From Synchronized Growth to Renewed Divergence and a Rubicon that will be Crossed

Heraclitus, the ancient Greek philosopher of change, is said to have taught that one cannot step in the same river twice.  So too it seems that the international political economy is always in a state of flux; becoming never being.  The synchronized global upturn appears to be giving way to renewed divergence.  It is hardly surprising that the US is expanding at a robust pace given fiscal stimulus, spending increases and deregulation that has been pursued.  What may have been less expected is the sharp slow down in Japan in Europe this year.

The likely upward revision to Japan’s Q2 GDP, due to a surge in capital expenditures (12.8% year-over-year, the strongest in 11 years),  will not alter this assessment.  The 0.5% initial estimate for Q2 GDP would have to double to for H1 18 growth to match H2 17.   Moreover,  Japan runs a significant fiscal deficit that is expected to increase from 3.5% of GDP in 2017 to 3.8% this year.  Japan has not recorded a budget deficit of less than 3.0% since 2007.

The Bank of Japan’s balance sheet may be growing more slowing since the introduction of “yield curve control” two years ago, but by increasing the size of its purchases this month through 10-year notes, is a clear signal to the market not to confuse the fewer pre-announced buying days with some sort of stealth tapering.   The risk of a debt crisis, which many had been “betting” on with little avail, has been effectively minimized by the central bank now holding roughly 45% of outstanding JGBs.   This risk has been supplanted by the real possibility that Japan’s business expansion cycle ends while monetary policy is still open-spigot and with a cyclically adjusted deficit relatively large.

This past week went from bad to worse for Germany.  It may have been the worst week in years.  Recall that after a soft patch at the start of the year, the survey data (PMI, IFO, ZEW) pointed to a recovery of the European economic engine and the world’s fourth-largest economy.   Such optimism has been dashed.

The week began with a downward revision from the flash manufacturing and services PMI.  The manufacturing PMI, perhaps undermined by the heightened trade tensions, was revised back to the June low, which itself was the lowest since the end of 2016.  The service sector PMI was revised lower, but still was an improvement from July.  In fact, the recovery in the service sector looks intact,  It bottomed in May and is now back at levels seen in February.

It is difficult to have much faith Germany services decoupling from industry for long, and there more indications of weakness in manufacturing.  Factory orders, for which economists expected a strong rebound from the 4.0% decline in June, fell 0.9% in July.  Factory orders fell in four months in 2017.  In 2018, they have fallen in six of the first seven months.  This was followed by an unexpected and large 1.1% fall in July industrial output.  The small upward revision to the June series (from -0.9% to 0.7%) meant little.  The 1.1% year-over-year pace is the weakest since January 2017.

To round it out, Germany also reported an unexpected decline (-0.9%) in exports.  The Bloomberg consensus had expected a 0.3% increase after a flat report in June.  In the first seven months of the year, German exports have fallen by 0.1% on average.  In the same period last year, exports averaged a 0.7% increase.

This string of German data, the widening premium beings demanded of the periphery, and trade tensions will likely color ECB President Draghi’s remarks following the ECB meeting on September 13.  The risk is that the staff trims this year’s GDP forecast of 2.1% made in June.  When everything is said and done, between June 1 and September 3, the euro had fallen a third of one percent against the dollar.  It was firmer against most of its other trading partners, except Switzerland.  Oil prices were also essentially flat.  As a consequence, the staff’s inflation forecast is unlikely to change much from the 1.7% headline pace forecast in June. 

Still, it seems unreasonable to expect Draghi to signal a course change.  In Q4, the ECB purchases will fall to 15 bln euros a month and then stopping at the end of the year.  The ECB will continue to reinvest the maturing proceeds, and through this remain active market participants and a source of demand.  Starting next month, the purchase by the ECB and BOJ will no longer offset the unwinding of the Fed’s balance sheet (increases to a terminal velocity of $50 bln a month).  The Rubicon will be crossed. 

The euro has fallen on the day of the last seven ECB meetings. The last time the euro appreciated on the day the ECB met was last September.  Over these seven meetings, it has fallen by an average of 0.83% and ranged from a 0.1% decline after the January meeting to a 1.9% drop after the June meeting.  The euro’s performance was evenly divided among the eight 2017 meetings between advances and declines.

The Bank of England meets next on September 13, the same day as the ECB.   It is an easy call:  unanimous decision to hold after hiking rates last month.  It seems that Carney, who had pre-announced his departure for the middle of next year may stay on an additional year ostensibly to help navigate Brexit’s impact. 

Much of the high-frequency data are likely to be sequentially moving in the wrong direction.  The trade deficit may have widened.  The pace of growth in industrial output and manufacturing are expected to be halved to 0.2% in July from June.  Construction looks to have contracted after a 1.4% surge in June. On the other hand, unemployment may have been steady at 4.0%, while average earnings growth may have picked up.  The net result is that the new monthly GDP series is will likely show a 0.1% growth rate in July the same as in June.  The three-month-over-three-month pace appears to have quickened for the third consecutive month.  A 0.5% increase would match the best pace since last August. 

Meanwhile, the market has practically no doubt that the Fed will hike interest rates a couple weeks after the ECB and BOE meet.  At the end of August, the Bloomberg model had a nearly 95% chance of a hike priced in, and the CME put it at a little more than 98%.  After the jobs data, the odds edged higher.  The market is also feeling a bit more confident about a December hike.  Bloomberg has that a nearly 69% probability was discounted, up from a less than 64% at the end of August.  The CME estimates that the probability of a hike increased to almost  80% from 72%. 

Not only is the fiscal stimulus still working its way through the system, but ahead of the November election, there is a campaign to provide more.  These measures may include making the middle-class tax cuts permanent as they were for businesses.  President Trump is considering allowing capital gains to be indexed to inflation. 

The two data highlights next week are the US August CPI and retail sales.  Consumer inflation is rising, but the pace is not accelerating.  In fact, a 0.3% rise in the headline is still consistent with a moderation of the year-over-year pace to 2.8% (from 2.9%).  Excluding food and energy, the core rate is expected to be unchanged at 2.4%.

Retail sales are more volatile, but the combination of rising employment and nominal wages continues to underpin consumption.  Nor should forget the role of credit.  Consumer credit is expected to have risen by $14.4 bln in July.  The average for the first half of the year was $12.8 bln compared with an average of $14.6 bln in H1 17.  Over the past two years, consumers borrowed an average of almost $16 bln a month for a total of nearly $385 bln, supplementing stagnant wages and meager savings (for education) 

Headline retail sales may be dampened by the soft auto sales that have already been reported.  Surging light truck sales could not make up for the weakness in sedans, and auto sales slipped sequentially in August, and at a 16.6 mln seasonally-adjusted rate, it is slowest in a year. However, the components used for GDP calculations are expected to have risen a solid 0.4%.  It would match the average of Q2 and better the year-to-date average of 0.3%. 

The US yield curve (2-10 yr) has stabilized over the past two weeks between 20 bp and 25 bp.  Issuance is increasing to pay for the budget deficit that could 4% of GDP and even more next year.  At the same time, one of the sources of demand is about to end.  US corporations have until September 15 to get last year’s tax treatment for pension fund contribution rather than this year’s low tax rate.  Reports indicated that these future liabilities have been met US Treasuries (as well as boosting stripping activity or separating the coupon stream from the principal repayment). 

President Trump is expected to announce in the coming days the levying of a 25% tariff on $200 bln of Chinese goods. The wide range of goods that will be hit includes many common consumer and household products, and even more if Trump makes good on this threat to impose another round of tariffs on $267 bln of Chinese goods.  The effect is not only to boost prices of Chinese goods but encourages other producers to raise their prices as well. China has pre-announced retaliation by imposing a tariff on $60 bln of US goods.  China’s retaliation seems mostly for show and, at any rate, design to minimize the unintended but foreseeable self-harm.

Chinese August trade data, released since the markets closed on Friday, showed a trade surplus little changed from July at $27.9 bln (July at  $28.1 bln).  Export growth slowed to 9.8% year-over-year from 12.2%.  The average pace through July was 14.1%.  Import growth also slowed, but not as much as expected.   Imports were a  fifth higher than a year ago after a 27.3% pace in July and expectations for around an 18% pace.   

While President Trump cites the relative performance of the equity markets to claim the US is winning the trade war, China reported another record bilateral trade surplus.   According to Chinese figures, its trade surplus with the US widened to $31.1 bln from $29 bln.   The anticipation of new tariffs may be distorting both imports and exports.  China energy imports were strong.  

Coal imports slipped a little from the four-year high reached in July.  Natural gas imports rose and through August are up a little more than a third.  Oil imports rose 6.6% in August to almost 9.1 mln barrels a day.   The small refiners (teapots) reportedly stepped up their purchases to maximize the current quotas ahead of next month’s review to set next year’s quotas.  

Chinese macroeconomic policy has changed in recent months and may be partly a response to the sense that the trade tensions with the US are a prolonged nature.  It is easing financial conditions and opening its purse strings a bit.  The high-frequency data like retail sales, industrial production, and fixed asset investment are expected to have stabilized, and any weakness will likely be shrugged off as not yet reflecting the change in direction.   Meanwhile, new yuan loans (bank loans) are likely to have continued to grow faster than aggregate financing.  The difference being the continued efforts to reduce shadow banking and get it onto the balance sheets. 

There has been some speculation that the US President wants to cite China as a currency manipulator in the Treasury’s October report.  It is possible but would seem to require a new definition of manipulation or ignoring the current criteria that had been worked out with Congress.  In any event, it is more symbolic than substantive.  Being cited as a manipulator would require bilateral negotiations, which are already taking place.  It could eventually allow US companies to sue China for alleged damages.  No country has been cited for nearly a quarter of a century.  It would not be the most unpopular decision of the administration. 


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