If Monday was a beer...

Summary

• Geopolitical tensions — UK, US & Saudi Arabia.

• Trade developments — Pour Xi a beer Yi Gang, I dare you.

• Macro update — Germany’s on it’s way to a technical recession. 

Geopolitical tensions have gone into overdrive over the past few weeks, stoking all manners of uncertainty in the market. 2 of the main issues that market participants have been at odds over for the last several years have been Brexit and the impeachment of President Trump — this week provided us with major developments on both fronts. Starting with the UK, Prime Minister Johnson’s efforts to try to circumvent Parliament on the decision to leave the European Union was viewed as illegal by the UK Supreme court. This puts the odds of a Brexit deal by October as fairly low and, if anything, may result in a new Prime Minister if Boris Johnson continues to face such a large opposition. Johnson's original plan was to leave the European Union come hell or high water by the end of October. The most likely scenario now results in a 3-month extension, taking the new official Brexit deadline to the end of January. The Bank of England weighed in on Brexit this week stating that monetary policy could go either way should the UK avoid a no-deal Brexit. With the UK economy contracting in Q2 and business confidence reaching lows seen during the Brexit referendum, these developments will likely continue to weigh on growth in the region. Meanwhile, in the US, an official inquiry into the impeachment of President Trump was opened this week following allegations that the White House attempted to leverage US foreign aid to Ukraine in exchange for information on Democratic presidential candidate Joe Biden. Whether these allegations have any bite we will have to see, the transcripts were released late last week and on the surface, things didn’t look good. There were also claims that the White House limited access to transcripts of phone calls with the Saudi Crown Prince after the murder of Khashoggi, a very controversial murder that happened inside a Saudi Arabian embassy in Turkey earlier this year. Markets have remained mute to any headlines relating to the impeachment of the President but that is prone to change should this investigation start to gain traction. Meanwhile, Saudi Arabia has agreed to a partial cease-fire in Yemen, marking a significant de-escalation of geopolitical tensions in the region following the September 14th drone attacks the caused the largest disruption in oil production. Saudi Aramco, the Saudi Arabian state-run oil company, has spent the last two weeks trying to restore output to convince the world that the Kingdom will continue plans to take the company public. Undoubtedly, investors are wary of the IPO as these latest attacks flag just how vulnerable oil infrastructure is to drone attacks. President Trump's comments at the United Nations helped set the tone for how trade rhetoric would unfold throughout the week, ultimately culminating in the US considering delisting Chinese companies from US stock exchanges. Markets dove when the news hit the wire on Friday but one reason why the market didn't react as violently as it arguably should have is that this whole idea is completely absurd. Indeed Treasury spokeswoman, Monica Crowley, sent Bloomberg an email confirming that “The administration is not contemplating blocking Chinese companies from listing shares on US stock exchanges at this time”. Putting aside the "at this time" part of the statement, which is troubling on its own, the sheer thought of contemplating blocking Chinese companies will inevitably infuriate Beijing. This comes ahead of a politically sensitive holiday in China, commemorating 70-years of communist rule, and just 2-weeks before the next round of trade talks. There was plenty of speculation that one of the reasons why China had taken such a passive role in the Hong Kong protests was to avoid bad publicity ahead of this celebration (This weekend protests ramped up and turned into one of the more violent weeks). All in all, this has been a rough week for China, with the FTSE Russel (an index creator) announcing that it would not include China in its flagship government bond index. If China was included, it could have had the potential to generate an additional $US 130 billion of inflows into Chinese government bonds during the phase-in period. The Yuan, China's currency, was down on the week following the news while the US dollar index continued to grind higher, flirting with multi-year highs. As I’ve mentioned in the past, a stronger dollar poses a serious risk to emerging market debt given that the majority of it is denominated in US dollars. Bloomberg ran a similar article this week highlighting that same risk in China, which last year suffered a record number of onshore defaults. Why does this matter? Well putting aside the clear impact of the tit for tat escalation in tariffs we have seen over the past year, policymakers in Beijing have been reluctant to deliver on the "kitchen-sink" type stimulus market participants have been hoping for. Instead, the PBOC (Peoples Bank of China) has tried a more targeted approach to avoid flooding the market with unnecessary liquidity. This caution stems from the multi-year deleveraging campaign aimed at promoting financial stability and reducing leverage. Without a targeted policy tool, the PBOC runs the risk of undoing all of the Chinese administration's hard work. Think about it like this, leverage is like the head on your beer, a little is ok, you might even want it, but too much of it and there’s a problem. If the PBOC slams overnight rates to the floor, they’re essentially opening the taps, allowing the beer to flow uncontrollably creating more of that frothy foam no one wants. The PBOC does not want to hand President Xi one of these.

Many analysts have been drawing parallels to the slowdown in 2015 however, Chinese fiscal stimulus is what set the stage for the global reflation trade at that time. This time around China will be far less willing to add fiscal support at the cost of financial stability. If offshore defaults pick up next year, it will act as a bit of a “trim the fat” situation where the weaker companies will fall out, improving the over all quality of debt in China.  Unresolved tensions in the market continue to weigh against the global macroeconomic

backdrop. The US data continues to send mixed signals, with manufacturing data printing better than expected and consumer sentiment falling the most in 9 months. Remember that the US consumer has been the main source of growth in the US and any cracks in spending may well remove the kevlar vest the US has been carrying around. Inflation remains benign stateside and there is scope for further easing. The chart below shows how high US policy rates are relative to other jurisdictions in the world, painting a clear picture of why the US dollar has remained buoyant against all of this trade banter.

Funding markets have dropped out of the headlines (thank God), and Fed officials have begun to lay out the groundwork for balance sheet expansion and the standing repo facility. This funding market episode has promptly brought all of the folks with their tinfoil caps out of their basements in search of the nearest table so that they can start pounding it screaming the world is going to end. There's no question the recent episode caught the New York Fed flat footed, and yes, there is some sketchy stuff going on beneath the covers (I plan to flush out these dynamics in the coming weeks). For the time being, it seems that the Fed has calmed the market (The Fed has added over US$ 100 billion in overnight and term repos since the episode). Below are some nice visuals from BNP. The chart on the left shows changes in the Treasury's chequing account (the TGA - Treasury General Account) and the number of reserves. Note that the TGA is inverted. The chart on the right shows the spike in the SOFR (secured overnight financing rate).

Meanwhile, in Europe, business confidence has also deteriorated, falling to the lowest level since 2014 in the latest string of dour headlines that paint a fairly bleak outlook for the region. Germany remains in trouble, plagued by a deep manufacturing recession (originating from a slowdown in China) and will likely slip into a technical recession this quarter. One analyst referred to the latest manufacturing data as "simply awful". The chart below highlights what simply awful entails — it ain't pretty (note that anything below 50 is contractionary).

With the looming risk of Brexit and the ubiquitous reach of the ongoing trade war, business investment in the region has collapsed. The ECB (European Central Bank) has, to the best of their abilities, come to the rescue but with interest rates hovering near the zero lower bound, many are skeptical of their capacity to “save the day”. The entirety of the German Bund curve remains below zero and there isn’t much evidence to support that lowering rates further will stimulate more lending — something the Deutsche Bank CEO made very clear. With that in mind, the market has pinned most of its hopes on fiscal stimulus, particularly out of Germany after Angela Merkel pledged to spend US$ 55 billion over the next decade to protect the climate. To the disgust of many analysts, the climate plan fell short of raising additional debt and will be financed by money raised from a combination of carbon certificates and higher taxes on flights and conventional cars. Despite the disappointment, Germany remains in the best position to borrow. The manufacturing recession may not be enough to incentivize officials to abandon their fiscal stance but, with several regional coal mine canaries beginning to roll over (South Korean and Singapore to name a few), it will be unlikely Germany can keep their chequebook closed if the sector slowdown morphs into a more severe downturn. Tiago Figueiredo