by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning to all those eight billion out there (that are growing older, btw)!  Equities are trending higher this morning, interest rates are falling, and the dollar is lower.  The driving factor behind the rally is primarily the meeting between President Biden and President Xi (although the better-than-expected PPI data gave another leg up to the rally), which will head up our Comment this morning.  Up next is broader China news.  Ukraine comes next, followed by our take on economics and policy.  An update on the crypto situation is the next item, and we close with international news.

Biden-Xi:  The leaders of China and the U.S. met yesterday for the first time since Biden has been in office.  Although unusually late for the leaders of the two largest economies on earth to delay a meeting, President Xi has mostly stayed home during China’s Zero-COVID policy.  Expectations about the meeting were low, and for the most part, these expectations were met.  The first clue that no new ground was broken was that there was no joint statement as both sides issued their own statements.

So, if the outcome was so pedestrian, why are markets surging?  Mainly because relations have become so difficult, even this outcome looks quite positive.  China’s official media was downright gushing.  Here are the key takeaways from our perspective:

• The meeting does appear to stabilize relations, which seemed to be on a downward spiral. Xi and Biden have a positive history as they met several times when both were second in command in previous administrations.  The meeting does suggest that at least the two sides can begin talking.
• Our take is that China needed stabilization more than the U.S. did. China is attempting to deal with a property bubble (see next section), and its Zero-COVID policy is hurting its economy.  We suspect that Beijing thought that after Trump’s loss, U.S. policy to China would ease, but that didn’t happen.  In fact, it may have become harsher.  Beijing was avoiding contact with Washington for a host of reasons, but a big one may have been to wait until after Xi was given his third term as general secretary.  China’s economy is still dependent on exports, and it needs to trade with the U.S.  Thus, cooling tensions makes sense.
• It appears that contact will continue. Secretary of State Blinken is scheduled to visit his counterparts as a follow up.  Even Australia is trying to mend relations.
• At the G-20, China also signaled it wasn’t happy with the war in Ukraine. China’s English language readout didn’t include the quote below, but it was in the Chinese readout (translation courtesy of Bill Bishop of Sinocism).

The two heads of state also exchanged views on issues such as the Ukraine crisis. Xi Jinping pointed out that China is highly concerned about the current situation in Ukraine. After the crisis broke out, I put forward the “four should,” and not long ago I put forward the “four commons.” In the face of a global and complex crisis such as the Ukraine crisis, there are several points that deserve serious consideration: first, there are no winners in conflicts and wars; second, there is no simple solution to complex problems; third, major power confrontation must be avoided. China has always stood on the side of peace and will continue to promote peace talks. It supports and looks forward to the resumption of peace talks between Russia and Ukraine. At the same time, China hopes that the United States, NATO, and the European Union will conduct comprehensive dialogues with Russia.

• At the same time, very large differences remain. The U.S. is more than happy to maintain the status quo in Taiwan as Washington supports a quasi-independent state without full independence.  For China, this is unacceptable, but it doesn’t really have a path to unify the island without setting off a war.  Biden is not fully in control of policy towards China and Taiwan, as Congress is becoming increasingly hawkish toward Beijing and toward supporting Taipei.  The actions taken on semiconductors have been viewed as a major step in a costly “cold war” with China, and it would be hard to pull back politically.  Much like U.S. administrations found in the Cold War, appearing “soft on communism” was a loser in elections.  Thus, we would not expect a major change in policy from the U.S. side.

Overall, it’s good news that the two sides are talking, but it’s important not to view this meeting as some sort of turning point.  The differences between the U.S. and China are great.  China is envisioning a world where it is a regional hegemon and expects the U.S. to acquiesce to its role and allow that to occur.  We don’t see Washington ceding that outcome without a fight.  The meeting does stabilize conditions, but we would not expect the U.S. to adjust its policy on trade or semiconductors.  But at least with both sides talking, the risk of miscommunication is lessened.

China News:  China moves to bolster its economy by easing COVID-19 restrictions and helping the real estate sector.

• Although the Zero-COVID policy remains officially in place, in practice restrictions are easing despite a steady rise in infections. Quarantine rules are being relaxed.  Tracking and investigation of reported cases are being eased.  Testing rules are becoming less stringent.  We would not expect a major announcement from the government in rolling back rules, but at the provincial level, Beijing is allowing local governments to ease up.  Although it may take a while for citizens to return to pre-pandemic behavior, this easing should boost economic activity.
• Banks are being instructed to extend deadlines, and regulations on how real estate firms handle escrow accounts are being eased. These measures are helpful, but there is increasing evidence that the sentiment towards real estate has fundamentally changed.  Before, real estate was seen as a safe investment.  In a country that restricted capital flows, real estate was one area where households could have a chance at a positive real return on savings.  That idea is now widely seen as outdated, and real estate is seen as risky, as household saving shows signs of building.
• Global investors are shunning China bonds.

War in Ukraine:  Discussions of peace talks are rising, but Russia and Ukraine appear to be in no hurry to begin serious discussions.

• One of the truisms of nuclear weapons is that a nation possessing them can never be forced into unconditional surrender. That doesn’t mean nuclear powers can’t lose wars, but that loss is a choice.  Essentially, a nuclear power loses a war when it concludes that the costs of continuing the conflict exceed the benefits.  For example, the U.S. and U.S.S.R. both lost wars in Afghanistan.  They both left not because they couldn’t win, but because they decided winning wasn’t worth the trouble.
  • Ukraine can’t force a surrender on Russia, since, as Moscow has warned, it can use nuclear weapons to avoid defeat. Thus, this conflict will end with some sort of negotiated settlement.  At this juncture, Ukraine sees little reason to talk as it is enjoying battlefield success.  And Russia expects Ukraine’s allies to tire of the conflict and thus sees every reason to continue to war, regardless of losses, hoping that the deprivations caused by the war will lead NATO to reduce its support of Ukraine.
  • And so, allies of the combatants are making comments about talks. General Milley recently suggested that a “window” for talks could emerge this winter.  The administration has “clarified” these remarks by saying it’s up to the Ukrainians to decide to talk, but the reality is that if the U.S. reduces its support, Ukraine will be forced to make a deal.
  • As noted above, China’s displeasure with Russia over the war could lead Beijing to pressure the Kremlin to sue for peace.
  • At this point, we don’t expect a rapid resolution to the conflict, but the war won’t go on indefinitely. Outside pressure on both Russia and Ukraine can likely force some sort of ceasefire.  We are not there yet as the U.S. sees value in degrading Russia’s military.  But the loss of Russian energy is a major problem for the EU, and China is clearly displeased with the course of the war.  So, by next summer, we could see some moves toward talks.
• The U.S. is warning Russia against the use of nuclear weapons. The U.S. has also added additional sanctions on Russia.

Markets, Economics and Policy:  Vice-Chair Brainard bolsters the case for slowing rate hikes, and student debt relief is in limbo.

• Although we don’t expect the FOMC to stop tightening anytime soon, the pace of hikes looks poised to slow. Vice-Chair Brainard suggested she would support a slowing in the pace of tightening, worried about the lagged effects of rising rates.
• The plan to offer student debt relief has been put on hold by the Eighth Circuit Court of Appeals. It is unclear when or if the plan will be revived.  In its place, the Biden administration is considering extending the current payment suspension.
• One area of concern is residential real estate. The spread between mortgage rates and Treasuries is widening, mostly because the buyers of mortgages are stepping away from the market.
• Layoff announcements are building rapidly, with tech and transportation leading the way.
• Railroad unions are continuing to reject the recent tentative agreement, raising the odds of a nationwide strike.
• Industrial metals are recovering on hopes of a China reopening.
• Martin Gruenberg will be nominated to run the FDIC; he has been acting director for several months.

Crypto:  The FTX debacle continues.

• An investigation by the Financial Times reveals that FTX had less than $1.0 billion in liquid assets backing $9.0 billion of liabilities. It has become clear that the company funded a large number of dubious crypto assets with little oversight, leading to lots of illiquid “assets.”
• The FTX bankruptcy is in chaos, and the company could have up to one million creditors.
• The collapse of FTX has affected the regulatory agenda regarding crypto as those advocating a light touch are retreating, and it is likely that policymakers will develop a restrictive regulatory stance.
• Although there is the potential for systemic risks to the financial system, so far, we haven’t seen signs of major stress.

A deal in Europe:  The U.K. and France have a new arrangement to deal with migrants attempting to move to the U.K.  Westminster will pay Paris $75 million to manage the migrant flows, an increase of $10 million from earlier agreements.

View PDF