Daily Comment (September 3, 2019)

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

[Posted: 9:30 AM EDT]

Welcome back!  Three-day weekends are great, but now we get to pile five days of work into four!  Trade worries continue to weigh on risk assets.  Brexit appears to be reaching some sort of resolution.  Hurricane Dorian dominated the weekend news flow.  Here are the details and other items we are watching:

Trade: On Sunday, a new set of tariffs went into effect.  Although it will take a few weeks, we may start to see it show up in the inflation data by November.  The focus has now shifted to meetings between trade negotiators later this month.  Both sides are struggling to figure out when to hold talks and who should participate.  If Liu He doesn’t make the trip, it will suggest the meetings are simply window dressing.  The U.S. has a 5% bump on $250 bn of Chinese exports due to come into effect on October 1 (from 25% to 30%) and a 15% increase on December 15 for the remaining $200 bn in imports.  There is hope that these may be delayed or reduced, but the lack of consensus on either side makes adjustments difficult.  On a hopeful note, China’s retaliation doesn’t really go into full effect until December.  At the same time, China has important party meetings in early October, and there is no way the Xi government can be seen as caving to U.S. demands before those meetings.

Meanwhile, China is taking steps to adjust to the effects of tariffs.  Additional stimulus is being planned, although the scale remains relatively constrained mostly due to concerns about debt capacity.  We note that the CNY has been allowed to quietly weaken.  While the currency fixes have been steady, the PBOC isn’t making much of an effort to force the market rate to the fix, suggesting it is allowing the currency to offset some of the impact of the tariffs.

China is also opening new fronts in the public relations battle.  In a press release denying that it stole smartphone camera technology from a Portuguese company, Chinese telecom giant Huawei Technologies (002502.SZ, 3.19) tried to turn the tables by claiming the FBI is harassing and threatening Huawei employees to get them to turn against the company.  It also said the U.S. has launched cyberattacks against it.  Given the continued U.S.-China trade war, growing concerns about China’s digital warfare capabilities and the Trump administration’s more aggressive use of offensive cyberwarfare operations, we actually think the accusation rings true.  If so, it is probably a good example of how the administration is conducting a full-court press against China, which bodes poorly for any near-term cooling of tensions.  In another sign of Chinese pushback against the U.S., the Ministry of Public Security touted its efforts to restrict fentanyl shipments since May.  After President Trump demanded Chinese action to help deal with the U.S. opioid crisis, China could have taken some additional steps as a show of good faith.  By pushing back instead, China seems to be signaling that it’s done making concessions, at least for now.

The global economy continues to suffer the effects of the trade conflict.  Chinese PMIs over the weekend were stable but didn’t improve.  The rest of the world, on the other hand, is struggling.

China: Vice premier and Politburo member Hu Chunhua told a meeting of top officials last week that surging pork prices – resulting mostly from an epidemic of swine fever that has decimated pig herds – have become a “major political risk.”  To get control over prices, Hu called for greater financial support for pig farmers and setting pork production targets for each province, though outright price controls can’t be ruled out.

Brexit: The situation with the U.K. and Brexit is getting as complicated as determining who is in the NFL playoffs three weeks before the end of the season.  Here is the rundown:

  1. MPs move to kill hard Brexit. The “rebel alliance” of MPs within the Tories is joining forces with opposition groups to vote on a bill that would prevent PM Johnson from leaving the EU without an agreement.  In case a deal with the EU isn’t reached, the bill requires Johnson to ask the EU for an extension until January 31, 2020.  The bill requires an extraordinary measure, the so-called “Standing Order 24” that allows MPs to debate important matters.  This debate and subsequent vote can only occur if the Commons Speaker, John Bercow, gives permission.  It is widely expected that he will grant the debate.  The odds of passage are high, but it would need to move quickly through the House of Commons and House of Lords to become law by early next week when Parliament shuts down.
  2. If passed, what does Johnson do? The most aggressive action would be for Johnson to call for new elections.  By calling new elections, Parliament would be dissolved immediately and the delay bill will be dead.  But, there is a catch.  For a sitting PM to dissolve Parliament and call snap elections he needs a 66% vote; a mere majority won’t do it.  Of course, if Johnson loses the delay bill and can’t muster enough votes to call elections, he will be mortally wounded politically.  A vote of no-confidence could follow.
  3. No-confidence may be the plan. Labour’s Corbyn has been pining for a general election but it isn’t obvious he would win.  K. politics has become jumbled in the Brexit process, with the two leading parties split.  In other words, the Tories and Labour are both divided over this issue, which would argue that new party arrangements are called for.  We would expect Johnson to make Brexit the key part of his platform in a new election to thwart the effect of the Brexit Party; some Tory MPs would likely defect to another party, putting their seats at risk.  Meanwhile, it isn’t obvious where Labour would fall on this issue.  Former PM Blair rightly warns that Labour is falling into an “elephant trap” and would likely lose a general election.  Complicating matters further is that Labour has just released a radical economic platform that may be too extreme to win a majority.  Johnson could easily move an election away from Brexit and toward Corbyn.  New elections are risky for all parties, but it may be the only way to break the current gridlock.  If elections are called, we would expect them before the Halloween exit deadline.

The GBP fell on the turmoil to historic lows but hasn’t collapsed.  Despite the concerns, so far, there is enough uncertainty to prevent either a strong relief rally or a meltdown.  But, as we have described above, there is enough that can go wrong that the risks of a volatile move in either direction are elevated.  For now, investors should remain cautious.

Hong Kong: The situation remains grim.  There were massive demonstrations over the weekend, with water cannons spewing blue water (a new twist on the tactic, making demonstrators easier to identify for arrest) and lots of tear gas.  The Chinese government’s Hong Kong and Macau Affairs Office continues to assert itself amid the continuing anti-China political protests in Hong Kong.  Today the office said the protests are looking more like the “color revolutions” that have toppled governments in Eastern Europe and the Middle East.  It also warned that it has the legal power to declare a state of emergency in the city, and outlined several steps it might take to get control over the situation, including the possible introduction of “patriotic education” into Hong Kong schools.  The office is still focusing on threats to diffuse the crisis, but the risk of a disruptive crackdown can’t be dismissed.

Argentina: Over the weekend, the government imposed capital controls in an effort to contain its latest debt and currency crisis.  Under the controls, residents aren’t allowed to buy more than $10,000 of foreign currency per month.  The peso jumped on the news, but it’s not yet clear whether its recent plunge will resume.

Italy: In another nail-biter in European politics today, Italy’s left-wing Five Star Movement will conduct an online poll of its members on whether to approve a deal with the center-left Democratic Party for a coalition government.  The deal is generally expected to be approved, but if it fails it would add to the sense of political chaos in Europe and weigh on assets ranging from the euro to Italian stocks and bonds.

Japan: Prime Minister Abe said he will reshuffle his cabinet on September 11.  Reports indicate most key players in the cabinet will keep their jobs, but Economic Revitalization Minister Toshimitsu Motegi may be promoted to foreign minister to reward him for his work negotiating the new trade deal with the United States.

Australia: In order to break China’s near monopoly on rare-earth and other critical minerals, the Australian government said it will support more than a dozen private-sector mining projects centered on those materials.

German regional elections: Germany held regional elections in two former East German states.  The AfD made a strong showing but the CDU did win the most votes.  Both the hard-left and the SPD had weak showings.  Overall, the results avoided the most unsettling outcome (an AfD majority), but also showed that the centrist parties are still struggling to gather votes.

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