Daily Comment (October 9, 2019)

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

On the eve of trade talks, hopes of a thaw are boosting risk markets this morning.  Powell coos.  Fed minutes at 2:00.  Here is what we are watching today:

Trade thaw?  Equity futures lifted this morning on reports that China, despite all the turmoil over visas and the NBA, is open to a limited trade deal.   According to reports, China signaled a willingness to buy more agricultural products in exchange for delays in tariffs.  It appears that Beijing is taking a page from the Abe playbook; Japan recently signed a limited trade deal with the U.S. making a promise to buy U.S. agricultural products and to delay more contentious issues for later.

There are good reasons on both sides to accept this arrangement.  First, a trade deal will improve market sentiment and reduce recession fears.  The trade conflict has hurt economic sentiment on both sides.  The slowdown in the U.S. is obvious and there are reports that retail activity during China’s “golden week” the first week of October, was rather soft.  Second, President Trump and President Xi will meet in November at the APEC meetings, and a partial agreement allows both to save face and promise further talks.  Third, China may believe it can get a better deal with a different U.S. leader.  Thus, signing a small deal now that delays tariffs and hoping for a new president makes sense.

The great unknown is how President Trump will react.  Helping the farm sector would improve his electoral standing in the Midwest.  We note that weather forecasts are becoming much colder for the northern parts of the corn belt with the potential for snow.  The corn crop hasn’t completely matured in these regions (the formal term is “dented”); cold and snow will ruin much of the crop, reducing it to silage.  The region could use a break.  Additionally, there is ample evidence that the White House pays attention to the equity indices.  At the same time, this partial deal isn’t what the president campaigned on, and he does believe that being tough on China is a positive for his supporters.  Our take?  The past nearly three years since his election have shown that predicting Trump’s behavior is difficult.  So, we think the odds of rejection are 55/45.  In other words, we lean toward rejection, but not with any strong conviction.

In other China news, Beijing has established its plan of retaliation to U.S. visa restrictions.  This weekend, China and India will hold a summit meeting; the line of control on the Indian/China frontier is likely to be discussed.  The recent trade blacklist from the U.S. will affect China’s AI plans.  Carrie Lam had not ruled out asking for help from Beijing to quell unrest; such a move would likely end Hong Kong’s special status.

Turkey’s incursion:  Turkey has announced that its military has moved into northern Syria, into the region controlled by the Kurds.  We may see sanctions applied to Ankara, but it doesn’t appear that the U.S. will take stronger measures to oppose this action.  At the same time, the threat of sanctions will likely limit the extent of the invasion.

Easing, not easing:  Chair Powell indicated that the FOMC will likely authorize an expansion in the balance sheet to address recent repo volatility.  However, he took great pains to argue that this action is not QE.   In one sense, this is a difference without a distinction.  The financial system should be indifferent to the intention of the balance sheet expansion.  However, market participants do pay attention to intention, so the impact of balance sheet expansion might not be all that impressive.  What will likely be the key factor is size of the expansion.  If it turns out to be more that $250 bn, it will, in reality, be QE.  The Fed minutes will be out this afternoon; although participants hang onto every word, we don’t expect the document to tell us very much.  Overall, the FOMC is divided on policy.

Brexit:  Recriminations continue on both sides.  Our expectations remain the same.  Johnson will sputter and shout but, in the end, he will extend Article 50 into late January.  The EU will grumble but accept the extension.  Corbyn will bring a no-confidence vote, and elections will be held.  The election is the big unknown.  The U.K. electorate will be faced with giving a mandate to the Conservatives who will use that to crash out of the EU, or give it to a multi-party mix of the SNP, the Liberal-Democrats and Labour which will run on a second referendum.  The second referendum will be “do you want to stay in the customs union or reject Article 50?”

Still, this outline isn’t certain.  UK PM Boris Johnson is expected to advise the Queen that she can not sack him if he loses a no confidence vote. The basis of his argument is based on a 70-year old constitutional convention known as “Lascelles Principles,” which the Queen could refuse to dissolve parliament under three conditions: 1) The existing parliament was capable of doing its job, 2) if a general election would be detrimental to the national economy and 3) if the British monarchy can rely on finding another prime minister who could govern for a reasonable period with a working majority of in the House of Commons. Johnson is expected argue that if the Queen were to sack him it would likely lead to economic chaos as a result of the looming Brexit deadline. At this time, it is unclear whether the Queen is willing to accept his advice but there have been rumblings that she was considering sacking him.

Protests:  We have been noting protests in Hong Kong for some time.  However, there are a couple of others we want to note.  First, protests in Algeria never really ended.  The military government likely hoped that pushing out the former leader would end the unrest, but the protestors don’t seem to want to merely accept another elderly military leader.  Second, Haiti is entering its fourth week of protests.  If these persist, we could see a rise in Haitian refugees moving to Mexico and the U.S.  Third, protests continue in Iraq with more than 110 people killed.  Fourth, Ecuador President Lenin Morena was forced to move its government out of the capital town of Quito, in response to his decision to cut fuel subsidies as Ecuador implements austerity to improve the odds it can get a debt relief package from the IMF.

Odds and ends:  A top secret unit from Russia appears to be engaging in all sorts of audacious actions to undermine Europe.   Research from Berkeley indicates that the effective tax rate for the 400 richest families was less than that of the bottom 50% of households.  Effective tax rates take into account all taxes—Federal income and corporate, social security, state and local—giving a more complete picture of the rate paid.  Wealthy households can afford to hire professionals to take steps to reduce taxes.  In addition, since social security taxes “max out” they become less of a burden for the wealthy and this tax only touches wages, not capital income.  This isn’t to say that the wealthy pay less, but less from each dollar earned.

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