Daily Comment (July 29, 2019)

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

[Posted: 9:30 AM EDT]

Happy Monday!  It’s Fed week.  The MLB trading deadline is Wednesday.  There was unrest around the globe.  Here are the details:

The Fed: It is all but certain the FOMC will cut rates on Wednesday.  Former Chair Janet Yellen came out in support.  However, once this action occurs, there is great uncertainty as to what follows.  There is growing doubt that this cut is the beginning of a cycle of reductions, even though it is obvious that this is what the market expects.  If this week’s reduction is isolated, it would suggest the Fed overshot its rate hikes and is adjusting to correct the action.  That would argue for a pause after this week’s reduction.  In addition, it appears to us the FOMC is divided on how to move forward.  We would not be surprised to see a dissent to the cut (KC FRB President George would be the most likely.)  If the Fed stands pat for a couple of meetings, dovish dissents are likely.  If we move into a period of “will they or won’t they” it is possible that equities will be rangebound for the next month or two.

Weak dollar?  President Trump reportedly rejected plans to purposely weaken the dollar through intervention or other measures.  The White House suggested that they didn’t think intervention would be all that effective.  Later, President Trump did indicate he hasn’t ruled out actions to depress the dollar.  We suspect he would rather see the dollar weaken due to aggressive easing from the Federal Reserve.

China trade:  Talks are set to resume, but neither side seems very excitedChina has indicated it is lifting agricultural imports from the U.S. and the U.S. will likely give China some limited export relief on technology.  President Trump suggested China may stall on talks, hoping to get a different figure in the White House after the elections.[1]  We expect talks to continue but we doubt much progress will be made.  The USTR has opened a plan to change how the WTO allows developing nations to use trade impediments during their development stages; China has been a major beneficiary of these “loopholes” and the U.S. wants to see these closed.

In related news, there are reports China is facing a glut of inventory.  This is evidence the U.S. trade action is having an effect.  Here is the basic macroeconomics:

0= (Investment-private saving) + (government-taxes) + (exports – imports)

China has used export promotion as a development model.  In that model, policies to generate saving are implemented.  China purposely has restrained household consumption with an undervalued exchange rate and low saving deposit rates.  If the private saving balance is negative (investment < private saving) and the fiscal account is balanced, by definition, a trade surplus will occur.  However, this is only if there is a ready buyer for the exports. The U.S. has played the role of “importer of last resort” for the world since the end of WWII but is pushing back against that policy.  As the U.S. restricts imports, the excess production will show up in the national income accounts as unintended investment, better known as “inventory”.  In other words, the private saving sector is forced into balance through unintended inventory accumulation.  If China wants to continue to export, it must further constrain consumption and drive down export prices.  Or, it can address the excess inventory by absorbing it with fiscal spending (which is a bit of what it is doing with infrastructure spending.)  Of course, another alternative would be to abandon export promotion altogether and absorb the excess with domestic consumption.  That doesn’t appear to be happening.  What the above article indicates is the U.S. policy is having an impact.

Brexit: The new government of Prime Minister Johnson has sent strong signals that a “hard Brexit” is now the most likely way the country will leave the European Union this fall.  Key advisor Michael Gove said over the weekend that the government is now “working on the assumption of no-deal,” while Foreign Secretary Dominc Raab said today that “the balance has shifted” to a no-deal exit. The GBP is coming under further pressure on this news.  The British auto industry is warning that a no-deal Brexit could be an “existential threat” to its survival.  The Congress of British Industry warns the EU isn’t ready for a hard Brexit either.

Hong Kong:  Protests continued over the weekend and are becoming increasingly violent.  Beijing, for the first time, has indicated it will respond to the unrest in a press conference.  The Communist Party newspaper, the People’s Daily, has today included an editorial calling on Hong Kong’s municipal government to act immediately and forcefully against the ongoing anti-Chinese protests in the city, saying the local officials “should not hesitate or have any unnecessary ‘psychological worries’ about taking all necessary steps.”  Chinese government said it still firmly supports Hong Kong Chief Executive Carrie Lam and the territory’s police force, in spite of the increasingly violent political demonstrations there. We continue to wonder how much longer Chairman Xi will tolerate this widespread dissent.  Separately, there are signs those political troubles and the ongoing economic slowdown in mainland China are weighing on the Hong Kong real estate market.

Protests in Moscow:  There were also major political protests in Moscow this weekend, as people demonstrated against the effort to keep opposition candidates off the ballot for the upcoming municipal elections (see our Weekly Geopolitical Report for July 15.)  The response from police was unexpectedly harsh, but even more ominous was what happened to opposition leader Alexei Navalny:  After being arrested last Wednesday for fomenting the demonstrations, he was rushed from the local jail to the hospital after he suffered an “allergic reaction.”  Given Moscow’s history, this sparked concerns that ruling officials may have poisoned Navalny in an effort to silence him.  While the U.S. government traditionally would have pushed back against such authoritarian transgressions, the reaction so far has been relatively muted.  It is possible the rather aggressive response suggests Putin is signaling to the factions within the Kremlin that he remains in power and that they shouldn’t consider siding with the protestors.  There have been sporadic protests around the country this year over a myriad of issues, including overflowing garbage dumps and poor economic growth.  The leaders of authoritarian governments are usually at greater risk to insiders abandoning the leader rather than to internal pressure.

Iran:  The Iranian government has thrown cold water on expectations that the United Kingdom and Iran could agree on an exchange of oil tankers, each has seized from the other, over the last couple of weeks.  Iran has decided to link the British seizure of an Iranian oil tanker to the nuclear deal, which will put that deal under further strain.  Britain has sent a second Royal Navy vessel to the Persian Gulf to protect U.K. shipping.  That should help keep alive some of the tensions in the Persia Gulf, buoying oil prices.

South Africa:  Although President Cyril Ramaphosa has been planning a constitutional amendment to allow land seizures and redistribution to the black majority without compensation, a government advisory panel has urged him to set strict limits on any such seizures.  The proposed law has soured investor sentiment on South Africa in recent months.

Japan:  The Cabinet Office has cut its forecast of economic growth to just 0.9% in the fiscal year ending March 2020, compared with 1.3% in its forecast six months ago.  The cut stemmed mostly from slowing export growth arising from weak demand in China and protectionist trade policies in the United States.

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[1] Just a thought: We have noted rising concern about foreign interference in U.S. elections.  Although such attempts are nothing new, the ability to use social media has become a significant force multiplier for all sorts of actions to sway public opinion.  We could end up with a “free for all” in 2020, where Russia and Israel might prefer to keep Trump in office while China and Iran would rather see him ousted.  Since all four nations have sophisticated cyber capabilities, social media could be flooded with conflicting campaigns, all trying for different outcomes.