The strategic objective is to integrate China into the world economy. The liberal international solution was trade, investment flows, and cultural exchanges. The rise of nationalism and China’s own willingness to flaunt the international rules are defeating the strategy. President Trump may suggest that China would prefer to negotiate with his main Democrat rival 18-months away from the election, both Pelosi and Schumer’s supported the hardline on China indicates a rare united national stance.
There are short-run and longer-term consequences. Most immediately, volatility in the equities has risen, which is associated with falling stock prices. A month ago the VIX was near 11.5% now. Now it is near 17%. The MSCI’s index for developed country equities fell 0.5% after shedding 2.4% the previous week. It is the first back-to-back weekly decline this year. The MSCI index of emerging market equities lost 3.6% after dropping 4.2% in the prior week. It has given back nearly 3/4 of the gains in the first four months of the year.
Bond yields also fell, and in derivative markets (futures, forwards, OIS), investors seemed to be pricing easier monetary policy. The implied yield of the January 2020 fed funds futures contract has fallen nearly 18 bp since Trump’s tweets than announced the end of tariff truce to about 2.02%. The current effective average rate (which is what the contract settles at), is 2.38%. This would seem to be consistent with one cut fully discounted and half of a second cut (50% chance) too.
However, with the effective funds rate is still above the interest the Fed pays on reserves, officials may want to take more action. They may continue to cut the interest on reserves to push it lower, though we still think a new facility to defend the top of the range as the Fed does with the lower end is needed. The point here if one allows if one assumes the Fed is pushing the interest on reserves to the lower end of the target range, then the market has nearly priced in a second cut this year.
Investors are pricing in aggressive rate cuts by the Reserve Bank of Australia, which are seen beginning in a few weeks. The market even appears to be pricing in an ECB rate cut by the end next year. But it is not just policy rates; it is also inflation expectations. Part of the falling inflation expectations is the belief that more trade frictions will cause slower growth.
However, part of it may be the consequence of the breakdown in the liberal strategy for making room at the economic table to a giant economy. In some ways, it is like the UK leaving the EU, there are orderly and disorderly ways it can happen. China’s sheer size and development-orientation mean that it will have a powerful impact on the world economy.
The real threat that China poses, and one that it would still present if it were market-oriented democracy, is similar to what rise of Germany and the US did at the turn of the 20th century. It is a huge deflationary thrust. China’s production capacity for a large number of goods far and away exceed its possible demand. Of course, it brings new demand as well, but the new supply is more deflationary than the increase in demand is inflationary.
Supplanting the liberal strategy, the Trump Administration is pursuing a containment strategy, which is one of China’s longstanding fears. It campaigns against the Belt Road Initiative and opposes China’s import substitution strategy (Made in China 2025) with its own (Make America Great Again). It hardwires into NAFTA 2.0 that Canada and Mexico cannot enter into trade agreements with China (though apparently, the US can). It has been forcing Chinese companies to divest of internet properties like Grindr and PatientsLikeMe. The US is selling new fighter planes to Taiwan, which it recognizes as a province of China. It demands that China honors its embargos against Iran and North Korea.
The number of Chinese students coming to the US to study has fallen. Chinese direct investment in the US has slowed. Businesses on both sides are being guided to minimize trips and exposures. The passage of a Hong Kong law will allow extradition to China, which the US protested because it makes Americans in Hong Kong more formally at the reach of Chinese officials than before. The tariffs will encourage many businesses to leave China, but that does not mean that the US will be the primary beneficiary.
Just like the Bitcoin and other cyber-currencies have a fork, so can the internet. The US ban buying Huawei products and selling parts to it could have far-reaching implications. Even if European governments don’t go along with it, it creates opportunities for Huawei’s competitors in the 5G space, like Nokia, Ericsson, and Cisco. There will be US/European protocols and Chinese protocols.
More importantly, is China will now have powerful incentives to do two things that will foster the fork. First, China is largely dependent on foreign semiconductors. It will cease to be so. Since the end of the tariff truce, the Philadelphia Semiconductor Index (SOX) has fallen nearly 9% (after rallying around 50% from the lows of late last year). Second, given the duopoly for mobile operating systems of US companies (OIS and Android), it is strategically necessary for China to introduce its own. Some reports suggest Huawei is prepared to do so if Android prevents its use.
The critical battle next week though is in the foreign exchange market. Chinese officials have in the past drawn a proverbial line in the sand at CNY7.0. The lower end of the “approved” dollar range, we thought was CNY6.70, though it did fray it a bit earlier this year. The dollar rose against the yuan in the three weeks before Trump’s tweets and has risen in the two weeks since. The CNY7.0 area held in late 2016-early 2017 and again at the end of last year and the start of this year. The same generally holds for the offshore yuan (CNH).
There are numerous policy levers that the PBOC can pull to defend its pain threshold, affecting the availability of liquidity as well as the price. It can also squeeze CNH shorts in Hong Kong. Until now it appears that market forces, including the broad strength of the dollar, is responsible for the yuan’s depreciation and the PBOC is perceived to be trying to temper the decline. If the CNY7.0 level does not hold and the dollar rises through it, it will be seen as the inability or more likely the unwillingness of China to mount a credible defense. It would likely send ripples through the capital markets. This would risk a vicious cycle of a weakening currency and falling stocks. Because this would distract from China’s economic objectives, we expect officials will defend it in a way that leaves no room for mistaking its desire.
Meanwhile, both the US and China reported disappointing April retail sales and industrial output figures in recent days. China will provide additional stimulus. The US will not. Minutes from the last FOMC meeting will be released at mid-week and will likely confirm that the bar for it to move as the market seems to think probably is rather high. That said the economy has lost the momentum seen in Q1. The Atlanta Fed tracker sees Q2 GDP at 1.2% while the New York Fed’s model puts it at 1.8%.
To the extent that the tariffs are understood as a tax, US policymakers will try to look through related price increases, just like they would if, for example, the tax on gasoline was raised. Economists project that the trade war could shave 0.5-0.75 percentage points off US GDP. Officials and investors will also want to look past Boeing’s effect on durable goods orders and shipments, which will likely be another headwind.
The main economic data point from Japan next week will be the first look at Q1 GDP. The monthly reports suggest consumption and investment fell in the first part of the year. The risk appears to be on the downside of the median forecast in the Bloomberg survey for a 0.1% contraction. Economists have under-appreciated the low prices and weaker growth in Asia as a whole and Japan in particular. Consider, for example, that before the weekend, Japan reported its March tertiary activities (service sector) index. The Bloomberg survey found a median forecast for a 0.1% gain. Instead, it fell by 0.4%.
The dollar rose to a seven-day high before the weekend near JPY110.20. This will likely help lift Japanese shares at the start of the new week. The Nikkei dropped about 7.25% from the year’s high in late April to the low early last week, which was nearly half of the year’s gain. It is worth mentioning again that although the sovereign yield curve is negative out a decade, the yield on Japanese stock indices is high. The dividend yield of the Nikkei is almost 2.2%, and the Topix yield is 2.50%, higher than the yield on US Treasuries.
European corporations also have high dividend yields. The German DAX yields nearly 3.2% and France’s CAC returns 3.3%. The FTSE 250 pays is yielding almost the same as the CAC, while Italy’s FTSE Milan Index has a dividend yield of 4%. In comparison, the US S&P 500 yields a little less 2%.
Europe’s economy grew faster in Q1 than the survey data suggested. The survey data may play a bit of catch-up. The preliminary May PMI will be reported. The manufacturing contraction is expected to ease, while the service sector continues to recover. The next result will likely be an uptick in the composite. There is a reasonably good chance that the Q2 composite PMI rises for the first quarterly increase (three-month average) since the end of 2017.
The European Parliament election begins on May 23, and the results are expected on May 26. The center-right and center-left groupings (People’s Party and Socialist-Democrats are expected to remain the largest parties, but could lose their combined majority in the face of right-wing populism and nationalist parties. Often in the EU Parliament elections, smaller and more extreme national parties are better presented than in their own national elections.
Farage’s Brexit Party is expected to do particularly well, but it has no (formal) representation in the UK Parliament. May is expected to lead the Tory Party into another thrashing, but it will be the last one. The Prime Minister is now expected to submit her Withdrawal Bill for the fourth and final time in early June and then step down. The jockeying for position for her successor has already begun.
Before the weekend, the US announced that in exchange for stronger enforcement, it was lifting the steel and aluminum tariffs on Canada and Mexico. While some deal had appeared to be in the works, Treasury Secretary Mnuchin explicitly denied that he was referring to ending the tariffs. Perhaps too, we did not appreciate the linkage between the deterioration of trade relations with China and need to improve them elsewhere. We suspect that the odds of the new NAFTA bill being enacted has increased from about 20% to 50%. The Canadian parliament has about a month to approve it before the summer recess and national election. The biggest remaining hurdle is US Congressional approval.
Steel tariffs that had been double on Turkey were cut back to 25%. Trump indicated there would be a 180-day delay before he decides whether to levy a 25% tariff on auto imports from Europe and Japan. While the market responded favorably, what the US is seeking is a voluntary export restriction, which while acceptable under GATT and in violation of the WTO rules. Also, the US put new tariff 17.5% tariff on $2 bln Mexican tomato imports and re-started an old anti-dumping probe.
Australia’s national election results will be known before the market’s open on Monday. The markets may not have a strong reaction. The prospect of a rate cut in a few weeks has helped drive the stock market to new highs since 2007. It has also been a weight, alongside the China contagion, on the currency, which has fallen for five consecutive weeks for a cumulative 4.75%.