What to look for from China this week

Market attention returns to China this week, with markets there opening after Chinese New Year Holidays.  US/China trade talks will dominate attention, with China’s Vice Premier Lie Hu meeting with US Treasury Secretary Mnuchin and Trade Representative Lighthizer in Beijing.  Tariffs are scheduled to be raised from 10% to 25% on $200bn worth of Chinese exports to the US on March 2.  If talks do not succeed it will act as another blow to the world economy.

The fact that US President Trump has said that he won’t meet China’s President Xi Jinping before March 1 suggests elevated risks of a no deal though both sides.  Moreover, US officials will be wary of being seen to give in to China given the broad based domestic support for a strong stance against China, suggesting that they will maintain a tough approach.  Even so, there is a huge incentive to arrive at a deal of sorts even if structural issues are left on the back burner.

At a time of slowing global growth and heightened trade tensions China’s January trade report will also be scrutinised this week.  Market expectations look for a sizeable 10.3% y/y drop in imports and a 3.3% y/y fall in exports.   The risks on imports in particular are skewed to the downside given the weakness in exports data from some of China’s trading partners in the region including South Korea, Taiwan, Singapore and Vietnam.  A weak outcome will result in a further intensification of concerns about China’s economy.

Another focal point is the direction of China’s currency (CNY).  As trade talks continue this week it is likely that China maintains a relatively stronger currency stance via stronger CNY fixings versus USD and stronger trade weighted (CFETS CNY nominal effective exchange rate).  As it is the CFETS index is currently around its highest level in 7 months.  Of course, if trade talks fail this could easily reverse as China retaliates to an increase in US tariffs.

 

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All Eyes On US/China Trade Talks

A major focus for markets next weeks is the US/China trade talks in Washington.  After the US reportedly turned down an offer of preparatory talks this week talks will begin on Monday, with China’s Vice Commerce Minister, Vice Finance Minister and central bank, PBoC governor.

It is unclear who on the US side they will meet, but the idea is to prepare the ground for the heavy weight talks between US Trade Representative Lighthizer, US Treasury Secretary Mnuchin and China’s top economic official Liu He, from Jan 30 to 31.

Both sides need a win on trade and markets are pinning their hopes on some form of a deal. The reality is that they are still very far apart on a number of issues.  As highlighted by US commerce secretary Ross, a trade deal is “miles and miles” away.

The easier issues on the table are increased purchases of US goods by China, something that China has already said they will do, in order to help reduce the record Chinese trade surplus with the US.  The tougher issues are more structural, including forced technology transfers, state subsidies, discrimination against foreign companies, regulations on intellectual property etc.

Not only is the US determined to gain China’s agreement on the above issues, but is also looking to find ways to ensure compliance monitoring.  However, China does not believe that foreign companies are transferring technology to Chinese companies, while they have already offered measures to increase access to foreign investors.  Overall, this means there is little room for negotiation.

In any case with just over a month left before the March 1 deadline that President Trump has set before he imposes increased tariffs of 25% on around half of Chinese exports to the US, there is little time to thrash out a deal on the key structural issues that would likely satisfy the US administration.

The likelihood is that negotiations will not be completed, especially on structural issues, leaving markets very little to be excited about.  While both sides may leave the talks, claiming a degree of progress, this will not be sufficient to allay concerns.  Risk assets will look vulnerable against this background.

 

Positive Start To The Week

Markets start this week on a positive note in the wake of 1) the strong US December jobs report, which revealed a larger than expected increase in non-farm payrolls of 312k and decent growth in average hourly earnings of 0.4% m/m, 2) positive comments by Fed Chairman Powell on the US economy, while noting that the Fed will be patient if needed and 3) the 1% banks’ reserve requirement (RRR) cut by the PBoC in China.   Powell’s comments will also weigh on the USD this week against the background of long USD positioning, helping EM currencies.  He speaks again on Thursday.

Events this week will be key in determining the tone for markets further out, however.  In the UK parliament returns after its holiday break, with debate on the “meaningful vote” taking place over the week and markets will watch for any sign that May’s proposed deal gains traction.  The FT reports that she is facing a fresh challenge, with senior MPs signing up to block the government from implementing no-deal measures with parliament’s consent. x

China’s RRR cut (announced on Friday) will help to put a floor under risk sentiment.  The total 1% easing will release RMB 800 bn of liquidity, according to the PBoC, ahead of the Chinese New Year. A cut was widely expected in the wake of weak data and strongly hinted at by Premier Li prior to the PBoC announcement. The PBoC already cut the RRRs four times in 2018, and more should be expected to come, including MLF and other targeted easing.

Focus will centre on trade talks between US and Chinese officials beginning today.   Both sides are under pressure to arrive at a deal in the wake of pressure on US asset markets and weakening Chinese growth, but the differences between the two sides remain large. The US delegation will be led by Jeff Gerrish, the deputy trade representative and he is joined by officials from the agriculture, energy and treasury departments, suggesting that talks will centre on more detailed content.

Looking For The Silver Lining

As the end of the year approaches it would take a minor miracle of sorts to turn around a dismal performance for equity markets in December.   The S&P 500 has fallen by just over 12% year to date, but this performance is somewhat better than that of equity markets elsewhere around the world.  Meanwhile 10 year US Treasury yields have dropped by over 53 basis points from their high in early November.

A host of factors are weighing on markets including the US government shutdown, President Trump’s criticism of Fed policy, ongoing trade concerns, worries about a loss of US growth momentum, slowing Chinese growth, higher US rates, etc, etc.   The fact that the Fed maintained its stance towards hiking rates and balance sheet contraction at the last FOMC meeting has also weighed on markets.

A statement from US Treasury Secretary Mnuchin attempting to reassure markets about liquidity conditions among US banks didn’t help matters, especially as liquidity concerns were among the least of market concerns.  Drawing attention to liquidity may have only moved it higher up the list of focal points for markets.

The other major mover is oil prices, which have dropped even more sharply than other asset classes.  Brent crude has dropped by over 40% since its high on 3 October 2018.   This has helped to dampen inflationary expectations as well as helping large oil importers such as India.  However, while part of the reason for its drop has been still robust supply, worries about global growth are also weighing on the outlook for oil.

But its not all bad news and markets should look at the silver lining on the dark clouds overhanging markets.  The Fed has become somewhat more dovish in its rhetoric and its forecasts for further rate hikes.  US growth data is not weak and there is still sufficient stimulus in the pipeline to keep the economy on a reasonably firm growth path in the next few months.  Separately lower oil is a positive for global growth.

There are also constructive signs on the trade front, with both US and China appearing to show more willingness to arrive at a deal.  In particular, China appears to be backing down on its technology advancement that as core to its “Made In China 2025” policy. This is something that it at the core of US administration hawks’ demands and any sign of appeasement on this front could bode well for an eventual deal.

RBI Governor Patel’s resignation hits India’s markets

Reserve Bank of India (RBI) governor Patel resigned yesterday in a surprise move.  Patel cited “personal reasons” but it is likely to have much to do with tensions between the government and RBI.  Although it had appeared they had reached a compromise, it appears that Patel didn’t feel that the RBI came out of it well. Patel’s resignation came just ahead of a RBI board meeting on Friday, and has hit India’s markets.

The timing is not good.  Patel’s resignation comes just ahead of the release of five state election results today, with Madhya Pradesh, Rajasthan, Chhattisgarh, Telangana and Mizoram, all having gone to the polls. Exit polls have suggested a weaker showing for PM Modi’s BJP, with Madhya Pradesh and Rajasthan likely to deliver blows to the BJP.  The outcome of the elections will be scrutinised for clued ahead of next year’s general elections.

Issues such as dealing with non-bank financial companies (NBFCs), implementation of the Insolvency and Bankruptcy code and even interest rate setting, have all been under scrutiny over recent months. How to deal with tightening liquidity has been a source of contention, with the government wanting the RBI to do more to ease liquidity and lending conditions. The RBI pushed back against the government’s request for a
higher payout from central bank reserves.

Although the government has not yet announced a replacement to Patel it will clearly be important that whoever it is, will be seen as independent of the government. The RBI under Patel has been seen to be overly hawkish by some and in this respect the government may be able to install someone who is more open to easing both monetary policy and lending constraints.The next steps will be important.

If the government nominates someone to replace Patel who is seen as more susceptible to political influence it could have much further and deeper negative consequences for India’s markets.  If however, the government is seen to nominate someone who can maintain the independence of the RBI it will bode well for confidence in Indian assets.

Calm after the storm

After yesterday’s carnage, global equity markets have recovered some of their poise. Whether this is a pause before another wave of pressure or something more sustainable is debatable. It appears that US equities are finally succumbing to a plethora of bad news.  Higher US yields have driven the equity risk premium lower.  Also there’s probably a degree of profit taking ahead of the onset of the Q3 US earnings season.

At the same time valuations have become increasingly stretched.  For example, the S&P 500 price/earnings ratio is around 6% higher than its 5 year average while almost all emerging market price/earnings ratios are well below their 5 year averages.  While strong US growth prospects may justify some or even all of this differential, the gap with emerging markets has widened significantly.

While US President Trump blames an “out of control” US Federal Reserve, it would have been hard for the Fed to do anything else but raise policy rates at its last meeting.  If the Fed didn’t hike at the end of September, bond yields would like have moved even higher than the 3.26% reached on the 10 year US Treasury yield earlier this week as markets would have believed the Fed is falling behind the curve.   However, as US yields rise and the equity risk premium reacts, the opportunity cost of investing in equities rises too.

In the FX world the US dollar could succumb to more pressure if US equities fall further but as we saw yesterday, USD weakness may mainly be expressed versus other major currencies (EUR etc).  Emerging market currencies continue to face too many headwinds including higher US rates and tightening USD liquidity, as well as trade tariffs.  The fact that emerging market growth indicators are slowing, led by China, also does not bode well for EM assets.  Unfortunately that means that emerging market assets will not benefit for the time being from any rout in US assets despite their valuation differences.

China easing as data softens

China’s decision over the weekend to cut the required reserve ratio (RRR) by 100bp (effective Oct 15), the fourth cut this year, will inject around CNY 750bn in liquidity into China’s money markets. The decision to ease comes in the wake of a run of recent soft data.   There should be no big surprise.  China is reluctant to ease policy via a policy rate cut to avoid fuelling any increase in leverage and therefore continues to embark on targeted easing in the form of RRR cuts.

It is likely that further RRR cuts in addition to fiscal stimulus are in the pipeline to cushion the slowdown in the economy.   Indeed, growth was already slowing before the US tariffs impact bites and will likely slow further in the months ahead as the impact of tariffs has a greater effect.   Recent forward looking data including the official and CAIXIN purchasing managers’ indices (PMIs) of manufacturing confidence have softened, with the exports component of the PMIs dropping significantly.

Such cuts will weigh on China’s currency, CNY/CNH and a continued spot depreciation versus USD is likely.   After its sharp decline in June/July FX the PBoC has succeeded in stabilising the CNY (in trade weighted terms) however.   Any decline in foreign exchange reserves has been limited as reflected in the latest FX reserves data, which revealed that FX reserves dropped by $22.7bn only in September, suggesting that as yet there have not been significant capital outflows (ie panic) from China and limited need for FX intervention to support the CNY.

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