Daily Comment (July 2, 2019)

by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA

[Posted: 9:30 AM EDT] We are seeing quiet financial markets this morning after a strong equity rally faded throughout the day yesterday.  Hong Kong, a new threat of tariffs on the EU and the Iran nuclear violation are topping the news.  Also, an apology—we forgot to mention one of our favorite holidays yesterday.  July 1 is “Bobby Bonilla Day,” the day the Mets send Mr. Bonilla a check for $1.19 mm as part of a deferred compensation plan that was affected by the Bernie Madoff scandal.  Here is what we are watching today:

Hong Kong: This is starting to get ugly.  Protesters broke into the legislature building yesterday and defaced the interior before being forcibly removed by security forcesCarrie Lam has condemned the violence, but the real issue is the patience of Chairman Xi.  Our concern is that Beijing isn’t going to tolerate these protests much longer and may force a serious crackdown on the former British colony.  There is some evidence to suggest the protest movement itself is divided, that a smaller group of protesters invaded the legislature but that action wasn’t supported by a broader group.  The protests do not seem to be supported in the mainland all that much.

One of the lessons from Tiananmen Square was that the West will protest and put China in a sort of geopolitical “penalty box” for a crackdown, but ruptures are not permanent.  Simply put, the interests of doing business with China will weigh more than defending the civil rights of Hong Kong residents.  The protesters are clear representation of the frustration and fears that Hong Kong residents have of encroachment from the mainland.  However, as much as they would prefer otherwise, this encroachment is likely to continue.

If Beijing deploys troops and forcibly restores order, there will be an immediate pullback in Chinese equities.  Protests in the West will be loud; stern letters will be written.  Even sanctions might result.  But, no foreign government is going to come to the aid of Hong Kong against the mainland.  We suspect that capital flight from Hong Kong will increase.  Taiwan will view what is happening in Hong Kong as a warning that it cannot allow the PRC to take over; look for a strong lobbying effort from Taipei to woo the U.S. to support its continued separation from China.

Iran breech: The U.N. has confirmed that Iran finally increased its uranium enrichment to violate the JCPOA and admitted to it.  The action, by itself, isn’t all that significant.  The level of enrichment is consistent with nuclear power but not nuclear weapons.  However, the symbolism is clear and the real test now comes from Europe.  The Europeans don’t want to completely kill JCPOA, or at least be seen as doing so.  Nevertheless, it is hard for the EU to continue to support an arrangement where the U.S. is applying sanctions while Iran is increasing enrichment.  European leaders are trying to maintain order in a situation that has become disorderly.

EU tariffs?  The U.S. is considering imposing additional tariffs on $4.0 bn of goods exported to the U.S. from Europe.  The action would be in retaliation to EU aircraft subsidies.  Currently, the U.S. has imposed tariffs on $21 bn of goods over this issue.  Although the financial market’s focus has been on China, trade frictions with the EU continue at a “slow boil.”

Israel missile strikes: The IDF carried out missile strikes in Syrian territory[1] against suspected Iranian and Hezbollah targets.  The broader geopolitical implications are interesting.  Syria is managing the influence of two important outside powers, Iran and Russia.  Israel wants to eliminate the influence of the former; interestingly enough, Moscow probably supports that goal.  Thus, the Russians, who might be able to prevent such airstrikes, clearly allow them to occur probably because they don’t want Iran in Syria either.  At the same time, Russia doesn’t want a direct confrontation with the Islamic Revolutionary Guard Corps or Hezbollah; both are more familiar with conditions on the ground and would draw Russia into a protracted asymmetric war that is probably unwinnable.  As a result, Russia will likely try to at least give the appearance of being on the sidelines, while quietly cheering Israel’s actions against Iran and its allies in Syria.

What to do with Huawei (002502, CNY, 3.59)?  Now that the U.S. has granted Huawei a reprieve, the bigger issue is what will policymakers do with the company?  In the short run, the company is a major customer of American chipmakers, who lobbied hard to see export controls eased.  These companies will continue to try to influence policymakers to continue to do business with the company.  At the same time, Huawei appears to be a significant commercial and national security threat and moving to address this issue would be the natural progression.  Often, the short-run/long-run tensions yield to the former in capitalist democracies.  We will be watching to see how this plays out.

And, finally: Yesterday, we noted that European leaders appeared to have a deal for the new EU commissioner.  That deal unraveled in what now looks like a major political blow to Chancellor Merkel.  Overall, this is another indication that the German leader is losing power, putting Europe into a situation of uncertainty.

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[1] Which, in itself is something of a misnomer, in that what was “Syria” really no longer exists.