1 February 2019
US jobs report: Stronger than ever

The main message is that strong employment growth is resulting in higher pay and this is attracting more people back to the labour market. The Fed is on pause, but the case for rate hikes will persist

Firms still hiring

This is another really strong jobs report with non-farm payrolls rising 304,000 in January. This was above even the most optimistic forecast in the Bloomberg survey and suggests that the US economy is in great shape with businesses desperate for workers. Admittedly some of this strength stems from a 90,000 downward revision to December 2018’s initially reported payrolls figure, but it suggests that the US economy hasn’t been adversly impacted by the government shutdown in any meaningful way.

Eurozone: No bounce back in GDP

GDP growth of just 0.2% quarter-on-quarter in the final quarter of 2018 confirms the slow growth environment that the eurozone has slipped into and there does not seem to be an easy way out as downside risks persist in early 2019

Hopes of a swift bounce back after the poor third quarter had already faded towards the end of the year, but the 0.2% growth in GDP remains disappointing nevertheless. After hopes of 2.5% growth at the beginning of the year, 2018 annual growth has turned out to be only 1.8%. The end of the year was marked by a disappointing recovery in auto production in Germany, downside risks further impacting confidence and yellow vest protests in France. The persistence in the growth decline indicates that there is more to it than one-offs with downside risks persisting early in 2019 as well.

Italy saw growth decline by -0.2% in Q4, therefore entering a technical recession and adding to worries about the stability of the third largest eurozone economy. More positive was France where despite the impact from the yellow vest protests, GDP growth held up at 0.3%. A much more severe impact had been indicated by the PMI, which had plummeted into negative territory in December. Exports increased significantly in France, offsetting stalling consumption growth. Germany also avoided a technical recession in Q4 judging from the annual growth figure for 2018 and Spain saw a slight acceleration of growth to 0.7%.

For the ECB, the weak growth rate means that the current staff projections of 1.7% growth for 2019 will be a tall order. Given the weakness in surveys about eurozone growth in January as well, it is likely that the 2019 growth forecast will see a substantial downgrade in March when the new staff projections are released. With this, the almost philosophical debate in the governing council of where we are and where we are going may take a more pessimistic turn that will please the doves…

Federal Reserve: Prudent patience

No change from the Federal Reserve as they emphasise they are in no hurry to raise interest rates. But if the data warrants it, and we think it will, they are prepared to tighten policy further later in the year

The Fed is in no hurry

The Federal Reserve has unanimously voted in favour of leaving the Fed funds target range at 2.25-2.5% and the clear message in the accompanying statement is that the Fed is on pause for some time to come. The key sentence was “the committee will be patient as it determines what future adjustments to the target rate” may be required. The statement also dropped the description that “some further gradual increases” in interest rates will be needed and have removed any reference to the balance of risks.

Certainly the unsettling effects of recent financial market volatility, trade uncertainty and the government shutdown give them clear reasons to adopt a wait-and-see stance. With inflation pressures described as “muted”, helped by the plunge in fuel costs, it looks as though it could be for quite a protracted period. Nonetheless, the economy is in decent shape with the jobs market described as “strong” and economic activity “solid”. 

Back in December, the Federal Reserve indicated that it would slow the pace of rate hikes this year to probably two from the four 25bp moves seen in 2018. This still seems sensible to us, but the dovish tone in today’s FOMC statement hints at downside risks to this view. The US does face more economic headwinds this year: The lagged effects of higher interest rates, the strong dollar, the fading support from 2018’s fiscal stimulus and trade tensions at a time of weakening global activity all suggest that the US economy will experience slower growth in 2019.

But, there are clear positives too with a strong jobs market, rising pay, plunging energy costs boosting real incomes and a recovery in equities supporting sentiment. We also expect core inflation to continue grinding higher, rising above 2.5% by the early summer. As Jerome Powell stated in the press conference, they are data dependent and if the data warrants it, they will hike again.

US-China trade talks: No solution in sight

The US and China meet tomorrow in an attempt to cut a trade deal. But chances are that protectionism will get worse before it gets better. US demands are too ambitious for quick fixes. The negative effects of higher tariffs are starting to kick in and economic growth will not provide much support to world trade either. Trade growth will drop to 1.3% in 2019

US-China trade talks: little chance for a deal before the 1 March deadline

US-China talks resumed on 7 January in Beijing with both sides positive about the prospects for a deal, continuing the constructive tone that had taken hold since the American and Chinese leaders agreed to a ceasefire at the beginning of December. But as we expected back then (see Don't cry victory yet), optimism has since faded. Although China has recently made some advances towards the US, the American wish list is very ambitious and wide-ranging. Alongside a much lower bilateral trade deficit, US negotiators are increasingly insisting on fundamental changes in China’s industrial policy ‘Made in China 2025’. More transparent foreign exchange operations and the value of the renminbi are on the list as well.

We don’t foresee a deal on all these issues being agreed before the deadline on 1 March. Just last week, US Commerce Secretary Wilbur Ross said the two sides were ”miles and miles away from a resolution”.

  • So, in our base case, we expect the US to turn the heat on China by increasing tariffs on $200 billion of Chinese imports to 25% in 2Q from the 10% rate imposed in September.  
  • In a downside risk scenario, the US expands tariffs further in 3Q to Chinese imports which have not yet been hit by higher tariffs (around $260 billion worth of imports).
  • On the other hand, an upside risk scenario could see Presidents Jinping and Trump reach a deal. China has already announced various policy aims of market-based reform and a rebalancing of its economy. So one route to a solution might involve China “announcing” a timetable of implementation (as seen in the 2018 announcement on liberalising the exchange rate and foreign investment regime) and agreeing to strengthen enforcement, with sanctions to be imposed in the case of no compliance. In this upside risk scenario, all tariff hikes from both sides thus far would be undone. That delivers a positive impulse of 0.6 percentage points for trade in 2019 (chart 1).  

We think it is almost impossible to reach such a deal before 1 March. So, if the upside risk scenario happens at all, it would happen later (3Q we assume) after the US increases pressure in 2Q.

What the Venezuelan oil sanctions mean for supply

The US has imposed sanctions on Venezuelan state-owned oil company PDVSA, effectively bringing US purchases of Venezuelan oil to an end. The announcement has had little impact on price, with expectations growing in recent days that such action would be taken. Furthermore, Venezuela will likely increase sales to buyers outside of the US

What was decided?

The US Treasury announced yesterday that it is imposing sanctions on Venezuelan state-owned oil company PDVSA, which would effectively close the US as a market for Venezuelan crude oil. Volumes currently being shipped will be exempt from sanctions whilst Venezuela will be allowed to sell oil to US refiners, however payments will have to go to a blocked account so that proceeds cannot be remitted to Venezuela.

The sanctions also prohibit the sale of diluents to PDVSA- usually blended with the heavier crude oil that Venezuela exports. The US exports around 120Mbbls/d of lighter oils to Venezuela for this purpose. Furthermore, US companies currently transacting/engaged with Venezuela have been given three months to wind down operations. Whilst Venezuelan refiner Citgo, currently operating in the US will be allowed to operate as normal but is not allowed to remit funds to Venezuela.

What is the impact on oil supply?

EIA data shows that the US imported on average 514Mbbls/d of Venezuelan crude oil over 2018. This supply is key for a number of refiners in the US Gulf Coast, who blend it with domestic light oil, making an optimum blend for US refineries. These refiners can switch to other origins for heavier crude oil though it may be fairly difficult for the time being.

The obvious choice for the industry would be to turn increasingly to Canadian oil. However, as a result of mandated production cuts in Alberta, the additional supply from Canada is likely to be limited. The other issue is logistics- the reason Canadian oil producers cut output was due to a lack of takeaway capacity and this is an issue that is likely to linger for quite some time.

Refiners could also turn increasingly to the Middle East for heavy crude oil supply. However under the current OPEC+ deal, members are likely to cut output of heavier crude oil first, given the discount at which it trades to lighter grades. Mexico is another supplier of heavier crude to US refiners but Mexican output has trended lower in recent years, which has also meant that exports of crude oil to the US have trended lower.  

Venezuela can turn to its next biggest buyers to increase purchases- China and India, which both took, on average, around 300Mbbls/d over the course of 2018. However for China, much of the exports go towards debt repayment, and so for PDVSA, this does little to help generate cash.

More downside to Venezuelan output?

Venezuelan oil output has been in decline for several years now, with a lack of investment in oil fields seeing production fall from close to 2.4MMbbls/d in late 2015 to around 1.2MMbbls/d currently. Given that US oil service companies will have to wind down dealings with PDVSA, this suggests the potential for a more rapid decline in Venezuelan crude oil output moving forward.

India: Bracing for yet another turbulent year

Markets are bracing for intensified political risk as a general election looms in May. Losses by Modi’s incumbent party in recent state elections raise the prospect of an indecisive vote and a coalition government. Re-pricing for this will exert upward pressure on government bond yields and the USD/INR exchange rate

A tumultuous 2018

The economy ended 2018 on a mixed note. Growth continued to grind lower as reflected by the slowdown in exports and industrial output towards the end of the year, while inflation dipped to the lowest in 18 months on persistently low food and energy prices. But core inflation remained high, feeding into rising inflation expectations. Public finances and external payments remained on weakening trends owing to high oil imports and election-related spending.

The conflict between the Reserve Bank of India (RBI), the central bank, and the government over the issue of the RBI sparing more of its reserves to fund a wider fiscal gap rocked markets in the last quarter. The rift ended with the resignation of Governor Urjit Patel in early December. Just as this paved the way for a stepped-up liquidity injection into the financial system under new governor Shaktikanta Das, the fiscal floodgates opened with further cuts in the Goods and Services Tax and extra-budgetary support measures for farmers. 

Global market volatility spiked towards the end of 2018 but local markets enjoyed a brief respite from lower oil prices. The government bond market had its best quarter in four years in the final quarter of 2018. Yet a rally in the Indian rupee (INR) in November with a more than 6% monthly appreciation against the US dollar was short-lived and the currency returned to being Asia’s worst-performer in December. 2018's annual depreciation of 8.5% was the most since 2013.

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In case you missed it: Goldilocks returns

Positive signs on the trade front, a surprisingly dovish Federal Reserve and another solid month for US jobs gave risk assets a boost this week, capping the best January for US stocks in 30 years. Goldilocks is well and truly here. But the bears are lurking.

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