Au bout du tunnel ? Pas si vite

Trade war: non-negatives are the new positives

Given the accumulation of risks and the disappointing data flow this year, we have learned to take comfort in small things. Assuming nothing gets in the way of the “phase one deal” announced by Donald Trump on Friday, while the details are hammered out in view of the meeting between the US and Chinese leaders on November 16th, there is now a good chance the US economy will avoid the next waves of tariff hikes. From a macro point of view though, we think the main impact of the trade war so far came through the “uncertainty channel”, not via the direct effect of tariff on costs. “Global macro stress” should probably be taken down a notch after Friday, but we are far from the “all clear”. We have been there before. Several times. And the announcement sounds more like a “truce” than as the harbinger of a proper resolution of the trade war.  

Let’s crunch some numbers first. Secretary Mnuchin confirmed on Friday that the additional hike in customs duties from 25% to 30% on USD 250bn of Chinese goods imported in the US due on Tuesday this week is suspended. This in itself is insignificant (0.06% of the US GDP). For now, the US government is remaining ambiguous on the planned December tariff hike, to maintain some pressure on Beijing as the negotiations are not yet over. This would be a “less small shock”: 15% on USD 160bn in mainly consumer goods, just before Christmas shopping (0.1% of GDP). But again assuming the agreement is finalised this is likely to be suspended as well. With Friday’s news, the US may have thus “saved themselves” an additional cost of a bit less of 0.2% of GDP concentrated in Q4 2019.

However, a true resolution of the “trade war” would in our view entail a dismantlement of the tariff hikes already implemented, and we are very far from this. The Peterson Institute in Washington DC maintains a very useful updated series for the average tariff levied in the US on Chinese products and in China on American ones. Since January 2018 It went from 3.1% to 21% for the former, and from 8.0% to 21.1% for the latter.  This amounts to a “mechanical cost” of 0.6% of GDP for the US.

Still, we have been arguing since our first issues of Macrocast that this mechanical cost is not the biggest issue. Uncertainty is. Corporates do not really care about the “average tariff” on the entirety of the US-China trade matrix. They care about the impact of their imported inputs and on their exported output.   With this trade war, they can never know beyond a few months which products are going to be hit and by how much. This can have a strong bearing on their investment behaviour. Even producers located outside the two parties to this war have to factor in the possibility that the US would extend their muscular approach to trade to other partners.

A recent research paper by Fed staffers, summarized in a very timely way as a FEDS Note by Dario Caldara et alii published on September 4th argues that the cumulated impact of the 2018 and 2019 “trade uncertainty waves” on global GDP would slightly exceed 1% by 2020, equally distributed across the US, the other advanced economies and the emerging countries. Interestingly, they don’t just explore the impact on aggregate data but also look at firm-level behaviour, building a “trade uncertainty index” for a sample of US-listed corporates by counting in their earnings statements the use of key words such as “tariff” or “import duty”. They find that the waves of rising uncertainty measured in this way are associated with a decline of 1.8% of the affected firms’ investment.

So down the road the crucial issue is whether we should take last Friday’s truce as the “beginning of the end” of the trade war, with Donald Trump allowing the issue to be dealt with quietly throughout 2020, or simply another manifestation of the pattern we have seen several times before: the US administration easing the pressure when the US macro indicators or equity prices start being hammered, to start again the minute the economy is looking perkier or the Fed is offering more monetary support.

True, this time Donald Trump is probably under more pressure to hold on to a truce. The deterioration in the US data flow is no longer contained to the manufacturing sector and he could do with some positive headlines when impeachment is lurking.

An issue for us though is that it may be too late to “put the genie back in the bottle” with US domestic politics unlikely to let go of the Chinese trade issue quickly. The “pre-agreement” is very limited. China has merely repackaged its pledge to raise its purchases of US agricultural products while their commitments on intellectual property and “transparency on currency policy” are vague at this stage. Crucially, since Friday no mention has been made of the “enforcement mechanism” the US has been so keen to see emerge to make sure any trade agreement is effectively complied with. We note the reaction of Chuck Grassley, Iowa Senator, who is the Republican party’s main spokesperson on trade affairs in the upper house: “after so much has been sacrificed, Americans will settle for nothing less than a full, enforceable and fair deal with China”. This is far from an unconditional endorsement. On the Democratic side, Elisabeth Warren – who at the moment is taking the lead - has been “tough on China”, criticising the country’s stance on the environment for instance and accused Beijing of currency manipulation. It could become politically expedient for the Democrats to “turn the table” and accuse the President of being too soft on China.

There is thus little political space for Donald Trump at this stage to completely back down. On Friday collectively the global economy won another respite, and this is very welcome given the speed at which the soft data in particular is deteriorating. But it is too soon to say we are out of that particular tunnel.

Brexit: tunnelling out or down?

Just as hopes of a deal were fading, we started the weekend on a positive note, as the British Prime Minister, following on a bilateral meeting with his Irish counterpart, altered his offer to the EU, with proposals Michel Barnier, Chief EU negotiator, qualified as “constructive”, finally allowing for in depth negotiations ahead of the European Council meeting on 17 October. This is undeniably progress, but the news-flow through the weekend became less positive. While we think the chances of a “no deal” exit on 31 October are now materially lower, we are not certain that a definitive clarification is coming just yet.  Extension is probably still needed.

The main shift - although no precise communication has come from the British government so far – seems to be on the Irish issue, with a very tempting fudge: Northern Ireland would remain part of the UK customs territory, but the EU custom rules and tariffs would continue to apply there. This would be intended by the British government as a way to avoid a physical border between Northern Ireland and the Republic while still ensuring the integrity of the EU’s single market– a key demand from Dublin and the EU. This would make customs and regulatory checks between Northern Ireland and the rest of the UK necessary though, a very big pill to swallow for the Ulster Unionists who are providing Boris Johnson with his wafer-thin majority in parliament.

However, in case the UK, finally free to negotiate with third countries any trade deal of its choosing, were to bring its customs duties below those of the EU, companies in Northern Ireland would receive a transfer from London equivalent to the difference (as long as they don’t re-export to the EU). This would make Northern Ireland a very attractive location as a production centre.

It was also reported that Boris Johnson has moved on the “consent issue”. Originally, he wanted any specific arrangement for Northern Ireland to be regularly submitted to the consent of the local institutions in a way which would de facto give the Democratic Unionist Party (DUP) a veto. He seems to have moved to a solution where consent would also need to be given by the nationalists (another key request of Dublin). But at time of writing (late on Sunday night) it was not yet clear such change had actually been communicated to the EU team. 

Actually, as the weekend wore off, noises from Brussels and the national capitals became less supportive of a chance to conclude a deal in time. Both the Guardian and the Financial Times were reporting that the EU negotiators were concerned with the technical complexity of such an arrangement for Northern Ireland, with significant risks of fraud. Michel Barnier reportedly qualified the customs proposal as “untested”. Talks will continue on Monday, but at this stage it seems that the threshold may not have been met for a proper agreement on the European Council on 17 October.

In any case, even assuming the EU could give its green light on such an arrangement the political conditions for it to be endorsed in the British parliament may not be met. Beyond the potential reservations of the DUP, there may be enough so-called “Spartans” in the Tory party to consider such a deal as unacceptable. Boris Johnson would need to reach out to some Labour Members of Parliament (MPs) elected in Leave constituencies. An issue though is that offering concessions on Northern Ireland is a way for Johnson to advance his agenda of a “clean break” from the EU for the rest of the UK, pursuing deregulation on labour market or environmental issues, which precisely makes such deal very difficult to accept for the left-of-centre MPs.  This is a difference with the approach pursued by Theresa May, who accepted the notion of a “backstop” for the entirety of the UK, which would have severely curtailed the possibility to diverge from the EU. We cannot exclude that even if a “deal” is actually accepted by parliament before the end of the month, the opposition would make it conditional on a confirmatory referendum.

Actually, this last argument may be weighing a lot on the European leaders’ thinking. Why should they take a risk with the integrity of the single market to help a British government who is explicit about becoming a direct competitor of the EU?  Especially if they perceive the risk of an actual “no deal” to be relatively low, since it is the position of the British parliament that, in the absence of a deal, the Prime Minister should seek an extension.

It seems Boris Johnson needs to make more steps towards the EU in the next few days to secure a deal. But with every step comes the risk of losing even more support in parliament. He probably counts on “Brexit fatigue”, a generic desire to be “done with it” which is undeniably rising among parliamentarians (and the general population). But this remains a hard sell. Extension beyond October 31st – at least a technical one to allow for the conclusion of the technical negotiations - should remain baseline at this stage, in our view. 

What the minutes tell us about the new ECB

Last week the “minutes” of the September meeting of the Governing Council confirmed what had already been reported in the press: the central bank is extremely divided. Not on taking some action – this was consensual – but on the timing and content of the easing package.  What we found more interesting though is those leaks in the Financial Times suggesting the ECB’s Monetary Policy Committee recommended against the resumption of quantitative easing. The MPC is made of senior staff from the ECB and the national central banks. Their role is essentially technical and that their advice was overruled is not problematic in itself. The fact that it leaked – for the first time to our knowledge – is a problem. It seems that as the central bank is preparing for a new boss, some stakeholders are trying to keep the debate live on Draghi’s last decisions, while at the same time vying for a more collegial approach to policy-making.

Interestingly, the same week Reuters reported that according to some “sources” at the ECB the central bank may have to take some limited liberties with the capital key – which apportions the purchases of sovereign bonds according to the share of each member state in the euro area’s GDP and population – to make space for the EUR20bn monthly programme, but that even so they may run out of mileage by the end of 2020. This is a reminder that a key decision – whether or not to dispose of the 33%  limit on the ECB’s holdings of sovereign bonds – will have to be made in the course of 2020 (and possibly more quickly if the dataflow deteriorates further and the ECB is forced into more action). Christine Lagarde’s tenure at the ECB will be tough very rapidly.

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