Daily Comment (November 9, 2018)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s Friday, just not a very happy one.  The market tone is definitely risk-off.  Today’s weakness is mostly made in China but there are other concerns as well.  Here is what we are watching:

China: The inflation data (see below) was mostly in line with expectations.  There was some welcome easing of inflation at the producer level.  We may see a pickup in import prices in the coming months due to recent CNY weakness.  Easing price pressures could give the PBOC room for further stimulus.  However, other media reports are raising concerns.  For example, over the past year, companies were trying to maintain borrowing when the PBOC was cracking down on shadow banking.  The response was to circumvent these restrictions by borrowing from banks using shares that were pledged as collateral.  As any financial advisor in the U.S. knows, this is a form of margin lending and the risk of such borrowing is that the value of the collateral declines, leading to the dreaded margin call.  In China, the pledged shares were not used for additional share-buying but for business needs.  The bear market in Chinese stocks has now raised concerns about the collateral of these loans, which are said to be about $620 bn, or about 10% of market capitalization.[1]  So far, lenders have not forced borrowers to sell shares and pay back the loans; we suspect financial regulators are pressing banks not to take this action.[2]  However, by not forcing the sale of shares, banks are now reserving against these loans, which will further crimp lending.

This isn’t the only area of concern in China.  For the fourth straight month, car sales have shown negative yearly growth, falling 12% in October.  For the year through October, sales are down 0.1% compared to the same period last year.  It appears a confluence[3] of events, including worries over trade, falling equity values and tightening credit standards, is undermining car sales.[4]  Sentiment weakness has also led to falling Chinese tourism.[5]

The geopolitical situation is deteriorating as well.  The Trump administration is accusing China of violating an Obama-era cyber-theft agreement.[6]  In fact, it appears cyber-theft jumped after Obama left office.  The U.S. has already responded with the DOJ starting a “Chinese initiative” to counter China’s activity.[7]  In the meantime, the U.S. Navy and the People’s Liberation Army Navy continue their dangerous encounters in the South China Sea.[8]  Defense Secretary Mattis has been working hard to maintain open lines of communication to reduce the chances of a spiraling conflict.[9]  Although President Trump has made no secret of his dislike for his SoD,[10] for now, his position appears safe.[11]

In summary, China’s financial situation is becoming increasingly perilous.  Although a sudden debt crisis is possible, we don’t think it is the most likely outcome.  Instead, we suspect China is going the route of Japan, post-1990, where growth slows to a level where additional debt isn’t necessary to support growth.  The key unknown is whether the CPC can change its political legitimacy from delivering high growth to something else.  Chairman Xi has amassed enough power to make changes that will address this issue; what we don’t know is whether he can come up with a new form of legitimacy that allows China to remain a single-party state.  The most likely outcome is a long period of slowing growth.  But, that doesn’t mean that a sudden stop isn’t possible—it’s just not as likely.

The Fed: There were no surprises in the FOMC action or statement.[12]  The Fed did acknowledge that unemployment is really low but also noted that business investment has been disappointing.  There is no doubt the Fed will raise rates in December.[13]  It should also be noted that every meeting going forward will have a press conference.  In theory, this could make every meeting live but we note that forecasts and dots will still only occur quarterly.  We will be watching to see if the FOMC will take action on rates when there are no new dots.

Oil prices continue to decline: Oil prices remain under pressure this morning, with WTI dropping below $60 per barrel.  The catalyst today was a report that the Keystone Pipeline project was halted by a federal judge, arguing that the administration didn’t take environmental concerns into account.[14]  To some extent, the market reaction doesn’t make a lot of sense.  If the Keystone project was functioning, it would be bringing Canadian tar sands oil to the Gulf Coast, adding to supplies there.  The bigger reason for the weakness is rising domestic inventories that are partly due to seasonal factors and partly due to rising U.S. production.  In addition, Iraq may be close to a deal with the Kurds that would restart exports from Kirkuk.[15]  Oil remains oversold but clearly hasn’t found a bottom yet.

Cabinet changes: Although the Sessions resignation has been the focus of the media, there are rumors that Wilbur Ross may be out at Commerce.[16]  A potential replacement could be Linda McMahon; she is considered a free trader and may signal a shift toward trade deals and away from punitive tariffs.  Although we doubt China will get much relief, a McMahon Commerce Department may be more open to deals with the EU and Japan. 

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[1] https://www.reuters.com/article/us-china-markets-pledgedshares-insight/in-china-response-to-pledged-share-meltdown-stirs-concern-idUSKCN1NE0PD?feedType=RSS&feedName=businessNews&utm_source=Twitter&utm_medium=Social&utm_campaign=Feed%3A+reuters%2FbusinessNews+%28Business+News%29

[2] https://www.apnews.com/c14fed9f16594f1d9df6baf9b656de66

[3] See what we did there?

[4] https://www.wsj.com/articles/china-auto-sales-on-track-for-a-down-year-1541750936

[5] https://www.wsj.com/articles/chinese-travel-giant-trips-up-investors-1541743516

[6] https://www.wsj.com/articles/china-violated-obama-era-cybertheft-pact-u-s-official-says-1541716952

[7] https://www.wsj.com/articles/u-s-accuses-two-firms-of-stealing-trade-secrets-from-micron-technology-1541093537

[8] https://www.nytimes.com/2018/11/08/world/asia/south-china-sea-risks.html

[9] https://www.reuters.com/article/us-usa-china-mattis-insight/how-mattis-is-trying-to-keep-u-s-china-tensions-from-boiling-over-idUSKCN1NE0FF

[10] https://www.nytimes.com/2018/10/14/us/politics/trump-mattis-democrat.html

[11] https://www.bloomberg.com/news/articles/2018-11-05/trump-says-he-plans-to-keep-mattis-as-defense-chief-after-vote

[12] https://www.wsj.com/articles/fed-doesnt-budge-1541710988

[13] https://www.ft.com/content/8989b08c-e387-11e8-8e70-5e22a430c1ad?emailId=5be51a6f4c00e900045a33a8&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22&kbc=undefined

[14] https://www.washingtonpost.com/nation/2018/11/09/keystone-xl-pipeline-blocked-by-federal-judge-major-blow-trump-administration/?utm_term=.9e32c5ce427a

[15] https://www.ft.com/content/4c7d6e66-e370-11e8-a6e5-792428919cee

[16] https://www.politico.com/story/2018/11/08/russia-probe-trumps-attorney-general-hunt-978771