Daily Comment (June 20, 2023)

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with many China-related reports, including a recap of U.S. Secretary of State Blinken’s weekend meetings in Beijing with top Chinese officials and a new report that Beijing and Havana are negotiating to establish a joint military training base in Cuba.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a new conservative government in Finland and welcome signs that the U.S. financial markets are comfortably digesting the massive issuance of Treasury bills now that the federal debt limit has been lifted.

United States-China:  In a bid to ease U.S.-China tensions, U.S. Secretary of State Blinken visited Beijing over the holiday weekend and held meetings with Foreign Minister Qin Gang, top diplomat Wang Yi, and President Xi Jinping.  Afterward, both sides described the marathon talks as “candid” and “constructive.”  The meetings do look like they could cool tensions, but we doubt that they will appreciably shift the overall trajectory in bilateral relations, in which U.S. leaders feel like they have to respond to China’s growing military and economic power and increasingly aggressive geopolitical stance.  As we’ve written before, increased tensions are likely to further disrupt trade, investment, and technology flows, putting investors at risk.

  • One key goal for the U.S. was to get bilateral communications back on track to reduce the risk of miscalculation and accident as Washington and Beijing compete ever more sharply in the military, diplomatic, economic, and technological spaces. The Chinese officials emphasized their commitment to taking back control of Taiwan and demanded that the U.S. not interfere with their development strategy.
  • In something of a win for the U.S., the Chinese side agreed to send Qin to Washington for a reciprocal visit at an undetermined time in the future. However, they repeatedly rebuffed U.S. requests to re-establish military-to-military communications.
  • The results of the meeting also look set to be overshadowed by a new example of Chinese aggressiveness reported this morning. According to the Wall Street Journal, Beijing and Havana are negotiating the establishment of a joint military training base on Cuba’s northern coast.  Such a base would imply that Chinese troops would be stationed less than 100 miles from Florida.
    • This and other recent developments suggest Chinese officials believe that taking ever more aggressive military steps against the U.S., even at the U.S. doorstep, will scare Washington into backing off China in the Indo-Pacific region.
    • Given that Republicans and Democrats in Washington share a strong and growing bipartisan sentiment that China is a threat, Beijing’s approach is ripe for miscalculation. Faced with an aggressive move such as rotating Chinese combat troops through Cuba, domestic U.S. political pressure could conceivably force the administration to act.  We therefore cannot discount the risk of an outright U.S.-China military crisis at some point, along with further disruptions in bilateral economic and financial ties.
  • Finally, it’s useful to remember that the risks for Western businesses in China don’t all come from government action. New reporting shows Chinese consumers have also begun to shift their buying toward domestic brands, at least in part because those brands have improved their quality, service, and marketing techniques.

European Union-China:  The European Commission today released a new economic security strategy that included a call for EU member states to consider restricting outbound investment into countries that could be a security risk.  Although the document didn’t specifically name China as a target, it was widely interpreted as being another example of how Brussels has swung around to embrace U.S. concerns about China, even if many of the EU’s national governments are still resisting any substantial efforts to restrict trade or investment ties with Beijing.

China:  Separately, Chinese officials continue to signal they plan to roll out a big economic stimulus package as the post-“Zero COVID” recovery peters out.  For example, the State Council said its Friday meeting considered several new policies aimed at boosting “effective demand” in a “more powerful way.”  Such policies would buttress the central bank’s interest-rate cuts last week and today’s cut in bank prime loan rates.  The question is whether President Xi will be willing to unleash enough new lending and spending to really rev up the economy, since doing so would worsen the structural challenges, like high debt, that Xi wants to bring under control.  Reflecting the limited policy space for stimulus, several Western financial institutions have cut their forecast for Chinese economic growth in 2023, sparking a risk-off stance in markets today.

Finland:  A coalition of right-wing parties has agreed to form a government with Petteri Orpo, the leader of the conservative National Coalition Party, as prime minister.  Besides the NCP, the government will include the right-wing populist Finns Party, the Swedish People’s Party, and the Christian Democratic Party.  Altogether, the four parties hold 108 of the 200 seats in parliament.

U.S. Financial Markets:  The Federal Reserve reported that utilization of its facility for reverse repurchase agreements, which allows money market funds to park cash with the Fed, last week fell below $2 trillion for the first time since June 2022.  The drop in usage of the facility suggests money market funds have instead been buying up the large amounts of fresh U.S. Treasury bills that the government has been selling following the recent lifting of the federal debt limit.

  • Money market fund managers have likely been enticed by the yields of approximately 5.15% available on Treasury bills maturing in one or two months, since that beats the current repo rate of 5.05%. The bill buying by money market funds could help ease fears that high Treasury issuance to replenish government coffers might disrupt the markets.
  • Nevertheless, risks remain, especially as the bulk of the new Treasury issuance is still to come. If money market funds and other investors can’t digest all the new issuance, interest rates could jump to the point where they cause instability.  In addition, if the Fed hikes its benchmark fed funds interest-rate target further, the reverse repo rate would also rise and might draw funds again from the money market funds and the banking system.

U.S. Defense Industry:  According to data from PitchBook, venture capitalists in the U.S. have closed more than 200 defense and aerospace deals worth about $17 billion just in the first five months of 2023.  That’s more than all the deals in the sector in full-year 2019, illustrating how the war in Ukraine and the prospect of higher global defense spending has heightened investor interest in military-focused startups.  We continue to believe that the trends will benefit both new and mature defense industry firms going forward, especially those focused on cutting-edge technologies.

  • Notably, the wave of VC funding into defense startups is reportedly rivaling the activity in artificial intelligence.
  • We find the VC surge into defense and artificial intelligence especially notable because high interest rates have sapped dealmaking in a wide range of other sectors.

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