Daily Comment (August 9, 2019)

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

[Posted: 9:30 AM EDT]

Happy Friday! Equities are giving back some of yesterday’s stronger gains.  The Italian government is near a collapse.  U.K. economy disappoints.  U.S. holds off on tech decisions.  And, five decades ago today, the famous album cover photo of Abbey Road was snapped.  Here is what we are watching today:

Italian troubles:  Making good on earlier threats, Deputy Prime Minister and League leader Matteo Salvini withdrew his party from government, and called for new elections.  Despite Salvini’s actions, new elections are not inevitable.  Italy’s president, Sergio Matarella, actually decides if the government will fall, and he might decide to give other parties the opportunity to form a new government.  The legislature is in recess for the summer (after all, it is Europe) and the president probably won’t want to take this action while lawmakers are away.  In addition, the body is working on budgets and bringing new elections at this time could delay that process.

We see two important takeaways from Salvini’s move.  First, as we noted yesterday, this action probably spells the end of the world’s only “Nader coalition,” one described by Ralph Nader in his book Unstoppable,[1] which is a coalition of right-wing and left-wing populists.  Although Nader’s idea of this coalition seems reasonable, the reality is that the differences between the two sides may simply be unworkable.  If so, a coalition between an elite group with a populist group is more likely; perhaps the most enduring one in U.S. politics was engineered by Franklin Roosevelt, who tied left-wing elites to right-wing populists.  This coalition dominated U.S. politics from 1940-65.  Since then, both elite groups have had looser ties with populists, but in reality, the right-wing and left-wing elites have governed as a minority coalition (at least in terms of economic policy) with ties of convenience to populist groups.  This is why we have seen the White House consistently shift between parties.  Second, the move by Salvini is roiling Italian financial markets.  The spread between German bunds and Italian bonds blew out this morning with German yields declining on flight-to-safety buying.  Salvini has been confrontational with the EU and if the government falls and he leads the next one, the odds of the conflict escalating increases.

Commerce delays:  The Commerce Department has decided to delay its decision on granting exemptions for companies wanting to buy equipment from Huawei (002502, CNY 2.83).  What seems to be occurring is that the U.S. wants China to buy U.S. agricultural goods, and China wants the U.S. to ease restrictions on Huawei.  However, both want the other side to make the first move, perhaps in order to show the other side “caved”.  In the 7th grade, similar disputes are either resolved by each party having a hand on what the other wants and releasing each good on the count of “3,” or by bringing in a third party to hold both goods in “escrow” and releasing each after both sides hold up their end of the bargain.  Apparently, the U.S. and China haven’t experienced these resolution measures.  The decision’s delay is probably behind today’s equity market pullback.

CNY fixing:  For the second straight day, the PBOC has fixed the CNY above seven CNY/USD.  Although Chinese officials are preventing the currency from weakening further, they are also clearly giving up on the previous ceiling at seven.[2]  Meanwhile, the White House jawboning for a weaker dollar continues; next week’s WGR will discuss the potential for a shift in the global forex regime.

Hong Kong:  Tensions remain very high.  China has singled out Julie Eadeh, a U.S. consulate official, for meeting with protest leaders.  Chinese official media is suggesting that the meeting is clear evidence the U.S. is influencing the protesters.  Protests are planned for this weekend; the U.S. has issued a travel warning.  Although the Trump administration has been mostly quiet about the protests, it is clear Chinese officials feel they need to paint the protesters as being influenced by foreigners to frame the protests are unpatriotic.

Global Economic Growth:  Japan and the United Kingdom, which typically represent the two biggest non-U.S. stock markets in the broad international indexes, today both reported their second-quarter economic growth.  Japan’s gross domestic product beat expectations with an increase of 0.4%, as trade headwinds were offset by rising corporate investment.  In contrast, the United Kingdom’s GDP unexpectedly declined 0.2%, marking its first contraction since late 2012.  The U.K. decline, which is driving sterling downward today, came in large part because pre-Brexit stockpiles built up in previous quarters have started to be consumed.

Global Oil Market:  The International Energy Agency cut its forecast for this year’s global oil demand for the third time in the last four months.  After demand in January through May increased at its weakest rate since 2008, the IEA now expects demand in all of 2019 to be up just 1.2 million barrels per day.  The cut in the forecast mostly reflected slowing economic growth around the world and the worsening U.S.-China trade war.  Separately, officials in Tokyo are hinting that Japanese naval forces may be sent to the waters off Yemen in order to help protect oil shipments through the Persian Gulf without unduly antagonizing Iran.  In another interesting development, Iranian oil traders have found themselves being wooed by Western intelligence agencies and surveilled by Iranian officials as the former tries to figure out how Iran is smuggling oil, and the latter tries to prevent the information from getting out.  Additionally, British private guards are being pulled from Persian Gulf shipping on fears they could be captured by Iran and used as potential bargaining chips.

Japan-South Korea:  As a sign that the Japan-South Korea dispute over World War II reparations is still not resolved, the South Korean Environment Ministry said yesterday it would tighten radiation checks on coal ash imports from Japan.  That comes after some positive news yesterday, when Japan approved the export of a key chemical to South Korea.  Although the dispute is likely to remain relatively contained, perhaps the worst aspect of it is that it shows how countries are now using protectionist trade measures as their weapon of choice in international disputes.

Turkey:  Sources say several high-level officials at the central bank have been removed from their posts, just weeks after President Erdogan sacked the previous governor because he “wouldn’t follow orders.”  The move is a sign that Erdogan’s effort to take control over monetary policy goes deeper than originally thought.  It also points to the kinds of developments that might become more common as other leaders – including U.S. President Trump – work to dismantle the independence of their central banks.  Attacks on central-bank independence raises the risk of politically motivated interest-rate cuts, higher inflation and a depreciating currency. However, the lira has responded little to today’s news so far.

Not only is President Erdogan trying to shore up his political fortunes with looser monetary policy, but he is also responding to popular anger over Syrian refugees, by pushing them out of the country.  The problem is that the plan would relocate some 700,000 of the refugees to Syrian territory that Ankara aims to seize from a U.S.-allied Kurdish group.  U.S. and Turkish military forces have in the past almost come to blows over Turkey’s desire to attack the Kurds, so the new plan again raises the risk of a confrontation.

Finally, in late breaking news on Turkey, China apparently negotiated a $1.0 bn swap arrangement with the Central Bank of Turkey, likely a move to shore up Ankara’s foreign exchange reserves.  This action is further evidence that Turkey is being pulled out of the West’s orbit.  Our latest WGR has analysis of the situation in Turkey.

Australia:  As more evidence that cybersecurity is now perhaps the key skillset for Western defense leaders, the new chief of the Australian Security Intelligence Organization will be Mike Burgess, the former head of the military’s top cyber defense agency, who had advised the government to bar Chinese telecom firm Huawei (002502, CNY 2.83) from the country’s new 5G communications network.  As a reminder, the U.S. government announced last month that Michael Gilday, the three-star head of the Navy’s Cyber Command, will be promoted over several four-star colleagues to be the new Chief of Naval Operations.

Russia:  Today marks 20 years since President Boris Yeltsin picked Vladimir Putin to be Russia’s prime minister, launching two decades of Putin’s effort to stabilize the Russian economy, rebuild its military and eventually make it a more assertive global power again.  Radio Free Europe today has a useful review of Putin’s years in power.

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[1] Nader, Ralph. (2014). Unstoppable: The Emerging Left-Right Alliance to Dismantle the Corporate State. New York, NY: Nation Books.

[2] Readers should note that the higher the exchange rate, the weaker the CNY.