Daily Comment (January 29, 2019)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] U.S. equity futures are modestly higher this morning after a drop yesterday.  It’s the last week of the Year of the Dog—my two are sad about its end.  The Year of the Pig starts next week.  Here is what we are watching this morning:

Trade talks and Huawei (Shenzhen, 002502, CNY 3.68): The U.S. DOJ has issued indictments against Huawei.[1]  This action was not a huge surprise.  The U.S. has also requested formal extradition of Meng Wanzhou, the CFO of the company (and daughter of the founder).[2]  The worry is that the indictment and potential extradition could scuttle U.S./China trade talks.  Although it could, we think odds favor the two issues remaining separate.  That doesn’t mean the trade talks will be much easier.  China is likely to offer to buy lots of commodities from the U.S. in a bid to narrow the trade surplus with the U.S.  Robert Lighthizer will insist on structural changes that will undermine China’s ability to move up the value chain.[3]  If both leaders didn’t need a deal, these talks would be pointless.  But, both Trump and Xi need some sort of face-saving win; Trump needs a better economy to help his reelection odds and Xi wants to avoid a bigger slowdown.[4]  We expect a deal but not the deal, which will delay the evolving break between the Chinese and U.S. economies.  Eventually, though, the U.S. seems to be heading toward the recognition that China is a strategic competitor and will work to reduce the ties between the two economies.[5]  Interestingly enough, we are starting to hear reports that Chinese capital flight is leaving the U.S.[6]  However, this likely reflects the Xi regime’s extending grip on flows and less of a lack of desire from Chinese citizens to find a safe place for their money.

Venezuela: The U.S. announced new sanctions on Venezuela, targeting the state oil company, PDVSA.[7]  With this action, the U.S. has effectively outlawed American businesses from transacting with PDVSA.  The U.S. imports around 0.5 mbpd from the country; that loss should be manageable, although it does affect the grade mix.  U.S. refineries are configured to utilize heavy/sour crude which is more difficult to refine.  The loss of Venezuela could complicate some refiners’ production.  In the short run, the U.S. refining industry is in maintenance season so the negative impact will likely be less than normal.  The U.S. has indicated that sanctions will end if Guaido is installed as president.  Companies can apply for waivers and oil at sea can still land.  Thus, it will be a couple of weeks before this action starts to bite.  However, the sanctions will soon reduce Caracas’s cash flows, which depend on refining dollars from Citgo, the PDVSA-owned U.S. subsidiary.[8]  These cash flows are important.  We note the stances taken by governments on Venezuela tend to neatly follow the interests of bondholders.[9]  Most U.S. and European bondholders, who are holding defaulted bonds, would benefit from a new government and an IMF deal, while China and Russia would not benefit from a change in government.

Fed meeting: The FOMC starts its two-day meeting.  While we won’t get new dots or forecasts, Chair Powell begins his (ill-advised, in our opinion) new policy of press conferences after each meeting.  No action on rates is expected; the markets are watching for comments on the balance sheet, although the committee’s comments on the economy will be interesting in light of the government shutdown (see below).  Our take on the balance sheet is that the impact was mostly psychological,[10] a position held by many policymakers and economists.[11]  The financial markets would love an endpoint, for Powell to indicate that the reduction will end at a certain level.  They won’t get that; most likely, Powell will indicate “flexibility” on both rates and the balance sheet, offering hope that policy tightening will be on hold if the economy continues to slow.

Brexit: It’s a big day for Brexit.  With 60 days to exit, Parliament is debating a number of measures to address the Irish backstop and proposals to prevent a hard Brexit and maybe allow for another referendum.  PM May addressed the body today and indicated that now is the time to tell the EU what it wants, not just what it rejects.  This article gives a rundown of the current amendments;[12]  it should be noted that the one given the best odds is designed to extend Article 50.  We suspect the outcome of all this will be to delay the exit and try to avoid a hard break.  That outcome would be mildly bullish for the GBP.

Shutdown’s over—when does the data return? Because the shutdown lasted so long, government statisticians will be forced in many cases to calculate two data sets, one for the lost month and one for the current month.  Other data will simply be delayed.  For example, the first release of Q4 GDP will be postponed due to the loss of work.[13]  In some cases, such as the retail sales report, the data is a survey; this may require canvassers to ask questions such as, “How were things six weeks ago?” that might be hard to answer.  Although economic data may not seem like a big deal compared to the world’s problems, it will affect the continuity of some series and may result in significant revisions over time.  In other words, the view of the economy may change in a period of uncertainty.

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[1] https://www.ft.com/content/c8e6d5b0-2375-11e9-8ce6-5db4543da632?emailId=5c4fe8dc1930b50004fbcc61&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22 and https://www.nytimes.com/2019/01/28/us/politics/meng-wanzhou-huawei-iran.html?emc=edit_mbe_20190129&nl=morning-briefing-europe&nlid=567726720190129&te=1

[2] https://www.washingtonpost.com/world/national-security/justice-dept-charges-huawei-with-fraud-ratcheting-up-us-china-tensions/2019/01/28/70a7f550-2320-11e9-81fd-b7b05d5bed90_story.html?noredirect=on&utm_term=.3e706d8d0ad4&wpisrc=nl_todayworld&wpmm=1

[3] https://www.wsj.com/articles/big-divides-remain-as-u-s-china-trade-talks-resume-11548717555

[4] https://www.cnbc.com/2019/01/28/reuters-america-update-2-china-to-offer-some-subsidies-on-cars-appliances-to-lift-weak-demand.html

[5] The topic of this week’s and next week’s Weekly Geopolitical Reports.  See WGR, What to do with China: Part I (1/28/2019).

[6] https://www.wsj.com/articles/chinese-exiting-u-s-real-estate-as-beijing-directs-money-back-to-shore-up-economy-11548757800

[7] https://www.nytimes.com/2019/01/28/us/politics/venezuela-sanctions-trump-oil.html?emc=edit_mbe_20190129&nl=morning-briefing-europe&nlid=567726720190129&te=1

[8] https://www.washingtonpost.com/national/health-science/trump-administration-announces-sanctions-targeting-venezuelas-oil-industry/2019/01/28/4f4470c2-233a-11e9-90cd-dedb0c92dc17_story.html?utm_term=.d54b378da587&wpisrc=nl_todayworld&wpmm=1

[9] https://www.axios.com/following-money-venezuela-nicolas-maduro-bonds-3022bbb1-42cd-4825-a27d-e81307510be3.html

[10] See Asset Allocation Weekly (1/4/2019).

[11] https://www.wsj.com/articles/a-4-trillion-scapegoat-for-market-volatility-the-feds-shrinking-portfolio-11548671432

[12] https://www.politico.eu/article/commons-brexit-showdown-watch-like-a-pro/?utm_source=POLITICO.EU&utm_campaign=58c6c0d451-EMAIL_CAMPAIGN_2019_01_29_05_43&utm_medium=email&utm_term=0_10959edeb5-58c6c0d451-190334489

[13] https://www.nytimes.com/2019/01/28/business/economy/economy-government-shutdown.html