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WHAT WE’RE WATCHING: TRUMP & CHINA, OPEC & THE FED

President-elect Trump stepped up his negotiations with China by questioning the "one-China" policy this weekend. Saudi Arabia surprised on the oil deal by suggesting they would lower production even further short-term. The Fed meets this week and is widely expected to raise the Fed funds rate.

TRUMP AND CHINA

The Trump and China relationship is taking center stage as we await the inauguration. Following up on speaking directly with the Taiwan's President Tsai Ing-wen, Trump this weekend questioned the "one-China" policy.

Appearing on Fox News, Trump said, "I fully understand the 'one China' policy, but I don't know why we have to be bound by a 'one China' policy unless we make a deal with China having to do with other things, including trade…I mean, look, we're being hurt very badly by China with devaluation, with taxing us heavy at the borders when we don't tax them, with building a massive fortress in the middle of the South China Sea, which they shouldn't be doing, and frankly with not helping us at all with North Korea…"

China had already reacted to Trump's initial phone call with Taiwan by flying a nuclear bomber over the South China Sea. Their level of concern rose after Trump's most recent comments.

Geng Shuang, a spokesman for China's foreign ministry, said Monday (NYSE:AP) that the "one-China" policy is the "political foundation" of the relationship between China and the U.S., and that ignoring it could harm the U.S. and China relationship. "We urge the new U.S. leader and government to fully understand the seriousness of the Taiwan issue, and to continue to stick to the one-China policy…"

While Taiwan is being used by Trump for leverage, there are other issues in play, including trade, the currency and the Paris Climate Agreement. China has also warned the U.S. not to pull out of the climate change agreement forged in Paris last year.

How the China and U.S. relationship plays out will have a major effect on the global and U.S. economies. While it is easy to see that there needs to be improvements to U.S. access to Chinese markets, it is not clear where the common ground can be found. It is clear that China has significant financial power that it can use in any negotiations.

One route that China could pursue in countering Trump's aggressive tactics would be to temporarily stop selling U.S. treasuries into the global bond market. That would result in the dollar getting even stronger, allowing the Chinese to sell their inventory into the global markets as the Yuan fell. What most people do not realize is that China has been holding it's currency up, not forcing it down, the past two years since the last U.S. quantitative easing program ended.

Another strategy for China, maybe part of a two-step would be to sell a massive amount of U.S. debt into the market forcing the dollar down and the Yuan up. Given China's goal to become a more consumer and less export driven economy, this one-two punch is quite plausible. What we do know is that China will do what is in their interest and that might preclude much of a deal on trade or any other issue.

A SAUDI SURPRISE

Last week, the somewhat surprising successful completion of the OPEC oil deal hit markets. This week, Saudi Arabia shocked markets by stating they were prepared to lower oil production even more than agreed upon last week.

"This is shock and awe by Saudi Arabia," said Amrita Sen, chief oil analyst at Energy Aspects Ltd. in London. "It shows the commitment of Riyadh to rebalance the market and should end concerns about OPEC delivering the deal." (Bloomberg)

Since November 30th, the price of oil has surged about 15% and is now above $55 per barrel. Oil sector stocks have rallied as well. Per our ETF Asset Class Quickview, oil and the oil services stocks have rallied to near the top of the market trends charts.

Looking forward, if OPEC and Saudi Arabia follow through on their promise to lower production significantly for the next six months, then we could see oil prices well into the $70s per barrel by summer. According to Woods McKenzie, oil decline rates for offshore oil are projected to be about 3mbd and North American production won't likely increase more than 1mbd. With nearly 2mbd coming off from OPEC and Russia, that will cause record inventories of oil to come down quickly over the summer.

Saudi Arabia's surprise piling on of cuts makes sense in the context of their long-term planning. The nation is trying to diversify away from oil as it sees significant demand challenges by 2030. Between now and then, Saudi Arabia will want to monetize as much of their oil as possible. Cutting production for the next six months, sets up a successful IPO of Saudi Aramco which seems certain to be oversubscribed.

Following the IPO of Saudi Aramco, we should expect production to go up before deep water oil producers can offset the about trillion dollars of capex cuts they made for the 2016-2020 period. That should keep OPEC and Saudi Arabia firmly in control of oil prices indefinitely as we drift into and eventually burst into the electric vehicle age.

THE FED

The Fed's meeting this week is likely to be anti-climatic as investors fully expect a quarter point rate increase by Janet Yellen. We will know the final answer on Wednesday.

With oil being one of the transitory issues that Yellen has repeatedly talked about with regard to inflation, it seems she will likely make reference to it again in light of the recent OPEC actions. She may signal that rate increases in 2017 could be more substantial if the price of oil does more than settle in a sub $100/barrel price plateau. However, it seems unlikely she would do more than increase rates a quarter point this time.

Contrary to public opinion, the Fed has not "printed" extra money for two years. The QE that they did provide for six years prior to that though does seem to have placed some floor under the markets. So, while a tightening Fed could cause more temperamental market behavior like 11 months ago, there doesn't seem to be anything the Fed could do at this point to cause more than a minor correction.

ECONOMIC CALENDAR

On Wednesday we get news of the expected Fed rate hike.

Retail sales and industrial production both come in on Wednesday as well. These could play a role in the next Fed decision.

Wednesday and Thursday give us CPI and PPI which yield clues on inflation. If these remain low, then the Fed might indeed allow the economy to run a bit hot or at least not raise rates quickly in 2017. We'll want to keep an eye on these numbers as oil prices rise.

On Thursday, we get initial jobless claims. As we've noted, the mergers and acquisitions boom will have an impact here eventually.

Friday we get a look at housing starts. If a softening pace occurs, as some expect, that could be a signal that the economy is ready for a short breather.

TACTICAL THOUGHTS

The Trump really just keeps on giving. Small cap stocks, financials, oil and mid-cap stocks are topping the trend charts and appear likely to continue to do so short-term.

While we are always concerned about the impact of the economy on markets, we realize that the markets are either forward or backward looking. It seems to us that the markets are looking forward to lower taxes, less regulation, repatriation and an improved healthcare system.

The monkey wrenches that could get in the way of the stock market rally are valuations, secular aging trends, global debt issues and potentially trade impasses with China. We have covered the first three of those rising risks in our last quarterly letter.

As tactical investors, we will go with the flow as long as trends remain viable. Our goal is to allocate money where it is treated best. Visit our ETF Asset Class Quickview to see the strongest sectors and asset classes in the markets.

To talk more about "What We're Watching" and how it might impact you, contact us to set up a time to talk.

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