Bottom line: The most likely scenario is one of rather sluggish global growth, stabilizing from some 2019 trends, but not a strong expansion into 2020. A U.S. recession is not a done deal, and monetary policy settings will shift to an easier mode. These trends will likely keep political pressures and distribution issues rising and increase the difficulties of making strong returns in public markets. Trade uncertainty will reinforce the uncertainty of final demand, but overall, self-inflicted pain in the U.S. and China (including reluctance to address the credit issues of past cycles) are more problematic, especially coming amid stretched valuations. The tenous U.S.-China truce mostly buys time (and avoids agricultural gluts) if it holds, but does not address a wide range of bilateral issues, some of which will be more problematic for their trading partners.
U.S. China Deal to Have a Deal: Scant Details
The U.S.-Chinese “early harvest” or mini-deal didn’t seem to last through the weekend, as Chinese officials looked to downplay the results. In contrast to the American framing of a deal covering the largest amount of trade (likely reflecting President Trump’s political imperative for a deal, Chinese officials seemed to be cautious about the deal, suggesting that talks would continue. If that’s the case, the deal avoids a tit-for-tat ratcheting up of tariffs including planned hikes that would have kicked in on October 15.
The deal signaled last week included pledges that Chinese buyers would increase their agricultural purchases including wheat, soybeans and more, coinciding with the harvest season. In exchange they agreed to increase market access for select financial purchases, and made some pledges to enforce their rules on intellectual property more tightly and continue to make progress on other market access. The deal is also likely to include a side clause on currency, which would likely include references to greater transparency on FX intervention and perhaps pledges to avoid weakening the currency. As with most trade deals, there are questions on enforcement of agreed terms especially intellectual property. Notably, the details have yet to be released – and any trade negotiators knows, the deal’s not over till all of it is all negotiated.
There are several scenarios:
Baseline: Continue to talk, new tariffs in Abeyance, persistence of technology obstacles and slow disengagement. This scenario is probably the most realistic and best outcome for now and reflects importance of avoiding an even greater splintering for both sides. The political trends and security issues especially in technology suggest that a truce may freeze tariffs in place. Under this scenario U.S. China trade becomes more managed both from China and the U.S. side and private interests remain challenged. Modest positive to global growth, neutral RMB, some USD weakness.
Upside: Progress towards a more meaningful trade agreement with some former tariffs and counter tariffs lifted. Some new enforcement mechanisms, perhaps facilitated by some coordination with other industrialized policies provides more clarity on the LT rules in China and globally. Some technology obstacles remain and both US investment in China and Chinese investment in the U.S. remain weaker than in prior years. Modest strength in RMB
Downside: Return of trade conflict and moves towards decoupling. Retaliation including new fines against foreign companies and new tariffs lead to diversion of trade and significant additional costs. Impact is net negative, and prompts Chinese to move to invest more domestically especially in technology.
These scenarios will be developed in a further scenario analysis.
Chinese Economy: Trade Wars Are a Convenient excuse
China’s economy has been struggling for the last year, with growth momentum going down including manufacturing and more recently consumption. These issues are largely homegrown as previous credit expansion added to drivers of a structural weakness (Chinese GDP gradually moving towards 5% growth). Credit financing costs are increasing, with debt service costs now a challenge for growth. This implies that both credit supply and demand is likely to remain sluggish. That said, economic conditions do not seem acute or consistent with a acute slowdown, but rather a slower grind. Key questions remain around the willingness to use the credit and fiscal space.
Weak Global Growth Momentum Starting to Weigh on U.S. Economy
Global growth momentum has been weak, especially in Europe and more recently in Asia, where sluggish Chinese domestic demand weighed on imports since late 2018, leaving the country more reliant on exports. European growth momentum too has been weak, as fiscal austerity continues to be a drag on domestic demand, while monetary stimulus continues helps keep financing costs low but seems to be doing little to foster fixed investment. Greece joined many of its peers in issuing negative yield debt, but this does more to help government financing and help the stabilization rather than generate growth. Brexit remains a source of concern to the UK economically (as the rules associated with trade remain uncertain at the 11thhour) and as a potential source of tumult to credit markets.
IMF forecasts, set to be released this week, will likely confirm the growth downgrades for 2019 (which is almost over) and 2020 that have characterized consensus forecasts. The institutions have been gradually marking down growth over the last year and a half, moving from the synchronized global expansion (of 2017) to asynchonized U.S. driven global growth (as Asian and Chinese demand slackened of 2018-19 to what is now being characterized as a synchronized global slowdown. Global manufacturing and investment is the weakest component of global growth, as inventories are being drawn down, and trade uncertainty reinforcing uncertain demand – the questions now remain – how resilient will services be to the manufacturing slowdown and whether the United States move into a recession, deepening the global slowdown. If so, how deep might this recession be? And what would the recovery look like?
To some extent the myopic focus on recession risks has obscured some of the underlying trends including the structural demand challenges in China, the lack of consumer pricing power in the United States and the over supply of energy (a trend which is exacerbated by welcome efforts to better price carbon globally. A U.S. recession is far from certain, especially as the U.S. economy continues to be among the most resilient, even as momentum slips. Key factors to watch including the resilience of services, the degree of drawdown of manufacturing.
but the global weakness and slack in manufacturing do raise concerns. Moreover, with cheap credit supporting debt issuance more balance sheet stress is possible. Overall, these trends argue against a strong expansion in the near-term, even if a recession is avoided. Uncertainty on the trade and investment side, as well as policy uncertainty following the US 2020 elections is likely to keep FDI weaker, especially from foreign investors who might trigger the CFIUS restrictions and regulations. China remains the primary target of such security reviews, but others including Brazil are also coming under scrutiny.
Globally, Monetary policy remains is neutral to supportive mode, with the Fed set to cut again in October, and at least once more the in the coming months and other DM central banks remaining in easing mode. This stance will allow some EM to continue selectively easing policy, but there are few major mispricings at this point. Russia, Mexico. India and Brazil stand out as countries with positive real rates and some scope to ease. China’s monetary easing will be modest, as it looks to avoid the FX depreciation that comes along with the weakening.
There remains some scope for fiscal support outside the U.S. – India, Saudi Arabia/GCC, Russia are among countries that are signaling some further stimulus, though there are implementation issues. The U.S. itself has used much of its fiscal space in the 2017 tax bill and if anything, the government preferences have reduced the willingness to use fiscal space. Germany and Europe are no longer as negative on fiscal support, though its hard to see if the political will has yet to materialize. In the UK, fiscal support is likely to only partly offset some of the self-inflicted harm from Brexit, even if another extension is granted. All in all, this suggests the most likely scenario is one of rather sluggish global growth, stabilizing from some 2019 trends, but not a strong expansion. These trends will likely keep political pressures and distribution issues rising… and increase the difficulties of making strong returns in public markets. These in turn are likely to infect some private markets, which have benefited from the shift from sovereign funds, pensions, HNWI and others reducing exposure to public markets.
Oil Markets Caught between Sluggish Demand and Renewed Risk Premium
Demand fundamentals and still ample supply from the Americas have dampened the impact of geopolitical risks in the Gulf including the Abiqaiq shutdown and the recent tanker attacks. Those trends have likely modestly increased the risk premium, but ample long-term spare capacity has capped this at around $5/barrel. Looking forward, demand growth is likely to be modest – around 1mbd next year at best. US shale production will likely remain a key driver – especially as recent declines in investment and drilling may reduce the amount of new production growth in 2020. Key to watch are the preferences of the PE firms that have been financing smaller shale producers.
Overall, this trend will likely cap oil price from much growth, even as some vulnerable OPEC countries continue to trim production. There is little scope to absorb new OPEC+ reduction. Overall, curtailment measures in Alberta relatively worked, but this discount is likely to remain high. Structurally, the push towards lower carbon portfolios and carbon taxes (a trend more more developed in Europe than in the Americas_ remains challenging to the sector, but this is unlikely to have a meaningful effect this year. Meanwhile IMO 2020 is likely to only drive some noise to product markets rather than being a major driver.
These trends limit the upside for energy producing regions, which now include parts of the US and suggest some of the oil related debt outstanding in US corporate bonds may see spreads widen vs the US treasury. Russian assets may be a relative outperformer (as they have external and fiscal balances), while GCC bonds benefit from the USD link. Saudi Arabia will continue to struggle to get meaningful FDI inflows, with a likely Aramco IPO benefiting from local support. Overall, government fueled investment will remain a major driver among these oil rich EM, as real diversification is limited.
Turkey: Other EM look resilient to sanctions risk
Following the Turkish military operation in Syria, The United States looks set to impose financial sanctions on Turkey, perhaps as quickly as later this week. The impact on Turkey and Its assets would depend on the scope, but the timing is problematic for Turkey which seemed to be entering another round of credit-fuelled growth as state banks support local investment. The United States policy towards Turkey, moving between the semblance of green lighting Turkey’s military operation to criticizing it within a few hours, has complicated the situation as has the lack of clarity about potential economic and financial repercussions. U.S. policy towards Syria has been one of several where the U.S. is sending mixed messages, which both makes it more difficult to negotiate a final deal or for allies to be sure of U.S. response.
Economically it could be more bark than bite, especially given the lack of detail, but this may imply greater market impact first until clarity of targets if any are clarified. The details of any sanctions remain unclear, though the recent congressional framework gives some clue – measures are likely to target military equipment and supply chains including suppliers globally to the armed forces and government. Despite the threats of “obliteration” of the economy, measures are likely to be more targeted on the military and may avoid energy supply chains. Turkey’s important role as a buyer of Iranian crude oil and gas and regional impacts suggest that the U.S. may have to choose between its different foreign policy priorities, reinforcing the mixed messages it sends.
Domestically, Turkey is vulnerable to shocks, albeit not as much as early 2018 when it was recovering from overheating. Turkey’s credit cycle has restarted earlier this year after recovering from last year’s FX devaluation and recession. The sharp deval and credit collapse contracted imports and weakened domestic demand. Local credit (mostly state-owned) is now expanding again. While Turkey’s balance sheet is stronger than in 2017 when it was overheating, the cyclical pickup could reinforce the impact of any sanctions as cost of capital goes up and lira and Turkish assets correct. Moreover, it could offset the benefits of some of the cheap credit available to Turkey at a time when investors are looking for only a small amount of yield.
When Turkish assets correct, investors often ask about contagion to other emerging market economies given the size and liquidity of the market. In this case, other countries look more resilient to Turkey specific shocks, with global liquidity and demand much more important. Foreign investors had remained somewhat wary of Turkish investment. The broader trends of weaker growth should support USD assets, and countries which are stabilizing, have a little more room to ease policy and are not having a lot of investment should do better. Countries with more policy space include Brazil, India, Russia, Indonesia – and of course China. Mexico and South Africa – with a major drag from contingent liabilities of state-owned enterprises look less resilient.