Tuesday, July 10, 2018

July-August 2018 Outlook: Political Football

July-August 2018 Outlook: Political Football
Mon, 09 Jul 2018 18:18 PM EST

The eyes of the world are on the World Cup in Russia, which has been a welcome distraction from the political and trade squabbles that have dominated the news lately. But as the tournament starts to wrap up the difficult geopolitical realities remain the same.

Economic fundamentals are solid and corporate results appear strong heading into the Q2 earnings season, but the contest over global trade has put a drag on markets. Despite stronger global economic growth, uncertainty is reflected in the over 20% drop in the Shanghai index in the last five months and the 9% drop in the DJIA since its January peak. Meanwhile, the yield curve is most definitely not ‘bending it like Beckham’: the 2-10 year Treasury spread has flattened to below 30 basis points for the first time in over a decade. While most analysts and central bank officials are not deeply concerned about this flattening, which they see as the result of a variety of special factors, if the yield curve remains flat for a prolonged period it could cause damage to sentiment.

The upcoming earnings season could deflect some of that uncertainty if companies put up strong numbers, but guidance may be clouded by the overhang of the nascent trade war. CEOs may inject a note of caution in their forward guidance as they consider political uncertainties around tariffs that will impact corporate decisions on capital expenditures, hiring and other investments. Corporate earnings are growing but stock multiples tend to contract during Fed tightening cycles, creating potential downside in equity markets over the medium term. Thus trade issues including tariffs and Brexit, and various domestic political dramas will keep markets on the edge of their seats long after the World Cup winner takes home the trophy.

Central Banks: On the Sidelines

While many central bankers no doubt have been rooting for their home teams during the World Cup, they strive to keep out of politics to help ensure their independence. The closest central bank chiefs have gotten to the current dispute is in a general agreement that protectionism is a major downside risk to the outlook.

The next two months will likely be quiet for the central banks as they enter their typical summertime dormancy. Most of the big monetary policy moves have already been made in recent months: the Fed raised rates again and withdrew its forward guidance, the ECB firmed up plans for tapering QE and exiting zero rate policy, and the PBoC cut its Reserve Ratio Requirement to spur lending.

The Bank of England may put a 25 basis point hike on the board at its August 2 meeting, but that’s only after ‘calling offsides’ on market prognostications of a May hike. The June meeting did result in a more hawkish stance, with a divided 6-3 vote and the threshold for tapering QE policy shortened to when rates reach 1.50% from the previous target of 2.00%. BOE officials continue to be confident that rates will rise slowly in the absence of any new shocks (so progress on Brexit talks would undoubtedly please the central bank).

The ECB was also a tinge more hawkish last month, though it took a more cautious stance than many expected on policy normalization. While President Draghi did finally announce plans for tapering QE during the last quarter of 2018, he also said that rates will not rise off the zero bound until the summer of 2019. With its policy line up now announced, the ECB should not present any surprises in the next couple of months.

Just a day before the ECB statement in June, the FOMC announced its second rate hike of the year, as expected, basing the decision on continued improvement in economic activity. The statement acknowledged that the Fed has reached its maximum employment goal and largely removed the central bank's forward guidance, another indication that policy normalization is fully underway. The updated Summary of Economic Projections (SEP) was also more hawkish. A shift in the 'dot plot' showed the median forecast from FOMC members is now fully factoring in four rate hikes this year.

In the end there is not that much distance between the Fed doves and hawks. Most agree on “gradual” tightening, leaving the question of when the end of the cheap money era will start to exert pressure on financial markets. At the moment, only the bond market is looking through to the next recession, reflected in the flattening yield curve. So far Fed officials have expressed little concern about a yield curve inversion and rates continue to march up the field. A week after the June hike, Fed Chair Powell stated that the Fed stance is still accommodative and may be 100 bps below the 'neutral' rate, indicating enough room for rates to keep rising well into 2019.

Politics: Group Stage

While monetary policy is on the sideline for the moment, politicians are playing a fast paced game, and many are looking to tear up the rulebook. The balance of political power within the EU and euro zone are being tested by the Brexit, populist issues like immigration, and policy rifts within coalition governments. Meanwhile a Supreme Court nomination battle and the culmination of the Russia investigation are likely to bring out the worst hooliganism that Washington has to offer ahead of the mid-term elections.

The most surprising development of the last month was the domestic upheaval suddenly shaking the coalition of the German Chancellor. Germany, still licking its wounds from its early ouster in the World Cup tournament, saw Chancellor Merkel narrowly avoid a similarly embarrassing defeat that threatened her government. Allied political parties put pressure on Merkel over illegal immigration policy, and she only managed to avert a domestic rebellion by pressing the issue at the EU summit meeting in June. There has been a great deal of political change in Europe over the last decade, but to see the four-term leader of the euro zone’s largest member suddenly threatened by a shift in the political winds was quite extraordinary. If the leaders at the core of the euro zone are vulnerable, then any government could potentially fall to abrupt changes in the political environment.

Case in point is Italy, where the only bigger national shame than failing to qualify for the Cup is the country’s inability to form a stable government. Analysts are closely watching the new government coalition, whose nationalistic tendencies have contributed to pushing the immigration issue to the fore. Even as they question euro zone rules, it remains to be seen how the coalition will reconcile the goals of the populist Five Star Movement, which promised more public spending, and the far-right Northern League, which wants tax cuts. Over time such policies would add to the country’s €2.1T in debt and could lead to a nightmare scenario for the EU: a Greek-style debt crisis in the euro zone’s third largest country. It will be up to PM Giuseppe Conte, a lawyer and academic with no political experience to navigate away from a fiscal crisis. His choices will be under the scrutiny of President Mattarella, who showed his willingness to utilize rarely used veto powers when he rejected the government’s first nominee for Finance Minister who Mattarella deemed as too anti-European. These tensions could lead to new battles within Italian politics that could easily spill over to the wider euro zone.

The partisan battle in Washington D.C. will intensify in the months ahead as the Republican and Democratic teams line up for the November election. The retirement of the Supreme Court’s swing voter, Justice Kennedy, is the latest flash point in the political game as Senate Republicans race to confirm the new nominee before the election. The financial world will likely look favorably on the new Justice, who will almost certainly be a pro-business jurist, though those taking a longer view may be uneasy about the court tilting further to the right on cultural and religious issues. The role of Chief Justice Roberts in leading the court will become even more prominent as he will now sit at the new ideological median of the court. After the new justice is sworn in it will soon become clear if Roberts will adhere to the core principle of following legal precedent or preside over a newly activist court.

The other legal issue hanging over Washington is the Russia investigation. The findings of the special counsel could be announced at any moment in the next few months, and, depending on their scope, could rock the Trump administration (and potentially draw votes away from the GOP in the November election). Unless the report either fully exonerates the President or is especially damning of him, its likely to further expand the partisan divide in Washington.

All of DC’s political issues are now fodder for the November election, which is increasingly being seen as a confidence vote on the President. Growing expectation that Democrats could retake one or both houses of Congress could eventually weigh on market psychology. Though the GOP tax plan can’t be rolled back as long as there is a Republican in the White House, a Democratic-controlled Congress would block any further major legislative initiatives by this White House.

In foreign policy matters, Trump is looking to hit Iran’s oil market with a red card. Just days after OPEC and other aligned producers agreed to a moderate production increase, the US declared a goal of wiping out most of Iran’s oil exports by November. If successful, the White House play could spur a significant price rise in oil, with at least one analyst suggesting the exclusion of Iranian oil from the market could send WTI to over $120 per barrel. Realizing higher gasoline prices would be a sore spot for US voters in November, Trump has been demanding even more production from OPEC.

Meanwhile Iran has been working the field, trying to extract compensatory concessions from Europe. However, if the US pressure campaign starts to cause real economic damage Iran could make good on threats to tear up the nuclear accord entirely. It’s worth noting that Iran’s Revolutionary Guard commander has threatened to block oil shipments through the Straight of Hormuz if the US throttles the flow of Iranian oil. While the Iranian navy may not be capable of backing up that threat, it is a sign that hardliners who were against the nuclear accord from the beginning may be gaining the upper hand in Tehran.

Disagreement over Iran policy could spill over into discussions with US allies. On the heels of the ill will that emerged from the G7 summit in Quebec last month, Trump faces a contentious meeting with NATO (July 11-12). Then on July 16th, Presidents Trump and Putin will meet in Helsinki. Trump is expected to ask the Russian leader to help push Iran out of the Syrian conflict, having already conceded the US rhetorical stance on removing Syrian strong man Bashar al Assad. The optics of a warm meeting between Trump and Putin right after the NATO gathering could put even more strain on relations with allies already upset with Trump’s trade policies.

Brexit: Elimination Round

After a lot of dramatics but little progress on trade issues, the negotiations to withdraw the UK from the EU are about to enter extra time with no score on the board. Prime Minister May appears to have one more chance to put the ball in the goal before the process faces a complete collapse. May is fighting her own Brexit Secretary and Foreign Secretary who continue to advocate for a ‘max fac’ technology based customs border for Ireland. The EU has already essentially rejected that option and the PM is now pushing for a ‘softer’ proposal that would adhere to EU trade rules at the border. If the PM can’t come to terms with her insurgent cabinet ministers, it could lead to a confidence vote against PM May and a leadership challenge by Boris Johnson (*Editor’s Note: as of July 9, Brexit Minister Davis and Foreign Minister Johnson have both resigned in protest).

After a day of knocking heads in a private cabinet meeting PM May emerged with a new proposal that attempts appeal to both hardline members of her cabinet and to Brussels with a “facilitated customs arrangement” that would apply domestic tariffs on goods headed for the UK and their EU equivalents for goods bound for the EU. The plan envisions minimum friction at the border while still allowing the UK to set its own tariffs and trade policy. Furthermore the new plan promises to maintain a common rulebook for all goods including agricultural products and for UK courts to give “due regard” to EU case law and to allow for binding arbitration.

The EU negotiating team will now assess whether the proposal outlined in a forthcoming white paper (due July 12) is workable, or just another false start in setting the terms of the new trading relationship. PM May has done a lot of arm twisting to get the factions within her own party to support her latest customs plan, but it will only matter if the EU sees the proposal as remotely credible and a basis for restarting real negotiations as the game clock continues to tick toward March 2019.

Trade: The Final

Trade tensions between the US and the rest of the world are likely to remain the main event in the months ahead. Though the US is absent from the World Cup, it most definitely is driving the geopolitical discussion under President Trump’s strategy of disrupting the staid global order built up over the last several decades. Trump is testing old alliances and adversaries alike with his brand of leadership based on unpredictability and putting “America first.” This policy is manifesting in a recalibration of global trade relationships, but it’s unclear if there will be any winners.

So far, Trump’s tactics have extracted concession from a few countries, but most are responding with tit-for-tat tariffs. Already over $20B in new tariffs on US goods have been imposed in retaliation for the steel and aluminum tariffs that the US imposed in March.

Specific American firms and industries will continue to suffer amid the rising tariff dispute. One report said China could cancel as much as 1.1M tons of US soybeans this year (China accounts for about half of America’s $14B in annual soybean exports). Harley-Davidson has taken direct criticism from President Trump after it announced it would move some production to Europe to avert tariffs. Micron just suffered an adverse patent ruling in China, and one can’t help but wonder if the trade war played a role in the court’s decision. Similar concerns may arise for Google this month as the EU is set to issue a fine against the firm over its alleged abuse of market dominance in the Android mobile operating system. Analysts expect the new fine could eclipse the record $2.8B fine that was levied against the company last year over its search market dominance. Predictions run as high as $11B, and the trade dispute may get blamed for influencing that figure if it runs toward the high end.

As of July 6, the US-China trade fight jumped to a new level. The US went ahead with $34B in new tariffs, which China immediately matched, with another $16B to be imposed by both sides in a couple of weeks.

The US has targeted the vast majority of its tariffs at capital or intermediary products, with the intention of making American firms’ supply chains less reliant on Chinese goods. The unintended consequence here could be disruptions in the synchronized global supply chain as companies shift production and sourcing. And protectionist measures beget more protectionism, so the tariffs are bound to spread to other countries. At a minimum, Canada and other major US trade partners are apt to put up their own trade barriers to China on concerns about goods being diverted through their markets in an effort to circumvent the US duties.

The burgeoning trade war could escalate quickly if China matches the entire $50B in new duties the US plans. Trump has threatened to expand tariffs by as much as $450B, an amount that would be difficult for Beijing to match. But China could retaliate in other ways, transmitting negative feedback through the bond and currency markets, or imposing burdensome inspections that could delay sales of durable goods or leave fresh foodstuffs to rot on the dock. If the markets start feeling pain, Trump may have second thoughts, especially after touting the rising stock market as the true measure of his approval rating.

The markets have latched on to auto tariffs as the line of demarcation for a full blown trade war. The US Commerce Department is currently considering auto tariffs on “national security” grounds (a Section 232 review), but a decision is not expected for months, leaving some time for international trade negotiators to broker a solution. Meanwhile the Commerce Department will hold hearings on the issue on July 19-20. As we saw with the Section 232 review on steel and aluminum, the outcome of the Commerce probe appears pre-ordained: its being used as a pressure tactic that will hang over the auto industry and trade talks for the rest of the year.

In early July, markets took some heart that a resolution to the auto tariff dispute can be found as one US official expressed a willingness to deal. A German press report noted the US ambassador to Germany told car makers the Trump administration is open dropping its tariff talk if European removes its 10% duties on US vehicles (and the US would remove its 2.5% duty). If, however, no deal is reached in the coming months, President Trump could follow through on his threat to raise the cost of autos imported from the EU by 20%. In that event, the Trump administration might also start talking more seriously about withdrawing from the WTO, which would be a crippling blow to the post-war global trade framework.

At this point there does not appear to be much high level dialogue going on especially between the US and China, so a trade war could rapidly get out of control. Rising trade barriers will put upward pressure on inflation, which could in turn force central banks to raise rates faster. Neither side wants a trade war, however, so there’s still a chance for a deal that would lead to freer trade, maybe even in time in time for the start of the American football season.

1: China Manufacturing and Non-manufacturing PMIs; China Caixin Manufacturing PMI; Mexico general election
2: UK Manufacturing PMI; US ISM Manufacturing PMI
3: UK Construction PMI; China Caixin Services PMI
4: UK Services PMI; US ISM Non-manufacturing PMI; FOMC Minutes; 4th of July Holiday
5: US ADP Employment
6: US Payrolls & Unemployment

9: China CPI & PPI
10: UK Manufacturing Production; UK Goods Trade Balance; China Trade Balance
11: US PPI; NATO summit (July 11-12)
12: BOE Credit Conditions Survey; ECB Minutes; US CPI; UK White Paper on new Brexit proposal
13: Preliminary University of Michigan Confidence

16: US Retail Sales; China Q2 GDP; China Industrial Production; Trump/Putin summit
17: UK CPI & PPI; German ZEW Economic Sentiment; US Industrial Production
18: UK Claimant Count & Unemployment; US Housing Starts & Building Permits
19: UK Retail Sales; Philadelphia Fed Manufacturing Index

23: US Existing Home Sales
24: Euro Zone Flash Manufacturing & Services PMIs
25: German Ifo Business Climate
26: UK Prelim Q2 GDP; ECB Policy Announcement; US Durable Goods Orders
27: US Advance Q2 GDP

30: German Prelim CPI; BOJ Policy Announcement
31: German Retail Sales; Euro Zone Flash CPI; US Core PCE Price Index & Employment Cost Index; US Personal Income & Spending; Chicago PMI; China Manufacturing & Non-manufacturing PMIs; China Caixin Manufacturing PMI

1: UK Manufacturing PMI; US ISM Manufacturing PMI; FOMC Policy Decision
2: UK Construction PMI; BOE Policy Decision; China Caixin Services PMI
3: UK Services PMI; US Payrolls & Unemployment

7: China Trade Balance
8: China CPI
10: UK Manufacturing Production; US CPI

12: Japan Prelim Q2 GDP
13: China Industrial Production
14: Germany Preliminary Q2 GDP; Euro Zone Q2 GDP; UK CPI & PPI
15: UK Unemployment & Claimant Count; UK Inflation Report; US Retail Sales; US Industrial Production
16: UK Retail Sales; US Housing Starts & Building Permits; Philadelphia Fed Manufacturing Index
17: Euro Zone Final CPI; Preliminary University of Michigan Sentiment

21: German ZEW Economic Sentiment
22: US Existing Home Sales; FOMC Minutes
23: ECB Minutes; Fed’s Jackson Hole symposium begins
24: Various European Flash Manufacturing & Services PMIs; US Durable Goods Orders

27: German Ifo Business Climate
28: UK Q2 GDP (second estimate); US Consumer Confidence
29: US Prelim Q2 GDP (second estimate)
30: German Preliminary CPI; US Core PCE; US Personal Income & Spending
31: German Retail Sales; Euro Zone Flash CPI Estimate; US Chicago PMI; China Caixin Manufacturing PMI