NN IP: Cross-currents, protectionism and the dollar

The difficulty facing investors is that we have had a period of weakness in indicators that seek to gauge the marginal change in economic momentum. In most instances this weakness has been moderate. The notable exception is surprise indicators, which have arguably been burdened with inflated expectations following the very strong performance in Q4’17. 

The weakness can in theory be attributed to at least three sources. First of all, some idiosyncratic/one-off events have impacted the global industrial sector, which is now feeling an inventory drag. The industrial sector has a disproportionally high weight in many indicators. As a result, the weakness in these indicators may have overstated the implications for the economy as a whole. 

Secondly, in the consolidation phase there will be some degree of volatility in the data flow. For a while, this can show up in negative readings on momentum indicators. One could argue that this should not last too long, because volatility is by definition two-sided. However, if the economy is close to the ultimate physical constraints on production, then the distribution of economic outcomes will have a large downside skew compared to the situation where there is still a lot of slack. Hence, even if noise is the only driver of momentum indicators (which is almost never the case) one would expect negative readings to somewhat outweigh positive ones. 

A third explanation is that various downside risks are making themselves felt, especially in sentiment indicators. To the extent that this is true, it is certainly a valid reason to take the signal from these momentum indicators very seriously. Of course, there are plenty of reasons to think that downside risks have increased over the past few months. Protectionist risks are the most important driver here, but there are other sources of worry as well, such as geo-political uncertainty and the potential for contagion from vulnerable countries such as Turkey, Brazil, Argentina or Italy.

The difficulty is that one cannot easily distinguish between these three sources. It is therefore not clear how “seriously” one should take the weakness in some momentum indicators. Last week we attempted to shed more light on this by examining expectations components and indicators pertaining to export/industrial/capital goods sectors. This week we will take a few steps back and examine from a different angle why the global economy is perhaps more susceptible to these risks than last year. In this respect we mostly pointed to the crucial difference between the acceleration and the consolidation phase in global growth. 

There is another issue, which we labelled a few months ago as the cross-currents beneath a relatively stable and robust trend surface. We discussed the links between regional growth divergence, monetary policy divergence, the potential for dollar strength, oil price increases and trade fears. With the benefit of hindsight, it is clear that regional growth divergence is the mother of most of these cross-currents, as many others directly follow from this or at least enhance it. 

Of course the degree of synchronicity and the level of global growth will, by definition, show a strong correlation. There are several reasons for this. First of all, global growth is a weighted average of individual country growth rates. If a large share of countries are growing above potential, global growth is more likely to be above potential. 

Secondly, individual country growth rates are from time to time driven largely by common shocks. A clear example here is the near-meltdown in the global financial system in September 2008. At the current juncture, rising trade risks also represent a common shock. What’s more, the intricate links between US monetary policy, the dollar and the global financial cycle (co-movements of gross capital flows, domestic credit growth rates, risky asset prices and balance sheet leverage) also act as an important common driver. At the same time, the GFC often sows the seeds of divergence because in a strong risk-on environment (often accompanied by an easy US monetary policy stance), capital will flow towards regions with the highest relative expected returns. This can easily become destructive by triggering the build-up of substantial imbalances. 

A third reason why a high degree of synchronicity will be correlated with the level of growth, at least when that level is strong, is that this will make the global economy more resilient to shocks. For instance, there will be less room for disruptive capital flows and exchange rate swings because expected relative return differentials will be smaller than in a world of less synchronized growth. On the real side of the economy, synchronized strong growth very often means that consumer spending and capex spending are pretty strong worldwide, simply because these are the main spending categories. The fundamental requirements for such a situation are the absence of widespread and large imbalances in the household and corporate sectors and a high level of confidence. 

Last year global growth was pretty synchronized, with more than three-quarters of the countries integrated in the global economy exhibiting above-potential growth. However, the degree of synchronicity declined substantially this year as US growth accelerated further in H1’18 while growth in Europe and Japan decelerated.  EM space held up relatively well in the first half of this year but may well experience a decline in synchronicity in the second half, as some regions are facing tighter financial conditions. From a global demand side perspective, we can say that the soft patch and rebound in global retail sales were relatively synchronized. 

Meanwhile, capex displayed less of a slowdown relative to H2’17 but it is less clear whether or not we will see a synchronized improvement there. This makes sense because it is where we would expect trade worries to start to bite first. However, abstracting from that, profit growth and business confidence levels are still at very robust levels, which would lead one to expect a pretty broad-based improvement in capex as well. This would still be our base case, but it needs to be mentioned that the dispersion in profit growth across regions and sectors has increased somewhat as well. This could potentially trigger a less broad-based pickup in capex than anticipated.

Adding all this up, the base case is still that European and Japanese growth will accelerate somewhat in the second half of this year. In both economies, the domestic demand fundamentals remain very much in place for this to happen. The Japanese consumer is benefiting from a pretty robust acceleration in real income growth, which should gradually translate into more consumption growth given the robust level of consumer confidence. 

Meanwhile, the Japanese corporate sector is maintaining a strong pace of hiring and seems increasingly willing to invest in labour-saving technologies, all of which goes hand in hand with a better rate of productivity growth. Labour markets in Europe also remain strong, and in the economies that are most advanced in the cycle, this is now also being translated into a mild acceleration in wage growth. Also, the combination of business confidence, easing lending standards, an accelerating demand for corporate loans and a robust level of profits argues for a reasonable capex performance. As such, DM space should support EM space in the second half of this year through increased import demand at a time when domestic demand in some EM countries could well go through a soft patch. 

Going into 2019, the effects of Chinese easing measures, some stabilization in EM capital flows and robust fundamentals in much of the region should produce a better EM domestic demand performance as well. Of course, it is easy to see various points in this story where things may not go as planned, i.e., if convergence in growth rates does not happen. The main suspects that may prevent it include possible contagion from weak EM countries and Italy, more dollar appreciation and a further escalation of protectionist risks.

An update on protectionist risks, with some thoughts on the dollar

It remains pretty difficult to filter the essence of what is really going on in trade space due to all the noise politicians on all sides are making. Of course, from Trump’s perspective it makes sense to apply a large-scale fiscal easing first and once the effects hit the economy, proceed with the implementation of his protectionist plans. After all, the fiscal boost will protect overall economic growth from the drag exerted by protectionist rhetoric. 

At the same time, the stock market side-effects of the fiscal sugar high allow Trump to make the incorrect claim that the US is winning the trade war, all the more so because the Chinese stock market has been suffering considerably. As always, this statement needs to be qualified substantially. So far, the Trump administration has not shown much skill in thinking through and/or admitting the general equilibrium effects of its policies. Trump tends to justify his policies with partial equilibrium analysis, which basically only focuses on the market in question and assumes that other markets are not affected.

However, the core of macroeconomics is that all markets are interconnected and influence each other. Hence, in a partial equilibrium world, it is easy to claim that tax cuts will boost savings and investment as well as hours worked and thus raise productivity growth and real wage growth. This may actually be true to some extent in an economy which has a lot of slack. But if these positive effects are somehow substantial, the likely consequence will be an increase in the trade deficit as a higher expected return on US assets will attract foreign capital. The tax-cut benefits will in all likelihood be much less in an economy which is close to full employment. This is because there will be more crowding out of private investment and the Fed may be forced to tighten monetary policy by more. In that case, the dollar will also be stronger, leading to a further deterioration of the trade balance.  

The idea that import tariffs will lead to a smaller trade deficit is also a case of bad analysis. The trade balance is, to a first approximation, a resultant of domestic and foreign desired net national savings. There is no a priori reason to believe that tariffs will change these as long as there is no effect on sentiment and financial conditions. These effects will arise at some point because a more fragmented global economy will have a lower level of productivity growth and will require the restructuring of all kinds of production processes. The latter will imply a big one-off hit to the value of part of the capital stock. 

Nevertheless, until we reach that point, exchange rates will move in such a way so as to leave the trade balance unaffected. One can even make a case that the stronger Trump’s perception that the US is “winning” the trade war, the bigger the dollar’s appreciation will be. This is firstly because of the aforementioned fiscal sugar high, which creates the false near-term impression that the US will not face economic costs from protectionism. Secondly, the Fed will be more hawkish due to strong growth and the robust stock market. A third reason is more subtle: “winning”, in Trump’s world view, also entails less than proportionate retaliation by the other players. Perhaps this is because there is a smaller amount of US exports to retaliate against, or because the other side decides this strategy is in its best interest. 

If we translate this as a larger increase in the US effective tariff rate compared to the effective tariff rate of its competitors, this will require the dollar to strengthen more to keep the trade balance relatively unchanged. The question then is whether this tendency for the dollar to appreciate will be less in a world where domestic and foreign net desired national savings are affected. That will depend on how exactly these are affected, but in general the stronger economy will still have the stronger currency. What’s more, in a world where sentiment and risk appetite in financial markets decline, the dollar will appreciate because of its safe-haven status. 

The upshot of this story is pretty simple. In our base-case scenario, where trade tensions remain manageable and do not materially affect sentiment and financial conditions, there should be a natural brake on dollar appreciation exerted by an increase in European and Japanese relative growth performance and, later on, by an increase in EM relative growth performance. However, in a world where trade risks are rising, the dollar may well strengthen further and, as such, enhance the cross-currents that weaken the stability of above-trend global growth. 

The crucial question thus still remains how far Trump will push all this. As we argued before, it pays to see all this as a game where the players are uncertain about the willingness of the other players to retaliate. Escalation is then a means to learn about the degree of willingness. In this game Trump still seems in the process of upping the ante. First of all, the US is trying to mitigate the negative fallout on the agricultural sector. Secondly, the US probably feels that fighting a war on several fronts could well lead to defeat. Hence, Trump negotiated a cease fire with European Commission President Jean-Claude Juncker in late July. The optics of the deal may be nice, but it is very light on substance. Still, the good thing is that the ceasefire may well hold as long as they are talking, which could be a long time. In addition to all this, the US is clearly increasing the rhetoric towards China by increasing the stakes and arguing that China is losing the trade war.

A superficial look at the Chinese side of the equation may indeed give the impression that Trump is right. After all, the Chinese stock market has suffered and Chinese growth has been slowing somewhat. But this would be jumping to conclusions. Chinese policymakers are much less sensitive to the stock market than their US counterparts because they do not face similar re-election risks and because stock ownership is less wide-spread in China. What’s more, the Chinese slowing should at least be partly understood as the result of past policy tightening in an effort to deal with excessive leverage. Chinese policymakers have now resorted to selective easing measures which should start to support growth towards the end of the year. Also, as a result of these easing measures the currency has weakened, which has more than offset the effect of tariffs so far. 

The most viable policy option for China remains a war of attrition in which China retaliates as much as is feasible and puts further restrictions on US companies. In addition to this stick, the Chinese leadership is likely to continue to offer the carrot of concessions. Also, China may well remain tolerant to further renminbi depreciation and to easing policy in general. It is important to bear in mind that this is not without risks. Monetary policy easing has been implemented by increasing the amount of liquidity in the Chinese banking system which has lowered Chinese short-term interest rates and has depreciated the currency. So far, the latter has not led to a significant increase in net capital outflows, but there is no guarantee that this will not happen at some point. On top of that, too much monetary easing for too long may store up increased financial fragility risks for the future.

Emerging markets: resilient growth

EM export growth is likely to slow in the coming quarters. This is not only because of the negative impact of US protectionism on Chinese exports and the spill-over to Asian component makers, but also because of the expected growth consolidation in developed markets. Still, the slowdown could turn out to be modest. China’s policy stimulus should boost growth in Chinese demand for raw materials, and the EM currency depreciation will help EM exporters remain competitive. Our projections are that EM export growth will slow from the current double-digit levels to around 6% in a year from now.

Meanwhile, China’s policy stimulus and the resilient EM credit growth should sustain EM domestic demand growth. The Chinese stimulus is likely to lead to a higher growth in Chinese fixed investment, which represents 42% of GDP. We have upgraded our Chinese GDP growth for 2019 from 5.9% to 6.2% based on our expectations for economic policy easing. The higher-than-anticipated Chinese GDP growth directly pushes EM aggregate GDP growth higher, as China represents 40% of total EM GDP.

The other key factor for EM domestic demand growth is credit growth outside of China. We have written numerous times about the EM credit cycle, which has been in a clear uptrend since early 2017 and has been remarkably resilient since the EM market turmoil started in April. As long as aggregate EM credit growth continues to improve despite tighter EM financial conditions, we should keep our positive view about the prospects for EM domestic demand growth. The main reason for the resiliency in EM ex-China credit growth this year is that the problem of tighter financial conditions has been limited to a selective group of fundamentally challenged countries: Turkey, Argentina, South Africa, Indonesia and Brazil. The macro picture in the rest of the EM universe is strong enough to preclude the need for sharp interest rate increases and to sustain credit growth without a painful widening of external imbalances. This helps explain why our own EM economic growth momentum indicator has moved back into positive territory in the past weeks. 

All in all, we expect EM economic growth to avoid a sharp slowdown in the coming quarters. The decline in export growth is likely to be modest and domestic demand growth should remain resilient. The Chinese stimulus and solid credit growth outside of the fundamentally challenged countries provided further reasons for confidence. We have an average GDP growth forecast of 4.9% for 2019, compared with the 5.3% expected for this year.