Friday, 31st of May 2019
“The point is that you can’t be too greedy.”
– Donald Trump
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Another week, another ugly market. By the close on Thursday, the S&P 500 was down -1.3% for the week, and it fell again at the open on Friday morning. Market indices in Europe and Asia have fared no better amid the sour global mood. Since the collapse of US-China trade talks in early May, there have been few signs that either side are willing to compromise to break the deadlock, or even get back to the negotiating table. Quite the opposite. The trenches are getting deeper and the threats more barbed.
For example, last week Xi Jinping took a choreographed tour of a factory in Shanghai that manufactures magnets from rare earth metals. China has a near monopoly in the supply of these minerals, which are used in everything from smart phones to warheads, with its mines producing 70% of world output. This gives China enormous power over the supply chains of many advanced manufacturing goods. Although, the Chinese President did not make explicit the threat to block exports of rare earth metals to the US, he was joined on the ostensibly impromptu visit by Liu He (i.e., China’s top trade negotiator). Hours later, state-controlled media decided to dispel any lingering doubts that China would consider a ban or other such measures if the trade dispute deepened.) Given their vital role in manufacturing processes the world over, restricting the sale of rare earth metals to the US would be something of a nuclear option for China. Firstly, it would undermine the country’s reputation as a producer and cause prices to soar, harming other trade partners such as South Korea and Japan. In practice, it would also be difficult to selectively block exports to the US given the circuitous nature of global supply chains. To be successful, China would likely have to ban all or most rare earth metal exports, which would clearly not be in its interest. Nevertheless, using such a ban as leverage in negotiations would not be a manoeuvre without precedent: China hit Japan with just such a move in a dispute over several islands in the East China Sea in 2010. China may never want to follow through on such a destructive threat, but it has plenty to gain from making it. Xi Jinping is keen to remind the US President, and those around him, that the size of the budget deficit is not the only way to size up your opponent in a trade war. China is not without options that could cause the US significant harm if Uncle Sam insists on further tariff hikes. Given the depth of hostilities, some have begun to talk about May 2019 as a turning point in US-China relations: the moment when the two global superpowers finally fell into the Cold War that had been looming since at least the rise of President Xi. If true, this could have big ramifications for markets.
Despite the scale of the crisis in US-China relations, President Trump has decided to open a new front with Mexico. The Donald announced on Thursday (by Twitter, of course) that he would soon hike tariffs on Mexican imports in response to an increase in the number of migrants arrested trying to cross the US border illegally. After funding for his ‘big, beautiful’ wall was blocked by Congress and the courts, Trump has finally decided to try to force Mexico into helping him realise his dream. From 10 June, US imports from Mexico are to face a 5% tax, but this will steadily increase to 25% by 1 October, unless and until the migration dispute is resolved. Unsurprisingly, the Mexican government has condemned Trump’s decision, with the country’s top diplomat to the US threatening a ‘vigorous’ response. However, President Andrés Manuel López Obrador has taken a more conciliatory approach, calling for dialogue. In recent months, Obrador has emphasised that Mexico would not give migrants fleeing from conflict and poverty in Central America ‘free passage’ to the US. However, he has also suggested that this was mostly for their own safety given the tendency for such ‘caravans’ to be exploited by traffickers. Mexico is heavily dependent on exports to the US and will not want to see additional US tariffs. But the Mexican population will undoubtedly punish anyone who caves in to Trump without a fight. Mexico will need to save face in any deal on the border and you can expect much fire and fury in the meantime (at least in public). The biggest casualty of Trump’s latest broadside is likely to be the recently agreed USMCA (i.e., the NAFTA replacement). Getting that deal ratified in the current climate seems unlikely. Sad!
Amid the negative headlines, bond yields have fallen sharply across the curve this week. The collapse in confidence that the US and China will end the trade war soon, Trump’s tariff threat against Mexico, escalating tensions in the Persian Gulf and the growing risk of a no-deal Brexit in October have all contributed to a rise in risk premia and a downgrading of interest rate and economic forecasts. Rate moves have a tendency to overshoot, but the inversion of 3m and 10Y yields is a warning sign, even if its efficacy as a predictor of recessions has declined in recent years. We are watching closely to see if this move is sustained or whether the spread between the two points reverses in the coming weeks. Given the significant drawdown in markets this month already, the still strong fundamental data coming in from the US and the absence of other recession indicators giving us pause, we expect that the US yield curve will eventually normalise (along with the markets). A lot will depend on what Trump decides to do next though… which is reassuring.
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