Never miss an issue of Master Investor Magazine – sign-up now for free!
Back in April, the International Monetary Fund (IMF) warned in its twice-yearly economic forecast that the party would not last. Global growth, it said, would slow by 2020 – if not before. The IMF suggested it could be sooner if there were to be a slowdown in international trade.
After all the rhetoric and threats there is now a trade war underway and it is escalating on two fronts. On the one hand there is the US trade war against China. On the other there is the US trade war against the EU, which President Trump has termed “as much a threat to US economic interests” as China.
On the Chinese front, in June the Trump administration announced a 25 percent tariff on $50 billion of Chinese goods, supposedly in response to the Chinese theft of US intellectual property. The Chinese promised to retaliate.
On the European front, first the Americans imposed tariffs on European exports of steel and aluminium, to which the EU responded by putting tariffs on popular American exports such as Harley Davidson (NYSE:HOG) motorcycles. (A mid-range iconic motorcycle will now cost about £1,650 more in the UK). Second, the US Department of Commerce is about to increase tariffs on European cars – possibly substantially. Cars (particularly German ones) are by far Europe’s most valuable export to the US. And the EU has already announced that it will impose $300 billion of new levies on American imports if and when that happens.
There are reports that the Commerce Department is considering whether it could use national security laws to impose import tariffs on Mercedes (Daimler AG (FRA:DAI)) cars – and the rest. This coincides with Mr Trump’s hectoring NATO countries this week to the effect that they must increase their defence expenditure – with the implication that they should no longer take American protection for granted.
There is now a trade war underway and it is escalating on two fronts.
Many economists have explained why these protectionist methods might harm not just China and the EU but also the USA itself. The US and the EU specialise in different segments of the automobile industry, so it is not certain that if a BMW becomes 20 percent more expensive an American purchaser would substitute it with an American-made Ford. Moreover, numerous European car manufacturers operate in the US and export much of their output, thus improving the US balance of payments. Harley Davidson announced on 25 June that it would shift some of its production offshore to avoid tariffs – suggesting that corporate USA believes that these new tariffs will endure for some years.
The America-first brigade will point out that GFG Industrials (Gupta Family Group – led by British-born Sanjeev Gupta) is re-opening a mothballed steel plant in the US in order to circumvent tariffs. The question is whether that plant will be as efficient as other steel plants elsewhere. If countries insulate themselves behind trade barriers, seek to become self-sufficient and abandon the march of comparative advantage, then the global economy as a whole will suffer.
On first inspection the US economy is in robust good health with strong growth, investment and retail sales figures. Having slashed the rate of corporate profit tax from 35 to 21 percent at the beginning of the year, billions of dollars of cash held offshore have been repatriated. By one estimate the rate of growth recorded between January and April was 5 percent on an annualised basis – the strongest since 2003 – though, the latest official figure was just 2 percent.
The dollar has been strengthening in the expectation that the Fed will continue to increase interest rates, as it has already done seven times since 2016. The Dow Jones Industrial Index, as we know, rose by 25 percent last year, hitting record highs on 70 days in 2017. Gains have been more attenuated this year though the tech-oriented NASDAQ is up around 7 percent.
Yet there is a red light flashing. The US Treasury bond market yield curve has gone flat again. The difference in yield between 2-year and 10-year Treasuries was down to just 27 basis points on Wednesday (11 July) – the same as it was in 2007[i]. Analysts are pointing out that a flat or inverted yield curve has preceded all nine US recessions since 1955.
Analysts are pointing out that a flat or inverted yield curve has preceded all nine US recessions since 1955.
Of course, correlation is not causation. The flat yield curve could suggest that the institutional players who dominate the US Treasury market lack confidence about America’s medium-term prospects. But it could also have something to do with the fact that the US Treasury Department, under Treasury Secretary Stephen Mnuchin, has been borrowing increasingly at the short term end and rolling over these issues at maturity.
In the credit markets, JP Morgan recently revealed that the yield curve on the overnight index rate swap (the rate at which corporate customers can swap floating rate liabilities into fixed rate ones) was inverting (i.e. trending downwards) at the 2-year maturity point. Some commentators regard this as an omen of recession because it suggests that the Fed will have to cut rates two years out in response to an economic downturn.
Readers will be aware of the current tribulations experienced by Frau Merkel’s coalition government around the issue of immigration and the treatment of refugees. What has achieved less attention is the stream of grim economic data coming out of Germany.
On 29 June we learnt that retail sales in Germany fell by 2.1 percent month-on-month in May 2018, much worse than the market consensus of a 0.5 percent drop. This followed a downwardly revised 1.6 percent rise in April[ii]. It was the biggest fall in retail trade since May 2011. Retail sales have fallen by 0.5 percent or more in six of the last 12 months. Moreover, in April this year industrial production fell by 1.3 percent, though it snapped back by 2.6 percent in May.
Under Frau Merkel (Chancellor since 2005) and her predecessor, Herr Schröder, (Chancellor, 1998-2005), Germany’s economy has become very unbalanced. The country generates massive trade surpluses – over eight percent of GDP last year – and its industrial companies generate huge profits. Yet they pay relatively modest wages. Low disposable incomes, plus a stubbornly high savings ratio, are two reasons why consumer spending accounts for a lower proportion of the economy than elsewhere.
The unemployment picture is benign, but, as in the UK a lot of the new jobs created seem to go to new arrivals from elsewhere. According to figures cited by Matthew Lynn[iii], 354,000 immigrants, mostly from Eastern Europe, have found jobs in Germany over the last 12 months. As I explained last week, an unlimited supply of new migrant labour as a country nears full employment stifles wage growth.
Germany’s economy has become very unbalanced.
The German automotive industry looks particularly vulnerable right now. Currently, the USA imposes a 2.5 percent tariff on German car imports while the EU imposes a 10 percent tariff on imports of American cars. Very soon President Trump is going to do something about that. Then there is the little matter of a possible no-deal Brexit whereby UK imports of German cars would be conducted under WTO rules, inevitably making them more expensive. And all this comes at a time when the big names – particularly Volkswagen (FRA:VOW) and BMW (FRA:BMW) – have still not recovered from the reputational damage of the various diesel emissions scandals.
The fact is that a nation such as Germany, which is highly skewed towards manufacturing, is more exposed in a trade war than one like Britain which is predominantly a service economy. Furthermore, Germany lags well behind in terms of high-tech start-ups, whether it be in fintech, biotech, digital communications or AI/robotics – which will be the core industries of tomorrow.
Then there is the German banking system, which has never looked more fragile since the launch of the euro back in 1999. Deutsche Bank’s (FRA:DBK) share price has been hitting fresh lows with tedious regularity. As I write its shares are trading at around €9.50 – less than one third of its value five years ago.
Italy continues to be a major worry. The debt-to-GDP ratio is likely to edge up above the current level of 132 percent. Italian banks are still carrying huge volumes of non-performing loans. If the Italian banking system folds, then French and German banks will be severely impacted given their large exposures to Italian banks.
The plan for further eurozone integration put forward “jointly” by President Macron and Chancellor Merkel (though in fact a French-inspired document) proposes greater risk-sharing between members of the currency bloc. This would increase the capacity of the various institutions to bail out tottering governments – but at the price of further restrictions on how they tax and what they spend. The proposal has already met with significant opposition from 12 of the 19 eurozone member states.
What President Macron and the French mandarinate seem unable to grasp is that no amount of risk-sharing will resolve the central problem at the heart of the currency union. That is that it is not possible indefinitely to sustain a currency union when one country generates a consistent trade surplus with all the others – unless those surpluses are recycled in the form of transfers to the deficit nations (an idea to which the Germans are adamantly opposed).
The Chinese growth rate has been declining this year – and with it the Chinese stock market, which is now about 22 percent down from its 12-month peak on 25 January and at a two-year low. Investment, consumption and exports all fell last month. The Chinese housing market is also slowing.
Some analysts are concerned about the volume of US dollar denominated corporate debt in the country at a time when the value of the yuan [renminbi] is falling. The People’s Bank of China (PBOC) is deliberately allowing the currency to depreciate in order to attenuate the economic slowdown. Just to put this in perspective, as I write the yuan is trading against the dollar at approximately the same rate as 12 months ago, having appreciated substantially from December last year until April this year.
That said, international investors no longer regard China as a safe haven and are now voting with their feet. According to Morgan Stanley, foreigners have been liquidating equity holdings on the Shanghai-Hong Kong Stock Connect.
China’s central bank, the PBOC, has cut the reserve requirement ratio (RRR) for banks again, most recently on 24 June. The RRR now stands at 15.5 percent. The stated aim is to inject more liquidity into the banking system in order to boost lending to small business and to encourage debt-for-equity swaps. The latest cut will inject an estimated 700 billion yuan ($108 billion) into the economy, exceeding market expectations.
International investors no longer regard China as a safe haven and are now voting with their feet.
The programme of debt-for-equity swaps is part of an ongoing drive to cut exorbitant levels of corporate leverage. The country’s major banks, all ultimately controlled by the government, have sought to sign deals with state-owned enterprises in order to ease their debt burdens and improve their credit standing[iv]. But the move will also weaken Chinese banks’ balance sheets at a time when systemic risk is increasing given a surge in the corporate default rate and a downturn in business investment. The sprawling conglomerate, HNA Group, is currently the object of a bailout to shore up its estimated $94 billion of debt[v].
The central government has invested heavily in the economy in recent years and there are plans afoot to give a fiscal stimulus to local government. However, it is likely that government spending overall will have to be trimmed. The problem for the Chinese authorities is that if they loosen the purse strings – fiscal and monetary – too much, that could weaken the yuan further which, in turn, could trigger further outflows of foreign capital.
This actually happened in 2015-16 when the PBOC used about $1 trillion of its foreign exchange reserves to support the currency. The fall in the yuan then was arrested when the Fed, under Chairwoman Yellen, came to the rescue by suspending its monetary tapering. That is not going to be repeated this year by the hawkish Fed under Jay Powell – especially if China imposes further punitive tariffs on American goods.
The uncertainty surrounding the shape of Brexit has not abated since the cabinet away-day at Chequers on 06 July. Mrs May’s proposals which came out of that amounted to a soft Brexit and they were broadly supported by big business. But the Tory Ultras, emboldened by the dramatic resignations of David Davis and then of Boris Johnson, will not wear it. These proposals will have to run the gauntlet of Tory parliamentary support, a vote in Parliament and the EU’s negotiating team. At the time of writing it is difficult to predict – but the balance of probability is that the dispensation outlined in the White paper, published on Thursday (12 July) will never become reality, at least in recognisable form.
The weakness of Mrs May’s position makes the prospect of a Corbyn takeover more likely, as I explained three weeks ago. That, in turn, will further deter foreign investment and could even precipitate a mass exodus of capital from the UK economy as institutional and private investors take flight.
The weakness of Mrs May’s position makes the prospect of a Corbyn takeover more likely.
Furthermore, Britain is on course to hike taxes at precisely the moment that it is leaving the EU. Increased tax revenues will be used to finance increased spending on the NHS and possibly also on defence. Such a tax hike – probably in the form of cancellation of planned reductions in corporation tax – could not come at a worse time. This will further dis-incentivise businesses that might wish to invest in the UK.
The UK construction sector is looking particularly weak. The number of housing starts was down 8 percent in Q2 – 14 percent below the 2007 peak. Property prices have gone soft, especially in London, the UK’s most expensive region. Although estate agents are reluctant to tell you, there is a huge glut of unsold property which has been on the market for 12 months or more.
UK exports are flagging, and despite encouraging jobs data, it is unlikely that the Bank of England will feel confident enough to raise rates when the MPC next meets in August.
The end of QE?
After 2009 all the major central banks, following the lead set by the Fed, rolled out programmes of Quantitative Easing (QE) by means of which they conjured money out of nothing and pumped it into the economy. The Fed was the first to halt this policy some two years ago. From September this year it plans to reduce the stock of money and to slim down its balance sheet by a programme of reverse QE: that is selling bonds and treasuries that it holds (rather than buying them). Monetary contraction combined with rising interest rates will almost certainly strengthen the dollar further.
As for the ECB, six months ago it was expected that QE could be tapered back substantially by now – but that has not happened. Now that growth in the eurozone is slowing, it may be ramped up even while eurozone interest rates are effectively negative.
Central banks are still in crisis mode.
Central banks are still in crisis mode. As a result of QE their balance sheets have ballooned since 2009. But despite the Fed’s much vaunted balance sheet consolidation, QE is still far from over. The ECB and the Bank of Japan are still running the money printing presses at full tilt.
Global stock markets have suffered their worst first half year since 2010 – even though the bull run on the New York market (as I predicted back in January) has continued. Yet, according to Bank of America Merrill Lynch (NYSE:BAC), money was flowing out of equities in the week ended 29 June. The European markets are on a downward trend, reflecting the prevailing sentiment that Europe may come off worse in the trade war.
Emerging markets are struggling to cope with a stronger US dollar and higher US interest rates. Currencies such as the Argentinian Peso and the Turkish lira have fallen back sharply in recent weeks. The MSCI Emerging Markets Index has fallen by some 20 percent since its peak in mid-January.
Putting it all together
The EU has asked to participate in a public hearing at the US Department of Commerce scheduled for 19-20 July. Jean-Claude Juncker and EU Trade Commissioner Cecelia Malmström hope to visit President Trump at the end of this month. But it seems that the President’s mind is already made up. Meanwhile Secretary Mnuchin has denied rumours that Mr Trump wanted to pull out of the WTO altogether.
It is problematic to try to quantify by how much global growth will contract in response to the new tariff regimes now emerging. But credit rating agency Moody’s expects that more tit-for-tat tariffs will generate more volatility in the financial markets. They could also weaken consumer confidence and restrain corporate investment globally.
The next recession will bring about a pronounced fall in living standards which won’t be cushioned by fiscal and monetary policy.
Mr Trump’s trade wars come at the moment when the robust growth across the global economy evidenced in the last two years is winding down. It is not so much that Mr Trump’s trade wars will directly cause a global recession: but they will very probably accelerate the arrival of a recession that would eventually have occurred anyway.
Government finances in developed countries, especially in Europe, are extremely ill placed to contend with another prolonged recession. Moreover, central banks cannot cut interest rates which are already at rock bottom. Taken together, this means that the next recession will bring about a pronounced fall in living standards which won’t be cushioned by fiscal and monetary policy.
The political, and geopolitical, consequences of such a scenario could be dire – as I shall explore soon.
[iii]Germany’s economy is dangerously unbalanced and may topple Merkel, The Daily Telegraph.03 July 2018.