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Hong Kong Is in the Crosshairs of the Trade War

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Executive Summary

1. Hong Kong in the crosshairs of the trade war. Hong Kong is experiencing massive protests against the Chinese government’s erosions of the city’s traditional liberties and democratic governance. These protests have occasioned the introduction of a bipartisan bill in the U.S. Congress that would strip the city of its special status -- status that essentially has allowed it to continue functioning as one of the world’s great centers of commerce and finance even after the British returned it to Chinese control in 1997. Hong Kong is a tremendously important global city, and gives the U.S. an important source of leverage in its trade negotiations with the Chinese government. Even a hint that the U.S. will change its special status for Hong Kong would be disruptive and send global capital out of the city and towards safer neighboring destinations such as Singapore, and a full rescinding of Hong Kong’s status would be an enormous loss for China. This negotiating leverage is not much covered in the news but it is some of the most important leverage that the U.S. has, and shows once again that China holds a fundamentally weaker hand than many observers assume.

2. The new robot overlords are hiring ethics consultants. The potential dangers of artificial intelligence and unrestrained, opaque deep learning algorithms have gotten increasing attention over the past few years. This can lead in an alarmist direction, so we point out how many venture capitalists who fund AI startups are beginning to require clarity and transparency in the ethical approach engineers are taking to their creations -- for example, requiring AI systems to be able to “explain” why they make the decisions they do. It is likely that ethical standards will coalesce around this new technology just as they have with other disruptive technologies in the past.

3. Market summary. The U.S. stock market continues to head towards old highs. While some data points are showing a slowdown in the economic expansion, our main indicators of recession risk are still flashing green. The U.S. Federal Reserve held rates steady at its meeting yesterday, while indicating more clearly its willingness to lower rates at coming meetings. Bond markets are indicating their certainty of a rate cut in July. In the U.S., we continue to like large software and hardware companies benefitting from long-term technology growth trends: cloud, data center, networking and storage, e-commerce, productivity, cybersecurity, and artificial intelligence. While signs are encouraging, and there may be positive news at the G20 summit where Presidents Trump and Xi may meet, we do not believe that speculation on next week’s meeting is likely to be rewarded.

Facebook FB finally released the white paper describing Libra, its long-rumored cryptocurrency. We will write in greater detail about this development next week.

Gold is poised to break out above multi-year resistance, buoyed by fundamental and technical support. If central banks remain supportive, both by easing monetary policy and by continuing their gold purchases, gold may advance to a near-term target of $1520.

Hong Kong: In the Crosshairs of the Trade War

Hong Kong, a former British colony, returned to Chinese control in 1997, but with a unique status. The mainland Chinese government pledged, under the rubric of “one nation, two systems,” to respect the traditional liberties and democratic governance of Hong Kong, and because of this separation, the city has been able to retain its stature as one of the preeminent global hubs of commerce and finance. In the 1992 U.S. Hong Kong Policy Act, the city was assured favored treatment from the U.S. distinct from whatever policy regime was adopted towards the mainland.

Last week, U.S. lawmakers introduced the “Hong Kong Human Rights and Democracy Act” with bipartisan support -- legislation which would permit the U.S. to include Hong Kong under a sanctions regime if the mainland government continues to erode the city’s legal autonomy.

The immediate occasion was the heavy-handed attempt of Hong Kong’s leader to introduce legislation that would permit Hong Kong citizens to be extradited to the mainland. Citizens of Hong Kong turned out in their millions to protest, since they (accurately) viewed this legislation as an existential threat to the freedom of speech and assembly that Hong Kong currently enjoys. The legislation was delayed, but has not yet been shelved. The protests are perhaps the most direct rebuke to Chinese President Xi Jinping since his accession to power. Of course, the ongoing trade conflict between the U.S. and China remains in the background. Hong Kong is one of China’s crown jewels; it sits, with New York and London, at the heart of the global financial system. The clear message being sent to Beijing is this: if the U.S. changes course and reverses nearly 30 years of favorable treatment, Hong Kong will become simply another Chinese city. The potential disruption for China would be severe, and the damage perhaps irreparable. Even short of Congressional action, President Trump could use the “bully pulpit” of Twitter to encourage a mass exodus of capital from Hong Kong to less risky neighboring jurisdictions such as Singapore.

This is pressure that China simply cannot afford to ignore, and is perhaps the most immediately consequential threat that the U.S. government can make.

Investment implications: Precipitous action against Hong Kong’s special status with the U.S. would be highly disruptive, not just for China, but for the global financial system. Short of that, investors should be aware that the U.S. administration has tools at its disposal that are out of the public eye to encourage the Chinese to come to the table. Questioning Hong Kong’s status is one of those. It is a threat of which the Chinese are certainly keenly aware. If the administration has not yet employed this leverage in public, it certainly has in private.

Our New Robot Overlords May Have To Run Their Evil Plans Past the Ethics Committee

Elon Musk, founder of Tesla TSLA and cofounder of PayPal PYPL, famously said in an interview in 2014 that artificial intelligence was “summoning the demon” -- likening it to a fairy tale in which an incompetent wizard brings forth powers beyond his control that ultimately destroy him. Musk is not alone -- a growing chorus of tech movers and shakers over the past several years have been expressing concern about the possible unintended consequences of AI deployment, including Jaron Lanier, the godfather of virtual reality.

AI, and particularly deep-learning technologies, worry observers because they teach and program themselves -- and often, even their creators cannot explain why these systems behave as they do. AI is coming to manage increasingly broad and intimate parts of our lives, from recommending sentencing for criminals, to hiring and firing employees, to diagnosing our illnesses, to moving us from place to place in autonomous vehicles. So it is important for the responsible humans in the room to be vigilant in ensuring that AI decisions are serving the human good, and not running amok.

Fortunately, the significance of human oversight is not lost on AI start-ups either. Increasingly, the venture capitalists who fund cutting-edge AI development are insisting that the companies with which they work must consult with ethicists who can help them keep the workings of their technology transparent.

One managing partner at an AI-focused fund said: “If a human cannot understand the logic behind an [AI system’s] action, it’s much more difficult to contain. So I see explainability as a core component of having an ethical guardrail around AI.”

Readers of classic science fiction will remember the “Three Laws of Robotics” created by Isaac Asimov in 1950:

“First Law: A robot may not injure a human being or, through inaction, allow a human being to come to harm.

“Second Law: A robot must obey the orders given it by human beings except where such orders would conflict with the First Law.

“Third Law: A robot must protect its own existence as long as such protection does not conflict with the First or Second Laws.”

Perhaps the new titans of Silicon Valley have not travelled so far that they can no longer see the wisdom that Isaac Asimov did more than half a century ago.

Investment implications: Alarmist forecasts of potential disasters caused by artificial intelligence are probably just that -- alarmist. We are encouraged that increasingly, the human beings who are building AI systems are aware of the ethical dimensions and are thinking about them. It’s always a matter of time before ethical norms coalesce around a new technology -- and that will happen with AI as well.

Market Summary

The U.S.

The U.S. stock market continues to head towards old highs. While some data points are showing a slowdown in the economic expansion, our main indicators of recession risk are still flashing green.

In particular, we note the comments of Canaccord’s Tony Dwyer, who has been a superlative macro analyst throughout the current bull market. In a recent note, Dwyer observed: “A reduction in short-term interest rates would not be due to political pressure, an economic catastrophe, or an emerging systemic failure it would simply reflect that the Fed is no longer worried about a tight labor market leading to increased inflationary pressures that did not materialize. The recent drop in the Fed’s favorite inflation measures gives it the flexibility to follow the lead of the US Treasury (UST) market. How do we know the UST rate drop is about inflation and not predicting an economic recession? We know because despite the weaker recent economic data, the non-UST areas of credit are near their best levels of the cycle. This differentiation is so important because there is a much more significant upside market reaction when the Fed makes an initial rate cut outside of close proximity of recession.”

The U.S. Federal Reserve held rates steady at its meeting yesterday, while indicating more clearly its willingness to lower rates at coming meetings. Bond markets are indicating their certainty of a rate cut in July.

In the U.S., we continue to like large software and hardware companies benefitting from long-term technology growth trends: cloud, data center, networking and storage, e-commerce, productivity, cybersecurity, and artificial intelligence. The leaders in these areas are the stalwarts of the “fourth industrial revolution” and can be core positions in long-term focused portfolios. Private and public expenditures on cyberdefense are growing rapidly, and we believe, will continue to grow rapidly for the foreseeable future.

China, Emerging Markets, and Trade

While signs are encouraging, and there may be positive news at the G20 summit where Presidents Trump and Xi may meet, we don’t think investors should expect a settlement to be announced. It remains possible that the Chinese will try to wait out the 2020 U.S. elections in the hope that their dialogue partners will then be more pliable. While we do see upside in China and in other manufacturing-focused emerging markets once a settlement is reached, we do not believe that speculation on next week’s meeting is likely to be rewarded.

Europe

Outgoing European Central Bank chief Mario Draghi will be remembered in history for his “whatever it takes” remark in the depths of Europe’s financial crisis that may have preserved the continent from financial ruin (at least in the near term). He recently commented that more central bank easing could be afoot if Eurozone inflation remains too weak. We simply remind readers that the powers of the ECB are limited in addressing the long-running problems responsible for Europe’s economic and financial malaise. Absent fundamental reforms in the Eurozone -- which would involve increasingly close financial ties among countries whose voters seem increasingly polarized about that prospect -- we see European potential as tenuous and would continue to avoid Europe for investment. If the UK succeeds in leaving with a good deal (by which we mean that it really leaves), they will be the winners, in our view.

Gold and Cryptocurrencies

Facebook FB finally released the white paper describing its long-rumored cryptocurrency; the currency itself will be called Libra. It will be a stablecoin, that is, it will be backed by a basket of fiat currencies held in reserve, which, if it were implemented successfully, would preserve it from the wild fluctuations experienced by other cryptos. The coin will be initially managed by FB, but in short order, management will be handed over to a consortium; the list of consortium members already secured is a who’s-who of fintech and other significant global tech and payments companies. Notably, although transaction confirmations will initially be performed by permissioned nodes, the white paper envisions a transition to a permissionless blockchain within five years. FB will certainly face both fierce competition and an uphill battle against both global regulators and a global public whose trust in the company has been severely challenged by recent privacy scandals. We will write in greater detail about this development next week.

Gold is flirting with a five-year high. We have highlighted the fundamental positives for gold in recent letters: many global central banks easing or preparing to ease, including the U.S. Federal Reserve; big retail investor cash flows into both bullion and gold-miner ETFs; and significant central banks, including China and Russia, buying gold aggressively. Of course, the prospect of declining interest rates boosts non-interest-bearing assets such as gold. Technical signs are positive, with gold poised to break above multi-year resistance. If that breakout holds, we see a near-term target of $1520.

Thanks for listening; we welcome your calls and questions.

- Guild Investment Management.

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