Daily Comment (December 6, 2018)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s a major risk-off day so far.  The key issues are an arrest and its impact on trade and a difficult OPEC meeting.  Here are the details and other items we are watching:

The arrest of Meng Wanzhou: Yesterday evening, Canadian[1] officials announced they had apprehended[2] the CFO of the Chinese telecom firm Huawei (002502, CNY 4.71), Meng Wanzhou, in Vancouver.  She is the daughter of Ren Zhengfei, the founder of the company, and one of the four chairpersons of the company.  The arrest is tied to an investigation that her company attempted to sell U.S.-made equipment to Iran, a violation of American sanctions on the Iranian regime.  There is suspicion that the company has violated U.S. trade controls on Cuba, Sudan and Syria as well.[3]  The U.S. is seeking and will likely get extradition of Meng.   Western intelligence agencies have viewed Huawei as a security risk, fearing the company is a tool of the PRC to penetrate Western telecommunications networks.  U.S. telecom networks are banned from using Huawei equipment; Canada, the U.K., Australia and New Zealand have also placed restrictions on Huawei equipment.[4]

This arrest is certainly justifiable.  Huawei appears to be a “bad actor,” acquiring U.S. technology and allegedly selling it to nations unfriendly to the U.S. after agreeing it wouldn’t do such things.[5]  However, as any law enforcement official will tell you, the decision to arrest is never automatic.  Just because someone is breaking the law doesn’t necessarily mean an arrest automatically follows.  Instead, the decision to arrest is just that—a decision.  We suspect the decision to arrest Meng was made at the highest levels of the U.S. government.  Although the arrest was certainly legitimate, the timing must also be seen as deliberate.

Since Buenos Aires, both China and the U.S. have sent mixed messages on what was decided.  Given that a joint statement wasn’t released, each side has issued its own statement and, as we noted on Monday, they don’t line up all that closely.  The president added to confusion with a series of tweets where he called himself “tariff man,”[6] suggesting the truce he negotiated with Xi wasn’t going to change things all that much.  The president has attempted to walk back some of those comments[7] but financial markets are in “Missouri mode” and are saying “show me.”

So, how will the arrest of such a high-profile Chinese executive affect trade negotiations?  It is possible that the White House thinks it can use Meng for leverage, promising to release her for concessions.  That is a very dangerous precedent; every Western executive in China would be put at risk.[8]  The most likely outcome is that the arrest will make negotiations difficult, if not impossible.  This outcome is clearly being reflected in the financial markets.

A key issue we are wrestling with is the nature of the U.S./China relationship going forward.  The two nations have had something of a symbiotic relationship for nearly three decades.  China has been willing to provide cheap goods produced by compliant labor, while America has provided investment, intellectual property and a steady source of consumption.  This has led to a flood of cheap goods into the U.S., which has kept prices low and contained labor costs.  The relationship allowed the Chinese economy to grow rapidly and has led to widening income inequality in the U.S.  We have been noting, for some time, that strains in this relationship have been developing.  For China, it has reached the economic moment where it has created too much industrial capacity and needs to reduce that excess capacity; if growth is going to continue, it needs to make major adjustments.

Every nation that has reached this point struggles with it.  When European economies reached this point, they turned to imperialism and, sadly, mass industrialization war.  The U.S. dealt with this moment with the Great Depression.  When Japan and Germany made a second turn at this problem after WWII, Germany addressed it by moving up the value chain and 21st century imperialism, otherwise known as the Eurozone.  Japan has adjusted with three decades of economic stagnation.  Chinese leaders know where they are and are trying to adjust.  They are attempting to move up the value chain by “acquiring” American technology and through imperialism with the “one belt, one road” project.  In the meantime, they need trade with the U.S. to maintain growth.  Although trade policy is getting all the attention, the real issue is technology.  If China is forced to develop indigenously it may take too long and could follow the path of Japan, which will put the Communist Party of China (CPC) at risk.  In addition, if the U.S. really “pivots” toward Asia, imperialism won’t work either.  Much can go wrong.

At the same time, nothing described above is a secret.  It has been generally acknowledged since 2010 that China needs to adjust.  However, its leaders were always fearful that moving full bore into adjustment would lead to a collapse in growth and undermine the CPC’s legitimacy.  So, leaders been putting off the adjustment in a sort of “stop/go” cycle that financial markets have gotten used to.  It is hard to know when the adjustment can no longer be avoided.  If we are at that point, then risks to the global economy are much more elevated than they have been.  There is some evidence that financial markets are starting to fear this outcome.

Will trade negotiators be able to overcome Meng’s arrest and stabilize the situation?  Perhaps, but the long-run path for the U.S. and China appears to be headed toward persistent confrontation.  What we don’t know is how close we are to this long-run outcome.

OPEC: Oil prices are plunging this morning as the cartel continues to struggle with the mechanics of production cuts.  The group has agreed, in principle, to reduce output.  But, how much and the allocation of reductions remain unresolved.[9]  OPEC probably needs a cut of 1.3 mbpd to bring prices back toward $55 per barrel (WTI) and the Saudis will likely need to represent 1.0 mbpd of that cut for the proposal to have any credibility.  In addition, Russia has to make promises to reduce output as well.  And, it will take a while before the recent decline in oil prices reduces American output, which has been surging.

Complicating matters is the Khashoggi affair.  Congressional leaders heard the CIA’s take on events yesterday and were scathing in their criticism of the White House over this issue.  There is concern that the Trump administration is using this event as leverage over MbS to keep Saudi output high and lower oil prices further.  Although this is possible, as we have noted, lower oil prices aren’t as much of an unalloyed benefit for the American economy as they used to be.  While it will make consumers happy, it will harm oil and gas activity and reduce investment.  In addition, lower oil prices will do nothing good for the Saudi economy.  At some point, the Saudi royal family may conclude that MbS is bad for business and sack him; we doubt he goes quietly.  If so, the geopolitical risk for oil is probably being underestimated.

Brexit: With everything else going on, this issue has sort of slid to the backburner.  As it stands now, PM May’s plan looks DOA; it will almost certainly be voted down next Tuesday and then we will see if (a) the vote is close enough to try to renegotiate with the EU, or (b) the vote is an overwhelming rejection which would lead to either the fall of May’s government and new elections or a new referendum.  The fact that the GBP is holding up suggests the financial markets believe a hard Brexit will be avoided.

Facebook (FB, 137.93): The company continues to marinate in hot water and its woes are raising questions for all of social media.  In Scott Galloway’s book, The Four, he notes that the only real business risks to the large tech companies come from government.  And, when he wrote his book, he suggested that the threat wasn’t all that strong because the companies had mostly co-opted regulators.  That condition has changed.  European regulators are leading the charge against Facebook directly but other tech firms as well.[10]  The Europeans are accusing Facebook and others of anti-competitive behavior and the companies have few allies on the continent since the industry is mostly centered in the U.S.  The fear of regulation is clearly hurting equity performance of these companies.  Interestingly enough, relations between the White House and the tech firms have been improving; they may realize they need friends.[11]

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[1] https://www.theglobeandmail.com/canada/article-canada-has-arrested-huaweis-global-chief-financial-officer-in/

[2] https://www.ft.com/content/10065056-f8e2-11e8-af46-2022a0b02a6c

[3] https://www.nytimes.com/2018/12/05/business/huawei-cfo-arrest-canada-extradition.html?emc=edit_mbe_20181206&nl=morning-briefing-europe&nlid=567726720181206&te=1

[4] These nations comprise the “Five-Eyes” network of Western intelligence agencies.

[5] Op. cit., NYT article above

[6] https://www.nytimes.com/2018/12/04/business/yield-curve-recession-stock-market.html

[7] https://www.politico.com/story/2018/12/05/trump-china-trade-deal-1045367

[8] Although, realistically, they are already at risk.  But, this action likely means the risks are elevated.  https://www.axios.com/huawei-arrest-china-retaliation-73f847b7-4dbb-4987-926a-d9ac915b2285.html

[9] https://www.wsj.com/articles/a-weakened-opec-convenes-with-market-dominance-in-doubt-1544087560

[10] https://www.axios.com/zuckerberg-at-war-with-european-regulators-fa6e0376-4894-42f7-a0a3-c130882e2471.html  and https://www.bloomberg.com/news/articles/2018-05-23/facebook-loses-eu-friends-as-bloc-s-lawmakers-weigh-break-up?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosam&stream=top

[11] https://www.axios.com/white-house-tech-meeting-silicon-valley-trump-stabilized-6403b20f-5376-46cc-9a3e-71063d72c391.html