1 June 2018
US-EU trade war: Time’s running out

The EU is set to retaliate against US tariffs on steel and aluminium by imposing tariffs of its own on Friday. Even though the economic impact of these measures will be relatively small, it will be felt in industries ranging from US bourbon and whisky to yachts, boats and motorcycles

Economic damage of tariffs will be limited

The EU will retaliate by imposing tariffs on 185 US export, according to a list already published.

These measures would hurt the economy on both sides of the ocean only a little. The direct impact of the steel and aluminium tariffs on the European economy are limited because exports of steel and aluminium to the US make up no more than 0.3% of worldwide goods exports by the EU and represent 0.05% of the EU's GDP.  And some of that will be lost anyway due to lower US demand as prices increase due to higher tariffs.

The effect of the retaliation on the US economy is negligible too. Most of the products on the list seem to be politically motivated because they target the constituency of important American politicians. For example, bourbon comes from Kentucky which is the home state of senator Mike McConnell. The total value of products charged with the tax is small: $2.8 bn which represents only 0.1% of US exports worldwide. Nevertheless, the targeted industries will feel the pain. 

For the EU the damage will be concentrated in steel and aluminium industries. The exact effect will depend on US price sensitivity for EU steel and aluminium. That depends on the homogeneity of the EU steel and aluminium. In other words: can it easily be substituted by steel and aluminium from domestic US suppliers or by foreign suppliers that aren’t subject to higher tariffs? To our knowledge, this type of information is unavailable at such a disaggregated product level.

But the damage will be contained because 88% of EU exports of steel have other destinations than the US. On the national level, steel industries in Sweden, UK and Greece have the most exposure to the US, but the German, Italian and Dutch exposure are the largest in absolute value (see Fig. 1).

For aluminium, the French, Italian, Austrian and UK industries stand out as prime victims of the US tariffs. But also for aluminium holds that the lion’s share of EU exports goes to other countries than the US. France is most dependant on American demand with around 6% of its aluminium exports going to the US.

Navigating Italian political risks: What’s next?

Although a 5SM-League government will be announced later today, we take a step back and outline four potential scenarios from the benign to severe and their implications for markets 

Italy's populist Five Star Movement and the far-right League have sent jitters across markets with their proposals to form a government on an openly euro-sceptic agenda. The President’s veto of a proposed Euro-sceptic finance minister at one point threatened a constitutional crisis.

Spain: Enter another minority government

Pedro Sanchez, the leader of the socialist party PSOE, is the new prime minister of Spain after his no-confidence vote against Mariano Rajoy passed in parliament. We expect the economic impact to be low in the short-run

Weak government raises odds of snap election

Sanchez said he wants to keep the 2018 budget and to continue to follow the stability programme presented by the previous government under the European semester, at least for this year. He will try to pass the 2019 budget and he does not want new elections.

The just-ousted government, led by Rajoy, was also a minority government with 134 seats in a parliament of 350 and governing was already difficult. As the PSOE only has 84 seats and there is no talk of a formal coalition, it will be even more difficult to govern. Officially, new elections are planned in 2020. But given the weakness of the new government, a snap election in the coming months is more likely.

These developments, of course, introduce some uncertainty into the economy. But we expect the overall impact to be low. As Sanchez will carry on with the fiscal policy decided by the previous government, financial markets should not worry about a spending surge by the new government for now, as in Italy. Admittedly, Sanchez could try to go for larger fiscal stimulus in the 2019 budget, but it remains to be seen if he will succeed in getting that budget through parliament.

Solid US jobs report keeps the Fed on track for a June hike

Rising employment and an above-consensus wage growth figure will reinforce expectations for a rate rise in a couple of weeks, although Fed voters will also have a firm eye on the latest trade developments

President Trump said shortly before today’s US jobs report that he was “looking forward” to seeing the numbers. And with the economy having added 223k jobs in May, he is likely to be fairly chuffed.

The unemployment rate fell to 3.8%, a new post-crisis low, and in fact, came within spitting distance of 3.7% once rounding is taken into consideration. This decline came as almost 300,000 job hunters found employment in May, according to the household survey.

But for the Fed, the key positive in this month’s report is that wage growth beat estimates, taking the year-on-year rate back up to 2.7%. This comes as firms appear to be finding it harder to fill positions. The proportion of small businesses finding it hard to fill job openings continues to flirt with all-time highs, while it’s taking around twice as long to fill vacancies than it did during the depths of the financial crisis. We think wage growth could test 3% again this year as these skill shortages gradually filter through to the official numbers.

We think wage growth could test 3% again this year

All of this means that a rate hike is still highly likely from the Fed in a couple of weeks’ time. Our base case is that the committee will hike a further two times after that in 2018, although of course there’s no doubt that Fed officials will be keeping a firm eye on the brewing global trade war, and this is the main risk to our view.

As far as the jobs numbers are concerned, we suspect it is probably too early to see the effect of Trump’s metal tariffs in this month’s data, but things could start to look a little more concerning over coming months.

There are reportedly only around 300,000 workers directly employed in both the steel and aluminium production industries. By comparison, some estimates have put the number of jobs in companies reliant on steel/aluminium inputs at around 6.5 million – in industries covering aircraft to beer cans. On this basis, the risks stemming from the metals tariffs are likely to be a net negative for the overall jobs market.

Why we’re forecasting the yuan to depreciate

Even though concerns about depleting foreign exchange reserves could limit the extent of yuan weakening, a depreciation trend is more likely than before. That's why we're changing our USD/CNY forecast to 6.60 for 2018 from appreciation to depreciation 

Why China will be more willing to take advantage of a stronger dollar

Trade war escalations between China and the US along with rising political risks in Italy and Spain have formed a strong dollar trend, and this is the key reason why we're revising our yuan forecast. 

A strong dollar is likely to create headaches for the US administration as this won't help narrow its trade deficit with China. As the greenback strengthens against most major currencies, China should be willing to allow a weaker yuan as it sends a signal to the US that the exchange rate movements are largely a result of a steep dollar rather than any manipulation by China. 

In other words, this means China is being passive ending up with a weaker yuan against the dollar. This passive influence by the strong dollar makes us think a slight depreciation of the yuan against the dollar is more likely than we previously believed, even though we thought this was unlikely.

Brazil: Strike weakens, but fiscal worries deepen

Brazil’s chief challenge is its unsustainable fiscal trajectory, which can only be addressed with the election of a new administration committed to fiscal austerity, and with considerable political capital to approve much-needed but unpopular initiatives

The truckers’ strike appears to be winding down amid mounting economic losses and growing questions about its legitimacy. The deterioration in economic activity and inflation should be short-lived, while domestic financial assets should stabilise with the support of market intervention by the Treasury and the Central Bank. But the fiscal impact should be lasting, complicating Brazil’s already challenging fiscal and political outlook.

China’s Xi speaks, Trump reacts

Tensions over a US-China trade war are far from over. On 28 May-before the US announced possible tariffs on Chinese imports and a control list on investments and exports to China- President Xi Jinping made a high-level speech about the need for China to be self-reliant on high-tech products  

The timing of President Xi's speech plays an important role in forthcoming trade negotiations

President Xi Jinping’s speech on 28 May emphasises building a self-sustained high-tech industry. We think the speech plays an important role in the China-US trade war. 

  • First, the speech was made by President Xi himself, suggesting the objective of building a self-reliant high-tech economy is concrete with a high chance of success given Xi's power of execution. 
  • Second, the timing of the speech is significant. It was given before the US administration announced a list of tariffs on Chinese goods (on 15 June) and a list of investment and export controls on high-tech products into China (before 30 June).  
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In case you missed it: Brave new world

The political shake-up in Italy and Spain begins to cool down, the threat of a global trade-war heats up as allies retaliate and the US unemployment rate hits a new post-crisis low which President Trump was 'looking forward' to

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