Daily Comment (May 28, 2019)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Good morning and welcome back from the long weekend.  Although financial markets are mostly steady, there was lots of news over the holiday.  Here is what we are watching:

European elections: EU elections ended over the weekend and the cross-currents are complicated.  Here are the highlights:

  1. The results were not clear cut. The centrist parties lost favor, while the center-left/center-right no longer command a majority.  Right-wing populists increased their representation but much less so than feared.  The Greens, an environmental party, did surprisingly well, as did more leftist parties.
    1. Anti-EU parties held a majority in Poland, Italy and Hungary. Le Pen’s right-wing populists narrowly defeated Macron’s party as the traditional right- and left-wing centrist parties in France are looking increasingly irrelevant.  Only in Spain and Ireland did Euro-skepticism fail.
    2. After the EU elections, Austrian Chancellor Sebastian Kurz lost a no-confidence vote. Elections are scheduled for September but may occur sooner.
    3. Greek PM Alexis Tsipras called for snap elections after his party did poorly in the elections.
    4. Chancellor Merkel has lost faith in her hand-picked replacement and is signaling that she intends to stay in power until 2021.
  2. U.K. voters sided with parties that had clear positions on Brexit. Neither Labour nor the Conservatives did well.  Parties that polled the best were the Brexit Party, which, of course, wants to leave the EU, the Liberal-Democrats and the Greens, which both want to remain.  Although it’s a bit early, Boris Johnson has the inside track to replace May.  The odds of a hard Brexit increase if he becomes PM given his mercurial nature.  At the same time, the Remain supporters are pushing for another referendum and the Alliance Party, a cross-community party in Northern Ireland, did very well and is also pressing for another referendum.  May’s Tories do not command a majority in Parliament and only have power due to their coalition with the DUP, a Unionist party.  The good performance of the Alliance undermines the value of the DUP in future governments.
  3. It isn’t obvious who will become the new president of the European Commission (EC). Germany had been pushing for Manfred Weber but, after the election, French President Macron is arguing for a different (read: French) candidate.  Meanwhile, the Greens and the Liberals are intending to use their newfound power to attain top EU positions.
  4. The EU and Italy may be setting up for another tussle over the latter’s debt problems. Eurozone officials indicated that the EC will likely start disciplinary steps early next month to force austerity on Italy.  A conflict is likely given the fact that the League won the plurality of votes in Italy.  Italian sovereign yields rose on the news.

The bottom line is that Europe is a mess.  The centrist parties have not figured out how to co-opt either the left- or right-wing insurgencies.  In fact, right-wing centrist parties that have moved to the right have tended to get swamped by the fringe.  So far, financial markets are taking all this in stride, probably because there is so much liquidity in the financial system that there is no clear alternative to holding bonds and stocks.  But, there is no obvious path for Europe at this point, which will eventually weigh on EU financial assets.

The Japan trip: For the most part, President Trump’s visit to Japan was mostly a photo opportunity.  There were hopes that a trade deal between the U.S. and Japan might be signed, but negotiations were not finished by the time of the trip.  The administration still favors getting a deal done with Japan.  President Trump did comment on a number of issues during his journey:

  1. Trade negotiations between China and the U.S. appear to be deteriorating further.
    1. The president suggested the U.S. is in no hurry to complete an agreement and suggested that China needs a deal more than America.  In addition, the president favors more tariffs on China.
    2. Meanwhile, China is signaling that the U.S. cannot dictate its policy on state-owned enterprises, which the U.S. believes receive unfair subsidies.
    3. We also note that China has warned the financial markets not to short the CNY; this statement suggests policymakers are getting worried that the lack of a trade deal could trigger a currency crisis and capital flight.
    4. Taiwan indicated it is changing the name of the U.S. foreign office in Taipei, calling the unofficial “embassy” the Taiwan Council for U.S. Affairs. The inclusion of the term “Taiwan” will be an issue for Beijing as it suggests separation from China.  This is an issue fraught with risks—if anything were to prompt a hot war in the region, Taiwan declaring independence would do the trick.
    5. During his trip to Japan, the president complained about the Fed again.
  2. There appear to be some differences between President Trump and National Security Director Bolton over North Korea. The president indicated that he is not troubled that Pyongyang had recently fired short-range missiles (his hosts were not as sanguine about the launches).  Bolton has indicated that the launches violated U.N sanctions.

Overall, the trip didn’t have significant market implications, but the lack of a deal and the U.S. president’s apparent indifference to the threat that the short-range missiles possess for Japan signal that the U.S. is less committed to Japan’s security.  That indication holds long-term implications for the region.

Chinese financial system: For the first time in two decades, China’s government took control of a bank.  Baoshang Bank was taken over by regulators after it was said to have “serious” credit risks.

Iran: It appears the president is trying to calm tensions with Iran.  Although his secretary of state and national security director seem to support increasing tensions, President Trump indicated that he is not seeking regime change in Tehran.  There are reports of diplomatic contacts between the two nations.  However, backing out of the Iran nuclear deal has soured Iran on talking to the U.S.; Tehran views Washington as unreliable.  The president clearly wants to avoid a military escalation with Iran, but there is no obvious path forward.  The tensions have generated a significant geopolitical premium into oil prices.

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