Daily Comment (July 23, 2019)

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

[Posted: 9:30 AM EDT] Good morning!  There are two big items today.  As expected, Boris Johnson is now the new PM of the U.K.  The IMF has lowered its global growth forecasts due to trade disruptions.  And, Mueller testifies today.  Here is what we are watching:

Johnson: Boris Johnson gathered 92,153 votes compared to Jeremy Hunt’s 46,656, a nearly 2:1 margin.  Clearly, among the Tory faithful, Johnson is their choice.  Theresa May will be PM for the next 24 hours, taking questions from the House of Commons tomorrow.  Shortly thereafter, she will make her farewell address while Johnson visits the Queen.  After that, May will officially tender her resignation and Johnson will take office.

Immediately, Johnson will have three cabinet positions to fill.  These leaders will join the MPs in the House of Commons to position against a no-deal Brexit.  Johnson faces three immediate issues:

  1. Brexit: No surprise here but Johnson has to deliver a “deal or no deal” by Halloween. The EU might grant Johnson more time but it doesn’t look like it will budge on the agreement that PM May negotiated.  A key fact often overlooked is that the EU must have unanimity on a treaty, thus changing what has been negotiated would require another round of EU negotiations that may or may not settle on a new arrangement.  The question for history is whether PM May was a bad negotiator or simply didn’t have a strong position to start with.  We suspect it was more the latter.  We would not be surprised to see snap elections; the current coalition of the Tories and the DUP is facing by-elections that could reduce the ruling coalition to one seat.  If there are new elections, a coalition government between the Conservatives and Brexit Party would not be a shock if the Brexit supporters are a majority of voters.  If Remain is the trend, the Liberal Democrats might cobble together a loose coalition of Remain MPs in the major parties.  A second referendum might also occur.  Our expectation is that British politics will remain sloppy.  One interesting note is that the government feels the need for a PR campaign in Northern Ireland on the benefits of Brexit.
  2. Iran: The Iranians currently hold a U.K. tanker. The U.S. is letting the EU know that it is responsible for its own shipping.  That means the Trump government is forcing some of the costs of global security on other nations, a cost Britain will now have to bear.  The British answer is for an EU-wide maritime mission in the Persian Gulf, ironically, in the midst of Brexit.  We would not expect the British program to get much traction.
  3. The economy: The British economy may be in recession The GBP has been weakening.  The BOE governor is set to resign and no one seems to want the job.  The primary economic support tool in case of a hard Brexit may be a weaker currency.  In democracies, leaders get tagged with economic performance even if they have little influence.

Johnson has his work cut out for him.  For those hoping for some sort of resolution in the next 12 weeks, that might not occur.  Instead, it looks like more turmoil is on tap.

A budget deal: Congressional leaders and the White House have reached an agreement.  Spending is set to rise sharply.  Defense is budgeted for a $738 bn increase over the next fiscal year, while non-defense spending will be up $632 bn.  The fringes of both parties are not happy.  On the left, social goals, such as ending the Hyde Amendment or restrictions on defense spending to prevent a border wall, won’t be pursued.  On the right, the deficit hawks are fumingSome members of the House GOP are pushing the president to reject the deal.  Although President Trump is capable of reversing position, the usual triggers of criticism in the right-wing media haven’t emerged quite yet.  President Trump was never all that interested in austerity.  Going into an election year, he should be even less so.  We would expect him to agree to the deal and sign the bill.

Sanchez in trouble: Spain may be heading toward another round of elections and the Socialist Party leader is struggling to build a coalition.  Although some of Sanchez’s woes are due to the fractured nature of Spanish politics, the difficulty in building a government has been a problem across Europe, reflecting ongoing divisions.

Middle East: Saudi Arabia has agreed to base U.S. troops on its soil.  The basing of Western soldiers in Saudi Arabia was one of the issues that led to the rise of al Qaeda.  So far, there is no evidence of a similar backlash.  The U.S. is sanctioning a Chinese company for importing Iranian oil.  This action will likely increase tensions between the U.S. and China.

There are currently 3.6 mm Syrian refugees living in Turkey.  The EU sends funds to Ankara as aid for these refugees to keep them in Turkey and away from Europe.  Turkey has suddenly started sending some Syrians back into northern Syria.  It appears public resistance to the presence of Syrians in Turkey is leading to the crackdown.  It is unclear if this action is systemic or simply for show in order to quell public unrest.  Nevertheless, if Syrians in Turkey begin to believe they will be susceptible to deportation, we would not be surprised to see the refugees flee toward Europe again, perhaps creating another crisis for the EU.

As tensions between Iran and the U.S. remain elevated, there is growing concern that the “theater” of the conflict might shift to Iraq.  The U.S. has 5.2k troops in the country.  There are large Shiite militia groups in Iraq, many with some affiliation with Iran.  The potential for these militias to begin targeting U.S. citizens in Iraq is high.  The U.S. has been taking steps to address this issue.  Non-essential embassy personnel have been moved out and several oil companies report they have removed their workers from Iran.  However, one response from Iran to U.S. sanctions could be to destabilize Iraq.

U.S.-China trade: The U.S. Congress recently passed defense-policy bills that would block transit agencies from using federal money to buy railcars and buses made by Chinese-controlled companies or companies subsidized by the Chinese government.  Interestingly, at least one Democratic lawmaker has tied the proposal not only to the need to protect U.S. industry, but also to the risk that the Chinese could install cameras or other intelligence-gathering devices on the equipment in order to spy on U.S. citizens.  That echoes the Trump administration’s purported concerns about Chinese telecom firm Huawei (002502.SZ, 3.22).  It also suggests that spying risks may become an all-purpose justification for clamping down on Chinese imports.

Russia-China-Japan-South Korea: South Korea’s defense ministry said Russian military planes violated the country’s airspace over the Sea of Japan this morning, flying over the disputed Dokdo islets claimed by both Japan and South Korea.  The flyovers are another example of Russia’s growing aggressiveness in probing South Korea’s defenses and demonstrate that it doesn’t recognize the country’s claim to the islands.  Adding complexity to the situation, other reporting suggests that, at one point, Chinese military planes joined the Russian jets in an encroachment on South Korea’s air defense identification zone.  Reflecting how risky the moves are, Japan and South Korea both scrambled fighter jets, and South Korea fired hundreds of warning shots to chase off the bombers.

North Korea: State media showed leader Kim Jong-un examining a new submarine that experts think could carry multiple missiles, including nuclear ones.  Military experts say the sub is a significant advancement in North Korea’s military capability.

Hong Kong: Pro-Democracy legislators yesterday criticized the Hong Kong police force for failing to stop a gang of thugs who beat and injured dozens of participants in last weekend’s anti-Chinese political demonstrations.  The legislators and other observers have suggested the police have enlisted organized crime groups known as the “triads” to intimidate the demonstrators, while obscuring any link with the Hong Kong government.  If true, that would seem to sync with similar government-criminal partnerships in other countries over recent decades, such as Russia and Iran.  The efforts have been successful in many respects, so we’ll have to see if the embattled government of Hong Kong Chief Executive Carrie Lam will make further use of them.

Germany: In a new sign of economic slowing in Europe’s heartland, a new survey by the Ifo think tank shows employers are responding to weak order books by cutting workers’ hours.  The phenomenon is especially widespread among vehicle manufacturers, where 30% of the companies surveyed reported that they had instituted “short-time” work.  Overall, 3.8% of manufacturers have cut workers’ hours, and Ifo expects that figure to rise to 8.5% in the coming months.

The Fed: Although the Fed is in its “quiet period” before it meets, Judy Shelton, a candidate for an open governor spot, said today that she would support a 50 bps rate cut.  We suspect Shelton will face strong opposition to nomination.

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