7 September 2018
Eurozone: Half full or half empty?

While the eurozone economy hasn’t suffered too much from the trade skirmishes, uncertainty around both the Italian budget and the Brexit deal is likely to prevent any growth acceleration in the second half of the year. With inflation only likely to pick up at a snail’s pace, the odds of seeing much monetary tightening remain low over the next two years

Second quarter growth was OK-ish and cease fire in trade war is good news

Is the glass half full or half empty? That seems to be the question for the eurozone economy. The second quarter saw 0.4% quarter-on-quarter GDP growth, the same as in the first quarter which was held down by exceptional factors. So no acceleration, but at the same time the eurozone economy hasn’t suffered too much from the trade skirmishes, initiated by President Trump. Where do we go from here? On a positive note we should mention Jean-Claude Junker’s visit to Washington D.C., which resulted in a cease fire in the trade hostilities, taking away some uncertainty for European companies. The first increase in nine months of the German Ifo-index in August is testimony to that.

Let’s also not forget that still loose monetary policy and a weak euro exchange rate will remain growth-supportive in the months ahead. At the same time, the international economic environment has become less upbeat, with several emerging economies experiencing financial tensions, though this might be compensated to some extent by the still buoyant US economy.

FX: Peak Trump?

The strong dollar and aggressive protectionism continues to ask major questions of vulnerable Emerging Markets. This narrative looks set to extend into the November US mid-terms. Add in the Italian budgetary position and EUR/USD should stay under pressure over coming months. The wild card here, however, is President Trump’s desire for a weaker dollar

President Trump has played his hand well

President Trump has played his hand well. After a relatively quiet first year in office, the protectionism characterising his second year has been launched from a position of strength. Here the $1.5 trillion fiscal stimulus agreed at that start of the year has provided a strong tail-wind to the economy. The tax break on repatriated profits has also provided direct support to the US stock market – and the dollar.

Whether US mid-term elections clip Trump’s wings remains to be seen, but we suspect we will see Peak Trump over coming months. That aggressive protectionism should be reflected in the dollar pressing new highs against vulnerable EM currencies and perhaps some marginal new lows in EUR/USD -  aided by uncertainty around the Italian budget.

Were Trump’s trade position to turn more conciliatory after the mid-terms and, as we forecast, the ECB to progress with monetary normalisation through 2019, then we should see EUR/USD recovering towards the 1.25 area. At some point as well, US twin deficits will catch up with the dollar – although this may not be a story until late 2019.

Rates:  Why they are so low

Core rates are low for many reasons, ultimately a reflection of excess demand over supply - which has been affected by quantitative easing. But there is also a fear factor in play, not just flight from struggling emerging markets, but also from the Italian story which could, although not our base view, disrupt the eurozone significantly

Flight to safety from emerging markets

Core rates are being constrained by fear. And it has little to do with future recession worries, at least not directly. The biggest fears are centred on various brewing idiosyncratic risks lurking outside core markets. There is an emerging markets aspect to this centred on the likes of Argentina and Turkey. The catalysts vary, but 40-50% collapses in respective currencies is as good as a barometer as any. This has generated a flight to safety, infecting the likes of Brazil, South Africa and Russia. The drivers vary, ranging from election uncertainty to macro mismanagement to sanctions fears. But one outcome is clear; this all generates flows into safer shores, like Treasuries and proxies.

US: Onwards and upwards

Given fiscal tailwinds, the strong jobs market and surging corporate profits, we look for the economy to continue growing robustly through the rest of the year, which will keep the Fed on its “gradual” policy tightening path

A positive story

For all the negative headlines regarding trade wars, interest rate hikes, political uncertainty and fears for what an inverted yield curve could portend, the US economy continues to perform very well. The US expanded 4.2% annualised in 2Q18 and we look for growth of 3-3.5% in 3Q with full year 2018 growth of around 3%. With all of the key inflation measures at or above the Federal Reserve’s 2% target policy makers are likely to continue with “gradual” interest rate hikes.

In terms of the 2Q GDP report, consumer spending made a major contribution as the combination of a strong jobs market and huge tax cuts boosted household incomes. Investment also performed strongly while net exports contributed around a quarter of the 4.2% annualised growth.

Japan: Mostly good

Japan’s economy is in decent shape, judging by GDP and the labour market performance, and its persistently low inflation is doing no harm at all. Which leads us to question the Bank of Japan’s continued extremely dovish policy stance

Except for an unrealistic inflation target, policy measures are working

If the Bank of Japan (BoJ) did not have such an unrealistic inflation target (2.0%), and therefore didn’t have to spend so much time, and let’s face it, so much money, trying to achieve the unachievable, we would look at Japan’s economy right now and conclude that the BoJ and the government were doing a decent job.

China: Ready to strike back

China is gearing up to respond to an expected escalation in US trade agression. Counter-measures against US exports and US business interests look likely, while fiscal and monetary stimulus aims to support the Chinese economy  

Trade war with the US likely to escalate

On 3 August China’s Ministry of Commerce announced a $60 billion list of goods on which to impose tariffs ranging from 5% to 25%. This came after US President Trump said he would increase the tariff rate on the next $200 billion of goods to be hit from 10% to 25%. Together with the US’s previous tariffs on $50 billion of Chinese exports, this would mean nearly half of China’s exports to the US are covered by tariffs. This will have a major impact on China’s export, manufacturing and logistics sectors, and therefore the economy as a whole.

China’s retaliatory tariffs will not be enough to match the US like-for-like because China imports much less from the US than it exports. For this reason,  China is very likely to impose qualitative retaliation (behind the border obstacles than make it more difficult for US companies to compete in Chinese markets) when the US imposes the next tariffs in order to fully match. The form that qualitative retaliation will take is uncertain, and how harsh these measures will be is also not known. Qualitative retaliation is open-ended in nature, and could create much more uncertainty in the market than simple tariffs.

The Chinese response will depend on how far the US goes with its next round of tariffs. Negative feedback from US companies could pressure the US government to trim the list of goods hit by tariffs, and lower the rate imposed. In that case, China would not retaliate as harshly and the dynamic between the two sides might change for the better. This may lead to risks subsiding gradually.

Reading time around 7 minutes

Global Economic Update: Peak Trump?

In our monthly economic outlook, we examine the turmoil in emerging markets exacerbated by a strong dollar, rising US borrowing costs and fears of a trade war. We also delve into Europe's troubles, with Italian politics in focus and mounting Brexit risks. Will US markets and the dollar continue to strengthen against this backdrop or are we past the peak?

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