US toughens tone on trade, ECB may lower its growth outlook and UK leadership contenders line up

The past few months have focused on US-China trade negotiations and developments continue to suggest rising chances of further escalation.

However, the US has not been content with rising trade tensions with China alone – on Friday President Donald Trump announced a rising scale of tariffs that could be imposed on Mexico from 10 June through October (from 5% to 25%), until the “illegal immigration problem is remedied”. Mexican President Andrés Manuel López Obrador stated in a news conference that his country could tighten migration controls to defuse these threats. The US also announced it would end India’s ‘preferential trade status’ – a scheme that allows some Indian goods to enter the US duty free – from this week, following a dispute over US access to Indian markets. These parallel increases in trade tensions add to US economic headwinds.

Financial markets have seen a marked tightening in financial conditions. For sure, the increased uncertainty and unpredictability of US policy-making adds uncertainty which will weigh on US business investment and beyond. The drop in US 10-year yields – currently trading at 2.12% and their lowest level in nearly two years – has led to a deeper inversion of the yield curve, something which to our minds raises the chances of an outright US recession developing over the coming 12 months. For now, much of US trade policy is yet to take effect and the US may pull back from implementation on a number of fronts. This would certainly lead to a marked easing in financial conditions. However, the uncertainty shock inflicted on the economy may not be so easily overcome.

China hits back on the Huawei ban and lays down conditions for a trade deal.

In a response to the US government putting Huawei and other Chinese technology companies on its “Entity List”, the Ministry of Commerce has launched its own “Unreliable Entities List” of foreign companies, organisations and individuals, who “blockade and stop supplying Chinese companies for noncommercial reasons, and seriously damage the legitimate rights and interests of Chinese companies”. Subsequent to the announcement, US delivery company FedEx was reportedly under investigation for diverting parcels belonging to Huawei to the US.

On Sunday, Beijing also released a White Paper to offer “China’s explanation” as to why the trade negotiation has grounded to a halt by accusing the US of repeatedly raising demands at the final stages of trade negotiations. In addition, Beijing reiterated the three principle conditions for which a deal can be struck, namely a full removal of existing tariffs, further imports from China need to reflect genuine demand, and the eventual deal needs to be equal and fair, preserving the dignity and sovereignty of the nation. Overall, these latest developments are among many recent instances that suggest a toughening stance of the Chinese government, which does not bode well for deal-making in the near term.

With the bilateral trade tensions quickly spreading to other fields, such as technology, the risk of a full-pledged economic and geopolitical standoff is on the rise. In that regard, there are two important events to watch this week: US Vice President Mike Pence’s speech on 4 June - reportedly focusing on China’s human rights issues at the 30th anniversary of the Tiananmen Square incident - and the G20 gathering by finance ministers and central bank governors on 8-9 June, where any interactions between the American and Chinese officials will be closely watched.

US White House toughens tone on trade across major developing countries.

Along the hardening stance taken against China and China’s recent response, the US Administration has been taking various actions against other countries. A 5% tariff increase on Mexican imported goods will take effect on June 10 (with escalation to 10% by July and 25% by October) as President Trump unexpectedly decided to pressure Mexican administration on tackling illegal immigration through improved border control. The conciliatory tone on the Mexican side keeps the door wide open to some sort of agreement but these latest decisions may complicate the approval of the United States-Mexico-Canada Agreement (replacing the North American Free Trade Agreement) by the US Congress which is about to start. Mindful of the fact that exchanges between US corporates and their Mexican subsidiaries make up two-thirds of imports from Mexico, a failure to appease these tensions may weigh back on US Inc earnings – with the auto sector at the forefront - while disproportionately weighing on an already weak Mexican economy (1.5% expected GDP growth this year).

Parallelly, back in March the US Administration expressed its intention to remove India and Turkey from its special trade programme, known as Generalized System of Preferences, which exempts import duties for some goods it purchases from developing nations. This preferential trade status was officially revoked last week for India after its elections and last month for Turkey (albeit concomitantly the US decided to halve steel tariffs back to 25%). The trade program exempted “only” 14% and 17% of the total imported goods from India and Turkey respectively. However, if these tensions were to further escalate they will weigh on investment prospects at a point in the cycle where economic growth is somewhat weaker in India - poor first quarter (Q1) GDP growth of 5.8% year-on-year was led by weak capex and exports - and extremely weak in Turkey, where investments fell 13% in Q1 and GDP contracted 2.6% year-on-year.

The European Central Bank (ECB) convenes its monetary policy meeting this Thursday.

We do not expect any changes to the key policy rates at this meeting. However, we do expect communication developments on several fronts. This meeting sees the Governing Council publish its latest round of quarterly forecasts. We expect it to lower its current growth outlook modestly, from 1.1% in 2019 and 1.6% in 2020, and acknowledge further downside risks to the outlook. We also expect it to modestly lower the inflation outlook from 1.2% in 2019 and 1.5% in 2020. Our own expectation is currently for growth of 1.1% and 1.2% in 2019 and 2010 (Harmonised Index of Consumer Prices: 1.3% and 1.4%).

This meeting is also likely to see the publication of details of the upcoming targeted long-term refinancing operations, TLTRO-III, which we expect to tend to the generous side. However, we do not expect the ECB to announce any plans to introduce any ‘tiering’ of commercial banks’ reserves subject to negative interest rates at this point. Indeed, we consider the heterogeneity of the European banking system as something that makes this unlikely looking further ahead. ECB President Mario Draghi will likely face questions on de-anchoring inflation expectations during the ensuing press conference. The ECB President is also likely to continue to reassure that the “ECB’s toolbox” is full and that the ECB has plenty of monetary tools that it can use if the outlook deteriorates further from here, although we are yet to be convinced of this assertion.

UK economic outlook remains second order compared with current political uncertainty and its implications for the path of Brexit.

Tory leadership contenders continue to line up and have espoused differing views on a no-deal Brexit, renewed negotiations and a possible second referendum, while additionally discussing plans for increased spending and/or tax cuts. Parliament returns to business tomorrow after the Whitsun break. However, Prime Minister resa May’s official resignation at the end of this week – after President Trump’s state visit - will continue to hold attention for the near-term, with the Tory leadership race only officially underway thereafter. Before that, the Peterborough by-election on Thursday could see the Brexit Party - the largest single-party winner of the European Union elections - gain its first Parliamentary seat. This will only serve to focus Tory minds further on who can lead the party next – and the implications for Brexit as the next deadline of 31 October looms.

Upcoming events

US: Chicago Fed conference on monetary policy, factory orders, durable goods orders (Tuesday), ADP employment change, services Purchasing Managers’ Index (PMI), ISM non-manufacturing index and Fed Beige Book (Wednesday), trade balance, weekly jobless claims, non-farm productivity and unit labour costs (Thursday), non-farm payrolls, unemployment and earnings (Friday)

Euro Area: EU19 flash Consumer Price Index and EU19 and Italian unemployment (Tuesday), EU19, German, French, Italian and Spanish services PMI, EU19 Composite PMI and Producer Price Index, Spanish unemployment (Wednesday), EU19 Q1 GDP, ECB announcement and German new manufacturing orders (Thursday), German industrial production and trade balance and French industrial production (Friday)

UK: BRC retail sales monitor and construction PMI (Tuesday), new car registrations and services PMI (Wednesday), Peterborough by-elections (Thursday), Theresa May resigns as PM and Halifax house prices (Friday)

China: Caixin services PMI (Wednesday), foreign exchange reserves (Friday)

Japan: Leading index (Friday)

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