Daily Comment (June 20, 2018)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s Wednesday! Financial markets are moving steadily higher this morning, mostly on the lack of new trade pronouncements. Here is what we are watching today:

Trade: The EU unveiled €2.8 bn of tariffs on U.S. goods[1] in retaliation to American tariffs. About a third of the tariffs (which will be a 25% levy) are applied to agricultural goods (e.g., peanut butter, bourbon), with the rest on a variety of consumer goods. The size of this action isn’t all that large, but it does show that the EU is willing to meet each U.S. action with a response. The general consensus in the financial media appears to be that China will eventually “blink.” The president is said to believe this as well.[2] On its face, this position makes sense. As a general rule, the trade deficit nation faces an inflation problem from trade impediments, while the trade surplus nation suffers unemployment.[3] The general belief is that China cannot tolerate rising unemployment and will cave as a result. However, this position has two potential flaws. First, Chairman Xi, unlike his predecessors, has amassed significant power. Like his predecessors, he is at risk to a weakening economy, but Xi has the power now to keep the middle class satisfied by taxing the wealthy. Second, one of the narratives around China’s rise is retribution against the West for the humiliation that began with the Opium Wars. Backing down to Trump may be more costly to Xi than the economic damage that a trade war would cause, at least in the short run.

Wars often begin because of an underestimation of the costs and overestimation of the benefits by the parties involved. Trade wars are no different. Foreign nations will target politically sensitive areas in the U.S. The EU choosing to tax bourbon isn’t an accident; it’s a key product of the home state of the Senate majority leader. China is considering targeting energy, which would affect states that have been solidly “red.”[4] It is true the U.S. will probably be less adversely affected than the current account surplus nations, but that doesn’t mean the negative effects on the U.S. are not significant.

Brexit: A key bargaining position for PM May is that she could walk away from an adverse deal from the EU and simply withdraw without a treaty arrangement. That outcome could harm the EU and thus gives the U.K. some leverage. However, the House of Lords and the House of Commons are taking steps to take that position away from May, leaving her with the unenviable choice of perhaps being forced to take whatever the EU wants to give her. Essentially, the bill before Commons would give the legislature a “meaningful vote” on the final position of Brexit.[5] How this outcome would affect the markets is binary. On the one hand, passing this law would likely lead to a “soft” Brexit that would almost look like the U.K. is still part of the EU. That outcome would be bullish for British financial assets. On the other hand, a loss on this bill could generate a no-confidence vote and an election that could bring Labour’s Corbyn to power, which would be a majorly bearish event for British financial assets, including the exchange rate. Consequently, increasing volatility is likely.

Merkel and Macron make a deal: The leaders of France and Germany have agreed to an outline[6] for greater European integration. Merkel agreed to a formula that could create an EU budget, allowing some degree of fiscal integration. This may include an EU finance minister. It doesn’t appear the budget would be very large, but Macron probably hopes that the creation of an EU budget will be the “camel’s nose under the tent” for fiscal integration. Merkel also agreed to plans for an EU rapid reaction military force; her change of heart may be tied to uncertainty surrounding America’s defense support.

Chinese market support: The PBOC unexpectedly injected funds into China’s money markets[7] and is considering lowering reserve ratios[8] in a bid to support the economy through the trade row with the U.S. These steps show that China does have some resources to deal with an economic slowdown due to the trade situation.

OPEC:The cartel meets Friday amid growing acrimony. The Iranian oil minister[9] is adamant in opposing any quota increases as new sanctions will probably limit its ability to increase exports and thus the resulting lower prices would merely reduce revenue. The Saudis find themselves in a delicate position. They do have excess capacity and could raise output. The kingdom is getting pressure from the U.S. to boost production and it appears highly probable that Russia will increase output, ending its cooperation with OPEC. We still expect a token increase in output quotas but Saudi Arabia appears to have little support for anything significant. If the meeting breaks without a clear settlement of these issues, the markets will likely assume that output will rise. This would be bearish for oil prices.