Palpable uncertainties that had been hanging over the investment climate in 2019 were lifted at the end. The UK election leaves no doubt that Brexit will take place at the end of January. The new NAFTA looks to be ratified in early 2020. The US and China have reached an agreement that marks a cessation of the escalation of the tit-for-tat tariffs.
Outside of NAFTA2.0, the immediate risks have subsided, but closure is elusive. The UK and EU will be locked in trade negotiations in 2020. If a new agreement is not reached by the end of the year, the UK could still leave the EU with only the WTO rules. The WTO itself has been hobbled as the US has successfully blocked the appointment of appellate judges. One judge remains of seven when three are needed to make a ruling.
The US-China deal leaves in place most of the US tariff increases over the past 18-months. The 25% tariff on roughly $250 bln of imports from China is untouched. What was halved was the 15% tariff on around $120 bln of Chinese goods. The tariff escalation that was threatened for mid-December was rescinded. In exchange, the US appears to have secured pledges from Beijing that would practically double overall exports to China over the next two years. The demand for agriculture, including nuts, and lumber, could push up prices in the US.
While this beats the alternative of escalating trade tensions between the two largest economies, it hardly marks the end of the rivalry. Both countries still seem to be determined to frustrate each other’s ambitions when possible. The trade agreement does not preclude a new type of Cold War. The disengagement scenario is not necessarily undermined by the trade accord. Conditions will likely be hospitable for direct investment, education, and tourism.
The past year or so, maybe the dress rehearsal for the end of the two-year period that the agreement covers. Other sources of animal and plant protein will be secured for China. The ban China has placed on government and public institution use of foreign soft and hardware will likely spur their domestic development and serves as an example of the import-substitution strategy in what could be considered the commanding heights of the new economy. A key sector here to monitor is semiconductor chip design and fabrication.
The US has secured its trade flanks by updating NAFTA and reaching a trade agreement with Japan. Attention in 2020 will turn toward Europe, which is under new leadership: a new president of the European Council (Michel), European Union (von der Leyen), and the ECB (Lagarde). There is a long list of outstanding issues (from the digital tax, and Airbus, to Huawei, NATO spending, Nord Stream II pipeline, and the trade imbalance) that draw the US ire. Europe also will be engaged in trade talks with the UK that set the terms for the new trade relationship. The incontrovertible fact is that members of the EU will have more favorable access to the Common Market than non-members. Negotiations will difficult and likely fraught with the type of brinkmanship investors may have become accustomed to.
It is not clear how much reducing uncertainty over US-China trade and Brexit will boost global growth. The slowdown in China appears mostly a function of its own internal dynamics. In the last couple of months of 2019, the economy seemed to gain some traction, led by infrastructure and construction. It was also reflected in higher prices for construction materials (e.g., cement, steel rebar, construction aggregate). However, some of this may be borrowing from the future as Bejing is allowing some cities to tap into next year’s infrastructure spending quotas.
Japan’s deep contraction in Q4 is a function of the sales tax increase and tsunami that struck at the start of the quarter. The Abe government has responded with fiscal stimulus, and that should help the economy recover into the July-August Summer Olympics. The Abe government assumes growth in 2020 will reach 1.4%. The market is less sanguine, and a Reuters poll found a median forecast of just 0.5%. India, which looks set to move ahead of France and the UK as the fifth-largest economy, is slowing as the shadow banking (non-bank financial institutions) was frozen, cutting off funding for many small and medium businesses. India, like Japan, has a fiscal response, and they are not alone. In the Asia Pacific region, they are joined by others, notably New Zealand and South Korea.
Germany’s stagnant economy cannot be reasonably attributed to the US-China trade conflict any more than Japan’s. German auto sector did rely on China for about a quarter of its sales, but the drop was not so much due to trade as the weakening of the Chinese economy and changing regulations on emissions. Also, German automakers arguably had overcommitted to diesel when the global push is toward electric vehicles.
The resilience of Europe’s service sector is promising, but the most optimistic observation is that the regional economy has become slightly less bad. Moreover, fiscal support is sorely lacking from Northern European countries, where the scope is the greatest, and costs are among the least. Public investment has been starved by the commitment to the “black zero” of balanced budgets in Germany, and even Bundesbank President Weidmann drew back from unwavering support for it.
UK Prime Minister Johnson promised fiscal stimulus, but the pressure on the Bank of England to ease policy is likely to increase, barring a significant improvement in economic conditions. It is not immediately clear how much uncertainty has really been removed by the UK election.
Brexit will take place 3.5 years after the referendum, but the new relationship with Europe is crucial. The preliminary signs suggest Johnson will seek what has been known as a hard Brexit, one in which the WTO rules largely govern the new trade relationship. On the other hand, the Tories’ victory may help attract global savings. International asset managers have been underweight UK assets, and re-balancing may underpin UK equities in the first part of the year.
Mark Carney’s term as Bank of England Governor has been its own form of Brexit. He has wanted to leave for some time and has been talked into extensions, most recently with the appointment of his successor Andrew Baily. Baily has been at the Bank of England for nearly 35 years but has not been directly engaged in the conduct of monetary policy. Carney has been talked into extending his tenure from the end of January until the middle of March.
Canada’s Prime Minister Trudeau, heading a minority government, is advocating tax cuts, while the Bank of Canada seems comfortable with its neutral stance. Governor Poloz’s term ends in June 2020. Deputy Governor Wilkins appears to be a favorite to succeed him. There is likely to be broad continuity between Poloz and Wilkins, who some suggest has been groomed for the job.
The US economy is challenging to read as 2019 draws to a close. Consider that the Atlanta Fed’s GDP tracker sees Q4 growth at 2.1%, while the NY Fed’s model projects 1.2%. Boeing’s decision to halt production on the 737 Max will weigh on Q1 US GDP with the loss of output estimated between 0.5% and 1.0% at an annualized pace. The median Fed official forecast at the December meeting and the median from the Bloomberg survey converge at 1.8% for 2020 GDP.
Thirteen Fed officials think that it will be appropriate to leave the target range (1.50%-1.75%) all of 2020. The four others think a hike will be needed. At the end of 2018, the median Fed forecast was for the target range to be at 2.75%-3.00% at the end of 2019 and 3.00%-3.25% at the end of 2020. The December 2020 fed funds futures implied an effective average fed funds rate of 2.20% at the end of last year. It now implies about 1.38%. This means that around a 70% chance of a cut is discounted.
A weak start to Q2, especially if accompanied by rising weekly jobless claims, can bring a Fed cut back into play. However, the first critical decision may be regarding the $60 bln a month of T-bill purchases. When initiated, the bill purchases were said to continue into Q2. We see these efforts as primarily about the transmission of monetary policy rather than policy itself, more about oil and petrol for an engine.
The US presidential election in November 2020 will be a focal point, but it is increasingly taken for granted that Trump will secure a second term. As ironic as it may sound, the re-election of Trump is perceived as less disruptive than a Democrat victory. That said, it has become part of the US political discourse for some to warn of catastrophic consequences if there is a change, such as Obama in 2008 and Trump in 2016.
Stylistic issues aside, tax cuts, deregulation, stronger stand against immigration, and conservative judges appealed to the traditional Republican base. At the same time, part of the Trump Administration’s foreign policy, including the confrontation with China and Iran, and the USMCA, saw bipartisan support. Although many predictive models place much emphasis on the health of the economy, the wide gender gap suggests a more nuanced analysis may be necessary. Also, while national polls are in the news, the outcome of the election could come down to a handful of midwestern states, as was the case in 2016.
35 Senate seats are will be contested, and the Republicans hold 22 of them. The Democrats need to pick up a net of four seats to move to secure a majority. The entire House of Representatives will be elected. It will be difficult for Republicans to secure a majority as the power of incumbency is being surrendered as 24 of its members have already announced plans to retire rather than see reelection. In recent years, the incumbent is re-elected 90% of the time, with rarely more than 5-10 incumbents being defeated
Taiwan holds national elections on January 11. Although the demonstrations in Hong Kong may not have won much support among the mainland public, they may have strengthened the support of the current president Tsai Ing-wen and the Democratic Progressive Party. Although the Kuomintang candidate Han Kuo-yu has moderated his views to become less pro-China, it has allowed Tsai to become more strident in her criticism of Beijing. The entry of a third candidate, James Soong, who is seen as more likely to take votes from Han. Tsai’s re-election may embolden her to further move against the mainland.
In September, Hong Kong holds legislative council elections. If the district council elections are anything to go by, those seeking to preserve Hong Kong’s independence (Pro-Democracy movement) are likely to do well. However, the popular vote only selects half of the 70 seats. Beijing can greatly influence the other half. There continues to be speculation that Hong Kong Chief Executive Lam will step down in the spring. While it seemed that Shanghai was destined to be the financial center of China, the prolonged demonstrations in Hong Kong risk expediting the process.
There are a few other elections in 2020 that may capture investors’ attention. Israel goes back to the polls in March after failing in April and again in September 2019 to elect a majority in parliament. South Korea’s legislature holds elections. President Moon has seen his support wane as the economy weakened. If the DPK loses its majority, Moon’s agenda may be paralyzed. Singapore holds national elections in May, but it is a foregone conclusion that the People’s Action Party that has ruled the city-state since 1965 will win again. A couple of more Indian states hold elections as well. Prime Minister Modi and the BJP lost two state elections at the end of last year as their fortunes are reversed after winning the national elections in April/May. The weakening economy and controversial policies, including most recently the laws pertaining to citizenship that has prompted large-scale mass demonstrations and confrontations with the police.
Risks and Opportunities
1. The key for investors and policymakers is that the economic green shoots take hold by spring in the Northern Hemisphere. Otherwise, the risk appetites which seem so bountiful now become satiated. Growth in many countries in Europe and Asia seemed to show signs of stabilizing, but a meaningful recovery has yet to be seen. How long will investors be patient? At the same time, rising oil and commodity prices may lift headline inflation measures, while the base effect will push in the same direction.
2. There are two main areas that many observers are fear are threats to financial stability. First, Beijing vacillates between deleveraging and moral hazard on the one hand and targeting levels of growth that require the expansion of debt on the other. China starts 2020 favoring the latter, and there is scope for easing monetary policy (via required reserve ratios and interest rates). Still, assuming this is successful, Beijing may move toward the other horn of its dilemma later in the year. Second, outside of China, there has been heightened concern about the collateralized loan obligations (CLOs) and other credit derivatives that have been pursued in the quest for yield. More broadly, there is fear that some financial instruments may not be as liquid as they maybe appear in other financial conditions.
3. Italy’s politics and banks seem to always candidates for disruption, and 2020 is no different. The Five Star and Democrat Party national coalition succeeded in holding the League at bay, but tensions appear to be rising. Eight of Italy’s 20 regions hold elections in 2020, and the PD governs eight of them. Germany’s coalition may be strained as the junior partner (SPD) recently chose new leaders. However, with Merkel’s term ending in 2021, and neither party (CDU or SPD) is doing well in the polls, the coalition may limp through 2020.
4. The technical condition (short-term) seems stretched as are valuations (medium and longer-term). Conviction levels are running high for long equity and short bond type of strategies. The Fear of Missing Out seemed to allow the equity rally to perpetuate itself. Equity markets extended their rally even bond yields were rising. Emerging markets (MSCI Emerging Market equity index and the JP Morgan Emerging Market Currency Index) underperformed in 2019 and maybe poised to outperform in 2020. Among emerging market currencies, the Russian rouble, Thai baht, and South Korean won look poised to do well. Continued rate cuts (scope for 50-100 bp in 2020) and AMLO policies may see the Mexican peso struggle after leading the Latam currencies in 2019. A better outlook for emerging markets may also be aided by better-performing commodities. The CRB Index performed well in the last third of the year enjoys strong momentum to start the New Year.
5. Economic nationalism and the increasing salience of non-economic considerations (such as national security and environmental sustainability) is not just a passing distraction. The gradual weakening of the multilateral institutions does not preclude the combination of old fashion government stimulus, in some countries, and low nominal and real rates underpinning, growth, inflation expectations. Hedge funds and many institutional advisers like equities and emerging markets in 2020, and are bearish bonds.
(recognizing the importance of initial conditions)
Spot Marc’s Guess End of 2020 Forward
Euro $1.1175 $1.1600 $1.1430
Yen JPY109.45 JPY106 JPY107.20
Sterling $1.3075 $1.3600 $1.3200
Canadian $ CAD1.3085 CAD1.2950 CAD.13080
Australian $ $0.6980 $0.7100 $0.7035
Mexican Peso MXN18.8650 MXN19.70 MXN19.88
Chinese Yuan CNY6.9960 CNY7.10 CNY7.0675