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

[Posted: 9:30 AM EDT]

Good morning and happy Friday!  Global equities are softer this morning as tensions between the U.S. and China continue to rise.  We discuss the latest with China.  As usual, we update what we know about COVID-19.  The Weekly Energy Update is available.  Chair Powell is holding a virtual discussion with former Vice Chair Blinder at 11:00 EDT.  Let’s get to it…

China:  The National People’s Congress has come to a close and it was a momentous meeting.  The decision to extend the national security law into Hong Kong, overriding the former colony’s legislature, strongly signaled that Chairman Xi is done with the “one country, two systems” approach that was adopted at the handover in 1997.  Here are the key points we are watching:

• The backlash: The U.S., Australia, Canada and the U.K. issued a joint statement opposing China’s national security law decision. The absence of New Zealand is notable; the four nations in the joint statement plus New Zealand represent the “five eyes” alliance.  The decision by Wellington not to join the statement suggests it probably does not want to disrupt trade relations.  We also note that Japan issued a statement of concern.  Beijing is aware it will face a backlash; however, it is likely banking on countries deciding that maintaining economic relations is more important than defending Hong Kong.  It is clear the EU won’t act against its economic relations with China.
• The U.S. reaction: The nation that really matters is the response from the U.S.
  • President Trump will hold a press conference today to unveil at least some of the action the administration is considering; we haven’t seen a time yet. We note equity markets fell on the announcement.
  • The most potent threat Washington has is sanctions against China’s banking system. Although the world rails against the weaponization of the dollar, the fact remains that being cut off from the dollar system is deadly for an economy; just ask Iran.  There are other actions the U.S. could take as well, including delisting Chinese stocks on U.S. exchanges.  There has been fear that doing such action would simply lead to Chinese companies listing on London.  However, given the level of British anger over Xi’s breaking of the 1997 treaty, that may not happen.  Listing in the EU or Japan just doesn’t have the same cache.
  • Another threat is denying China access to the U.S. system of higher education. The U.S. is moving to expel Chinese graduate students in the U.S. who have ties to Chinese military schools.  A bill is winding through Congress that would restrict Chinese student access to STEM programs in the U.S.
  • It appears the White House will sign a bill sanctioning Chinese officials for the suppression of Uighurs.
  • Although not directly related, the U.S. is stepping up freedom of navigation operations and boosting sales of weapons to Taiwan. Both remind China that the U.S. does have the military power to operate in its area of the world.
  • While China realizes relations are deteriorating, it doesn’t appear it is ready to completely end the relationship, suggesting it needs us more than we need it.
• The pain: Since the late 1970s, China has moved from being insular to becoming a major global economy. It has been a key part of globalization as Western firms have built production facilities to take advantage of China’s low-cost labor.  The last time globalization peaked, in 1913, it was considered unthinkable that it could reverse.  Of course, it did, and the reversal damaged global economic growth.  China is betting that nations will overlook its actions on Hong Kong to continue to benefit from trade.  As noted above, the EU appears to be taking that stance.  Major Wall Street firms could suffer greatly from a break in relations.  At the same time, Hong Kong remains China’s financial and investment window to the world.  If the world decides it doesn’t want to invest directly in a country that has rule by law instead of rule of law, China will suffer as well.  China is well aware that the move in Hong Kong could have negative repercussions for its economy and announced steps to support it with fiscal and monetary easing.
• Capital flight: When China was set to acquire Hong Kong from the British in 1997, there was a flurry of capital flight. Any visitor to Vancouver can see the impact.  We expect another round of outflows of people and cash, not just from Hong Kong citizens but from wealthy mainlanders as well.  The latter tended to use Hong Kong as a safe zone to evade Beijing; with that door closing, these Chinese may seek to create their escape pods outside of China.  We will be watching West Coast real estate markets for activity in the coming weeks.
  • The U.K. is extending visa rights to 300k Hong Kong citizens who hold a British National Overseas passport. These were issued to citizens who resided in the colony before 1997.  The extension would make it easier to flee.
  • As we have been noting, Taiwan is also making it easier for Hong Kongers to seek asylum on the island.
  • One factor that increases capital flight is a weaker CNY. Although Beijing could use currency depreciation to offset new sanctions and tariffs, the tool is limited if fears of currency weakness trigger outflows.  We note China has moved to stem recent weakness today, signaling it doesn’t want a freefall in its currency.

Equity markets have staged a remarkable recovery since the March lows.  As we detail in this week’s Asset Allocation Weekly (see below), much of this rally has been driven by supportive Fed policy.  However, a flare-up in tensions with China is a risk to the rally that we will continue to monitor.

COVID-19:  The number of reported cases is 5,837,541 with 360,919 deaths and 2,437,965 recoveries.  In the U.S., there are 1,721,926 confirmed cases with 101,621 deaths and 399,991 recoveries.  For those who like to keep score at home, the FT has created an interactive chart that allows one to compare cases and fatalities between nations, scaled by population.

The virus news:

• The good news:
  • The U.S. may use the military to assist in vaccine distribution if/when one is created.
• The bad news:
  • Herd immunity is the best long-term solution to managing the virus. Unfortunately, the world appears a long way from achieving that level of immunity.

The policy news:

• The House has passed a bill easing rules on PPP loans. Policy restrictions were discouraging companies from taking the loans so Congress is moving to address that issue.  However, there may be some sticking points about the House bill that will need to be changed to get passage through the Senate.
• As extraordinary measures approach their end dates, Americans are growing worried that they may not be able to find new jobs or go back to their old ones. If this is the case, the economy could stall later this year.  We do expect other forms of relief to come (rules that reduce the cost of hiring and employment bonuses, for example), but if they fail the economy will bear some risk.
• The Fed’s balance sheet is now over $7.0 trillion. We noted earlier this week that officials are considering yield curve control.  Policymakers at the Fed are continuing to look for ways to support the economy and, as noted in the opening, Chair Powell may address some of those today.

The finance news:

• One of the reasons we don’t expect the Fed to engage in negative nominal policy rates is because of the heavy reliance of the non-bank system on money market funding. Negative policy rates would almost certainly cause money market funds to “break the buck” and trigger disintermediation.  We note that money market fund managers are already under stress, waiving fees to offer investors at least some paltry yield.
• One of the common media questions is, “Why is the stock market ignoring the economy?” As we detail in this week’s AAW, it has to do with the expectations of a short recession and massive policy support.  However, the U.S. equity market isn’t the only one doing well.  The Tehran Stock Exchange has been on a tear.  There are a couple of reasons for this rally.  First, Iranian investors have the TINA[1]  Second, equities do offer some protection from high inflation.  Interestingly enough, we saw something similar in Zimbabwe during its hyperinflation period.  Although rising inflation harms P/Es, stocks do offer some element of inflation protection as firms can boost earnings and become something of a safe haven relative to bonds during periods of high inflation.

The foreign news:

• The DOJ has indicted some North Koreans and Chinese nationals of operating a massive money laundering scheme. Twenty-eight North Koreans and five Chinese citizens are accused of laundering $2.5 billion in assets.
• In a rare public statement, the NSA is accusing Russian government hackers of targeting U.S. email servers.
• Turkey’s central bank is borrowing dollars from its commercial banks to boost reserves. This action will stabilize the TRL but starve the banking system for dollars, making importing more difficult.
• The administration may override congressional concerns to sell more weapons to Saudi Arabia.
• As talks between the EU and the U.K. stall, Ireland is starting to prepare for a disruptive Brexit.

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[1] There Is No Alternative.