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

[Posted: 9:30 AM EDT] | PDF

It’s Friday, the 19^th anniversary of 9/11.  Equity futures are signaling a recovery this morning after failing to hold early gains yesterday.  Also, yesterday the ECB kicked off a rally in the EUR after the bank indicated it wasn’t overly concerned about the recent strength in the European currency.  The rally in foreign currencies continues this morning.  We lead off with Brexit today, followed by an update regarding the geopolitical tensions in Europe.  China news comes next, and some commentary about the economy and policy will follow, along with a note about the elections.  We close with pandemic news.  The Weekly Energy Update is available.  Here are the details:

Brexit:  It seemed like we discussed Brexit all last year.  Early in 2020, it appeared we finally put that issue to rest.  But it’s back with a vengeance.  As we have noted recently, PM Johnson wants to abridge the exit agreement signed earlier to give him greater freedom to grant state aid to various industries and sectors.  State aid is a big issue for the EU; European nations have a long history with national champions, and to maintain cohesion within the bloc such spending is regulated.[1]  If the EU gives Johnson what he wants and allows mostly open trade, it will almost certainly see its firms competing with U.K. firms that are being supported by British taxpayers.  In reality, such state aid occurs, but from the perspective of the EU, just because it happens doesn’t mean it should be enshrined in law.  The U.K. rightly fears that if it accepts the EU proposal and then uses state aid to bolster economic growth in depressed areas of the country, then the EU may use this aid to sanction exports from these regions.  Another way of thinking about this is that the U.K. fears it will be held to the letter of the law once outside the EU, but EU nations will face a more flexible legal regime.  It should be noted that the British spend about 0.3% of GDP on state aid to businesses compared to an EU average of 0.8%.

The EU has delivered an ultimatum to the Johnson government; within 30 days the U.K. must pull the Internal Market Bill or face legal action.  The problem for the PM is that he did sign the earlier withdrawal agreement and now he is trying to rewrite it.  Not only is this a violation of international law, but it also may not be acceptable to his own party.  However, behind all the rhetoric, we note that the EU wants to sue, but not necessarily force a hard Brexit. For example,   trade talks continue.  At the same time, the EU does seem to be preparing for a clear break with the U.K.  Ireland, which would be “ground zero” if talks fail, is beginning to take measures that would bring a hard border with Northern Ireland.  Parliament will begin the debate next week.

So far, the GBP has weakened on the news but is not in a free fall.  Either (a) Brexit won’t be a big deal because we all have had ample time to prepare, or (b) markets believe that this current turmoil is a “tempest in a teapot” and will eventually be resolved.  We tend to think the first possibility is the true one, and we will continue to watch events to see if that is correct.  If it is, any weakness triggered by a hard break is probably a buying opportunity.

European news:

• • Although Brexit is a big deal, there are other issues complicating matters for EU officials. We have been monitoring tensions between Turkey and Greece.  This is nothing new; Turkey and Greece have been in conflict for centuries.  The current spat focuses on two areas, border issues and immigration, and oil and gas exploration around Cyprus.  Turkey has been using the threat of allowing Middle East refugees to flood into the EU as a way to extract aid.  Unfortunately for Greece, it is on the front lines of this threat. EU rules state that a refugee must be taken care of by the nation where the person lands, which explains why Malta, Italy and Greece tend to try to prevent refugees from landing.  The second issue has become a problem because Turkey has been sending drill ships into disputed areas around Cyprus.  The island’s political situation has been divided for years and remains unresolved.  The EU wants negotiations with Turkey and is threatening sanctions if Ankara doesn’t comply.  There have been bilateral talks between Turkey and Greece at NATO headquarters to reduce the chances of a military confrontation.  French President Macron has also been actively involved.  At the same time, Greece appears to be preparing for conflict; its military spending is rising as it confronts Turkey.  During the Cold War, the U.S. would have taken steps to quell this dispute between NATO members.  Those days are past, and the divisions within Europe are being exposed.
• Germany finds itself caught between wanting to stand up to Russia over the Navalny poisoning and wanting a direct source of natural gas from Nord Stream 2. Due to the decision to end atomic energy and a move to renewable energy, Germany will need natural gas to fill the energy gap until reliable battery storage is available.  Currently, Germany gets much of its gas through pipelines that traverse Ukraine.  Given Russia/Ukraine relations, this source is unreliable.  The Netherlands has been the other main supplier of natural gas, but that nation is taking steps to reduce its output for environmental reasons.  Increasing reliance on Russia for natural gas, unfortunately, means it would be forced to acquiesce to Russian behavior.

 China news:

• S. ambassador Terry Branstad penned an op-ed for the People’s Daily. The paper has refused to publish the editorial, prompting the SoS to point out the hypocrisy of the CPC.  After all, Chinese officials often use American media to publish their views.  This event will pass, but it does show continued deterioration in relations.
• Although Indian and Chinese officials did meet in Moscow at the Shanghai Cooperation Council meetings, tensions remain elevated. Chinese paratroopers have been conducting military exercises in the area, suggesting China is preparing for a broader conflict.  Meanwhile, it looks like China is engaging in its pattern where it makes a minor incursion which allows it to control territory but isn’t, by itself, enough to trigger retaliation.  We have seen similar behavior in both the South and East China Seas.  At some point, the U.S. or India is going to react militarily to one of these moves.  Until then, China’s behavior will likely continue because it is successful.
• European companies are expressing concerns that deteriorating political relationships will lead to retaliation. We suspect their concerns are justified.
• SoS Pompeo is urging South Asian nations to “stand up to China.” This will only work if these nations believe the U.S. will back them up in a confrontation with Beijing.
• Although the political process tries to draw distinctions between parties and politicians, in reality, political leaders are usually constrained by the conditions they inherit when they take office. There is a growing realization that relations with China will likely deteriorate regardless of who is in the White House.

Economic and market news:  It is generally acknowledged that Q3 GDP will rise sharply from the Q2 trough.  The consensus among economists is that a nearly 24% annualized rise in Q3 is likely.  One of the consequences of this pop in growth is higher imports; ports are reporting breakneck activity.  The smaller stimulus bill from the Senate GOP failed yesterday as expected.  It is notable that moderate Democrats in the House are expressing concern about the lack of progress.  Meanwhile, the executive order that boosted unemployment insurance payments is running out of funding.  In our commentary about the elections earlier this year, we noted that Russia’s main goal was sowing chaos.  Sadly, it appears our projection is true.  Russia is reportedly hacking both parties.

COVID-19:  The number of reported cases is 28,205,308 with 910,157 deaths and 19,023,884 recoveries.  In the U.S., there are 6,397,629 confirmed cases with 191,802 deaths and 2,403,511 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 that 19 states are less than one, and 31 are greater than one.  A reading above one means rising infection rates.  California has the lowest rates, while West Virginia has seen a surge.

Virology: 

• As we noted yesterday, Brazil was becoming a favorite spot to test vaccines due to the high level of infections. China is testing its vaccine there; the Brazilian state of Bahia is buying 50MM doses of the Russian vaccine to test.
• Turkey is considering testing the Russian vaccine as well.
• President Duterte of the Philippines appears to be linking the pardon of a U.S. Marine to obtaining access to a U.S. vaccine when it is produced.
• Washington University is conducting a worldwide test to see if the MMR vaccine, usually given to children, can offer limited immunity to COVID-19.

 Odds and ends:  There are new fires at the Port of Beirut.  Russia will hold local elections over the weekend.

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[1] At least in name.  One of the curiosities of Europe is the split between the Anglo/Saxons and the Romance language nations in terms of rule of law.  The former view laws as a minimum requirement, while the latter view them as goals to aspire to.  And so, rules are often written from the Romance perspective, which means they are strict, respected but not necessarily enforced.  Naturally, this situation tends to drive Anglo/Saxons to distraction.