Combating Recession Risks

Following a volatile last week market attention will remain on trade tensions, measures to combat the risks of recession and will turn to the Jackson Hole central bankers’ symposium at the end of the week. The inversion of the US yield curve has led to growing expectations that the US is heading into recession and has spurred inflows into bonds. As a result US Treasury yields continue to fall and the stockpile of negative yielding debt has risen to well over $16 trillion. While economic data in the US remains relatively firm, the picture in the rest of the world has deteriorated sharply as reflected in weakening German and Chinese trade, against the background of a weak trade backdrop.

There have been some mixed headlines on trade over the weekend – Larry Kudlow, Director of the National Economic Council under President Trump, said yesterday that recent phone calls between US and Chinese trade negotiators had been “positive”, with more teleconference meetings planned over the next 10 days.  Separately US media reported that the US commerce department was preparing to extend a temporary license for companies to do business with Huawei for 90 days. However, Trump poured cold water on this by stating that “Huawei is a company that we may not do business with at all”.  A decision will be made today.

In the wake of growing expectations of recession, attention is turning on what will be done by governments and central banks to combat such risks.  The Jackson Hole meeting on Thursday will be particularly important to gauge what major central bankers are thinking and in particular whether and to what degree Federal Reserve Chairman Powell is planning on cutting US rates further.  We will be able to garner further evidence of Fed deliberations, with the release of the Fed FOMC July meeting minutes on Wednesday.

While central bankers look at potential monetary policy steps governments are likely to look at ways of providing further fiscal stimulus.  Kudlow stated that the US administration was “looking at” the prospects of tax cuts, while pressure on the German government to loosen is purse strings has also grown.  Even in the UK where a hard Brexit looms, the government is reportedly readying itself with a fiscal package to support growth in the aftermath.   Such news will come as a relief to markets, but recession worries are not likely to dissipate quickly, which will likely keep volatility elevated, and maintain the bias towards safe haven assets in the weeks ahead.

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Taking Stock

As we get to the end of the week trade headlines are still continuing to capture most attention. However, it has been increasingly difficult for anyone to guess what comes next in the long running trade war between the US and China.  Most investors and analysts think the trade war will persist for a long while but President Trump tweeted that it would “fairly short” and that talks with China were on track to resume next months.

Markets are not convinced and becoming increasingly desensitised to the news flow over trade, which seems to shift from good to bad news on a regular basis.  For example, the decision to delay the imposition of tariffs on around $156bn of Chinese exports until December failed to fuel a bounce in US equities. The decision has also left Chinese officials unperturbed.  China has vowed to retaliate, stating that the US had “deviated from the correct track of consultation and settlement of differences”.

The situation in Hong Kong is adding another dimension to the trade war.   President Trump has said that believed China’s President Xi could “work that out in a humane fashion” while in contrast many in the US Congress are pushing for a stronger stance. The eventual reaction will depend on whether demonstrations persist and how China moves going forward.

Hong Kong’s economy and markets are under pressure too, unsurprisingly. The economy is now facing the prospect of a technical recession, with growth in the third quarter likely to be negative following a -0.3% q/q drop in GDP in the second quarter.   Industry bodies have revealed that tourism has dropped sharply, with double digit declines in hotel occupancy and sharp reductions in purchases by mainland tourists. The number of tour groups from mainland China have declined by close to 30% in June compared to the average this year while hotel occupancy rates are expected to drop 40% y/y in July.

Fed’s Powell, China trade, Japan-Korea tensions

Markets cheered Fed Chair Powell’s testimony to the US Congress this week, with Powell all but confirming that the Fed will cut interest rates in the US by 25bps later this month.  Powell’s comments yesterday and Wednesday highlighted the risks to the US economy including the threats from persistently low inflation, worsening global trade outlook, weak global growth, and possibility that Congress does not raise the debt ceiling, even as he saw “the economy as being in a good place”.  His comments highlight that any easing this month, would be an insurance cut, but markets are expecting the Fed to ease further in the months ahead, with at least one more priced in by the market this year.

Meanwhile attention remains focused on trade tensions. On this front, president Trump complained overnight that China hasn’t increased its purchases of US farm products, something that he said China had pledged to do at the G20 meeting when he met with China’s President Xi.  Data released yesterday showed that Chinese purchases of US agricultural good have actually slowed.  According to the US department of Agriculture China bought 127,800 metric tons of US soybeans last week and 76 tons of US pork, both sharp reductions compared to previous weeks.  Chinese media for its part says that the country had not committed to increasing purchases, but rather that Trump had hoped China would buy more goods.  Clearly, there is has left plenty of confusion about what was actually agreed upon.

Trade tensions have also risen in Asia, with tensions between South Korea and Japan intensifying.  Japan is implementing restrictions on exports to Korea of chemicals essential for chip making in retaliation over a ruling by Korea’s Supreme court awarding damages against Japanese companies for forced labour during the second world war. Japan says that such claims were settled under a 1965 treaty and is seeking arbitration. Korea evidently disagrees. The trade spat could also have widespread implications given the wide range of products that South Korean chips are used in, impacting supply chains globally.  Meetings between Japanese and Korean officials today will be watched for any rapprochement but any near term solution looks unlikely.

Fed’s Powell & China trade data in focus

US jobs data released at the end of last week will diminish hopes of more aggressive policy rate cuts from the Fed FOMC at its policy meeting at the end of the month. Non-farm payrolls rose by 224,000 last month, beating market forecasts, a sharp improvement from the disappointing 72,000 increase in the previous month.

Despite the stronger than expected reading in June, the Fed is still likely to cut interest rates by 25 basis points amid concerns about a loss of growth momentum, trade tensions against the background of low inflation.  Soft US June CPI releases on Thursday this week will likely confirm the subdued inflationary backdrop.

Markets will be able to garner more clues during Fed Chair Powell’s testimony to Congress on Wednesday and Thursday while Fed FOMC minutes from the last meeting will also provide greater detail on Fed thinking.  Both are likely to help confirm expectations of a 25 basis point cut in rates at the next FOMC meeting.

The USD has recovered some if recent losses, helped at the end of last week but the US jobs report.  Further gains are likely to be limited (with the USD index likely to struggle to break 98.0) though much will depend on Powell’s testimony this week.

Also in focus this week will be China’s June trade data.  This data will be scrutinised in particular, for the trade surplus with the US and whether there are any signs of this surplus beginning to narrow.  The data will also give some indications of the health of China’s economy, with another weak print for imports, likely to show further softening in China’s growth momentum. Similarly weaker exports will highlight the softening in demand from key trading partners such as Korea.

Further evidence on the outlook for China’s economy will be seen in the release of monetary aggregates including new loan growth and aggregate financing. Meanwhile, China’s currency continues to remain stable amid the trade truce with the US.

 

US-China Trade Truce Boosts Sentiment

Weekend developments will help set up the markets for a risk on day.  However, any improvement in sentiment will likely be capped. The good news was that the US and China agreed to a trade truce at the G20 summit, President Trump and North Korean leader Kim Jong Un met at the demilitarised zone while separately the EU and Mercosur agreed upon a trade deal in a strong retort against the rising trend of protectionism.

Presidents Trump and Xi agreed to delay the implementation of new tariffs (on the remaining $300bn of Chinese exports to the US) while agreeing to restart trade talks, albeit with no time table scheduled as yet.  The delay in tariffs escalation and restart of trade talks was in line with expectations but concessions on Huawei were not.   Trump stated that US companies can sell equipment to Huawei without giving details on what can be sold while China also agreed to buy more US agricultural goods.

The chances of a US-China trade deal have risen, but it could still take several months before various remaining structural issues (forced technology transfers, state subsidies, discrimination against foreign companies, regulations on intellectual property etc)
are ironed out. The lack of time frame on US-China trade talks, ongoing structural issues, lack of details on what equipment US suppliers can sell to Huawei and a host of data releases, will limit the improvement in sentiment and reduce the likelihood of any near term deal.

Looking ahead, sentiment may be clouded somewhat by the disappointing China purchasing managers’ index (PMI) yesterday, with the manufacturing PMI coming in at 49.4 in June, the same as in May, with manufacturing continuing to contract.  However, markets may be willing to overlook this as trade tensions were likely a prime reason for the continued weakness in manufacturing confidence.   As such, China’s currency CNY and asset markets will likely react positively overall.

The events over the weekend will likely reduce the chances of a 50bps rate by the Fed at their next meeting, but much will depend on upcoming data.   This includes the June US ISM survey today and employment report on Friday.  Markets expect a 160k bounce back in payrolls in June after the surprisingly weak 75k increase in the previous month.  Assuming the data is line with expectations it seems unlikely that the Fed will feel the need to ease policy by more than 25bp when they meet at the end of the month.

G20, Fed and Iran

Market attention this week will focus on Fed speakers, the G20 meeting and tensions between the US and Iran.  Here are my thoughts on all three:

Federal Reserve Chairman Powell and Vice Chair Williams are both scheduled to speak tomorrow.  Investors will be looking for any further clues on the path, timing and magnitude of Fed interest rates in the months ahead and whether they validate market expectations of easing at the July FOMC meeting.   Markets are already pricing in several cuts and a result the USD has weakened sharply over recent months, suggesting that the bar to an even more dovish stance is high.  Nonetheless, the Fed is at least likely to deliver a 25bp rate cut at the July meeting followed by at least one or two further hikes this year.

The main event this week (Fri-Sat) is the G20 meeting in Japan and in particular the potential meeting between Presidents Trump and Xi on the sidelines.  Expectations/optimism towards some form of progress on trade talks appears high.  Markets are set to remain upbeat heading into the G20, suggesting that risk assets will maintain their rally this week, which will bode well for equities. However, the reality is that the gap between both sides remain wide and there may be some positive noises emanating from the G20 on trade, concrete progress is likely to be limited.

Trump and Xi are likely to discuss a range of issues, with trade teams from both sides preparing the topics for discussion, after talks broke down last month.  It is likely that both Trump and Xi will agree to continue more formal talks, with both leaders sounding positive in the run up to the G20.  However, the threat of additional 25% US tariffs on the remaining $300bn of Chinese exports to the US, remains in place and it is unlikely that this will be taken off the table without some major concessions from China.  As I’ve previously stated it could take months before a concrete deal is agreed upon.  In the meantime global trade will continue to deteriorate.

Elsewhere geopolitical tensions remain in focus as President Trump threatens Iran with additional sanctions in an effort to force Iran to renegotiate the 2015 nuclear accord, as early as today. This follows Trump’s decision to call off planned air strikes in response to Iran’s shooting down of an unmanned drone.  Iranian oil exports have plunged as a result of sanctions and oil prices continue to react, rallying by around 8.7% in just under a week.  Markets will remain nervous over the risks of any further escalation, leaving oil prices susceptible to a further push higher.

 

Dovish Fed Hits The US Dollar

The US Federal Reserve shifted towards a dovish stance yesterday and asset markets applauded.   Against the background of signs of slowing growth, intensifying trade tensions and growing “uncertainties” about the economic outlook, the Fed removed the previous “patient” stance and instead noted that “act as appropriate to sustain the expansion”.   The bottom line is that the Fed is priming the market for easing as early as July, though the market had already primed itself by moving sharply in terms of pricing in rate cuts over recent weeks.   The market is now pricing in three rate cuts this year and at least one next year, which seems reasonable.

Clearly there are a huge number of uncertainties ahead, making the Fed’s job particularly difficult and the picture could look quite different should the upcoming G20 meeting in Japan (28-29 June) deliver some form of trade agreement between the US and China.  This would likely result in less need for Fed easing.  As I have noted previously there are still a huge number of challenges and obstacles to any such agreement, suggesting that market hopes of an agreement stand a good risk of being dashed.   Until then, risk assets will remain upbeat, with equity markets rallying in the wake of the Fed decision even as bond yields moved lower and gold prices reached a 5-year high.

The USD remains under pressure and took another blow in the wake of the FOMC meeting.  The USD has now lost ground against almost all G10 currencies except GBP amid Brexit concerns over the last month.  This has extended today and the currency looks set to remain under pressure in the short term as markets continue to price in Fed rate cuts.  The tension between President Trump and Fed Chairman Powell is not doing the USD any good either.  The USD index (DXY) is now threatening to break below its 200-day moving average (96.710) though this has proven to provide strong support in the past.  A sustained break below this level could see the USD extend losses against major and many emerging market currencies.

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