Daily Comment (February 8, 2019)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] U.S. equity futures are under pressure again this morning.  Here is what we are watching today:

Trade: Yesterday, we noted that the lack of dollar depreciation was starting to become a problem for equities.  Although the reversal of the FOMC on monetary policy is, by itself, negative for the dollar, in forex, everything is relative and weakening global growth is triggering even easier policy abroad.  It appears dollar concerns, tied to weakening global growth, caused yesterday’s initial drop.  However, the decline was exacerbated by reports that Presidents Xi and Trump will not likely meet before the March 1 deadline for talks.[1]  That news was followed up by an appearance by Larry Kudlow, who suggested the parties are far away from a deal.[2]  The fact that the president’s meeting may be held later than March 1 isn’t by itself a serious problem; both parties could decide to postpone the deadline.  However, Kudlow’s comments are more worrisome.  We pair Kudlow with Mnuchin as part of the establishment wing of the administration.  The former member of the Reagan government and chief economist for Bear Stearns is usually upbeat and normally frames the trade talks in a positive light.  Thus, his caution either (a) reflects his personal concern, or (b) is a signal from the establishment wing of the administration that the talks are stalling and financial markets are being harmed.  In other words, Kudlow may be trying to push the president to intervene and make a deal over the heads of the anti-trade populists.  We would expect a market decline if a trade deal isn’t made and tariffs on China go into effect.  We still expect a trade deal simply because both sides need to reduce tensions in the short run.

There were two other trade items of note.  The recently negotiated USMCA is facing a serious challenge in Congress.  Democrats want additional worker and environmental protections and establishment Republicans are worried that the new treaty has too many impediments to trade.[3]  If the new trade deal fails to pass and NAFTA (which remains in force for now) ends, then it will be a major shock to all three economies but especially Mexico and Canada.  As we noted yesterday, President Trump is expected to issue an executive order which would ban telecom equipment produced by Huawei (002502, Shenzhen, CNY 3.47).  As part of this order, the U.S. will likely consider sanctions on countries that continue to use the equipment.[4]

France v. Italy: In an unusual inter-European spat, France recalled its ambassador to Italy[5] after the leader of the Five-Star Movement, Luigi Di Maio, met with leaders of the “yellow vest” movement.[6]  Di Maio is a deputy PM and his party is a major coalition partner in the government.  For a leader of a European government to meet with opposition leaders of another European government without warning is a serious breach of international protocol.  The meetings highlight the growing establishment/populist divide that is undermining European unity and cooperation.

OPEC and the crown prince: As is common with our news cycle, we move from outrage to outrage.  The horrific assassination of Jamal Khashoggi has mostly slipped from the headlines.  However, we note that two new stories emerged yesterday.  The first is evidence that Crown Prince Mohammed bin Salman had personally threatened Khashoggi more than a year before his murder.[7]  We also note the U.N. issued a report suggesting the Saudis interfered with Turkey’s investigation of the event.[8]

What we find interesting about these news items is that they come closely behind reports that OPEC is wooing Russia and other nations aligned with Moscow to join the oil cartel to increase the group’s market power.  The U.S. would oppose such an arrangement.  We also note that Congress is opening up an old threat to use American anti-trust laws against the cartel.[9]  We suspect the aforementioned reports are the U.S. signaling to Riyadh that Washington is opposed to the combination of OPEC and Russia.  Now we will watch to see the degree of decline of American influence in the Middle East.

Brexit: There are reports that the May government is moving rapidly to create emergency plans for a hard Brexit.[10]  The acknowledgement (or perhaps leak) is a signal that either (a) the government is coming to the conclusion that the likelihood of a hard Brexit is increasing, or (b) the government wants to signal to Parliament that if it wants to avoid a hard Brexit, it will need to accept May’s deal.  A hard Brexit will be difficult for policymakers because the event would be a supply side shock (the aggregate supply curve will move violently toward the origin and steepen), but the best short-term tools are demand side (tax cuts, fiscal spending, easier monetary policy).  If the government implements the latter into the former, a major inflation spike will result.  If the BOE accommodates the spike, the GBP will plunge; if it attacks the rise, the U.K. economy will suffer a nasty decline.

One of the factors we have been investigating lately is that a hard Brexit might actually accelerate the end of the United Kingdom.  Scotland has been holding periodic referendums to leave the kingdom; so far, they have all failed but leaving might be more attractive if the economy collapses after a hard Brexit.  The same problem exists in Northern Ireland.  Demographics are slowly moving toward unification of the island and an economic crisis in the U.K. might accelerate the process.  For now, these scenarios are rather distant but, seeing how the leadership is handling the current situation, it is hard to make a case that Scotland is better off in the U.K. and Northern Ireland could be better off aligned with Dublin.[11]  It should be noted that both areas voted for “Remain” in the referendum.  The irony of all this is that the goal of Brexit was to improve the sovereignty of the U.K.; it would be a bitter outcome if it ends the kingdom altogether.  At some point, we could see a move by moderates within both the Conservatives and Labour to join and prevent a hard Brexit.[12]  But, such a move would likely lead to a split in the Tories and Labour domination for the foreseeable future.

So, with all this uncertainty, why is the GBP holding on so well?  The PredictIt decision markets suggest that the March 29 deadline will be postponed.

(Source: Predictit)

Note that in November the odds of exiting at the end of March were at 70%; odds are now down below 40%.  As long as the market believes Brexit will be delayed, the selloff in the GBP will be avoided.

And, now for something completely different:Japan is apparently facing a crime wave led by senior citizens.  Poverty is leading some older people in Japan to opt for arrest.  At least in prison the government will provide basic food and shelter.[13]

View the complete PDF

[1] https://www.axios.com/trump-xi-china-trade-war-meeting-401840ad-896f-4569-a569-c43829bf218d.html

[2] https://www.cnbc.com/2019/02/07/kudlow-theres-a-pretty-sizable-difference-before-a-china-trade-deal-happens.html

[3] https://www.nytimes.com/2019/02/06/business/nafta-trump-deal.html

[4] https://www.politico.com/story/2019/02/07/trump-ban-chinese-telecom-1157090

[5] https://www.nytimes.com/2019/02/07/world/europe/france-italy-ambassador-yellow-vests.html?emc=edit_mbe_20190208&nl=morning-briefing-europe&nlid=567726720190208&te=1

[6] https://www.france24.com/en/20190206-france-italy-di-maio-meets-yellow-vest-protesters-unacceptable?wpisrc=nl_todayworld&wpmm=1 and https://twitter.com/GerardAraud/status/1093518723913261056?wpisrc=nl_todayworld&wpmm=1

[7] https://www.nytimes.com/2019/02/07/us/politics/khashoggi-mohammed-bin-salman.html?emc=edit_mbe_20190208&nl=morning-briefing-europe&nlid=567726720190208&te=1

[8] https://www.ohchr.org/EN/NewsEvents/Pages/DisplayNews.aspx?NewsID=24143&LangID=E

[9] https://www.wsj.com/articles/congress-moves-to-counter-opecs-pursuit-of-pact-with-russia-11549573722

[10] https://www.ft.com/content/58637ad8-2a31-11e9-a5ab-ff8ef2b976c7?emailId=5c5d05bdd83b3f00042c1d53&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[11] No doubt hardline Protestants in Northern Ireland would blanch at joining the south.  But, their numbers are shrinking and they could always immigrate to Britain.

[12] https://www.politico.eu/article/theresa-may-tory-mps-brexit-prisoners-dilemma/?utm_source=POLITICO.EU&utm_campaign=fe431629fe-EMAIL_CAMPAIGN_2019_02_08_05_46&utm_medium=email&utm_term=0_10959edeb5-fe431629fe-190334489

[13] https://www.bbc.com/news/stories-47033704?utm_source=pocket&utm_medium=email&utm_campaign=pockethits