Daily Comment (May 20, 2019)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Happy Monday! U.S. equity futures rolled over in the early morning hours on trade concerns. Tensions with Iran increase. Here is what we are watching:

China trade: Positions appear to be hardening, but the tariffs are becoming less of an issue and the restrictions on Huawei (002502, CNY 3.63) are becoming the more critical point. Over the weekend, U.S. spymasters held meetings with tech executives to discuss the dangers of dealing with Huawei.[1] Reports that tech firms were starting to suspend business with Huawei took equities lower overnight.[2] Tensions with the company are starting to affect trade talks; both sides do not appear in a hurry to meet again.[3]

Rising tensions with China pose broader issues for markets. We have heard numerous commentators suggest that a new “cold war” is looming between the two nations. This is probably the wrong analogy. The geopolitical rivalry between the U.S. and Soviet Union didn’t have a significant economic element to it. There wasn’t much trade between the U.S. and the U.S.S.R. before WWII; because of this lack of economic ties, the policy of isolating the communist bloc was rather easy. However, this is not the case between the U.S. and China. Because China used the U.S. hegemonic trading system (accepted the dollar as reserve currency, operated in WTO), American and Chinese economic ties are rather deep. A better historic analogy is the U.K. and Germany before WWI. The former saw the latter as a rising power that it needed to contain, while the latter saw the former as trying to constrain its development. There is an apocryphal story that at the onset of the war, British insurance companies complained to the Admiralty that the Royal Navy was sinking German ships that they had insured. Isolating the communist bloc during the Cold War didn’t adversely affect most of the Free World economy, but trying to isolate China will have serious ramifications on the global economy. The seriousness depends on how far it goes. We note a high level of bipartisanship in Congress toward the administration’s China policy. There is the potential that the markets are underestimating the impact of the economic war with China. And, as the WWI experience showed, economic ties might lead to geopolitical calculations and increase the odds of conflict.[4]

Meanwhile, the rising tensions with China are leading the U.S. to make peace in other trade venues. This factor could help other markets, mostly Canada and Mexico.[5]

The Iran issue: It appears there are divisions within the Trump government on this issue. The president has little interest in armed conflict with Iran, but that can’t be said for his secretary of state or his national security director. However, we note that the president warned Iran not to attack[6] the U.S., suggesting it would be the “end of Iran.”[7] We doubt that either side wants a full conflict; in fact, such a war would be out of character for Iran, which tends to prefer less full wars. But, the potential for miscalculation is elevated, and supporting oil prices.

OPEC: Although there is clear reluctance on the part of the Saudis, it does appear that the cartel is leaning toward boosting output in June. Several producers, notably Venezuela and Iran, are unable to meet their quotas and the rest of the group may increase output to offset these losses. Saudi Arabia would likely want to see higher prices but the Russians, due to their pricing structure, are keen to lift output. We would look for a modest increase at mid-year.[8]

Elections: The biggest surprise was in Australia, where the Conservative incumbent outperformed the polls and won election.[9] It appears PM Modi will hold serve in India.[10] And, a political scandal will bring new elections in Austria.[11]

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