Markets Look for Direction, while Nord Stream II and SMIC are in the Cross-Hairs

Overview:  The capital markets are looking for fresh directional cues after last week's equity declines and seeming reversal in the US dollar.  The MSCI Asia Pacific Index fell 1.6% last week, its largest drop since April.  Markets in the region were mixed, with Japan, Taiwan, and especially China and Hong Kong moving lower.  European shares are doing better, and the Dow Jones Stoxx 600 is recouping most of its pre-weekend losses.  US shares are little changed.  Bond markets are quiet.  Asia Pacific bonds seemed to play some catch-up after the rise in US yields after the jobs report before the weekend, but today the US 10-year yield is flat around 72 bp, and European benchmark yields are slightly higher.  The dollar is mostly firmer, with Brexit developments weighing on sterling.  The pullback in the Canadian and New Zealand dollars and Norwegian krone give a sense of diminished risk appetites.  This is also the takeaway from the emerging markets currencies, where most of the liquid and accessible currencies, like the South African rand, Turkish lira, Mexican peso, are on the downside.  Following a larger than expected trade surplus, the Chinese yuan is the strongest of the emerging markets currencies, gaining about 0.15% against the greenback.  Gold is a little heavy, but within the pre-weekend range, but it looks like it wants to test the $1900 area.  October WTI was near $43.50 a week ago.  It continued last week's decline today to reach $38.55 before finding a bit.  Demand concerns seem to be behind Saudi Arabia's decision to cut October prices.  

Asia Pacific

China reported August trade figures.  Exports were stronger than expected, rising 9.5% from a year ago, while imports were weaker than anticipated, dropping 2.1%.  The median forecasts in the Bloomberg survey were for a 7.5% rise in exports and a 0.2% decline in imports.  The result was a $58.9 bln surplus, about $9 bln larger than projected, but smaller sequentially from July's $62.3 bln surplus.  The particularly politically sensitive bilateral surplus with the US rose to its highest since November 2018.  Imports from the US increased by about 1.8% from a year ago.  A couple of additional details are notable.  First, China's exports of textiles, which include some masks, rose by a third.  Electronic exports also rose.  Second, the decline in imports seemed like a function of falling prices.  In discussions of Chinese trade, rarely are the terms of trade or prices integrated into the analysis.  Third, China's iron ore imports fell by 11%, and this, in part, reflects the sharp drop in imports from Australia (~-26.2%) amid growing tensions in the bilateral relationship. 

The US effort to limit China's ability to secure and develop its semiconductor business may be on the verge of a new step.  Reports suggest it is considering blacklisting SMIC (Semiconductor Manufacturing International Corporation), China's largest semiconductor foundry. Ostensibly, the argument is that it has ties to the Chinese military.  It secures about 50% of its fabrication equipment from US producers.  Its shares fell, as did the shares of other Chinese semiconductor companies. Such action would be seen as an escalation. It would likely encourage China to redouble its own efforts, expected to be in the next five-year plan, to become a world-class semiconductor producer and reinforce the drive to be self-sufficient (import substitution).    

For the third session, the dollar has held above JPY106.00.  It has been confined to about a quarter of a yen range above JPY106.15.  Nearby resistance is seen in the JPY106.40-JPY106.50 area, but the more important cap is near JPY107, where a $1.4 bln option expires tomorrow.   The Australian dollar recovered from around $0.7220 to $0.7300 before the weekend and is consolidating today in the upper end of that range.  Support emerged near $0.7270, and it has not traded above $0.7300 today.  The PBOC set the dollar's reference rate at CNY6.8386, in line with the bank models.  Recall that the yuan has appreciated against the dollar for the past six weeks.  China's August reserves rose by $10.2 bln to $3.165 trillion, which was about half the increase expected in the Reuters survey.  China's reserves rose by a little more than $42 bln in July, which we suspect was largely a function of valuation the non-dollar components appreciated sharply.   

Europe

Nord Stream II, a pipeline for Russian gas that bypasses Ukraine and goes below the Baltic Sea directly to Germany, has been controversial since Day 1.   Despite some international pressure, which included sanctions by the US, Germany has pressed ahead.  Reports suggest the pipeline is more than 90% completed.  In light of the Novichok poisoning of Navalny, a vocal critic of Putin, Germany is threatening to end the project.  Russia has a few days to respond.   If it does, a large payment is due to Gazprom.  The US position seemed nuanced.  On the one hand, the US has been critical of the pipeline because it increases German dependence on Russia.  On the other hand, the US wants to provide more gas to Europe, and US crude oil and unfinished fuel imports from Russia rose to 96.07 mln barrels in the first half of this year compared with 78.2 mln barrels in H1 19. While reluctant to impute a strategic view to Trump Administration's attitude toward Russia, one cannot help to recall that Nixon-Kissinger worked to open up relations with China, not because they thought it could become like the West.  The China card played in the context of the Cold War with the Soviet Union.  If there is a Cold War with China, like many, including ourselves, suggest, then the Russian card could be played to help check China.  That said, Russia's behavior on the international stage is too odious, and the threat from China not sufficiently urgent to overcome this critical obstacle.

A UK paper recycled the possibility that in the trade talks with the EU, it threatens access to its capital markets unless Brussels compromises.  Such a move, until now, has been rejected for good reasons.  It would threaten the special role of London in global finance.  For sure, the UK can inflict some short-term pain and disruption on European companies and their capital-raising mechanisms, but the medium and long-term damage could be significant.  Continental Europe has long wanted its own world-class financial center.  The UK leaving the EU may be a challenge for London; denying European companies access would likely expedite a process.

More credibly, the Financial Times reported that the UK government is going to submit legislation as early as mid-week that overrides key sections of the Withdrawal Agreement relating to state aid and, critically, Northern Irish customs.  The implementation of the Withdrawal Agreement is the keystone upon which the current trade negotiations are predicated.  The government will likely claim it is merely re-interpreting the withdrawal bill and the Northern Ireland protocol. Still, Brussels will see it as the coup de grace of talks that the UK was not particularly serious about from the get-go.  Negotiations are to resume tomorrow, but surely these reports cast a pall over them, 

Following a disappointing factory orders report before the weekend (2.8% instead of 5%), Germany reported that July industrial output increased by only 1.2%.  The median forecast in the Bloomberg survey was for a 4.5% increase after the 8.9% rise in June.  Strength was seen in the auto sector, while machinery output fell.  The government estimates that industry is about 90% back to pre-crisis levels. 

The euro has been confined to about a quarter-cent range above $1.1825.  The euro found support in the last two sessions in the $1.1780-$1.1790 area.  However, many participants seem reluctant to bid it up ahead of the ECB meeting on Thursday.  There are about 1.2 bln euro in options in the $1.1800-$1.1810 that expire today and about 1.9 bln euros in options that expire tomorrow at $1.19.   Sterling is near the pre-weekend low around $1.3175.  It has fallen steadily today after rebounded to almost $1.33 in late activity before the weekend.  The brinkmanship over Brexit trade talks could see sterling test stronger support near $1.30.  The euro is also rebounding against sterling after testing three-month lows last week (~GBP0.8865).  The near-term potential is toward GBP0.9000-GBP0.9030.    

America

Last week's employment data was sufficiently strong as to diminish further the likelihood that another stimulus bill will be agreed upon between the White House and the House of Representatives.   The 1.4 mln jobs created were flatted by 250k temporary census workers.  Around 1 mln private-sector workers returned to their jobs, and retail and restaurant employment picked up.  Still, to keep these large numbers in perspective, consider that the US has about 11.5 mln fewer jobs in August than it did in February.  The number of job losses that are permanent rose to 3.4 mln in August from 2.9 mln in July.  The larger than expected drop in the unemployment rate to 8.4% from 10.2% may have been bolstered by the return of self-employed and gig workers whose extended benefits expired in July.  

The US data highlight of the week may be the August CPI on Friday.  The headline is expected to tick up to 1.2% from 1.0%, while the core rate is forecast to be unchanged at 1.6%.   Canada reported strong August jobs growth.  The nearly 246k jobs created was near estimates, but unlike in July, the lion's share of the jobs were full-time positions (almost 206k).  The highlight of the week is the Bank of Canada meeting on Wednesday.   We don't expect fresh initiatives, though it will likely reassure investors and businesses that it is prepared to act if necessary.  The ball is really in the government's hand, and the opening of the parliament session later this month is seen as the next key event.  Mexico reports August CPI and industrial output figures this week.  Both are expected to tick-up.  Mexico's central bank meets on September 24, and the scope for near-term easing is limited.  Banxico is likely to stand pat.  

The US dollar briefly dripped below CAD1.3000 early last week but has since found support in the CAD1.3030-CAD1.3040 area. Initial resistance has been encountered in the CAD1.3140-CAD1.3160 area.  The 20-day moving average, which the greenback has not traded above since the third week in July, is near CAD1.3160.  A break above there could spur a move toward CAD1.3240. The US dollar fell against the Mexican peso for the fourth consecutive week and frayed its 200-day moving average (~MXN21.5280) for the first time since early this year.  Amid a bout of profit-taking, initial resistance is seen near MXN21.80 and then MXN22.00.  

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