5 October 2018
US: A President under pressure?

The US economy continues to roar, and with upward inflationary pressures, the Fed remains in tightening mode. But with just under five weeks to go until the November mid-terms, the Republicans are seemingly facing an uphill battle, which could lead President Trump to focus even more on his protectionist stance

The US economy continues to prove the doubters wrong. Activity is incredibly strong, and job creation is vibrant while wages and asset prices are on the rise. As such it’s no surprise that business and consumer confidence are at multi-year highs. Given the often repeated comment that elections are all down to “the economy, stupid” it would be fair to assume the Republicans should be riding high in the opinion polls ahead of the mid-term elections. But they aren’t. 

In fact, polling analysts and bookmakers suggest it is likely that the Democrats will win control of the House of Representatives. This will have implications for President Trump’s agenda, the outlook for trade policy and as a direct result, the economy and financial markets.

FX: Still a very clouded path ahead

While Sterling remains caught in the Brexit negotiations, we retain a constructive EUR/USD outlook for the next year, expecting the pair to move into the 1.25-1.30 area. And we remain cautious about the extent of the potential upside to emerging market FX as trade war rhetoric may return again

Italy weighing on the euro yet again

Yet again, Italian politics hit the euro - and this time by the higher than expected Italian budget deficit plan which translated into the BTP sell-off and a lower euro. But with the Italian authorities at least signalling their willingness to adjust the path of the deficit lower for the years beyond 2019, the worst for the euro may be behind, for now at least.

China: More retaliation on the way

With trade tensions with the US only set to increase, we expect the People's Bank of China to allow the yuan to depreciate to 7.00 by the end of this year

Trade war looks set to be long and increasingly complicated

On 18th September, China announced fresh tariffs on a list of $60 billion worth of US goods. The tariff rates are set between 5 to 10%, which is lower than the 5 to 25% that was proposed previously, following a US decision to initially limit tariffs to 10% on its list of $200 billion worth of goods. However, these lower tariffs are only set to last until the end of 2018, and if the US increases the rate to 25% in 2019, as it has suggested, we expect China to follow suit – as it initially suggested back at the start of August.

Given that China imports less from the US than it exports, there is only so much China can do quantitatively. So the focus is now increasing on China’s qualitative retaliations

This so far includes the reinstatement of a 2013 WTO dispute and lowering import taxes on various goods - a move designed to weaken the competitiveness of US companies in China. This decision will benefit other countries’ exports to China, while US imports suffer from the additional tariffs and this is a situation is similar to that of US automobiles, which face higher tariffs in China than imported cars from other economies.

But the trade war doesn’t end with tariffs. Geopolitical tensions in the South China Sea escalate at a time where China will not return to the negotiation table until after the US mid-term elections. The new trilateral trade bloc of US, Mexico and Canada (USMCA), will include a clause that allows any member to veto trade agreements between China and other members. With negotiations between China and the US delayed, the trade war is set to be a long and increasingly complicated process, which undoubtedly will continue into 2019.  

Eurozone: Italian turmoil returns

With a proposal to refrain from any deficit reduction over the next three years, the Italian government has put the markets on high alert again. We still believe that a compromise with the European Commission can be found, but the lack of further Eurozone integration means that this kind of tension will return

The budget situation has put markets on high alert

The Italian government's decision to deviate from last fiscal year’s stability program was more or less anticipated, but the scope and, more importantly, the persistence of the deviation is a reason for concern. Where until recently it was assumed that the target deficit for 2019 could be set at just below 2% of GDP and that the subsequent decline would be slower than agreed by the previous government, the current Italian government announced a deficit of 2.4% for three years in a row. With a debt-to-GDP-ratio above 130%, this clearly increases risks to medium-term debt sustainability.

While the fine print of the deal isn’t clear yet, the European Commission is unlikely to accept this without any alterations

On top of that, credit rating agencies will be tempted to cut Italy’s rating. Of course, the current proposal is not necessarily going to be the outcome (it seems that the Italian government is already backtracking a bit), but markets have been put on high alert as the 10-year bond spread with Germany climbed above 300 basis points.

We believe that the European Commission, while not playing hardball, is going to try to direct the Italian spending plans to the most productive expenditures, finding a balance between giving Italy some leeway to boost economic growth, while at the same time keeping debt sustainability in mind and an outcome might have to wait until December.

Japan: The third arrow

The Japanese economy is experiencing a strong period, with the most convincing reason being the reduced efforts from the Bank of Japan to maintain low bond yields. That said, risks regarding a US-Japan tariff war still prevail

Perhaps the most convincing confirmation that the Japanese economy is enjoying a strong spell is the continued reduction of effort put into maintaining low bond yields by the Bank of Japan.

Rates: Why the core rates are being slowly released

Some of the factors holding core rates down have subsided, and there has been a clear shift in central bank thinking. There are a number of things at play pointing to high rates, but it’s never straightforward. However, it does seem that the waters are finally parting in the direction of a further nudge higher in rates

Some of the factors that had been holding core rates down have subsided.

Brexit blog: Finally, a fudge?

Reports suggest UK Prime Minister Theresa May is inching towards a compromise on the Irish border issue, which could help break the deadlock in Brexit negotiations. But will it fly with the DUP and Conservative Brexiteers, or even the EU?

Headlines suggest possible UK compromise on Irish backstop

Away from the noise of the Conservative Party Conference, the big story of the week is that Theresa May could be gearing up to propose a compromise with Europe on the contentious Irish border issue. So what does this mean in practice, and crucially, will it be enough to convince UK lawmakers?

Reading time around 6 minutes

Global Economic Update: Looking for a silver lining

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