Daily Comment (January 3, 2023)

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with an update on all the key global developments over the holiday period, including the latest on China’s new COVID-19 wave and how it’s affecting international relations.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including an update on Brazil’s new president and today’s election in the U.S. Congress for Speaker of the House.

China COVID Crisis:  Over the holiday weekend, additional major developed countries imposed COVID-19 testing requirements on travelers from China due to its recent relaxed pandemic controls which have caused a surge in infections.  The rules generally require travelers on flights originating in China to submit a negative test no more than two days before boarding.

  • The list of countries requiring tests now includes the U.S., Canada, Japan, the U.K., France, Spain, and Italy. Although the new rules were probably spurred by legitimate concerns about importing new COVID-19 cases from China, it’s notable that the countries imposing the tests are all important members of the evolving U.S.-led geopolitical and economic bloc.
  • Even if the testing rules are short-lived, as planned, they have angered the Chinese government and will likely prove to be yet another brick in the wall being erected between the U.S. and Chinese blocs. This geopolitical and economic wall has, thus far, been focused on impeding trade, technology, and capital flows, but the new COVID-19 testing rules show that the wall can also limit human travel and migration.

China-European Union:  Today, the European Commission announced that it has offered China free doses of the West’s highly effective, variant-adapted vaccines, but Beijing immediately rejected the offer, citing the “strengthening clinical efficacy” of its “ample” domestic shots.

  • China’s prompt rejection of the EU’s offer illustrates how strongly politics plays into Beijing’s pandemic policy. In Beijing’s eyes, accepting the EU’s offer would legitimize Western vaccines and highlight the relatively low effectiveness of China’s domestic shots, and would run counter to Beijing’s “East is rising, West is falling” political mantra.
  • The relatively low vaccination rates in China, especially among its elderly population, is a key reason for the new wave of infections following the lifting of President Xi’s draconian Zero-COVID policies.

China-United States:  Faced with the U.S.’s aggressive new restrictions on exporting advanced computer chip technology to China, an official at the China Semiconductor Industry Association stated that his country will likely shift its strategy toward making incremental improvements in its current, relatively basic capabilities, rather than building new, cutting-edge technologies.  The revamped approach would put more resources into areas where China already has an advantage and where the U.S. is less likely to impose export curbs, such as mature process technologies.

  • Even though the U.S. is still working to bring key allies onboard with its full export restrictions, the CSIA official’s statement shows that the new rules are already proving effective in changing China’s behavior and suppressing its technological and economic prospects. Over time, such technology headwinds will likely weigh on the Chinese military, economy, and financial markets.
  • We suspect that many Western observers still don’t fully appreciate how aggressive the new U.S. technology restrictions are.
    • The rules essentially aim to clamp down on exports of advanced U.S. semiconductors, semiconductor technologies, computer chip components, chip-making machines, and even chip-related services to China.
    • If similar rules were being enforced by the U.S. Navy somewhere in the South China Sea, it would amount to a partial naval blockade, i.e., an act of war.

Eurozone:  As the European Central Bank continues to hike interest rates aggressively and cut back on its bond purchases, nine out of 10 economists polled by the Financial Times said that Italy is the Eurozone country most at risk of an out-sized sell off of its government bonds in 2023.  Despite Italian Prime Minister Meloni’s plans to rein in her country’s budget deficit, investors are focused on the fact that Italy’s total government debt burden remains one of the biggest in Europe, at about 145% of gross domestic product.

United Kingdom:  The country continues to face waves of strikes as the new year begins, with railway workers set to walk out on Tuesday, Wednesday, Friday, and Saturday this week in a dispute over pay, job security, and changes to working practices. Train drivers represented by a separate union will walk out on Thursday in a dispute over pay, completing five days of travel misery for passengers.  The strikes, in multiple industries, are creating political challenges for Prime Minister Sunak and further disrupting British economic growth.

European Union-United Kingdom:  Irish Prime Minister Leo Varadkar has admitted that the trading arrangements imposed pursuant to the post-Brexit trade deal between the EU and the U.K. are being applied too strictly.  Importantly, he admitted that the deal’s Northern Ireland Protocol, which creates a trade barrier between Great Britain and Northern Ireland, had made unionists in Northern Ireland feel less British.

  • Varadkar’s conciliatory statement raises hopes that the EU and the U.K. may come to an agreement to adjust the protocol in the coming months.
  • Adjusting the protocol could ease EU-U.K. tensions and potentially boost British economic growth by restoring some U.K. trading links with the EU.

Russia-Ukraine War:  Heavy fighting continues along the front lines running from eastern to southern Ukraine, although it appears neither side is making significant headway at the moment.  Meanwhile, the Russians continue to launch missile and kamikaze drone attacks against Ukrainian infrastructure, but the Ukrainians claim that they are now able to shoot down virtually all the Iranian-made drones sent against them.  If that claim is accurate, it could potentially mean that Russia will eventually give up on the tactic or escalate to the use of Iranian-supplied ballistic missiles.  Meanwhile, poor operational security apparently allowed the Ukrainians to kill dozens of recently mobilized Russian troops with a U.S.-provided missile system over the holiday weekend, prompting a new round of criticism from Russian ultra-nationalists and creating more political headaches for President Putin.

Brazil:  Former President Luiz Inácio Lula da Silva was inaugurated again on Sunday, but without the traditional passing of the presidential sash meant to symbolize the peaceful transfer of power.  That was precluded because President Bolsonaro had fled to Florida on Friday in an apparent attempt to shield himself from the new government’s corruption investigations.  Among Lula’s first acts under his new presidential mandate to move Brazil’s economic and social policy to the left, he has:

  • Reiterated his intention to abandon Brazil’s constitutional cap on public spending to increase outlays on his preferred social programs.
  • Revoked an eleventh-hour decree from the Bolsonaro administration that gave a tax break to large companies.
  • Ordered his ministers to end studies on privatizing energy group Petrobras and the national post service Correios.
  • Revoked a decree that allowed for “artisanal” gold mining on indigenous land.
  • Revoked a decree that made it easier to buy guns.

Uruguay:  Allegations that a personal bodyguard to President Luis Lacalle Pou was selling fake passports, potentially to Russians trying to flee their country after its invasion of Ukraine, have now ballooned into a wide-ranging corruption scandal.  The scandal threatens to undermine Uruguay’s reputation as one of South America’s more stable and well governed countries.

U.S. Congressional Politics:  In the race to become the new Speaker of the House, Republican Kevin McCarthy’s bid remains up in the air due to opposition from his party’s right wing.  McCarthy has acquiesced on requested rules changes that give rank-and-file members more power, including making it easier to oust the speaker, but it’s not clear whether that will be enough to win the gavel when the voting takes place at midday.

U.S. Labor Market:  New analysis from the Atlanta FRB shows that wages for workers who stayed at their jobs were up 5.5% in November from a year earlier, averaged over 12 months.  That marked the biggest annual wage gain in the 25 years of available data.  Moreover, the report showed that workers who changed companies, job duties or occupations saw even greater wage gains of 7.7% year-over-year.

  • The wage gains are likely contributing to today’s elevated inflation rates as companies boost prices to cover their higher labor costs.
  • All the same, the wage gains haven’t necessarily been enough to offset the higher costs that workers are facing. Data from the Labor Department shows that after accounting for price inflation, wages for all private-sector workers were down 1.9% from the same month one year earlier.

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