Daily Comment (August 6, 2018)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Markets are rather quiet this morning, a reflection of the “dog days” of summer. However, there was a lot of news over the weekend. Let’s dig in:

Trade talks: China indicated it is preparing for a protracted trade war.[1] In a new turn, Chinese state media pointedly blamed President Trump for the trade war and indicated it won’t back down.[2] This comes after the president tweeted a thread where he suggested that tariffs are working.[3] As we have noted before, there are really no winners in a trade war but prevailing in a trade war is more about how much pain one can accept. China appears to be betting that an authoritarian system can bear a greater burden than a democracy. This belief is common among authoritarian supporters because democracies can be so divided. However, those divisions have historically melted away when an external threat refocuses the electorate. In addition, it might be a mistake to overestimate the CPC’s ability to rally the population to suffer through a trade war. Although authoritarian regimes appear to outsiders as monoliths of stability, history shows they can collapse with frightening speed.[4] We note a recent report in the FT[5] suggesting that Xi may be cracking under the strain as evidence that China may not be able to resist U.S. pressure to the degree as expected. The PBOC reinstated a 20% reserve requirement on yuan forwards,[6] effectively boosting the price of shorting the currency. Although this action did stabilize the currency, the act itself shows a growing degree of concern. China knows that depreciation will reduce the impact of U.S. tariffs. However, a rapid decline in the CNY will also trigger capital flight and increase financial market risk. After all, when a nation engages in policies to prevent a currency from weakening, it is a clear signal that it believes the currency will weaken further in the absence of such measures. Such moves are perhaps justifiable if one believes the pressures are short-term in nature. But, if the pressures are structural, the actions won’t work.

A drone attack: Over the weekend there was an assassination attempt against Venezuelan President Maduro via drone strike.[7] The optics of the attack were not favorable.[8] As the drone flew over a military parade where Maduro was reviewing the troops and making a speech, the soldiers on parade scattered and the generals surrounding Maduro looked to be protecting themselves first. Although Venezuela blamed foreigners, it appears the attack came from dissident elements in the Venezuelan military.

Saudi Arabia: The dominating news report is a diplomatic spat between Canada and the Kingdom of Saudi Arabia (KSA). The Canadian foreign minister called for the release of dissident women’s rights activists who are being detained. The KSA reacted strongly, expelling Canada’s ambassador and freezing trade.[9] This appears to be a rather strong reaction to a normal complaint and perhaps is a reflection of the inexperience of the crown prince. Oil prices jumped on reports that Saudi oil output unexpectedly declined.[10] It is unclear what caused the shortfall but it does raise questions about the KSA’s ability to boost oil production and is bullish for oil prices. Additionally, there are reports that the KSA, with U.S. support, paid elements of al Qaeda to vacate areas[11] in Yemen. This looks to us like the Houthis are the focus of the war in Yemen. Al Qaeda has generally supported the Houthis even though they are regarded as Shiite; the Saudis likely believe that this support isn’t deep and are therefore trying to exploit the division. Of course, history shows that making deals with al Qaeda is fraught with risk. After all, al Qaeda was an element of the jihadist resistance to the Soviets in Afghanistan. Although the jihadists were instrumental in defeating the communists there, al Qaeda was behind the attacks on 9/11. There are reports that the KSA was considering an invasion of Qatar in 2017. According to these reports, then SoS Tillerson opposed the invasion and the KSA and the UAE joined efforts to get Tillerson removed.[12]

Iran: The first phase of sanctions against Iran go into effect today,[13] although there does appear to be less unity compared to earlier sanctions efforts.[14] We note that Iran held war games last week in the Persian Gulf and simulated a “swarming” attack.[15] However, we are hearing reports suggesting there are backchannel talks going on between Iran and the U.S.[16] It would not shock us if President Trump wants another summit meeting similar to the North Korean event. It has been well documented that North Korea is still working on missiles and nuclear weapons so even a summit meeting might not change conditions very much. But, Iran should be willing to engage in talks if for nothing more than to delay further sanctions until the November mid-terms with the hope that the GOP loses its grip on Congress and the president is subjected to constant investigations by the House. In reality, the U.S. doesn’t want a hot war in Iran. It’s not clear what the objectives would be and there is no guarantee that regime change would actually improve anything.

Germany:We are noting two developments. First, Germany is considering bringing back what is effectively a draft, although it would allow for some to perform national service instead of a stint in the military.[17] However, of greater concern is that Germany is also pondering whether it needs its own nuclear deterrent.[18] One of the key elements of American foreign policy has been increasingly forgotten—NATO was more about the U.S. providing security for Western Europe because the Europeans couldn’t get along and had triggered two world wars. Although American presidents have consistently asked for more defense spending from Europe, in reality, they never wanted too much because the Europeans may not listen to U.S. policy directives if they had formidable militaries. However, due to intergenerational forgetfulness,[19] the U.S. appears to be promoting the rearming of Europe. That just doesn’t seem like a good idea.