7 June 2019
World trade heading for the worst year since 2009

The strong setback to world trade growth at the end of 2018 and the damage from the trade war will make 2019 the worst year for trade since the financial crisis, with only 0.4% growth. 2020 is likely to show growth around 2%, but that improvement could vanish if the trade war drags on in 2020

Uphill battle

The outlook and this article were updated on Monday the 10th of June to include the effects of the US - Mexico migration deal.

World trade is fighting an uphill battle in 2019. During the last two months of 2018, global trade levels dropped more than 3%. An economic setback in the world’s largest (trading) economies and plunging confidence among investors led to the largest fall in trade volumes since the global financial crisis.

Disappointing US jobs report: A huge miss

While we were expecting jobs growth to slow down this time, few could have predicted such weak payroll numbers. The poor reading only cements market expectations for Fed rate cuts ahead

The latest US jobs report has done little to stem the wave of economic pessimism sweeping over markets. Jobs growth slipped to 75k, although importantly we think is more likely to be down to constrained supply rather than weaker demand for labour. Admittedly there have been one or two pockets of weakness – manufacturing employment growth has slowed in recent months, but in May, manufacturing growth barely moved from the previous month (slowed to 3000). However, we expect it to come under further pressure as production slows in the near-term

The manufacturing sector isn’t immune from the wider skill shortage issue that has swept through the jobs market. The NFIB small business survey suggests that almost 40% of firms have positions they cannot fill, while these firms cite labour quality as by far their single biggest problem.

In other words, a slower trend in jobs growth over coming months shouldn’t necessarily be interpreted as a sign of emerging weakness. Importantly, there are broad signs that these supply constraints are gradually translating into higher wage growth.

Average hourly earnings missed estimates but still rose by 0.2% on the month and there are also signs are having to offer a broader range of incentives to retain/attract staff. The latest Federal Reserve Beige Book talked of firms using expanded benefits packages to improve retention.

In short, the latest jobs report still suggests the US economy is in relatively solid shape for the time being. With wage growth outpacing inflation and consumer confidence close to multi-year highs, consumer spending should continue to underpin overall growth during the second quarter.

But with rising concerns over where President Trump will take his trade war to the next stage, risks facing the economy are undoubtedly growing – albeit the 100bp of easing now priced in by the end of 2020 may be a little overdone.

Fed easing and the dollar: Necessary, but not sufficient

There is a conviction that the Fed is going to have to cut rates to insulate the economy from trade wars. US rates are collapsing, but the dollar is holding up reasonably well.  We suspect that is due to wide US yield differentials and uncertainty over overseas growth prospects. That said, expect defensive positions to build against the dollar

Markets are convinced the Fed will ease

After all the discussion about whether the flat/inverted US yield curve portends the next US recession, it now seems the market is convinced that the Federal Reserve has to act. Beyond the aggressive pricing of Fed cuts (67bps by the end of 2019 and another 33bp by end 2020), we are starting to see a clear, bullish re-steepening of the US 2-10 year Treasury curve.

After all the discussion about whether the flat/inverted US yield curve portends the next US recession, it now seems the market is convinced that the Federal Reserve has to act

During the last three major Fed rate cutting cycles this curve steepened around 250bp as reflationary Fed policy filtered through the market. Typically a weaker dollar plays a role in reflationary US policy, but its decline is not always immediate. In particular, 2001-02 saw the dollar stay temporarily supported even as US interest rates crumbled.  

What will it take to sink the dollar now? We think a dollar decline will have to come through two clear, but related channels: i) interest differentials and ii) growth differentials. The former drives fundamental FX hedging (corporates) and investment (FX reserve manager) decisions. The latter drives broader portfolio (debt and equity) allocations and at some point will pressure-test widening US deficits, commonly seen as the Achilles heel of the dollar.  

Germany: Horrible start to the second quarter

Disappointing April data from industrial production and trade suggest that the latest ECB’s dovishness is justified

German industry had a disappointing start to the second quarter. Both industrial production and trade fell in April, adding to the latest concerns that the eurozone’s largest economy will not be able to maintain its growth pace of the first quarter of the year.

Industrial production fell by a sharp 1.9% month-on-month in April, from 0.5% MoM in March, the first drop since January this year. On the year, industrial production was down by 1.8%. Production in all sectors dropped, except for activity in the construction sector.

At the same time, German exports (seasonally and calendar adjusted) fell like a stone, dropping by 3.7% MoM in April, from 1.6% MoM in March. Imports decreased by 1.3% MoM, from 0.4% MoM in March. As a result, the trade balance shrank to €17.94 billion in April from €22.6 billion in March.

Two data points - one story

Let’s be clear, this is a horrible start to the second quarter for German industry, as global trade tensions as well as temporary problems in the automotive sector and chemical industry have left their marks. One-off factors should have disappeared by now and even turned into temporary positives. Yet the experience of the last few years shows that there is almost always another disruptive one-off factor waiting around the corner. This means that industry will continue to fluctuate between, on the one hand, low interest rates, high capacity utilisation and a strong need for new investments which eventually should be supportive and, on the other hand, disruption from trade tensions as well as structural changes in the manufacturing sector.

Despite the order book deflation since last summer, businesses still report filled pipelines of assured production. At the same time, however, another sharp increase in inventories brings back memories of last year and should curb the optimism.

The German export sector also continues to suffer from the trade conflict. But it's not all gloom and doom. Maybe it was hoarding in the run up to the first Brexit deadline but exports to the UK increased in the first few months of the year. In fact, German exporters almost sold as much to the UK as to China over this period. Also, the share of exports going to the US slightly increased though this could clearly be a two-sided sword as it is shows how vulnerable the German economy is to possible US tariffs. At the same time, the weakening of the effective exchange rate since September 2018 should have partly cushioned the negative impact from global trade tensions. Currently, the effective exchange rate is below its 2018-level, providing some tailwind for exports in the months ahead.

Down but not out, yet

Looking ahead, the past has often shown that a single month is clearly not a good illustration of German industry or the entire economy. The April data could even be partly distorted by seasonal effects. However, there is no doubt that the German economy had a disappointing start to the second quarter, justifying the European Central Bank's new dovishness. It now needs even stronger domestic demand and a bounceback in May and June to avoid a return to recessionary territory.

EUR & ECB: Ready to offset the possible dovish Fed

Despite the lack of explicit action, the European Central Bank (ECB) got as close as it gets to an interest rate cut. This means that if the Fed starts cutting, the ECB will likely do too. Hence, calling for an imminent and pronounced EUR/USD upside may be premature

As close as it gets

While President Draghi could not deliver a clear and explicit dovish bias due to the lack of a meaningful change to the eurozone (EZ) growth and inflation ECB staff forecasts (note that the ECB staff projections did not fully capture the recent deterioration in the global trade war outlook due to the cut-off date), the signal was very clear. In our view, the ECB is as close as it gets to an interest rate cut (see ECB: Dovish vehemence from Vilnius). If the Fed is in a situation whereby it needs to cut interest rates (largely due to the trade war effect) it is likely that the ECB will deliver interest rate cuts as well.

ECB: Dovish vehemence from Vilnius

Dovishness all over. With today’s meeting, the European Central Bank is, in our view, only a small economic slip away from a rate cut

At its meeting in Vilnius, the ECB today clearly tried to convey a dovish message to financial markets, demonstrating its willingness and readiness to act. Today’s meeting was as dovish as it can get without actually engaging in new action.

The ECB’s concerns mainly seem to be driven by increased and prolonged uncertainty, rather than the fear of an imminent collapse of the eurozone economy. In fact, the ECB’s macro-economic assessment remained relatively unchanged. The latest round of ECB staff projections (to be accurate, from the eurosystem staff) showed only minor changes compared with the March projections.

  • The growth outlook for 2019 was even revised upwards to 1.2% (from 1.1%), while the 2020 and 2021 forecasts were slightly lower than in March, now at 1.4% (from 1.6%) and 1.4% (from 1.5%).
  • As regards inflation, there were also hardly any changes, with headline inflation now expected to come in at 1.3% in 2019 (from 1.2%), 1.4% in 2020 (from 1.5%) and 1.6% in 2021 (unchanged).

In sum, the staff projections did not actually provide sufficient room to act. Instead, ECB President Mario Draghi explicitly cited prolonged uncertainty, noting in the press conference that the trade conflict and Brexit have not disappeared as quickly as the ECB had hoped in March. In fact, these uncertainties are here to stay for much longer, according to the ECB.

Against this backdrop of increased and prolonged uncertainty, the ECB today decided to:

  1. Push its forward guidance on interest rates to “at least through the first half of 2020”, from “at least until the end of 2019”. 
  2. Offer a new series of cheap loans for banks (TLTRO III) at 10 basis points above the main refinancing rate (currently 0.1%) and 10 basis points above the deposit rate for banks reaching an ECB benchmark for net lending similar to the one in the previous TLTROs (this rate would currently be -0.3%).
  3. Finally, the ECB definitely shelved the issue of a tiering system for the deposit facility for the time being, stating that the “positive contribution of negative interest rates…is not undermined by possible side effects on bank-based intermediation”. Still, this discussion is not entirely dead. The ECB will continue to monitor it carefully and Draghi kept the door open, pointing to the possible necessity of a tiering system in case of changed (rate) circumstances.

Enshrining the legacy

An interesting aspect of today’s change in forward guidance is that it will actually bind Draghi’s successor to continue with his legacy for almost a year, at least. This was definitely not the main goal of today’s decision but the Governing Council committed any next president to its current monetary policy. There will be no reversal of monetary policy like in 2011 when Draghi started his term.

Fierce determination to act

The most important part of today’s meeting came during the Q&A session when Draghi repeated several times the ECB’s readiness to act “if adverse contingencies were to materialise”. The surprise moment was when he reported that the ECB today actually discussed options like rate cuts and restarting quantitative easing in such a scenario. According to Draghi, no one should have doubts about the ECB’s policy stance.

Only one economic slip away from a rate cut

All of this means that the ECB has joined the choir of global central banks which have either already delivered new easing measures or are contemplating them. In fact, the ECB is now only a fraction away from new stimulus. It’s not their preferred option but it will probably only take a small economic slip for the ECB to cut rates.

We were wrong on RBI policy, but for the right reasons

The shift in Indian central bank policy stance from ‘neutral’ to ‘accommodative’ doesn’t’ mean there will be more rate cuts. Hopefully, the central bank recognises pipeline inflation pressures and stays put in the meetings ahead 

Another RBI rate cut - not quite what we expected

As expected by an overwhelming majority in the Bloomberg survey, the Reserve Bank of India slashed the key policy rate by 25 basis point for the third time this year, taking the repurchase rate to 5.75% and reverse repo rate to 5.50%. The central bank also changed its monetary policy stance from 'neutral' to ‘accommodative’ but there was no change to the 4.00% cash reserve requirement ratio for commercial banks.

We thought the RBI would see through the latest GDP slowdown recognising pipeline inflation pressures from food and fuel prices, a weaker currency and an excessively loose fiscal policy

We were a consensus outlier in our forecast of an 'on-hold' policy, partly based on our conviction that this is what we think the central bank should be doing rather than what it would necessarily do, given that the economy has had enough stimulus - two rate cuts earlier this year, plus significant fiscal boost from government's re-election bid.

We believed the RBI would see through the latest GDP slowdown recognising pipeline inflation pressures from food and fuel prices, a weaker currency and an excessively loose fiscal policy.

Italy: Debt-driven excessive deficit procedure recommendation: take two

The move from the EU Commission, which did not come as a big surprise, will now force a clarification between the Italian government stakeholders on the future attitude towards Europe. Should a compromise not be reached, chances of a September political election would likely shoot up

EU Commission recommends debt-driven excessive deficit procedure against Italy

After the exchange of letters between the Italian government and the EU Commission, the latter decided earlier today to recommend the opening of a debt-driven excessive deficit procedure against Italy for the 2018 divergence.

China: Revising yuan lower but 7.0 should hold

We are revising our USD/CNY and USD/CNH forecasts to reflect expectations for a weaker yuan. This is a result of the rising tensions between China and the US over trade and technology. However, we don't expect the currency pairs to pass through 7.0. Here's why

Our yuan forecast has been hit by the technology war

Back in April, we thought trade negotiations were progressing well. We were wrong. China has since demanded a revision to the terms of the draft trade deal which it says are "disrespectful" to China. This move has rocked the market globally.

USD/CNY jumped from 6.7349 at the end of April to 6.7915 at the open of the first trading day in May. This change of sentiment means the yuan is going to depreciate rather than appreciate for the rest of the year.

China also wants to leverage the yuan's depreciation, showing that it does not intend to appease the Trump administration, which has urged Beijing to stabilise the value of the yuan.

Reading time around 14 minutes

In case you missed it: Dovishness all over again

US jobs miss forecasts cementing market expectations of a slowdown, and if the Fed cuts rates, the ECB will probably follow suits as it is a smidge away itself. Elsewhere, we've revised our yuan forecast lower amidst President Trump's trade crusade as the damage from the trade war is set to make 2019 the worst year for trade since the financial crisis

In this bundle