Press reports reminded investors about risks that may have been underpriced. U.S. trade policy (and retaliation/choices of plan B) remains to be a major risk for 2018 and beyond, that is, if US policies move beyond bark to meaningful bite. However, they seem much more likely to be sources of friction that cap profits rather than a major risk in and of themselves.
How do today’s reports play into the key themes for 2018+? What triggers could undermine the recent positive sentiment in a more sustained way? What should we expect from Chinese foreign capital allocation and trade policy? I try to answer some of these in this blog (see my 2018 outlook posts for a more general overview.
FX reserves: Chinese officials seem to have mentioned reducing or capping UST purchases as they may no longer be as attractive an asset, especially given the risk of trade tensions. Meanwhile investors are worried about the withdrawal of accommodative global monetary policy amid U.S. issuance increases. Some of this seems true, but not particularly new. China’s own interests in stability (domestically) suggest choices in U.S. asset allocation are a function of its own external policy and what markets are open to them. Meanwhile if rates rise I’d expect plenty of interest in buying. Chinese officials might well be taking advantage of past actions to remind US officials of the mutually assured destruction of major trade friction, but a new policy change seems unlikely.
Rather than worries about Chinese purchases, I’d monitor closely Chinese domestic policy and momentum. USD asset (and foreign asset choice is a function of the accumulated external surplus and currency focus. As for China, great reviews of FDI (eg the big energy deals announced on the President’s Asia) trip suggests that if China has lot of USD to place, the treasury market will likely receive much of it.
A little history- Chinese officials have already been cutting purchases for the last few years due to their own domestic policy choices- their drop in reserves (2015-6) and slow accumulation (2017) meant china reduced the need to buy US assets. China (and many other sovereigns) added to their UST holdings – these were largely a function of their own domestic policies (capping FX appreciation). After this drop, and modest increase China ’s USD portfolio has stabilized (as described in lucid detail by Brad Setser) and others (initially the Fed, and then American investors and more recently foreign investors (Japanese and Euopean pension funds) seem to have continued to buy USTs and would welcome a use in yields.
Triggers to watch: meaningful tightening of Chinese domestic liquidity, increase in outflows, U.S. broad-based sanctions.
NAFTA worries (and general trade policy) is heating up too ahead of the next round of negotiations later this month. Press reports (subsequently withdrawn) that Canada was preparing for the U.S. to withdraw led to pressure on CAD and MXN today. CAD has historically been more resilient to NAFTA risks, but a market reassessment of BoC hikes may have added to the pressure.
As I highlighted regularly last year, NAFTA risk is likely to be an intermittent market driver though at least H1. I remain convinced that the negotiating partners will stick to their Q1 negatiating schedule. I would interpret today’s measure as one of the latest attempts to energize the business interests in the U.S. to support the deal. As I noted in my IMF trip notes, I continue to be surprised that people are surpised by the possibility that NAFTA might evolve into a zombie institution. Expect these debates to continue even if the half-life ebbs.
We are also starting to see more posturing and planning around the “plan B’s” of U.S. trade partners. Canada has been much slower than Mexico or Europe to highlight these trends The Canadian WTO measure was a real escalation but a wise one given that even if NAFTA persists its likely to have weaker dispute settlement mechanism directly.
Trade policy risks at best create friction and volatility in supply chains.
Global backdrop remains important. However with monetary conditions becoming slightly less supportive globally, global growth momentum beginning to moderate and valuations looking stretched. Prepare for some short-lived but recurrent shocks.
So what could change this (in 2018):
- Meaningful slowdown in Chinese growth: this would hit commodities and contribute to tightening of global financial conditions. Chinese credit is moderately supportive as is fiscal policy. Local policy would be the most likely trigger of this and I don’t see any willingness for meaningful policy change in 2018. And reflation and crackdown on shadow banks in 2017 has actually bought more time.
- broadbased tariffs that boost cost of imports (price effect). Should US trigger a broader rather than selected trade policy measures, it would add uncertainty for business and might result in a sharp dollar appreciation.
- Over tightening (Fed): but probably offset by other easy stance.
- Hit to consumer spending from rising commodity prices especially oil. This would require an increase well in excess of the current 70/barrel markets.