• This is a harbinger of wider politically-driven changes to central banks
• The politically turbulent UK looks like a prime guinea pig candidate
• Either a Labour or a hard Brexit government could politicize the BoE
This view focuses on the risks arising from developments in the Sino-US trade war. It contains sections by different TS Lombard experts on what is currently ‘priced-in’ in financial markets; on China’s politics and economy; on EM ramifications, including the development of regional political-economic blocs; on European and Pacific rim weaknesses; on the US economic slowdown; on the progress of Sino-US negotiations; on political pressures in the US; and, lastly, on the risks of a much worse outcome than our mainstream forecast, including global recession.
• We stick to our view that trade-war threats will be contained, BUT
• While the June G20 meeting may steady nerves, major risks remain
• This View is a glimpse over the brink
• ‘Who’s No.1?’: now the key driver – trumping Trump’s agenda & tactics
• US v. China rivalry will fester into the 2020s even in the benign scenario
• A globalised world could shift to regional blocs, hurting equity values
• The short-term danger of the trade-war negotiations derailing is high
• Failure to extend the Huawei truce in August could ruin scope for a deal
• If so, the world economy could tip rapidly into recession
Charles Dumas, Chief Economist at TS Lombard on Italexit – economics say perhaps yes, politics say no:
Fiscal front-loading has front loaded China’s growth. Record-breaking fiscal expansion in Q1 is leading a surge in; infrastructure spending, industrial production and commodity imports. The stimulus has put a floor on growth for 2019, but the impulse will fade by Q4/19. Barring an escalation of the Trade War, credit easing will remain modest as Beijing focuses on financial risk control, we have reached peak China stimulus for 2019, says Rory Green, Economist China & South Korea at TS Lombard.
Charles Dumas, Chief Economist at TS Lombard on why Chinese inventory restraint may herald greater productivity:
- China has been tough on inventories since 2015 – raising productivity?
- The high US inventory/sales ratio is sapping manufacturing in 2019 H1
- Likewise Germany & Japan (weak exports) and the UK pre-Brexit
The atmosphere among investors at this year’s IMF-World Bank spring meetings was distinctly bullish. But scratch the surface and one could sense a caution, even reluctance, as if to say “I’m bullish but maybe I shouldn’t be”. Another way to characterise the mood is that investors do not reckon that the facts on the ground support such a bullish view but rather are being swept along by a broader “group think” that everything is moving in the right direction, says Lawrence Brainard, Chief EM Economist at TS Lombard:
After the inversion of the 3m-10y portion of the yield curve last week there was a cacophony of recession calls, says Oliver Brennan, Senior Macro Strategist at TS Lombard. It is true that 3m-10y inversion always precedes a recession, but that does not mean it is necessarily a useful timing signal, either for the economy or for markets. However, we do find some signal in the noise when it comes to sectoral S&P returns.
Dovish Central Banks are ultimately supportive of risk assets. Short term global macro data will continue to disappoint. Yuan to stabilise. Fed dovishness via QT Taper & probable rate cut to deliver ‘stealth QE’. Equities not expensive but technically stretched – don’t chase, says Martin Shenfield, Managing Director, Macro Strategy.
The UK parliament has last week ruled out a no deal Brexit and supported a postponement of Brexit day beyond 29 March. This is a temporary respite, however. While last week’s parliamentary votes reinforce our already high-conviction view excluding the worst-case scenario of economic disruption – i.e. a no deal ‘crash-out’, the outlook remains one of protracted uncertainty on the back of endless political battles. This would still be the case even in what we see as the unlikely event that Theresa May finally succeeded in passing her withdrawal package.
These battles should be seen as episodes in a long war. All politics involve a struggle for power, but the struggle in this case is all the more bitter because of the particular kind of power in question – that is, the power to shape and conduct the substantive negotiations on the UK’s long-term relationship with the EU. This is seen by UK politicians – reasonably enough – as both a determinant and a reflection of the kind of country they want the UK to become. When the UK next holds a general election – perhaps as early as this year – there will be hopes for a resolution. Such hopes may well be disappointed, with the ‘Brexit war’ continuing afterwards. The only reliable escape route would be via a new referendum resulting in a ‘Remain’ victory. As things stand, another referendum appears to be among the less likely scenarios. For it to become more likely, all other options would first have to fail. That, in turn, would mean even more intense political battles.
The outlook is poor, therefore, for confidence in the UK economy.
Be warned: Trump’s ‘trade war’, focused so far on China, is now poised to take renewed aim at Europe, says Christopher Granville, Managing Director EMEA and Global Political Research. The likely main specific target is the automotive sector and, therefore, Germany. The cue is the US Commerce Department’s Section 232 report, due out on 17 February, on auto imports as a threat to national security. We base this warning on analysis of Trump’s track record – and, in particular, the way that he never gives up on his policy fixations. Core agenda items may often disappear from view – only to come roaring back. Our analysis of recurrent implementation patterns indicates that Trump’s advertised China trade war endgame is a likely cue for the drums of European trade war to start beating again.
Euro area financial conditions have improved since the start of the year, taking a cue from rest of the world. But how sustainable is the bounce? says Shweta Singh, Managing Director, Global Macro.
The recent shift in Federal Reserve policy may seem, to some, that the FOMC is caving-in to the market and perhaps even political pressures. This narrative is, we believe, false - says Steve Blitz, Chief US Economist at TS Lombard. The FOMC is reacting to the shift in market prices, notably the relative return on lending, that inevitably slows the pace of credit extensions and, eventually, real growth. There are, true, long lags between the change in pricing and seeing a measured impact on real activity. The Fed, however, also understands that waiting until signs of slowing real activity appear will very likely move them to drop the federal funds rate to the zero-bound in short-order. In no mood to tempt fate and reopen the full array of unconventional monetary tools, the FOMC is engaging in an ounce of prevention. And we think they are correct in doing so.
Following the December CEWC, monetary policy appears to be moving towards measured easing, from a neutral policy in H2/18, says Bo Zhuang Chief China Economist. Frontloading of local government bond issuance in Q1/19 will drive total credit growth. But the rebound in total credit growth will be smaller than in previous cycles. The fiscal deficit target will be hiked to more than 3% of GDP in 2019 vs 2.6% last year. We also expect more tax cuts, but the short-term impact on growth will disappoint.
Recent falls in producer prices signal a new industrial downturn, says Bo Zhuang, Chief China Economist. Deflation risk will re-emerge as domestic PPI falls into negative territory in H1/19. As a result, nominal GDP growth in China could rapidly decelerate to ~8%. Apart from deflation, uncertainty in the housing market and domestic consumption will be the principal domestic growth risks over the next 12-18 months.
Global growth downgrades and trade war pessimism have seen stocks erase their gains this year. But we reckon most of the bad news is now largely ‘priced in’ and valuations are becoming cheap, says Oliver Brennan, Senior Macro Strategist at TS Lombard. We remain relatively optimistic; although equity markets are unlikely to make new highs in 2019 the Fed pause and trade war truce are positive for risk over the next few months. We discuss our equity upgrades, and our negative stance on fixed income, in this video.
EMs, now 40% of world GDP, were doubly hit in mid-2018 by the US-China trade war, says Charles Dumas Chief Economist at TS Lombard. The sharp dollar rise pushed up the cost of imports, while the yuan slump made exports less remunerative – for non-oil economies that have been in large deficits for 12 years. The resulting debts also cost more as dollar interest rates rise. Export-dependent surplus countries also suffered, notably Japan and the Asian Tigers, but also Germany and Italy. Even the US is being slowed by trade-war uncertainty and the overvalued dollar.
The meeting between Presidents Xi and Trump was welcome because it confirmed a de-escalation of the relentless US-China trade war, says Larry Brainard Chief EM Economist at TS Lombard. The 90-day truce is too short a time to reach agreement on all the issues that are on the table but there are good chances that it gets extended multiple times. What is unsettling however is that the White House has now ramped up its war on technology transfers to China by taking an unusual step of asking Canada to extradite the CFO of Huawei on unknown charges. The US-China economic confrontation has moved onto new ground.
How serious of a slowdown for the US economy? Whenever the dynamics turn negative it is always dangerous to presume a constrained slowdown at the outset, says Steve Blitz, Chief US Economist.
ECB’s QE-exit comes at a particularly difficult time for the euro zone, says Shweta Singh, Managing Director Global Macro at TS Lombard. A slowdown in external demand, tighter global financial conditions and Italian risks will continue to weigh on euro area growth. But in the absence of a meaningful fiscal boost and in the face of various constraints on ECB policy, the central bank’s options seem limited. The lopsided nature of ECB QE could worsen when its capital key is revised next year. We think some form of TLTRO is likely, although this is not a solution for the mounting pressure on Italian banks. A proper Fed-style Operation Twist could be more effective, but it is unlikely at this point. A passive maturity transformation seems more feasible.
What will happen to the yield curve asks Steve Blitz, Chief US Economist. As we have been saying flatter is not an inversion. At this point in the cycle a 26 basis point spread between the two-year and 10-year Treasury yields should be considered “normal” when the Fed is no longer artificially holding down the short-end of the curve to pump liquidity into the financial system and boost credit demands.
The 7% rise in the dollar and fall in China’s yuan since the spring, had hurt the rest of the world with higher costs for imports and more competitive Chinese prices for exports. The worst hit are non-oil EMs, but also slowing are Japan, Asian Tigers and the Eurozone. The dollar’s elevation also means the US economy is slowing sharply, and that stock markets are undermined says Charles Dumas, Chief Economist at TS Lombard.
If you take the Fed’s “dot plots” at their word, three or four more hikes in 2019, after raising rates in December would seem to be the order of the day, says Steve Blitz, Chief US Economist. There is, of course, an inherent disconnect between the Fed continuing to put out these forecasts and the evolving economic outlook.
Discussion of Brexit outcomes risks missing the important point that, leaving aside the remote possibility of a ‘Remain’ victory in another referendum, this saga will not be resolved before the next scheduled UK election. Christopher Granville, Managing Director EMEA & Global Political Drivers, highlights the implications of this for sterling and the UK economy.
Markets are wrong to expect typical China credit easing, says Rory Green, Economist, China and South Korea. Xi Jinping is not panicking and we expect stimulus measure to continue along existing modest lines. Domestic debt levels and the likelihood of a protracted China-US confrontation necessitate sustainable stimulus measures to support short and long term growth.
We reckon the US will end up imposing 25% tariffs on almost all imports from China, says Ollie Brennan, Senior Macro Strategist. At TS Lombard's September seminar we surveyed clients, most of whom thought there would be further trade war escalation. But US stock markets have continued to make new highs. We discuss why we think this is happening and what triggers to look out for over the next few months.
India is in the spotlight, but high oil prices add to the risks facing South Africa, Turkey and Indonesia, says Jon Harrison, Managing Director, EM Macro Strategy.
All this discussion about curves is disingenuous on the Fed’s part, says Steve Blitz Chief US Economist. Negative curves do create recessions because they shift incentives away from lending, just as the Fed uses a positive curve to incentivize lending coming out of recession. A flatter curve is normal and conducive to growth. When and if the Fed chooses to chase inflation in this cycle and thereby sends policy rates above two-year yields, a recession will begin in six to 18 months.
Trump has a record net negative rating but the good news for him is that deterioration is relatively minor in comparison with past Presidents, says Steve Blitz Chief US economist. At the time, there is near record positive sentiment about the economy. Given how the path to the House majority is through whiter, better-educated, more affluent districts, we see the Democrats managing to eke a small majority in the House and failing to take control of the Senate. The fireworks begin after the election, between Trump-loyalists and the rest of the Republican party.
The Fed is on the trajectory of raising policy rates to match up with real growth in the economy. What could stop-out the upward march is market concerns over the impact of Trump’s trade tactics on growth. If market rates stall out, so too will the Fed’s upward trajectory for policy yields, says Steve Blitz Chief US Economist.
The evident economic difficulties that have hit Turkey and Argentina this year have so far been viewed by markets as largely confined to those two countries, with limited spillover potential to other EMs. What has changed is Brazil, says Larry Brainard, chief EM economist. The likelihood of a market friendly outcome in the 7 October Brazilian election first-round has receded, which has the potential shock markets out of their complacency about the prospect for essential fiscal reform. At the same time, fallout from the steady exit from QE on the part of the Fed and ECB affects EMs via tighter liquidity, and Trump’s Trade War is about to enter what could be its most economically damaging stage yet.
As the trade war risks morphing into a currency war, we downgraded our CNY stance from 0 to -2 this month. Andrea Cicione, Head of Strategy, and Ollie Brennan, Senior Macro Strategist discuss the downgrade and its knock-on impact on USD and on US stocks and also highlight where they reckon trade-war risk is not in the price.
The currency crisis in Turkey keeps getting worse. The hard-landing that our EM team has been forecasting looks increasingly likely to morph into a crash-landing. With Europe’s large exposure to Turkey through banking sector flows, investors are increasingly worried about the fallout as the crisis unfolds. We explain through charts the direct and indirect exposure of European lenders. Some key conclusions by Shweta Singh, Managing Director Global Macro, are:
• European banks are some of the most vulnerable to Turkey’s currency crisis
• Direct financial linkages are large, but the indirect exposure is much bigger
• Spanish lenders are most vulnerable, followed by French and Italian lenders
• The exposure is concentrated in some banks with relatively thin capital buffers
• Yet, the fallout from Turkey does not appear systemic at this point
As the trade war situation has now escalated we now see this as a key political shock. We expect China to retaliate vigorously to any fresh US import tariffs and see the likely battle ground as Foreign Exchange. China’s probable response would be to slash the exchange rate putting enormous pressure on a wide variety of countries and resulting in a major hike in the dollar. An FX War would certainly be damaging for stocks, perhaps bonds too, says Charles Dumas, Chief Economist at TS Lombard.
Despite a nominal depreciation against the dollar, the renminbi has exceeded last year’s highs vs the basket, says Bo Zhuang, Chief China Economist. Xi’s approach of claiming the moral high ground by defending globalization and openness leaves little room for speculation about a major devaluation of RMB in the near term to boost exports. We expect RMB CFETS index to move down towards 95-96 before yearend.
PBoC is moving towards a new interest rate-based monetary policy framework, says Bo Zhuang, Chief China Economist. Banks will increasingly have to fund themselves in the more competitive deposit markets. We expect the PBoC to slash RRRs by another 150bps before yearend. Recent policy moves also suggest a relaxation of unwanted policy tightness along with a less aggressive stance on financial deleveraging. We believe total credit growth will stop falling in 2018H2.
From a calendar perspective, the cycle is certainly old enough. From the perspective of what makes a cycle old – borrowings to finance capital expenditure – the cycle is still relatively young. The current flattening of the yield curve is a sign the economy is finally moving to the middle stages of the business cycle not the end. There is the possibility that by late 2019 the Fed will have pushed rates high enough to begin slowing growth, as it chases rising inflation. If, however, capital spending grows a lot faster than anticipated by the markets and the Fed, this cycle has a lot further to run.
There are increasing concerns about whether disappointing euro-area data since the start of the year reflect a ‘soft patch’ or instead mark the start of a more serious period of economic weakness. We remain optimistic. We think that the underlying picture is of an economy that continues to grow at a healthy pace and still has significant cyclical upside. Some brief points from our quick take on euro area Q1 GDP data realised this morning –
The latest tit for tat measures do not amount to a Trade War, but are nonetheless warning shots, says Jon Harrison, Managing Director EM Macro Strategy. Even if there is no full on Trade War, investors should pay attention to supply chain risks. The US objective of preventing Chinese technological development is unrealistic, which leaves the trade deficit as the most likely way for the US to claim victory. A negotiated settlement remains likely, but in the meantime, the US has yet to formulate a coherent negotiating strategy – and its chaotic negotiating style will ensure that markets remain on edge.
Charles Dumas, Chief Economist comments on:
For market-moving geopolitical risk, Syria matters less than the “geo” element in the US-China ‘trade war’ saga, says Christopher Granville, Managing Director EMEA and Global Political Research. Tariff tit-for-tat is a sideshow compared to US anxieties about Chinese leadership in advanced technology. This will make expected deals tricky to finalise – and precarious. In short, here is a long-term geopolitically-based volatility driver.
Oliver Brennan, Senior Macro Strategist, discusses the US' maneuvering to reduce its trade deficit with major trading partners, and to weaken the dollar. But if the troubles go too far it could induce a risk-off move.
Martin Shenfield, Senior Macro Strategist at TS Lombard views the recent market selloff as a healthy correction. There are 4 fundamental reasons for this:
The short-term risks to the market as rising real bond yields and currency swap basis. The medium-term risk is a genuine bubble developing which central banks will have to clean up.
Steve Blitz, Chief US Economist at TS Lombard on the Fed: Financial Stability Not Inflation to Drive Fed Policy
Steve Blitz, Chief US Economist at TS Lombard talks on US Growth: Tailwind from tax cuts helps Capex lead a strong Growth Year.
Hear what our Chief US economist Steve Blitz and our Senior Macro Strategist Ollie Brennan have to say about currency markets, the impact of the Trump tax cuts, and offshore dollar liquidity.
Larry Brainard, Chief Emerging Markets Economist, highlights our best calls from 2017 as well as what to expect in 2018.
Charles Dumas, Chief Economist, on TS Lombard's outlook for 2018.
TS Lombard was formed in September 2016 following the merger of Lombard Street Research and Trusted Sources.
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