Daily Comment (August 5, 2019)

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

[Posted: 9:30 AM EDT]

It’s Monday, but far from a happy one.   Global equity markets are taking a beating while interest rates continue to decline.  Geopolitical tensions are rising in several theaters.  The U.S. is dealing with two mass shootings.  And, the Haj begins today.  Here are the details:

Trade wars:  Media reports indicate that nearly all the president’s advisors (Peter Navarro was the exception) did not want to see tariffs implemented on China.   As we have noted in the past, the president believes that the incidence of the tariffs falls on Chinese exporters and thus it is a “free tax” for the U.S.  Although this point is often disputed with great certainty by the media, in reality, it can work as the president suggests.  Without question, a tariff raises the price to a U.S. importer.  If the transaction were that simple, the president’s critics are correct.  However, the Chinese exporter, in order to maintain market share, may reduce his price to the level of the tariff.  In that case, the incidence falls on the exporter.  Or, the foreign nation may depreciate its currency by the amount of the tariff, offsetting the levy.  In that case, the incidence of the tax falls on U.S. exporters (the price of their goods increased due to a weaker currency) and on consumers in China (the cost of imports rises for those buyers).  In other words, it’s complicated.

However, China followed the textbook and this morning allowed the CNY to fall, as the currency broke seven CNY to the USD.  This was a level that markets assumed the PBOC would defend.  Instead, monetary officials simply allowed the currency to decline.  Although this action is consistent with international economic theory, Chinese officials tended to hold the line on this level due to worries about capital flight.  Although there have been conflicting reports, it appears China may be halting agricultural purchases.   In addition, China has disputed Trump’s claim over fentanyl exports.  Fears of a currency war are clearly undermining investor confidence.  At the same time, investors should be aware that the president could flip on this position at any time, as we saw with Mexico.  The hurdle for making a switch isn’t all that high.  All China would probably have to do is announce soybean purchases and make some show about seizing narcotics.  Although, doing so and not appearing to cave to the U.S. is tricky, especially in front of party meetings.  In addition, China is blaming the U.S. for not just the tariffs, but for unrest in Hong Kong; giving in to U.S. demands in this atmosphere looks unlikely.

India:  India appears to be moving to remove autonomy from Kashmir.   In the past few days, New Delhi has warned tourists to evacuate and has put the region on lockdown.   Communication links have been broken and local officials have been placed under house arrest.   The region has been a flashpoint in tensions between Pakistan and India, both who claim control over the districts.  The area, mostly Muslim, wants autonomy from both nations but neither are inclined to cede it to the other.  If India moves to absorb its area of control into greater India, local unrest will almost certainly escalate, and Pakistan could become involved.

Hong Kong:  There a no signs of cooling in Hong Kong.  A general strike, the first in 50 years, has been called for today and widespread protests occurred over the weekend.   Public transportation was disrupted over the weekend, and civil servants held protests against their government.

Iran:  Iran has seized another petroleum tanker although it appears it may be a smuggler’s vessel.  Iran subsidizes its petroleum products and there is an active business in buying product at lower prices in Iran and selling elsewhere in the region.   A broader problem for the U.S. is that China is actively defying U.S. sanctions on Iran by smuggling oil from Iran.  Smuggling adds complications not only with Iran but with China as well.  Iran is indicating it is reducing its commitment to JCOPA; the more Iran goes down this path, the greater the odds Europe will be forced to shift to the U.S. position on Iran.

Brexit:  Boris Johnson appears to be preparing for a snap election due to the narrow nature of this coalition.  Polls in Scotland show a rise in separatist sentiment due to Brexit.

International Monetary Fund:  Leaders from the European Union over the weekend settled on Bulgarian economist Kristalina Georgieva as their candidate to replace Christine Lagarde as head of the IMF.  The Europeans have traditionally been afforded the right to name the IMF chief, while U.S. government names the World Bank head.  Perhaps the more interesting element of the decision is that it marks the second time in the last few weeks that French President Macron got his way with a major EU personnel decision.  At least for the moment, the French president seems to be in the ascendency, even as German Chancellor Merkel sees her power on the wane.

Russia:  For a second straight weekend, demonstrations against unfair municipal elections led to more than 1,000 arrests in Moscow alone.  Perhaps more important, authorities have reportedly started to investigate whether the anti-corruption group run by opposition leader Alexei Navalny has been using illegal financing.  Such investigations are often used to muzzle government critics in Russia.  Now that President Putin’s approval rating has fallen to a six-year low of 64%, the government may be getting desperate to nip any further political protests at the bud.  Although we doubt Putin’s regime is in any danger, conditions are not good in Russia.  Consumer debt is becoming an issue, massive, uncontrolled wildfires are occurring in Siberia, and in the Ukraine, the new leader there is making life difficult for Putin.

Japan-South Korea:  The South Korean government’s free-trade commission has fined four Japanese companies for rigging bids to supply South Korean automakers.  Although this could be just a run-of-the-mill action, it could also be retaliation for Japan’s decision last week to tighten its control over exports to South Korea.  South Korea is taking steps to reduce its reliance on Japan’s technology.  That move was retaliation over Seoul’s continuing demands related to Japan’s colonization of the Korean peninsula before and during World War II.  There are deep tensions between China, Japan and the Koreas going back centuries.  One of the keys to post WWII peace has been America’s ability to freeze these hostilities and force cooperation on the parties.  However, as the U.S. retreats from the world stage, these ancient disputes are becoming a problem again.  The tensions threaten the U.S. security arc in the region.  Interestingly enough, China is meeting with both Japan and South Korea in December to hold a security summit.  China may be trying to fill the security gap by calming tensions between Japan and South Korea.

The U.S. and South Korea are set to start military exercises today.

The NY FRB:  The New York Fed is the most important of the regional Fed banks.  It is the only one whose president is a permanent voting member and it executes the Fed’s activities in financial markets.  The president of this bank has often come from the financial services industry, but its current president is more of a policy wonk out of the San Francisco FRB.  John Williams has apparently fired two long-time high-ranking officials in a dispute over management priorities.  Although this may be nothing more than a leader wanting his own people in place, firing officials with front line experience over the past two decades appears a bit rash.

Middle East:  Congressional officials are trying to convince President Trump to keep American soldiers in Afghanistan.  The U.S. is trying to stop Turkey from invading northeast Syria, the home of Kurdish fighters who have been allied with the U.S.


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