Covenant Weekly Market Synopsis for October 5, 2018

October 8, 2018

Last Week Today: Italy’s anti-establishment government announced a budget with a deficit of 2.4%, pushing back against the European Union’s warnings for Italy to shore up its finances. | Fed Chair Jerome Powell remarked “The US is experiencing a remarkably positive set of economic circumstances…We’re a long way from neutral Fed Funds at this point, probably…  We may lift rates past neutral.”  Powell’s Fed is trying to engineer a “soft landing” for the economy, a task made more difficult by a balance sheet bloated through QE combined with unprecedented late cycle stimulus. | All eyes were on the August payroll report, even though Hurricane Florence likely distorted the data. A below-consensus estimate of 134k jobs were added in September, but revisions to July and August data more than made up for the shortfall, adding 87k jobs. The headline unemployment rate (U-3), fell to 3.7%, the lowest since December 1969 (the same month Vince Lombardi coached his final football game). Average hourly earnings rose 0.29%, but the rise was likely inflated by the absence of lower-paid workers evacuating from Hurricane Florence. Regardless of “Flo’s” impact, it was a solid labor report that stoked concern the Fed may be behind the inflation curve.

Strong economic data and messaging from the Fed led to a sharp rise in interest rates and a drop in equities late last week.  Rates rose across the yield curve, but more so at the long-end resulting in a steeper curve.  While generally a welcome change from recent flattening, the speed with which rates have risen thus far is more important to equity investors than the absolute level of rates which remain low by historical standards.  Based on last week’s moves, the current yield curve looks like this:

  • 2-year +0.07% to 2.89%, a ten-year high
  • 10-year +0.17% to 3.23%, a seven-year high
  • 30-year +0.20% to 3.4%, a four-year high

Equities declined globally.  Emerging markets bore the brunt of the pain, falling -4.5% (-11.6% YTD), developed markets ex-US stocks declined by -1.6% (-2.6% YTD), and the S&P 500 fell -0.9% (+9.5% YTD).  The technology-focused Nasdaq Index was the worst performing domestic index, selling off by -3.2% (+13.8% YTD).  Volatility increased, as is typical during market sell-offs, with the VIX Index rising 22.3% for the week, though at 14.82 volatility remains 4-5 points below its long run, historical average.  WTI Crude oil rose +1.5% (+23.0% YTD) to $74.34 per barrel.   The national average price for a gallon of gasoline reached $2.91, a 16% year-over-year rise.  For more detail on weekly, month-to-date and year-to-date asset class performance, please click here.

What if a trade deal is not the objective…for the U.S. or China? Many celebrated the trade agreement with Mexico and Canada (the “USMCA”) as the first step in a broader strategy to further isolate China in global trade, thereby increasing pressure on Chinese President Xi Jinping to come to the negotiating table. However, what if the NAFTA revamp instead merely opens the door to a prolonged battle with China? This is the thesis of Arthur Kroeber, an analyst for the well-regarded macroeconomic research firm Gavekal. Kroeber posits that a fairer trade agreement for the U.S. with China is not what’s at stake. Instead, the stakes are much higher and focus on China’s existential threat to continued U.S. global dominance.

Politics was a primary source of motivation for President Trump to complete the USMCA deal because more than half of U.S. states count Mexico or Canada as their largest export market. Absent an agreement, the Republican party would have invited increased political vulnerability in the mid-term elections. Moreover, neither Mexico nor Canada present a threat to U.S. geopolitical power. However, with China the situation is decidedly different:

  • China is the top export market for only five states, reducing political fallout from a trade stalemate.
  • China presents a clear-and-present danger to US influence in Asia (i.e., China’s “Belt and Road” project designed to secure trade links with Central Asia, Europe, and Africa).
  • China represents a strategic threat as they have openly stated their intent to surpass the U.S. to become a leading producer of cutting-edge technology, such as artificial intelligence.

Fundamental to the last two points, a subset of President Trump’s advisors consists of trade warriors and national security hawks who now see an opportunity to reverse China’s growing global influence. In sum, the political limitations are looser and the long-term implications far higher in the dispute with China as compared to Canada and Mexico.

If Kroeber is correct, the objective of U.S. policy is to break or, at least, severely reduce the reliance of US companies to manufacture goods in China. Evidence of success would be US companies moving manufacturing operations to other countries, removing a critical source of intellectual property and business investment from an obvious strategic rival. For example, last week Bloomberg reported that the Chinese military had embedded microchips in servers used by at least 30 US companies (including Apple and Amazon), as well as the Department of Defense and Department of Justice, to gather intellectual property along with trade and government secrets. It’s notable, relative to Kroeber’s thesis, that this act of espionage was first discovered in 2015 but is just now being made public. This revelation alone is likely to reduce U.S. management team’s enthusiasm for investing in China and will assist the U.S. government in its efforts to break the China-US manufacturing supply chain.

On the other side of the world, and the geopolitical chess match, China may not be all that interested in rushing to strike a trade deal with the United States. If China’s long-term strategy is to compete with the U.S. for global leadership, it will need to consolidate regional power, de-link its currency from the US Dollar, and take steps to be viewed as a safe harbor for countries to invest excess currency reserves, according to Gavekal’s Founding Partner, Charles Gave.

As it turns out, China has been moving in this direction for several years now. For example, the “Belt and Road” venture is a massive infrastructure project that will increase China’s financial and commercial cooperation with more than 70 neighboring countries across the Eurasian land mass and beyond.



Concerning further de-linking the Chinese Renminbi (RMB) from the US Dollar, earlier this year China took a significant step forward by launching an RMB-denominated oil futures contract. Importantly, the launch of the futures contract strategically lines up with the near completion of hydrocarbon pipelines between Russia and China. The ability to hedge oil prices in the local currency via the RMB-oil futures contract makes RMB a more attractive medium of exchange and reduces the need for China to pay Russia in US Dollars for imported Russian oil.


Finally, to provide a repository for countries’ excess currency reserves, in early 2017 the Chinese government opened its bond market to foreign investors via the “bond connect” program to serve as the Asian equivalent of a risk-free asset. The government did so after several years of ensuring that Chinese bonds outperformed traditional safe-haven assets, like the German Bund and US Treasuries, to attract investors. Indeed, since the beginning of 2013, Chinese bonds have outperformed both US and German equivalents, and foreign holdings of Chinese bonds are now 1.5+ trillion RMB, an increase of more than 60% from a year ago (source: Bloomberg). If the bonds continue to perform and the RMB remains stable, at least relative to other Asian currencies, Chinese sovereign bonds will allow governments in the region to invest excess capital within Asia.

These articles illuminate the deeper strategic objectives of the two most powerful countries in the world. Most observers still believe the U.S. and China will eventually reach a trade deal as it seems to be in both countries best immediate interests. That may still be the case. However, if Gavekal’s theses prove accurate, trade is merely a pawn in each country’s longer-term strategy.

Early warning signals that Kroeber is correct include the U.S. levying higher tariffs, limits on visas for Chinese tech workers and students, and sanctions on Chinese companies with a record of cyber-espionage. If Gave’s thesis is accurate, China will delay substantive trade negotiations choosing instead to use this time to more firmly entrench itself as a regional hegemon. As the famous Chinese military strategist, Sun Tzu wrote: “He who knows when he needs to fight, and when he doesn’t, will be victorious.

Kroeber and Gave are fundamentally speaking about two sides of the same geopolitical coin. The reasons the U.S. may not be interested in a trade deal with China reflect the Chinese government’s actions to compete head-to-head with the U.S. for global supremacy.  What’s interesting about Krober and Gave’s theses, unlike most macroeconomic discourse, is that they are not mutually exclusive and both may be correct.

Be well,