Monday, May 27, 2019

Capital Markets: Trade and Rare Earths and Brexit and Other Stuff

After all these years I should know better but it still seems hilarious that the totally misnamed "VanEck Vectors Rare Earth/Strategic Metals ETF" (REMX) with their tiny little 8.38% exposure to rare earths jumped 14% over 4 days after President Xi went to visit the rare earth magnet maker.

Anyhoo, from Marc to Market, Saturday May 25:

The Evolution of Three Issues are Key in the Week Ahead 
As May winds down, the light economic calendar will allow investors to take their cues from the evolution of three disruptive forces--trade, Brexit and the US economy.

With actions against Huawei and possibly a handful of Chinese surveillance equipment producers, the US raised the stakes. The retaliatory tariffs are effective on June 1, but Beijing has not formally responded to the moves against Chinese companies.

The Trump Administration seems to believe that the pressure from the tariffs and other actions will get China to capitulate to US demands. Officials were still playing up the likelihood that the two presidents meet on the sidelines of the G20 meeting in Japan at the end of next month. There is a relatively benign consensus narrative that the tariffs are a tactic, and, like at the end of last year, a meeting between Trump and Xi will jump-start talks again. However, there is nothing for China to gain at this juncture by talks. The US tariffs have already been lifted on $200 bln of its imports to 25%. The process has already begun to slap a 25% levy on the remaining Chinese goods that have escaped a penalty tax thus far, including popular consumer products like cell phones, tablets, and computers.

Say what you want about Chinese trade practices, and no one seriously defends them, but the US red lines cannot be the basis of serious negotiations. Trump has indicated that the US will not accept a mutually beneficial deal because it needs to be compensated for past wrongs, and he has explicitly stated that he will not allow China to become the largest superpower. Many observers seem to think that because China sometimes speaks in communist ideological terms, it is monolithic. It is not. The US demands cannot do anything but strengthen the hardline hawkish camp within China's ruling circles.

A meeting at the G20 meeting plays into Trump's hands. It could look as if China capitulated. Trump had demonstrated a flair for the dramatic as he showed when he walked away from North Korean talks and also again this past week when he walked away from the domestic bipartisan talks for an infrastructure initiative. The G20 venue and the spontaneity would be to Trump's advantage. Chinese officials prefer a more scripted event.

Xi and Vice Premier Liu visited a rare earth facility at the start of the week. Intended or not, it was understood as a small reminder of vulnerabilities and asymmetries that China can exploit that are not captured in the macro data that US policymakers rely on to think that they can dominate the tariff escalation ladder. While the Trump Administration is stretching national security to justify steel and aluminum tariffs and threaten protection for the auto sector, the rare earths are truly essential for defense, as well as modern technologically advanced goods, including electric/hybrid cars, windmills, computer memories, cell phones, rechargeable batteries, and even some medicines.

Last year the US imported about 4100 tonnes of rare earths from China at the cost of about $175 mln, which is hardly even a rounding error for the bean counters who understand prices but not values. Most of the rare earths are embedded in the products it imports. US dependence on China for rare earths is well documented.

Reports suggest that China will impose limits on rare earth exports to the US as a way to express its displeasure. There is precedent from nine years ago when in a dispute with Japan, China cut its access to rare earths. Given the complex supply chains and distribution channels, it is difficult for China to play this card directly. Just like it is not very easy to weaponize the yuan or China's Treasury holdings, weaponizing rare earths could have broad impact, not the kind of laser focus that the PRC seems to prefer. This is not to say China can't or won't. The argument here is less bold: the cost of doing so is high and therefore, likely at a higher rung in the escalation ladder.

In China's command economy, a quota is set for rare earth production. The most recent one for H1 19 was set mid-March. The mining quota was set at 60k tonnes in H1 19, which is down nearly 18.5% from a year ago. The smelting and refining quota was cut by almost 18% to 57.5k tonnes. The decline partly reflects the high quotas from the first part of last year, which were later balanced with lower quota in the second half. The 2018 quotas for the entire year worked out to be 120k tonnes of mining and 115k tonnes of processing. The quotas for the second half are expected to be announced by the end of June.

A date for the trade talks to resume has not been set. The rhetoric remains bellicose. Reference in Chinese state media about another "Long March" and the importance of "self-reliance" are meant to pull on the nationalist strings. The trajectory of developments since the end of the tariff truce does not appear to have run its course yet....