Friday, May 4, 2018

May-June 2018 Outlook: The Art of the Deal, Part II May-June 2018 Outlook: The Art of the Deal, Part II
Fri, 04 May 2018 14:31 PM EST

The new era of deal making promised by President Trump may finally bear some fruit in the months ahead if the President’s own chaotic tendencies don’t derail it. After a year of rhetorical bluster and blunders, this new kind of transactional President may be on the verge of some tangible achievements through negotiation – if things go right.

Arguably Trump’s combative style has produced movement on trade and possibly on North Korea as well. Though no decisive victories have been won yet, there appears to be a good chance of breakthroughs on these issues in the months ahead (potentially altering the bleak calculus for Republicans in the November mid-term elections). It’s less clear if the political version of ‘The Art of the Deal’ will produce positive results in the Middle East and Iran.

Deal-making remains challenging in Europe too as officials continue to wrestle with the Brexit negotiation. The deadline for a finalized deal is just six months away and the fault line between Northern Ireland and the rest of Éire has become a very tangible symbol of the divisions between the EU and UK negotiators.

Meanwhile, as fiscal stimulus is kicking in, central banks are recognizing that they have completed their ‘deal’ to rescue the global economy and have begun the process of dismantling historic monetary accommodation. Stronger inflation and rising rates have revived volatility and blunted the bull market in stocks, fraying some nerves, but credit markets remain calm for now. Cinching some of the big global agreements being contemplated right now could safeguard that calm, but if these deals start to fall through the markets will be in for a rough patch this summer.

Trump L’oeil

While debate continues over whether President Trump is truly an artful negotiator who can pull off the deals he is promising, his intentions on trade are clear. The US administration has attacked trade issues on three fronts: NAFTA talks with the immediate neighbors, intellectual property sanctions directed at China, and blanket tariffs on steel and aluminum nominally imposed on all trading partners.

Many US allies have been given exemptions from metals tariffs in exchange for minor concessions, and others have been promised the same treatment as part of larger trade negotiations like NAFTA for Canada and Mexico. To apply pressure, the Trump administration has granted a “final” one month extension of temporary tariff exemptions until June 1, but that may not be enough time to hammer out new deals with all of the US’ major trading partners.

It does however appear the talks amongst North American trading partners may meet that June deadline. As the latest round of high level talks in D.C. went into overtime, reports emerged that a deal could be sewn up by the first of May. That didn’t materialize, but negotiators are still said to be in “intense” talks and cabinet level officials will come together again on May 7 to assess progress, and ministers sound hopeful.

If a NAFTA revamp is not completed in the next few weeks, the conclusion of talks may get pushed to late in the year. That’s because the populist leader Andres Manuel Lopez Obrador is expected to be elected Mexico’s next President on July 1, with his National Regeneration Movement (MORENA) replacing the current center-right government. Lopez Obrador has pledged to abide by a new NAFTA agreement if is wrapped up before the election, but if not, he undoubtedly will want to put his own imprint on the deal after he is sworn in on the first of December. Given that Lopez Obrador has used Trump’s fiery rhetoric toward Mexico and immigrants as an effective campaign tool, the new Mexican administration may take a harder line in talks with the US, raising the risk that Trump will make good on threats of tearing up the NAFTA treaty.

As difficult as the NAFTA talks have been, reaching new trade agreements with other large trading partners in a matter of weeks may be unrealistic, raising concerns that the US tariffs could go into full effect and trigger immediate trade retaliations. The US team seems to be focused on getting automobile tariffs lowered in Europe and China for starters but may seek other trade concessions in the single-minded pursuit of paring trade deficits. The Europeans seem highly resistant to changing existing treaties so the drumbeat of a ‘trade war’ may get louder as June approaches. China appears to be a little more willing to play ball with the Trump administration, and as of early May a high level US trade delegation is in Beijing seeking a breakthrough that could keep the world’s two largest economies from devolving into an exchange of tit-for-tat tariffs.

The Nuclear Option

The only issue that may overshadow trade war concerns is the potential for sliding into a real shooting war with North Korea or Iran, whose nuclear ambitions remain high on President Trump’s foreign policy agenda, and whose fates seem intertwined. Trump’s tentative progress with North Korea could be blown apart by his treatment of the Iran nuclear treaty (JCPOA). In October Trump decertified the JCPOA saying it was not in the US national interest, but signed a waiver on US sanctions against Iran. On May 12, Trump has to decide on whether he will extend the waiver for another several months (though he stated flatly in January that he would not sign another 120 day waiver). If Trump fully withdraws from the nuclear accord – a move that European allies have said they will not follow – it will give Tehran a rhetorical talking point to put a wedge between the US and Europe, but it could also give the North Korean regime second thoughts about trusting any treaty with the Trump administration.

At a White House meeting in April, French President Macron attempted to use his warm relationship with Trump to sway the President toward a different tactic with Iran. Instead of unilaterally pulling out of the accord, Macron argued for allies to negotiate more restrictions to address concerns about Iran’s missile program. It’s unclear if the other ‘major powers’ would be willing to go along with this tactic to assuage the US administration, but discussions about an ancillary sanctions agreement may get some traction in the weeks ahead. Ever the showman, Trump told Macron “no one knows what I will do” on May 12.

Trump’s impulsive decision to agree to a summit with Kim Jong-Un appears to have opened the door for an agreement with North Korea, but it could also prove to be a political embarrassment if the high level meeting doesn’t produce a tangible treaty. The growing détente between the two Koreas has raised hopes for an eventual reconciliation, starting with promises to end the state of war that has lasted seven decades. But Trump will have his work cut out for him as negotiator-in-chief if the meeting with Kim goes forward. The US is demanding that tangible and verifiable actions to dismantle the nuclear program be taken before sanctions are lifted, giving Kim little incentive to give up his main bargaining chip. Meanwhile, the more peaceful posture of North Korea could lead China to ease its end of the sanctions regime against the Pyongyang. If no agreement comes from the summit it will be a clear victory for Kim, being politically elevated by a face-to-face meeting with the US president, even if Trump resumes name calling and blaming Kim for the failure.

Double Irish

Europe remains consumed with its own historic political and trade negotiation, where the fate of the Brexit deal may come down to the seemingly intractable Irish border issue. The status of the Irish border was supposed to be resolved last year, but continues to hang over the negotiations with no clear resolution, as Irishmen on both sides of the line have taken hardened positions. Amid these challenges the Brexit bill and Prime Minister May’s government look to be in increasing peril.

The PM is getting hemmed in by her own Parliament as the House of Lords has been voting to add restrictive amendments to the EU withdrawal bill. The upper house has a pro-European tilt and has recommended several amendments to the bill against the PM’s wishes. The Lords have so far voted to recommend keeping the UK in the Customs Union with the EU, and to give the Parliament a “meaningful say” over what the next step for the country would be if the government fails to agree on a separation plan with Brussels (or if the Parliament rejects the proposed deal). Thus if a Brexit accord isn’t achieved on schedule or if PM May threatens to walk out and take a hard Brexit, Parliament could compel the government to return to Brussels and negotiate different terms, or by some reckoning possibly call off the Brexit entirely. The PM will now have to rally her troops in the House of Commons, spending political capital to ensure the thin majority held by her Conservative party and its Northern Ireland partner (the DUP) rejects the amendments attached by the House of Lords.

Ireland’s border and the state of the customs union at that border remain a sticking point. Recently the UK’s chief Brexit negotiator bluntly stated that he is “not at all sure” if they can achieve an Irish border agreement by June. That same day the Irish PM proclaimed there is a real risk the EU will miss the October deadline on presenting a finalized Brexit withdrawal treaty if they don’t see real progress by June. The latest reports say May’s core cabinet largely opposed the PM’s preferred option of a hybrid “customs partnership”, with Britain collecting tariffs on behalf of the EU, on the grounds that it would essentially be a back door customs union relinquishing border control. Reportedly some Brexiters were ready to resign from the cabinet if the PM pushed for the customs partnership, which could have led to a leadership challenge to replace May as head of the party. That leaves the favored option of the Brexiters on the table, a maximum facilitation (‘max-fac’) proposal, which would seek to expedite trade by relying on new technology to check vehicles and goods at the border without stopping them.

However, the UK civil service has cautioned that the max-fac solution could take five years to fully implement and the Irish government has spurned this notion of an ‘invisible border.’ Ireland’s ideal scenario would be maintaining the EU customs union, or failing that, giving Northern Ireland special status to keep following EU rules – but that has been rejected by the DUP, whose support PM May needs to ratify the final deal. Ultimately, the UK government may opt to kick the can down the road again by considering extending membership in the customs union temporarily, while a successor arrangement is implemented.

Promotional Offers

Global central banks have started to realize that they can’t keep kicking the can indefinitely when it comes to unwinding unprecedented stimulus programs. The Fed has already begun the process while other central banks are starting to wrap their heads around the problem.

In early April, the market believed a BOE rate hike in May was a done deal, but some recent soft data has eroded that confidence. At the prior meeting in April, Governor Carney cast doubt on the outcome by stating that there will be “some differences of opinion” at the May 10th MPC meeting and that he was conscious that there are other rate setting meetings throughout the year. Further, he noted one should not get fixated on the exact timing of hikes, but should stay focused on the general path, and that Brexit uncertainty was still dampening investment in the UK. This walk back of expectations caused some short term volatility in the sterling, and has since erased the expectation of a May hike, and possibly any hikes this year. Reinforcing that sentiment, the UK stats agency (NIESR) has just substantially downgraded the growth forecast for 2018 to 1.5% from 1.9%, after raising its forecast two-tenths just a few months ago.

The ECB is also moving very slowly on unwinding accommodation. The latest reports about ECB thinking indicate that the policy committee feels it has room to wait until the July meeting to signal the end point of the QE program. In April, ECB President Draghi noted that the council has not had any formal discussion of a roadmap for exiting policy accommodation or a tapering plan. That struck some observers as odd based on the expectation that the ECB might provide such a roadmap in the next few months for an exit policy that might start around year end. Draghi also shot down a comment from the Austrian central banker Nowotny who mused that when rate hikes begin, the process could start with a 20 basis point hike in Deposit Rate to -0.20%.

Draghi’s comments indicate that the council is certainly not in a rush to publish a plan for reversing its policy of the last decade. The only baby step taken so far this year was the March move to drop the ECB’s explicit pledge to increase size of QE if needed. The only other policy indicators for now are the occasional leaks out of the ECB, which currently indicate the central bank is broadly comfortable with market expectations of the first rate hike in Q2 2019.

As for the Fed, at the May 2 meeting it signaled that it’s satisfied that inflation is moving to target and will stabilize around that 2% level. That keeps the policy committee on track for another rate hike in June, at which time the Fed may also take up the task of communicating its sentiment on inflation overshooting the 2% target. Since March 2017 Fed officials have emphasized that the inflation target is “symmetrical”, allowing for it to equally overshoot or undershoot 2%, but there is still some debate about the degree of overshooting that the committee would be comfortable with. The June press conference may delve into this issue, though Fed Chair Powell may not be comfortable with declaring a specific overshoot level (above 2.25%? 2.5%?) that would require a monetary policy reaction.

Almost uniformly, central banks have been surprised by how slowly inflation has recovered, but now it is finally gaining traction, in part due to rebounding energy prices. OPEC and its non-cartel partners have successfully kept production capped, with compliance on the deal consistently above 100%. That has been enough to offset rising production from North American shale producers taking advantage of rising prices. OPEC will have a check in at the regular semi-annual meeting on June 22, but by all accounts members are pleased with the results of the production agreement and are ready to keep it up through the end of the year. Some reports say that Saudi Arabia desires to see the price of Brent crude rise to $80 or even $100/barrel, though OPEC Secretary General Barkindo was quick to deny that talk and state that OPEC and their non-OPEC partners do not set any price objective. Later this year it will be worth watching the compliance levels with the production deal for any signs of slippage as it draws toward a conclusion.

US rates are on the rise and other central banks are starting to contemplate tighter policy too. But with the Fed relatively far ahead on reversing stimulus policy, the dollar has begun to strengthen – back to about where it started the year – and the Treasury yield curve continues to flatten, with the 2-10-year spread narrowing towards 40 basis points for the first time in more than a decade. This has contributed to stocks stalling out, along with some questions about earnings quality in Q1. The bullish stock market sentiment that was still dominant in January, has evaporated in the face of market staples like Caterpillar proclaiming that this quarter may be the “high water mark.”

The stock market correction has not shaken the Powell Fed off of its rate hike path, with members seeming to show some relief that ‘normal’ volatility has returned after an over a year-long absence. At this point it would appear that stocks would have to suffer a selloff more severe than a 10% correction to stir the Fed into taking a shallower rate path. Discounting the very real chance of trade or nuclear talks going wrong in the months ahead, the Fed looks to be shifting toward a four hike scenario for 2018, putting pressure on the BOE and ECB to get their monetary tightening strategies in order.


1: UK Manufacturing PMI; US ISM Manufacturing
2: UK Construction PMI; Euro Zone Prelim Flash Q1 GDP; FOMC Policy Statement; China Caixin Services PMI
3: UK Services PMI; Euro Zone Flash CPI Estimate; US ISM Non-Manufacturing PMI
4: US Payrolls & Unemployment Rate

8: China CPI & PPI; China Trade Balance
10: UK Manufacturing Production; BOE Policy Statement; US CPI
11: Preliminary University of Michigan Sentiment

14: China Industrial Production
15: Euro Zone Flash Q1 GDP; German ZEW Economic Sentiment; UK Inflation Report Hearings; US Retail Sales
16: UK Claimant Count & Unemployment Rate; US Housing Starts & Building Permits; US Industrial Production; Japan Preliminary Q1 GDP
17: Philadelphia Fed Manufacturing Index

22: UK CPI & PPI
23: US New Home Sales; FOMC Minutes
24: Euro Zone Flash Manufacturing & Services PMIs; UK Retail Sales; US Existing Home Sales
25: German Ifo Business Climate; UK Second Estimate of Q1 GDP; US Durable Goods Orders

29: US Consumer Confidence
30: German Preliminary CPI; US Prelim Q1 GDP (2nd reading)
31: German Retail Sales; Euro Zone Flash CPI Estimate; US Personal Income & Spending; Chicago PMI; China Manufacturing & Non-manufacturing PMIs; China Caixin Manufacturing PMI

1: UK Manufacturing PMI; US Payrolls & Unemployment Rate; US ISM Manufacturing PMI; US steel & aluminum tariff exemptions expire

4: UK Construction PMI; China Caixin Services PMI
5: UK Services PMI; US ISM Non-manufacturing PMI
7: China CPI & PPI; China Trade Balance
8: UK Manufacturing Production

12: UK CPI & PPI; German ZEW Economic Sentiment; US CPI
13: UK Claimant Count & Unemployment; US PPI; FOMC Policy Statement & SEP Forecast; FOMC Press Conference; China Industrial Production
14: UK Retail Sales; ECB Policy Statement; US Retail Sales; BOJ Policy Statement; World Cup Tournament in Russia begins (through July 15)
15: Euro Zone Final CPI; US Industrial Production; Preliminary University of Michigan Consumer Sentiment

19: US Housing Starts & Building Permits
20: US Existing Home Sales
21: BOE Policy Statement; Philadelphia Fed Manufacturing Index
22: Euro Zone Flash Manufacturing & Non-manufacturing PMIs; OPEC Regular Meeting

25: German Ifo Business Climate
26: US Consumer Confidence; US New Home Sales
27: US Durable Goods Orders
28: German Retail Sales; US Final Q1 GDP
29: UK Current Account; UK Final Q1 GDP; Euro Zone Flash CPI Estimate; US Personal Income & Spending; Chicago PMI
30: Fed to announce bank stress test results by June 30

1: Mexico general election