Daily Comment (October 1, 2019)
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA
[Posted: 9:30 AM EDT] Happy Q4! Although there is a lot of news, not much is market-moving. A poorly received bond auction in Japan has lifted bond yields around the world. Here is what we are watching this morning:
China’s anniversary: China held its 70th anniversary parade. There were lots of soldiers and military equipment, including a hypersonic missile. During the parade, protests continued in Hong Kong. There were reports that a protestor was shot with live ammunition; this is a serious escalation. Now that the anniversary is past, we will be watching to see how Xi handles the Hong Kong situation. We doubt we will see anything as blatant as the Tiananmen Square event. Instead, we would expect a steady suppression of protests designed to slowly reduce the number of participants and make the protests appear to be tapering off. We note that China has been moving security personnel and military groups toward Hong Kong. Essentially, this buildup could be used to eventually stifle the uprising. One thing to keep in mind is that China spends much more on domestic security than on its military.
We note that Xi’s speech had much to say about unity. The Chinese state is trying to do something it has never done in its history, which is to have a strong economy that is unified. Throughout its history, periods of strong economic growth have led to divisions between the outward-looking coastal regions and the interior. When Mao unified the country, he did so by cutting off China from the world, which allowed him to tie the coast to the interior. Deng’s economic reforms have led to economic divisions again that, so far, have not led to political divisions. However, Xi’s behavior, including a massive crackdown on “corruption,” the suppression of the Uighurs and of religion, points to a leader trying to force unity on the country while maintaining growth. If history is any guide, Xi will have to choose between a strong economy or a unified country. Our best guess is that he will choose the latter if forced. That would mean slower economic growth not just for China but for the world. It is also worth noting that some of Xi’s “colleagues” may prefer the other option; perhaps this is why he spent his first term purging the party. For now, we expect Xi to try to have both growth and unity, but that may not be possible.
Japan: The country’s value-added tax officially rises to 10% today, from 8% previously. While VAT hikes have derailed the Japanese economy in the past, today’s relatively smaller hike isn’t causing as much concern, in part, because it could be offset by a system of differentiated rates, cashback rewards and spending related to the upcoming rugby World Cup tournament. Although the VAT hike is being taken well and Japanese equities remain firm, as noted above, the Japanese bond market is tumbling after the Bank of Japan said yesterday that it will slash purchases of longer term bonds in an effort to steepen the yield curve. Meanwhile, the Government Pension Investment Fund said it will pivot toward buying more foreign debt.
Brexit: PM Johnson has told the Tories that he expects to “know by the weekend” if he can get a Brexit deal done by the end of the month. The issue remains the Irish backstop. There are rumors that Johnson will propose customs clearance centers on both sides of the Irish frontier. Johnson has denied the rumors; having customs on both sides of the border is a potential problem because the ones on the Northern Ireland side would become targets for the IRA. We don’t think this is going to work. If Johnson can’t sway the EU, then expect a delay in Brexit and new elections. One interesting side note is that the U.K. apparently exports a significant amount of its trash to the Netherlands, where it is separated and some is incinerated and the rest recycled or landfilled. If there is a hard Brexit, the Brits will have to handle their own rubbish, which could become a political problem for the Johnson government.
A cautionary tale: For 24 hours last week, the U.S. shut down its air command center at the Al-Udeid Air Base in Qatar and shifted operations to South Carolina. It was described as a drill, but the timing does suggest the U.S. has concerns about the safety of the base and is testing its backup plan. This comes on reports that Saudi Arabia is trying to ease tensions. So far, Iran has been playing “hard to get” with regard to a meeting with the U.S.
United States-North Korea: The United States and North Korea said working-level talks on denuclearization will resume on Saturday. The talks may show whether progress can start again now that hardliner John Bolton is no longer U.S. national security advisor. If progress can be made, it would probably feed into the developing bullish narrative of reduced tensions in Asia.
Peru: Frustrated with legislators refusing to pass his popular anti-corruption proposals, President Martín Vizcarra ordered the dissolution of Congress and new elections. However, Vice President Aráoz declared the move illegal and had herself voted in as the new leader, potentially setting up a period of continued political uncertainty.
Odds and ends: Riots emerged on the Greek island of Lesbos, where a fire broke out in a refugee camp. Although it hasn’t caught the attention of the media, refugee flows have been increasing recently. Greece is working to improve conditions. Italy has increased its budget deficit projections but will seek to avoid a conflict with the EU. The WTO is warning that world trade is slowing and that this factor will likely weaken global growth. The dollar share of world reserves has declined to its lowest level in six years; the JPY was the greatest beneficiary. Finally, surveys are suggesting that banks are tightening credit conditions on smaller firms.