Daily Comment (December 13, 2018)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Risk markets are mixed this morning with the pattern of fading overnight equity futures rallies continuing.  Here is what we are watching:

ECB:  The ECB is meeting today and has released a statement indicating that QE is ending[1] but the balance sheet will be maintained for the foreseeable future.  That means the ECB will continue to invest in new bonds as old bonds expire.   Interest rates were not changed.  Overall, this outcome was mostly expected.  The European economy has been weakening this year despite currency weakness and policy accommodation.  Thus, we don’t expect the central bank to begin raising rates anytime soon.  In the press conference, ECB President Draghi noted the weakness of recent data, which suggests policy won’t really tighten anytime soon.

May wins—now what?  As expected, PM May won her leadership challenge and, based on Tory party rules, cannot face another internal party leadership challenge for a year.  The vote was closer than expected, 200/117, which is disappointing.   May had to promise not to run for PM in the next election, which is a bit of a humiliation. [2] On the other hand, she probably has no chance anyway.  So, for now, May will lead the government into Brexit.

This is what we see going forward.  First, there is little chance the EU will make material changes to the current agreement.  Although there is nearly universal dislike for what May has negotiated, she was in a really weak position and was mostly forced to take whatever mercies the EU was willing to grant.  Second, there is no stomach for a hard Brexit.  It is now common knowledge that a hard Brexit will lead to serious economic disruption.  Imagine the U.S. making a sudden stop to trade with Canada and Mexico.  Grocery stores would quickly run out of some products (no guacamole!) and car production would halt as parts flow hit a sudden stop.  Over time, the supply chains would adjust but the change would be painful and almost certainly inflationary.  Although the BOE has made brave talk about raising rates to fight stagflation, in reality, a central bank facing inflation and recession will tend to fight the latter.  Only under unique circumstances, like we saw in the late 1970s, will the first be the primary policy focus.  Third, if our analysis is correct, the next likely step is a second referendum.  Although this outcome is fraught with risk, there is no real middle ground between impossible new negotiations and a hard Brexit.  Thus, a referendum to at least delay implementation might make sense and it’s possible a second referendum could reverse the outcome of first.   Although there is grumbling about the elites re-running the vote until they get the outcome they want, one could argue that a second vote would be more informed because now the parameters are clearer.  It should also be noted that holding multiple votes isn’t unprecedented; separation referendums have been held on multiple occasions in Quebec and Scotland.  In the end, at a minimum, we think a hard Brexit will be avoided and the deadlines will be extended.  And, “calling the whole thing off” is a clear possibility.

China trade:  Negotiations continue and, actually, the situation appears to be improving.  The Meng issue remains; in fact, a second Canadian was arrested in China yesterday.[3]   On this issue, the Xi government is pressing Canada hard but is studiously avoiding taking actions against Americans…so far.  If Meng is extradited, that could change.  But, for now, China appears willing to restrict aggressive steps against Canada alone.

Meanwhile, trade talks continue and China is taking steps to improve the optics for the situation,[4] making high profile announcements.  For example, China announced large purchases of U.S. soybeans.[5]   The timing is important, as farmers are struggling to find storage space for the recent harvest, especially with steel tariffs driving up the price of silos.[6]  China is moving to cut tariffs on U.S. autos from 40% to 15%.[7]  It has asked for high level trade talks.[8]   It is even offering to change its “China 2025” program to increase foreign participation.[9]  We suspect that Xi is betting that Trump will accept a trade truce to improve sentiment going into 2019 to raise the odds of re-election.  We doubt China has any intention to actually meet U.S. demands.  From China’s perspective, the Plaza Accord of 1985 (which drove up the value of the JPY) and Reagan-era “voluntary” car export restrictions on Japanese car exports (interestingly enough, negotiated by none other than Robert Lighthizer), paved the road for Japan’s 30 years of economic stagnation.  That isn’t exactly true, because Japan could have taken policy measures to adjust more quickly, but U.S. policy undermined Japan’s ability to export to the U.S. and made the adjustment process more difficult.  Beijing fears the U.S. has similar plans for China.  At the same time, offering concessions can buy China time, especially when the Chinese economy is slowing.

The unknown is the reaction of the Trump administration.  If it is taking a long-term view, it should continue to press its advantage and force China to make significant concessions.  However, that path would keep financial markets under pressure.  Holding the line might be the best long-term policy but will reduce the president’s chances of re-election.  We suspect the administration will soften to improve market sentiment.

Italian budget news:  Yesterday, there were reports the Italian government was giving in to EU demands, offering an adjusted budget with a mere 2% deficit/GDP.[10]  Although the reports were initially downplayed, in fact, it appears the reports were accurate.[11]  Italian bonds have rallied strongly on the news.  We suspect the bond market forced the Italian government to offer concessions.

More on tech:  Apple (APPL, 169.10) has announced a significant investment plan in the U.S., boosting American employment by 20k by 2023.  It is unclear if any of this $1.0 bn on new investment will bring production back to the U.S. (that seems unlikely for now).  The high profile investment spending will improve its political profile.[12]

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[1] https://www.ft.com/content/bc0a5184-fd44-11e8-ac00-57a2a826423e?emailId=5c11f0b0859321000480fa79&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[2] https://www.nytimes.com/2018/12/12/world/europe/theresa-may-no-confidence-brexit.html?emc=edit_mbe_20181213&nl=morning-briefing-europe&nlid=567726720181213&te=1

[3] https://www.reuters.com/article/us-china-icg/china-says-second-canadian-being-probed-for-harming-state-security-idUSKBN1OC0A4

[4] https://www.nytimes.com/2018/12/12/business/china-trade-war.html?emc=edit_mbe_20181213&nl=morning-briefing-europe&nlid=567726720181213&te=1

[5] https://www.reuters.com/article/us-usa-trade-china-soybeans/exclusive-china-makes-first-major-buy-of-u-s-soybeans-since-trump-xi-meet-idUSKBN1OB29S

[6] https://www.ft.com/content/2387f97c-fd7e-11e8-aebf-99e208d3e521?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[7] https://www.scmp.com/news/china/diplomacy/article/2177536/trade-talk-movement-china-agrees-slash-tariffs-us-auto-imports

[8] https://www.scmp.com/news/china/diplomacy/article/2177358/trade-war-chinas-liu-he-and-us-steven-mnuchin-and-robert and https://www.reuters.com/article/us-usa-trade-china/china-commerce-ministry-would-welcome-u-s-trade-delegation-visit-idUSKBN1OC0R7

[9] https://www.wsj.com/articles/china-is-preparing-to-increase-access-for-foreign-companies-11544622331

[10] https://www.bloombergquint.com/onweb/italy-to-propose-new-fiscal-targets-to-european-union-wednesday#gs.YKz3mng

[11] https://www.ft.com/content/18d29fbe-fe19-11e8-ac00-57a2a826423e?emailId=5c11f0b0859321000480fa79&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[12] https://www.axios.com/apple-to-expand-in-austin-00c6c2a5-2e5d-4444-a5a7-4d117879cfe3.html