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US-China empire building, Eurozone stability, Brexit - DFX Key Themes

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JohnDFX

The United States and China Jostling for Economic Supremacy

The world’s largest economies are starting to update on the status of their health. And, though it may not seem to be the case in these speculatively charged markets, financial performance relies heavily on a healthy global expansion. This past Friday, China reported its third quarter GDP reading. The 6.5 percent clip would be an enviable pace for most of the developed world, but for this debt laden country, this is slowing to a pace that is more likely approaching ‘stall speed’. In historical context, the reading represented the slowest clip of expansion for the country in 9 years – a period that was plagued by a global recession that had in turn prompted the government to plow funding towards infrastructure spending to buy it more time. Time is crucial for the world’s second largest economy. It needs to be balance its relatively rapid pace of growth with financial stability long enough that it can solidify its position as one of the dominant economic superpowers. 

For decades, the country has relied on the rapid growth that is borne from trade, financing, speculative appetite and practices that emerging market countries often utilize that are considered unacceptable among their developed counterparts. That said, it is odd that the second largest economy is still classified as an ‘emerging’ market and one of the roots of contention from the United States and others. Over the past three to four years, China’s intent and timeline have become more clear. Having avoided a the Great Recession, they had seen their standing in the global economy move up to a more stable plateau. To ensure they secured their position, the government has attempted to turn towards a more accepted growth plan and to reduce capital borders in order to become a full-fledged member of the globalized community. Without interruption, that initiative would have succeeded. Unfortunately for the Politburo, the Trump Administration has exerted enormous pressure on the country and threatens to undermine growth and/or tip the financial stability balance to create a permanent hurdle. 

The question of how successful this effort to stymie the economic engineering effort will be is only one facet of the equation, there is also the question of how much fallout the US itself will suffer along the way. The United States’ effort to bring trade pressure against its largest economic peer will come with an economic cost to the instigator, which they are attempting to offset by fostering investment and business growth through tax cuts and fiscal spending – a combination that breaks norms of its own (deficit control). In the week ahead, we are due the United States’ 3Q GDP update. This is the period through which the trade war truly ramped up, and it will be used as an evaluation of whether the polices are boon or burden at home. Should this and other more timely economic readings head lower, buoyant sentiment readings over the past year will start to flag and make a self-fulfilling prophecy of financial concern. 

The Euro’s Fundamental Path is Growing More Complicated 

For the most part, the Euro has spent the past 18 months either in a fundamentally enviable position or simply a neutral bearing that could take advantage of weaker counterparts. Economic activity has been slow but steady with members bearing extraordinary austerity following the Eurozone sovereign debt crisis finally turning a corner. Further, the initial threat of the region having to pursue the same costly economic war against the United States was averted when EU President Juncker agreed with US President Trump to avoid further tariffs so long as both sides continued to negotiate. Meanwhile, the mere anticipation of a rate hike from the European Central Bank leveraged the kind of speculative front-running appeal for the Euro through much of the past year that so closely mirrored the Dollar’s own charge in 2014 and 2015. That passive state of speculative appeal is starting to falter however. While growth readings still seem to be following a stable path, the commitment to slower growth to achieve fiscal improvement through austerity is starting to break down. Populism is spreading across the continent. 

Chief concern in the evaluation of Euro-area conviction is Italy. The country’s government has applied pressure and backed off in regular tide of ebb and flow; but through these phases, ever increasing the tension. It seems we have reached the point of no return where rhetoric will no longer be enough to satisfy markets. Heading into this past week’s EU Summit, the leadership of the Italian government made clear that it intended to rebuff budget restrictions to support growth and fulfil campaign promises. There was no mistaking the Union’s perspective on Italy’s intended path: they said the spending and deficit projections in their plans were unacceptable. This standoff remains unresolved, but the financial markets are starting to pull back to curb their exposure to the risk. The FTSE MIB is suffering more acutely than its large counterparts and Italian sovereign bond yields are climbing rapidly. A 10-year yield spread of over 400 basis points over the Germany bund equivalent is considered a level akin to serious financial pressure.

 We were just above 300 basis points to close out this past week, but that was before the news after the close that Moody’s had downgraded the country’s credit rating a step to Baa3. That will have an inevitable impact on funds that have to abide credit quality when dictating their exposure. In the week ahead, we have another assessment of Italy’s financial condition coming from Standard & Poor’s. This fundamental impact on the Euro is not the only theme competing for influence. Monetary policy is another fundamental strut that could buckle or hold the currency strong through the growing pressure. There is no change expected from the gathering Thursday, but there is growing concern over the internal and external risks for the Eurozone. If they cool expectations for the first hike coming mid-2019, there is still premium for the Euro to give up. A further complication to consider: if the Euro drops materially, expect the Trump Administration to raise its pressure on the regional economy. 

Brexit Risk Jumps after EU Summit, Rumor of Border Breakthrough, Protests and New Credit Ratings 

The Brexit countdown is taking on a Edgar Allen Poe-level resonance. The European Union summit this past session was specifically targeting discussion between the UK and 27 leadership to see if they could make a high-level breakthrough on the divorce proceedings. The primary hold up at the end of the gathering remained the border issue and the complications that it invites. It may seem that there is plenty of time to negotiate with a little more than five months until the official split, but there is considerable work to do in passing the proposal through so many different governments and working out the technical aspects thereafter. So long as this situation is unable to pass the critical step of an acceptable draft agreement between both sides, the Sterling is likely to see steady retreat as capital funnels out of the country to avoid the uncertainty facing London’s financial center specifically. With the risks growing, the attention on progress will intensify. 

With that said, there seemed a possible breakthrough in the closing hours Friday when it was reported that Prime Minister May was prepared to drop their Brexit demands on the Irish border issue in order to earn a breakthrough. Such a move would likely earn the ire of Brexiteers who would balk at likely permanent participation in the EU’s customs union. It remains to be seen if the UK’s government would back such a appeasement, but it doesn’t seem enough for many Brits. Over the weekend, a protest in London calling for a second EU referendum drew reportedly between 600,000 and 700,000 participants – one of the largest in the capital’s history. It is unlikely however that the government will return to the polls on the issue unless there are a number of political turns that force the issue. Ahead, we will have to keep a very close eye on the headlines to see what transpires in the political environment in England as well as between the UK and EU. That doesn’t mean though that there aren’t any meaningful milestones on the docket to mark on our calendars. 

At the very end of the coming week – after the close Friday – we are due two credit rating updates on the United Kingdom from Standard & Poor’s and Fitch. These groups have generally maintained a wait-and-see perspective until it became clear that there would be a compromise scenario or a crash out. However, time is a factor that they can no longer ignore in this equation. With each week that passes without a breakthrough, the economic and financial ramifications deepen. More stark warnings are likely if there is not a confirmation of the border issue and a downgrade is not impossible.  

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