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The Markets This Week

May 28, 2019 | Weekly Commentary

by Connor Darrell CFA, Assistant Vice President – Head of Investments

Geopolitical Update: China & Iran Represent Risks
We have raised our “International Risks” rating to a 7 from a 5 following recent developments in the Middle East and escalating tensions between the United States and China. We continue to stress that geopolitical events tend to have a smaller impact on markets than fundamental economic factors such as GDP, corporate earnings, and consumer confidence, but believe that recent news flow warrants investors’ close attention.

Earlier this month, the Trump administration ordered the deployment of significant military assets to the Persian Gulf, citing intelligence that suggested a rising probability of Iranian attacks on U.S. interests in the region. The Iranian economy is under significant pressure as a result of U.S. sanctions, and there appears to be growing concern within the Iranian government that Donald Trump will be re-elected in 2020. We have already seen multiple instances over the past few weeks where Saudi oil assets were sabotaged, and the general consensus in the intelligence community is that these attacks were carried out by Yemeni rebels on behalf of Iran. U.S.-Iranian relations are at their weakest level in years, with Secretary of State Mike Pompeo and Iranian Foreign Minister Mohammad Javad Zarif never having directly spoken to one another. The lack of a direct channel of communications between the two chief diplomats underscores a growing concern that any potential confrontation may be blown out of proportion and escalate quickly. Any meaningful escalation of tensions in the region would have the potential to de-stabilize oil prices (20% of the world’s oil travels through the Strait of Hormuz on its way to end markets) and further strain the United States’ relationship with China.

The trade negotiations between the U.S. and China have been thoroughly explored in virtually all media outlets, as well as in previous iterations of The Weekly Commentary, but there is another dimension to the discussions which extends beyond trade deficits and trade surpluses; the race to 5G. It has become increasingly apparent that the United States government views the race to establishing and dominating the world’s first 5G (fifth generation) cellular network technology grid as a matter of national security. First adopters of 5G technology are expected to sustain a meaningful long-term competitive advantage, and China is heavily focused on pushing to challenge the United States as the dominant force in the evolution of the world wide web. China’s approach to controlling information on the internet is vastly different from the openness championed by traditional American values, and in many ways, the race to 5G represents a philosophical battleground over the flow of information; one that has continued to escalate in recent weeks.

Shortly after the most recent round of trade discussions fell through, President Trump announced a ban on Chinese smartphone manufacturer Huawei. The ban blocks U.S. companies from doing business with Huawei, and essentially prevents it from accessing key inputs to its manufacturing process (which are produced by American companies). We see this decision as a clear and meaningful step to explicitly hamper China’s advancement in 5G technology and keep U.S. companies on a level playing field (Chinese companies receive direct support from the Communist-led government).  From an investor perspective, a meaningful disruption to the supply chain of technology equipment or additional bans would have the potential to cause volatility in equity markets as companies’ revenue streams are impacted. Even if a trade deal is reached within the next several months, the complexities of the technological rivalry between the two countries is likely to persist and will represent potential challenges for global companies which may be caught in the crosshairs of further policy action. Furthermore, a prolonged period where tariffs are imposed on Chinese goods would likely have a negative impact on economic growth. Recent research published by the New York Fed estimated that the newest round of tariffs could cost the average American household $831 per year. The focus on China and trade has the potential to draw the market’s focus further away from fundamentals and toward the unpredictability of the president’s Twitter feed. Such an environment will be very difficult to navigate for market timers and short-term traders.  In our view, the best defense for this type of uncertainty is broad diversification and discipline. We will continue to utilize The Weekly Commentary to share our thoughts on new developments as they unfold.