The Art… or chance of a Deal

The outlook for economic growth implied by global bonds continues to worsen as risk-free yields continue to fall. The current source of pessimism is the trade war between the US and China. Contrary to the rhetoric of the US Administration, hiking tariffs is not good for the welfare of the US (or global) economy. Markets know that and are probably only avoiding a more pronounced sell-off because there is still a chance of a deal. Failing that, the bond market has got a Fed cut priced in. With 2020 an election year in the US, one would think that President Trump doesn’t want to ruin his economic legacy too much, but there are massive risks from protectionism. Slower growth, higher inflation, and resorting to a reliance on central bank balance sheets again are the ultimate consequences of policies that disrupt trade flows and consumption. Until it is clear that this is not the ultimate direction, it is hard to be overly bullish on risky assets.

Pareto sub-optimality

In very simple terms, President Trump’s trade policy is designed to shift the consumption preferences of US consumers away from Chinese derived goods (imports) towards US (and other) derived goods. In general equilibrium analysis this would be described as shifting the slope of the US consumers’ budget line by affecting the terms of trade of the US relative to China. Raising tariffs on Chinese goods makes them more expensive to US consumers relative to US produced (and those imported from other parts of the world). This is designed to shift consumption away from Chinese goods and, in the mind of the US Administration, this will result in an increase in the marginal utility of consumption for US consumers i.e. they will be “better off”. Most economists would argue, however, that tariffs are a distortion to relative prices and that shifting consumption as a result of increasing tariffs would result in a sub-optimal position in terms of the global economy (in other words, the attempt to make US consumers “better off” will result in making Chinese producers “worse off”.) It could be worse – both US consumers and Chinese producers could be worse off and experience a reduction in their utilities because of the trade war. (Anyone interested in an economics textbook explanation should google “Edgeworth Box”, a tool that can be used to analyse how trade between individuals/nations can lead to higher or lower levels of utility).

US pays 

President Trump seems to have some difficulty in understanding that the cost of the tariffs is borne mostly by the US consumer or by US firms that must pay higher prices for imports. The impact on final consumer prices or profit margins of importing firms is one that is negative relative to pre-tariff increase position. From the Chinese point of view there should be some impact on demand for their exports and thus a need to reduce prices, either directly or through the mechanism of the exchange rate. Whether by design or not, the Chinese renminbi has been declining in value versus the US dollar in the currency markets. The USD-CNY exchange rate is currently trading at CNY 6.9/USD. This has moved higher (CNY has weakened) from 6.7 just a few weeks ago and is rather coincidental with intensification of trade tensions. Relative to a year ago, the Chinese yuan is around 7.8% weaker against the dollar, which will have provided some respite to the impact of higher tariffs. Although the People’s Bank of China has stated that it does not want the currency to trade through the CNY 7.0 level against the dollar, any additional trade sanctions would add to the risk of this happening.

Risk-off driven by trade

Markets certainly don’t think that the US trade policy is designed to reach some new Pareto optimality. Neither does the real economy if we believe what the data is telling us. As I mentioned last week there is clear evidence that the global manufacturing cycle has weakened over the last 6-9 months. The month of May, so far, has seen lower equity prices with markets reacting negatively to the increase in tariff rates last week. Bond yields are lower as well while risk indicators have increased (VIX index, crossover CDS index, for example, although both have moved a little lower again this last week). The performance of the S&P index this month has bucked the seasonal trend of recent years with May normally being a positive month in terms of returns for equities. In the bond market, credit has underperformed in May despite still outperforming government bonds on a year-to-date basis. German bund yields are now below Japanese government bonds at the 10-yr maturity level and Spanish 10-year bond yields have just hit a record low as I have been writing.

Downside risks

There is clear concern that trade could be the issue that tips the global economy into a more profound slowdown. At the time of writing it is not clear when the US and Chinese governments would resume trade talks while at the same time there are concerns that the US could move to start increasing tariffs on European exporters. Economic analysis suggests lower GDP growth as a result of what has already been implemented and further downward revisions to growth forecasts would come if protectionism intensifies. While models predict relatively modest implications for GDP, models probably won’t pick-up the impact on sentiment and business confidence and the implications of that for investment and employment decisions.

Fed cuts?

Under these circumstances, the chances of the Federal Reserve hiking interest rates again look very remote. At the same time, if the Fed does have to respond to increased equity market volatility on the back of fears of a sharp decline in corporate earnings because of the trade war, it is hard to see monetary policy offsetting the real economic impact. The theory from the trade hawks is that US production, or production from other countries, will eventually fill the gap opened up by lower demand for Chinese output. However, even if that is possible it will take time and, at the same time, Chinese growth will falter which has enormous implications for the world economy. Protectionism has often gone along with competitive currency policies and these may be a result of central banks having again to resort to money printing. In the worst-case scenario, protectionism will lead to a worsening of both growth and of inflation (there is an even worse case scenario as students of history will know, but we don’t want to go there on a spring Friday).

If only…

I would feel much happier about the economic outlook, and therefore on the prospect for market returns, if the US and China were able to do a deal, if the UK had settled on a less Europhobic position, and if there was clearer leadership in the European Union to deal with many of the banking and fiscal integration issues that are outstanding. Instead, we are in an era of uncertain politics on both domestic and international levels. It is hard to see a revival in the hegemony of liberal market attitudes that embrace globalisation and cooperation at the policy making level any time soon. Instead we have the rather sinister leveraging of supposed popular discontent with the way things have been by political operators that spout “anti-elitist” and “pro-ordinary people” rhetoric. The real issues of ageing society, poor educational attainment, high health-care costs, and low productivity are rarely addressed in everyday political discourse. The upcoming European parliamentary elections and what is likely to be a very long US-Presidential election campaign are probably going to highlight this even more. Markets will keep fearing that policy decisions resulting from this political climate will do little to enhance the quality of economic growth or the prospects for sustained wealth accumulation. I guess it will all come back to whether central banks can generate enough liquidity to keep financial asset prices from falling.

On the bright side…

The good news is that outside of political circles, optimism remains a driver of activity. There are amazing things happening with technology. There are great things happening in terms of mitigating climate risks. Asset managers are striving to deliver a more accessible and more affordable product to more and more savers. While China is under pressure from the current US Administration, it is using its economic power to bring development to other parts of the world through its “belt and road” policies. There are massive investment opportunities to be derived in the “new economy” and in the need for infrastructure refurbishment and modernization. But it would help if politicians stopped playing the blame game and started to really think about how to raise utility rather than offering pipe dreams at the expense of others.

Carry

As always, the key to a bond strategy depends on what one thinks about rates and what one thinks about credit risk. Neither bother me at the moment, as rates are on hold and low rates mean that there are few financing stresses. Thus, for the time being having some duration and having credit risk is the preferred strategy. Returns are likely to be lower than in the first quarter, so bond investors need to rely on carry and the re-investment of coupons to accumulate returns over time. If there is going to be a market wobble this summer, then it will be the higher beta parts of the market that suffer – high yield and emerging market debt – but if that is the case and there is confidence that any weakening of global growth is a transitory one – then the strategy will be again to load up on credit. It worked in 2016, it worked in January of this year and it will work again. But now, spreads are too tight to add.

Have a great weekend,

Chris

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