Economic data releases during the summer of 2018 did little to upset the apple cart: they continued to point to clear US outperformance in terms of economic activity, while the eurozone looked to have settled into a satisfactory rather than a stellar growth trajectory.
China saw a growth slowdown, while on the whole, Japan muddled through. Politics and policy provided markets with more excitement, though the issues have generally been local, limiting any contagion.
Risk of a US trade war with China on the rise
The vagaries of US trade tactics have most definitely caused a stir. Where Europe is concerned, the Trump administration has pursued a policy of de-escalation.
Likewise, tensions with Mexico have subsided with the very real prospect of a bilateral trade deal if progress on re-booting NAFTA comprehensively stalls.
The dynamic with China however is very different: the administration is seemingly still wedded to the path of escalation and raising tariff barriers. Should the next iteration of tariffs on Chinese goods be implemented, it could lead both investors and the Federal Reserve to pause for thought as the supposed tail risk of a severe trade war will start to look a more realistic proposition.
Meanwhile, domestic US issues – be it the Mueller election interference probe, the upcoming mid-term elections or talk of impeachment – remain on the radar screen of investors who, however, have so far remained stoic and firmly in business-as-usual mode.
A more measured response in China
In China, there has been evolution, not revolution, in the policy stance. The economic slowdown has forced the authorities to deviate – at least temporarily – from the medium-term strategy of deleveraging. Financial markets periodically suffer from spasms of concern about the state of the Chinese economy and the risks of a so-called hard landing. This is understandable as the size of the Chinese economy necessarily implies seismic global ramifications.
We think such fears are overdone: investors are underestimating the willingness and capacity of the authorities to deliver macroeconomic stability: we believe they are determined to avoid a sharp slowdown and to engineer sufficient growth on average to hit the 2020 target of doubling national income.
Having said this, the policy response this time looks somewhat different. In the past, the authorities relied upon sizeable injections of liquidity, significant cuts in interest rates and required reserve ratios and major increases in investment in infrastructure. This time, the action is proving more limited and more selective. The explanation lies with both the objectives of the Xi administration and the shadow cast by the trade tensions with the US.
It seems clear to us that policymakers now attach greater importance to financial stability concerns and therefore are more focused on containing the build-up of debt than was the case in years gone by. They will obviously be mindful of the risk that the trade dispute escalates with potentially serious repercussions for the economy and they may have chosen to hold back policy ammunition, to be used in just such an eventuality. But if that risk does not materialise, the policy focus is likely to swing back towards deleveraging in the medium term, once the economic picture has stabilised.
The Bank of England strikes pre-emptively, or did it misfire?
In the UK, the Bank of England’s move in August to raise the bank rate for only the second time in a decade (from 0.5% to 0.75%) was not a huge surprise though the rationale was well short of compelling.
The policy-setting committee appears to believe that capacity constraints are sufficiently severe in the UK to justify a tighter monetary policy and choke off any domestically generated inflationary pressures that might otherwise emerge.
Nonetheless, core inflation could fall further below the official target in the coming quarters with UK wage growth still anaemic and the one-off effects of a weaker currency starting to drop out of the year-on-year comparison. The real question is what the balance of risks is around Brexit. The BoE governor is on record as arguing that the chance of a no-deal Brexit is “uncomfortably high” and that this would be “highly undesirable”.
Given that the Bank of England has precious little orthodox monetary ammunition left, a severe negative shock to demand from Brexit could have a long-lasting impact. Under these circumstances, the conventional central bank response would be to keep the monetary stance looser than is strictly necessary to ensure that the economy is in better shape in the event that the downside risk crystallises. It is surprising that policy-setters rejected this argument, with the governor arguing that the BoE could always ease policy later if it needs to. More perplexing still is the comment by the bank’s chief economist to the Treasury Select Committee that the BoE would not necessarily ease policy in the event of a “no-deal” outcome.
Reading the tea leaves at the Bank of Japan
Meanwhile, the Bank of Japan pulled off the impressive feat of tweaking its yield curve control (YCC) framework without disturbing the market. Investors did not see the move as the bank capitulating on its commitment to reflation and going back to the bad old ways of learning to live with deflation. Instead, the BoJ nominally left the headline indicators of its policy stance including the yield target unchanged, but widened the band within which the yield is allowed to move up and down. But don’t be fooled: in practice, yields will tend to settle towards the upper end of that range, so in effect, the widening of the tolerance band represents a stealth increase in long-term rates.
Looking ahead, we are concerned that the Bank of Japan has discovered a plausible exit door from yield curve control. We believe that it wants to find a way to allow further volatility back into the market and to gradually let go of curve management, but without causing a tantrum in the markets. Maintaining the guidance that rates will stay around zero, while gradually increasing the supposedly symmetric tolerance band could prove to be an effective way to exit.