Since the beginning of the year, two major potential downside policy risks have receded, the risks of overtightening of financial conditions due to Fed and other central bank tightening and a further escalation of the tariffs associated with the U.S. China trade war. The combination has led to a strong asset market rally and reversal of the late 2018 sell-off. However macro conditions remain weak as the U.S. economic momentum seems to have slowed, following a slowdown of some of its key trading partners. This is in line with our expectations of a softer 2019, but not a U.S. or global recession. There are some signs of trade stabilization and Chinese local growth stabilization, but few of a meaningful re-acceleration of growth. This contrasts with some growth-influenced assets like equity which are again looking expensive in some developed economies – and may be cheap for a reason in some big emerging markets. I continue to worry the low volatility (amplified by central bank support) may be underpricing risks.
Some trends I’m watching:
Deal likely, but U.S. China strategic competition to persist:Trade negotiations especially the U.S. and China will remain key to global growth and business sentiment. The existing tariffs are adding costs and uncertainty to global consumers and prompting businesses to diversify their exposure. The baseline is that they continue to talk before a deal is announced later this year – one that can be done at the U.S. executive level. This suggests a neutral market impact, with underlying macro demand issues and monetary policy cues having more importance.
A veneer trade deal is likely only after several rounds of further negotiations. It is likely to include mandated purchases of U.S. agricultural and resource goods as well as select manufacturing items. The volume of purchases could be meaningful, displacing some other providers including South American sellers of soybeans, other sellers of LNG and perhaps impacting some intermediate goods trade. However, its unlikely to address the broader overall U.S. trade deficit, given the broader U.S. policy mix. It is also likely to include an agreement on the currency side. For now, U.S. and Chinese interests are aligned and neither want a weak RMB, the U.S. due to worries about dollar strength, China because of financial stability worries about capital outflows at a time when broader debt and equity flows are more important. Chinese officials are likely to be reluctant to tie their hands over the long term and accept trade remedies. Expect more promises on market access and perhaps some opportunities for co-investment.
Coming to terms on the dispute settlement and other issues especially on the structural side may take longer. Veteran watchers of trade agreements would tell us– its not over, till its over (it could take many more months) and don’t believe all the leaks. There is clearly interest in a deal from both U.S. and Chinese officials, but it remains to be seen what President Trump would see as a “good deal.” My baseline assumes no new ratcheting up of tariffs, but I would see meaningful lifting as an upside risk that could delay until after a deal is announced.
Meanwhile, strategic competition between U.S, and China is likely to continue, forcing trading partners to choose sides. Technology including the 5G platform will be one area of competition. These and other strategic issues are unlikely to resolved easily, with legal battles only increasing. Cases of economic coercion for economic and commercial reasons (see recent spat with New Zealand on tourism and Canada on many goods are likely to increase).
Catalysts to watch:deliverables from upcoming meetings, CFIUS bills in congress. Implementation of new Chinese investment laws, potential joint ventures.
U.S. Divided Government and Pressure on the Fed
The Fed yielded to market pressure and confirmed as dovish a stance as markets hoped in its March meeting. Before the meeting, hikes for this year had long been priced out of US bond markets, but not necessarily other markets including some other FX markets (EM and DM). By signaling caution on the balance sheet side, the Fed decision was more dovish than I’d expected, and sets up two potential complications. 1) is the macro outlook even weaker than expected 2) if macro conditions surprise and are more resilient, will the Fed be able to reprice in hikes without undermining key markets? Both are likely premature at this point, but could be relevant for 2020, when the political pressures might actually be greater as the U.S. long election gets enmeshed in primary season.
The Tightening of financial conditions clearly posed a drag on the U.S. and global economies, reflecting also the slowdown in global final demand growth, especially in China, something the Fed cited. Other analysts have noted the shifting of the composition of the Fed including the reviews prompted by Rich Clarida back onto inflation trends rather than employment and a focus on average inflation. At this point with signs of slowing, admittedly moderately and little signs of inflation pressure, the macro and the political pressures line up, especially as the sugar rush from the fiscal measures seems to have worn off.
Still, with equity markets bouncing back, in the U.S. if not elsewhere, the Fed put may be back in play. Divided government suggests more policy stasis, including a tougher passage of the USMCA (passage still my baseline, but as we noted last year, its likely to be a tough battle) and divides on health care. Meanwhile, the markets have a lot of US Treasurys to absorb, something that has put pressure on other US bond assets, if not high-yielding frontiers.
The U.S. shift to net energy exporter has shifted the overall macro impact of oil on the economy. While cheaper fuel still helps the consumer, the slowdown in investment from any tempering of production tends to be a net negative, if a modest one. This will be important to assessments going forward.
Chinese economy stabilizing at best
The start to 2019 in China has been weak, as expected, with the carry through of weak exports remaining a drag so far. The underlying momentum won’t yet be clear for a few weeks and months, when we get the macro data from March and April, given the distortions of the Lunar New Year. There are some signs of stabilization and modest improvement on a sequential basis, perhaps helped by the liquidity situation – however, there don’t seem to be meaningful signs of rebalancing or significant increase in final demand growth, an issue for commodity producers relying on increase. The announced fiscal support, while tempered, could be a positive sign, though support via social spending programs rather than only corporate taxes could be positive.
Catalysts to watch: quarterly sequential data on Credit, consumption and investment. Detail on the announced fiscal measures.
Energy Sector: Bullish for Now, Watch for Shale in H2
Oil prices have rallied sharply as several planned and unplanned outages have tightened the medium-term outlook. Geopolitical priorities including the impact of pressure on Iran and Venezuela have amplified the uncertainty around OPEC production and led to a reduction in supply of heavier crude. The ongoing battle around the iran “waivers” and exemptions and the distrust between Saudi Arabia and the U.S. is likely to add to price uncertainty and likely support prices in the near-term. In the second half of the year, U.S. shale production is likely to surprise on the upside again, especially as estimates have been pulled back to some rig and investment slowdown. Cost compression in the shale patch and other efficiencies is likely to bring a net increase of 1.5-1.7mbd this year, offsetting some other outages.
The U.S. focus on key foreign policy goals especially Iran is likely to complicate some of their other priorities including consistent energy prices, as well as its efforts to reduce exposure in the middle East and regime change in Venezuela. Further complications include lack of clear policy on Russia and increasing divides between Congress and the Administration on Russia and Saudi policy.
Catalysts to watch:Rig counts and other measures of production in U.S., OPEC+ Cohesion. Next round of Iran waivers.
Europe: Political Drag
While Brexit and French and Italian political dynamics have stolen the headlines, the broader demand dynamics in Europe remain weak, with countries like Germany barely avoiding a technical recession. The ECB seems stuck in supportive mode, though not enough to bring a major EUR depreciation. Meanwhile Europe continues to show negative trends on the economic surprise index, underwhelming other regions.
Brexit has come down to the wire and may likely crash through the deadline. I recommend reading Blonde Money for updates. The terms of any bilateral trade and investment deals remain uncertain, which will likely weigh further on investment.
Meanwhile Xi Jinping’s recent visit to Europe has added to divides within the EU and within select EU member state parties about the role of China. Despite efforts to coordinate policies on Chinese technological competition, there is likely to be a lot of country and sector -level policies. Next up: the EP elections and new Commission, which will likely remain reactive for some time. With a lot of domestic looking policy, its hard to see meaningful coordination on some of these security issues or even in countering what are seen as more sanctions overreach from the U.S.
Catalysts to watch: Brexit votes, German investment vehicles around China investment, trade statistics in the Q1 data (likely weak)
Emerging Markets: Tighter Financial Conditions and Uncertain demand.
The more dovish fed (and continually dovish other major central banks) have bought some breathing room for select emerging markets, especially those with inflation under control and those which have less reliance on short-term external finance. Expect to see some major EM central banks to keep a dovish bias, reinforcing some of the capital flow into their debt markets. Others including Turkey, South Africa, Argentina, and even to a lesser degree Mexico have much less room to maneuver due to local price pressures, contingent liabilities from SOEs and higher reliance on external financing. The political cycle in many of these countries means that recent growth slowdown is particularly unwelcome. With significant rallies in many EM and frontier debt, expect differentiation based on external balance and to a lesser extent real rates. This suggests that GCC countries. Russia. Colombia and even Brazil could be better placed.
On the trade side, even if trade discussions with China may be neutral, the overall environment is becoming more constrained, with Steel and Aluminium tariffs still present if not enforced for many countries. As a longer-term issue, the recent decision to strip Turkey and India of their GSP access, and to encourage Brazil to give up its separate but equal benefits at the WTO, suggest a broader set of complex trade negotiations between EM and DM which are likely to impact trade and investment decisions… and take place at a time of heated sanctions and coercive policy.