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

[Posted: 9:30 AM EDT] | PDF

Happy Friday!  It looks like a risk-off morning.  Foreign news is the opening focus—the U.S. has engineered the UAE’s recognition of Israel, only the third nation in the region (Jordan and Egypt are the others) to grant formal recognition.  China news comes next, in which Chinese concerns about financial sanctions and threats to Taiwan dominate.  We update the virus news and close with economics and markets.  Being Friday, the new Asset Allocation Weekly is available, along with the podcast and chart book; the topic this week is precious metals.  Here are the details.

Foreign news:

• In a momentous breakthrough, the UAE has agreed to formally recognize Israel. The UAE offered Israel a deal—if Israel didn’t annex areas of the West Bank, the UAE would grant formal recognition.  The U.S. was cool to the idea of annexation anyway, so, from the American perspective, this development is a win.
  • In fact, it’s historic, not quite on the same level as Egypt’s normalization,[1] but it’s close. Editorial writers are lauding the agreement.
  • The next step is to see if other Persian Gulf states follow the UAE’s lead. Pressure on Riyadh will be elevated.  If normalization becomes a trend, the agreement with the UAE would be the most significant in history.
  • The Palestinian leadership is devastated.
• So, what’s the bigger picture here? The driving force behind this outcome, in our opinion, is the U.S. reducing its geopolitical footprint in the region.  A key “known/unknown” is how the world acts as the U.S. pulls back.  S. hegemonic management after WWII assumed that three “hot spots” would require constant U.S. engagement to prevent an outbreak of hostilities.  These areas were Europe, where the German problem had to be managed, the Far East, where the endemic conflict between Japan and China had to be quelled, and the Middle East, where a colonial legacy left states designed to be unstable.  Optimists believe that if the U.S. pulls back from these hot spots, Japan and China will work out their differences, German regional hegemony in Europe will be beneficial, and the Middle East will adjust without going to war.  Pessimists expect that optimists are falling into the trap of mistaking hope for a plan.
  • As the U.S. withdraws from the Middle East, the nations there need to figure out how to counteract Iran’s malign influence, control Turkish ambitions, and manage outside actors, such as Russia. Israel and the Gulf States have mutual interests—they all want to contain Iran, are uncomfortable with Russia, and have enough memories of the Ottomans to want to keep the Turks at bay.
  • As long as the U.S. was guaranteeing security, these nations could avoid uncomfortable compromises. But if that guarantee is fading, the Arab States and Israel have an urgency to make common cause.
  • And so, this agreement is a “win” for the optimists. And, it allows the U.S. to focus its efforts on China.
• A theme we have held for a while is that if U.S./Chinese economic relations are set to fray, Mexico should be a major beneficiary. Although there is clear evidence of pressure, most U.S businesses, so far, are trying to keep their ties to China.  In addition, AMLO’s government in Mexico has not been considered “business friendly” and his management of the economy and the pandemic have been a disappointment.  Mexican equities have tended to underperform; over the past five years, the iShares Mexico ETF (EWW, 34.14) is down 37.1% compared to the S&P over the same time frame, which is up 61.6%.   However, at long last, perhaps Mexican leaders are starting to see their geographic advantage―reports suggest Mexico is working actively to lure U.S. firms that are considering leaving China.
• For the first time, the Trump administration has seized Iranian fuel shipments that violate American sanctions. This action will further raise tensions between the two states.
• The EU is formally protesting U.S. sanctions on the Nord Stream 2 project. This project would bring Russian natural gas to Europe under the Baltic Sea, bypassing Ukraine.  The U.S. has consistently opposed this project.

China news:

• U.S. and Chinese officials will meet tomorrow to update the Phase One trade deal. It looks like there is little chance China will meet its obligations, but it doesn’t appear that either side wants to scuttle the arrangement.  Thus, we expect a smooth meeting with lots of promises.  An actual break in the deal would be a shock.
• We are seeing increasing reports that Chinese officials are worried the U.S. will move to exclude China from the global dollar infrastructure. Although we haven’t seen anything directly suggesting the Trump administration is considering something so radical, it would have significant effects on the global economy.
• The tech battle between the U.S. and China continues. SoS Pompeo intimated that recent executive orders are “broader” than just TikTok and WeChat (TCEHY, 65.32).  American corporations are warning U.S. officials that the tech ban would harm their businesses.  Despite all the tensions, U.S. firms are generally maintaining their ties to China, although there is rising reluctance to operate in Hong Kong.
• China’s retail sales were disappointing. Essentially, we are seeing a plateau after a sharp recovery.
• China’s financial regulators are warning of a surge in bad loans in the near future.
• We are seeing moves and countermoves on the military front between the U.S. and China. The U.S. has moved B-2 bombers to Diego Garcia; usually, this is done when tensions rise in the Middle East, but this action appears to be designed to counter Chinese naval exercises, especially recent ones around Taiwan.
• There is no sign of easing tensions between China and India.

COVID-19:  The number of reported cases is 20,950,402 with 760,235 deaths and 13,015,379 recoveries.  In the U.S., there are 5,254,878 confirmed cases with 167,253 deaths and 1,774,648 recoveries.  For illustration purposes, the FT has created an interactive chart that allows one to compare cases across nations using similar scaling metrics.  The FT has also issued an economic tracker that looks across countries with high frequency data on various factors.  The R_t data shows 28 states with a reading less than one, a positive development.  The lowest state is Maine, while the highest is Hawaii.

• Russia has introduced a vaccine for limited use with very limited testing. It appears that some of this was a headline grab.  We will be watching to see how it does and hopefully it will work.
• One of the frustrating elements of this virus is that we are all learning on the fly. There is a tendency to try to project facts off limited data.  One of the items that has been noted is that children, for the most part, seem to be less affected by COVID-19.  That isn’t to say all are safe from it, and it says nothing to the issue of carrying the virus to others.  The effects on children are critical to the reopening of schools.  A new datapoint seems to suggest that minority children may be at greater risk to the virus, which complicates the reopening issue.
• A vaccine is the most likely path to normalization. This report highlights the difficulties in producing and distributing a vaccine once one is developed.

Market and Economic news:

• The recent executive order about suspending the payroll tax is increasing uncertainty for businesses. Since the tax is only deferred, businesses are not sure if they should continue to collect it or give it to their workers only to take it back in a lump sum early next year.  This was clearly not the intent of the order, but it does show the difficulty of governing without legislation.
• Yesterday, we noted that mortgage insurers were preparing to assess a new fee on refinancing.  The White House is criticizing the move.

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[1] Egypt was the most significant military threat to Israel; the normalization between Israel and Egypt meant that the former didn’t need to worry about its southern border and the latter could operate in the Sinai without risk.