The past three months have been dominated more by political than economic news. A new government with a radical agenda has formed in Italy, triggering a seismic re-pricing of peripheral eurozone sovereign bond spreads. Meanwhile, an established government was toppled in Spain but the market barely blinked. Japanese and British Prime Ministers Shinzo Abe and Theresa May have come under significant political pressure but both remain in post. However, there will be a reckoning in financial markets should either of them fall, as investors will be forced to reassess the fate of ‘Abenomics’ and Brexit.
On the geopolitical front, there has been increased tension in the Middle East following America’s unilateral withdrawal from the Iran nuclear deal and an historic summit between the leaders of North Korea and the US. However, the most important political theme has been the ebb and flow of trade tensions.
Tariff tensions – how will they play out?
The US administration’s trade policies remain a critical focus for investors given the role that tariffs play in Donald Trump’s ‘America First’ trade strategy, which is focused on reducing bilateral trade deficits and revitalising the US manufacturing base. These efforts are unlikely to wane any time soon. The pledge of increasing jobs by reworking international trade norms and agreements played a central part in Trump’s election, and unlike immigration, tax policy and judicial nominees, the administration has few concrete accomplishments to show in this area.
However, how the administration’s efforts will play out remains an open question. To date, the threat of tariffs – and, in a few cases, their implementation – have not yielded significant concessions from major trade partners. However, they have created uncertainty in sectors of the US economy that could face rising input costs or could see foreign sales declining as a result of retaliatory measures on US goods. Yet the threat of tariffs has increased, with President Trump more recently highlighting the potential for tariffs against a wide range of Chinese imports as well as foreign-made vehicles.
Despite the risk of further protectionist measures and retaliation by major trade partners, it has become increasingly clear that the administration views tariffs largely as a negotiating tactic and has shown a willingness to scale back when trade partners offer concessions. The administration is also facing pressure from the Republican leadership in response to concerns raised in the business community. This constraint over the direction of trade policy has the potential to become more significant, given an emerging Congressional effort to consider legislative means that would reduce the executive branch’s trade authority.
Still, the administration’s efforts to reduce the bilateral goods deficit with China, open Chinese markets to US firms and make Chinese policies on technology transfer and intellectual property rights less injurious to US interests, enjoy bipartisan support and are unlikely to wane. Negotiations with China are likely to remain challenging and have the potential to unsettle markets further, particularly if the Trump administration grows impatient with any lack of progress ahead of the November mid-term elections.
Asian exporters could suffer the most
Due to China’s pivotal role in the global supply chain, a fall in Chinese exports due to the Sino-US trade conflict could inflict collateral damage on other economies and thus affect their macroeconomic risk. The potential collateral damage can be estimated by stripping out the foreign value-added content in China’s gross exports and reassigning them back to its original source countries to assess their ultimate export exposure to the US.
While the estimated damage to China would be rather limited, a drop in Chinese exports would be quite damaging to most of Asia’s export-oriented economies, with six of the top 10 most-exposed countries being Asian (see chart). From an asset allocation perspective, ceteris paribus, China seems to be the Asian market least affected by the Sino-US trade frictions. A market study also finds that among Asian countries, the industries that could be hit hard include textiles, leather and footwear in Vietnam, computers and electronics in Taiwan and Malaysia and chemicals and petroleum products from Singapore.
It the trade friction worsens, broader risks for the world markets may include China using extreme policies such as devaluing the renminbi, dumping US Treasuries and hitting US investments in China by invisible trade retaliation measures.
Final export exposure to the US compared to direct exports to the US in 2016
Sources: UN Comtrade, Eurostat, OECD-WTO TiVA database, IMF, national statistics, CEIC, Nomura, BNPP AM (Asia)
Synchronised global growth – really?
Turning to the news on the data front, incoming information has increasingly called into question the prevailing narrative of robust and synchronised global growth that seemingly underpinned market prices at the start of the year.
The eurozone had been identified as the stand-out performer going into 2018, with the business cycle indicators near stratospheric levels. However, those indicators have slipped back and the official data also shows the pace of growth slowing in the first quarter of the year. Data surprise indices, which reveal whether out-turns have typically under or outperformed expectations, illustrate how times have changed. Eurozone data was consistently above expectations at the start of the year whereas it has consistently surprised to the downside in recent months.
And the slowdown is not unique to the eurozone. The pace of growth eased in the United Kingdom in the first quarter and activity actually contracted in Japan, bringing to an end an encouraging run of consecutive quarters of economic expansion.
It is likely that the activity data has been distorted somewhat by erratic factors, such as bad weather, that have temporarily depressed activity. Indeed, the Bank of England appears to be putting a lot of weight on this explanation for the slowdown in UK GDP. From our perspective, it seems unlikely that the recent weakness in the data can be entirely ascribed to such factors and the weight of evidence points at the very least to a shift in the balance of risks around the growth outlook. However, it is important to emphasise that the data in most places is still satisfactory, with the near-term risk of recessions still remote.
The one obvious exception to the slowdown has been the US, where the growth outlook remains upbeat. It is therefore no surprise that the dollar has appreciated, as the narrative has shifted from synchronised to desynchronised growth, which brings us to news on interest rates.
The US Federal Reserve is still on course to raise interest rates four times this year and continues to signal that further rate rises will be required in future years. However, comments by members of the Federal Open Market Committee have muddied the waters somewhat, revealing that some members are open both to the idea of taking a pause from tightening when rates reach a neutral setting and the strategy of allowing inflation to modestly overshoot the target.
Elsewhere, the picture is more straightforward. The European Central Bank and Bank of Japan are both still engaged in quantitative easing (QE), although the former looks set to wind down its QE programme by the end of the year. Stepping back, it remains the case that while global inflationary pressures remain subdued, the stance of monetary policy should remain loose.