In a surprise move, the United States is now fighting a full trade war on two fronts as of this past week. With the path to a US-China compromise still lacking any clear hand holds, US President Donald Trump announced a wholly unexpected economic move against neighbor Mexico this past Thursday evening. According to his tweet, the United States would charge a 5 percent import tax on ALL Mexican goods coming into the country as of June 10th. He further made clear that this was move not in retaliation for trade issues – in fact conditions had seemed to improve significantly on that front with the US dropping the steel and aluminum taxes on both of its direct neighbors in a bid to push through the USMCA agreement. Instead, Trump said that this move was in response to his administration’s frustrations with illegal immigration from Mexico into the US. This political move drew serious consternation from a number of officials and institutions. Aside from the obvious Mexican bewilderment and condemnation; it was reported that Trump’s senior advisers (Mnuchin and Lighthizer) had argued against the move, Congressional members on trade and finance questioned the motivations and the economic impact and business groups in the US moved to bring legal action in a bid to prevent the inevitable hike in their supply chain costs (GM for example produces an estimated 30 percent of the cars it sells in the US in Mexico and could absorb a $6.3 billion hit).
We are starting to see some of the disparate systemic themes that have individually pulled at the markets – trade wars, political risk, growth concerns – begin to converge. There is little doubt that the growing chants of impeachment from some portions of the Democrat party are pushing the President to a more aggressive stance with domestic and foreign policies. Looking to secure a ‘win’, he is attempting an alternative route to curb illegal immigration to circumvent the roadblock in Congress. This solution, however, carries serious threat to growth and diplomatic relations; and the possibility of an alternative source of support via an a delicate infrastructure spending program negotiation which would rely heavily on Democrats seems a non-starter.
As this new fissure grows, it is important not to forget the extraordinary and expanding risk from the US-China row. It has been a few weeks since the US hiked the tariff rate on $200 billion in Chinese imports from 10 to 25 percent and China’s matching retaliation on $60 billion in US imports (which went into effect June 1). The mood has only further soured since this salvo. The banning of Huawei – China’s largest telecommunications company with a global presence – has lead to considerations of a response through Apple, using rare earth materials and reports of a recent draft on US companies that could be partially or completely blacklisted. Theoretically, the US is counting down to an expansion of the goods it is taxing to encompass all of China’s imports, but that timeline doesn’t look solid. The US and Chinese Presidents are due to meet at the end of the month, but a lot can happen between now and then. What’s truly worrying is that both sides are increasingly favoring escalation in a bid to break their counterpart’s will – a game of economic chicken.
Ignoring the Fallibility of the Dollar’s Reserve Status
There is general acceptance that the Dollar is the world’s most liquid currency backed by the largest economy and market. That is easily confirmed through data, but with these statistics comes a level of undeserved assumption. Because the country is a superpower and the use of its currency around the world accounts for nearly two-thirds of all global transactions, it is assumed by many on faith that these standings are permanent. I would venture a guess that the British felt the same way 100 years ago, the Spanish 300 years ago or the Romans two thousand years ago. Looking far enough into the future, the US Dollar will not be the principal means of transaction, whether that leads to a direct and singular counterpart (Yuan?), an aggregate (the long-fabled effective SDR) or the era of the blockchain. Regardless of the next epoch of money, there was an inevitable move towards evolution as the rise of global trade and spread of wealth around the world raised issues with transacting through third parties.
The bottleneck risks from a common currency were further exposed in the last two financial crises. The excess leverage produced by the Dot-com bust was particular acute in the United States which witnessed a convergence of economic strength, favorable policy and supportive regulation to land on an investment phenomena. When the excess peaked and started to cave in on itself, the fallout was transmitted to the rest of the world. The following financial crisis in 2008 was even more obvious in its amplification of a US-originated problem (subprime housing) tipping the global dominoes until an unprecedented response from the world’s policymakers was the only feasible means of restoring stability. Many governments and institutions in the aftermath of this worldwide crisis stated some level of need to mitigate future contagion risks by reducing their unchecked exposure where possible – including the dependency on the US Dollar. Yet, the haste to make this shift was throttled initially by extreme monetary policy creating fragility in domestic financial paths while the economic expansion also encouraged feet dragging. That landscape has shifted however in recent years with a slowdown in global growth that looks natural in the waning light of the cycle while barren monetary policy stores looks increasingly incapable of holding back any storm tides. It is in this troubling convergence that populism has taken hold. Policies that favor domestic growth at the expense of shared expansion lowers the aggregate potential for the global economy but it sells well to the electorate. The Trump White House has certainly seized on that fervor with the President pushing for trade policies that look to correct perceived imbalances.
If the US kept its fight isolated to China, there would be little outcry from other developed and developing economies that have felt the Asian giant’s policies unfair. That said, the US has embarked on a global fight with the metals tariffs from last year, the emergence of the Mexican tax, lingering threats made against Europe and the lurking consideration of a global auto import tariff. When the world’s largest consumer raises barriers, it can be difficult to retaliate in a meaningful economic way. However, when there are many countries that share the burden and willing to cooperate in order to ease the pain – and deliver some punishment – there is greater capacity to retaliate as a group. A plan to pullback on economic ties to the United States translates into a diminished use of the US Dollar which in turn reduces the need to hold the country’s currency and risk-free debt as a financial balance. That accelerates the seismic tide changes in currency dominance and economic position. Add to that the pressure through forced sanctions (such as the demands to trade partners to stop doing business with Iran) and the need for an alternative route increases further. Even at this pace, it will be a very long time before the Dollar is fully supplanted, but the measurable influence will show through far more quickly.
A Jostle of Growth Data, Monetary Policy and Brexit Ahead
My number one rule for the successful employment of fundamental analysis is to determine which theme or themes will carry the greatest potential influence. It seems intuitive, but many traders will end up assuming far greater weight to every known event – especially those that are prescheduled – than is reasonable. And, when you assume greater influence for every eddy in the market’s stream, you inevitably drown out those factors that are truly market moving. In gauging the fundamental landscape ahead, there are both themes and specific events that hold the potential of significant volatility or trend development if they render the proper outcome. Aside from the dominant force of trade wars, monetary policy will be a substantial influence over the coming days. The most pointed events in this vein will be the RBA and ECB rate decisions. According to overnight swaps there is an approximate 95 percent probability of a rate cut. That degree of discount means an actual cut is likely already priced in, so the Aussie’s response will depend on either the language in the aftermath of the cut or a surprise hold. As for the ECB, they have already made their dovish move a few months back with a hold on any intent for rate hikes and the deployment of the LTROs to compensate for the end of QE. This is a mess of exit from extreme easing and it leaves serious questions about the health of the global economy and financial system. In addition to these two policy calls, we have a host of central bankers speaking including the chiefs of the Fed (Powell), BOJ (Kuroda) and BOE (Carney).
Another collective theme that will find significant prompting ahead will be the general concerns for the state of economic growth. We have received most of the 1Q GDP figures at this point, but Australia is due its own figure. Instead, we will look for more timely metrics that act as good proxy to the big picture. There are a range of monthly PMI stats for May due – though the US and European figures are ‘final’ measures. The US ISM metrics are given considerable credit as are Japan’s quarter capital spending report, the US quarter net household wealth and NFPs data. It is not the concentration for any single economy that matters here but rather the breadth of the statistics that can form a clearer picture of global growth. With the growing interest in market measures like the US yield spread, this stands to be an important theme ahead.
In terms of region-specific event risks that are worthy of our close watch, I will dedicate significant mental energy to following the progression of the Brexit situation for the Pound and the EC-Italy fight for the Euro. on the former, the British and European conversations on terms for divorce are actually still on ice. That is due to the long reprieve afforded the Article 50 extension but also the state of politics in the UK. Prime Minister Theresa May is due to step down on Friday and the leadership battle is clearly underway. The PM’s shortcomings and the EU Parliamentary election results are likely to encourage support for a candidate that is more friendly to using the no-deal outcome to make progress on the separation. That of course means greater uncertainty and preemptive capital flight as the markets await the fog to lift. In Europe, the cohesion among EU members will come under scrutiny with a number of events scheduled around the state of play in Italy. PM Conte was shown strong supporting in the EU Parliamentary elections, and he is looking to pull together the various countries’ nationalist seats. Given their stated policies, a loosening of cohesion to the foundations of what holds the Euro together will be a consequence. Alternatively, the European Community is not simply waiting for the disruption. The group is due to take up its review of Italy’s breaking financial rules, which Deputy PM Salvini recently warned could land Italy a 3 billion euro penalty recently.