Daily Comment (September 24, 2019)

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

[Posted: 9:30 AM EDT]

Good morning!  Boris gets bad news.  Europe is turning on Iran.  China is looking to control its large firms.  President Trump will address the U.N. General Assembly today.  Here is what we are watching this morning:

The U.K. Supreme court rules against PM Johnson:  In an 11-0 verdict, the U.K. high court ruled this morning that the Johnson government acted illegally when it prorogued Parliament.  John Bercow, the speaker of the Parliament, has indicated lawmakers will return tomorrow morning.  The GBP rallied modestly on the news.  It is unclear exactly what happens now.  The current government is in minority.  Under current law, Johnson needs a two-thirds majority to call elections and earlier attempts to bring elections have failed.  However, the official opposition party, Labour, is a mess—it is obvious the next election will be about Brexit and the party doesn’t have a clear stance.  And, there is a looming deadline coming on Halloween.  There is not enough time to create a new arrangement and it remains possible that the U.K. could crash out of the EU simply because no one can figure out how to avoid it.  It appears the most logical solution would be a delay of Brexit and new elections to form a government with a full mandate to do something.  However, it is just as likely that new elections will not bring a clear path to either leaving or staying in the EU due to the deep divisions within the U.K.

Here is a way of thinking about this issue.  The EU and globalization in general offer citizens of a particular nation a tradeoff—prosperity for sovereignty.  In other words, joining a supranational union (the EU), or large multinational trade deals (WTO, TPP, TTIP, NAFTA) requires participating nations to give up some level of sovereignty.  In return, the broad trade arrangement makes economies more efficient and supports growth (prosperity).  However, when the fruits of that prosperity are not shared among the majority of households, a common condition in Western nations at present, those “left behind” are not necessarily better off economically but have given up sovereignty as well.  As a result, the position of the left-behinds is that getting sovereignty back can’t hurt, and they don’t feel they are giving up much prosperity either.  This group becomes the opposition to globalization.  This problem is, to some extent, the heart of the globalization debate and is key to the Brexit issue.

Isolated Iran:  In a somewhat surprising development, France, Germany and the U.K. have all blamed Iran for the recent missile and drone attack on Saudi Arabia.  PM Johnson has called for a new deal, which would effectively end (JCPOA).  This is an interesting turn of events; the EU has created a financial workaround for Iran to continue exporting, although it hasn’t been very effective.  We suspect two factors are in play.  First, the EU is deeply worried that an outbreak in hostilities would lead to oil shortages negatively affecting Europe’s economy and second, we doubt these nations would make such statements if they thought the U.S. would use them to justify military action.  In other words, these leading EU nations must believe that the Trump administration is not likely to use military force.  Thus, the EU has turned on Iran, leaving the Mullahs increasingly isolated.

So far, the bet against the U.S. using military action against Iran has been a good one.  At present, the only military action that appears to be under consideration is cyber, which has the characteristic of deniability.  Despite the appearance that escalation isn’t likely, we caution that conditions can change.  Iran is in a difficult spot; sanctions are crushing its economy, and the U.S. is in no hurry to negotiate.  No other nations appear interested in helping them out.  Desperation in Iran may lead to further aggression.  The creator of the archetypes of American foreign policy, Walter Russell Mead, has an op-ed today where he notes that Trump is a Jacksonian, and he lays out “red lines” that would likely trigger a military response.  For now, time is on the side of the U.S.  There is no need to escalate, but that doesn’t mean Iran won’t.  It is quite possible that financial markets are underestimating the chances of a conflict and higher oil prices.

We are from the government and are here to help:  China announced it will place CPC officials in 100 private firms in China.  The official reason given for this move is to “boost local manufacturing,” but it is rather obvious that the goal is to force these firms to follow government directives.  For years, Chinese law has given the government power to place officials in firms for monitoring purposes.  However, prior to Xi, firms were allowed near complete freedom to operate. That may be changing.

China and trade:  Equity markets continue to tick higher on hopes of a trade thaw. Treasury Secretary Mnuchin said he expects top-level U.S. and Chinese trade negotiators to meet during the week of October 7.  Mnuchin also claimed some progress was made at last week’s deputy-level meetings.  However, we have two areas that suggest caution.  First, the DOJ reports that China is accelerating its theft of trade secrets.  Second, Matt Pottinger has been appointed deputy national security advisor.  Pottinger is considered a hawk on China, meaning that an important figure in the administration will be likely framing a hostile policy toward China.

European Union-Italy:  EU leaders agreed to adjust their immigration policy to help the new government in Rome.  Germany and France would automatically take in some migrants rescued in the Mediterranean, while other EU nations would volunteer to take in some refugees landing in Italy.  The deal could help to stabilize EU politics by undermining anti-immigrant populists.

China:  Commenting on three regional banks rescued by various entities since May, central bank chief Yi warned that some regional lenders have overstretched into high-risk loans, and that their top shareholders would face “primary responsibility” if they failed.  Yi said he wouldn’t sharply cut interest rates, but he did ask banks to lend more to local clients in the real economy.

Odds and ends:  The opposition to Maduro in Venezuela appears to be fracturing, meaning it will be even more difficult to oust the current government.  In a surprising development, the Bolsonaro government in Brazil has slashed tariffs on more than 2300 products.  Traditionally, Brazil has leaned toward import substitution policies for development, meaning it created tariff barriers which allowed local firms to make goods that could be more cheaply imported.  Reversing this policy will tend to lower inflation and increase productivity; it will also, at least initially, increase unemployment and local firms will face import competition.

View the complete PDF