Daily Comment (February 13, 2023)
by Patrick Fearon-Hernandez, CFA, and Thomas Wash
[Posted: 9:30 AM EST] | PDF
Our Comment today opens with a number of observations regarding China’s relations with the rest of the world, driven by the wave of Chinese surveillance balloons belatedly discovered in North American airspace (although we don’t delve into why the North American Defense Command (NORAD) can track a small sleigh and eight reindeer every Christmas but can’t seem to locate a 200-foot-high balloon). We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including improved economic forecasts for the European Union and the stock market implications of the Kansas City Chiefs’ win in the Super Bowl last night.
United States-China: As U.S.-China tensions continue to spiral, the U.S. is set to expand its economic measures against China to include restrictions on direct investments and private equity stakes in certain Chinese technology sectors. The new rules will add to the U.S.’s big tariffs against Chinese imports, its clampdown on data and technology transfers to China (an effort that was expanded Friday with the naming of six additional Chinese firms that will be shut off from U.S. exports due to their work on China’s surveillance balloon program), and its hurdles to investing in the publicly traded stocks of certain Chinese companies, such as those that don’t share their accounting data with U.S. regulators and those related to the Chinese military. The restraint on direct investments and private equity will reportedly apply to Chinese sectors such as artificial intelligence and supercomputing.
- The new rules could be issued within two months, after the Treasury Department finishes reaching out to other governments, including the EU, to ensure that they don’t rush in to provide similar financing to China after the U.S. cuts it off.
- U.S. firms reportedly are still trying to resist the new restrictions, but the report suggests the new limitation is virtually a foregone conclusion. Of course, big U.S. technology and finance firms are among the most active private equity investors in China, and the new rules will likely cut them off from many opportunities in the country.
- This illustrates yet another way in which investors are likely to be caught in the crossfire as U.S.-China tensions worsen.
- With the recent discovery of Chinese surveillance balloons in North American airspace, the latest of which was apparently shot down by the U.S. on Sunday, the risk of outright conflict and further harm to investors appears to be growing. That’s especially true now that the Chinese are saying they’ve spotted unidentified flying objects over their own territory and are ready to shoot them down if needed. The situation seems ripe for a trigger-happy fighter pilot or missile operator to shoot down a manned vehicle (or, God forbid, an airliner) from one side or the other, which in these tense conditions could easily spiral out of control.
China-Africa: Not only is China facing a broad economic counteroffensive from the U.S., but it is also running into pushback against its influence-building campaign in less developed countries. A new report shows that Chinese infrastructure development loans to sub-Saharan Africa under its signature Belt and Road Initiative fell by 54% to just $7.5 billion in 2022. The lending decline reflects both new Chinese caution after several previous loans went sour and borrower fears that China is deliberately pushing them into debt traps.
- The ongoing pullback in BRI lending is notable, given that the program provided almost $1 trillion in infrastructure development loans primarily to developing countries over the last decade.
- The drop in BRI lending is probably slowing China’s effort to build influence in less developed countries, but the country still has plenty of other economic carrots in the form of export opportunities, cheap imports, and direct investments. We suspect China will continue using those incentives to attempt to bring more developing countries into its evolving geopolitical and economic bloc.
China-South America: As evidence that China’s BRI stumbles are not stopping it from trying to build alliances with less developed countries, last week, the Chinese and Brazilian central banks signed a memorandum of understanding to set up yuan-clearing arrangements in Brazil. The deal shows how China continues attempting to establish the CNY as a reserve currency for its evolving bloc (perhaps in a digital, resource-backed form in the future). We note that Brazilian President Lula da Silva has recently called for a free-trade agreement between China and the Mercosur economic area composed of Brazil, Argentina, Uruguay, and Paraguay.
Japan: Investors continue trying to assess the surprise announcement that independent academic economist Kazuo Ueda will be named as the next Bank of Japan governor. Amid concerns that Ueda may be more willing to abandon Japan’s longstanding yield-curve control and allow bond yields to rise, Japanese stocks are trading down so far this morning. The JPY has also weakened today, apparently reflecting concerns that Ueda would still not be able to close the gap between Japan and U.S. interest rates.
European Union: The European Commission today boosted its forecast for EU economic growth in 2023 to 0.8%, compared with an expectation of just 0.3% last November. It lifted its forecast for the Eurozone’s growth to 0.9% from 0.3%. In each case, the organization now believes there will be no recession this year, matching private forecasts and validating the recent outperformance in European stocks.
Germany: The conservative Christian Democratic Union (CDU) won Berlin’s municipal elections over the weekend, dealing an embarrassing defeat to Chancellor Scholz’s center-left Social Democratic Party (SPD) and pushing it out of the city’s government for the first time in decades. The CDU may have trouble forming a coalition capable of governing the city, but the results still illustrate how Scholz and the SPD have been politically damaged by a range of missteps over the last year.
Turkey: Following last week’s big earthquakes and complaints about the government’s response, President Erdoğan has ordered the arrest of dozens of architects, engineers, and others potentially involved in shoddy construction that led to the building collapses. With the death toll from the quakes now approaching 30,000, the president is apparently trying to divert attention from his government as he prepares for the elections upcoming in May.
U.S. Defense Industry: Last week, the Defense Department released a targeted list of weapons it’s willing to purchase under long-term contracts, which defense firms argue would be necessary in order for them to invest in expanded production capacity. The list includes weapons such as specialized air defense systems, long-range missiles, and rockets.
- Shifting toward multi-year contracts from single-year orders is becoming a key demand of defense contractors as they bump up against factory capacity constraints in their struggle to boost output and make up for the weapons and ammunition being sent to Ukraine for its defense against Russia. Longer-term funding commitments by the Defense Department may also be needed to boost defense industry expansion as the U.S. prepares for a potential future conflict with China.
- Nevertheless, as shown in a hearing by the House Armed Services Committee last week, multi-year contracts alone would not be a panacea for any U.S. rearmament program. Defense contractors also warn that such multi-year orders also need to include inflation adjustments. The contractors also say their ability to surge production is being hampered by other factors, such as a lack of skilled workers and supply disruptions.
- In any case, the increased policy debate on expanding the defense industrial base is consistent with our view that U.S. and allied defense spending is likely on a prolonged upswing that should be a boon for traditional defense contractors and the producers of dual civilian-military goods and technology.
U.S. Cryptocurrency Regulation: The New York Department of Financial Services has ordered Paxos Trust, which issues and lists Binance’s dollar-pegged cryptocurrency, to stop creating more of its BUSD token, although it can continue redeeming the stablecoin. The order reflects the ongoing crackdown on crypto assets in the U.S., following a year of widespread bankruptcies and other issues in the sector.
U.S. Super Bowl Indicator: With the Kansas City Chiefs’ 38-35 win in the Super Bowl yesterday, adherents of the “Super Bowl Indicator” will be looking for a further down-leg in U.S. stock prices. The indicator supposedly shows that a win for a team from the American Football Conference is historically associated with a bear market in stocks in the coming year. We continue to believe that the impeding recession is the more likely reason for a potential further decline in stocks.