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It is getting warmer?

24 May 2019

Unfortunately this headline is not intended to suggest that things are getting better, but rather that Donald Trump’s trade war is heating up. In a way I feel reminded of the Cold War between the US and the USSR in my youth, when the odd skirmish or shot down spy plane reminded the world that things could get a lot worse.

The past week demonstrated as much in the trade war. The US indicated that China tech giant Huawei’s mobile phones would be pretty useless without US software. China riposted straight away by reminding the US that their global technology leaders would be thrown into a similar existential crisis if China stopped access to their rare earths deposits, without which mobiles, computers and advanced batteries are hard, if not impossible to build (China is home to 90% of currently accessible deposit of rare earths).

A timely reminder that trade wars have no winners (and are hard, not easy to fight…!) and yet stock markets still only wobbled a little, but in no way were willing to price in the fact that this dispute could leave a considerable dent in corporate earnings, particularly those of the recent stock marked darlings in the US tech sector.

The positive take-away was that China kept its calm and did not remind the US President of its ‘nuclear’ option, which would be to devalue the ¥-Yuan/Renminbi towards and beyond 7¥ per US$. This would shift the trade war pain burden disproportionately towards the US economy and would tell us that despite the Huawei assault, the Chinese remain willing to talk. This is important, because Trump is also rapidly losing the position of strength he believed he had, as last year’s positive economic momentum in the US economy is rapidly slowing down. The latest release of business sentiment indicators shows that the mood has soured very decisively over recent weeks.

The minutes of the last US central bank meeting did not help. Those who like to think that monetary policy easing by the US Fed will quickly come to the rescue were once again disappointed by the more hawkish than expected tone that left little room for imminent rate cuts. We suspect this has less to do with  rate-setters  misreading the economy, and more to do with their concerns that the shadow banking market is once again gaining ground in US credit provision, and is very hard to control with traditional central bank tools.

We are not the only ones who note that this looks suspiciously similar to last year’s pre-correction environment, when a slowing economic outlook and a seemingly unresponsive central bank triggered the Q4 sell-off. For the moment these are only concerns, but should Trump be unable to put the trade war genie back in the bottle before the summer break, then the markets’ bullish assumption that H2/2019 corporate earnings growth will be better than H1 will be disappointed, and could lead to a repeat of last year’s correction.

The week’s only muted negative response by capital markets suggests that a majority of investors still believe that the two sides are mainly posturing but are still aiming for a resolution at the G20 summit in late June. They may well be reading Donald Trump correctly and we know that he removes tariffs as fast as he puts them up, but the longer this stand-off lasts the higher the risk of further miscalculations on both sides. In a way the poor US data this past week was quite positive, as it increases the pressure on Trump to act, but unfortunately the relative calm of stock markets does not. We do hope that he will not escalate the matter so far that markets stage a riot, but after last week’s events we cannot be so sure any longer that it might not happen over the coming weeks or months.

This would a very different type of correction than the earnings-related one mentioned earlier, in that it might not last very long and might lead to another even steeper recovery, should it spur politicians towards a timely resolution.
Against the backdrop of political turbulence in the UK this may all feel quite far removed and abstract, but clearly Brexit also centres around terms of trade. The final chapter of Theresa May’s time as prime minister had many people worried about what might come next. This included the currency markets with £-Sterling duly falling a couple of percentage points further against the US$ and the €-Euro in anticipation of a higher probability of a harder Brexit.
I am not convinced I can follow this much repeated logic (both by domestic media, as well as across the Continent).

The next Conservative leader to be chosen by the Tory party members will face the same dynamics in Parliament that had Theresa May’s Brexit plans flounder. A more aggressive Brexiteer like Boris Johnson will therefore think twice before taking on this poisoned chalice. They may seek salvation in snap elections, but given most MPs (including Labour) will be reluctant to take such a step for fear of deselection, this move also seems less probable than many suggest.

The most likely outcome therefore would seem to me to be further extensions that eventually lead to another referendum, the outcome of which is much harder to predict than either side proclaims. The results of the European elections across the UK may provide further hints about possible future developments and we will therefore have to pick up the topic again next week.