Daily Comment (December 11, 2020)

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

[Posted: 9:30 AM EDT] | PDF

Good morning and happy Friday!  The lack of progress on a stimulus package, the potential for a government shutdown, and the increasing likelihood of a disruptive Brexit are all weighing on equities this morning.  Accordingly, we lead off our coverage this morning with an update on the U.S. policy situation and Brexit.  The EU budget and other related news comes next.  We discuss China, followed by pandemic news, and we close with a wrap of international news.  Since it’s Friday, a new Asset Allocation Weekly is available, with the associated chart book and podcast.  This week, we discuss gold.  Starting in January, in a bid to shorten this report, we will no longer publish the AAW at the bottom of the Daily.  It will be available only as a stand-alone report but will be linked within the Daily Comment.  Here are the details:

Economics and Policy:  Stimulus talks are stalled.  Senate GOP leadership is backing away from the current proposals circulating in Congress.  The sticking points are the size and composition of the stimulus, liability protections, and state and local government support.  This week, Congress passed a one-week bill to keep the government funded.  Members are now using the looming shutdown as leverage to press for their legislative agendas.  We did see something worth noting yesterday―Senators Sanders (I-VT) and Hawley (R-MO) both supported a new round of stimulus checks.  For the record, Sanders is saying he would block government funding to get the money, whereas Hawley wouldn’t go that far…yet.  However, what caught our attention is that populists from the left and right joined forces on legislation.  This is the so-called “Nader coalition” that we have been watching for years.  Although it exists in theory, it is rarely seen in the wild.  Politically, this is important.  Although politics is usually parsed by party (Democrat/Republican) and leaning (conservative/liberal), we view these as superficial.  The real breakdown, in our opinion, is between populist and establishment, of which there are left- and right-wing varieties of each.  As populism rises, expect to see more left and right unity over various policy goals.  We don’t think Nader coalitions really work, because the social gaps are too wide.  But, on certain policies, there is enough common ground that coalitions can be built that appear to be jarring if one is not dividing politics along establishment/populist lines.

  • After a borrowing binge, it appears we may see a pullback in new issuance next year. Many firms have refinanced the debt to lower interest rates and the likelihood of doing that next year is low.  And, the need for investment funds is less likely too, given how much slack remains in the economy.  If true, this development could help narrow credit spreads.

Brexit:  Both sides of the English Channel are warning that a hard break is increasingly likely.  It is difficult to tell whether these are real warnings or simply negotiating tactics.  If we take leaders at their word, it looks like the dreaded hard Brexit may be a reality.  We have been talking about this issue for a long time and must admit we are surprised that a compromise wasn’t possible.  And, it is still possible; the EU doesn’t tend to get anything done without a hard deadline.  That being said, the two sides are so far apart that there may not be enough strategic ambiguity to cover the gaps.

So, if we do get a hard Brexit, what happens?  As we have said in the past, there is a high likelihood of a sharp depreciation of the GBP ($1.20/$1.15) and a selloff in U.K. equities.  This weakness is probably a buying opportunity as the currency is already undervalued.  In the long run, we do expect some degree of accommodation to evolve.  The U.K. outside the EU is a serious threat to the latter; look for the U.K. to make limited deals with individual countries and industries that will send Brussels into apoplexy.  There will be losers, though.  A hard break is very supportive for U.S. financial firms—New York will gain on London.  We don’t see London’s business migrating to the continent but to the U.S.

EU:  We have a budget deal.  Fiscal stimulus and pandemic aid will be coming, funded in part by a Eurobond.  Poland and Hungary are claiming victory and so is the rest of the EU.  We think Poland and Hungary are the real winners as they will get money and not have to bend to EU rules on an independent judiciary.  We view this as bullish for the EUR, although it is likely that the market has already discounted this outcome.

China:  Tensions remain elevated on a number of fronts.

  • Haze Fan, a Chinese national employed by Bloomberg news, has been detained on suspicion of endangering national security. Relations between international media and China have been fraught for a while and this is another example of stress.
  • It’s the two-year anniversary since Michael Kovig and Michael Spavor were detained by Chinese officials. The “two Michaels” are Canadians and are thought to be held in retaliation for the detention of Meng Wanzhou, the CFO of Huawei (002502, CNY, 2.80).  Meng was arrested in Canada for extradition to the U.S. on charges that she violated U.S. sanctions on trade with Iran.  Soon after, China arrested the aforementioned Canadians.  The standoff continues, although we would not be shocked to see a swap at some point.
  • Taiwan is facing a near constant barrage of threats from the mainland. The Chinese military continually flies near Taiwan, forcing the latter’s air defenses to be activated.  There is growing concern that these tactics are a precursor to the PLA eventually unifying the island with China by force.  President Tsai has been working to tighten relations between the U.S. and Taiwan, but the real issue is whether the U.S. views Taiwan as a strategic interest.  Taiwan would be a key strategic asset for any power trying to contain China, but it is uncertain whether the U.S. would be willing to risk a major conflict with China over the island.  That uncertainty is probably behind China’s incursions.
  • The saga of Chinese corporate bond defaults continues to reverberate. The recent default by Tsinghua Unigroup (600100, CNY, 6.24) was notable because the company defaulted on bonds denominated in USD, which are often created to attract foreign buyers.  China has been steadily moving toward allowing market forces to determine the fate of firms.  Given China’s state of development, this makes sense.  However, there will almost certainly be a tradeoff, which is usually slower growth.  As Michael Pettis has said for years, China can have any level of growth it wants; it all depends on how much debt it is willing to incur.  If China is going to allow widespread defaults, even on SOEs, the tradeoff will be that investors will be more cautious, and this will tend to depress economic growth.
  • For the past two decades, we have seen parallel trends in China between those wanting more state control over the economy and those wanting market control. Leaders since Deng have tended to vacillate between the two poles; fostering the former gave leaders more control but stifled growth.  Supporting the latter boosted growth but allowed power to develop outside of the CPC.  One way in which leaders tried to square the situation was to give entrepreneurs party membership.  However, as we noted over recent crackdowns on Chinese fintech firms, China appears to be opting for control over market freedom.  We would expect that decision to slow growth, a point the CPC leadership would probably dispute.
  • The American Chamber of Commerce in China is a “friendly” group for Beijing. It is composed of American businesses operating in China and tends to be an ally of the leadership when dealing with Washington.  At a recent meeting/dinner, Wang Chen delivered a keynote speech.  It is generally assumed that Beijing insisted on him giving the delivery.  What makes this notable is that Wang is under direct U.S. sanction.  This is either an “own goal” by Beijing or a clear indication that it is willing to embarrass a group that is generally supportive of harmonious U.S./China relations.
  • After China decided to bar critics, the China-Europe Trade Forum was cancelled.

COVID-19:  The number of reported cases is 69,738,975 with 1,585,048 fatalities.  In the U.S., there are 15,618,685 confirmed cases with 292,192 deaths.  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 Rt data continues to show high levels of infection.  Only eight states have a reading <1.  Arizona is the highest, while Wyoming is the lowest.

Virology

Foreign news:

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