Against all odds, the Organization of the Petroleum Exporting Countries (OPEC) on Wednesday finally sealed its first deal in eight years to cut oil production, sending prices soaring.
Oil began the week lower amid flagging expectations OPEC would reach an elusive compromise. We had seen the movie before - officials publicly expressing optimism only for negotiations to break down at the final hour due to disparate agendas and political tensions. This time oil ministers even began to downplay hopes early in the week. Russia, not an OPEC member but a major producer and necessary party to any agreement, announced it would not attend the crunch talks in Vienna. Saudi Arabia insisted the supply glut would work itself out naturally next year anyway, so a deal to curb production wasn't even necessary. Iran doubled down on the notion it wouldn't participate in any upcoming cut.
Crude prices tumbled 5% on Tuesday as Goldman Sachs put the odds of an agreement at 30%. However, U.S. investors woke up Wednesday to shocking news a deal had been consummated, confounding critics writing the cartel's obituary. The agreed-upon cut, which reverses a two-year strategy of pumping at will, was OPEC's first since 2008 and the first to include Russia since 2001. OPEC producers agreed to collectively trim production by 1.2 million barrels per day, with non-OPEC producers pitching in an additional cut of 600,000 barrels per day. Russia agreed to make up half of the non-OPEC reduction. The total daily decrease of 1.8 million barrels represents around 2% of total world output.
The only parties exempted from cuts were Nigeria and Libya, while Iran came out the big winner. The rising Middle Eastern power was permitted to raise its output to 3.8 million barrels per day, the special treatment provided justified by its recovery from economic sanctions. Saudi Arabia had sought to limit Iranian production to just over 3.7 million barrels. The Saudis bore the brunt of the cut, agreeing to reduce output by 486,000 barrels to just over 10 million per day. OPEC's second-largest producer, Iraq, had previously sought special considerations in order to fund its ongoing war with ISIS. It ultimately agreed to reduce output by 210,000 barrels per day. The United Arab Emirates and Kuwait contributed a combined 270,000 barrels per day worth of cuts.
From its lows Tuesday to Friday's close Brent crude prices gained 15%, finishing the week at $54.46. Global energy stocks rallied in kind, among biggest winners being higher-cost U.S. shale producers.
The agreement didn't get done without a bit of last-minute drama. In the wee hours of Tuesday morning ahead of the crucial meeting, OPEC members remained at odds over deal terms. Of particular concern was the lack of participation from Russia, a non-starter. However, a 2 AM (Moscow time) phone call between Saudi Arabian Energy Minister Khalid Al-Falih and Russian counterpart Alexander Novak reportedly broke the deadlock. Novak promised for the first time to curb production by 300,000 barrels, half of the desired non-OPEC total, if the cartel could iron out its own production cuts. With fresh impetus, Al-Falih took the Russian proposal into Wednesday's OPEC gathering and sealed a deal. Iraq was the last to come aboard. The war-torn country agreed to its first cut since 1998 after a phone call from Iraqi Oil Minister Jabbar al-Luaibi to Iraqi Prime Minister Haider al-Abadi.
Iranian Oil Minister Zanganeh hailed the deal: "It's possible to be in the midst of rivalry and intense political differences and yet cooperate."
As excitement over the agreement wore off, skepticism emerged about the sustainability of oil's rally. Morgan Stanley, Goldman Sachs and Japan's Mitsui & Co. all expect crude prices to once again retreat as U.S. shale drilling and Asian investment ramp up. Shale fields could bring operations back on line in as few as four months, with recent record-setting discoveries of new deposits only increasing American the potential for U.S. energy independence by as early as 2017.
U.S. Economic Data Continues To Bounce Along The Bottom
With December kicking off, it was a busy week for U.S. economic data. Headline numbers were solid but there were discouraging signs under the hood.
Friday's jobs report revealed U.S. unemployment fell to a nine-year low of 4.6% after the economy added 178,000 non-farm payrolls (versus expectations for 180,000). The unexpected drop in the jobless rate stemmed from a sharper-than-expected decline in labor force participation, which slipped to 62.7%, its lowest level since the early 1970s. While the average length of unemployment fell to 26.3 weeks, its lowest level since August 2009, the statistic remains at elevated levels based on previous cycles. The last time unemployment clocked in at 4.6% was August 2007, at which time the average length of unemployment was just 17 weeks. Similarly, the percentage of workers out of a job for six months or more (24.8%) is much greater than it was the last time unemployment was this low (17.5% in August 2007). The divergence reflects a wide skills-gap in the U.S. economy, where workers don't have the proper training to fill available jobs. Also reflective of the mismatch between open jobs and eager workers is the fact the U.S. economy has added 638,000 part-time jobs over the last three months while dropping 99,000 full-time jobs.
Still, the most disappointing aspect of the jobs report was wage growth. Average hourly earnings fell 0.1% in November (versus expectations for 0.2% increase). Economists expected year-over-year (yoy) wage growth to hit 2.8%, its highest level since the crisis, but due to November's decline only grew 2.5%. On the other hand, the lackluster wage growth will at least temporarily ease pressure on the Fed to accelerate its rate hike calendar for 2017.
On a more positive note, GDP, manufacturing, consumer confidence and earnings data all came in better than expected.
The second reading of U.S. GDP was revised up from 2.9% to 3.2% (versus expectations of 3.1%), the strongest gains in more than two years. The upward revision was almost entirely due to a rise in recorded personal consumption growth from 2.1% to 2.8%. The Commerce Department report also revealed after-tax earnings rose 5.2% in Q3, the first increase since 2014 and strongest growth since 2012. S&P 500 actual earnings, which strip out unusual items, grew 4.2% against expectations for a 2.6% increase. Growth would have been 7.9% if not for a 67% drop in energy sector profits.
The Institute for Supply Managers (ISM) purchasing managers index (PMI) rose to 53.2 (versus expectations of 52.5). U.S. manufacturers have just begun to hit their stride after adjusting to the dollar's swift 2014 rally, only for the greenback's recent rise to potentially portend trouble on the horizon. Consumer confidence from the Conference Board also rebounded to a post-recession high, echoing last week's reading from the University of Michigan. In both surveys, consumers expressed relief over the conclusion of the U.S. election.
The Fed's Beige Book, a collection of data from its 12 regions, showed a modestly improving economy but no signs of overheating.
Economic readings this week do nothing to alter the Fed's thinking regarding a December rate hike, which is still perceived as a done deal. The question is whether the recent risk-on sentiment in financial markets is a leading indicator of faster growth.
China Moves To Stem Tide Of Capital Outflows
After seeing outflows accelerate in 2016, Chinese government officials are re-thinking their decision to sacrifice stability in order to liberalize its economy.
Last year the reform-minded head of China's central bank, Zhou Xiaochuan, convinced the communist party to allow the renminbi to float more freely in hopes the IMF would recognize it as an official reserve currency. In making his case, Zhou downplayed the potential negative effects. However, the tsunami of capital leaving China via overseas acquisitions this year has caused officials to question the more open approach. China's State Council has begun to draft proposals (leaked this week to the press) designed to curtail cross-border deal-making.
Chinese officials aren't just worried about currency outflows, they're also concerned panicked companies are making financially unsound deals. Non-financial outbound investments by Chinese companies measured almost $150 billion over the first 10 months of 2016 after finishing at only $121 billion in all of 2015. Money has been lavished by highly leveraged companies, for example, on foreign soccer teams and real estate properties.
The proposed limits focus on large transactions (greater than $10 billion) but could target smaller deals outside of the expertise of acquirers' core businesses. Bank managers in Shanghai have reportedly been informed all cross-border payments exceeding $5 million will have to be approved by government officials. The rules could conceivably slow recent spending sprees by firms with opaque ties to the Chinese government like Anbang and Dalia Wanda, but the ambiguous regulatory procedures could simply allow the communist regime to pick winners and losers. Among the losers: wealthy Australians like Cate Blanchett who are now having trouble closing luxury real estate deals with Chinese buyers.
Speaking of shadowy cross-border M&A from companies with ties to people high up in the communist party, Reuters this week uncovered a tangled web in regard to Canyon Bridge Capital Partners' $1.3 billion takeover of U.S.-based chip maker Lattice Semiconductor Corp. According to filings, Canyon Bridge is funded in part by cash originating from China's State Council. The Lattice transaction would be the largest attempted venture by a Chinese-backed firm into the U.S. semiconductor industry, raising potential national security concerns. The firm involved, China Aerospace Investment Holdings Ltd., also manages China Aerospace Science and Technology Corp. (CASC), which develops and launches rockets, manned spacecraft, satellites, strategic missiles and other weapons.
Ironically, things in the Chinese economy are actually looking up. Industrial firms recorded a 9.8% year-over-year increase in profitability in October, thanks largely to rising producer prices. The official factory gauge climbed to 51.7 in November, the highest level since 2012. PineBridge Investments' Arthur Lau believes the top five Chinese banks could absorb the shock of a worst-case non-performing loan cycle over the next two-to-three years without hurting their capital or liquidity ratios.
China's move to tighten capital controls reflects its manic approach to financial reform, and leaked reports of tighter capital controls could actually accelerate outflows because they exacerbate investor anxiety. The communist regime is not going to get the foreign exchange recognition it covets without learning to let go.
Italian Constitutional Referendum Holds Key To European Banking Future
After SkyBrief hits your inbox Sunday we'll learn the results of the Italian referendum on constitutional reforms. The outcome could shape the next wave of re-positioning in global markets. Polling is prohibited in the final two weeks of Italian political campaigns, but before the dark period commenced on November 19 the 'no' vote held a modest lead. If Italian voters reject the reforms, youthful Prime Minister Matteo Renzi has promised to step aside, paving the way for the country's nationalistic Five Star Movement - which seeks a referendum on EU membership - to grab power.
The referendum will most directly affect Italian banks in the midst of audacious recapitalization efforts. Banca Monte dei Paschi di Siena just embarked on the first leg of its turnaround plan, swapping nearly $5 billion in junior bonds for equity. It took a sweetheart offer from the bank to get a deal done. The swap values Tier 2 bonds at 100% of face value despite them currently trading at half their nominal value. The debt-conversion will raise only one-fifth of the capital needed to put the bank on more solid financial footing, but paves the way for an attempted equity raise in late December of €4 billion - more than seven times the bank's current market capitalization. Monte dei Paschi Chief Executive Marco Morelli recently told aides the entire plan "is like making several holes-in-one in a row," according to sources with knowledge of the matter. If 'no' prevails in the referendum, the whole conversation could be moot.
Fearful investors have piled out of Italian banking stocks ahead of Sunday's vote. The FTSE Italia All-Share Banks Index is down 12% in the past month and 20% since Brexit, while the spread between Italian and German government bond yields has widened to the most in more than two years. Not only could a 'no' victory roil the markets to the point of making an ambitious secondary offering untenable, it could set in motion a sequence of events causing European authorities to approve a modified bailout in order to prevent contagion in the bloc's banking system. Even Italy's largest bank, Unicredit, needs to offload €20 billion in bad loans and raise €13 billion to strengthen its balance sheet.
The ECB reportedly stands ready to ramp up its purchases of Italian bonds in the event Sunday's vote triggers a spike in borrowing costs. However, if 'no' wins, global markets could be set for another volatile period. Rick Rieder, BlackRock's Global Chief Investment Officer of Fixed Income, has been buying European financial stocks ahead of the referendum, believing the worries are overdone.
Meanwhile, unemployment in the euro zone dropped to 9.8%, its lowest level since July 2009. Euro-area inflation in November grew just 0.6%, giving the ECB cause to potentially extend its stimulus efforts at the much-anticipated December 8th meeting. The central bank's current asset-buying scheme is set to expire in March and investors have been probing for clues about its future plans. ECB President Mario Draghi continues to beat the drum about the risks of low growth, but the committee is running out of paper yielding enough to meet the constraints of its program. The ECB could be forced to tilt stimulus toward countries with higher borrowing costs - a scenario more likely if Italy becomes the next euroskeptic domino to fall.