Friday, 19th of July 2019
“I have no desire to suffer twice, in reality and then in retrospect.”
– Sophocles
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Equities reverted somewhat this week after an underwhelming start to the Q2 earnings season and on the news that US-China trade talks have stalled while the US government weighs how best to respond to Chinese demands that they lift restrictions on Huawei before there can be any in-person meetings. Investors have so far been rather schizophrenic in their reading of the negotiations and the broader state of international trade, leaping from one conclusion to its opposite based on all titbits of information fed to them by officials (or simply plucked from the ether). We have seen before that a little knowledge can be a dangerous thing: in May, investors became convinced that a comprehensive trade deal was at hand, thanks to a flurry of optimistic statements (and tweets) and newspaper columns, before it wasn’t. The result was a significant correction. Therefore, we do not read much into the latest reports. After all, who believed that Huawei would not be a sticking point? Since when were ‘complicated issues’ (as highlighted by US Treasury Secretary Steve Mnuchin) not at the heart of these negotiations?
Our view is that a tough approach to trade is and will remain one of the President’s central talking points in the campaign to ‘Keep America Great’ in 2020, particularly in the rustbelt states that Trump believes hold the keys to victory. Even if a trade deal with China can be sold as a show of pragmatic savvy from this self-styled dealmaker-in-chief, the US President may well choose to fight another trade battle to keep the Democratic opposition on the backfoot and his base energised going into the election. The EU looks particularly vulnerable to Trump’s rampant electioneering, what with the UK’s impending exit from the bloc and the anaemic growth rates recorded in core states, like export-dependent Germany, which is suffering from the Chinese growth slowdown already. Trump’s rhetorical flourishes on the campaign trail certainly suggest that he is lining the Europeans up for round two…
Perhaps most crucially, however, when determining how trade rivalries will drive markets going forward is the simple fact that it takes two to tango in any negotiation and it is not clear that China wants a deal today. Chinese officials may well have concluded that President Trump is unlikely to be so belligerent after the election when his ‘legacy’, and not his voters, are at the top of his mind or, indeed, when the Presidency may have passed to someone who is less keen to fight a damaging trade war with China over its most contentious policies. It is true that China could do with an economic boost right now and that punitive tariffs are taking their toll. Official figures (which flatter the economy and smooth any bumps in the road, but which tend to show the underlying trend at least) suggest that the country grew at 6.2% YoY in Q2, the slowest pace since records began in 1992. In recent years, the Middle Kingdom has witnessed a rapid and unsustainable rise in corporate debt, which has ballooned to support the economy as productivity improvements stall. Much of this debt is owed by inefficient SOEs in obsolete industries, but which have party connections that make reform a politically sensitive and administratively complex process. If China wants to avoid a punishing financial or economic crisis that relegates them to middle income status for the foreseeable future, they need to tackle such structural inefficiencies (as their perilous demographics). But in what way? Cutting tariffs and subsidies is one approach, and likely to form part of the solution, but who decides? Chinese leaders, and Xi Jinping in particular, will never take the lead from America. The Chinese leadership are building an authoritarian state with a neo-Confucian governance model in which the Communist Party has an iron grip on China’s people and future – a fundamentally different enterprise from that which exists in the West. They are patient, happy to wait out the noisy political cycles in their more democratic rivals. And they are ruthless, having sent 1m Muslims and other minorities in Xinxiang to re-education camps, for example, as a callous means to secure China’s Western border, project power into Central Asia and reinforce the BRI. The notion that a celebrity billionaire’s election timetable will drive Chinese trade policy is for the birds. China will take a long-term view when handling the US and any concessions will be driven by cold calculation, their own priorities and the perceived urgency of their domestic development agenda. Wringing anything from this stone will be a tall order – and could be beyond even the most stable of geniuses.
Luckily for markets, progress towards a global trade rapprochement is of secondary importance to the musings of central bankers with their ever-expanding monetary toolkit. On Friday, it was revealed that the ECB has begun a study into whether their inflation-targeting regime is fit for purpose. At present, the bank aims to keep inflation “below, but close to, 2%”. But momentum has been growing behind a group of macroeconomists, including such leading lights as Ben Bernanke, who argue that this target is too low and/or that it biases inflation expectations downwards in such a way that prevents real interest rates clearing the market for savings and investment. Basically, the presence of the zero-lower-bound means that one cannot cut nominal interest rates much beyond zero – or far enough for all savings to find a home and for aggregate supply and demand to come into balance. Inflation is needed to reduce the real value of nominal rates in such a scenario. The problem is that the current inflation target anchors expectations so low that even when the ECB eases policy, little inflation results. To get that inflation, so the argument goes, it is necessary to push expectations higher by changing the target. We spoke about this change in the intellectual landscape in April, and it appears such concerns are not confined to the Fed and the US. The ECB President, Mario Draghi, favours a so-called ‘symmetrical’ approach to inflation-targeting whereby the bank has similar flexibility either side of 2%. In particular terms, he thinks that the ECB should be able to let inflation run hot for a while to allow price momentum to become more entrenched, reduce real rates and boost growth. Changing the inflation target in such a way would give policy a strong easing bias. Whatever the precise mechanism, should something similar become policy then interest rates in Europe are going nowhere soon. Markets rejoice!
Staying in the EU (for now) the UK – or, more precisely, the membership of the Conservative Party – is about to elect the country’s new Prime Minister, with the outcome due to be announced on Tuesday. We have previously stated our firm view that Boris Johnson would win given his high level of support from grassroots Tories, and this has since become more or less a consensus forecast. Clearly on day one, the biggest issue for markets (and the country) will be Brexit, and how to reach a deal – or at least an answer – by the 31 October deadline. Although previous deadlines have come and gone, this one is looking rather harder that those presided over by Theresa May, so some movement from both sides will be necessary to avoid a ‘no deal’ exit in the Autumn. The EU has so far not given much ground but, to be fair, it has not been in its interest to do so, so remote did the prospect of no deal seem under Mrs May. The presence of a committed Brexiteer in Westminster could focus minds. But, at this late stage, many EU officials will believe that there is simply not time for an alternative deal to be done either way. As such, the risk of the Brexit negotiations ending with no agreement has never been higher and the outcomes for sterling never so binary. If you stay in UK assets, stay nimble or stay for the long-term.
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