US trade threats continue to weigh on markets, RMB may breach key level and ECB on hold

He giveth, and he taketh away.

Last Monday we reported our surprise and dismay over the threatened implementation of tariffs on Mexico by the US unless the country addressed perceived shortcomings with migration. This threat weighed heavily on financial markets across the course of last week, sending 10-year US Treasury yields lower to hover around 2.10%. However, as quickly as this threat materialised, it disappeared. On Friday, the US and Mexico announced agreement that tariffs would be indefinitely deferred following a number of initiatives proposed by the Mexican government. This included the Mexican National Guard being deployed to its southern border and an expansion to the US Migrant Protection Protocols that allow the US to send asylum seekers back to Mexico while they undergo immigration procedure.

Financial markets rallied on the news – not least as it came on the back of a disappointing payrolls report, which suggested a trend of decline in payrolls growth from 2018’s solid pace. Yet so far financial markets have not regained their pre-Mexico poise. To us, this reflects two issues. First, that broader global concern still focuses on China relations - despite another two-week waiver to Chinese import tariffs also introduced last week, significant uncertainty still surrounds any détente between China and the US. Second, financial markets are still left with concerns that trade tensions could re-emerge over the coming months. This latter uncertainty creates an insidious disincentive to US business investment. It is this ongoing undermining of longer-term business confidence that the Federal Reserve may have to address with easier policy, even if trade tensions with China are resolved later this month.

Export growth rebound to be short-lived, risks of the renminbi (RMB) rising above seven to the US dollar increase.

China’s May trade numbers contained a mixed bag of surprises. Export growth rebounded to 1.1% from -2.7% in April, possibly due to front-loading shipments to the US as buyers tried to beat the anticipated tariff increases on the remaining $300bn of products. These front-running purchases could support export growth in the coming month or two, but the eventual payback will likely sink the sector further into the negatives in the third quarter (Q3). On the import side, May recorded a sharp growth decline to -8.5%, from 4% the previous month. Weakness in processing trade was partly to blame, suggesting that global demand remained weak, but ordinary imports were also quite soft reflecting lackluster domestic activities. Today’s trade data corroborates last week’s Purchasing Managers’ Index, pointing to a rising chance of a double-dip in the economy.

Separately, the People’s Bank of China (PBoC) governor Yi Gang commented on the RMB over the weekend, noting that the PBoC does not have any “numerical targets” for the exchange rate. The offshore Chinese yuan (CNH) jumped to 6.95 to the dollar in reaction, reaching a six-month high. Since recent comments from current and former PBoC officials were seen as Beijing preparing the market for further currency depreciation, we see an increasing chance of the RMB breaching the seven level, particularly if the upcoming G20 meeting fails to produce a breakthrough.

The European Central Bank (ECB) meeting last week confirmed our outlook for an ECB essentially on hold, with few immediate instruments at its disposal.

The ECB downgraded its growth outlook: 2019 was actually revised higher by 0.1 percentage points (ppt), but subsequent years revised lower by 0.2ppt and 0.1ppt to 1.2%, 1.4% and 1.4% respectively. The inflation outlook for 2021 was left unchanged at 1.6%. In terms of policy, the ECB introduced two developments. First, the terms of its targeted long-term refinancing operations (TLTRO) liquidity injection were less generous than last time – the most generous terms being 10 basis points over the deposit rate. Second, the ECB adjusted its forward guidance to suggest rates would not change at least until mid-2020.

Markets were disappointed by the former and nonplussed by the latter, already discounting rate changes far beyond that (as do we). While ECB President Mario Draghi rehearsed the scope of potential policy instruments to hand, we doubt the ECB would be keen to lower the deposit rate further. In our assessment, the ‘tiering’ likely necessary to accommodate further rate cuts would be difficult to implement because of Eurozone heterogeneity. What’s more, quantitative easing remains difficult not only because of the ECB’s own rules but more so because of the difficult political background - for example the European Commission embarking on an Excessive Deficit Procedure with Italy. On balance, the ECB looks by far more comfortable with the policy status quo. Whether it will be allowed this luxury is as likely to depend on the above-mentioned outlook for global trade tensions as on developments in the Eurozone.

In the UK, the focus remains on the Tory leadership election - officially underway today and facing its first ‘knock-out’ round on Thursday.

Boris Johnson’s lead appeared to firm over the weekend after revelations about Michael Gove seemed to dent his own leadership hopes. Separately, Amber Rudd announced support for contender Jeremy Hunt, bolstering his centrist credentials. With candidates focusing on the small group of around 120,000 Conservative Party members, outside observers and markets may wonder at some of the hopefuls’ promises to deliver a no-deal Brexit and suspend Parliament as a viable course of achieving that end. This commentary is likely to persist for this phase of the process. However, the final candidate will face a Parliamentary confidence vote and we expect significantly fewer extreme views to emerge from the final candidate ahead of this vote.

While Brexit continues to dominate the political outlook, it is also having a visible effect on economic data. Manufacturing output in April contracted by 3.9% on the month, its biggest single monthly fall in 17 years. This looks to be dominated by two factors: first, the shutdown that the auto industry scheduled for April to coincide with the original Brexit deadline. This alone stripped around 1.4ppts from headline manufacturing output but may have been echoed by other manufacturers. Second, any unwinding of inventories built up in preparation of a no-deal Brexit. Combined with reports of a sharp drop in May’s retail sales, we see increasing downside risks to our outlook of GDP growth of 0.2% in Q2 after a seemingly buoyant Q1.

Upcoming events

US: NFIB small business optimism and Producer Price Index (PPI) (Tuesday), Consumer Price Inflation (CPI) (Wednesday), Weekly Jobless Claims (Thursday), retail sales, industrial production and Michigan consumer sentiment (Friday)

Euro Area: Spanish Harmonised Index of Consumer Prices (HICP) (Tuesday), German HICP and CPI and Italian unemployment (Thursday), French and Italian HICP (Friday)

UK: Unemployment and average earnings (Tuesday), RICS Housing Survey and first Conservative leadership ballot (Thursday)

China: CPI and PPI (Wednesday), industrial production, retail sales, fixed asset investment and unemployment (Friday)

Japan: Private ‘core’ machinery orders (Wednesday), industrial production (Friday)

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