The outlook for trade remains the dominant issue in financial markets, but it is not alone with monetary policy tightening and the process of unwinding quantitative easing also contributing to uncertainty on top of the back and forth over Brexit in Europe and the UK. The combined effect of all of these issues is to keep market sentiment on edge.
Second quarter GDP growth in the United States may have been strong, rising by 4.1 per cent on an annualised basis, but markets are becoming ominously aware that this might be the high-water mark of the current US growth cycle. Growth was driven by consumption and business investment but the chances are that it will slow in the second half of the year as monetary tightening starts to bite and as the consequences of trade war uncertainty begins to be felt.
While the risks of a US-EU trade war may have diminished last week, with US President Trump and Jean-Claude Juncker, the president of the European Commission, having agreed to suspend the imposition of any new tariffs while the two parties negotiate over their respective trade terms, the chances are that trade tensions will resurface again over time. It is also unlikely that the harmony between Mr Trump and Mr Juncker will affect the bigger dispute between the US and China.
If Mr Trump imposes tariffs on $200 billion of Chinese imports, China is likely to respond by targeting US multinationals, which would potentially put much more pressure on US stocks that have risen since late-June. Clearly the impact would be even greater if the US were to impose tariffs on all $500bn or so of Chinese goods imports, as Mr Trump has repeatedly threatened.
Overall, markets still appear surprisingly sanguine, with Facebook’s and Twitter’s 20 per cent declines the exceptions against a generally positive backdrop of strong earnings results.
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However, there are some worrying signs with Federal Reserve surveys citing supply disruptions and increases in raw material costs related to the effects of tariffs on steel and aluminium. Mr Trump has also announced a $12bn support package for US farmers hurt by trade tariffs, highlighting the contradictions that can follow from protectionist policies.
The risk is that trade wars may also spillover into currency wars as seemed to be happening when Mr Trump called out the Chinese yuan for “dropping like a rock” a fortnight ago, implying that the Chinese currency is being manipulated. Markets pulled back a little from this conclusion in the wake of some soothing words from the G20 meeting, but with monetary policies continuing to diverge it also probably won’t be long before currency rhetoric becomes more extreme again.
The Fed is likely to continue tightening, especially in the wake of the second quarter GDP report, with two more rate hikes expected between now and the end of the year. European Central Bank president Mario Draghi struck a dovish tone, however, following the ECB’s press conference last Thursday, with the bank reiterating its “patience” regarding the first increase in interest rates which is likely to come pretty late next year, and then proceed gradually after that.
This combination of a tightening Fed and a dovish ECB should keep the euro under pressure. Mr Draghi did say that “the exchange rate is not a policy target” but he also indicated the ECB would not be rushed into early hikes by charges of currency manipulation. China also engaged in both fiscal and monetary policy stimulus measures last week, which while designed to underpin the domestic economy also caused the Chinese yuan to weaken further, with USD/CNY hitting a 12-month low on Friday. Should the People’s Bank Of China cause the yuan to devalue further it will not only raise alarm in Washington, but will also put pressure on regional trading partners.
The Bank of England is thought likely to follow the Fed in raising rates for the second time this decade in the coming week, but somewhat surprisingly the Bank of Japan is rumoured to be mulling a move away from its zero per cent yield curve target as well. With Japanese inflation still well below the BOJ’s 2 per cent target, any such adjustment would be a surprise, but it would be reminder that zero rates left for too long can actually complicate the recovery process.
Tim Fox is group chief economist and head of research at Emirates NBD