Chinese tariffs, Brexit speculation and the prospect of a Fed hike
As summer temperatures soar across Europe, so the heat appears to be affecting press headlines. Press reports over the past week focused on developments surrounding the US trade war, the prospects for UK post Brexit and growing uncertainties over the outlook for Italy. In each case, we find fewer actual developments than the stories suggest. We suspect that, like markets, ‘volumes’ in international news will be low over the summer months, which might lead to more volatile headlines than substance would usually dictate.
In the US, the past week was a busy one for economic events with the US Federal Reserve decision and payroll numbers. The Fed left policy unchanged as we and markets had expected. There was little information in the accompanying statement, but the shift to describing the US economy as “strong” is consistent with the Fed hiking interest rates at its September meeting. Friday’s employment report confirmed a solid backdrop, even as one-off effects depressed employment gains to 157,000 in July itself. The three-monthly pace of employment gains stands at a robust 224,000 unemployment dropped to 3.9% and the broader measure of U6 underemployment fell back to 7.5% from 7.8% - a 17-year low. That the participation rate remained at 62.9% despite demographic effects suggests a cyclical rebound that may be helping to subdue any wage effect at present, with annual earnings growth at 2.7%. The coming week sees the release of July inflation data, with producer prices on Thursday and consumer prices Friday. With growth robust, the labour market continuing to tighten and ‘core’ CPI inflation expected to remain at 2.3%, the Fed is likely to continue with its gradual policy withdrawal over the rest of this year.
China has proposed additional retaliatory tariffs following US President Donald Trump’s threat to raise tariffs on $200bn of Chinese imports to 25% from 10%. China has responded to additional US threats by proposing additional tariffs on $60bn of US exports across four different tax rates (5%, 10%, 20% and 25%). Together with the previous $50bn tariffs, the combined target list now covers all major categories of US exports to China, including electronics, machinery, chemicals, raw materials, and medical products. It is worth emphasising that, at this stage, the $60bn tariff is just a threat to match the status of Trump’s proposed $200bn tariffs - Beijing noted that the timing and likelihood of the final execution will solely depend on additional actions by the US. Moreover, China’s retaliation this time is less than proportional, with a lower weighted average tariff rate of 18% (our estimate) vs. the US at 25%, and a smaller targeted amount at $60bn vs. the US’s $200bn. Apart from the physical constraint that US exports to China were only $150bn last year, we think Beijing is also demonstrating restraint in the hopes of preventing an escalation of tension. On the FX front, the People’s Bank of China last Friday announced an increase in the reserve requirement ratio on onshore FX forward transactions to 20% from, suggesting that the authorities are keen to control the risks associated with too much speculation and rapid CNY depreciation. As a result, the yuan has retreated to below 6.85 against the US dollar from almost 6.90 last Friday.
In the UK, the Bank of England’s Inflation Report provided a welcome break from Brexit speculation. The MPC’s unanimous decision to increase the policy rate by 0.25% took the Bank Rate to 0.75%, its highest level in nine and a half ½ years. The Inflation Report outlook went on to implicitly endorse a gradual pace of policy withdrawal of around 0.25% per year over the subsequent two years. However, this assumed a “smooth” Brexit transition, and that was where the Brexit hiatus ended. BoE Governor Mark Carney warned the following day that there was an “uncomfortably high” risk of the UK leaving the EU without a deal. In this, the BoE Governor’s view chimes with those of Brexiteer Trade Secretary Liam Fox who has just revised his view to the UK being “odds-on” to leave the EU without a deal - he had previously stated that an EU-UK deal would be “one of the easiest in human history”. The summer looks likely to continue with a range of speculation over the Brexit outcome, but little hope of actual developments until after the summer. This week we focus on the second quarter GDP growth release, which we expect to come in t at 0.4%.
Thin markets and budget fears hit Italian spreads. Italian spreads hit the 250 basis point threshold last week, when Italian government disagreements on the future budget law stirred rumors of a potential resignation by the Italian finance minister, Giovanni Tria. On Friday, Poste Vita also reported a lower than expected Solvency II ratio, which further exacerbated tension on the bond market. On the top of all these factors, low volumes - as it is typical during summer – have also accentuated the movement. Spreads have partially retraced on the back of a reassuring outcome of the meeting on Friday meeting between Prime Minister Giuseppe Conte, M5S’s Luigi Di Maio, League’s Giancarlo Giorgetti, Tria and European affairs minister Paolo Savona. It is also important to remember that the Update Note to the Economic and Financial Document has to be sent to the Italian parliament before 27 September every year, so we should have more clarity on the numbers of the 2019 budget law by early September.
Euro Area: Industrial production for Germany (Tuesday), France (Friday respectively), ECB Economic Bulletin (Thursday)
US: July PPI (Thursday), July CPI (Friday)
UK: Second quarter GDP, Industrial Production and International Trade (Friday)
China: International Trade (Wednesday), CPI (Thursday)
Market and asset types measured by the following indices: Equities = MSCI. Fixed Income = JP Morgan and BofAML.
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