth in Sept, which was the highest since Dec 2010, so a dip would not hurt. The overall trajectory is upward, as the tradingeconomics.com chart shows. It won't last. The forecast is for 3% by quarter-end and 2.6% in a year. The longer-term forecast is 1.10% in 2020, i.e., a deceleration. This is useful to know because the number associated with industrial production, capacity utilization, is on the high side, if not scary high. Economists argue about whether utilization is measured correctly and whether it really affects inflation as the models have it, but the general rule is that when capacity utilization gets stretched to 80-85%, prices go up. The expected drop in output over the next couple of years suggests we need not fear inflation from this quarter.

Removing an inflation factor is a good thing in its own right but may have implications for Fed policy going forward. Something else we shouldn't forget—as industrial production winds down from a red-hot pace, residential investment is already winding down and might be in the soup by then. See the chart from The Daily Chart. We have written about this risk before and sure enough, it's materializing. The average Joe can't afford new houses, a high percentage of homeowners are still under water and not moving, and because of tariffs real and expected, building costs are going up. This is not exactly a double whammy but is going to haunt the Fed next year as it contemplates hiking rates, including mortgage rates.

We can try to care about US industrial production or Italy or other issues, but let's face it, the one thing on everybody's mind is whether UK PM May can extricate herself from the Brexit sinkhole. Last evening The Economist reviewed the forces arrayed against May, including members of her own party and N. Ireland coalition partner, and concludes "the parliamentary arithmetic looks impossible." May gave the speech of her life to Parliament, but you can't argue with arithmetic.

A leadership challenge is in the cards, with one of the potential new PM's the former Brexit negotiator Raab. How sharper than a serpent's tooth. The Economist concludes with this: "A leadership election would be embarrassing as well as bloody. The party would spend weeks tearing itself apart when it ought to be grappling with the most complicated bit of statecraft in a generation. It would destroy what little credibility it still has with voters. Young people in particular are already furious with the Tory party for dividing the country over Brexit. They will be more furious still if the party abandons itself entirely to civil war.

"It is hard not to despair about the state of British politics. Mrs May's Brexit deal clearly offers a worse outcome than the status quo, including an obligation to obey the EU's rules for the foreseeable future without any say over what those rules should be." [In Parliament yesterday] "There was plenty of parliamentary rhetoric of a high order. The pity was that it was all devoted to appraising a deal that has little chance of making Britain a better place."
Yes, and something bigger is going on, too—the dissolving of a conservative political party in a major western country. The Tories were founded in 1915 and now the party exists as a unified entity only in name. Two things: this is exactly what Russia wants—to break up the European Union so it can pick off each country one by one. When we say pick off, we mean disrupt and render dysfunctional. It came close in France—remember Marine LePen? A Russian tactic was employed by LePen and others—nationalism that polarizes the public, nurtures anger and grievances, and destroys parties from within. A lot of it is anti-foreigner and racist and anti-Muslim. We can note that Catholic Ireland remains at odds with Protestant N. Ireland but that's not the focus of Brexit nationalism, which is directed more at the Continent and its hordes of Polish plumbers and Middle East refugees.
Did Russia actively engage in promoting the Brexit movement ahead of the referendum? Investigations seem to bear it out (see stories in The Guardian, for example), but there is never enough to bring a case. Sound familiar? What is happening in the UK—the nationalism, the revulsion at having Others in the neighborhood—is the same thing that is happening in the US, with our own particular flavorings. It's a tragedy, to be sure, in both places. And the whole world is watching. Google "Brexit news now" and you get newspaper reports from Hawaii, for heaven's sake. Interest is widespread because people always slow down to see the car wreck.
As for sterling, first we acknowledge that currencies always overshoot. Most financial assets do overshoot on an Event. But currencies take the cake. To find a sensible idea of how bad the carnage might be, we consulted purchasing power parity. The OECD is offering exchange rates at PPP for 2009. (Why do we support this organization?) The Economist's Big Mac version has now been updated to show implied, market and perceived value, with an unclear explanation of what the hell those words mean. Bottom line, market value is the exchange rate at the time in January 2018 and out of date (average 1.3500). Implied value is the classic PPP, and it means that £60.43 would buy the same number of Big Macs as $100.
In other words, the pound is overvalued. "If we calculate backwards the implied value of 60.42 GBP is 100 USD and the real market value of 60.42 GBP is 83.58 USD. In other words that means that in terms of actual purchasing power, having 100 USD in United Kingdom would be the same as having 119.65 USD in United States." Aha, perceived value is the inverse of PPP. The pound is overvalued by 19.65%. Let's assume the recent low at around 1.2725 is the jumping off point. Devalue by 19.65% and you get $1.0231. Now overshoot, say by another 10% (to be conservative). You get $0.8958 per pound. A silly number, maybe, and the Bank of England no doubt has better or at least more respectable methodology.
For one thing, devaluations do not pay the slightest attention to purchasing power parity. But the implications are tremendous. Does the BoE wish to avoid such a vast devaluation? We saw desperate measures when sterling was forced out of the ERM and Soros made one of his fortunes (September 1992). Intervention, rate hikes—those are the tools. We have no reason to suppose this time will be any different. A massive devaluation is good for trade but horrible for consumers and businesses in an island nation that must import rather a lot—vehicles, food, electrical machinery, oil, clothing, industrial machinery and paper lead the list. If you are interested. Food is about $23.4 million and medical stuff, $29 million. A big devaluation means shortages (and inflation), and in many instances, outright impoverishment.
Scare story? You bet. This is what you get when nationalism runs amuck and politicians misbehave. That referendum was a stupid thing from start to finish. There may be a vote of no confidence next week. Reuters reports that sterling gained some support from euroskeptic Environment Secretary Gove announcing he will stay in the cabinet—and he's one of the likely leadership challengers if it comes to that. Inside the tent, so to speak.
Martin Wolf in the FT writes the next step "might mean another referendum, a general election, a request for postponement of the departure and an attempt at a renegotiation, or some combination of these. The one certainty is that, one way or the other, Brexit will haunt the UK's economy and politics for the indefinite future. Britain cannot at present resolve its relationship with the continent. This is the one clear truth. Comparisons with the 1956 Suez crisis do not get close to the mark. This is a far more significant mess than that."
What hardly anyone notices is that the Brexiteers, the ones who fought (and lied) to get the referendum outcome, are noticeably absent when it comes to alternatives or leadership. We say this smells fishy.
Bottom line, unless May can pull a rabbit out of the hat, sterling will jerk downward some more, taking the euro with it. We just need a trigger. Having said that, it looks like the ECB may be retreating from the scenario in which it raises rates late next year while the Fed might be retreating from three hikes next year, too. This reduces divergence, and is not dollar-favorable.

Tidbit: A full-bore Trumpian attack on China would include disallowing Chinese investment in US real estate and companies, but really insulting would be to forbid Chinese companies to do IPO's. The chart here comes from the Daily Shot, which publishes private newsletters we mere mortals hardly ever get to see. This one indicates the number of IPO's is small and the dollar amount trivial in the grand scheme of things, but the insult factor is pretty big.

 


 

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