The year is ending better than it started

Key points

  • Boris Johnson’s ample victory gives him ample leeway to move away from his campaign rhetoric and secure a decent Free Trade Agreement with the EU. There will be noise though, with a first test on financial services to come by June 2020.
  • We were expecting the December 15th planned tariff hike to be postponed. We are getting more than this from the “Phase One” deal between the US and China, with a partial roll-back.
  • ECB: focus moves from the short-term reaction function to long-term strategic considerations. We think the debate is polarising around “revisionists” – who think trying too hard to deliver on the current inflation target entails too big a risk in terms of financial stability - and “fundamentalists” – who think that “giving up” on the 2% entails too big a risk in terms of economic growth.
  • The Riksbank will have to be brave. We think they will bring the repo rate back to zero this week, but the data makes it a more challenging decision. This will be scrutinised in Frankfurt.

It is unclear if the markets have been deserving children this year, but it seems some presents are on their way as 2019 is drawing to a close. The US did not implement the comprehensive round of tariff hikes on Chinese products scheduled for December 15th , while the UK general elections have produced a Conservative majority which should endorse the withdrawal agreement negotiated with the EU. These two outcomes had been largely expected by the markets for some weeks, but there seems to be a case for even more optimism in both cases, even if caution remains warranted. The White House has gone beyond a mere postponement of the tariff round to pledge a roll-back of some of the previous hikes, while the larger-than-expected Conservative majority should provide for a  clearer  – if still complex – roadmap to the next steps of the Brexit process. This justifies the current “pause” in the monetary stimulus on both sides of the Atlantic, even if the “strategic debate” is only starting, at least at the ECB.

Johnson granted ample leeway to move away from campaign rhetoric  

The first item on Boris Johnson’s to-do-list will be to get Parliament to endorse the withdrawal agreement (WA) he negotiated with the EU. This will be done by the first few weeks of January so that the U.K. will leave the union on January 31st. Indeed, since every Tory candidate explicitly pledged to endorse the deal, this is now a formality.  As per the WA the U.K. will then enter the “transition phase” during which nothing actually changes, which is normally running until the end of 2020, but can be prolonged until 2022. This means that a “no deal Brexit”, with all the uncertainty it entailed for U.K./EU trade, now comes with a virtually zero probability until the end of next year. This alone is significant progress.

One of the purposes of the transition period is to allow time to negotiate a free trade agreement (FTA) to “ensure no tariffs, fees, charges or quantitative restrictions across all sectors” impair trade,  as per the Political Declaration accompanying the WA.  Getting this FTA through is not going to be a simple process.

While the Political Declaration has the potential to maintain a fairly tight economic relationship between the UK and the EU, for instance on regulatory cooperation, during the campaign Boris Johnson made it plain that he wanted the U.K. to diverge from the EU on, for instance, social and environmental standards, helping him to negotiate trade deals with other regions. The EU has made it equally plain that without close alignment on those standards, British access to the EU’s single market would be severely curtailed. The ambiguity of the Political Declaration is encapsulated in its paragraph 17: “ the Parties agree to develop an ambitious, wide-ranging and balanced economic partnership …[which] will be underpinned by provisions ensuring a level playing field for open and fair competition…while respecting the integrity of  the Union’s Single Market….as well as recognising the development of an independent trade policy by the United Kingdom”.  This is a heavily constrained equation.

Johnson will thus have to balance the pros of divergence - which may not materialise quickly - against the cons of damaging the UK’s most crucial trade relationship - with more immediate consequences for the British economy. The EU will have to balance the willingness to preserve the integrity of the Single Market against the risk of pushing the U.K. into belatedly opting for a “no deal Brexit”, which would be the automatic outcome of a failure to agree on a trade deal by the end of the transition period.

The asymmetry for us is clear, and has not changed since the beginning of the Brexit debate: a no deal Brexit would entail a much more significant cost to the U.K. than to the EU (if only because the U.K. receives 13% of the Euro area exports, while the Euro area receives 40% of British exports). This means the EU keeps the upper hand. We would add that since it is now clear that there is no chance left of the U.K. ultimately staying in the union, the Europeans can afford to be much tougher in their handling of the “British Question”: there is no reason left to be “nice” to British public opinion.

Boris Johnson’s instincts are probably skewed towards diverging strongly from the EU, but although his majority his large, he owes it to the economically vulnerable population of Northern England. His popularity would plummet very quickly if economic growth were to deteriorate to the point that his quite expensive public spending programme would become impossible to fund.

So it is our baseline that Boris Johnson will need to depart from his campaign rhetoric. An ambitious Free Trade Agreement would take time to negotiate, and he may well have to renege on his campaign pledge not to extend the transition period beyond December 2020. The decision will have to be made by June 2020. Given his larger than expected majority Johnson is less dependent on the support of the most extreme Eurosceptic wing of his party, whose favourite outcome would actually be a no deal Brexit. The road to a fairly swift Brexit trajectory next year is thus fairly clear in our view.

It won’t be plain sailing though. Even if Johnson ultimately accepts concessions on regulatory alignment to secure a workable trade relationship with the EU, there will be moments of tension.

There will be many occasions for Brussels and London to lock horns, for instance on fishing rights or on how concretely trade will work in Northern Ireland which will remain aligned on the EU and where for the first time Republican, pro- Irish unification parties secured more seats than the loyalists. Scotland will be restless also, and with their landslide the nationalists there have a good case to argue in favour of a second referendum. The EU will probably have a hard time not showing sympathy to Scotland, generating some tension with London.

An interesting test will come in the first months of 2020 with the financial services issue. Indeed, the Political Declaration makes it plain that the “equivalence” regime will be the basis for trade in financial services between the UK and the EU, where each party retains the sovereign right to deem the other party’s financial regulatory regime as sufficiently close to its own. The Political Declaration has the end of June 2020 as a soft deadline for such assessment to be finalised.  There could be tension on the British side between the temptation to radically de-regulate the financial industry to get a competitive edge, and keeping a regulatory regime which would remain close to the EU’s to retain access. Equivalence will the regularly tested in the future so any decision will be provisional anyway, but Brussels could well use the first assessment to set clear red lines for London.

So there will be noise, and down the road, Brexit in any case is going to hurt the UK’s long term growth prospects (no FTA will bring the same benefits as EU membership). But from the point of view of the interests of Europe, the outcome of those elections is actually quite good news.

Change of trajectory for the trade war

Our baseline 2020 outlook hinged on no further escalation in the trade war between China and the US, with in particular a postponement of the December 15th round of tariff. The announcements from Washington and Beijing last Friday – although still lacking in details – seem to go beyond that, with a partial rollback.

To be more precise, the proposed tariff hike for December 15th  – on $160bn worth of imports from China (the remainder of the $300bn in total threatened from July) - will not take place. The US had already increased tariffs on the first $140bn in September to 10%. These were scheduled to rise to 15% in October, but this was deferred and never actually took place. The US President referred in his tweet on Friday to taking this tariff level back to 7½%. The 25% tariff on the $200bn that had been gradually increased from February 2018 to May 2019 remains at 25%.

The December 15th tariffs mattered a lot as they would have weighed directly on US consumption through goods produced in China but often sold under US brands (in particular computers and other electronic products). Beyond the direct relief that repealing this tariff hike offers, the Phase One deal should support US and global growth by reducing uncertainty overall. Indeed, a point we have already made in Macrocast is that the adverse effect of the trade war is not so much because the after-tax price of some products actually rises, but rather because firms can never be sure if their inputs and outputs are going to be hit by the next wave of tariff hikes, clouding investment decisions. The Phase One deal should herald a change of trajectory reducing the probability of further skirmishes. This justifies ex post the confidence expressed by the Fed in the appropriateness of its current monetary policy stance at the latest FOMC meeting.

We will remain cautious though. The “deal” has not been published nor “translated” in legally-binding terms. It will need to be formally endorsed by China and the US in January. We cannot exclude some episodes of tension in 2020 if for instance the US considers that China is not delivering its side of the bargain, for instance in terms of purchases of US agricultural products or on allowing US companies to operate more freely on its territory. We will also closely watch the January 7th hearing on the tariff retaliation proposed by the US treasury against the French digital tax to make sure the US does not turn its focus on Europe after buying some “peace on quiet” on the Chinese side. More fundamentally, we cannot exclude the White House will find it convenient to re-start the trade war once the presidential race starts in earnest.

Lagarde’s strategy

Not every central banker is lucky enough to start a tenure with a bang, as Mario Draghi did in 2011 when he announced a rate cut at his first press conference as head of the European Central Bank (ECB) and immediately hinted at a profound change of orientation for the institution. But equally Lagarde is not unfortunate enough to take up her new role while the central bank is besieged by investors clamouring for emergency action. She is benefitting from the fairly long shelf-life of her predecessor’s last package, very mediocre but non-catastrophic data (the ECB is now detecting some “signs of stabilisation”) and can respond to any thorny question by answering it will be dealt with within the “strategic review” which we now know could take up to the entirety of next year.

The new batch of forecasts offered the crucial issue of substance in Lagarde’s first presser. We were expecting the ECB economists to “play it safe” and pencil in an inflation forecast for 2022 – probably as close to the “medium term” policy horizon as can be – which would be consistent with their definition of price stability. But they came up with a low 1,6% (1.7% in year on year terms in q4 2022) and Lagarde quite candidly acknowledged during the Q&A session that is not “satisfactory”.

This would normally call for questions on the possibility for the ECB to do more, but there was no elaboration on policy space from Lagarde. We think her answers were broadly consistent with our baseline. She repeated that the Governing Council is very aware of the side-effects of their policy but also that it still has a “net positive” effect. According to “ECB sources” quoted by Bloomberg after the press conference, some members of the Council actually argued for a less balanced approach and a clearer recognition of the counterproductive effect of negative rates. They did not win the day. Our interpretation of Lagarde’s communication is that the compromise position of the Council right now is to neither contemplate further cuts nor allow the market to price in a technical normalisation any time soon. On quantitative easing (QE), she simply stated the Council had not discussed the headroom.

It seems to us all the ECB’s energy is going to be invested in the strategy review in the coming months, which promises to be quite comprehensive. Everything seems to be on the table. We will come back in January to some of the substantial issues the review will have to address, but at this stage we think the debate is likely to be framed around two opposite “lines”. The “revisionists” consider that the current inflation target, as it is defined (“below but close to 2%”), is out of reach without taking unacceptable risks to financial stability, because some structural shits in the economy – technological change or a lasting change in wage bargaining power - have brought trend inflation down. The “fundamentalists” consider that “giving up” on the current inflation target, and allowing for a quicker normalisation of the monetary policy stance, would mean taking an unacceptable risk in terms of economic growth. The first camp would probably prefer to see the inflation target expressed as a range (as for instance proposed by Klas Knot), with a lower bound at 1%. The second camp would want to make the objective more “symmetric”, which could be done for instance by disposing of the “below” to retain only “close to 2%”.

This division blurs the line between “hawks” and “doves” on the actual policy options. Indeed, a “fundamentalist” can perfectly believe negative rates are on balance a bad thing now – and an increasing number of “centrists” or doves in the Governing Council have been quite explicit on this lately – but at the same time he or she would be ready to find ways to by-pass the limits to Quantitative Easing the ECB has imposed onto itself to make sure enough stimulus is available as long as inflation is below 2%. Symmetrically, a “revisionist”, usually very worried about giving governments a free pass on fiscal policy, may accept negative policy rates for longer just to avoid more QE.

We suspect that one of the battlefields will be the measure of inflation itself. A “revisionist” would be keen to look at alternative measures of prices – for instance by including house prices – which would boost the inflation metric. We found it interesting Lagarde was explicitly opened to that possibility during her press conference.

Under Draghi we have no doubt the “fundamentalists” would have won the day. Given the changes in the Governing Council, it is less clear-cut today.

Will the Riksbank be brave next week?

The Riksbank on October 24th telegraphed a hike in its policy rate from -25 basis points (bps) back to zero, scheduled for this Thursday. We covered this in some details in a previous Macrocast “Northern lights” as the Swedish central bank is often seen as an interesting “laboratory” for the ECB. At the time, the immediate market reaction to the pre-announcement had been quite muted, with in particular no steep appreciation in the Kronor. Six weeks later, it seems exiting from negative policy rates may well be less swift than expected. The market has fully priced the hike, as reflected by the forward money market rates (see Exhibit 1), and with a small lag the Swedish currency has appreciated relative to the euro (+1.6%). This in itself may not be of great concern to the Riksbank since the currency has merely returned to its early summer level, but the deterioration in the economic dataflow may be more of an issue. The Swedish manufacturing PMI had been quite resilient since the peak of late 2017, but in November 2019 it fell below the level seen in the Euro area (Exhibit 2).

Exhibit 1 – The Swedish currency has woken up to the news

Exhibit 2 – Swedish economy losing its edge relative to the Euro area

This does not mean the Riksbank should give up on its exit from negative rates, in our view, but it will make the “accompanying dovishness” even more important. In October, the Riksbank chose to lower the forecast for its policy rate beyond December 2019, telegraphing it would “stay put” for long after the hike to zero. This would help. We note as well that contrary to the ECB the Riksbank would have much more leeway to re-start Quantitative Easing at a fast clip if needed than the ECB which is very close to its self-imposed cap on holdings of sovereign bonds. We think this is an essential difference between Sweden and the Euro area, but we fear many at the ECB will choose to focus only on the fact that a reputable central bank in Europe has chosen to exit negative rates, rather than on the difference in the policy arsenal.

Upcoming events
Mon: Empire State mfg survey, prel. mfg and services PMIs, NAHB housing market index; Tue: industrial production; Thu: Philadelphia Fed index, current account; Fri: final GDP, PCE price index
Euro Area:
Mon: Composite Eurozone PMI, Eurozone, French and German mfg and services PMIs; Wed: final Eurozone HICP, German Ifo business climate index; Thu: French manufacturing Insee index
Mon: Composite, mfg and services PMIs, BoE Financial Stability report; Tue: unemployment; Wed: CPI; Thu: retail sales, BoE MPC decision; Fri: GfK consumer confidence, final Q3 GDP, PSNB
Mon: industrial production, retail sales, unemployment
Mon: prel. mfg and services PMI; Tue: trade balance Thu: BoJ meeting and decision

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