Will Australia be caught in the US-China crossfire?
When I went to bed last night, the Dow Jones Industrial Average was up around 150 points continuing its recovery. Then the spread between the 10-year treasury stock and the two-year rate rose to 5 basis points. This is the bond recession indicator and the market slumped closing down 120 points.
I think share investors around the world are tiring of the dramatic gyrations in stock prices as each twist in the US-China trade war saga swings markets. And many of those twists are prompted by the tweets of the US President. It is the first time we have had a global share market that is related to the tweet phenomena.Â
The bond market is telling us that there is grave danger of a significant downturn in the US. So I want to look at some of the fundamentals that are part of this complex market tangle.Â
The first is that manufacturing powerhouses of China, Germany, South Korea and Japan are in a clear slowdown. And in the US, those overseas downturns are beginning to affect American factories which are starting to retract for the first time in a decade. This is not good news.
And many American farmers are being hit very hard. In corn, apart from the China tariffs, there was an underestimation of the crop so corn futures have slumped. Soybean growers are being hit by China’s clamps.
President Trump is trying to develop increased markets for rural products in Japan and Canada but it is not easy to do that quickly. The combination of lower factory outputs and troubles on the farms normally infects consumers.
But at this stage, American consumers are holding up well and it is the strength of their buying that is making the US Federal Reserve reluctant to lower interest rates further despite pressure from President Trump.
In Europe apart from the US-China trade war, you have the disruption of Brexit. Prime Minister Boris Johnson is starting to put pressure on the Europeans, threatening to withdraw UK financial compensation and undertake a massive trade deal with the US which would secure UK markets.
The whole exercise will almost certainly damage both the UK and Europe, but a UK with a strong US trade agreement and extra food supplies via Australia might come out of it much better than expected. However, with the prospect of a no-agreement, Brexit is a further world dampener.
So you conclude that if the trade war keeps going, we are going to have a world downturn and we won’t be helped by central bank interest rate moves because interest rates are already low. Conversely, as we have seen already in the markets, if China and the US can come to a truce then most likely a global set back can be avoided.
Given that President Trump is facing an election in 2020 and China is battling with the Hong Kong situation, I have always believed that a deal would be reached. But so far I have been wrong.
As greater publicity unveils some of the elements of the negotiation, it is clear for there to be a deal China needs to step back to somewhere near to the agreement it pencilled last year before recanting. Unfortunately, the whole negotiation on the China side has become a question of ‘saving face’. That makes it hard to make a settlement that both sides can agree on. Meanwhile, the domestic pressure on both China and the US to settle this matter is going to intensify.
Back in Australia, we are watching these events almost with a sense of unreality. The prospect of even lower interest rates is causing homebuyers to bid up dwellings with a twinge of desperation. Given the state of the world economy, this carries risk. They might not realise it, but dwelling buyers are punting that the US-China war will be resolved. If it is not, then we will be caught up in the fallout.
Iron ore is likely to fall in price, university enrolment from overseas students will almost certainly decline and we may also see mainland Chinese exit Australian property. So accordingly, we need to understand that we are not isolated from the rest of the world and those racing in to bid up residential properties in Sydney and Melbourne need to realise that in the short term they are betting on China/US settlement or an avalanche of Hong Kong money and people if China plays hardball.
One of the likely fallouts from any extending trade war between the US and China will be a decline of the Australian dollar. We have already been hammered, but if the situation worsens so will our currency to reflect the new environment. If the Australian dollar keeps falling, then at some point in time it will have to affect our retail prices.Â
A vast amount of goods are purchased overseas to be sold in our stores and that extends to clothing, cars and even partly to food. At this point, the impact of the recent fall in the currency has not yet hit retail stores because of buying in advance. In the coming months, the lower dollar will lift the selling prices of many goods.Â
In the classic economic textbooks, a falling Australian currency is inflationary because it pushes up the value of our required goods and services. So far the suppliers and retailers have not increased prices dramatically preferring to hold market share with different pricing arrangements. In addition, distribution systems have been made more efficient.
But there is a limit to this and in due course, we will see a rise in retail prices. We are already seeing public servants and government employees aiming to get wage rises above the rate of inflation so the combination of those events would put pressure on inflations. The Reserve Bank wants inflation to rise but there is a limit.
Amongst the results this week, it was disappointing to see Caltex struggling with its new retail operation. It was a herculean task to invest heavily in new food retailing outlets to replace or reduce its petrol selling and oil refining activities. The company is bringing in a new chief executive with new strategies to achieve its goals. Whenever you are a shareholder of a major enterprise and it changes its activities dramatically, it is better to get out as there are usually difficulties ahead. For Caltex, is now a question of whether the new CEO can make it work.