New year, old issues

Key points:

  • US elections: middle-class hunting is conducive to fiscal adventures.
  • China: the state of the financial system calls for a more prudent policy-mix, capping the capacity for rebound this year.
  • UK: doom in June? Boris Johnson has six months to choose his battles with the EU.
  • Euro area’s “tectonic immobility”: what needs to be done for further euro area integration may be clearer, but also riskier electorally, especially when three major economies are potentially politically unstable. National politics, under pressure from the European debate, will generate some episodes of volatility in 2020.
  • Middle East: escalation or domestic radicalisation?

Our top five list of concerns for 2020

Washington DC has often been a major source of global economic stress since 2016, but at least the last few weeks of 2019 have brought some respite with the announcement of a phase one deal between the US and China which is now due to be signed on 15 January (at least according to the US President; no confirmation has come from Beijing yet). Our preferred source on global trade issues from a US perspective is the Peterson Institute and in their latest offering on the subject, they highlighted the fact that the truce brokered between Washington and Beijing would still leave tariffs on Chinese products at 19.3% on average from 3% before the trade war. This is not costless, but at least the uncertainty for corporations has declined with a lower risk of seeing their input or output prices suddenly affected by a new wave of American tariff hikes and/or Chinese retaliations.

We suspect though that US politics will remain a key focus for global markets. Our main point on this first area of concern will be the fiscal implications of the presidential race, as Republicans and Democrats compete for the non-College educated middle class vote. Another area of concern for us is the capacity of the Chinese economy to rebound. The latest policy decisions have been somewhat contradictory there, with on the one hand another layer of monetary stimulus and on the other an explicit willingness of the Chinese authorities to allow more corporate bond defaults, which we would see as a way to foster market discipline to try to help with the clean-up of the financial system. Our baseline is that Beijing will tolerate some domestic slowdown as a necessary corollary to a less exuberant debt build-up. In third place we have this old chestnut, the Brexit saga, with some tough decisions to make on the kind of relationship the UK wants to establish with the EU post leaving. In number four, we have the political economy of the euro area, still disappointing on institutional progress and with three of the biggest economies facing major political uncertainty.

Finally, we are finishing this first Macrocast of the year while tensions in the Middle East are returning, with the possibility of further escalation between the US and Iran. This is sadly familiar, and we will keep a close eye on this. We highlighted several times in 2019 that a major rise in oil prices, stemming from a blockade of the Strait of Hormuz, could be the last straw for an already mediocre global cycle. Consumption has been resilient nearly everywhere, partly offsetting the weakness in investment. The last thing we need right now is a negative shock on purchasing power.

The US elections: middle class hunting

The middle class – usually defined as those between two third and twice the median income – is comparatively small in the US (a 2017 paper by the Pew Centre put it at 59% of adults, when correcting for family size, against more than 74% in France and 72% in Germany). Yet, it is still the main target of those competing for the US presidential elections. This is arithmetically rational. Hilary Clinton won decisively among those earning less than USD50K per year. Her defeat came from her inability to beat Donald Trump in the middle-income group. This is where the last election was decided.

The usual definition may not be granular enough though. The key dividing line within this group was between those with a college education and those without. This was substantiated very quickly after the last elections by Nate Silver: Hillary Clinton improved on Obama’s 2012 performance in 48 of the 50 most-well-educated counties in the US by an average of 9 percentage points (ppt), while she lost ground relative to Obama in 47 of the 50 least educated counties by an average of 11ppt.

So when the democratic hopefuls state that “the middle class is in trouble” and needs to be reassured about its future, so that it avoids falling for “phoney populism”, to borrow words from Joe Biden, in reality it’s the non-university educated, usually white workers they have in mind.

Quite often the shift to Donald Trump of this key demographic is explained by “cultural factors”. This was at the heart of Jean Pisani-Ferry’s op-ed in Le Monde on 27 December, questioning why some people end up voting “against their economic interests”. Views on immigration or gender roles would matter more than economic platforms. Symmetrically, Clinton’s 2016 victory in the low income groups may have had more to do with the over-representation of minorities there than with her economic platform.

The Democrats can hardly compete with Trump on “cultural issues” – even if they wanted to this would make them lose some other key demographics, for instance university-educated women who supported the Democratic candidate more in 2016 than in 2012. But they can try to improve their offer in terms of “economic interest” to lure these former democratic voters back. And that is what they are all doing.

The ambition of their platforms differs, between the “radicals” – Sanders and Warren – and the “moderates” – Biden and Buttigieg – to name only the four candidates topping the polls in the first two primaries (Iowa and New Hampshire). But they all share a fairly traditional focus on redistribution and protection against risk which would normally be in the best interest of the most fragile members of the “middle class”, i.e. those whose education makes them most at risk in a globalised and automatizing economy.

Warren’s flagship measure is “Medicare for all” – in a nutshell replicating the universal, State-provided healthcare provided in most other developed economies. This would be partly paid by tax reform, including a levy on accumulated wealth. Biden wants to extend the Obamacare system involving private insurances, which would bring the proportion of Americans without any type of health coverage from 8% today to 3%. Tax on the highest income brackets would have to be introduced to pay for the additional cost, with the biggest tax increase coming from the taxation of capital gains at the normal rather than reduced income tax rate.

What may be missing here– is a compelling narrative on the reasons behind the deterioration in the economic conditions of the middle class – something Donald Trump suppled in droves in 2016. All Democratic candidates support “fair trade” and a muscular approach to China, but they can’t beat the US President on his home turf: making uncontrolled free trade the source of the all the woes of the median American worker. In a nutshell the Democrats focus on how to mitigate the consequences of globalisation. The Republican candidate claims he can rebalance it to the benefits of the US.

This would actually help answer Jean Pisani-Ferry’s question: maybe a lot of the non-university educated workers of America perceived Trump’s platform as aligned with their economic interest, despite his intention to roll-back on Obama’s progress on welfare.

Still, Donald Trump as well needs to deal with a “narrative issue” for 2020. He will probably present his “phase one deal” – as well as the changes to the trade relationship with Canada and Mexico – as an overwhelming victory for the American worker. But one cannot have twice the same victory, and a Republican campaign with the trade deal on the fore-front would be more backward than forward-looking. Of course he may at times revive the trade war theme for immediate electoral advantage, especially if the Chinese have trouble delivering their side of the bargain (doubling imports of US products in two years will be daunting), but by and large Donald Trump will have to insist he was right to cut a deal.

It is thus likely Trump will have to add another narrative on 2020, and we think this will take the form of a major tax cut for the “middle class”. This would help him fend off criticisms about his previous tax reform which was massively skewed towards the top end of the income distribution. This has already been floated by Larry Kudlow in October 2019. Given the present division of Congress, there is no chance such a package could pass this year. But this would actually be a major tactical trap for the Democrats: either they offer the President a major victory just before the election, or they can be branded as the “enemies of the middle class” by blocking tax cuts.

So ultimately it seems a major victim of this year’s election will be fiscal prudence. Interestingly, despite the high density of venom in the US political arena at the moment, Republicans and Democrats managed to agree fairly swiftly on raising again the “expenditure ceiling” last month. The two parties, for different reasons, are ultimately quite relaxed on the quantum of deficits their policies would yield. The Republicans vow to reduce tax rates on “ordinary Americans” while they have -  unusually so - very little to say about curbing public expenditure. The Democrats vow not to raise tax on the middle-class, to put the entire burden of their spending plans on the upper class, and that is something both Biden and Warren share. This is a notoriously elusive tax base, and the overall return on such tax hikes is often disappointing. In addition, the funding of Warren’s Medicare for all is based on what could well may be generous assumptions on the capacity of a single payer system to lower costs.

To make a likely further deterioration in the US fiscal position in the years ahead sustainable, support from the Fed will be key. Even if this not enough for the US President’s liking, the Fed has been quite pragmatic and pre-emptive in 2019. Their equation may change however if they are faced with a significant fiscal stimulus. The conflict between the White House and the central bank could escalate. Jay Powell is safe until February 2022, but we could see some fireworks.

China: when is the best time for the big clean-up?

Reading the International Monetary Fund (IMF)’s latest comprehensive review of China released in August 2019 is quite interesting with the hindsight of six months. At the time, the IMF advised against additional stimulus, but also conceded that this could be warranted “in case of trade war escalation”. Their caution was explained by their fairly severe assessment of the Chinese financial system and their concern excess monetary stimulus would fuel more debt building. From this angle, the People’s Bank of China (PBoC)’s decision last week to cut again the banks’ reserve ratio was quite surprising. The latest dataflow is actually quite encouraging, with both the official and the Caixin manufacturing Purchasing Managers Index (PMI) back in expansion, and the “trade truce” allows for cautious optimism when looking into 2020.

Still, it seems this additional layer of accommodation is targeted at one specific sector of the economy: freeing financial resources to the private, smaller companies which have been faced with a dearth of banking intermediation lately. This is actually one of the thorniest issues for Beijing, and not just for today’s cyclical stabilisation, but also for the country’s long term growth trajectory. Indeed, as China is getting closer to the technological frontier, productivity growth will slow down. “Simply” pouring more capital and labour in the system will not yield the same GDP growth as before. Innovative, or even disruptive practices will be needed to boost “total factor productivity”, i.e. this bit of growth which cannot be accounted for by the mere accumulation of capital and labour. The small, privately-owned companies can provide this.

However, after several years focusing on shoring up the capital position of Chinese banks, it is not very surprising to observe they would rather lend to State Owned Companies(SOEs), with their “implicit state guarantee”, than to riskier small, private companies. This is the Chinese dilemma: how to improve financial stability conditions without impairing growth in the short and the long term. It will be difficult though for Beijing to support both sectors of the economy at the same time without generating more imbalance building, in particular in the housing sector. We continue to think China will take the opportunity of any improvement in its external conditions allowed by the truce on the “trade war” to let domestic demand cool off a bit.

UK: doom in June?

The relief after Boris Johnson’s larger than expected victory was short-lived, as the market focused on his rejection of an extension of the transition period beyond 2020, now passed into law (for now…). We wrote in December that Johnson’s instincts are to diverge from the European Union, which is consistent with a “low quality” Free Trade Agreement (FTA), generator of instability as we would expect the EU to insist on “rendez-vous clauses” impairing UK products’ access to the Single Market in the future if and when such divergence were to materialise. Of course, in such a configuration there is a non-zero probability that we end up with “no deal” and a cliff on December 31st 2020 given the extremely tight schedule.

However, we want to remain constructive. A significant share of Conservative Members of Parliament now represent industrial areas which need easy access to the EU. This should gradually weigh on cabinet decisions. Also, now that the UK is definitely leaving, minds will focus less on trying to conjure up another outcome, in pursuit of “remain”, and more on making the best of the exit. The energy of the “remainers” – who are strong in the business community – should now focus on a detailed lobbying on the content of the FTA.  Finally, the latest British dataflow has not been particularly supportive recently. Economic realism should work in favour of striking a deal, even a mediocre one. From the EU’s point of view, what matters is to avoid “no deal”. Still, we would expect quite a lot of market stress in June 2020, when the deadline to request an extension of the transition period will be looming.

Euro area reform: tectonic immobility?

In the torrent of “wrap-ups of the past decade” in the international press ahead of the end of 2019, there was an amusing flurry of articles in British newspapers expressing surprise, with various degrees of awe, at the survival of the European project. It was a common view in the UK that Brexit, coming on top of the sovereign turmoil of 2010-2012 and the refugee crisis of 2015, would be the last nails in its coffin. And yes, it should be a moment of pride for Europeans to realise that their shared institutions have survived. Mere survival is not enough though. Adaptation is necessary to protect Europe against the next crises, and on this we beg to disagree with Martin Sandbu’s hopeful piece in the Financial Times on 31 December 2019 (“The Eurozone’s tectonic plates are shifting”).

On the facts alone it is easy to agree with Sandbu: gradually through the months of 2019 all the ingredients for a sweeping “grand bargain” which could have enhanced the crisis-fighting capacity of the Euro area started lining up on the negotiators’ worktable. This would have included a reform of the European Stability Mechanism (ESM) finally allowed to provide a financial backstop to the banks’ Single Resolution Mechanism, and the completion of the Banking Union with a joint deposit insurance. The price for this would be easier sovereign restructuring (lower threshold for triggering Collective Action Clauses) and more efforts on cleaning up banks’ non-performing loans and reducing their exposure to domestic sovereign bonds. It all unravelled at the end of the year, in particular because of Italy’s opposition to the deal.

The conclusions of the Euro Summit on 13 December are not very committal, to say the least. “We task the Eurogroup to continue to work on the ESM package of reforms, pending national procedures, and to continue work on all elements of the further strengthening of the banking union, on a consensual basis… We encourage work to be taken forward on all these issues and will come back to them at the latest in June 2020.”

Sandbu’s main point is that if the resolution is taking time, at least the terms of the grand bargain are now in the open. Now that member states’ positions are clear, negotiations towards the necessary compromises can start in earnest. Our take is different: those positions have been well known since 2012, but they were a point of focus only within a fairly small circle of policymakers and observers. Now the absence of resolution precisely stems from the fact that the trade-offs have become crystal clear for national public opinions and will enter the domestic political debate. Italy has always had a problem with anything which could alter its sovereign risk; Germany has always had a problem with any reform of the system which would trigger some automatic transfers. The issue now is that Italian and German politicians have to convince their electors the next step of Euro area integration is necessary.

Italy provides the best example. The ESM reform is now explicitly used by Salvini against the new coalition in power in Rome, which is itself quite divided on it. Lega has dampened its anti-euro positions over the last few months, reacting to the change in perceptions in the Italian public opinion but commitment to the single currency is not the same thing as accepting the Euro area’s institutional set-up. There is a lot of political hay to make on these issues, especially as key regional elections are looming. At the margin, the pressure from the European themes on already complex national political configurations raises the risk that we see some episodes of intra-European spread instability this year.

Down the road, we think the root of the current institutional paralysis in the euro area lies in a very specific political configuration at the national level: in the four main economies of the monetary union, we find at the moment two quite fragile coalitions (Germany and Italy) and one minority government (Spain). France’s current pollical stability (no national elections before 2022) cannot easily advance its ambitious European agenda if all the other major players are looking inward.

The European Central Bank has been filling the gap so far. We have already in 2019 expressed our doubts the coming “strategic review” will offer new capabilities to the central bank, but we will devote an entire Macrocast to this specific issue in the next few weeks.

A few words on the Middle-East

We mentioned last year several times in Macrocast that a blockade of the Strait of Ormuz has the potential to raise oil prices towards USD100/bl. The world economy has become less dependent on oil over the last decades, but a negative shock on purchasing power of between 0.5 and 1% in the developed countries would come at an already weak time for the global cycle.

We don’t want to conclude this first Macrocast of 2020 on too gloomy a note. We were intrigued by a short paper issued by Pierre Ramond of the geopolitical centre of Ecole Nationale Superieure (only for those who read French though) in reaction to the death of General Soleimani. Although he clearly admits the new escalation risks, up to full-on warfare, he also sees the American operation as another demonstration of the US strategy of continuing to reduce physical military presence abroad while using technology to maintain pressure on opponents and demonstrate the asymmetry of the conflict. Of course, the announcement of US reinforcements to the region immediately after the strike contradicts this strategy, but it is true so far the Trump administration has been keen on disengagement. A part of Donald Trump’s electoral appeal also comes from his reluctance to deploy forces to fight “foreign wars”. This should be an argument against “all-out” escalation on the US side. On the Iranian side, Pierre Ramond notes the possibility that the regime – with limited economic capacity at the moment and facing internal protests - reacts to the death of General Soleimani with domestic radicalisation instead of resorting to warfare.

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