Rising trade temperature sets the tone for August
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Risk aversion is on full display and for good reason as a rising trade temperature is going to make August a hot and torrid month for markets.
The trade salvo delivered by President Donald Trump against China (with Beijing promising retaliatory measures) is reverberating across markets. The entire German bond market out to the 30-year yield was at one point in negative territory on Friday for the first time, with the 10-year Bund yield setting a new record low of minus 0.50 per cent.
Leading global bond markets are at the forefront in flagging a serious hit to global growth and inflation expectations. Another important trade story is the spat between Japan and South Korea. Tokyo has removed South Korea from its export control “white list” and will expect a counter strike from Seoul — that’s just what two economies suffering from weaker Chinese demand need.
In the US, Japan, Germany and the UK, two- and 10-year government bond yields all currently trade below the official overnight rates set by their respective central banks.
Lower interest rates represent a blunt weapon for addressing a fundamental recasting of trade relations and frankly will do little to arrest a significant hit to global business investment.
Brown Brothers Harriman makes a key point:
“Easier monetary policy is a second-best response to a trade war. What’s the first best? End the war by eliminating the tariffs.”
Here’s how bond markets are pricing the expected path of policy easing for the major central banks:
Eventually, faltering capital spending runs the risk of registering with consumers and a still-resilient service sector. Eurozone data on Friday showed retail sales in June climbed the most since late 2017, reflecting a tightening jobs market. But like Friday’s US jobs data (see Quick Hits below), this is a backward-looking indicator whereas markets are assessing what’s beyond the horizon.
As for global equities, the drop in bond yields is not helping improve sentiment and this comes at a time when earnings for a number of companies are being challenged by margin pressure. And as Bank of America Merrill Lynch note, just 6 per cent of the stocks in MSCI’s All World equity index account for more than half of its 14.3 per cent gain so far this year, a very narrow market leadership.
What’s readily apparent from the short history of trade protectionism during the course of Mr Trump’s administration is that equities take a hit for several weeks, before selling pressure abates. There have been three major equity corrections: early 2018, the autumn of 2018 and May of 2019, triggered by the US escalating tariffs on Chinese goods, as shown below:
The FTSE All-World index had its largest weekly decline since last December and it’s a similar story for the S&P 500. Equity jitters means gold is finding buyers, but $1,450 an ounce remains a tough level to crack, as the US dollar is generally firmer bar the exceptions of the usual havens: Swiss franc and Japanese yen.
Worryingly, the Chinese renminbi is sinking towards Rmb7 per dollar and has plumbed to its lowest level for 2019. Should Beijing allow the currency to weaken and support its economy, the trade war is likely to escalate as Mr Trump has frequently grumbled about what he perceives as countries manipulating their currencies.
TD Securities expects a slide towards Rmb7.2250 and argues:
“We think this will help China to preserve some negotiating strength via credible FX threats. It also has the added impact of easing monetary conditions to offset the adverse impact of tariffs. As a consequence, this puts currencies with trade exposure to China back in the crosshairs.”
A weaker renminbi will also not help emerging markets in general. EM currencies via the JPMorgan index are back at levels seen in mid-June, while the MSCI EM equity index has fallen in the past eight trading sessions, slicing through its 200-day moving average. EM exposure was a heavily favoured trade in recent months and like all crowded positions in markets, any rush for the exit only compounds volatility.
August is also a month when market liquidity dries up as traders and investors like to take holidays, too. This is not a good time for cutting risk and the prospect of sharp fluctuations across a number of markets makes for a hot and sticky August indeed. And of course there’s Brexit and the performance of the pound to add into the mix.
On that note, a good weekend to all readers and, as always, thanks for your feedback.
Quick Hits — What’s on the markets radar
The game-changer — That’s the view from economists at Bank of America Merrill Lynch on the proposed new tariffs from the US on Chinese goods.
“Past measures had mostly avoided consumer goods. By contrast, the threatened tariffs would cover $120bn of consumer goods, out of $300bn in total.”
Crossing the consumer goods Rubicon, says the bank, means the likelihood of further escalation:
“Given the administration’s willingness to go after consumer goods, we think all options now may be open in terms of further trade-war escalation. Our base case assumes only modest additional measures on various fronts. But we would not rule out across-the-board 25% tariffs on Chinese imports, tariffs on autos and parts or measures against countries such as Vietnam that have large and growing trade surpluses with the US.”
US job creation moderating — The average for the past three months is 140,000, the slowest pace seen in nearly two years. July saw 164,000 new jobs added, a sliver below the 165,000 forecast, but prior month gains were downwardly revised. Wage gains were a touch better than forecast at a 3.2 per cent annual pace, a figure that would normally have pressured Treasury prices, but not on Friday.
David Riley at BlueBay Asset Management says the jobs data “underscores the policy dilemma facing the Fed” and adds:
“The state of the US economy does not warrant multiple interest rate cuts, but the Fed has chosen to provide ‘insurance’ against downside risks from weaker global growth and especially trade policy uncertainty. But as all insurers understand, offering protection against losses can encourage the very behaviour that leads to paying out on the insurance policy.”
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