Lingering Disappointment

Another soft close to US stock markets at the end of last week sets up for a nervous start to the week ahead.  The S&P 500 has now declined for a third straight week, with tech stocks leading the way lower as more froth is blown way from the multi-month run up in these stocks.  Lingering disappointment in the wake of the Federal Reserve FOMC meeting is one factor that has weighed on risk assets.  More details on how the Fed plans to implement its new policy on average inflation targeting will be sought. Markets will also look to see whether the Fed is pondering any changes to its Quantitative Easing program. This week Fed officials will get the opportunity to elaborate on their views, with several Fed speeches in the pipeline including three appearances by Fed Chair Powell. 

Disappointment on monetary policy can be matched with a lack of progress on the fiscal front, with hopes of an agreement on Phase 4 fiscal stimulus ahead of US elections fading rapidly.  A loss of momentum in US economic activity as reflected in the NY Fed’s weekly economic index and declining positive data surprises as reflected in the Citi Economic Surprise Index, are beginning to show that the need for fresh stimulus is growing.  On the political front, the situation has become even more tense ahead of elections; following the death of Supreme Court justice Ruth Bader Ginsburg attention this week will focus on President Trump’s pick to replace her, adding another twist to the battle between Democrats and Republicans ahead of the election.    

Another major focal point ahead of elections is US-China tensions, which continue to simmer away. China’s economy and currency continue to outperform even as tensions mount.  August’s slate of Chinese data were upbeat and China’s currency (CNY) is increasingly reflecting positive economic momentum, with the CNY CFETS trade weighted index rising to multi week highs.  There is every chance that tensions will only get worse ahead of US elections, likely as the US maintains a tough approach in the weeks ahead but so far Chinese and Asian markets in general are not reacting too much.  This may change if as is likely, tensions worsen further. 

After last week’s heavy slate of central bank meetings, this week is also going to see many central banks deliberate on monetary policy.  The week kicks off with China’s Loan Prime Rate announcement (Mon), followed by policy decisions in Hungary and Sweden (both Tue), New Zealand, Thailand, Norway (all on Wed), and Turkey (Thu).  Markets expect all of the central banks above to keep policy unchanged as was the case with the many central banks announcing policy decisions last week.  The lack of central bank action adds further evidence that 1) growth is starting to improve in many countries and 2) the limits of conventional policy are being reached.  While renewed rounds of virus infections threaten the recovery process much of the onus on policy action is now on the fiscal front. 

US/China – The Gloves Are Off

The delay in the Phase 1 trade deal review (initially slated for Sat 15 Aug) will come as a disappointment though it was reported that it did not reflect any substantive problem with the trade deal, but rather to give China more time to increase purchases of US goods.  China’s reported desire to include TikToK and WeChat restrictions to the discussions may have also played a part.  The Phase 1 review delay followed by President Trump’s order for ByteDance to divest TikTok’s US operations within 90 days and ending of a waiver allowing US companies to continue selling goods to Huawei, ratchets up tensions another notch.

It is abundantly clear that ahead of US elections in November the gloves have come off.  More is yet come and next steps may involve sanctions against more Chinese companies and eventually even Chinese banks.  China’s reaction continues to be measured, which suggests the broader impact on risk appetite will remain contained for now.  China wants to retain foreign investment and has continued to enact measures to open up to such investment.  Reciprocating sanctions on US companies in China would go against this path and seems unlikely to take place unless tensions worsen further.

However, it is not clear that China’s actions will remain measured. The US administration is set on pushing more sanctions on Chinese individuals and companies in what has become a whole of government approach. This is something that has broad based bipartisan support within the electorate.  The risk of crossing certain red lines, perhaps (though still unlikely as Trump sees this as a key success of his Presidency) by scrapping Phase 1 or perhaps by sanctioning Chinese banks by cutting them out of the USD liquidity and payments system and/or by some sort of military escalation in the South China Sea, could yet lead to a much more significant reaction from China and a more severe impact on global markets.

The likely path however, is that the US administration will try to keep Phase 1 alive even as China is far behind its targets on imports of US goods; according to PIIE through the first 6 months of the year China’s purchases of US goods were 39% (US exports data) or 48% (Chinese imports data) of their year-to-date targets.  Given the gap, in part due to Covid, but also due to initially ambitious targets, the delay in the Phase review should not be a big surprise.  The US may be wiling to give China some room to try to move towards reaching its targets, but the gap will not be easy to bridge.  Regardless, US/China tensions will be an ever present part of the landscape in the months ahead of US elections and markets may not remain as sanguine as they have been so far.

Revoking Hong Kong’s Special Status – Data/Events This Week.

In a further escalation of US-China tensions, President Trump revoked Hong Kong’s (HK) “Special Status” as revealed in a speech on Friday.  What does this mean? At this stage there is scant detail to go on.  Trump also promised to implement sanctions against individuals in China and HK who he deems responsible for eroding HK’s autonomy, but no names were given. Markets reacted with relief, with US equities closing higher on Friday, perhaps in relief that that the measures outlined by Trump were not more severe, or that the lack of detail meant that there could be various exemptions.

On the face of it, removing Hong Kong’s “Special Status” would deal a heavy blow to Hong Kong’s economy and to US companies there, while hurting China’s economy too.  However, while still an important financial centre, Hong Kong’s economy relative to China is far smaller than it was at the time of the handover in 1997, at around 3%.   As such, removing Hong Kong’s “Special Status” could be less painful on China than it would have been in the past.  This may explain why the US administration is focusing on other measures such as student visa restrictions, sanctioning individuals, restricting investment etc.  Even so, tensions will continue to cast a shadow over markets for some time to come and will likely heat up ahead of US elections in November.

Data wise, the week began with the release of China’s May manufacturing and non-manufacturing purchasing manager’s indices (PMIs) today.  The data revealed a slight softening in the manufacturing PMI to 50.6 in May from 50.8 in April, indicating that manufacturing activity continues to remain in expansion.  However, the trade related components were weak, suggesting that China’s exports and imports outlook is likely to come under growing pressure, weighing on overall recovery.  China’s currency, the renminbi, has been weakening lately against the US dollar and against its peers, though it rallied against the dollar on Friday.  Further gradual weakness in the renminbi looks likely over coming weeks.

This week there will be attention on various data releases and events including US May jobs data, ISM manufacturing, European Central Bank (ECB) and Reserve Bank of Australia (RBA) policy decisions and UK-EU Brexit discussions.  Of course markets will remain tuned into Covid-19 developments as economies around the world continue to open up.   While the US jobs and ISM data will likely remain very weak, the silver lining is that the extent of weakness is likely to lessen in the months ahead.  Consensus forecasts predict a massive 8 million drop in US non-farm payrolls and the unemployment rate to increase to close to 20%.  The RBA is likely to leave policy unchanged at 0.25% while the ECB is expected to step up its asset purchases. Meanwhile UK-EU Brexit discussions are likely to continue to be fraught with difficulty.

 

 

 

US-China tensions – Risks of a body blow to markets

Tensions between the US and China are once again escalating, resulting in growing nervousness in markets and raising concerns of a further deterioration in global trade at a time when the world is increasingly reeling from the devastating economic impact of Covid-19.   As many countries open up their economies hopes that activity can finally begin to resume, has strengthened.  However, the economic cost is still mounting and as revealed in awful economic data globally over recent weeks the picture is a horrible one.

It will be a fine balancing act for the US administration between imposing more trade tariffs and in turn hurting US importers on the one hand and punishing China for accusations of concealing information about spreading Covid-19 on the other.  President Trump recently threatened to “cut off the whole relationship” with China, which threatens the “Phase 1” trade deal reached at the beginning of this year.   Recent moves by the US administration include instructing a federal pensions fund to shift some investments in Chinese stocks and tightening export controls on Chinese telecoms company Huawei and its suppliers, which the US administrations says are contrary to US national security.

However, the White House may want to keep trade separate from other measures including tighter export controls and investment restrictions.  Indeed recent talks between senior US and Chinese officials on implementing the Phase 1 deal appeared to be cordial and constructive while Larry Kudlow, director of the National Economic Council said on Friday that the trade deal is continuing.  This is logical.  Renewed tariffs on imports from China would hurt the US consumer, while likely retaliation from China would mean any chance of China increasing its purchases of US goods as part of the Phase 1 deal would disappear, inflicting more pain on the US economy.

One other major consequence of a new round of US tariffs on China would likely be a weaker Chinese currency.  So far China has avoided weakening the yuan, which could also provoke increased capital outflows from China (as it did in Jan 2015 and mid 2016) and a drain on FX reserves at a time when Chinese growth is slowing sharply.  However, China may yet opt for a sharp depreciation/devaluation of the yuan to retaliate against fresh tariffs and to support its exporters as it did when the US first imposed tariffs on the country.  Although this comes with risks for China as noted above, if it was sold as a one off move and was well controlled, it need not fuel an increase in capital outflows from China. This is something that the US will wish to avoid.

Although the US may want to avoid trade as the primary target of any pressure on China, this does not mean that tensions will not increase.  In fact it is highly likely that the relationship between the US and China will worsen ahead of US elections in November, especially as it is one issue which garners broad support among the US electorate. As such, US measures will likely skirt trade restrictions but will most probably involve a whole host of other measures including tightening export controls, student visa restrictions, investment restrictions, and other such measures.  Markets hardly need a reason to be nervous, but after a multi week rally, this is an issue that could prove to be a major body blow to risk assets.

UK Elections and US-China trade: Removing Risk Factors

Following the euphoria over the decisive UK election result and the US/China “Phase 1” trade deal markets look primed to end the year on a positive footing.  Two of the major risk factors threatening to detail market sentiment into year end have at least been lifted.  However, some reality may begin to set in early into 2020, with investors recognizing that there are still major issues to be resolved both between the UK and Europe and between the US and China,

Although full details have yet to be revealed, Chinese officials will likely be relieved that the hike in tariffs scheduled for December 15 will now not go ahead. However, there are still questions on how China will ramp up its purchases of US agricultural goods anywhere near the $40-50bn mark that has been touted.

Also the dollar amount of the roll back in US tariffs is relatively small at around $9bn, which hardly moves the needle in terms of helping China’s growth prospects.  “The United States will be maintaining 25 percent tariffs on approximately $250 billion of Chinese imports, along with 7.5 percent tariffs on approximately $120 billion of Chinese imports.”  This still means that a substantial amount of tariffs on Chinese goods remains in place.

According to Trade Rep. Lighthizer, the deal will take effect 30 days after its signing, likely in early January. To sustain any improvement in sentiment around trade prospects there will need to be some concrete progress in removing previous tariffs as well as progress on structural issues (state subsides, technology transfers etc) in any Phase 2 or 3 dealss. The bottom line is that agreement in principle on “Phase 1” will need to be followed by further action soon, otherwise market sentiment will sour.

In the UK Prime Minister Johnson now has the votes to move forward with Brexit on January 31 but that will leave only 11 months to negotiate a deal with the EU. The transition period finishes at the end of 2020 unless of course there is an extension, something that Johnson has ruled out.  In the meantime the immediate focus will turn to the next Bank of England governor replacing Mark Carney.  This decision could take place this week.  Markets will also look to what fiscal steps the government will take in the weeks ahead.

GBP has rallied strongly over recent days and weeks, extending gains in the wake of the Conservative Party election win.  However, further gains will be harder to achieve given the challenges ahead.  UK equities have underperformed this year and are arguably relatively cheap from a valuation perspective, but further gains will also involve removing or at least reducing much of the uncertainty that has kept UK businesses from investing over recent months.  In the near term GBPUSD could struggle to break above 1.35 unless there is progress on the issues noted above.

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