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SGX: Market Insights with Eurasia Group - US-China Phase 1 Deal a Limited Truce Rather Than Peace

 

The recent conclusion of a US-China “Phase 1” trade deal signals a limited truce that will likely last through the US Presidential Election rather than a return to the pre-2016 status-quo. Although President Trump’s electoral concerns will likely lead to a standstill rather than either progress and escalation, multiple irritants in the relationship will leave headline risks in place. Meanwhile, the Chinese leadership’s own calculations will lead it to focus on containing a buildup of financial risks and accepting a gradual economic deceleration rather than engaging in fresh bouts of big-bang stimulus.

With the US and China agreeing on the outline of a “Phase 1” trade deal, the stage is set for both countries to enter an extended, uneasy truce that will likely persist until the 2020 Presidential election in the US. The deal involves a delay on the tariffs due to be imposed in December 2020 and a reduction of US tariffs on 125 billion USD of Chinese imports imposed in September 2019 from 15% to 7.5% but maintains the earlier 25% tariffs on 250 billion USD of Chinese exports to the US. In exchange, China has pledged to buy at least 40 billion USD of US agricultural goods annually, pledged measures against IP theft and forced technology transfer, and committed to easier access for US financial firms. A currency provision, presumably meant to dissuade China from seeking CNY weakness (which was not really a Chinese goal anyway) will likely be made easier by the Fed’s dovish reaction function and a minor thaw in trade tensions. The deal suggests that President Trump has decided that it is more consistent with his political interests to make a deal with China and perhaps exaggerate its benefits rather than run the risk of entering the next election with a more trade-hawkish strategy that might disrupt the economy and financial markets.

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Despite the deal, bipartisan Congressional hawkishness on China will persist, as will structural tensions in the relationship but these are now more likely to be displaced from tariffs into arenas such as national security, technology standards and pressures for financial decoupling. US trade and security hawks, meanwhile, are likely to be troubled by the absence of any commitment to China to move on some of their core concerns—its policies on innovation and import substitution in targeted high-technology industries. At the same time, the limited tariff reductions are also likely to have snapback provisions in case China does not follow through with certain commitments. The politics of renewed tariff escalation in an election year argue against any such step, but there are enough irritants in the US-China relationship that the prospect of snapback tariffs will remain a source of headline risk next year. It is very unlikely that the conclusion of this Phase 1 deal will be followed by a Phase 2 next year. The relatively easy docket of this deal (agricultural purchases, market opening for US financial firms seeking entry into China e.g.) was still subject to torturous negotiations and repeated cliffhangers. The Phase 2 docket includes items such as technology subsidies, data location etc, that are far more contentious in China, as are any further tariff rollbacks in the US Congress.

Within China itself, the deal and its relatively favorable terms will be welcomed as easing some economic pressure, but the leadership remains committed to its project of limiting financial risks while accepting a gradual economic deceleration. Accordingly, it will tolerate a drop in 2020 growth, as long as it remains in the 5.5-6.0% area. The recently completed meeting of the CCP’s Central Economic Work Conference indicates that the leadership will target counter-cyclical measures to stabilize growth, while focusing on key political and economic goals, including boosting strategic industries and increasing domestic value-added in advanced technology industries; tackling politically sensitive quality-of-life issues such as pollution and the social safety net; and avoiding an increase in systemic financial risks. In addition, while the government may increase targeted stimulus via tax and fee cuts, it appears very unwilling to engage in any big-bang fiscal expansion, keeping more of the onus of supporting growth on monetary policy.

A freezing of US-China trade tensions and increased tolerance by the Chinese leadership of a gradual and limited slowdown in 2020 (to the 5.5-6.0% area) will be the major features affecting the broad contours of the economy and market sentiment on China. However, the broader relationship will remain tense, with technology (e.g., the role of Huawei in global 5G) remaining an especially contentious issue. This, alongside other potential irritants in Hong Kong, Taiwan’s Presidential election in 2020, heightened US public and congressional attention to Xinjiang etc., will make the US-China relationship a persistent source of headline risk in 2020 despite a more subdued season of trade conflict.

 

Asia’s risks from a technology Cold War

Asian markets have received good news on three fronts in early December—the conclusion of a US-China phase 1 deal, the elimination of the tail risk of a hard Brexit, and the confirmation of an easy Fed stance heading into 2020. However, underneath these benign signs, Asian economies face the medium-term prospect of a deepening Cold War in technology that represents a serious threat to the transpacific technology ecosystem. Though there will be benefits for “winners” from both the US and China pursuing a “decoupling” agenda, the broader implications of such a form of geopolitically-driven market failure will be negative for growth and efficiency in both the US and Asia.  

As markets head into a new decade, early December has seen a reduction of uncertainty on three major fronts. The US and China are likely to sign a trade deal that puts on hold the next round of tariff increases; the specter of a no-deal Brexit has abated; and despite a near-term resolution of these oft-cited geopolitical issues weighing on growth, the US Federal Reserve has reaffirmed its dovish outlook on US rates for 2020.  These factors together are likely to alleviate some of the concerns that have been weighing on markets but come alongside deeper structural issues that the major Asian economies will have to face.

On the international front, despite the dissipation of some of the clouds of US-China trade conflict, it remains the case that the US and China are locked into a pattern of longer- term geopolitical rivalry that will intensify pressures to “decouple” their economies, particularly in the sphere of technology, which is seen as a determinant of economic and military supremacy in the coming decade. Even if tariffs do not remain the chosen instrument, US pressure on corporations and investors to limit “leakage” of sensitive technology and IP into China is likely to intensify, as will the pressure on other countries to limit the use of Chinese high-technology equipment. Conversely, increasing Chinese sensitivity to US decoupling efforts will lead to China ramping up its own efforts at import-substitution in key technologies to reduce its vulnerability.

These pressures will also feed into third-countries, almost of every single one of which would prefer not to be forced into choosing between the world’s largest and second-largest economies (and their largest or second-largest trading partner).  But whatever their preference, other countries are likely to find themselves drafted into this battle to some degree, if only because transpacific technology supply chains involve a regional cross-border networks that combine pure academic research, corporate intellectual property, intermediate goods (most critically microchips), manufacture, assembly and final sales of enormous complexity. The issue is compounded by divergent national rules on data protection, ownership and “transportability” across borders, which will become increasingly salient as data is the raw material to power not just single applications, but also advanced techniques of machine learning.

From the market’s point of view, geopolitically-induced regulation in this area will lead to a significant increase in regulatory and other frictions, essentially resulting in a form of market failure. As with all such instances of market failure, there will be winners in the form of countries and corporations that benefit from US efforts to redirect supply away from China, from Chinese efforts to “design out” US IP, and from broader patterns of import substitution. At the same time, the broader implications of market failure will also likely hold—a structural deterioration of efficiencies that affects not just the US and China but also the whole world. In this regard, for all of President Trump’s assertions that trade wars are “good and easy to win,” IMF research has found that the impact of trade conflict has negative impact on both the US and China, and that the impact relative to trend growth prospects might be even more negative in the US. It is worth keeping in mind, e.g., that US research dominance in a range of STEM fields is powered to a massive degree by the role of the US universities as an academic destination for scholars receiving their pre-doctoral educations outside the US, especially in South and East Asia.  From the point of view of the broader market, given the role of technology-centric corporations in generating a significant portion of aggregate equity gains in the US and in Asia, there could be a long-term chilling effects from a technology Cold War despite the better political and economic news of the last few weeks.

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Fed decision reiterates dovish stance heading into 2020

The FOMC’s latest decision, projection materials and press conference confirm the institution’s broad-based transition to a more dovish reaction function over the course of the last year. Rather than being a response to President Trump’s hectoring of the Fed, it reflects the Fed’s doubts about some of its prior models, recognition of the positive distributional effects of low unemployment and new ways of thinking about the USD interactions between the US and global economies. These changes in the Fed’s reaction function will likely persist even through a partial resolution of many of the geopolitical uncertainties that had troubled the Fed.

The December decision of the Fed and the associated press conference by Chair Jay Powell set the seal on Fed dovishness into 2020. Among other markers of this stance, the “dot plot” implies no hikes in 2020, and NY Fed President John Williams has said that the FOMC is not planning on raising rates “for a long time.” The Fed’s reaction function appears to be asymmetric, reflecting a willingness to cut rates further if needed in response to unanticipated economic weakness, but with a limited inclination to hike them again any time soon.  While President Trump’s propensity to tweet at the Fed demanding further rate cuts is well-documented, the changes in Fed reaction functions are driven by a broader set of internal intellectual adjustments that while not overtly political are acutely aware of the political context in which the Fed operates. This reconsideration incorporates several points.

The first is a recognition (and practically a mea culpa) that the Fed had misjudged where NAIRU was, how high labor force participation could go, and how little passthrough there might be from sub-NAIRU unemployment into higher inflation. This rethink moves the level of NAIRU itself into the metadata observed by the Fed, within a broader framework of “data dependence” in determining rate moves. Even more interesting (and this shift is perhaps the most influenced by broader socio-political context), the Fed is now overtly welcoming the effects of allowing wage increases above productivity growth as a useful distributional corrective after a period in which wage growth had lagged productivity.

The Fed has also become increasingly vocal that anchoring inflation expectations at 2.0% requires a symmetrical reaction function around its 2.0% target, thus definitely tolerating (and for some FOMC members, even encouraging) a period of “makeup” above-target inflation. In addition, during the tenure of Stanley Fischer as Vice Chair (2014-18), his experience as a leading international macroeconomist, former Deputy MD of the IMF, and former governor of the Bank of Israel led to a very substantial rethinking of the interactions between the US and global economies. This led to increased attention to the role of the USD as the predominant currency for international invoicing and cross-border borrowing, and an acknowledgement that a stronger USD tightens monetary conditions in the US via the trade channel and in many emerging markets via the financial channel.  The increased focus on financial spillovers from the US into the rest of the world and real spillbacks from the rest of the world into the US economy has been further elaborated by Lael Brainard and Richard Clarida. This in turn has led to a formalization of the relationship between the exchange rate and interest rates with Lael Brainard acknowledging that a 1% appreciation of the trade-weighted is equivalent to a 10bps hike in the Fed Funds. With emerging Asia accounting for roughly 1/3 of the trade-weighted USD, this gives exchange rate developments in Asia a significant impact on US interest rates.

Yet another element contributing to a more dovish reaction function has been the Fed’s treatment of the trade war as being a more substantial shock to aggregate demand (via the impact on business investment in the US and around the world (and thence back to the US) than a shock to supply (via of tariffs/supply chain impairments etc). The treatment of trade shocks as disinflationary rather than inflationary (a fundamental reversal of the Fed’s reaction function in the 1970s) has been in another factor behind the increased dovishness of the Fed.

The broader point story here is how the Fed has arrived independently and plausibly at conclusions that are consistent in direction (if not in extent) with what Trump wants from the Fed on rates. These conclusions (and consequent changes to the Fed’s reaction function) are likely to be persistent, with a longer-term impact on US and global FX and rates than the ephemeral impact of Trump tweets.

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Strong Johnson majority as Tories return may lead to a slightly softer Brexit

Boris Johnson’s return as PM means that the UK will leave the EU on January 31st rather than crashing out with a deal, even though the future trading relationship between the UK and EU will still have to be determined. The strength of Johnson’s majority and the need to protect Conservative gains in Labour’s Northern industrial strongholds could give him room to outflank hardline Euroskeptic Brexiteers and attempt a marginally softer exit from the EU. However, negotiations with the EU will still be difficult, given a tough December 31, 2020 deadline and EU/ECB determination to reduce the role of London as a dominant financial center for the Eurozone.

The conclusion of the UK General Election on December 12th brings to end one significant factor of global uncertainty that began with the UK referendum in June 2016 when a 52-48 majority chose to leave the EU. The Brexit-focused election resulted in the Conservatives winning a commanding lead in the 650-member parliament, with a gain of 47 seats for a total of 365 seat. The election gives Johnson the opportunity to “get Brexit done” as promised and his majority will allow him to leave the EU on January 31, 2020 in line with the deal reached with EU members in October. Among other things, that deal created a de facto customs border between the EU and the UK in the Irish sea, preserving the substance of the Good Friday Agreement by ensuring a significantly higher customs and regulatory higher between Northern Ireland and the Republic of Ireland (and hence the EU).

Leaving in accordance with that deal also gives the EU and UK some limited time to work out the future relationship between the two parties. This so-called transition period between the UK’s formal withdrawal and the launch of a new trading relationship could, in theory, last until December 31 2021 but Johnson has adamant that he does not wish to extend the transition beyond December 31, 2020, leaving a very limited amount of time to arrive at a fresh agreement with the EU. Meanwhile, the nature of the future relationship could also open fresh rounds of uncertainty, though the scale of Johnson’s victory could temper some concerns. 

Before the elections, the Conservatives had seen the ranks of more hardline Brexiteers associated with the European Research Group (the ERG) become an increasingly important influence within the party. This Euroskeptic group had not only urged for years that Britain exit the EU, but also wanted a radical agenda of deregulation in a post-Brexit UK that would make it more difficult to achieve a future UK/EU FTA. If the Conservatives’ margin of victory had been much smaller, it would have increased the prominence of these voices.

However, the scale of Johnson’s majority and the fact that the scale of the Tory victory was driven by substantial expansion into Labour’s former heartlands in the North and Midlands is likely to change Conservative intra-party dynamics. For one-thing, the size of the Tory majority will give Johnson much more room to maneuver vis-à-vis the ERG, particularly since many of the first-time Tory MPs will owe their positions to him. Further, the scale of inroads into Labour strongholds and the new Tory reach among working class voters will also likely have an impact on Johnson’s strategies regarding the economy and the future trading agreement with the EU. Accordingly, this could limit the extent of the Conservative deregulation agenda, particularly on labor matters. Secondly, the new composition of the party’s majority could create incentives to minimize the impact of Brexit on UK industrial jobs, many of which (particularly in the auto sector) depend on frictionless trade links with the EU. These factors are not going to lead Johnson to recant his agenda of “getting Brexit done” but could lead to a more flexible approach to negotiations than would have been the case under a stronger ERG influence on the new PM, and thus a marginally softer Brexit.

Despite this, three major factors of broader uncertainty are likely to persist over the medium-to-longer term. The first is the limited amount of time available to sign a new deal with the EU, where despite Johnson’s stronger hand domestically, he will still find it difficult to walk away from his promise to leave on December 31, 2020. Secondly, even under the scenario of a softer-Brexit, the EU and the ECB will remain set on their goal to reduce the importance of London as the dominant center for trading Eurozone assets, which in turn will negatively impact the UK’s trade surplus in services. Finally, the outcome of the election will lead to increased emphasis by Scottish Nationalists to hold a fresh referendum on independence. Although Johnson has ruled out allowing such an “Indyref” a very strong showing in regional elections in 2021 by the SNP (which is likely to campaign on holding a second referendum) will make it hard to deny. 

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Slowing Indian economy requires not just stimulus but a positive structural confidence shock

India’s slowing growth trajectory raises a broader set of concerns about the need not just for a cyclical push to the economy but also broader structural changes. Government responses focused on increased fiscal stimulus, perhaps with more retail-focused tax cuts in the February budget are likely to be only a temporary boost, given broader concerns about the fiscal trajectory. The question of whether the government’s renewed privatization agenda will be geared towards maximizing revenues or towards bringing in fresh strategic investors will be viewed by investors as a sign of the government’s appetite for reform amid concerns about increased economic nationalism.

The recent growth figures for Q2 growth in India show a further slowing of the economy, coming in at 4.5%, the slowest in 6 years, even as markets wait for a response from the government. Finance Minister Nirmala Sitharaman has been coy about the government’s response, shying away from predictions about the timing of recovery and promising intervention in the economy but with little specificity on actual measures that it might take.

Meanwhile, concerns have also risen about stagflationary dynamics in the economy, with headline retail prices rising to a three-year high to 5.5% (driven primarily by food prices) even as industrial production has fallen for its third straight month. The RBI recently paused its rate cuts (after a cumulative 135 bps this year) at 5.15%, 165 bps above core inflation, but beyond the level of nominal and real rates, it also appears that there are significant issues in the credit pipeline preventing monetary easing from passing through into the broader economy. This is an obvious result of concerns in the financial sector, most obviously in private sector non-bank financial institutions and public sector banks. While there have been efforts to fix some of these issues (such as via government guarantees for tranches of NBFI securitization), cyclical factors and eroding business confidence are leading to reduced credit demand alongside tightened credit supply.

The government is being urged to launch a fresh of stimulus (following on its belated surprise corporate tax cut in September) to boost the economy, but such measures are unlikely to come before the February budget. Industry has been urging a reduction in either income or consumption taxes, and the government could plump for an income tax cut in early 2020. However, this will come alongside increased fiscal deficits, with one indication of the pressures on the central government coming from delays in remitting the states’ share of GST revenues back to them. The central government might not find funding these deficits to be particularly problematic in a global context where the Federal Reserve is on hold for an extended period and risk-sentiment is improving on trade hopes. However, questions are likely to remain about the underlying need for a positive confidence shock to boost trend growth performance beyond routine cyclical pump-priming at a cost to fiscal performance.

It is in this context that the fresh round of mooted privatizations will provide an important signpost. The government announced its plans to privatize the Shipping Corporation of India, BPCL (a downstream oil major), and a stake in the Container Corporation of India, alongside the long-planned (and once scuttled) privatization of Air India. Given the government’s fiscal needs, a key question is whether the privatization agenda will be driven by a need to maximize revenues to cover fiscal holes, or to draw in private sector expertise, particularly from overseas. There have been previous instances (such as the divestment of a government stake in the troubled Industrial Development Bank of India) where the state-owned Life Insurance Corporation (LIC), which is the largest institutional shareholder in India, came to the rescue as a backstop for a stake sale. The government’s official line thus far has been that it will pursue a strategic sale, with Aramco rumored to have a particular interest in BPCL. At the same time, given the role of India’s powerful public sector unions and the broader strength of economic nationalist factions within the ruling party, it remains to be seen how these considerations will play out. National Security concerns may also play a part, particularly for the Shipping and Container privatizations, sectors where NatSec arguments have stymied past asset sales elsewhere, as in the case of Dubai Ports planned acquisitions in the US in 2006. 

A related issue is the strength of potential acquirers in the domestic private sector against a broader backdrop of high levels of leverage (and consequent indigestion) among broad swathes of industrial promoters. These issues are reflected in the negative ratings momentum of corporate India per domestic ratings agencies. The nexus between corporates and financial institutions (private but especially public) is another area where a positive confidence shock from takeovers via external capital infusions would likely be welcomed by markets. However, to do so would require a significant change in a politicized culture of forbearance at the public sector banks, a culture that may indeed be strengthened amid government concerns about cyclical weakness in the economy.

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