Great Wall or Cold War?

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Today I write about the tenuous relationship between the U.S. and China, walking through the recent developments that culminated on Friday with China threatening Hong Kong's autonomy in an affront to democracy and capitalism, and placing the financial markets at risk.

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It's hard to fathom there would be any greater risk to the global financial markets than the deep global economic concerns related to the forced shutdown of global economies over the last few months. After all, the uncertainty about how the reopening will go is extremely high, the time it will take to recover is unknown, and the collateral damage to industries, businesses, workers, and consumers is in question and remains to be seen.

The increasingly tenuous relationship between the U.S. (and others) and China, however, is quickly becoming an international geo-risk for the financial markets that rivals the ongoing concerns about the health of the global economy. It's not only the financial markets that are exposed to these risks, either. Capitalism and democracy are being threatened by the desire for global dominance and the authoritarian rule of the Communist Party (CCP) in the People's Republic of China.

International outrage has been building against China for hiding the facts on the origin and seriousness of the coronavirus as it was spreading, yet still contained, within its borders. China's silence, many world leaders have opined, is to blame for what has now surged to over five million confirmed cases worldwide and 333,500 deaths (according to JHU data).

President Trump has also been highly critical of the World Heath Organization (WHO), threatening to permanently withhold U.S. funding and to withdraw from the body for being a puppet for and complicit in China's suppression and lies.

China has been loathe to admit any culpability, much less to accept a thorough, independent investigation. Instead, officials there have placed the blame for the international spread of virus on the U.S., first accusing the U.S. Army of bringing it into China, and later saying officials failed to contain it within the U.S.

The rhetoric between officials on both sides has heated up and the actions being taken have intensified over the last few weeks. Here's a list of some of the developments:

• In late April, Pres Trump and Sec'y stepped up the rhetoric and implied steps can be taken (including tariffs) to punish the behavior.
• In the first week of May, Pres Trump said he may hit China with more tariffs in retaliation for its handling of the virus. The president asserted that China had villainous motives in allowing the virus to "travel" to the U.S. (to get out of the phase one trade agreement and to hurt him in the 2020 election). ??Pompeo said there is enormous evidence that the virus originated from research in the Wuhan laboratory while Pres Trump told FOX News there would be a conclusive report coming from U.S. intelligence soon. The president also indicated the trade deal with China would be terminated and renegotiated if it doesn't follow through on buying U.S. products. ??Reuters reported the "The Trump administration is “turbocharging” an initiative to remove global industrial supply chains from China as it weighs new tariffs to punish Beijing for its handling of the coronavirus outbreak".
• Recently, a number of American states and other countries began to seek retribution from China.

The tenuous relationship between the U.S. and China worsened last week with the rhetoric and actions being taken indicating the fissure is expanding:

• China's state supported Global Times reported "China is extremely dissatisfied with the abuse of litigation by the US against China over the COVID-19 epidemic and mulling punitive countermeasures against US individuals, entities and state officials".
• Trump admin officials took steps to prevent the government retirement funds from investing in Chinese equities.
• Senate Republicans put up a bill that would subject China to sanctions if it “fails to cooperate and provide a full accounting of the events leading up to the outbreak”
• Pres Trump told FOX he doesn't want to talk with Xi. In the interview, he publicly contemplated severing trade ties with China.
• The FBI issued a warning on Chinese hackers targeting companies and universities engaged in Covid-19 research in an effort to access virus and vaccine data.
• The U.S. Commerce Dept blocked chip shipments to Huawei.

This week, things started to get serious:

• Pres Trump posted on Twitter a four page letter to the WHO threatening to make the temporary freeze of U.S. funding permanent and to reconsider U.S. membership if it doesn't "commit to major substantive improvements within the next 30 days" and ultimately demonstrate independence from China. The letter laid out the U.S. case with specificity.

• Reuters reported the Nasdaq will be releasing new listing requirements for IPOs that will include more stringent accounting rules, effectively making it more difficult for Chinese companies to list on the exchange, and to raise capital.
• The Senate passed, by unanimous consent, legislation that would require listed companies to attest they are not owned or controlled by a foreign government. It would also require them to adhere to U.S. accounting standards that govern all firms looking to the U.S. financial markets to raise capital. Obviously, the Holding Foreign Companies Accountable Act was tailored with China in mind. Chinese ADRs and ETFs tied to China took it on the chin on the news.
• China moved into a full-on propaganda war using traditional and social media, mainly targeting the U.S.
• Pres Trump launching his most direct attack on China's Xi in a series of tweets:

"China is on a massive disinformation campaign . . .Spokesman speaks stupidly on behalf of China, trying desperately to deflect the pain and carnage that their country spread throughout the world. Its disinformation and propaganda attack on the United States and Europe is a disgrace....It all comes from the top. They could have easily stopped the plague, but they didn’t!"

Pres Trump via Twitter May 20, 2020

Based on the chronology of events, you can get a sense for how quickly the relationship has deteriorated. Everything culminated yesterday and today, potentially setting the stage for even more destabilizing action on the part of China and responses from the U.S.

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China opened its week long policy planning conclave of lawmakers, the National People's Congress (NPC) on Friday (today). In the lead-up to it, China went on the offensive by signaling it will be "safeguarding its sovereignty and interests" by imposing a national security law in Hong Kong as it looks to squash the pro-democracy movement altogether and to put an end to the former British Colony's autonomy after promising in 1997 Hong Kong would maintain it for a period of 50 years.

According to the South China Morning Post (via Bloomberg), China will "soon pass measures that would curb secession, sedition, foreign interference and terrorism" in Hong Kong, leading many to suggest that the city's autonomy will soon be a thing of the past.

Not only this, there would be knock-on implications. The May 22 edition of Wall Street Journal highlighted one major potential repercussion in this way:

"Enacting new security restrictions could further undermine the Western-style rule of law and freedoms that have underpinned Hong Kong's role as a global financial center"

Pres Trump's initial reaction on Thursday was "If it happens,we’ll address that issue very strongly.” The Trump Administration responded more directly on Friday indicating that the move by China could damage Hong Kong's special trading status and could result in tariffs on Chinese products.

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In 2012, China's President Xi secured the tightest grip on the Party in decades. More recently, though, he has been facing political risk at home, mainly because of a weak economy. Last year's pro-democracy movement in Hong Kong and the inability to get it under control also weighed on his support. Most recently, the outbreak of the coronavirus and the depths of the recession that has resulted from his economic shutdown has put him under even more scrutiny.

Pres Xi knows full well that . . .

"In Chinese history, diseases, famines and other natural disasters have foretold the end of dynasties"

Wall Street Journal - May 19, 2020

. . . and he has come out swinging. The NPC is expected to pass the national security law at before the end of the meetings on May 28. We'll see if officials will implement anything or just use it as a threat to keep the demonstrations in check. If China does crack down, the market risks will escalate. The pro-democracy protests ramped up again on Friday and could intensify over the weekend.

Unfortunately, this has become much more than the tit-for-tat exchange of barbs that we grew accustomed to as the trade war was raging on. This is a campaign by China to save face at home and to assert its desired dominance on the global stage.

The first step in doing so is to shore up all that China views as sovereign rights. Hong Kong, Taiwan, Macao, the South China Sea are all points of contention between China and the U.S. and international community, and China is in the process of protecting those "rights". They are all potential hot spots.

Pres Trump has taken a much more hard-lined view toward China recently, and it seems that China is effectively calling his bluff. China knows this is an election year for the president and thinks, because of it, Pres Trump will only go so far as to retaliate verbally or passively with sanctions and the like.

On the issue of China, though, the president has strong bipartisan support. There is also international support against China's handling of the virus. Even though officials in China and in the U.S. have said the trade deal is on track, it is fragile at best and could break apart if this thing escalates further.

This is a fluid situation, and it requires swift, high level diplomacy. It has suddenly become a a big source of risk for the markets just weeks after the most major market dysfunction since the great financial crisis was healed by aggressive action monetary and fiscal authorities.

Risk aversion picked up overnight after Thursday's multi-faceted developments related to China. The stock market in Hong Kong plunged more than -5% amid fears of the end of the Special Administration Region's autonomy, special trade status, and role as a financial market hub.

Watch equity and currency markets in the Asia-Pacific region for signs of concern, stress, and risk aversion. China and Hong Kong are at high risk of capital outflows. China's yuan currency traded at the cheapest level vs the U.S. dollar since last Fall on Friday.

It's early in this new crisis. The diplomatic stakes are high and the financial market risks are budding. We can only hope the situation is diffused before saber rattling enters into the equation. The last thing we need right now is a kinetic threat between the world's major military superpowers.

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This article is part of my LinkedIn Newsletter Series: Indicators and Insights – Perspectives on the Top Financial Market Movers with a View of What's to Come.

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This report represents the opinions of its author. It reflects market and financial information that we have obtained from third party sources; we believe it to be accurate, but we make no warranty to that effect and are not responsible for any inaccuracies in the information presented. Nothing in this report constitutes personalized investment advice to any reader or a solicitation to effect or attempt to effect transactions in securities. All investments involve risk. Past performance may not be indicative of future results. Due to various factors, including changing market conditions, the opinions set forth in this report may no longer reflect the current views of the author. The author is not an investment adviser, law firm, or accountant, and nothing in this report should be construed as investment, legal or accounting advice. Additional information is available upon request. Copyright (c) 2020. All Rights Reserved. The Mitchell Market Report,LLC