Covid-19 Economic Toll Worsening

Unease about the economic toll of Covid-19 is starting to dent the rebound in equity markets.  The disconnect between the strength of the rally in equities and the reality on the ground has become increasingly visible following recent earnings releases including from tech heavyweights Apple and Amazon, and dismal economic data which included sharp falls in US and Eurozone Q1 GDP data.  Q2 will look even worse as most of the economic damage was inflicted in April, suggesting that the pain is just beginning.

Meanwhile geopolitical tensions between the US and China are adding another layer of pressure on markets, with US President Trump stating that he had seen strong evidence that Covid-19 originated from a laboratory in Wuhan.  Trump’s comments have raised the spectre of a renewed trade war between the two countries at a time when in any case it was looking increasingly difficult for China to live up to its end of the agreement to purchase a substantial amount of US goods in the wake of a Phase 1 deal.

Some of the economic pain emanating from the shutdowns will be on show this week, with the US April jobs report likely to reveal a sharp rise in the jobless rate and massive decline in non-farm payrolls, with markets looking for an increase to around 16% and a drop of 22 million, respectively.  Already jobless claims have risen to over 30 million, with the only silver lining being that the rate of increase in claims has declined over recent weeks.  The extremely sharp deterioration in job market conditions threatens to weigh heavily on recovery.

The US dollar fell towards the end of March due in part to month end rebalancing (given US equity and bond market outperformance over the month), but also due to a general improvement in risk sentiment, reducing any safe have demand for dollars.  If as is likely markets become increasingly nervous about the sustainability of the rally in risk assets, the USD is likely to move higher during the next few weeks. Even in an environment where global equities sell off, US assets are still better placed in terms of return potential than those elsewhere, implying US dollar outperformance.

In terms of data and events focus this will turn to the Bank of England and Reserve Bank of Australia policy meetings.  Neither are likely to cut interest rates further, but the BoE could announced a further increase in asset purchases, while conversely the RBA is likely to maintain its asset purchases tapering path.  Aside from the US jobs data noted above, the other piece of data globally that will be watched carefully is China’s April trade report.  A weak outcome is likely for sure, but the extent of deterioration in exports and imports, will have very negative global consequences.

China Data Fuels A Good Start To The Week

Better than expected outcomes for China’s manufacturing purchasing managers indices (PMIs) in November, with the official PMI moving back above 50 into expansion territory and the Caixin PMI also surprising on the upside gave markets some fuel for a positive start to the week.   The data suggest that China’s manufacturing sector has found some respite, but the bounce may have been due to temporary factors, rather than a sustainable improvement in manufacturing conditions.  Indeed much going forward will depend on the outcome of US-China trade talks, initially on whether a phase 1 deal can be agreed upon any time soon.

News on the trade war front shows little sign of improvement at this stage, with reports that a US-China trade deal is now “stalled” due to the Hong Kong legislation passed by President Trump last week as well as reports that China wants a roll back in previous tariffs before any deal can be signed.  Nonetheless, while a ‘Phase 1’ trade deal by year end is increasingly moving out of the picture, markets appear to be sanguine about it, with risk assets shrugging off trade doubts for now.  Whether the good mood can continue will depend on a slate of data releases over the days ahead.

Following China’s PMIs, the US November ISM manufacturing survey will be released later today.  US manufacturing sentiment has come under growing pressure even as other sectors of the economy have shown resilience.  Another below 50 (contractionary) outcome is likely.  The other key release in the US this week is the November jobs report, for which the consensus is looking for a 188k increase in jobs, unemployment rate remaining at 3.6% and average earnings rising by 0.3% m/m. Such an outcome will be greeted positively by markets, likely extending the positive drum beat for equities and risk assets into next week.

There are also several central bank decisions worth highlighting this week including in Australia, Canada and India.  Both the Reserve Bank of Australia (RBA) and Bank of Canada (BoC) are likely to keep monetary policy unchanged, while the Reserve Bank of India (RBI) is likely to cut its policy rate by 25bps to combat a worsening growth outlook.  Indeed, Q3 GDP data released last week revealed the sixth sequential weakening in India’s growth rate, with growth coming in at a relatively weak 4.5% y/y. Despite a recent food price induced spike in inflation the RBI is likely to focus on the weaker growth trajectory in cutting rates.

Brexit Developments Sharply In Focus

Two major market risks have been sidelined, though admittedly not taken off the table.  Firstly the prospects of an intensification of the US-China trade war appears to have diminished and secondly the risks of the UK crashing out of the EU without a deal have lessened.  This presents a calmer and less volatile backdrop for markets even as global growth continues to remain under pressure.  Separately markets are hoping and expecting for some icing on the cake in the form of Fed easing later this month. As long as US Q3 earnings are not too bad, this suggests a period of calm ahead.

US-China trade developments are likely to take a back seat in the run up to the APEC meeting on 16-17 November in Chile where a ‘Phase 1’ trade deal may be signed by both US and Chinese leaders.  Talks rumbling in the background appear to progressing well, with US Treasury Secretary Mnuchin and Trade Representative Lighthizer scheduled to speak to China’s Vice Premier Liu He this week by phone.  Markets will carefully eye what the prospects are for a delay of the $156bn of US tariffs on China that are due to take effect on December 15.

Brexit developments will move sharply back into focus today, with UK Prime Minister Boris Johnson set to make a fresh attempt at passing a ‘meaningful vote’ today or gaining a majority in a vote on legislation implementing the deal tomorrow.  This follows having to jettison a vote on Saturday and being forced to write to the EU requesting a three-month delay to the Article 50 exit process.  The government thinks it has the number of votes necessary to pass the vote and the fact that GBP has only lost a little ground today (at the time of writing) suggests that markets think the chances are high.

Other than this, the European Central Bank meeting on Thursday will garner attention although President Draghi is unlikely to offer any further changes in policy, having come under criticism from hawks in the ECB governing council who opposed the renewed bond buying from the ECB.  Expect Draghi to maintain a dovish stance at this meeting.  Other central banks in focus this week include Norway, Sweden, Turkey and Indonesia.  The former two are likely to leave policy unchanged while both Turkey and Indonesia are likely to ease policy.

 

A world of lower yields

This is yet another important week for Brexit deliberations as UK Prime Minister May, under pressure to resign, may bring her Brexit deal agreed with European Union back to Parliament.   Parliament could vote on different Brexit options in a series of indicative votes as early as Wednesday, including possible options of a soft Brexit or second referendum.  MPs will decide today whether to take control of the parliamentary agenda.  GBP meanwhile continues its two steps forward, one step back trajectory, but appears to be finding solid demand on any down step.

Also in focus this week will be a number of Fed speakers who will speak at a time when bond yields are sliding globally.  Markets were roiled by growth worries at the end of last week following a sharp drop in German manufacturing confidence (The Markit/BME PMI fell to 44.7 in March from 47.6 in February), which dampened hopes that weakness in the Eurozone economy would be temporary.   Taken together with dovish comments from G10 central bankers, the net result was an inversion of the yield curve and German bond yields turned negative.  Such signs have in the past been associated with the onset of a recession.

Despite a host of factors including lower US yields, a more dovish Fed stance, markets shifting towards pricing in US rate cuts, and restrained USD, emerging market (EM) assets have not benefitted greatly.  EM assets are torn between these factors on the one hand and global growth concerns on the other.  A host of idiosyncratic factors, whether it is political noise and pension reform in Brazil, or the impending Moodys’ review of South Africa this week, Thai elections etc, etc, are also resulting in more discriminatory investing.

US –China trade talks will also continue to be in focus this week, with the US administration’s Lighthizer and Mnuchin schedule to be in Beijing on March on Thursday and Friday to meet with China’s Lie He, who is planned to travel to Washington in the week after.  Structural issues such as technology transfers, state subsidies and intellectual property and the removal of all tariffs, have been stumbling blocks so far.  Latest reports reveal that China is refusing to back down on US demands that it eases restrictions on digital trades.   The absence of progress on trade talks are yet another reason for markets to trade under a shadow.

 

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.

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.

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.

%d bloggers like this: