Daily Comment (October 11, 2019)

by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA

Happy Friday!  It’s a day starting with great optimism.  It appears that a mini-trade deal may have been struck with China.  There seems to be progress on Brexit.  On the darker side, an Iranian oil tanker was struck by missiles in the Red Sea.  Here are the details:

The trade deal:  U.S. and Chinese negotiators appear to have made some progress on a trade dealThis won’t be the trade deal but a trade deal, a confidence-building measure toward a larger agreement, or at least a truce.  Here is a rough sketch of what seems to be developing.

  1. The U.S. will offer some sort of tariff relief. It is unclear which of the two tranches of tariffs, one set to begin in four days and the other in December, will be rescinded (unlikely) or postponed.  China will press for them to be withdrawn; the U.S. will want to keep the threat hanging over the trade talks to keep China at the negotiating table.  If the tariffs are merely postponed, it will dampen the bullish impact.
  2. China will offer to buy lots of agriculture products. This action serves several constituencies.  The farm sector, which has been suffering greatly, will be helped.  This will also help the president’s reelection campaign.  China will be able to reduce food inflation.
  3. A currency deal will likely be struck. Why?  Because it’s mostly unnecessary.  The U.S. is clearly upset that in a floating forex arrangement, the impact of tariffs is usually blunted by currency depreciation.  Thus, it wants to prevent China from using a weaker CNY to offset the tariff threat.  However, China was reluctant to use currency depreciation as a tool.  A weaker CNY tends to trigger capital flight, so the PBOC wasn’t poised to depreciate its way out of tariffs anyway.  Nevertheless, getting China to promise to not depreciate its currency does allow both sides to declare progress in the negotiations.
  4. The intellectual property issue will probably not be resolved, but some minor arrangements could be made. However, USTR Lighthizer considers this a key point of the trade talks and wants changes in Chinese legislation to enshrine it.  We don’t think this one is resolvable and this will be one of the key sticking points if talks fail.
  5. Huawei (002502, CNY 3.06) remains, from the U.S. perspective, a global security threat. We might see some extension in waivers from Washington but would not expect the U.S. to “green light” the company.

So, if we got this right, where does that leave us?  We will get a market lift and may make new highs.  Investors have been very cautious this year, and FOMO might drive a strong Q4 lift.  The risk is that what we have outlined above may be nothing more than a delay.  Beijing will likely want to delay because it might get to negotiate with a different president after the elections.  The administration should accept a delay because it could either prevent or delay a recession long enough to support the president’s reelection chances.  However, there is still a lot that can go wrong.  China may not accept a mere delay in tariffs.  The U.S. may not accept promises on intellectual property.  In these talks, each side has consistently overestimated its own position and underestimated the other side.  It is also important to remember that we could see what looks like an agreement in Washington only to see the deal scotched when Chinese negotiators return home.  That happened, in effect, last May.  What would help bring a deal now is if both sides convince themselves that this is a temporary agreement that buys them much needed time. 

Brexit:  After meetings between the PMs of the U.K. and Ireland, both claimed to have seen “a pathway to a deal” on Brexit.  European Council President Donald Tusk said there were “optimistic signs.”  It is still not to be revealed what changed but, whatever it was, it appears to be significant.  Michel Barnier, the EU Brexit negotiator, thinks enough of the deal to open intensive negotiations.  The GBP soared on the reports.

There is a clear change in sentiment.  What happened?  Well, we don’t know for sure but the fact that the EU is suddenly interested suggests to us that Johnson has agreed to keep Northern Ireland in the customs union and put the trade border at the Irish Sea.  Obviously, we don’t know this for certain, but here is our reasoning:

  1. The DUP (Irish Unionists) have been strongly opposed to this measure for good reason. Once the Northern Ireland economy is effectively separated from the U.K., it’s probably just a matter of time before unification with the Republic of Ireland will occur.  In PM May’s government, the DUP was what allowed her to have a majority.  However, PM Johnson likely realizes that if he can deliver Brexit and then hold elections, he will likely win a smashing victory and won’t need the DUP, or Northern Ireland, anymore.  Recent polls show the Tories with a 35% share and the Brexit party with 12%.  If Brexit is executed, the two groups of voters will likely coalesce around the Conservatives and give them a near-majority.  History suggests getting 45%+ of the vote will almost certainly give Johnson a strong majority in Parliament.  To put it bluntly, Johnson is securing his election by selling out the Unionists.
  2. The EU position on Brexit has been clear—no trade border in Ireland. The EU wasn’t even really open to a time-limited deal.  The sudden enthusiasm exhibited by Varadkar and Barnier suggests they got what they wanted and want to seal the arrangement before opposition can develop against it.

Essentially, the impasse was the Irish border.  If that’s resolved, there is little to stop a deal.

Iran:  An Iranian state-owned shipping firm claimed one of its oil tankers in the Persian Gulf was damaged by two separate missiles this morning.  The Iranian foreign ministry hasn’t yet assigned blame for the attack, and since ship-tracking services show the vessel is now sailing at normal speeds, there is some doubt as to whether the attack really occurred.  If it didn’t really happen, it would suggest Iran is trying to manufacture a justification for new, explicitly Iranian attacks after the likely Iranian attacks on Saudi oil facilities last month failed to draw the U.S. into the region.  On the other hand, if the attack really did happen, there is a chance that it was instigated by the U.S. and/or Saudi Arabia in retaliation for the attacks on Saudi Arabia.  As might be expected, the risk of escalating tensions has boosted oil prices today.

On a side note, oil shipping costs have soared after the U.S. sanctioned a Chinese tanker company for violating the ban on Iranian oil exports.  Apparently, the ban has cut shipping capacity and led oil exporters to scramble to secure space on tankers.

Hong Kong:  To apply “new innovative tactics to deal with the cunning rioters,” municipal Police Commissioner Lo Wai-chung has promoted the former commander of the department’s elite tactical squad to be his new operations chief.  That signals a potential shift in how the police deal with the continued anti-China protests, but not necessarily a Chinese army-led crackdown.

Russia-Ukraine:  As more evidence of slowly improving relations between Russia and Ukraine, the foreign minister of Ukraine said Russia will soon return three naval vessels that it attacked and impounded in November 2018.  Two dozen Ukrainian sailors detained in the incident were released in early September.

Poland:  Jaroslaw Kaczynski and his conservative-nationalist Law and Justice Party look set to comfortably win Sunday’s parliamentary elections.  While that would ensure continuity in government policy, it would also ensure that Poland will continue to be at odds with EU leaders in Brussels.

Japan:  A typhoon considered to be the equivalent of a Category 4 hurricane is due to hit central Japan this weekend.  According to the country’s Meteorological Agency, the typhoon could trigger record rainfall on par with a 1958 storm that left more than 1,000 dead or missing.

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