Daily Comment (August 30, 2019)

by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA

[Posted: 9:30 AM EDT]

It’s the last business day of “cultural summer” (the autumn equinox doesn’t occur until September 23), but the summer season generally ends with Labor Day.  Trade optimism continues to buoy equities.  There are elections in Germany over the weekend.  Hurricane Dorian is bearing down on the Atlantic Coast of Florida.  Here are the details and other items we are watching:

China trade:  Optimism abounds but the evidence of progress is rather thin.  There are reports that trade negotiators are maintaining “effective communication” but it isn’t clear what exactly that means.  Both sides appear to be trying to look reasonable and seem to be seeking a way to reduce tensions.  However, underneath all the happy talk are increasingly long odds that the negative impact of the trade tensions can be avoided.  Here are few items of note:

  1. The CNY dropped sharply in August, its biggest monthly fall in 25 years. Although the usual reaction to tariffs is currency depreciation, we expect the PBOC to resist further sharp declines.  First, Chinese firms are holding around $500 bn of dollar-denominated debt and CNY weakness increases the cost of debt service.  Second, fears of currency weakness tend to lead to capital flight in China; there are reports that authorities in China are increasing their efforts to contain outflows.
  2. There has been a timing problem with trade tensions. Recall Q4 2018…equity markets were declining, in part on trade concerns, which led Presidents Xi and Trump to declare a temporary ceasefire.  One of the factors that led to this easing of tensions was that China had passed its party meetings.  China has informal meetings in August (which have just concluded) and major party gatherings in the first week of October.  It’s difficult for any Chinese leader to concede anything to foreigners until these meetings have passed.  This year is particularly sensitive because it is the 70th anniversary of the founding of the communist government on the mainland.  Chairman Xi is slated to give a major policy speech on October 1 to commemorate the event.  Giving that speech while making concessions to the U.S. is just about impossible.  Thus, we may have meetings between negotiators next month, but we would not expect any breakthroughs unless the U.S. completely caves, which looks highly improbable.
  3. Although reports of contacts continue, both sides are preparing for more of the worst. China is said to be measuring its exposure to U.S. technology firms as it prepares a “blacklist” of unreliable U.S. trade partners.  The Trump administration is considering a plan to reduce taxes by the amount raised by the tariff levies.  If the U.S. were planning to pull back on tariffs, it would not need to create a mechanism to recycle the revenue.
  4. Nazak Nikakhtar, the acting chief of the Commerce Department bureau reviewing U.S. company license applications to trade with Chinese telecom firm Huawei (002502.SZ, 3.06), has mysteriously resigned in order to return to the more junior position she previously held elsewhere in the department. The licenses to trade with Huawei have become an important bargaining chip in the U.S.-China trade dispute.  As an inducement to China, President Trump has promised the licenses would be issued, but none have been granted to date.  Nikakhtar’s curious decision to step back to a lower-level role suggests there was something about the process that she found unpalatable.
  5. Pain from the trade war is rising. S. businesses complain their Chinese operations have been adversely affected by the trade war and are warning that the conflict is hurting their overall business.  The Peterson Institute has a fine summary of the impact we have seen from the trade war.
  6. Although the process is slow, it does appear that some operations are moving out of China. India is attempting to become a destination for this outflow.  However, there is scant evidence that production is coming back to the U.S., a goal of the administration.
  7. There is a risk that the trade war could trigger a financial event, most likely in China. Two items caught our attention, in addition to the aforementioned level of dollar debt held by Chinese firms.  First, the PBOC is trying to contain potential problems in smaller banks that could be at risk to the slowing economy.  Second, the Chinese youth, unlike their parents, are spending heavily and racking up debt to maintain their lifestyle.  They could be vulnerable to a decline in growth.  Although the Xi government would appear to be able to absorb more pain than the Trump administration, one must be careful not to overestimate Chinese resilience.  At the same time, as noted in point two, the odds of a deal before mid-October are very low.

German local elections:  Germany will hold state elections in Brandenburg and Saxony on Sunday, 9/1.  The AfD is making a strong showing; if the CDU loses, it could undermine Merkel and her successor, AKK.  In addition, a poor showing might tempt the Social Democrats to exit the grand coalition and bring down the government.

Hong Kong:  The municipal police have arrested several high-profile democracy activists on charges of instigating unlawful demonstrations.  Those arrested include Joshua Wong, a key leader of the “Umbrella Movement” in 2014, and Agnes Chow, a leader in Wong’s group, as well as two elected officials and the former head of a student union.  Wong and Chow were later released on bail, but the arrests are seen as a warning for anyone trying to organize further protests like those that have been going on all summer.  More ominously, two other well-known activists were attacked and beaten by masked assailants, suggesting the government could still be using organized crime figures – or at least their tactics – to intimidate demonstrators.  After the Hong Kong government’s refusal yesterday to grant a permit for another big demonstration on Saturday, its organizers officially cancelled it, but other democracy and anti-China activists are calling for unsanctioned protests.  The potential for miscalculation and violence remains high, which will likely continue to be a cloud over the Hong Kong economy and assets.

In a report that should dispel hopes that Beijing will make concessions to the Hong Kong protestors, Hong Kong Chief Executive Carrie Lam evidently proposed a formal withdrawal of her controversial extradition bill this summer, but Chinese officials rejected the idea.

Brexit:  Courts in Scotland and Northern Ireland have both declined to issue an immediate injunction against Prime Minister Johnson’s plan to suspend Parliament in order to prevent legislation that would block a no-deal Brexit.  Instead, both courts have scheduled hearings on the matter next week, but legal experts suggest the suspension is a prerogative of the prime minister that is not subject to review.

Otherwise, the game of chicken is on.  PM Johnson is pressing for talks with the EU to damp down the outrage over closing Parliament.  The opposition is considering a no-confidence vote, even picking up some Remain Tories, but that requires getting behind a caretaker government led by Jeremy Corbyn, a distasteful option.  The EU shows little sign of changing anything; Ireland remains upset with the U.K. over the backstop.  Again, as we noted yesterday, despite all the turmoil, the GBP is holding its own, suggesting that we may be seeing a short-term bottom in the currency.

Japan:  In its budget request for the fiscal year starting April 1, the Defense Ministry proposed converting a destroyer into Japan’s first post-World War II aircraft carrier, and buying U.S.-made F-35B jet fighters to arm it.  The proposal is consistent with Prime Minister Abe’s drive to revamp the country’s pacifist constitution and adopt a more muscular, independent approach to national defense.  As they continue to push for the U.S. to step back from its traditional role as global hegemon, President Trump and his administration will likely applaud the possibility that Japan could soon be able to shoulder more responsibility for its own defense.  However, it’s important to remember that a future carrier could also allow Japan to project power in ways that might be at odds with U.S. interests, such as pressuring South Korea over the disputed Dokdo islands.

Iran:  There is apparently growing sentiment in Iran that it will be forced to acquiesce to talks with the U.S. because President Trump might win a second term and the Iranian economy probably won’t be able to withstand another five years of sanctions.  If this is the case, Iran will probably try to ramp up its disruptive actions in the Middle East to improve its bargaining position.  The risk, of course, is that it overreaches and triggers a military response.  Of course, hawks within the administration would support escalation; we note that Israel is uncomfortable with U.S. and Iranian talks.  This situation is bullish for oil until talks ensue.

Odds and ends:  Ridesharing firms are deploying a massive lobbying effort to thwart attempts by legislators that would make it more difficult to treat their workers as independent contractors.  There is evidence that wealthy Americans are cutting back their spending, perhaps signaling a loss of confidence.  Argentina suffered a three-notch downgrade by Standard and Poor’s.  The country’s long-term foreign debt now carries a CCC rating.  ECB hawks are pushing back against Mario Draghi’s planned easing expected next month.  There are increasing reports that businesses are simply unable to find workers in some markets, a reflection of tight labor market conditions and a growing lack of mobility among American workers.

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