US-China trade tensions show little sign of ending

Increasing tensions at the APEC summit between the US and China, which resulted in the failure to issue a joint communique (for the first time in APEC’s 29 year history) highlight the risks to any agreement at the G20 summit at the end of this month.   Consequently the chances of US tariffs on $250bn of Chinese goods rising from 10% to 25% in the new year remain  high as does the risks of tariffs on the remaining $267bn of goods exported to the US from China.  Contentious issues such as forced technology transfers remain a key stumbling block.

As the Trump-Xi meeting at the G20 leaders summit approaches, hopes of an agreement will grow, but as the APEC summit showed, there are still plenty of issues to negotiate.  US officials feel that China has not gone far enough to alleviate their concerns, especially on the topic of technology, with the hawks in the US administration likely to continue to maintain pressure on China to do more.  As it stands, prospects of a deal do not look good, suggesting that the trade war will intensify in the months ahead.

Despite all of this, the CNY CFETS trade weighted index has been remarkably stable and China’s focus on financial stability may continue as China avoids provoking the US and tries to limit the risks of intensifying capital outflows.  China may be wary of allowing a repeat of the drop in CNY that took place in June and July this year, for fear of fuelling an increase in domestic capital outflows.  However, if the USD strengthens further in broad terms, a break of USDCNY 7.00 is inevitable soon, even with a stable trade weighted currency.

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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.

Sour end to the week

It’s a sour end to the week for markets. Just as emerging markets (EM) were beginning to see some signs of stability, a surge in US Treasury bond yields (hitting a high of 3.23%) acted to fuel another round of pressure, pushing bond yields higher globally while denting equity market sentiment.   As a result EM equities took another beating and EM currencies fell against a resurgent USD.

The surge in US yields followed a run of strong US data including a gauge of service sector sentiment (ISM non-manufacturing index hit a new expansion high) and strong private sector jobs data (ADP jobs report).  Constructive comments from Fed Chairman Powell on the economy, supporting expectations that US interest rates will be hiked again in December, added to the upbeat mood on the economy.   At the time of writing attention is focused on the US September jobs report which is unlikely to detract from the upbeat US growth story.

US-China tensions are another factor weighing on sentiment.  While there has been no sign of any progress on trade talks even as the US agreed trade deals with Canada and Mexico, criticism by US Vice President Mike Pence on Chinese policy, has weighed on Asian markets.  There appears to be no sign of any appeasement between the two countries, suggesting that tensions will not easy anytime soon.

Any hope of a recovery in risk assets especially in emerging markets as we go into the final quarter of the year are beginning tofade.   After losing ground over much of September the USD has bounced back with a vengeance, while US assets continue to outperform much of the rest of the world, attracting even more capital.  While heavy long USD positioning and increasingly stretched US equity valuations hold risks against further gains in both, markets are not yet willing to run from US assets.

US dollar weakness providing relief

The US dollar index has weakened since mid-August 2018 although weakness in the broad trade weighted USD has become more apparent since the beginning of this month.  Despite a further increase in US yields, 10 year treasury yields have risen in recent weeks to close to 3.1%, the USD has surprisingly not benefited.  It is not clear what is driving USD weakness but improving risk appetite is likely to be a factor. Markets have been increasingly long USDs and this positioning overhang has also acted as a restraint on the USD.

Most G10 currencies have benefitted in September, with The Swedish krona (SEK), Norwegian Krone (NOK) and British pound (GBP) gaining most.  The Japanese yen (JPY) on the other hand has been the only G10 currency to weaken this month as an improvement in risk appetite has led to reduced safe haven demand for the currency.

In Asia most currencies are still weaker versus the dollar over September, with the Indian rupee leading the declines.  Once again Asia’s current account deficit countries (India, Indonesia, and Philippines) have underperformed most others though the authorities in all three countries have become more aggressive in terms of trying to defend their currencies.  Indeed, The Philippines and Indonesia are likely to raise policy interest rates tomorrow while the chance of a rate hike from India’s central bank next week has risen.

As the USD weakens it will increasingly help many emerging market currencies.   The likes of the Argentinian peso, Turkish lira and Brazilian real have been particularly badly beaten up, dropping 51.3%, 38.5% and 18.8%, respectively this year.  Although much of the reason for their declines have been idiosyncratic in nature, USD weakness would provide a major source of relief.  It’s too early to suggest that this drop in the USD is anything more than a correction especially given the proximity to the Fed FOMC decision later, but early signs are positive.

 

Turkey hikes, ECB and BoE don’t. Trump dampens trade hopes

Despite comments from Turkish President Erdogan railing against prospects for a rate hike, Turkey’s central bank, CBRT hiked the repo rate to 24%, a much bigger than expected 625bp increase.  This may not be sufficient to turn things round sustainably but will at least prevent a return of the extreme volatility seen over past weeks.  The decision saw USDTRY drop by about 6% before reversing some of the move.  Undoubtedly the decision will provide support to EM assets globally including in Asia today.

Elsewhere the European Central Bank (ECB) delivered few punches by leaving policy unchanged and reaffirming that its quantitative easing will reduce to EUR 15bn per month (from EUR 30bn) from October while anticipating an end after December 2018.   The ECB also downgraded its growth outlook but kept the risks broadly balanced.  The outcome will likely to help put a floor under the EUR.  Unsurprisingly the Bank of England (BoE) left its policy on hold voting unanimously to do so, leaving little inspiration to GBP.

President Trump poured cold water on US-China trade talks by denying a Wall Street Journal article that he faces rising political pressure to agree a deal with China.  Trump tweeted, “They are under pressure to make a deal with us. If we meet, we meet?” . Meanwhile US CPI missed expectations at 0.2% m/m, 2.7% y/y in August, an outcome consistent with gradual rate hikes ahead.   The data will also help to undermine the USD in the short term.

China Trade talks, ECB, BoE and CBRT

Today marks the most interesting day of the data calendar this week.  Central banks in the Eurozone (ECB), UK (BoE) and Turkey (CBRT) all announce policy decisions while US CPI (Aug) is released.  The ECB and BoE meetings should be non events.  The ECB is likely to confirm its €15 billion per month taper over Q4 18.  The BoE monetary policy committee is likely have a unanimous vote for a hold.

The big move ought to come from Turkey.  They will need to tighten to convince markets that the central bank it is free from political pressure and that it is ready to react to intensifying inflation pressures.  A hike in the region of 300 basis points will be needed to convince markets.   This would also provide some relief to other emerging markets.

The big news today is the offer of high level trade talks from US Treasury Secretary Mnuchin to meet with Liu He (China’s top economic official), ahead of the imposition of $200bn tariffs (that were supposedly going to be implemented at end Aug).  This shows that the US administration is finally showing signs of cracking under pressure from businesses ahead of mid-term elections but I would take this with a heavy pinch of salt.

Mnuchin appears to be increasingly isolated in terms of trade policy within the US administration. Other members of the administration including Navarro, Lighthizer, and Bolton all hold a hard line against China.  Last time Mnuchin was involved in such talks with China in May they were derailed by the hawks in the administration.  So the talks could mark a turning point, but more likely they are a false dawn.  That said it will provide some relief for markets today.

Equities weaker, US yields lower, USD softer

The US Federal Reserve’s rejection of capital raising plans by several banks taken together with further confrontation between the US and Russia and a disappointing US durable goods orders report were sufficient to result in a sell off in equity markets, lower US yields and a weaker USD.

Gold failed to benefit in yet a further sign that its bull run has ended, with the metal honing in on its 200 day moving average at 1296.71. On the US data front headline February US durable goods orders beat expectations (2.2%) but core orders (-1.3%) were weaker than expected.

Although the lead for Asia is a weak one markets may still find some resilience due to expectations of policy stimulus from China. Similarly dovish talk from the European Central Bank will offer further support to market sentiment while undermining the EUR somewhat. On the data front today the main releases are US Q4 GDP revision (upward revision likely), and UK retail sales (rebound likely).

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