Daily Comment (February 26, 2018)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST]

Looking for something to read?  In our travels we are often asked about books we recommend.  As a result, we have created The Reading List.  The list is a group of books, separated by category, that we believe are interesting and insightful.  Each book on the list has an associated review to help you decide if you want to read it.  We will be adding to the list over time.  Books marked with a “*” are ones we consider classics and come highly recommended.

There was a lot going on this weekend.  The Winter Olympics ended without incident and there was lots of news out of China.  Here is what we are watching:

Xi as leader for life: At the CPC meetings in October, the party suggested that Chairman Xi could be planning to remain head of the communist party after two five-year terms.  Xi has systematically eliminated rivals and surrounded himself with allies.  It should be noted that the policy of chairing the CPC for just two terms is not law but a custom created by Deng Xiaoping to prevent another Mao.  However, the chairman of the CPC is also the president of China; in other words, that person is both head of the party and head of state.  The president is (or, at least, was) restricted by law to two five-year terms.  Over the weekend, the government indicated that the term limit law would be abolished at government meetings.  In some respects, this is a surprise.  Although the real power in China lies with the CPC, a formal change in the constitution to allow for more than two terms as president is important because it gives Xi (and his successors) formal power.  We will have more to say on this issue going forward; for now, given the jump we saw in Chinese equities, this is being seen as positive.  However, in the long run, it sets up another potential Mao and a new cult of personality.

Chinese debt: Last week, we commented on the Chinese government’s effective seizure of Anbang insurance.  We suspect that much of this action is designed to corral debt growth.  A handful of Chinese conglomerates have used leverage to buy foreign assets, a practice that, at one time, was supported by Beijing.  As Xi moves to deleverage it signals to these debt-laden conglomerates that it is now time to not only stop borrowing but it is also necessary to actually reduce debt.  However, it isn’t clear to us whether it will be sufficient.  Local government borrowing is also significant and will be much harder to reduce without significantly slowing growth.  At the same time, if Xi wants to move in this direction, he clearly has amassed enough power to do so.

North Korea: There are two trends we are watching.  First, North Korea is apparently signaling a willingness to negotiate with the U.S.[1]  It isn’t clear what would actually be discussed; the U.S. wants North Korea to give up its nukes and that is probably a non-starter for Pyongyang.  North Korea would probably like a formal end to the Korean War, which the U.S. has never fully granted, and sanctions relief.  Washington will only give in to those desires when the nukes are gone.  At the same time, the U.S. has now sanctioned individual vessels apparently engaged in sanctions busting.  We are getting about as close to a blockade as one can get without a formal blockade, which is an act of war by most measures of international law.  We continue to watch these parallel tracks but believe we are probably closer to war than peace.

Trump 2.0: In the administration’s first year, despite lots of populist rhetoric and fiery tweets, this has looked like a GOP establishment government.  Regulations and taxes have been reduced.  However, we are approaching the period when the first principal figures begin to leave the administration.  In other words, we may shortly begin to see the generals and industry leaders exit to be replaced by persons less independent of the president.  The area we are focusing on is trade.  The White House is apparently considering a promotion of Peter Navarro to an assistant to the president.[2]  Navarro is a hardline trade warrior who wants to lift tariffs and bring about a trade surplus.  We also note that the White House is considering punitive tariffs on steel for national security purposes; interestingly enough, the military is cool to the idea, worried about undermining allies.  Overall, it is still unclear how this administration will evolve but, if we see a more populist government emerge later this year, then multiple contraction could offset the earnings boost facilitated by the recent tax cuts.

Other items: Chair Powell gives his first Congressional testimony later this week in his new role.  Italians go to the polls this Sunday, and we will also find out if the German Socialists will join with the conservatives to form a grand coalition. 

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[1] https://mobile.nytimes.com/2018/02/25/world/asia/north-korea-us-talks.html?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosam&stream=top-stories&referer

[2] https://www.nytimes.com/2018/02/25/us/politics/peter-navarro-trade.html