Ending a Trade War is a Windfall for Growth?
US and Chinese trade officials met this past week to lay the groundwork for another attempt to push for a breakthrough in the superpowers’ ongoing trade war. These are lower level meetings aimed at finding concessions and terms for which Trump and Xi would eventually sign off on. With over $350 billion in goods from both countries saddled with import taxes, the economic toll the engagement is exacting is starting to show through in data. In the US, trade figures have shown a rise in the deficit and sharp drop in exports to China, costs have risen for a range of goods normally curbed by cheaper foreign production, and confidence metrics have reversed course. The NFIB small business sentiment survey for example has fallen back to the level it stood at during the Presidential election. China’s economic updates have also marked multi-year lows in GDP, industrial production and more. While they are generally all firmly in positive territory, there is likely a ‘premium’ China attributes to its data.
A growing number of institutions and economists are warning that the world’s second largest economy may be on the path for a stall and/or the collapse of its excessive low-quality debt market. The Trump Administration seems to have gotten whiff of at least one of those analyses as they have made repeated remarks about the strained position of their counterpart’s health when justifying their steadfastness. Officials jawbone (or talk a market or asset to a higher or lower level) for a number of reasons. Some central banks have attempted to talk down their currencies (BOJ, RBA, RBNZ), the Fed turned it into a tool (forward guidance) and economic leaders are constant cheerleaders for their own economies and markets. Yet, it is highly unorthodox, to say the least, for leadership in one of the largest economies in the world to stoke fear in a global peer. And yet, that is what President Trump, Chief Economic Adviser Kudlow and Treasury Secretary Steve Mnuchin have done over these previous months.
If neither of these countries were to blink, it would inevitably tip a financial or economic crisis for at least one of them. And, if one slips into the abyss, it will pull the other in with it. Perhaps this recognition is starting to sink in, or the ‘game of chicken’ is simply too dangerous now with the US equity markets sliding with the President starting to take some of the blame. It has been reported that Trump has told his team that he wants a deal to be struck to help stabilize the markets. It wouldn’t strain belief at all to imagine this was a serious demand from the President. There were some boilerplate remarks of optimism this past week which were largely overlooked, but the Chinese Vice Premier’s planned visit on January 30-31 may indicate they may be close to resolving their issues. It is worth evaluating a future where a resolution is struck. Yet, putting the scenario to the test, would pulling out of a destructive economic policy in turn translate into a windfall of growth and investment opportunities? No. It would remove a manufactured threat that has already inflicted permanent damage and would allow the focus to shift to a host of other unresolved issues. Preventing further damage is the best the two sides can hope for in this situation.
The Lasting Effects of a Record Breaking US Government Shutdown
We have broken a record over the weekend. As of Saturday, the partial shutdown of the United States government surpassed 21 days to count for the longest closure on record (surpassing the 1995-1996 stretch during the Clinton era). This is not a record to be proud of as it will translate into weaker economic growth, a drop in sentiment and the complicated progression of lower sovereign credit quality. The general economic implications are perhaps the easiest to envision. Government supported industries (such as airlines) will see their costs and revenues suffer while the 800,000 federal employees that are furloughed will not be paid. It is estimated that every week, the US economy will lose between 0.05 and 0.1 percentage points of growth owing to the situation.
Even three weeks of that is significant given the state of economic conditions when this factor is excluded. Perhaps a (small) silver lining was the strong bi-partisan vote by Congress to provide backpay for those same federal employees – though that doesn’t offset the ultimate pain. Sentiment is another victim of this situation. We have seen consumer, business and investor sentiment sink the past months for a few reasons, but this shutdown is no doubt a contributing factor. If the country can’t come to an agreement on a basic stop-gap funding, what is the probability that they will be able to fulfill the infrastructure investment plan touted ever few months for years? My greatest concern for this situation is the damage it does to the United States credit quality. All of the three majors have issued some sort of warning on pursuing this path, but the most recent official statement came from Fitch this past week. There are those that don’t believe a downgrade is possible for the US sovereign rating, to whom I say it already happened when Standard & Poor’s cut the country one step to AA+ back in 2011.
There are far more that believe it wouldn’t matter if another cut was made – and they would use the 2011 example as their evidence. When S&P cut the US rating, there was a distinct and severe move in credit and risk assets. Eventually, the market’s did stabilize and push the concern to the background because exceptions were made for the event. Even though many covenants only allow for top credit rated assets as ‘risk-free’, most agreed to make accommodations so as not to completely upset a financial system that relies heavily on the haven status of T-notes. Add a second, third or more cuts, and it looks less and less like a one-off. It registers as an absolute need to diversify. It may be hard to appreciate how systemically important this is, but the tipping point could fundamentally change the financial system and US standing in the world.
Breakthrough or Not, A Brexit Vote that Can Charge the Pound
We are just over 75 days away from the official date that the United Kingdom is due to separate from the European Union. If all that was necessary was to come to terms with an agreement between the two parties on their relationship post-split, this would perhaps not be so frightening. Instead, there is considerable preparation that needs to be done before that date even comes around. Most would agree, that the time table for an accord and steady transition was some months ago. Now, with each passing week that infighting persists, the consideration and appreciation of painful scenarios increases. We have the opportunity to finally find agreement from the UK’s side this week. On Tuesday, Parliament is set to vote on the Prime Minister’s Brexit proposal. You may recall that a vote was called on a previous plan, but May called it off at the last minute when it became clear that it would be handily defeated.
It is nowhere near as clear time around that the MPs will deal the PM another rejection, but that is the leading consensus. If the proposal is accepted and the UK can return to the table with the EU, it would certainly be construed as lifting a significant weight off the Sterling’s shoulders. There are still a host of unknowns including cross boarder investment, financing and banking liquidity; but at least there will be a viable path the markets can follow. If however, she is rejected, the markets will grow increasingly agitated, fearful that an accident will happen. Following recent votes, Parliament passed law that if the proposal was rejected, the government would have to produce a ‘Plan B’ within three sessions (Monday as Friday is closed) rather than the standard 15. They had also previously ruled that if the country were heading for a ‘no-deal’ Brexit, that Parliament would have more say over the ultimate path.
As it stands, there seems less risk of a crash out; but the hurdle for an agreement between the government and parliament remains very high. Uncertainty is a bearish pressure on the Sterling. An agreement would remove a considerable amount of that fear and perhaps help stoke a recovery. Looking at the CME’s Pound Volatility Index, fear remains troublingly high relative to other currencies and even other assets. Outcome or no, be prepared for Pound volatility.