Daily Comment (July 24, 2019)

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

[Posted: 9:30 AM EDT]

Good morning!  Mueller testifies today; we mistakenly expected it yesterday.  Although the testimony will be the focus of the media, it probably won’t move the financial markets.  Here is what we are watching:

Trade optimism: Equity markets rallied yesterday on news that the U.S. and China will begin face-to-face meetings at the end of the month.  We expect a few “good faith” actions.  The U.S. will likely grant some export waivers on tech trade with Huawei (002502, CNY 3.23).  China will probably buy soybeans from the U.S., although the amounts will likely be modest.  The fact that meetings are occurring is positive, but the chances of a comprehensive agreement are small because neither side can get a deal without it looking like they gave in to the other.  Thus, we expect negotiations to continue into next year.

Tech action: The government is moving against the tech sector.  First, the DOJ is opening a new anti-trust review of the industry.  This review will likely be lengthy and may weaken merger activity.  Second, the DOJ is reviewing encryption with the idea that the government may demand a “key” to private encryption for national security purposes.  If this goes forward, it will tend to shift encryption into the “gray market.”  Third, the FTC is forcing the CEO of Facebook (FB, 202.36) to personally certify that his company is protecting consumer privacy; if the firm fails to take appropriate steps, it could make Mark Zuckerberg personally subject to legal action.  Perhaps the most significant risk to the tech sector is government regulation.  Although the Trump administration has generally leaned toward deregulation, the trend beyond party politics has been to reduce the power of this sector through regulation.  The impact of regulation on equity performance is somewhat mixed (the breakup of Standard Oil was positive for shareholders, for example); however, we would expect regulation will attempt to inject some competition into the industry that, at least at first, will probably be taken as negative.

Weaker global growth: The flash PMI data from Europe (see below) was weak and suggests the continent is heading into recession.  This data may mean tomorrow’s ECB meeting will lean toward a more dovish tilt.  The data tends to confirm what we heard from the IMF yesterday.  The international situation is probably playing a key role in the Fed’s move to lower rates, although there are signs of weakness here as well.

China escalation: Beijing is making somewhat veiled threats that it may use military force against protesters if the local government requests such support.  China has been consistently indicating that it believes the West is behind the protests, a common trope employed by authoritarian regimes in the face of civil unrest.  China also reiterated threats against Taiwan’s independence movement in a national security report, indicating it would use military force against a decision to declare separation.  Using the military against Hong Kong would almost certainly trigger a Western response, although we doubt the U.S. or Europe would go to war to maintain Hong Kong’s system.

While all this is happening, the Beijing Auto Group (BMCLF, USD 0.67), a State-Owned Enterprise (SOE), has agreed to make an investment into the German automaker Daimler (DMLRY, 13.43).  The investment will represent 5% of the company.  The Zhejiang Geely Holding Group (GELYF, 1.55) owns about 10%, meaning that two Chinese companies, one of them an SOE, holds about 15% of this iconic German company.  Such investments highlight the problem of deteriorating relations with China; although both Europe and the U.S. acknowledge that China’s rise is problematic geopolitically, the economic ties may make responding to the geopolitical challenge difficult.

Boris as PM: Boris Johnson is nearly finished with the process of taking office.  The EU has already signaled that it doesn’t intend to renegotiate the current agreement.  Johnson is pushing to at least have the threat of a no-deal Brexit, which the IMF notes is a major risk item for the global economy.  With regard to the China discussion above, Johnson said his government would be very pro-China and would keep the U.K. the most open economy in Europe for Chinese investment.  In fact, in a break with U.S. policy, Johnson said his government would be “very enthusiastic about the Belt and Road Initiative,” whereby China is providing massive funds for infrastructure development from Asia to Europe in an effort to build its global influence.

Iran: Iranian President Rouhani indicated that Iran is ready to negotiate but only if talks don’t mean “surrender.”  We suspect that “surrender” for Iran would mean the U.S. forces Iran to abandon its goal of being the regional hegemon. That is exactly what the U.S. is demanding, or at least the hardliners in the administration, SoS Pompeo and NSD Bolton.  On the other hand, Trump might just be willing to negotiate a deal that would look a lot like the JCPOA.  The problem is that the goals of the U.S. and Iran are not really compatible.  If the U.S. continues to want to constrain Iranian hegemony, which the Gulf States and Israel both support such constraint, it’s hard to see how the issue can be resolved.  As a result, we expect the U.S. to simply play for time while continuing to apply sanctions, and Iran to try to break out of its box by further escalation.

European heat wave: France is dealing with extreme heat, with new temperature records being set.

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