The Week in Review: May 25, 2018

No trade war, but still a long way from trade peace.

Investment markets and key developments over the past week

The past week has again seen geopolitical issues dominate with renewed trade worries out of the US, the cancellation of the North Korean summit and rising angst around the formation of a populist coalition government in Italy. Despite this, US shares managed a slight rise but Eurozone, Japanese, Chinese and Australian shares all fell. Bond yields continued to blow out in Italy but declined elsewhere helped by haven demand. Commodity prices were mixed with gold and metals up but oil and iron ore down. The Australian dollar managed a small rise with the US dollar basically flat. 

No trade war, but still a long way from trade peace. Trump has been blowing all over the place on US-China trade talks in the last two weeks – no he doesn't expect much from them, yes the benefits of the initial talks are massive, and no he's not really pleased with the outcome. But this is just classic Trump who says what he thinks at the time, wants to appeal to his base and will say extreme things in order to get what he wants in negotiations. The good news though is that negotiations between the US and China are off to a good start and China is keen on reducing tensions with the US. As well, the US has put the starting date of tariffs on hold, which was originally from May 22, 2018. But there is still a long way to go – a problem that took decades to build won't be negotiated away in just a few weeks – and if there is not enough progress the threat of returning to tariffs remains. However, our view remains that ultimately a full-blown US-China trade war will be averted. In the meantime, of course, the North American Free Trade Agreement (NAFTA) renegotiation looks like it has a way to go. Trump has ordered a consideration of imposing tariffs on US auto imports and the European Union's exemption from US steel and aluminium tariffs will expire again on June 1 (but is likely to be extended). Given that 29 per cent of US auto imports come from Mexico and 19 per cent from Canada, the latest move is clearly designed to pressure them on NAFTA. But it will also impact Japan, Korea and Germany. However, it's all about Trump posturing around negotiations, and like the steel and aluminium tariffs, any impact is likely to be significantly watered down from what markets initially fear. 

The June 12 summit between Trump and Kim Jong-un has been killed for now by the Libyan model. With North Korea flouting agreements, going hot and cold for decades, it was always debatable as to whether much would come of the summit anyway. So now we are back to where we were. But this doesn't mean military conflict is on the way. The North Korean regime knows it will get annihilated if it does anything and the US knows that a pre-emptive strike will result in mass casualties in South Korea. And of course, as North Korea is economically desperate, there is still a chance a summit could happen – albeit only ahead of the US mid-terms if Trump sees a very good chance of success. 

Turn down the noise on Trump. There is no denying that Trump's comments impact markets and the risks around Trump are greater this year than last (with tax reform and deregulation behind us, the mid-terms approaching and the Mueller inquiry getting closer to Trump). However, much of what he says is bluster and posturing. Yes, he should be taken seriously, but not literally. And more importantly, with the investment fundamentals remaining fine, the key for investors is to turn down the noise on Trump. 

Back to the Eurozone crisis? Investors are right to worry about a populist Government in Italy. Proposed fiscal policies will blow the Italian budget deficit through the EU limit of 3 per cent of GDP, leading to conflict with the EU, sanctions, the EU excluding Italy from its bond buying program, and ratings agency downgrades. Anticipation of this and risk the Five Star Movement and Northern League will return to their push for Italy to exit the euro has already caused a sharp spike in Italian bond yields. Bond holders are trying to protect against redenomination risk, or even default. So far this month, Italian 10-year bond yields have been pushed up by 69 basis points to 2.38 per cent. This is a long way from the 2011 crisis highs around 7 per cent, but the more yields rise from here, the more it will hit Italian banks, borrowing costs and the Italian economy overall. Ultimately, the Italian Government will have to back down as a result and it will all look a bit like what happened with Syriza in Greece, with Italy remaining in the euro (because it's too costly to leave). But in the process, it will be bad news for Italian bonds and shares, will act as a drag on the euro, and will cause occasional bouts of volatility in share markets — including Australian shares, recall the volatility around Grexit. Although, the risk of Italy exiting the euro triggering contagion to the rest of the Eurozone is low, as countries like Spain, Portugal and Ireland are stronger than in the crisis years and popular support for the euro is high. 

Time to remain alert but not alarmed regarding Chinese debt. This issue has been wheeled out regularly for years and the Reserve Bank of Australia had another go at it in the last week. Yes its gone up too fast, yes the growth of ‘shadow banking' has been an issue, and yes some of the debt will turn bad — so yes, it's a risk. But there is nothing new here. China is different to most countries that get into debt problems though. For starters, it borrows from itself, so there's no pesky foreigners to cause an FX crisis. Secondly, much of the rise in debt is owing to corporate debt that's partly connected to fiscal policy, and so, the odds of government bailout are high. Thirdly, the key driver of the rise in debt is that China saves around 46 per cent of GDP and much of this is recycled through the banks where it's called debt. Therefore, unlike other countries with debt problems, China needs to save less and turn more of its savings into equity than debt. The Chinese authorities have long been aware of the issue and have been working to slow debt growth. So yes, keep an eye on it but there is no need for alarm.

Major global economic events and implications

US data remains solid. While home sales slipped in April, home prices continue to rise and the Markit Purchasing Managers' Indices (PMIs) rose further in May, consistent with strength in regional business surveys. Meanwhile, the minutes from the US Federal Reserve's last meeting didn't tell us much that we didn't know. The meeting tilted to the dovish side with the Fed upbeat on the economy and on track for another hike next month, but tolerant of a temporary inflation overshoot of 2 per cent as it's consistent with the symmetric inflation target. So just because inflation goes above 2 per cent, doesn't mean it will slam on the brakes. However, its comments are consistent with three more rate hikes this year (starting in June) whereas the money market is still not there yet.

Eurozone business conditions PMIs fell again in May. While more public holidays than normal may have played a role and they are still strong, their decline relative to US PMIs is a big driver of why the euro is now falling against the US dollar.

Japan's manufacturing PMI also fell in May but remains consistent with moderate growth. A further fall in Tokyo's core inflation to just 0.2 per cent year-on-year highlights yet again that the Bank of Japan is along way from being able to exit easy money. In turn, this is negative for the Yen — barring bouts of safe haven demand.

Australian economic events and implications

Australian economic data was on the soft side over the last week with skilled job vacancies falling and construction activity coming in virtually flat in the March quarter. Public construction is rising strongly as the infrastructure boom rolls on, but this is being offset by weakness in private sector construction driven by non-residential building. The latter suggests a soft input into March quarter GDP numbers to be released in early June.

Shane Oliver is the Chief Economist at AMP Capital.

 

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