A Host Of Global Risks

Last week was a tumultuous one to say the least.  It’s been a long time since so many risk factors have come together at the same time.  The list is a long one and includes the escalation of the US-China trade war, which last week saw President Trump announce further tariffs on the remaining $300bn of Chinese exports to the US that do not already have tariffs levied on them, a break of USDCNY 7.00 and the US officially naming China as a currency manipulator.

The list of risk factors afflicting sentiment also includes intensifying Japan-Korea trade tensions, growing potential for a no-deal Brexit, demonstrations in Hong Kong, risks of a fresh election in Italy, growing fears of another Argentina default, ongoing tensions with Iran and escalating tensions between India and Pakistan over Kashmir.

All of this is taking place against the background of weakening global growth, with officials globally cutting their growth forecasts and sharply lower yields in G10 bond markets.  The latest country to miss its growth estimates is Singapore, a highly trade driven economy and bellwether of global trade, which today slashed its GDP forecasts.

Central banks are reacting by easing policy.  Last week, the New Zealand’s RBNZ, cut its policy rate by a bigger than expected 50 basis points, India cut its policy rate by a bigger than expected 35 basis points and Thailand surprisingly cutting by 25 basis points.  More rate cuts/policy easing is in the pipeline globally in the weeks and months ahead, with all eyes on the next moves by the Fed.  Moving into focus in this respect will be the Jackson Hole central bankers’ symposium on 22/23 August and Fed FOMC minutes on 21 August.

After the abrupt and sharp depreciation in China’s currency CNY, last week and break of USDCNY 7.00 there is evidence that China wants to control/slow the pace of depreciation to avoid a repeat, even as the overall path of the currency remains a weaker one. Firstly, CNY fixings have been generally stronger than expected over recent days and secondly, the spread between CNY and CNH has widened sharply, with the former stronger than the latter by a wider margin than usual.  Thirdly, comments from Chinese officials suggest that they are no keen on sharp pace of depreciation.

Markets will remain on tenterhooks given all the factors above and it finally seems that equity markets are succumbing to pressure, with stocks broadly lower over the last month, even as gains for the year remain relatively healthy.  The US dollar has remained a beneficiary of higher risk aversion though safe havens including Japanese yen and Swiss Franc are the main gainers in line with the move into safe assets globally.  Unfortunately there is little chance of any turnaround anytime soon given the potential for any one or more of the above risk factors to worsen.

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Awaiting More US Tariffs And China Retaliation

Weekend developments in the trade war included China’s denial that they had reneged on any prior agreements, contrary to what the US administration has said as a rationale for ratcheting up tariffs on China.  In fact, China’s vice-minister Liu He said that such changes (to the draft) were “natural”.  He also said the remaining differences were “matters of principle”,  which implies that China will not make concessions on such some key structural issues.  This does not bode well for a quick agreement.

Meanwhile Trump’s economic advisor Larry Kudlow suggested that Trump and China’s President Xi could meet at the G20 meeting at the end of June. This offers a glimmer of hope but in reality such a meeting would achieve little without any agreement on substantive issues, which appears a long way off.  Markets now await details from the US administration on tariffs on a further $325bn of Chinese exports to the US effectively covering all Chinese exports to the US.

China has promised retaliation and we could see them outline further tariffs on US exports in the next couple of days as well as the possible introduction of non-tariff barriers, making life harder for US companies in China.  The bottom line is that any deal now seems far off while the risk of further escalation on both sides has risen.  Global markets are increasingly taking fright as a result, especially emerging market assets.

There are no further negotiations scheduled between the US and China though Kudlow has said that China has invited Treasury Secretary Mnuchin and trade representative Lighthizer to Beijing for further talks.  Given that Trump now appears to have a unified administration as well as many Republicans and Democrats behind him while China is digging its heels in this, don’t expect a resolution anytime soon.

China’s currency CNY is facing growing pressure as the US-China trade war escalates.   The CNY CFETS index has weakened by around 1% in just over a week (ie CNY has depreciated relative to its trading partners) and is now at its weakest since 20 Feb 19.  While not weaponising the currency, there’s every chance that China will manage CNY depreciation to help compensate Chinese exporters for the pressure faced from higher tariffs (as appeared to take place last summer). Expect more pain ahead.

‘Beautiful’ Letter Fails To Stop Tariffs

At 12.01 EST the US escalated tariffs on China, following up on US President Trump’s tweets last weekend.  The tariffs escalation follows what the US administration says was backtracking by China on a number of structural issues in an earlier draft of a trade agreement.   Markets had been nervously anticipating this escalation all week, but also hoping that it could be avoided in some way.

A day of talks in Washington between Chinese officials led by Chinese vice-minister Liu He and US officials including US Trade Representative Lighthizer and Treasury Secretary Mnuchin failed to lead to any agreements or even any sign of progress despite President’s Trump’s tweeting that he received a “beautiful” letter from Chinese President Xi.

Talks are set to resume later but chances of any breakthrough appear slim.  China appears to have taken a harder line on subordinating to some of the US demands for structural changes and don’t appear to have been too phased by the increase in US tariffs on $200bn of Chinese goods from 10 to 25%.  The US side on the other hand appear to be taking a tough stance emboldened by the strength of the economy.

China has vowed retaliation but at the time of writing has not outlined any plans for any reciprocal tariffs.  Trump has also stated that the US is preparing to levy 25% on tariffs on a further $325bn of Chinese goods though this could take some weeks to roll out.  China does not however, appear unduly worried about talks extending further and may be content to play a waiting game.

Market reaction in Asia has been muted today and Chinese stocks have actually registered strong gains, reportedly due active buying by state backed funds, while the Chinese currency, CNY has registered gains.  The USD in contrast has been under broad pressure.

Overall however, markets will end the week bruised and in poor shape going into next week unless something major emerges from the last day of talks.   The CNY meanwhile, could end up weakening more sharply in the weeks ahead, acting as a shock absorber to the impact of higher tariffs on Chinese exports.

For more on this topic I will be appearing on CNBC Asia at 8.00am (Singapore Time) on Monday morning.

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.

 

Chinese renminbi (CNY) set to stay firm amid trade talks

Since the beginning of November, the onshore CNY and offshore CNH have strengthened by around 3.5% versus USD. Both are now trading at pivotal levels close to their 200 day moving averages. Their appreciation cannot be solely attributed to USD weakness, with the CNY CFETS trade weighted index appreciating by around 1.8% over same period. In other words China’s currency has outperformed many of its trading partners.

The relative strength of the CNY may be an effort by China to placate the US authorities ahead of trade talks. Indeed according to my estimate China has been selling USDCNY over the last few months, albeit not in large amounts. Interestingly China has not used the counter cyclical factor to push CNY lower as fixings have been stronger than market estimates only around 50% of the time over the last 3 months.

Much of the strengthening in the CNY move came after the US administration announced a pause in the trade war at the start of December, with a delay in the planned increase in tariffs from 10% to 25% on around half of Chinese exports to the US. The implication is that China does not want to antagonise the US administration with CNY weakness, despite the fact that recent Chinese trade numbers have been awful.

China had given itself some room to allow CNY appreciation by previously letting the currency fall by around 5.8% in trade weighted terms (from around 19 June 18 to end July 18) in the wake of the imposition of US tariffs. Its appreciation over recent weeks looks modest set against this background. As such CNY is likely to maintain a firm tone around the trade talks this week.

Trade war heats up

After the US administration announced that it will impose tariffs on $200 billion of Chinese imports to the US, China responded by announcing retaliatory tariffs on $60 billion of US goods.

The US tariffs of 10% will be implemented on September 24.  The tariffs could rise to 25% by the beginning of next year if no deal is reached between the US and China. This is important as it implies some breathing space for a deal and means that the immediate impact is less severe.

There have been some exemptions on goods that were on the original list including smart watches and Bluetooth devices. Aside for allowing time for negotiation the delay in increasing to 25% to 1 Jan 2019 also gives US manufacturers time to look for alternative supply chains.

The reality is that these tariffs should not be surprising. There has been little room for compromise from the beginning. China wants to advance technologically as revealed in its “Made In China 2025” policy as part of its efforts to escape the so-called middle income trap by fostering technological progress and movement up the value chain.

In contrast the US clearly sees China’s policy as a threat to its technological dominance especially as the US holds China responsible for intellectual property theft and forced technology transfers.US administration hawks including trade advisor Peter Navarro and US trade representative Lighthizer were always unlikely to accept anything less than a full blown climb down by China, with moderates such as Treasury Secretary Mnuchin and head of the National Economic Council Kudlow unable to hold enough sway to prevent this.

President Trump stated that if China retaliates the US will pursue further tariffs on the remainder of $267bn of Chinese imports. This now looks like a forgone conclusion as China has retaliated.

Further escalation from China could target US energy exports such as coal and crude oil. China could also target key materials necessary for US hi-tech manufacturers. Another option for China given the lack of room for tit for tat tariffs is to ramp up regulations on US companies making it more difficult to access Chinese markets. It could give preference to non-US companies while Chinese media could steer the public away from US products. Such non trade measures could be quite impactful.

It seems unlikely that after allowing a rapid fall in the renminbi (CNY) and then implementing measures to stabilise the currency (in trade weighted terms) China would allow another strong depreciation of the CNY to retaliate against US tariffs. Even so, as long as China can effectively manage any resultant capital outflows and pressure on FX reserves, it may still eventually allow further CNY depreciation versus the USD amid fundamental economics pressures.

Central banks in focus this week

Several central bank decisions are on tap this week including Japan (BoJ), Switzerland (SNB), Norway (Norges Bank), Brazil (BCB) and Thailand (BoT).  Among these only the Norges Bank looks likely to hike rates.

US data is largely second tier this week, with August housing data due for release.  After a run of weak readings a bounce back in starts and existing home sales is expected.   RBA minutes in Australia and NZ Q2 macro data are also in focus.

Political events will garner most attention, with the delayed announcement on China tariffs ($200bn) possible as early as today after being delayed due to the consideration of revisions raised via public comment.  Another twist in the saga is that China is considering declining the US offer of trade talks given the recent Trump threat of fresh tariffs (WSJ).

Other political events include Japan’s LDP election and US trade negotiations (assuming China participates) at the end of the week.   A few Brexit events this week include the General Affairs Council and Informal EU Summit.

 

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