Daily Comment (October 1, 2018)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s Monday!  It’s a risk-on day and the U.S, Canada and Mexico have struck a deal on NAFTA.  U.S. equity futures are higher, while precious metals and Treasury prices are lower.  Here is what we are watching:

A NAFTA deal: Although the deadline wasn’t as “dead” as it looked, Canadian and U.S. negotiators reached a deal late yesterday.[1]  Mexico’s president-elect had indicated he would sign whatever deal was made, meaning the deadline wasn’t as crucial.  There had been fears that AMLO would not go along with the arrangement and thus a deal had to be reached before September 30 for the current Mexican president to approve it.  Still, a deal was reached.  Although details are still sketchy, it does appear that U.S. dairy farmers will get access to the Canadian market while the dispute mechanism that Canada wanted to keep was retained.  In fact, the new arrangement appears to have a new name—the United States, Mexico and Canada Agreement (USMCA).[2]

It should be noted that Congress will have to approve USMCA and the composition of the House will almost certainly change.  It is unclear if congressional approval will occur because the White House has lost “fast-track” authority.  Still, the president is making some progress on revamping U.S. trade patterns.  His administration has a free trade arrangement with South Korea and is negotiating with Japan and the EU.  So, for the most part, we are seeing some positive movement.  Of course, the real issue remains with China, and trade policy with Beijing appears to be going beyond mere trade.

Conservatives meet: The Tories in Britain are meeting this week and tensions are elevated between the hardline Brexiters and the rest.[3]  It is possible that Boris Johnson could make a leadership challenge; if he does, it raises the chances that the government will face a no-confidence vote and broader elections.  We expect lots of strong headlines but little new movement from these meetings.

China news: There were some interesting articles regarding China in the weekend media.  First, the NYT reported that Chinese authorities are directing journalists to refrain from making negative comments about the economy.[4]  Specifically, they are to avoid discussing worse than expected economic data, local government debt risks, the trade war with the U.S., any signs of weakening consumer confidence, stagflation and personal interest stories showing economic hardship.  It is not clear exactly what is going on here.  One possibility is that the economy is worse than it looks and the Xi regime wants to avoid a crisis of confidence.  Another is a trend we have seen for some time, which is that the CPC derives its legitimacy from delivering strong growth and if growth slows it fears that the result won’t be just a downturn but will undermine the legitimacy of the communist party.

A second interesting development is that the Trump administration actively considered cutting aid to El Salvador for ending diplomatic relations with Taiwan in favor of China.[5]  The idea of punishing nations that end relations with Taiwan in favor of China gets into a very touchy issue.  The U.S. and China have employed strategic ambiguity regarding Taiwan.  This diplomatic term means that two parties use exactly the same words but the words have different meaning to each party.  For the U.S., Taiwan should, maybe someday, in a time far, far, away, formally become part of China.  For China, Taiwan should be absorbed into China soon.  Hardliners within the Trump administration (Bolton, mostly) are agitating to support a more independent Taiwan.  As relations between China and the U.S. deteriorate, using Taiwan as “the point of the spear” is looking increasingly attractive.  However, from China’s perspective, this would be like Beijing encouraging Florida to separate from the U.S.  Simply put, the harder the U.S. pushes for Taiwan independence, the greater the chances are of a Chinese overreaction.  These odds may be higher than we think, considering the above analysis.  If the Chinese economy is undermining CPC legitimacy, a war would do wonders to boost it.

Oil:The EU and Iran are said to be close to an agreement, which would allow the latter to continue its oil sales to the Europeans.[6]  We really don’t see how this will work but, for now, we will continue to monitor this development.  Our expectation is that the largest European oil companies, which need access to the U.S. financial system, will likely decline to participate.  If we are correct, European governments will be forced to buy the oil and the Trump administration will have to sanction governments directly.  The U.S. will need to decide if the escalation is worth it.  There are reports that President Trump called King Salman,[7] most likely to press for higher oil supplies.  We doubt the Saudis will make significant changes because the kingdom is running out of excess capacity.

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[1] https://www.ft.com/content/8a43c9f4-c51e-11e8-8670-c5353379f7c2?segmentId=a7371401-027d-d8bf-8a7f-2a746e767d56

[2] Contact the Village People—I see music video potential.  https://www.youtube.com/watch?v=Vc0gYbTNctU

[3] https://www.ft.com/content/60f62f1a-c49c-11e8-8670-c5353379f7c2?emailId=5bb1a5ff2c91a600040730ff&segmentId=22011ee7-896a-8c4c-22a0-7603348b7f22

[4] https://www.nytimes.com/2018/09/28/business/china-censor-economic-news.html

[5] https://www.nytimes.com/2018/09/29/world/americas/trump-china-taiwan-el-salvador.html

[6] https://www.nytimes.com/2018/09/29/us/politics/iran-trump-zarif.html?action=click&module=In%20Other%20News&pgtype=Homepage&action=click&module=News&pgtype=Homepage

[7] https://www.reuters.com/article/us-saudi-us-oil/trump-calls-saudis-king-to-discuss-oil-supplies-idUSKCN1M90SE